Monetary Policy in Advanced and Transition Economies: Illustrations from Canada, Poland and Ukraine
Monetary Policy in Advanced and Transition Economies: Illustrations from Canada, Poland and Ukraine
James W. Dean
Simon Fraser University
1. Monetary Policy: Instruments, Targets and Goals
A major task of central banks is to conduct monetary policy. This usually implies issuing currency, holding the country’s foreign reserves, acting as banker to the government, serving as a lender of last resort, and, most importantly, controlling the money supply. Traditionally, this policy was aimed at achieving six basic
: high employment, economic growth, price stability, and interest-rate stability, stability of financial markets and stability of foreign exchange markets. Some of these goals are consistent with each other, some are preconditions for the others, and some are mutually conflicting. For example, inflation that is either too high or too low (especially deflation) can hamper growth, increase unemployment, and threaten the stability of financial and foreign exchange markets. Thus, maintaining inflation at an appropriate level should be a principal objective of central banks.
To guide themselves to their goals, central banks typically
three price and quantity variables: exchange rates, monetary aggregates, and inflation rates (in this latter case, the target is the same as the goal). All three targets are transparent for the public. They are relatively easily understood and send clear signals to the public and markets about current monetary policy and expectations concerning price stability. To achieve their targets, central banks typically use three
: open market operations, the central bank discount rate, and bank reserve requirements.
Exchange rate targeting
often involves anchoring the domestic currency to a foreign currency that is expected to remain relatively stable. If this target is credible, inflation expectations should fall and the inflation rate should decline. The cost of such targeting may, however, be significant. In particular, the domestic central bank largely loses control over national monetary policies. Its money creation capacities become constrained by a foreign policymaker. Moreover, it risks speculative attacks on its exchange rate. While a developed market economy typically has relatively flexible factor and product markets, developing and transition economies may lack this flexibility - that is, may lack shock absorption capacities - and hence may suffer serious consequences from an inflexible exchange rate regime.
Monetary aggregate targeting
enables monitoring of a central bank’s performance (though not achievement of its ultimate goals) and thus promotes accountability of policymakers. It also helps to form inflation expectations. However for useful monetary targeting, strong relationships between monetary aggregates and inflation should exist. Financial innovations, brought about by improved information technologies and the development of new financial instruments and techniques, have blurred the distinction between monetary aggregates. This complicates monetary policy by making it less predictable and, thereby, less accountable. Moreover, if money velocity is unstable (as it is frequently the case in the transition countries), the relationship between monetary targeting and inflation remains weak, and thus monetary targeting is not very effective.
has become popular over the past decade, and enjoys the important advantage that the public can directly monitor achievement of an ultimate goal. It makes central banks clearly accountable and helps reduce outside pressures on the conduct of monetary policy. Like monetary aggregate targeting, it preserves flexibility of the exchange rate and thus an automatic mechanism for adjusting to shocks to the domestic economy. Also, velocity shocks become less destabilizing since no fixed relation between money aggregates and price changes is assumed. The main problem is that the central bank does not directly control the movement of prices: there are substantial time lags between policy measures (instrument changes in response to inflation indicators) and their effects on inflation.
2. New Approaches to Monetary Policy
In the last twenty years there have been dramatic changes in consensual approaches to monetary policy. These changes, arising largely from continuing developments in macro- and monetary economics, have led to four policy recommendations:
1. The goal of the central bank should be price and output stability, rather than long-term employment behavior.
2. The central bank should be independent from elected government.
3. Monetary policy should choose explicitly between an inflation target and an exchange rate target.
4. As a corollary of 3, the exchange rate should either be fully flexible or credibly fixed.
These recommendations are in contrast to earlier thinking that central bank independence was not crucial, central banks were expected to pursue vaguely defined mixtures of price, employment and output goals, and countries were encouraged to manage their exchange rates.
The goals of monetary policy were reformulated as a result of the rational expectations revolution and a careful examination of the inflation-unemployment tradeoff. In the 1960s economists believed this tradeoff to be permanent, that a permanent reduction in unemployment could be achieved at the cost of a permanent increase in inflation. However, Edmund Phelps (1970), Robert Lucas (1973) and others argued that the tradeoff is only temporary, that while a permanent increase in the inflation rate does, initially, reduce unemployment, after some time it returns to a normal, or “natural” level. These theoretical developments undermined the belief that monetary policy could affect long-term levels of unemployment. The consensus now is that monetary policy in the long run should be aimed at keeping the inflation rate low, although in the short run it may be used to stablize output and employment.
This change in thinking about the role of central banks was also prompted by the dynamic inconsistency literature, which began with a seminal paper by Finn Kydland and Edward Prescott (1977). They showed that a policymaker whose discretionary power prevents credible commitments has incentives to change its plans over time: it is “dynamically inconsistent”. This framework was applied to monetary policy in two influential papers by Robert Barro and David Gordon (1983a, b) who showed that a central bank whose mandate is to minimize both inflation and unemployment will adopt policies that lead to excessive inflation and have little effect on unemployment.
Strictly speaking, price stabilization means a policy of targeting the price level; by contrast inflation stabilization means targeting the inflation rate. Hence price stability means an inflation rate of zero. However, throughout this paper, I will use the terms price and inflation stability more or less interchangeably.
and central bank independence
Several solutions to the central bank’s dynamic inconsistency problem have been proposed. The first involves delegation of monetary policy to someone who particularly dislikes inflation. Appointing as the head of the central bank a person who cares more about inflation and less about output than the general population leads to lower average inflation, but at the cost of an inferior response to macroeconomic disturbances. Another approach is to establish a reputation for the central bank as an inflation fighter.
Both approaches involve granting the central bank independence from elected representatives. For example New Zealand, in the early 1990s, gave its central bank independence and, moreover, made price stability the only goal of monetary policy. A second example was provided by the newly elected Labour government in Great Britain in 1997. Its first policy decision was to grant the Bank of England independence, abolishing the long-standing practice that the Governor reported to the Chancellor of the Exchequer.
These reforms curtail, or sometimes eliminate, the discretionary power of monetary policy. But while reducing the average rate of inflation, they restrict the central bank’s ability to react to real shocks. However the evidence from developed market economies (e.g., Alberto Alesina, 1988) was that inflation rates were indeed lower in countries with more independent central banks, and that furthermore there were no significant differences in output behavior.
Explicit policy targets
The rational expectations revolution and consequent changes in the mandates of central banks changed the way policy is formulated and communicated. Central bankers traditionally followed a policy of ambiguity: the conduct of monetary policy was only vaguely defined, targets, if any, were implicit and the public was left to guess what actions the central bank might take. This gave the monetary authority insurance against loss of credibility: as the precise goals were not publicly known, the central bank ran no risk of not meeting them. However this approach also made it difficult for the bank to affect expectations and increased the costs of anti-inflationary policies.
Over the last decade, many central banks have switched to explicit targets. In developed countries, the most popular are inflation targets. The central bank commits itself to maintain inflation in a narrow band: for example in Canada, between 1 and 3 percent per year. This target is explicitly announced. There are two reasons for making the goal explicit. First, public knowledge of the goal may have a beneficial effect on inflationary expectations, and so reduce the output and employment costs of disinflationary policy. Second, explicit announcement of the goal makes the central bank accountable. This is particularly important if the central bank has been given independence from the elected government.
Flexible versus fixed exchange rates, revisited
The last decade has seen a rash of currency crises worldwide. They were experienced in several Western European countries in 1992-1993, Mexico in 1994, Southeast Asia in 1997-1998, the Czech Republic in 1997, Russia and Ukraine in 1998, Brazil in 1999, Turkey in 2001 and Argentina in 2002. Recently, economists have begun to distinguish between credibly fixed exchange rate regimes (for example “currency board” systems anchored by large stocks of foreign exchange reserves), and so-called “pegged” rate regimes that are not credibly anchored. Some Western European currency-crisis countries chose to credibly fix within the European Monetary System (now the European Monetary Union), but Britain chose full flexibility. And in the late 1990s, flexible exchange rate regimes replaced the pegged policies in Southeast Asia, Russia and Brazil.
To some extent, pegged rate regimes have become more vulnerable as a result of huge increases in the volume of funds available to speculators in case of currency misalignment. Between 1977 and 1995 the ratio of foreign exchange trading to foreign trade increased from 3.5 to 58 (Felix, 1995). The volume of
foreign exchange trading in 1995 was USD 1.2 trillion, or about USD 280 trillion a year, as compared with an annual volume of foreign trade in goods and services of about USD 4 trillion (Frankel, 1996). It is not surprising that maintaining pegged exchange rates has become much more difficult than in the past. It requires huge amount of foreign exchange reserves that even rich countries (for example Britain in 1992) do not have. A good example of a credibly fixed rate regime that survived speculative attack during the Asian crisis was Hong Kong’s currency board system. The monetary authority of Hong Kong had at its disposal about USD 85 billion in own reserves, plus USD 125 billion as reserves held by the Bank of China. A second example was China’s fixed rate regime, which was also backed by very large reserves, not to mention shielded from speculation by currency controls.
It is important, however, to understand that pegged exchange rates will be attacked by speculators only if fundamental circumstances – for example, high inflation, persistent current account deficits, unreliable capital inflows, or inadequate foreign exchange reserves – dictate devaluation. Moreover, governments are subject to pressure by interested parties – such as exporters and borrowers in foreign currency – and hence, typically, delay devaluation after “fundamentals” deteriorate. It is this delay by governments that provides speculators with the opportunity to bet on ultimate devaluation with the odds in their favor. And the very act of speculation increases the probably of success: that is, devaluation – and often a currency crisis – becomes “self-fulfilling.” The Asian crisis, in particular, demonstrated the futility of pegged exchange rates when fundamental circumstances warrant devaluation.
3. Monetary Policy in Transition Economies
The monetary policies just described may work quite well in countries with developed financial and banking systems, stable national currencies, strong foreign exchange markets and credible policies. However in transition countries, the conduct of monetary policy is more complex. Although they have gradually established monetary instruments and financial markets, transition countries still lack the adequate institutional environment to apply standard monetary policy effectively.
High inflation rates typically characterized the initial stage of transition. Since transition involves both structural and institutional changes, monetary policy is complicated by instruments and markets that malfunction at best and are often completely absent. Moreover, the inflationary process itself is different from that in developed countries. First came price liberalization and substantial adjustment at the beginning of transition. This led to a significant reallocation of resources. The initial decline in real output accompanied by unrelenting budget needs These needs were due to the necessity to perform functions of three governments: (1) a central-planning government -- to own and manage activities of state enterprises; (2) a market-economy government -- to perform policies consistent with a competitive market economy; and (3) a transition government -- to establish new institutions and help adjust old ones to the market’s needs. resulting in accumulating large deficits. These were financed either by excessive external borrowing or internally, via inflationary monetary policy. Hence, the price stability was a primary goal from the outset, and indeed remains so now, even after the initial price stabilization has been achieved.
Central banks were unable to use some of the standard monetary policy tools due to lack of confidence in the creditworthiness of central banks’ operations, a lack of competition among commercial banks, and shallow, underdeveloped government securities markets and commercial credit markets. Indeed even today in countries such as Ukraine, many banks are still operated in the old fashion – they largely depend on the central bank’s support, on preferential credits and on subsidized loans. Consequently, the demand for bank reserves is almost insensitive to changes in interest rates. Central banks typically lack effective instruments to control the monetary base. For example, only in 2001 did the National Bank of Ukraine feel prepared to institute regular open market operations using government securities.
Monetary policy in transition economies struggles with many other difficulties. One of them is de-monetization of the economy. When the banking system does not serve as an efficient financial intermediary, and currency markets are malfunctioning, economic agents seek means to effect transactions. Barter, inter-enterprise arrears, mutual settlements, various money surrogates and other non-monetary means of payment are associated with financing difficulties of transition and become widely used in such economies. Their use entails huge costs - for example transaction costs, lack of transparency and retreat to the shadow economy – and also undermines the central bank’s control over monetary and inflationary processes.
Unstable price, currency and banking environments also result in currency substitution or “dollarization”: circulation of foreign currency in parallel with the national currency. Such substitution undermines the effectiveness and credibility of central bank policy. As a result, standard macroeconomic forecast models and policy evaluation techniques are readily less applicable.
An important precondition for effective monetary policy is independence of the central bank. However in transition economies, the central bank is often not separated from the political process and is frequently subordinated to government’s financing needs. The problem is aggravated by the fact that the very institution of a modern central bank is new for post-Soviet economies. In the Soviet period, only a single “monobank” operated. Other banks were highly dependent on this monobank, which formulated policies, allocated resources, controlled the implementation of these allocations, and enjoyed a monopoly over commercial banking operations. The newly established (or re-constituted) central banks had to practice “learning-by-doing” while formulating their tasks and arranging their activities.
4. Monetary Policy in Canada
A brief history
The Bank of Canada Act states that the Bank is responsible for both monetary and output stability. The weights of these two often-conflicting goals of policy have never been made explicit and their determination has been left to the Bank.
In the 1960s Canada was on a fixed exchange rate regime, with the Canadian dollar pegged at USD 0.925. The operating procedure was to adjust short-term interest rates to control capital flows. This policy ultimately proved inflationary as the Bank of Canada paid little attention to monetary growth. When US monetary policy became expansionary during the latter part of the decade, the Bank of Canada, under its fixed rate regime, was forced to follow suit.
The fixed rate regime was abandoned in 1970 in response to massive inflows of capital. The inflows, combined with lower inflation in Canada than in the US, led to a significant appreciation of the Canadian dollar. But initially, the Bank of Canada continued to suppress upward pressure on interest rates in order to assure smooth functioning of the bond market. Less attention was paid to monetary growth and inflation. Monetary aggregates increased at double-digit rates in 1971-1973 and as a result the inflation rate exploded, reaching double-digit levels in 1974. These developments led to a change in monetary policy in 1975: the Bank of Canada began targeting the rate of growth of narrowly defined money, M1. The goal was flexible, with the growth rate of M1 initially to be kept in a “cone”, which was then to be followed by a band. The target monetary growth rate was to decrease over time. In the end the gradualist policy failed. The main reason was instability of money demand. Financial innovations allowed substitution from M1 to M2, and even as the rate of growth of M1 fell, the rate of growth of M2 continued at double-digit rates. After falling initially, the inflation rate rebounded to levels above 10 percent in 1980 and 1981.
In 1981 the Bank of Canada switched to active anti-inflationary policy. Interest rates were raised significantly, triggering a deep recession. However the inflation rate fell rapidly. Following the recession the Bank adopted a multifaceted approach to monetary policy, paying attention both to monetary aggregates as primary targets and the exchange rate as a secondary target. The overriding goal was to maintain inflation at low levels. This policy was successful, despite large federal budget deficits. The inflation rate remained in a narrow range of 3 to 5 percent for the remainder of 1980s.
At the end of 1980s, however, inflationary pressures began to build up. The economy was booming, and introduction of the Goods and Services Tax (GST) was expected to cause a 1-2 percent increase in the price level. In part because of these pressures and in part due to his strong preference for low inflation, John Crow, the newly appointed Governor of the Bank of Canada, embarked on a program of
Interest rates were raised substantially, and the Canadian dollar appreciated significantly. The combined effect of these changes caused a sharp drop in aggregate demand and a recession.
The recession while not as deep as the one in early 1980s, lasted much longer since before it was over the federal government started a rapid deficit reduction program.
As a result the inflation rate declined rapidly, falling below 2 percent by 1992.
Changes at the Bank of Canada
Changes in the goals and practice of the Bank of Canada began during the tenure of John Crow. Price stability was promoted to almost the only goal of monetary policy. Efforts to stablize unemployment and output almost ceased, being regarded as inappropriate goals. The thinking was that, by assuring stable prices, the Bank would create predictable economic conditions that would foster economic growth. While during the tenures of Crow’s successors, Gordon Thiessen and now David Dodge, the Bank appears to be more concerned with short-term performance, it is clear that price stability remains its main goal.
The Bank of Canada was one of the first central banks in the world to introduce inflation targets. They were adopted in 1991, initially as a declining band and, subsequently, as a fixed band with inflation boundaries of between 1per cent and 3 percent per year. The targets were very successful. For almost the entire period 1991-2001 inflation remained within the band. (In 1994 it fell below 1 percent due to a reduction in cigarette taxes). These targets have been an important factor in maintaining both low inflationary expectations and a low inflation rate in Canada.
Since 1971 Canada has had flexible exchange rates. The official policy of the Bank of Canada is to leave exchange rates to be determined in the market and intervene only in cases of rapid changes (both depreciation and appreciation), to prevent too rapid movements, but not to affect the eventual value. While some economists argue that the Bank is following an implicit exchange rate target, evidence does not support it: between 1991 and 1998 the Bank allowed the currency to depreciate by almost 30 percent against the US dollar, while the level of international reserves was relatively stable.
During the last thirty years, there have been no significant changes in the legal status of the Bank. The Bank of Canada Act requires that the Governor consult regularly with the Minister of Finance, but it is the Bank that makes the decisions about monetary policy. The Governor is appointed for seven years, i.e. for longer than the government’s term in office. The only limitation on the Bank’s independence is the so-called Directive. In the case of a significant disagreement, the Finance Minister has the right to issue instructions (the Directive) to the Bank that the Governor must implement. It is understood that the Governor would then resign. This limitation leads many researchers to conclude that the independence of Canada’s central bank is significantly restricted (for example, Alesina, 1988), but opinions are divided. The Directive, though introduced over thirty years ago, has never been used. One interpretation is that successive governors have simply avoided any policies unacceptable to the Department of Finance. Another interpretation, however, stresses that high potential political and economic costs (for example significant damage to the Bank’s credibility) have deterred use of the Directive, even in the cases of substantial disagreement. It must be officially announced and it forces the Governor to resign. The political cost of such action, together with the economic cost of undermining independence of the Bank may have prevented successive Finance Ministers from using it even in cases of significant disagreement.
In short, the degree of independence of the Bank of Canada is not clear. It appears to have a substantial degree of freedom in setting monetary policy, although in recent years the influence of the government may have increased. There was clearly a fundamental disagreement between John Crow, who wanted a further decrease in inflation, and the new Liberal government elected in 1993.
as a result, John Crow was replaced with his deputy, Gordon Thiessen. In 2001 the government appointed another new Governor, David Dodge, who was once a Deputy Minister of Finance. While he has reputation for being independent-minded, it is not yet clear what effect this will have on cooperation between the Bank and the Minister of Finance in the setting of monetary policy over the coming years.
To summarize, over the last 10 years Canadian monetary policy has evolved to follow all four of the “new approaches” listed in Section 2 above. Price stability has become the main goal. There have been no significant changes in the Bank’s independence. Explicit targets have been used successfully. Foreign exchange intervention has been minimal. Due to low inflation expectations, Canadian interest rates fell and have tended to be lower than US rates. This policy has been successful in creating stable conditions for Canadian companies, including both domestic and foreign investors.
5. Monetary Policy with a Dominant Trading Partner
Canada is unique among developed countries and, indeed, among most countries, in terms of its dependence on a single trading partner. No large developed country comes even close to the degree of economic integration between Canada and the US.
However some smaller economies and certain developing countries – notably Mexico – are comparably dependent on a single partner.
The share of Canadian exports to the US is now over 85 percent. Other developed economies that export large shares to a single country are Japan (about 30 percent of exports to the US), followed by Austria, the Netherlands, and Switzerland, each of which ships about 25 percent of its exports to Germany. In terms of export-to-GDP ratios, Canadian exports to the US (about 30 percent) are about twice as high as Irish exports to the UK, Dutch exports to Germany and Belgian exports to Germany. The picture changes somewhat when exports to trading blocks are considered. Whereas Canadian exports to its NAFTA partners were just over 30 percent of GDP, Irish, Belgian and Dutch exports to EU were about 50, 40 and 35 percent of GDP, respectively. During recent years, Canadian trade with NAFTA partners has increased rapidly. Furthermore, the share of re-exports in total exports is much higher in Ireland, the Netherlands and Belgium than in Canada.
The integration of the Canadian and US economies is often compared with that of the Dutch and German economies. But it is important to note that monetary arrangements in Canada and the Netherlands are quite different. Since 1970, Canada has followed a flexible exchange rate regime with only occasional interventions, and since then monetary policy in Canada has been relatively independent from the U.S. By contrast, since the 1970s, the Netherlands had an effectively fixed exchange rate against the German mark, with the band for the Dutch guilder around the German mark narrower than for other countries. Effectively, the Dutch central bank abrogated its monetary policy in order to reduce foreign exchange fluctuations.
There are two complementary explanations of these different approaches. The first is the bigger structural differences between the Canadian and the US economies than between the Dutch and the German economies. The second is that rates of inflation were, historically, more similar between the Netherlands and Germany than between Canada and the US.
The structure of economies is an important determinant of so-called
optimal currency areas
(Mundell, 1961). The Dutch economy is quite similar to the German economy. On the other hand, the Canadian economy is much more resource based than the US economy. About 30 percent of Canadian labor is employed, directly or indirectly, by natural resource oriented industries, while the corresponding figure for the US is less than 10 percent.
As resource prices are very volatile, a country that is a significant resource exporter benefits from adopting flexible exchange rates. A change in resource prices means a change in export prices relative to import prices (the “terms of trade”) and hence in the so-called real exchange rate. Under a flexible exchange rate regime the nominal exchange rate adjusts, cushioning the economy from the shock. For example, a decrease in the price of exported resources lowers their relative price. Under a flexible rate regime, the currency depreciates, reducing foreign currency prices of other exports and thus increasing foreign demand. As a result, the drop in output of resource industries is offset by the increase in output of non-resource exporting industries. This mechanism does not operate under a fixed exchange rate regime.
Implications for Ukraine
Under a fixed exchange rate regime, domestic inflation is determined by the inflation rate of the dominant partner. In case of Ukraine the dominant trading partner is Russia. Russia is a resource-based economy, with the bulk of its exports being oil, gas and energy products. An increase in the price of energy would appreciate the Russian ruble relative to other currencies. If the exchange rate between the hryvnia and ruble were fixed, the hryvnia would follow the ruble and also appreciate relative to other currencies. Under a flexible exchange regime, the hryvnia would depreciate relative to the ruble (and possibly relative to other currencies), increasing exports and offsetting the negative effect of higher prices of imported energy.
The inflation rate in Russia has been unstable in recent years. Moreover, Russia’s dependence on natural resource exports remains very high. As long as Russia does not restructure its economy toward a more diversified export mix, its trade balance and hence its currency will remain potentially unstable. Both because of potentially unstable inflation and a potentially unstable exchange rate, the Russian ruble is not a good currency to rely on. Attachment of the hryvnia to the ruble would import this potential instability into Ukraine.
If, for various reasons, a pegged exchange rate would be preferable to the current arrangement, it would be more beneficial to fix the rate with the euro (or even the Polish zloty (since the latter will soon be significantly attached to the euro). The euro zone is an important trading partner, and enjoys low inflation.
6. Polish Monetary Policy
Poland is an example of a transition economy that began the 1990s with severe macroeconomic problems, and managed to tackle these problems relatively successfully over the next decade. By mid-1989, galloping inflation in Poland had escalated to hyperinflation, after liberalization of agricultural and other retail prices. Month-to-month inflation exceeded 40 percent. Pressures to print money were exacerbated by subsidies to food production and to state enterprises that increased the government budget deficit to 8 percent of GDP. Adding to the strain on the budget, not to mention foreign exchange reserves, was the putative need to service foreign debt that in convertible currencies had exceeded USD 41 billion.
This pressure was alleviated by a major Paris Club debt reduction of bilateral government-to-government debt in 1991, followed by a London Club reduction of commercial bank debt in 1994-95.
Early monetary regimes
From the beginning of the transition period, the over-riding goal of the National Bank of Poland (NBP) has been to reduce the inflation rate, and then stabilize it at single-digit levels. To achieve this goal, the NBP targeted broad monetary growth from 1993–1995, and growth in the monetary base from 1996–1997. But at the outset, its primary target was the exchange rate. For this purpose, a stabilization fund of up to USD1 billion was set up at the end of January 1990 from contributions by 10 countries. The exchange rate was fixed at 9500 zloty (PLZ) to the US dollar (USD), and then devalued in May 1991 by 11 percent, to 11,103 PLZ/USD. At this point it was pegged to a basket of five convertible currencies, with a 45 percent share for the USD.
In October 1991 the peg was modified to a crawling peg, with the rate of crawl set by the NBP and the Ministry of Finance. On top of this crawl, the zloty was devalued stepwise in February 1992 to about 13,300 PLZ/USD. In May 1995, in the wake of rapid capital inflows and the consequent need to gain control over monetary growth, the crawling peg regime was replaced by a more flexible target zone arrangement.
Central bank independence
From 1990 – 1994, the need to finance the budget deficit limited the NBP’s independence from the Ministry of Finance. The government was forced to rely on monetary financing of the deficit because the Polish capital market was as yet underdeveloped. Hence the legal ceiling on central bank credit to the government (3 percent of GDP) was suspended by Act of Parliament. However by 1995, domestic capital markets, funded in part by foreign portfolio inflows, were sufficient to alleviate significant deficit pressures on monetary expansion, and the NBP largely regained its independence.
Early instruments of monetary control
In the early 1990s, the NBP was forced to rely on credit ceilings to control money-creation, since there was no money market (real interest rates were negative), and excess reserves were highly unpredictable due to an efficient inter-bank payments system. However the NBP did manage to mop up considerable excess liquidity by introducing “National Bank” bills, which were, in turn, replaced in 1991 by Treasury bills. In addition, refinancing policy was tightened, interest rates were increased to positive real values, and reserve requirements were hiked to the maximum legal limit of 30 percent. An interest rate term structure began to emerge, and credit ceilings were lifted at the end of 1992.
Since 1993, open market operations – repos, reverse repos, and outright bond and bill sales - have been the main instrument of monetary control. This is supplemented by bank reserve requirements, the use of which became feasible after the payments and inter-bank settlement systems were reformed in 1993.
By 1994, capital inflows were substantial and increases in foreign exchange reserves had become a sufficient problem for monetary control that sterilization operations were introduced. These were effective but very expensive, a measure of the cost being the difference between yields on domestic government bonds and the (much lower) yield on foreign exchange reserves.
Later monetary regimes
In 1997, the NBP announced a policy of targeting the monetary base. In 1998, it switched to targeting interest rates. This latter policy could have compromised its ultimate goal of reducing inflation, since it risked losing control of the money supply. But although interest rates
The target was the spread between the one-month Warsaw Interbank Offer Rate (WIBOR) and the Lombard rate.
were the operating target, broad money was the intermediate target. Achievement of monetary targets was facilitated by a wide exchange rate band of plus or minus 12 percent); thus monetary discipline remained an overriding objective. In fact the rationale for interest rate targeting was not to stimulate borrowing but the reverse: the economy’s sharp recovery had led to a rapid expansion of credit demand that could only be monitored and controlled via interest rate hikes. This period is best characterized as discretionary rather than rule-based monetary policy.
In 1998, the newly formed Monetary Policy Council published a strategy paper covering monetary policy from 1999 – 2003 Medium Term Strategy of Monetary Policy (1999 – 2003), Monetary Policy Council, Warsaw, 1998. . This paper coincides not only with the office term of the first Council but also with Poland’s preparations for accession to the European Union (EU) and, ultimately, European Monetary Union (EMU). The strategy paper reaffirms the NBP’s goal of reducing inflation, and adds the additional goal of fostering modern financial markets.
Joining EMU will require that the zloty be pegged to the euro within a plus or minus 15 per cent band for at least two years, and that the inflation rate must be reduced to the not more than 3 – 4 percent. The Monetary Policy Council undertook several decisions to implement these goals:
- The monetary base as an operating target for monetary control was replaced by short term interest rates. Open market operations remain the primary instrument of control.
- Crawling devaluation of the zloty was abandoned.
- The zloty was then allowed to float with a wide band.
- Finally, in April 2001, the zloty was allowed to float freely.
- The free-float was combined with direct inflation rate targeting.
The strategy of direct inflation targeting implies abandoning intermediate targets such as the money supply. The NBP’s announced goal is to reduce inflation below 4 percent by 2003. This disinflationary strategy may well put painful pressure on the non-tradable sector; but in the absence of modified “Maastricht” conditions for joining EMU, it is likely to be implemented. Lower and more stable inflation will, in turn, ease the job of stabilizing fluctuations of the zloty against the euro, whereas the free float will help to establish an equilibrium rate appropriate for the ultimate conversion to the euro. All this is to be complemented by fiscal discipline so as to minimize pressures for inflationary finance and maintain the NBP’s independence.
Broadly, Poland’s monetary strategy since 1990 has been successful in achieving its primary goal of disinflation. Moreover, disinflation has been achieved without paying a high long-term price in terms of lost output: although output contracted in 1990-1991, Poland’s real growth since then has been remarkable. Poland’s real GDP growth was the highest in Central Europe, reaching 7,5 percent in 1995–1997. In subsequent years Poland lost its leading position. Currently real growth is down to 1,0 – 1,5 percent . Nevertheless the strategy encountered several challenges along the way, and in retrospect might have been improved upon.
A common criticism is that disinflation was too slow. Indeed, inflation according to the consumer price index, which was 249 percent in 1990, and reduced to 60 percent in 1991, was still 30 percent by 1995 (but by early 2002 stood at 3.5 percent). The records of the Baltic states were better: they quickly brought inflation down to single digit levels. The common feature of their policies is that monetary policy was anchored to strict exchange rate stabilization.
By contrast, Poland’s exchange rate stabilization was compromised, until 1995, by a policy of crawling over-devaluation, the rationale for which was
to stimulate export demand as well as encourage capital inflows. Indeed the policy so successful in this respect that foreign exchange reserves put severe pressure on the money supply, necessitating sterilization measures in 1995 that came with high quasi-fiscal costs.
Monetary control was also compromised in the early years by pressures for inflationary finance stemming from large budget deficits. And finally, intermediate targets may have been inconsistent, shifting as they did between domestic credit, the monetary base, monetary aggregates and interest rates.
Nevertheless the broad strategy worked: an over-riding goal of disinflation, accomplished initially by exchange rate stabilization, followed by ever-wider exchange rate bands, and culminating with a free float and direct inflation targeting. Likewise, strategies for monetary control worked, in particular the early introduction of a Treasury bill market, which allowed open market operations to begin by 1991-1992. The challenge now is to reduce inflation to 4 percent or below by 2003 in order to satisfy pre-conditions for EMU and ultimate adoption of the euro.
7. Ukrainian Monetary Policy
After the Soviet Union collapsed in 1991, Ukraine, like other countries in the initial stages of transition, faced high inflationary pressures. Despite partial price control, particularly for food, consumer prices rose by 250 percent between December 1992 and January 1993. Wholesale prices, which were less regulated, rose 740 percent. Since prices were liberalized even more rapidly in Russia, Ukraine faced a problem of export arbitrage. Hence in August 1991, to help retain goods for domestic consumption, Ukraine partially removed itself from the ruble zone by introducing a quasi-currency called “coupons”. Since coupons, unlike rubles, were issued domestically, Ukraine was able for the first time to obtain seigniorage. However domestic currency issuance also fuelled inflation.
Karbovanets and deficits
In November 1992, Ukraine left the ruble zone and introduced “karbovanets”. Although this new currency was issued exclusively by the newly constituted National Bank of Ukraine (NBU), the Bank was by no means independent of parliament, the Verkhovna Rada. As a result, in 1992 – 1994, the NBU directly financed Ukraine’s consolidated budget deficits. The budget included not only national government expenditures but also direct subsidization of state-owned enterprises. Moreover the NBU financed state-owned enterprises, as well as the agricultural sector, both directly and via the former state banks.
Money and interest rates
In 1992, the NBU increased its refinancing or discount rate from 30 percent to 80 percent, and inflation ran at 2100 percent year to year. Highly negative real interest rates led to heavy borrowing: in 1992 and 1993, commercial bank credits to enterprises were 54 percent and 27 percent of GDP respectively, and NBU credits to the government were 36 percent and 9 percent of GDP respectively. In 1993, the money supply increased by almost 3000 percent, and year-to-year inflation exceeded 10,000 percent.
1994: anti-inflationary policy begins
The adoption of a “Program of Economic Reforms” in late 1994, which included price and trade reforms as well as accelerated privatization and encouragement of private enterprises, also signalled the beginning of stricter monetary and fiscal policies. In August the discount rate was set at 140 percent, positive in real terms. The nominal value of bank deposits increased seven-fold over their 1993 level, against a five-fold increase in the price level.
1995: first auctions of OVDPs; budget no longer money-financed
By 1995, with both inflation and interest rates declining, domestic confidence in the reform program was sufficient that the government was able for the first time to finance budget deficits by selling Treasury bills or “OVDPs”. Funds raised in 1995 were a modest UAH 304 million, but by 1996, OVDP auctions were contributing UAH 3063 million to the budget, and in the following year revenues peaked, at UAH 8322 million. Correspondingly, with budget financing no longer dependent on printing money, M2 growth decreased to 112 percent (from 567 percent in 1994), and the inflation rate decreased to 180 percent (from 400 percent in 1994).
1996: introduction of the hryvnia; OVDPs and “crowding out”
Successful introduction of a new currency, the hryvnia, in September 1996, reduced pressure on the NBU and the commercial banks for direct lending. However the latter were generally cautious about lending to the nascent and risky private sector, preferring to hold Treasury bills: in 1996, banks bought three times the value of OVDPs as they lent to enterprises. In short, private-sector finance was largely “crowded out” by public spending.
1997, first half: capital inflows
By 1997, non-residents were buying substantial volumes of OVDPs. These capital inflows led to substantial upward pressure on the hryvnia, which in turn reduced the competitiveness of Ukrainian exports. The NBU then introduced a target exchange rate band of UAH 1.7 – 1.9 per USD. By then end of 1997, foreign exchange reserves had risen to USD 2.3 million, up from USD 1.0 million at the beginning of 1996. Inflation declined to just 10 percent for the first half of the year, and allowing the NBU to lower the discount rate from 40 percent to 16 percent. Over the first half of the year, OVDPs sold briskly to non-residents: even with 22 percent nominal rates, they were yielding more in real terms than Russian GKOs, and less than 20 percent of the total issues were purchased by the NBU.
1997, second half – 1998: capital outflows
The second half of 1997 did not go so well. The Economic Reforms Program was stalled, and it became clear that much credit had been inefficiently allocated. The East Asian financial crisis triggered capital outflows. To defend the hryvnia, the NBU spent foreign exchange reserves and raised interest rates. After the Russian ruble crisis in August 1998 capital outflows accelerated. By October 1998, the exchange rate had stabilized at 3.4 UAH/USD, within a revised target band of 2.5 – 3.5 but this cost the country most of its foreign exchange: by the end of 1998, reserves had declined to USD 760 million. Stabilization came with other costs: the discount rate was hiked to as high as 80 percent, stifling real growth. To finance the government deficit without re-igniting inflation, bank reserves were increased with an OVDP requirement added; nevertheless, the NBU was forced to purchase almost two-thirds of primary OVDP issues. Eventually, OVDPs were restructured, with non-residents offered conversion to two year bills with 20 percent yields, and bank and other non-resident holders required to convert to longer term bills.
1999 – 2000
May 1999 saw passage of landmark legislation: the Law “On the National Bank of Ukraine”, which regulates the relationship between the NBU on the one hand, and the President, Parliament and Council of Ministers, on the other. One of its main features is to prohibit direct financing of the budget deficit. 1999 also saw some easing of monetary policy, and by 2000 recovery was underway, although growth slowed in late 2000 due to a political crises. Net credits to central government stopped growing for the first time since independence, reflecting diminished pressure to repay foreign debt (due to a successful rescheduling) and an improvement in tax collection. The Treasury bill market began to recover from its collapse in 1998. The broad money supply grew by 33 percent in 2000.
2001 - 2002
In early 2001, the NBU instituted open market operations, as well as refinancing against T-bill collateral – so called “repo” facilities. The practice of direct lending was stopped, and banks were refinanced via NBU auctions and the repo facility. The discount rate fell to new lows of 12.5 percent in 2001 and 10 percent in April 2002. In late 2001, bank reserve requirements were lowered to 6-14 percent, depending on the type of deposits, and have since been lowered further. This improvement in and easing of monetary policy led at last to growing credit to the private sector. Real GDP growth, which had been a healthy 6 percent in 2000, rose to 9 percent in 2001. Despite 42 percent growth in broad money, inflation fell to just 6per cent since the demand for money rose due to real growth, increased financial intermediation and reduced barter.
Since the second half of 2001, export surpluses and capital inflows have put upward pressure on the hryvnia. The NBU’s policy has been to limit appreciation by purchasing foreign exchange, with the result that reserves have accumulated rapidly, reaching USD 3 billion by the end of 2001. The NBU’s priorities in 2002 include inflation targeting, stimulating real growth and maintaining a stable real exchange rate. The nominal exchange rate is expected to average UAH 5.6 per USD over the year.
These priorities may prove to be incompatible with each other. Stabilizing the nominal exchange rate will involve continued foreign exchange purchases and monetary creation, which will be inflationary. Sterilization of monetary growth might be possible for a limited period via open market sales of government securities, but at the cost of higher interest rates and a hence damper on real growth. Moreover higher interest rates would have a quasi-fiscal cost, and also could potentially accelerate the inflow of portfolio capital, with further inflationary consequences. Ukraine has a breathing space from this latter problem for the moment, since portfolio capital inflows are inconsequential. Nevertheless in the judgement of this writer, the NBU should resolve this incompatibility of targets and goals by allowing the hryvnia to appreciate.
8. Lessons for Ukraine from Poland
After 1995, Ukraine’s success at stabilizing inflation was somewhat more rapid than Poland’s. However for a variety of reasons, output growth (until 2001) was much slower, as was the country’s ability to attract foreign direct and portfolio investment. Strong foreign portfolio investment was of great help to Poland’s fostering of its Treasury bill market. However the foreign market for Ukraine’s Treasury bills dried up after the crises of 1997-1998, which culminated in involuntary lengthening of maturities for some holders. The continued absence of a non-bank market for Treasury bills, either foreign or domestic, remains an impediment to monetary control in Ukraine. But the more serious consequence is that credit to the private sector is crowded out. As long as Ukrainian banks are able to survive substantially on income from Treasury bills, their incentives to seek private borrowers will be blunted.
Ukraine would do well to consider the long-term sequence of monetary policy goals that has been pursued by Poland with some success, albeit with short-term deviations and setbacks. Initial stabilization was pursued by targeting an exchange rate crawl and then the rate itself within ever-widening bands, much as Ukraine has done since the mid-1990s. This was gradually replaced by an anti-inflationary policy that first targeted the broad money supply, then the monetary base and now inflation directly, with full flexibility given to the exchange rate. Such a sequence of targets is appropriate for transition economies: exchange rate targeting to bring inflation down to single-digit levels, then monetary targeting as control instruments such as open market operations become available, and finally inflation targeting as data and forecasting become more sophisticated. See Krzak and Ettls (1999) on the pros and cons of inflation targeting for Central European countries. The advantage of the latter is that it can be combined with a fully flexible exchange rate, which provides an important shock absorber against volatile capital flows. Of course Ukraine has not yet reached the stage of transition when capital flows are large enough in volume that overshooting of inflows and outflows poses a problem, but it probably will soon.
Finally, Ukraine should re-consider its current exchange rate policy, which is, of course, simply one aspect of its monetary policy. The present policy of limiting appreciation in order to stimulate exports, encourage capital inflows and accumulate foreign exchange reserves is somewhat reminiscent of Poland’s policy of “over-devaluation” in the early 1990s. A necessary by-product of such an exchange rate policy is rapid monetary growth, roughly at the rate that reserves accumulate. In 2001–2002 rapid monetary growth in Ukraine was accompanied by high real growth, but to the extent that monetary growth exceeds real growth, inflation is inevitable. Sterilization of monetary growth would prove even more expensive in Ukraine than it did in Poland in 1995, since the non-bank market for government securities is so thin. Ukraine would do well to retreat from its recent policy of intervention to limit appreciation of the hryvnia, and move toward a fully flexible rate with inflation targeting.
In the longer run, once transition-related shocks to the current and capital accounts become less problematic, Ukraine, like Poland, will probably want to harden its exchange rate against the euro, especially once EU and EMU membership become options. A fix against the ruble would not be wise, for reasons discussed in Section 5.
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