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The balance sheets of the world’s four largest central banks have expanded 2.6 times over the last five years from US$3.5tn in January 2007 to US$9.1tn in March 2012 at a compound annual growth rate (CAGR) of 20%. Between 2000 and 2007, the balance sheets of central banks in advanced economies remained within a range from 9% to 13% of GDP. Since then they have risen to over 20% of GDP.

Two major events have instigated this rapid expansion, the financial crisis in 2008 and the European sovereign debt crisis in 2011.

The balance sheets of the world’s four major central banks expanded by 60% during the global financial crisis, from US$4.2tn in August 2008 to US$6.8tn in December 2008. The largest increase was in the US, where the balance sheet of the Federal Reserve increased by 145% from US$0.9tn to US$2.2tn during the same four-month period.

Central banks expanded their balance sheets to provide monetary support to counteract the effect of a massive debt de-leveraging in the global economy. They have used equity to purchase debt instruments to help rebalance debt levels. Consumers, banks, businesses and governments took on too much debt in the years prior to the financial crisis. Subsequently, a widespread withdrawal of access to credit has forced massive debt de-leveraging as borrowers have been forced to reduce their levels of debt to equity.

To soften the blow to the global economy, central banks have bought “unconventional” assets (mainly their own country’s sovereign bonds) and, as lenders of last resort, provided liquidity to banks (mainly by relaxing collateral requirements) to avoid a seizure in the financial system.

For example, during its first quantitative easing programme the US Federal Reserve increased its holdings of bank debt, mortgage-backed securities (MBS) and US government bonds by around US$1.3tn during the financial crisis and until mid-2010. MBS accounted for the majority of these purchases. The Federal Reserve’s second round of quantitative easing involved the purchase of US$0.6tn of mainly long-term Treasury securities from November 2010 to mid-2011. The quantitative easing programme of the Bank of England involved US$0.5tn of purchases of mainly government debt, but also some high-quality private debt.

These actions come on top of a raft of other government measures to directly support the global financial system and economy. The IMF calculated in 2009 that official rescue efforts totalled almost US$12tn.

Following the financial crisis, the size of the four major central bank balance sheets stabilised in 2009-10, only growing at a CAGR of 2.1%. However, the expansion accelerated to 22% in the year to March 2012 as the European sovereign debt crisis led to greater official support.

The balance sheets of the Euro Area central banks expanded by 48% in the year to March 2012. The ECB has initiated two main expansionary programmes. Firstly, the Securities Markets Programme, enabled it to purchase around US$0.4tn of mainly Italian and Spanish bonds in 2010-11. Secondly, in late 2011 and March 2012 the ECB initiated long-term refinancing operations to tackle liquidity concerns by loosening its collateral terms. European banks took secured loans totalling US$1.3tn for three year terms.

The expansion of central bank balance sheets is ongoing. A further round of quantitative easing has been under consideration by the Federal Reserve as has the purchase of mortgage-backed securities. The ECB has recently increased the size of its bailout fund to US$1tn and stands ready to use its balance sheet should any further sovereign debt issues emerge. Rising yields on Spanish government bonds are of particular concern. The IMF has also recommended more action from the ECB. The Bank of Japan could also consider further expansionary measures to combat deflation.

There are a number of risks emanating from this balance sheet expansion, which is unprecedented in scale.

Firstly, increasing the amount of liquidity in the financial system could drive inflation higher and poses a risk to financial stability. However, this may not be wholly negative as inflation would also devalue outstanding debt, helping to combat the cause of the ongoing financial crisis.

Secondly, the increase in supply of government bonds, which are used to expand the balance sheets of central banks, could crowd out lending to the private sector. If banks can easily profit from yields on government bonds, then they are less likely to lend to the private sector.

Thirdly, the expansion of central bank balance sheets could distort global financial markets. As central banks buy government bonds, they increase demand, driving up prices, which lowers the market return, or yield from these instruments. This lowers the benchmark, or “risk-free”, borrowing cost and, for large central banks, has a knock-on effect, lowering interest rates throughout the global financial system. This could either lead to excessive credit expansion owing to cheap borrowing costs or excessive de-leveraging as it provides banks with little incentive to lend.

This situation could lead to a liquidity trap, where banks hoard cash, rather than lending, to protect themselves from further future financial instability.

As the major central banks continue to expand their balance sheets, they may be propping up the global economy for now, but they could also be creating bigger problems in the long term.


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