The emerging slowdown, apparent in the developed countries economic data, is giving rise to a debate on whether the central banks in
Japan, the UK and the US should expand their respective balance sheets further. Some commentators favour an immediate monetar y
stimulus in the next few weeks, in the absence of the ability of most governments to provide further fiscal stimulus. Some other
commentators fret about the negative effect on the long-term currency values stemming from an out of control expansion of central bank
It would be interesting to understand why a central bank would like to expand its balance sheet. Some key reasons are:
1.To provide normal liquidity support to financial sector, so as to tide over short term cash flow issues. This expansion is expected to reverse in a matter of weeks, or at most, quarters.
2.To provide liquidity support to the settlement system, if there are any severe imbalances emerging in various sub-segments of the
settlement system. Since most of this support is virtually automatic, it is very difficult to say if this support is only a l iquidity support or
a solvency support. If this support does not reverse in a few quarters, one needs to suspect that the central bank facility is used for
3.To provide solvency support to systemically important institutions. Typically, before 2008, this support was provided mainly by
emerging market central banks. However, since 2008, central banks in the developed world have been providing this support on a
regular basis. This support typically lasts for at least one business cycle – of two to five years.
4.To ensure that market prices of certain assets, especially foreign exchange, behave the way central banks want. PBOC intervention
in the forex market is a good example of this type of expansion. This expansion usually lasts many years, till relative terms of trade
5.To ensure that the market prices of broad range of assets get a boost, and as a result, confidence of consumers and businesses
improves. We would classify the FED QE II in this category. This boost remains in place for a long period of time, usually till risky
assets go to the next level of nominal highs, and market thinks that the previous levels are unobtainable now.
6.To ensure that deflation is averted. The Fed’s stated objective for QE II was to avoid deflation. This stimulus lasts till consumer and
business demand remains at elevated level for a long period of time.
After understanding the above analysis of reasons for expansion of central bank balance sheets, it would be useful to look at the relative
sizes of major central bank balance sheets, compared to the respective GDPs, as shown in the Chart below.
Also, it would be instructive to see how the central bank balance sheets have expanded since the start of the credit crisis in 2007.
From the above analysis, can we draw a conclusion that some of the central banks have scope to expand their balance sheets further, to
support their respective objectives?