Surplus liquidity, central bank losses and the use of reserve requirements in emerging markets

• Published date: 01 November 2017
• DOI: http://doi.org/10.1111/roie.12292
• Date: 01 November 2017

ORIGINAL ARTICLE

Surplus liquidity, central bank losses and the use of

reserve requirements in emerging markets

Andreas Hoffmann

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Axel Loeffler

2

1

Institute for Economic Policy, Leipzig

University, Germany

2

Deutsche Bundesbank, Frankfurtam

Main, Germany

Correspondence

Andreas Hoffmann, Leipzig University,

Institute for Economic Policy,

Grimmaische Str. 12, 04109 Leipzig,

Germany.

Email: ahoffmann@wifa.uni-leipzig.de

JEL Classification: E52, E58, F30

Abstract

Since the turn of the millennium, stocks of foreign reserves

held by central banks in many emerging markets and devel-

oping countries have exceeded currency in circulation. To

steer money market rates, these central banks have been

absorbing liquidity from, rather than providing it to, the

banking sector in their regular monetary policy operations.

When interest rates in countries with major reserve curren-

cies are low, the yield on foreign reserves is low. A higher

interest rate on liquidity-absorbing operations may expose

central banks to losses. Although a central bank is not a

profit-maximizing institution, central bank losses can under-

mine the independence of the central bank. Using data for a

large panel of central banks, this paper provides some evi-

dence that central banks tend to apply low-remunerated

reserve requirements when profitability is at stake.

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INTRODUCTION

Central banks of countries that provide international currencies to the international monetary system

provide liquidity at their respective policy rates to the domestic banking system. They are creditor cen-

tral banks. By contrast, since the turn of the millenium most central banks in emerging markets have

been confronted with surplus liquidity in the domestic banking system owing to the accumulation of

foreign reserves. These central banks aim to structurally absorb liquidity rather than provide it in their

regular monetary policy operations. They are debtor central banks. The fact that these central banks

owe interest on liquidity-absorbing instruments exposes them to the threat of losses when yields on

assets held as foreign reserves decline. In 2009, interest rates in the United States and euro area

dropped toward zero, and with them the profitability of debtor central banks.

In general, central banks have a monopoly on the issuance of legal tender. Therefore, they should

be profitable in the long run (Buiter, 2008). A temporary erosion of the capital base should be of minor

importance as losses can be made up for by long-run seigniorage gains. Regaining profitability,

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C2017 JohnWiley & Sons Ltd wileyonlinelibrary.com/journal/roie Rev IntEcon. 2017;2 5:990–998.

Received: 18 July 2014

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Revised: 28 February 2017

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Accepted: 8 March 2017

DOI: 10.1111/roie.12292