This is going to be a long post. Understanding Central Banks in general is going to be important in the next couple of years and understanding what is going on with Venezuela’s Central Bank shows why unless oil prices rebound, really rebound, we are in trouble because of the irresponsibility of our current Government. Simply put expect devaluation and inflation like we have never seen before.
At the same time, the recent credit crisis does imply that the money supply in the US has also increased because of its aid packages and it will have its consequences when the recovery of the economy arrives in the form on inflation. Devaluation in the US? Well, the difficulty there is that Central Banks in both Europe and the US have been printing money to get out of the crisis, the guessing game will be who will print more and therefore, who will devalue more and have more inflation.(Which benefits Asia which avoided much of the credit crisis, even if it is feeling it)
But let’s start at the beginning.
1. Your personal balance sheet
Your personal balance sheet has two parts: Your assets, that is what you own, have, have saved, etc. and your Liabilities, as an example:
In this example you are quite solvent, you have more assets than Liabilities: you have equity. There is no problem, your net worth is 58,000 units. If you had to pay your debts, liquidate everything ad you will have 58,000 whatevers in your bank account.
But suppose you were a subprime credit risk in the US and your balance sheet looked like this:
Here you would be bankrupt if you were for some reason forced to liquidate, as in the end you would have more debt (303,000 units) than assets (278,000 units): your equity is negative. But, as long as you have your job and the money to make payments every month on your mortgage, credit cards and loans you will be alright: You can service your debt, you have cash flow. As long as you can pay your debts every month, nobody wil bother you.
As an aside, part of the recent credit crisis arose because people’s homes dropped in price and payments increased, but people realized that they owed more on their homes than the value of the home, so why bother? Better take the loss, give up the house and pay rent.
2. The Balance Sheet of a Central Bank
The Balance Sheet of a Central Bank is not too different from yours, except that the Central bank does a lot of different things, including issuing money. But it may look something like this (simplified):
Note the equity is included on the liability side, because if it is a company or bank the equity is “owed” to the shareholders. If the company is dissolved, the equity will be distributed to the owners. If the Central Bank is dissolved, in Venezuela the Government wil get the equity (if it exists)
Now let’s look at the simplified Balance Sheet of the Venezuelan Central Bank in Bs. x 10^6 Times (one million), as of December 31st. before US$ 12 billion in reserves were taken out:
It looks ok at first sight, Liabilities equals Assets, nothing funny at first sight. However, if we “open” the “Assets in Bs.” line, it is composed as follows:
As you can see mot of these assets are in the last two lines which add up to Bs. 32.2 billion or US$ 14.98. The “notes” refers to the notes attached to the Financial Statements which were published in El Universal on January 28th. When you go to these notes it turns out that Note 9 is just the US$ 6 billion transferred to Fonden in 2005-06 and Note 10 contains US$ 8.3 billion also transferred to Fonden in 2007, for a total of US$ 14.3 billion.
Notice the problem?
This money no longer exists!
US$ 14.3 billion the assets of the Venezuelan Central Bank, which has Equity of US$ 6.3 billion (see above) has vanished into Fonden and has been spent. Thus, the Venezuelan Central Bank has negative equity, this is like the second case in 1). In fact, since this was the picture on Dec. 31st., by now, with the transfer of US$ 12 billion in mid-January to the Fonden, a full US$ 26.3 billion in assets are listed in the balance sheet which will soon no longer exist.
Truly revolutionary indeed! But, what does it mean?
If it were you, it would mean, you kept the mortgage, but the house was sold, you have nothing to back the loan.
As in the second case above, the question is whether the Central Bank is insolvent because its balance sheet is insolvent, or whether it is insolvent because it can not pay its obligations, its debt.
A Central Bank has costs, not only those related to running the bank, but also it can issue money, but issuing money, increases liabilities and increases inflation. So, this is limited in scope. To function, the Central Bank has to pay interest on commercial banks reserves,as well as offering instruments when it needs to control monetary liquidity.
Currently the Venezuelan Central Bank has some US$ 25.4 billion in deposits from commercial banks, not all of it bearing interest and has issued US$ 10.7 billion in CD’s that it has used in operations to absorb monetary liquidity.
Where does the Central Bank get money to pay for the interest on this?
Easy, from interest it receives on investing international reserves and, of course, once again it can print money. It becomes a vicious circle.The more money that is printed, the higher inflation and the more difficult it becomes to control inflation. Zimbabwe is an example.
This whole thing can be written as an equation, which I will not do, but basically, there is a condition such that the Central Bank needs to have a net worth that will not be wiped out in the future in order to keep its operations. (I don’t want to go into more detail on this)
What happens now, as oil prices fall, is that the Central Bank will have lower income, but the monetary mass will be larger, there will be more money going after the same goods. More Inflation. In the last few years, as Chavez has taken money out of international reserves, oil prices have gone up, allowing international reserves to increase and give the Central Bank enough money to pay its costs. If no devaluation takes place, this will no longer be possible soon.
That is why devaluing is such a convenient tool. You devalue and the Bolivars you need to keep the Central Bank functioning become less in terms of the US$ dollars it holds in international reserves. Reserves can once again pay the way of the Central Bank. But you get hit by inflation.
However, even if you devalue, the Treasury of the country needs to at some point to recapitalize the Central Bank. Until that is done, the problem is not over, it will repeat. That is why taking the Fonden reserves is such an irresponsible act: At some point, at whatever rate of exchange it may be, the Treasury will have to put the money back to replace the lost equity of the Central Bank.
The more the currency is devalued, the cheaper it will be for the Treasury…and so on…
And that is a key difference between what is happening in Venezuela and in the US. So, let’s look at that case briefly.
3) The Balance Sheet of the US Federal Reserve
I will look first at the balance sheet of the US Federal Reserve last year before the collapse of any financial institution. It sort of looked like this:
So, with the aid to JPMorgan to take over Bear Stearns and TARP I and Tarp II, what has happened is that the US Federal Reserve created more money, but it exchanged it for assets, mostly preferred stock in these banking institutions.
This is a huge difference, because these are assets in the balance sheet and they produce income for the Fed. The Balance Sheet of the Fed after the first TARP round may look like this (Assuming 800 billion dollars in new money and assets):
This is of course, terribly inflationary, as there will be a lot more money out there. However, the difference is that if the plan works and banks become healthy again, they can buy back those preferred shares that were added on the left side and the Fed can then eliminate that money from the money supply. It may not work, but that is the theory behind it. Additionally, before this happens, banks will pay the Fed interest on those preferreds and that money will be useful for the Fed to maintain its ability to pay its debt.
But there is another difference: Venezuela has dollar liabilities, dollar debt. The US does not. The US can print and print and as long as it can pay the debt it issues, it will do it all in US$. But Venezuela has lots of debt in US$ and while it ca print Bolivars to pay that, it needs to have the dollar to purchase them and pay debt.
Once again, devaluation can fix that problem easily.
Of course, I have oversimplified the whole thing, but I hope you get the idea. There are problems in Venezuela and the US, but ours are much worse because of the invention of the “excess reserve” concept and the existence of dollar liabilities.
And this will lead to more inflation and devaluation…