The central bank has a balance sheet like any other company, but there is a fundamental difference in the components of its assets and liabilities.
Liabilities or obligations of the central bank = banknotes issued and traded outside the central bank (with individuals, companies, banks, and the government). Any banknote inside the central bank is canceled as if it doesn’t exist.
In the past, if the banknote was completely covered in gold, you would have gone knocking on the door, paying EGP 10, and taking the corresponding gold.
This system is still used (banknote = obligation on the central bank), but you cannot exchange the pound for gold or fiat currency from the central bank now. This system ended in the 70s worldwide.
The Mechanism: Explained
Example:
The Central Bank’s balance sheet on December 31, 2022, in Egyptian pounds and the dollar exchange rate = EGP 10
Assets
USD = EGP 100 (meaning $10)
Liabilities
Banknote outside the central bank = 100 pounds
This means that there’s a EGP 100 that were issued to the people, and the value of these notes stems from the fact that they are completely covered by the dollar reserves.
If the Central Bank wants to increase the supply of the pound in order to revive the economy, what should it do? Since the Central Bank prefers that the issued cash be completely covered by the dollar at the current exchange rate, the Central Bank will link the monetary policy decision to the balance of payments flows. This is a very, very important relationship because the monetary policy does not work in isolation.
In 2023, Abu Qir Fertilizers exported chemicals at $20 while the government imported wheat at $10 and there were no other dealings with the outside world.
The two parties deal with the National Bank of Egypt. The surplus in the balance of payments = $10, and this surplus is in the treasury of the National Bank and is not negotiable in Egypt because buying and selling are only allowed in Egyptian pounds.
The National Bank wants EGP instead of USD so in order to loan them and earn a profit, they will call the Central Bank to buy the $10 at the prevailing exchange rate, which is 10 pounds for the dollar.
The Central Bank agreed and the balance sheet now looks like this:
December 31, 2023
Assets
Reserve of dollars = EGP 200 ($20)
Liabilities
Banknote outside the central bank = EGP 200 (of which EGP 100 are National Bank’s vault)
The Central Bank printed EGP 100 and bought the $10 that went into Egypt to the treasury of the National Bank through the net balance of payments operations.
In conclusion, liquidity increases and decreases according to the conditions of the balance of payments.
Net USD inflows through the balance of payments → USD goes into banks → Central Bank then buys surplus USD by printing EGP → Increase in liquidity.
Net USD outflow through the balance of payments → USD exit from Egypt → Central Bank that sells USD to banks and withdraws EGP → decrease in liquidity.
How does the CBE issue Bank Notes
