CIGI / UNEP Inquiry Research Convening December 2014 Should Central Banks engage in Social Impact Investing? Andrew Sheng1, I apologize that I will not be able to be present at this important meeting in Canada organized by CIGI and UNEP. As compensation, here are some thoughts on how central banks and policy makers might want to think about central bank financing of social and sustainability efforts. We need to do this primarily because advanced economy (AE) central banks opened up the Pandora box when they intervened at the outset of the Global Financial Crisis in 2007 using unconventional monetary policy. Unconventional monetary policy was applied to rescue failing banks and to prevent the economy from descending into recession. It was unconventional because after lowering interest rates to nearly zero (the lower bound), the only way to influence market behavior other than the price of money was to apply quantitative easing (QE), namely, increase the quantity of liquidity through expanding the central bank balance sheet. It is understandable that central banks undertook such emergency action to rescue the economy from a financial crisis that few predicted or understood. They took bold action in the absence of decisive fiscal action and structural reforms because of political weakness and indecision. Current EU President Jean-Claude Juncker said it all when he said on behalf of politicians – “we all know what to do, we just don’t know how to get re-elected after we’ve done it.2” Since then, central banks have been mesmerized by ECB President Mario Draghi’s statement of “whatever it takes”. Can non-elected officials do whatever it takes to prevent financial crisis by whatever action without a political mandate? Does unconventional monetary policy actually work3? Moreover, does it compromise central bank independence? What are the appropriate limits of central bank intervention? These important questions are outside the scope of this paper. It explores instead a more narrow focus. If central banks can buy financial assets, can they take into consideration social and environmental objectives? In more fashionable language DRAFT– should central banks engage in social impact investing? 1 I am grateful to my colleagues, Ng Chow Soon, Jodie Hu and Jillian Ng for helpful research assistance and comments on this draft. All opinions, errors and omissions are personal to the author. 2 Said during height of euro crisis, sourced in Wikiquotes. 3 See the important debate on this by William White, Claudio Borio, Hyun Shin and others, available at www.williamwhite.ca and www.bis.org. Should Central Banks engage in Social Impact Investing?Page 1 CIGI / UNEP Inquiry Research Convening December 2014 Emerging market economies4 (EMEs) central bankers have been more open to such policy debates and have experimented with central bank funding in innovative ways. But the convergence of orthodoxy, driven by free market ideology, induced many EME central banks to give up “policy-based lending” and to buy only safe assets, usually government securities and foreign exchange. Now that the Pandora’s box has been opened, fresh questions need to be answered. Section 1 surveys the size of central bank balance sheets at the current and historical level, using recent papers on the subject, notably Caruana5 (2011) and Ferguson, Schaab and Schularick6 (2014). Section 2 discusses what types of instruments central banks could buy or hold in implementing their mandate of monetary and financial stability and helping economies in crisis. Section 3 debates whether social inclusion and environmental objectives should be added into the central bank policy framework and toolbox. The debate raises questions on how one defines public goods and social impact, and the quality of metrics on how to measure accountability and impact. Section 4 concludes. 1 Central Bank balance sheets in global context In combatting the global financial crisis in 2007-2009, AE central bankers violated Bagehot’s Dictum7 that in a financial crisis, central banks should lend freely at market interest rates and only against good collateral. Instead, they intervened massively, lend freely at near zero interest rates, and began to acquire assets of dubious asset quality. Entry into unconventional monetary policy has proved easier than exit. In December 2011, Jaime Caruana, General Manager of the Bank for International Settlements, raised the alarm on central bank balance sheets, by pointing out that central bank balance sheets in Asia had risen to over 45% of GDP because of foreign exchange intervention, whereas AE central banks had risen to over $8 trillion or 20% of GDP. The current size of just four central banks (ECB, Fed, UK and Japan) was $10 trillion and 27% of their GDP at the end of 2013 and still rising. Caruana pointed our four policy risks – inflation, financial stability, financial market distortions, and sovereign debt management conflicts. 4 The term EME uses the IMF definition as applied in the IMF World Economic Outlook, but includes data from the four Newly Industrialized Asian economies to contrast non-AE financial market asset size and GDP with the AE data. DRAFT 5 Jaime Caruana, Why central bank balance sheets matter, Bank for International Settlements, December 2011, www.bis.org. 6 Niall Ferguson, Andreas Schaab, Moritz Schularick (2014), Central Bank Balance Sheets: Expansion and Reduction since 1900, ECB Forum on Central Banking, May 2014. 7 Bagehot, W (1873): Lombard Street: a description of the money market. Should Central Banks engage in Social Impact Investing?Page 2 CIGI / UNEP Inquiry Research Convening December 2014 These are serious and significant risks, but there are no simple answers. The puzzle is that inflation does not seem to be a threat currently, financial stability is questionable, although the global bank capital has increased, but financial market distortions are rising with almost all stock markets in record highs or record turnover, and sovereign debt has risen to unprecedented levels. But first we must put the broad parameters of the global financial system in context. Looking from a long-term macro perspective, the financial system has become larger, faster, more complex, interconnected and more globalized8. The financial system is larger because total conventional financial assets (bank asset, stock market and bond market capitalization) were 108% of GDP in 1980 and 378% of GDP at the end of 20139. A major factor in the expansion of the financial system relative to the real sector is rising leverage. Financial centres like Luxembourg can have financial assets as high as 3,152% of GDP, whereas the UK is 799% and Japan and EU are in access of 500% of GDP. Including the notional value of financial derivatives, another 16 times GDP may have to be added, but the exact meaning of a collapse of the notional value of derivatives on the real sector is debatable. The financial sector is faster, partly due to technology in speeding up transactions, but also due to the removal of friction, such as transaction taxes and intermediation costs. According to the BIS Triennial Survey, global annual total FX turnover was $5.3 trillion per day in 2013, compared with $4 trillion in 2010 and $3.3 trillion in April 2007. Using 250 trading days, total FX was $1,325 trillion in 2013, or 17.7 times GDP, compared with 15 times GDP in 2007. The largest financial markets today are dominated by high frequency traders who trade via computerized algorithms that spread trading to different markets, such as commodities, bond and futures. This adds to the risks of “flash crashes”, crowded exits and high correlationship between different market movements that may add to the speed of contagion. Global financial markets are today more concentrated, with total assets of G-SIBs (globally systemically significant banks) having assets equivalent to 63.3% of GDP compared with 47.7% in 2002. In every financial field, including rating agencies, trading platforms, financial news and credit cards, the bulk of the business is concentrating in a few major players, creating risks of too big or too interconnected to fail. The financial sector is also more powerful, because financial services contribute to roughly 6% of EU GDP and employ 11 million people with 2 million in the UK, contributing to 12.6% of GDP, with many in the super-remuneration class. In the US, the financial sector is one of the major contributors to the funding of elections and for lobbying efforts. DRAFT The Financial Stability Board (FSB) has recently published data on global financial assets through its detailed survey of global shadow banking as of the end of 201310. Its survey universe covered 8 Mark Carney, Chairman of the Financial Stability Board, argued in a recent speech that the system is simpler, safer and fairer. “The Future of Financial Reform”, November 17, Bank of England, www.bankofengland.co.uk. 9 IMF Global Financial Stability Report, 2014, October, Appendix Table 1, Capital Market Size, pg. 163. 10 Financial Stability Forum, Global Shadow Banking Report, 2014, data estimated from Figure 2.1, available www.financialstabilityboard.org/wp-content/upload/r_141030.pdf. Should Central Banks engage in Social Impact Investing?Page 3 CIGI / UNEP Inquiry Research Convening December 2014 total financial assets of 20 key jurisdictions and euro area, accounting for roughly 80% of global GDP and 90% of global financial assets. The FSB survey estimated total financial asset size of roughly $300 billion11, of which the banking sector accounted for 46% or $138 trillion, the shadow banks (non-bank financial intermediaries 25% or $75 trillion, and the insurance and pension funds $55 trillion or 18% of total financial assets surveyed. Central bank balance sheets today are $24 trillion or roughly 8 per cent of the total world’s financial system assets. This is equivalent to 32% of GDP.