The Yawning Deficit That Nobody Is Counting

Oct 11, 2013

The Bank of Israel’s NIS 39 billion negative equity is not substantially different from the government deficit but everyone ignores it

The Bank of Israel’s financial report for the end of 2012 shows it has negative equity of close to NIS 39 billion. In order to grasp the significance of this figure, it’s important to first try to understand what the report tells us about the central bank, which operates without any profit motive but rather to achieve policy objectives, chief of which is maintaining price stability.

As opposed to an ordinary business entity that becomes insolvent if it can’t cover its debt, the central bank always has the option of printing more money. Doing so, however, is undesirable; its debt in effect is then assumed by the entire economy. To put it another way, central bank reports will never carry a “going concern” warning no matter how much their liabilities exceed their assets, but in extreme cases it could lead, in essence, to a going concern warning for the whole economy.

Conventional financial accounting wasn’t designed for central banks, but applying its principles create some interesting insights into the workings of monetary policy. Conventional accounting encapsulates the central bank’s activity in a closed framework, even if its balance sheet items aren’t always conventional. For instance, one unique liability listed on a central bank’s balance sheet is “bank notes and coins in circulation” since money issued to the public actually constitutes a liability by the bank towards everyone holding it. At the end of 2012 this liability for the Bank of Israel reached NIS 54.8 billion, reflecting all the cash in circulation at the time. The Bank of Israel’s other assets and liabilities, though, are fairly commonplace.

The Bank of Israel’s enormous negative equity stems from an approximately NIS 18 billion loss on exchange rate differentials. This began in 2010 after then Governor Stanley Fischer embarked on a policy of buying dollars to contend with the declining value of the dollar against the shekel. The current structure of the bank’s balance sheet, where the assets in foreign currencies (mainly the dollar) generate lower interest than that paid on shekel-denominated liabilities, has meant that the deficit didn’t even go down in 2012 even though the dollar’s average exchange rate rose 8% against the shekel.

Accounting applied by central banks is based for the most part on normal accounting rules, but a key exception relates to measuring profits because of the asymmetric relationship between central banks and governments; profits produced by the bank are immediately transferred to the government, but the government doesn’t necessarily cover losses generated by the bank.

Countries have different types of legislation concerning losses. In some, the government covers the losses by issuing bonds. In Israel, however, the government doesn’t cover the losses at all. The new Bank of Israel Law mandates that three months after a new year begins the bank must transfer its profits to the government as long as its equity exceeds 1% of assets. It doesn’t say what to do in the case of a loss or deficit.

The Bank of Israel operates according to a similar principle followed by the European Central Bank based on postponing income recognition. Bank of Israel reports include a liability termed “revaluation accounts.” This includes unrealized profits arising from exchange rate differentials on foreign currency-denominated balances as well as unrealized profits from inflation linkage and the revaluation of tradable securities to fair value.

Danger to independence

To analyze the overall general condition of the Bank of Israel in a way that is closer to standard accounting practices, the revaluation account balance can be added to equity. If we add this balance at the end of 2012, the deficit shrinks to about NIS 23 billion. Revaluation accounts, even according to accounting theory, aren’t classified as liabilities. After all, the Bank of Israel doesn’t owe it to anyone else whatsoever, so theoretically they should be counted as equity. Discounting, on the other hand, creates an actuarial liability that could add another NIS 5 billion to the central bank’s deficit.

The Bank of Israel isn’t the world’s only central bank operating with negative equity. The central banks of Chile, Costa Rica and the Czech Republic, for example, have operated with negative equity. In 2010 the ECB harshly criticized the Czech National Bank, saying this could damage the bank’s ability to function and endanger its independence.

It must be stressed that the separation between central banks and the government in which they operate is artificial to a certain extent, so the separate financial statements of a central bank don’t really provide a full picture of the outcome of its performance.

Accordingly, the performance of the Bank of Israel governor can’t be judged solely based on the accounting results showing an increase or decrease in the bank’s equity during his term. The reason is that the results of the Bank of Israel’s policies aren’t completely reflected in its reports. For instance, the Bank of Israel’s deficit ballooned because of its dollar buying in an attempt to prevent appreciation by the shekel, which had positive implications for the economy in terms of boosting exports and employment. None of this was reflected in the Bank of Israel’s financial reports.

In any case, the Bank of Israel’s deficit can be regarded from an economic standpoint as an accumulated deficit in the overall government budget – with all the negative consequences this implies. There is not much difference between the government issuing bonds to cover its budget deficit and the Bank of Israel’s doing so in order to roll over its liabilities.

To put this in complete perspective, suffice it to say that there are countries where the practice is for the government’s budget to finance the central bank’s deficit, so that the deficit is considered part of the overall budget deficit. In such a case, the central bank’s equity can’t, in effect, be negative – a situation that conveys a sense of stability and security.

Financing the deficit from the state budget is seemingly a strictly technical matter in light of the fact that central banks prepare financial statements separately from the rest of the government to maintain their independence. In an absurd way, however, this affects the measurement of the budget deficit. In Israel’s current situation, with the state budget’s not covering the Bank of Israel’s deficit, nobody really counts it.

This leads to the strange situation whereby the Bank of Israel, part of whose duties are to advise how big a fiscal deficit the govenment can take on, doesn’t include its own deficit in the equation.

Bloomberg and Tomer Apelbaum