Monetary Policy Challenges Under High Euroization

SEE after EU Enlargement and before AccessionApril 4-5, 2005

Budapest

Boris VujčićDeputy Governor

Croatian National Bank

The degree of dollarization in transition economies

Source: Feige, E. (2002)

0%

10%

20%

30%

40%

50%

60%

70%

80%

Cro

atia

La

tvia

Bu

lga

ria

Slo

ven

ia

Ro

ma

nia

Slo

vak

Re

pu

blic

Cze

ch R

ep

ub

lic

Es

ton

ia

Lith

ua

nia

Hu

ng

ary

Po

lan

d

Ma

ced

on

ia

The degree of dollarization in transition economies

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Rus

sia

Bel

arus

Cro

atia

Aze

rbai

jan

Latv

ia

Ukr

aine

Bul

garia

Arm

enia

Slo

ven

ia

Geo

rgia

Turk

ey

Mon

golia

Ky

rgy

zsta

n

Rom

ania

Slo

vak

Rep

ublic

Cze

ch R

epub

lic

Est

onia

Lith

uani

a

Alb

ania

Hun

gary

Pol

and

Mac

edon

ia

Uzb

ekis

tan

Source: Feige, E. (2002)

Foreign currency deposits as a % of total deposits in banking system

70

72

74

76

78

80

82

84

86

88

90

01

.95

07

.95

01

.96

07

.96

01

.97

07

.97

01

.98

07

.98

01

.99

07

.99

01

.00

07

.00

01

.01

07

.01

01

.02

07

.02

01

.03

07

.03

01

.04

07

.04

Source: CNB

Foreign currency deposits as a % of M4

0

10

20

30

40

50

60

70

80

01

.95

07

.95

01

.96

07

.96

01

.97

07

.97

01

.98

07

.98

01

.99

07

.99

01

.00

07

.00

01

.01

07

.01

01

.02

07

.02

01

.03

07

.03

01

.04

07

.04

Source: CNB

Foreign & domestic currency in circulation (EUR mio)

0

500

1000

1500

2000

2500

3000

3500

08.0

1

09.0

1

10.0

1

11.0

1

12.0

1

01.0

2

02.0

2

03.0

2

04.0

2

05.0

2

06.0

2

07.0

2

DEM EUR HRK

Why foreign currency?

• long history of macroeconomic instability dating back to ex-Yugoslavia: high inflation, frequent devaluations, partial foreign exchange deposit expropriations

• financial markets might not have a long memory, but citizens do

• large diaspora, tourism• simple inertia

Interest rates on long-term domestic and foreign currency

deposits

0

5

10

15

20

25

30

07

.95

.

01

.96

.

07

.96

.

01

.97

.

07

.97

.

01

.98

.

07

.98

.

01

.99

.

07

.99

.

01

.00

.

07

.00

.

01

.01

.

07

.01

.

01

.02

.

07

.02

.

01

.03

.

07

.03

.

01

.04

.

07

.04

.

%

kuna deposits

foreign currency deposits

Consequences of de facto euroization: structure of bank

lending, 2004Domestic currency

27%

Foreign currency

12%

Indexed to foreign currency

61%

Balance sheet effect:

• Banks hedge exchange rate risk with euro-clause in their loan contracts

• only an imperfect hedge - transforms exchange rate risk into the credit risk

• most borrowers have kuna denominated receipts

High degree of euroization – high liquidity and solvency risks

• CNB requires banks to keep 35% of the amount of their foreign exchange liabilities in liquid foreign currency instruments

• together with the central bank reserves: required liquidity buffer for the financial system

• high-cost insurance

Consequences of de facto euroization:

quasi currency-board monetary policy

0

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.0001

/97

.

1/9

8.

1/9

9.

1/0

0.

1/0

1.

1/0

2.

1/0

3.

1/0

4.

mil

. US

D

CNB International reserves

Base money

Quasy currency-board monetary policy:

• ER stability, but no commitment from the central bank

• trying to get the best of both worlds:• credibility associated with the ER stability and low

inflation

• keep two-way risk in order to discourage speculative capital and make speculation more difficult, as well as to allow the ER to reflect changes in fundamentals, although maybe in a limited way

• difficult game to play

What helps:

• low degree of integration into the international financial markets

• capital controls:• explicit as in ‘98, • or implicit like

regional political instability lack of EU integration banking problems or a two way risk in the ER market

What makes it difficult?

• Lukewarm capital: • reacts to bad news and exchange rate

movements

• domestic instead of foreign players • many instead of few • elements of herd behavior, but different

animal than institutional investors like pension funds, investment banks or hedge funds

Foreign currency reserves of the CB relative to base money and M1

0,0

0,5

1,0

1,5

2,0

2,5

3,0

01.9

7

06.9

7

11.9

7

04.9

8

09.9

8

02.9

9

07.9

9

12.9

9

05.0

0

10.0

0

03.0

1

08.0

1

01.0

2

06.0

2

11.0

2

04.0

3

09.0

3

02.0

4

08.0

4

International reserves/M1 International reserves/ base money

Net usable reserves/M1 Net usable reserves/ base money

Source: CNB

Average monthly exchange rate

5,5

6,0

6,5

7,0

7,5

8,0

8,5

9,0

01

.99

05

.99

09

.99

01

.00

05

.00

09

.00

01

.01

05

.01

09

.01

01

.02

05

.02

09

.02

01

.03

05

.03

09

.03

01

.04

05

.04

09

.04

HRK/EuroHRK/US$

Source: CNB

Leaning against the wind in a highly euroized economy

Source: CNB

-1.600

-1.200

-800

-400

0

400

800

1.2001

/1/9

6

24

/6/9

6

16

/12

/96

9/6

/97

1/1

2/9

7

25

/5/9

8

16

/11

/98

10

/5/9

9

1/1

1/9

9

24

/4/0

0

16

/10

/00

9/4

/01

1/1

0/0

1

25

/3/0

2

16

/9/0

2

10

/3/0

3

1/9

/03

23

/2/0

4

16

/8/0

4

mill

ion

HR

K

6,6

6,8

7,0

7,2

7,4

7,6

7,8

8,0

EU

R/k

un

a

Foreign exchange interventions - leftExchange rate - right

Foreign exchange interventions vs. change of the exchange rate

-1,5%

-1,0%

-0,5%

0,0%

0,5%

1,0%

1,5%

2,0%

-2000 -1500 -1000 -500 0 500 1000 1500

Intervention in million kuna

EUR

/HR

K (

chan

ge

in 4

day

s

pre

ced

ing

inte

rve

nti

on

)

Source: CNB

Foreign exchange interventions vs. the level of exchange rate

Source: CNB

6,8

6,9

7,0

7,1

7,2

7,3

7,4

7,5

7,6

7,7

7,8

-2000 -1000 0 1000 2000

Intervention in mil. Kuna

EU

R/H

RK

1996-1997.1998-1999.2000-2002.2003-2004.

A problem…?(enterprises fx deposits after and prior to the liberalization of

the fx market)

0

200

400

600

800

1000

1200

1400

1600

1800

01

.99

05

.99

09

.99

01

.00

05

.00

09

.00

01

.01

05

.01

09

.01

01

.02

05

.02

09

.02

01

.03

05

.03

09

.03

01

.04

05

.04

EU

R m

illi

on

FX liberalization

…and an unorthodox solution!

• 42% of RR on foreign currency deposits has to be held in local currency

• weapon of detterance

• mismatch in banks’ balance sheets• regulation allows banks to have non-zero net

foreign currency position of up to 20% of liable capital

Reserve requirement monthly rate and volume

0

5000

10000

15000

20000

25000

30000

35000

40000

01

.93

.

08

.93

.

03

.94

.

10

.94

.

05

.95

.

12

.95

.

07

.96

.

02

.97

.

09

.97

.

04

.98

.

11

.98

.

06

.99

.

01

.00

.

08

.00

.

03

.01

.

10

.01

.

05

.02

.

12

.02

.

07

.03

.

02

.04

.

09

.04

.

HR

K m

illio

n

0

5

10

15

20

25

30

35

40

%Reserve requirement volume (LHS)

Reserve requirement rate (RHS)

Prudential regulation has an impact on monetary policy

• coverage of foreign exchange liabilities by foreign exchange claims: minimum 35% – in effect limits the growth of domestic credits

• net foreign currency exposure: maximum 20% of the risk-based capital – banks grant kuna credits indexed in f/c

=> fx risk transformed into credit risk

What cannot be done?

• use of nominal depreciation for competitiveness improvement

• quick portfolio shift from a local currency• rising interest rates (procyclical monetary

policy)• possible pass-through on inflation• “original sin” - domestic agents are not able to

transfer exchange rate risk (balance sheet effect)

Impact of ER movements and banking problems on the flow of bank deposits

y b0 hrk/dem crisis _2R

DW

TOTAL 0.04 (4.11)

0.87 (1.95)

-0.46 (-3.05)

0.56 1.80

KUNA 0.01 (0.94)

-1.94 (-2.99)

-0.44 (-2.34)

0.39 1.86

CRISIS 1

FX 0.05 (4.93)

1.38 (3.07)

-0.45 (-3.02)

0.57 1.71

TOTAL 0.04 (4.09)

0.86 (1.93)

-0.44 (-3.10)

0.56 1.84

KUNA 0.01 (0.85)

-2.04 (-3.11)

-0.42 (-2.27)

0.40 1.88

CRISIS 2

FX 0.05 (4.63)

1.38 (3.02)

-0.44 (-3.01)

0.57 1.81

TOTAL 0.03 (2.65)

0.83 (1.34)

_ 0.49 1.82

KUNA 0.01 (0.47)

-2.24 (-2.03)

_ 0.31 1.99

SUBPERIOD 1994:6 – 1998:3 FX 0.04

(3.36) 1.57

(2.42) _ 0.50 1.63

(OLS): t values in parenthesis

What cannot be done? - cont.

• irreversibility of euroization• dollarization hysteresis arising from

inflation/depreciation expectations• inertia• network externalities in the use of foreign

currency

What are the options?

• unilateral euroization

not acceptable

• continue with de facto euroized financial system

until euro is introduced de jure upon entry into the EMU

only then balance sheet risk will be removed from the system