Analysis

It’s an Aussie battler’s worst nightmare. You’ve got a macking big loan with the bank but the value of the family home is falling. Times are tough. You’re veering towards the dreaded ‘negative equity’ territory,  that is, being underwater on your mortgage, or owing more to the bank than your home is actually worth.

As it turns out the Reserve Bank of Australia is having a ‘negative equity’ nightmare of its own. Just a three per cent fall in the value of its assets and the RBA is underwater. Good thing the RBA has a sugar daddy, Joe Hockey.

To explain, Treasurer Wayne Swan blithely snipped a $500 million dividend from the Reserve Bank’s wilting cash reserves last year. The bank had just made its first profit in three years and the government commandeered almost half of it. It had to make the budget look good somehow.

Governments do this from time to time. Since the central bank was formed in the 1960s though, the money has never flowed the other way; from the government into the RBA that is.

That may change. According to a story by economist Christopher Joye featured on page six of the Australian Financial Review today, Shadow Treasurer Joe Hockey is planning to top up the Reserve Bank’s emergency capital ‘buffer’ to the tune of $4 billion.

Even before the Treasurer took his half a billion dollar ‘Don’t-mind-if-I-do’ dividend - something RBA governor Glenn Stevens was definitely not pleased about - the Reserve’s cash reserves were under serious pressure.

The rising $A had cut $5 billion from its capital base in 2009 and 2010. As the local currency rallied against its peers, the value of all its foreign currency assets fell. Now its ‘reserve fund’ or capital buffer hovers at just $1.95 billion.

Another rise in the $A, and Australia’s central bank could find itself in ‘negative equity’.

To deploy the analogy of the Aussie battler, this is akin to a fall in the value of the family home to just above the value of their loan from the bank. We are talking here about a battler with a three per cent deposit and a home loan worth 97 per cent of their home. That is where the Reserve Bank stands today, remarkably.

According to its own data, the Reserve Bank’s gold and foreign exchange assets dropped in value by $4.6 billion during the week to April 3 alone as the $A rose and the price of gold fell.

These are volatile assets, especially as there is a global currency war raging. Europe, the US and Japan are all belligerently inflating their way out of trouble, debasing the value of their currencies to lend themselves an edge over their trading partners. Japan has even started buying property and stock market funds.

Against this backdrop of central banks printing unlimited amounts of money, the Reserve Bank is fighting the war with a pinky finger - given its skinny capital buffer and commendable monetary virtue.

The bank holds $48 billion of ‘at-risk’ gold and foreign exchange. There is another $20 billion of government bonds yet these don’t count for the buffer.

Its target emergency buffer to protect against losses on the assets it holds, and indeed the capital which it encourages the big banks which it oversees to keep in reserve, is 10 per cent of risk capital.

You could say that, at $1.95 billion, its own buffer is now less than one-third of its own ‘recommended retail’ buffer. Another rally in the $A might wipe out that buffer entirely and send Australia’s central bank hurtling into negative equity – a place it has never been, and a place it would presumably be loathe to share with the likes of Czech Republic and Chile.

For Australia’s banks, the RBA is the lender of last resort. It has even set up a $380 billion bail-out fund called the Committed Liquidity Facility (CLF) which the banks can tap if they get into strife.

Ironically, the RBA has said it will give banks access to the CLF if they are insolvent and illiquid, but not if they are in ‘negative equity’. That is, if their assets are worth less than their liabilities.

Under these rules, the RBA would not qualify for its own bail-out money if its currency and gold assets fall another 3 per cent.

Hence Joe Hockey’s proposal for a $4 billion cash infusion. For Hockey it simultaneously embarrasses his nemeses Wayne Swan while potentially delivering him the stupendous title of the Man Who Saved the Reserve Bank.

If the RBA though is the lender of last resort for the banks, the taxpayer is the lender of last resort for the RBA.

So, under the Hockey bail-out plan, unlike the CLF, the government can’t simply print money for the banks, it would have to find some cash somewhere, perhaps by gifting bonds to the RBA or injecting cash via some kind of Special Purpose Vehicle.

The other difference in the two bail-out plans is that the central bank could hang onto Joe Hockey’s $4 billion cash infusion forever. As the lender is the taxpayer, the lender would never have to be paid back – though the RBA would still be susceptible to marauding politicians plugging their budget gaps.

Over the past 10 years the RBA’s capital as a proportion of its at-risk assets has averaged 7.2 per cent. The escalation in the value of the $A has caused real havoc, chiselling the capital ratio down to less than 3 per cent.

This week Australia’s exchange rate weighted against our major trading partners’ currencies hit its highest level in 28 years.

So with the currency so high and the buffer so thin, the bank is leery of expending its capital by ‘shorting’ it.

There have been many times in the past when the RBA has been well ahead ‘on the punt’ – currency trading that is. Punting is not in its charter of course but managing the currency is. So it often wades in and buys the $A when it is too low, and sells down when it is too high. Until now, the bank has not had much of a problem doing this. But being a bee’s appendage away from negative equity presumably gives the Martin Place boffins much pause on the trading front – particularly with RBA leverage in the thirties.

As an aside, you would think it should have an edge when it comes to currency trading since interest rates are the single most critical factor in foreign exchange, and the RBA sets them. 

But as the financial crisis has proven once again, nobody is bigger than the market, not even the central banks.

The end game for Governor Glenn Stevens and his colleagues is preserving the stability of the financial system. The spectre of negative equity and the attendant credibility issues are a nightmare.

On Stevens’ side is the bank’s virtuous track record on the inflation front, not bowing to calls for deep interest rate cuts to boot up growth and devalue the currency. With rates at three per cent, he has room to move, unlike many of his global peers who cut to zero, or thereabouts.

Despite this luxury of having some fat in official interest rates, the Reserve Bank’s wafer thin capital buffer remains a problem that either it or politicians will eventually have to fix.