monetary policy challenges under high euroization
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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
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