The speakers

We had two highly decorated former central bank governors to discuss this topic:

Glenn Stevens, Former Governor of the Reserve Bank of Australia (2006-2016)

Glenn Stevens has served in various roles in the RBA and was the Governor of the RBA from 2006 to 2016, navigating the global financial crisis as well as the following years of economic growth. He graduated from the University of Sydney in 1979 with a Bachelor of Economics, first-class honors. He then joined the University of Western Ontario for the Masters of Arts Program.

In 2014 he was awarded honoris causa, a Doctorate of Laws from the University of Western Ontario. Stevens has held many positions, such as Visiting Scholar at the Federal Reserve Bank of San Francisco, Head of the Economic Analysis Department, the Head of the International Department, and was Assistant Governor (Economic) at RBA before assuming the role of Governor.

Athanasios Orphanides, Former Governor of the Central Bank of Cyprus (2007 to 2012)

Athanasios Orphanides is currently a Professor of the Practice of Global Economics and Management at the MIT Sloan School of Management. From May 2007 to May 2012, he served a five-year term as Governor of the Central Bank of Cyprus and was a member of the Governing Council of the European Central Bank.

He is also an Honorary Advisor to the Bank of Japan’s Institute for Monetary and Economic Studies, a member of the Shadow Open Market Committee, a Research Fellow at the Centre for Economic Policy Research, a Senior Fellow at the Center for Financial Studies. Athanasios Orphanides obtained undergraduate degrees in mathematics and economics as well as a Ph.D. in economics from MIT.

The webinar was moderated by Eli Remolona, Professor of Finance and Director of Central Banking at the Asia School of Business.

Key Takeaways

Let’s take a look at the key takeaways from the hour-long discussion.

Bloated Balance Sheets: It’s not a new problem

One of the key things to remember is that bloated balance sheets are not a new problem, and it is the consequences of the market situations that existed in the last few years. Central banks of leading countries like the USA, UK, and Japan have increased their assets by purchasing government bonds in increasing quantities.

The percentage of government debt held by the central banks in these countries is also interesting reading. The Bank of Japan holds 50% of the government debt while the other central banks hold about 20-30% of government debt.

How we got here is a good place to start. Central banks have been forced to adopt a policy of Quantitative Easing to navigate the global financial crisis. The COVID-19 pandemic and the health risk created a supply shock in the market too. Glenn Stevens says that being in a time of crisis, the banks have to respond to the crisis by buying government bonds to increase liquidity in the market.

Bloated balance sheets are a risk, but they’re not the biggest problem

Both Glenn Stevens and Athanasios Orphanides touched upon the fact that a bloated balance sheet is not a problem in itself, but other risks need to be considered. The crisis meant that the central banks had to act anyway, and not taking on this additional risk would have led to more serious issues in the market.

But this carries risk in 3 ways – Interest risk, Credit Risk, and Moral hazards associated with it can be considered as a risk too. “The problem with this policy is that the markets will expect the central banks to act in this way when the next crisis hits.

Central banks cannot let the markets correct themselves because the risks there would be far more than the actual risks incurred in expanding the balance sheet.” Athanasios, in his opening remarks, stated that the central banks wouldn’t be doing their job if it refuses to take on additional risk in a time of crisis, citing moral hazard as the reason.

He also presented his ideas to show how this is a structural problem and not just related to the crisis. “We needed a standard monetary policy easing that we could not execute due to prevailing low-interest rate conditions in the previous years. Most of the balance sheet expansion we see today could have been controlled by controlling the short-term interest rates, had it been higher.”

The Exit Strategy: What next?

The next part of the conversation focused on what the central banks should be doing to fix the bloated balance sheets. Both Glenn and Athanasios believe that this is not something that we can fix easily in the short term. They also agree that the banks cannot merely sell the debt and shrink the balance sheet because that would be contractionary for the economy and can be done only when the economy is stronger.

The real solution lies in enabling growth in the economy that ensures that the nominal GDP rates grow at a steady rate of 4-5% each year in the coming years so that the balance sheet balances itself. This will need a good balance between monetary and fiscal policy. Athanasios also stressed the importance of creating a growth narrative.

The narrative should focus on fiscal measures aimed at demand generation, combined with supply-side interventions that increase productivity as well as supply. Both the speakers believed that the central banks have to communicate more clearly regarding their policies and rules. The narrative should focus on keeping inflation low and having extremely accommodative policies that will encourage economic progress,” says Glenn.

It is too early to discuss exit strategy as there is no clear alternative to central bank intervention in such a crisis but what we need is a structured approach to the problem where we are intervening only when required and also maintaining the credibility and independence of the central banks.

Conclusion

The webinar saw a lively discussion and also answered questions from the listeners, majorly about exit policy and what is the right approach to managing the balance sheet problem. In closing remarks, Athanasios said that balance sheet problems are trickier to fix than interest rate problems.

So while central banks may still have to make some debt purchases in the future too, it needs to be re-emphasized why they are doing what they are doing and clear rules to ensure that the markets have clarity. “Balance sheet policies work when it is systematic and with clear inflation targets. That’s what the central banks have to do”, says Athanasios.

Glenn also remarked that the issues of governance, clarity of objectives, and preserving the independence of central banks are all important issues that need to be addressed through clear communication.

“What is important is that the central banks can quickly diagnose the issue, find what they need to do, be clear on what others need to do, and define what success looks like. If they do this job well, they can still retain its credibility,” says Glenn. More experts and practitioners will be sharing their views on the other sessions in this webinar series.

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