Budget windfall from Central bank profits drying up
An important strategic consideration for Minister for Finance Pascal Donohoe in framing next week’s budget is the reliability of different strands of revenue. Already he has been warned of the dangers of relying too heavily on corporation tax, as decisions by a small number of firms could have a big negative effect on future revenues.
The profits of the Central Bank have been another significant source of income for the government over recent years. In 2010 and 2011, the bank contributed €700 million to government coffers. In 2016 and 2017, it amounted to around €1.8 billion. This has been a very important source of funding during very difficult times. However, the bank’s deputy governor Sharon Donnery, in a recent article with colleagues, pointed out that this particular revenue source is likely to dry up as the euro zone economy normalises.
Since 2010, the Central Bank has made substantial annual profits, and has transferred 80 per cent of these to the Department of Finance. (For technical reasons, only two-thirds of this transfer is available for use in the budget this year, the rest goes to reduce the debt.)
In 2010 and 2011, a key factor in the Central Bank’s profitability was that distressed banks which needed emergency liquidity assistance had to pay a penalty rate of interest to receive funding from the Central Bank. As a result, the bank made a profit that was remitted to the Department of Finance, making a small but welcome contribution to the taxpayer to compensate for the massive losses the troubled banks imposed on society.
More recently, a key source of profit for the Central Bank has been from the sales of the portfolio of assets it acquired from the liquidation of IBRC (formerly Anglo Irish).
Cost of funding
The interest rate the Central Bank earns on these notes is much higher than the bank’s cost of funding. As a result, it makes a profit which, in turn, it passes on to the Department of Finance.
However, as conditions have improved in terms of financial stability and the economy more generally, the government bonds that are part of the portfolio are being sold off more rapidly than expected. Once they are sold, the potential profit of the Central Bank will also fall.
While the bank is selling the bonds related to the promissory notes, it is also, like other euro zone central banks, buying a large quantity of normal government bonds in the secondary market as part of the quantitative easing programme. These bonds will mature many years hence. The yield on them is very low by historical standards, but it is currently, on average, significantly more than the Central Bank’s cost of funding. So the bank is currently making a small profit on these bonds, even if the bond purchases are being made for monetary policy reasons.
Recovery in euro zone
However, with a recovery in the euro zone economy, it is expected that by the end of this decade, the ECB will have raised significantly interest rates which are linked to the Central Bank’s cost of funding. Meanwhile, the interest rate that central banks receive on their bond purchases has been fixed at a very low level. As a result, central banks may at that time make a loss on the assets they bought to support the monetary policy objectives
The ECB and its member central banks must pay a price for having done what Mario Draghi termed ‘whatever it takes’ to return the euro area economy to working order
of the ECB.
The particular bond portfolio held by Ireland’s Central Bank limits the scale of potential losses it is likely to face in future years. Other euro zone central banks that bought lower-yielding government stock, such as German bonds, are likely to face larger losses.
The Federal Reserve, the US central bank, is likely to move from profit to loss for similar reasons as it unwinds the policy of exceptionally low interest rates. These losses may arise earlier for the Fed than for European central banks, because of the different state of the US economic cycle.
To prepare for these future losses, the Central Bank this year made a provision in its accounts of €165 million. It would be prudent for the Minister for Finance to take similarly precautionary steps in the light of this pending loss of revenue.
The ECB and its member central banks must pay a price for having done what Mario Draghi termed “whatever it takes” to return the euro area economy to working order.
And while government revenue has been boosted in recent years by the resulting economic growth, we now need to plan for this looming revenue adjustment.