The unwinding of balance sheets and its implications

The Fed and the ECB are leading the way in the reduction of balance sheets. — Bloomberg

First things first. This is this column’s 300th publication since the first article was published in June 2018 and I would like to thank Star Media Group for giving me this opportunity to explore and discuss various issues related to the economy, market, finance, corporate governance and different asset classes. For this week, the focus is on the central bank’s balance sheet.

After peaking at just over US$30 trillion in early 2022, the size of the four main central banks’ balance sheets has now shrunk to approximately US$25.8 trillion in the latest filing, with both the US Federal Reserve (Fed) and European Central Bank (ECB) leading the way in the reduction.

For the Fed, which saw its balance sheet peak just under US$9 trillion in April 2022, it has been able to reduce the balance sheet to US$7.4 trillion in its latest filing, a reduction of 17%.

The ECB has been more aggressive, reducing the size of its balance sheet from €8.8 trillion to just €6.6 trillion, a €2.2 trillion or 25% reduction in euro terms.

While both the Fed and ECB have been persistent in shrinking the size of their balance sheet, the two major Asian central banks, the Bank of Japan (BoJ) and People’s Bank of China (PBoC) have been on a different path as both are seeing the size of their balance sheet expand to record highs based on recent data.

BoJ’s balance sheet was last seen at about 755.7 trillion yen or approximately US$5 trillion, just off the recent peak of 760.4 trillion yen, while PBoC’s balance sheet presently stands at 446 trillion yuan or US$6.2 trillion from the all-time high of 457 trillion yuan or US$6.4 trillion.

Fed’s quantitative tightening

The Fed, which saw the size of the balance sheet almost quadruple before the 2008 Global Financial Crisis via various quantitative easing (QE) programmes to stimulate the economy, started to shrink its balance sheet in June 2022 under its quantitative tightening plan, some US$95bil worth of US Treasury securities and mortgage-backed securities to runoff its balance sheet every month.

However, in reality, the runoff has been carried out at a slower pace, approximately US$75bil per month.

The question as to when will this end is not entirely clear but it is widely understood that the Fed intends to maintain a large balance sheet to provide the minimum level of reserves consistent with being considered abundant or “ample”.

Most market enthusiasts expect runoff to cease between later this year and the middle of 2025, which will likely take the Fed balance sheet to between US$6.3 trillion and US$7 trillion – and still well above the pre-Covid-19 level of US$4.2 trillion.

ECB’s aggressive measure

The ECB has been more aggressive in its balance sheet runoff as it has already shrunk its balance sheet by 25% since it started in 2022 as it has drained out the excess liquidity that it previously injected into the eurozone economy.

The shrinking of the balance sheet also helps the ECB to maintain benchmark interest rates where they are for now as a withdrawal of liquidity in the economy translates to higher rates.

Despite taking €2.2 trillion off the balance sheet, the ECB has still a long way to go to shred the bloated size of its assets and it is likely the quantitative tightening programme will be carried out for the foreseeable future.

While there are calls to maintain the size of the balance sheet to a reasonable level, the ECB will likely continue to carry out its quantitative tightening programme by at least another €1 trillion to €2 trillion, bringing the size of its balance sheet to between €4.5 trillion and €5.5 trillion.

The quantitative tightening programme will likely be extended up to 2026 to ensure that it is done in a measured manner and not disruptive.

Pump priming

Both Japan and China are on a different path altogether as BoJ and PBoC are near record levels when it comes to the central bank’s balance sheet and both have domestic challenges that they are trying to address.

BoJ has instead been buying up government bonds in its efforts to provide liquidity while its yield curve control plan was ditched recently as the central bank finally came out of the negative benchmark rate and has now set the new overnight call rate at a range of between 0% and 0.1%.

BoJ will have a tough time shrinking its balance sheet as the current size of its balance sheet is close to 120% of its gross domestic product (GDP), the highest among developed economies.

Based on estimates, it will take BoJ at least eight to nine years to shrink its balance sheet from the level where it is today to what is deemed appropriate, which is at about US$2 trillion level.

In terms of the size of the central bank balance sheet to GDP, the eurozone has the second-highest at approximately 45%, followed by China at 35% and the Unite States at 27%.

When taking into consideration public debt and based on official 2022 figures from the International Monetary Fund, Japan also has the highest public debt to GDP at 261%, followed by the US at 121%, the eurozone at 90% and China at 77%.

For China, which has been up against a slowing economy, a troubled real-estate market and a sluggish investment climate, the government too has been busy providing support to the local economy via various stimulus measures.

Whether PBoC will continue to expand its balance sheet is left to be seen while the government is expected to continue to provide economic stimulus to sustain what is perceived as reasonable growth for China, which is deemed at 5% per annum.

Liquidity crunch

History suggests that markets are bullish when central banks are providing liquidity in abundance and that is reflected in the rally that we have seen in various asset classes, including the equity market.

Will the opposite be true, with markets as well as other asset classes falling due to the liquidity crunch as central banks unwind their balance sheets?

So far, both the ECB and the Fed have already deflated US$4 trillion from their respective bloated balance sheets but the market has yet to blink.

The difference in quantitative easing and quantitative tightening is well documented as quantitative easing is usually done hurriedly to jump-start the economy in response to a crisis (Global Financial Crisis, Covid-19 pandemic) while quantitative tightening is carried out in a phased manner and over a long period to smoothen the impact on the economy and markets.

The experience of 2013 is still fresh among investors as unanticipated comments by the Fed chairman then on quantitative tightening caused market jitters.

Quantitative tightening also allows room for central banks to respond in a more prepared manner for the next crisis as it will then have added bullets to jump-start the economy should the need arise.

At the same time, as inflation targets have yet to be achieved by both the Fed and the ECB, the shrinking of their respective balance sheet will accelerate the pace of disinflation (although the evidence of this is still not clear) and give room for the central banks to cut rates from its current peak levels.

Pankaj C. Kumar is a long-time investment analyst. The views expressed here are the writer’s own.