Monetary, Credit and Exchange rate Policies in the Czech Republic

Josef Tosovsky (*)


INSTITUTIONAL FRAMEWORK

In the former Czechoslovakia a two-tier banking system was introduced only at the beginning of 1990, later on compared to Hungary and Poland. As in other emerging market economies (EMEs), this departure from the mono-bank system initiated a dramatic increase in bank and non-bank financial intermediaries. From only 7 commercial and savings banks operating in the former Czechoslovakia in January 1990, numbers have steadily grown, amounting to 58 licensed banks in the Czech Republic alone at the end of 1994. More than 2/3 of them were banks with foreign capital participation, either partly or wholly foreign owned, including subsidiaries and branches of foreign banks. Most operating banks acquired the form of joint-stock companies.

While all existing banks were state-owned at the beginning of 1990, at the end of 1994 there was only one bank in the Czech Republic, Consolidation Bank, entirely state-owned, apart from the Central Bank (1). However, via the shares held by the National Property Fund the state has retained a significant stake (about 40%) in most "old" banks privatised through a voucher scheme. Though controversial in theory, this concept of "partial" privatisation proved justified in the existing conditions. Given the large share of inherited bad loans in portfolios of major banks and only limited reserves and loan-loss provisions they possessed at the start of transition, the state's stake provided them a temporary "umbrella". At the same time, this arrangement made possible for monetary authorities to exercise, if necessary, a "window" guidance in already liberalised, but still underdeveloped and imperfect money markets.

The adopted legal framework, in particular the Act on Banks (No 21/1992) provided for a universal type of banking, integrating both commercial and investment banking activities. Accordingly, most banks were established as universal banks. Those banks are entitled to acquire shares and stakes up to 10% of the capital of a non-banking institution. The total volume of a bank's stakes in non-banking firms should not, however, exceed 25% of its own capital and reserves. Along with universal banks, a number of specialised institutions also started their activities, including Czech-Moravian Guarantee and Development Bank targeted to promote new small and medium firms, savings banks for housing construction as well as banks dealing in mortgages.

The principal goal of the central bank, the Czech National Bank (CNB), is to secure internal and external stability of the currency. In pursuit of this goal CNB enjoys a high degree of constitutional independence from the state's executive authorities. CNB has full discretion on monetary and credit policies and on their instruments and it is not expected to take any instructions from the Government. The financial flows of CNB are separated by a transparent dividing line from those of budgetary and fiscal spheres. CNB is only entitled to grant short-term credits to the Government to settle temporary fluctuations in its finance, but only up to the limit of 5% of the Government's previous year's revenues.

Within a relatively short time span of a few transition years interbank money and foreign exchange markets were established and their standard activities and instruments gradually introduced and made operative. Capital markets and non-bank financial intermediation have had to be developed, unlike credit markets, practically from scratch. There was virtually no institutional and legal basis for their emergence at the start of transition. They have got, however, an important impetus due to voucher scheme privatisation. Investment privatisation funds emerged spontaneously from the "bottom up" and developed into investment funds and investment companies, i.e. into a form of institutional investors. The Prague Stock Exchange was founded (in fact re-established after 55 years) in July 1992 and opened for regular business in April 1993.

Though a satisfactorily functioning commercial banking system must inevitably be the core of any financial system in the conditions of a transition economy, the policies towards catching-up in the activities and in the role of non-bank financial institutions, including capital markets, have been of increasing importance.


MONETARY AND CREDIT POLICY

The scenario of economic reform in 1990 called for a restrictive stance in monetary and credit policies as an integral part of the macroeconomic stabilisation and liberalisation package. The aim was to restore and maintain price and monetary stability while implementing a sweeping price, foreign trade and foreign exchange liberalisation while profound institutional and systemic changes began to materialise. With the benefit of hindsight it can be claimed that the adopted policies succeeded in securing the mentioned aims.

The highly restrictive stance set for 1990 and in particular for the first half of 1991 could be relaxed already in the second half of 1991. The policies from 1992 onwards shifted in principle to "neutral" character and, in the course of time, they could increasingly support economic recovery and the turnaround to positive growth rates. It is obvious, however, that the central bank had to flexibly react to the emerging destabilizing factors, to the changed expectations and shocks and to calibrate its policies accordingly. The tightening of the policies became urgent particularly when the dissolution of the former Czechoslovakia was to take place and when, as a follow-up, the common currency was also split. The main challenge to maintaining monetary stability and managing the money supply at the present stage comes, on the other hand, from massive capital inflows developing especially since the second half of 1994.

To establish a policy guidance, the central bank resorted to monetary targeting, using in particular the money supply expressed in the terms of M2 as an intermediary target. The derivation of such monetary targets was not, however, clear-cut and unambiguous in the conditions of a transforming economy. An entire overhaul of the institutional setting, including transmis-sion mechanism of monetary policy, has been under way.

As a result, the relationship of monetary aggregates could not be so stabilised and credible enough as required for monetary targeting. Nevertheless, the approach proved feasible and rewarding in reality, despite the mentioned constraints. Some occasional divergences notwithstanding, the overall trend of monetary developments in the first transition period appeared remarkably consistent with the central bank intentions.

Along with monetary targets the central bank also adopted an exchange rate objective. In implementing this policy stance, the nominal exchange rate of the Czech koruna has been maintained stable with respect to the currency basket since the beginning of 1991, which is an unique development and achievement among transition economies.

The exchange rate objective was conceived as complementary to the monetary target, not as its alternative. This type of arrangement could be made smoothly workable in the conditions when domestic monetary developments were still relatively independent from the outside environment and external flows affected money supply only to a minor degree. However, the recent dramatically increased role of net foreign assets in the generation of the money supply and the enhanced monetary and financial openness of the Czech economy make such a "dual target" solution much more demanding and less viable in future.

While the type of intermediary monetary target, M2, has remained unchanged since the start of transition, the ways of its implementation as well as the monetary policy instruments applied were continuously adapted and up-graded in accordance with advances in the institutional framework and macroeconomic environment.

In this respect two different periods can be identified. In the first phase of transition, since 1990 to the second half of 1992, monetary authorities made use of credit volume's and interest rates ceilings to secure implementation of monetary policy targets and to prevent unwarranted soaring of interest rates in the still rather imperfectly competitive conditions of domestic money markets. Those direct forms of regulation were phased out in the course of 1992 and increasingly substituted by standard market instruments, including discount rate and lombard rate policies, minimum reserve requirements, refinancing credits, open market operations, open foreign exchange positions. Drawing on those instruments the central bank developed its policies to meet operational targets in terms of monetary base control and, later on, control of free reserves of banking institutions.

Though the identified developments made our situation comparable to standard market economies in technical terms, we still have to cope with a number of barriers constraining the implementation of monetary policy and enhancing the quality of financial intermediation. Those constraints were reflected in a persistently wider gap between lending and borrowing rates compared to developed market economies, in higher costs of financial intermediation of domestic versus foreign institutions, in a still unsatisfactory controllability of the interest rate's developments as central bank rates, money market rates and clients rates continued to develop in a rather "independent" way.


EXCHANGE RATE POLICY

At the start of transition the fixed exchange rate regime was adopted in the former Czechoslovakia to play the role of a nominal anchor of the stabilisation process, generating disciplining and anti-inflationary effects and stabilising both current developments as well as expectations. Given the entire "shake up" of cost, profitability and price ratios after sweeping price and foreign exchange liberalisation, the stable nominal exchange rate was expected to provide a fixed point in an environment of general "chaos", a benchmark for evolving price adjustment.

The Czechoslovak koruna (CSK) was pegged to a currency basket since the early 1980s. However, this peg has become really effective and binding only with the start of transition. After corrective devaluations effected in 1990, the peg has remained virtually untouched in the course of the entire transition period up to now (2). It implies that since January 1991 the nominal exchange rate of the Czechoslovak koruna and later on the Czech koruna has been kept constant with respect to the basket (within a narrow band of 0.5% ), reflecting only the changes in the cross-rates of basket currencies.

An important corollary to the adoption of the fixed exchange rate regime at the very start of transition was the decision to move simultaneously to a limited (internal) currency convertibility for most current account items. To make their parallel existence sustainable and credible, the initial devaluation had to be higher and the stance of macroeconomic policies more restrictive than otherwise might seem justified in the relatively stabilised macroeconomic situation of the Czechoslovak economy. Given the degree of existing uncertainty and discontinuities, the choice of the "entry" parity could not be a clear-cut and non-controversial decision. The discussed values ranged from 16 to 35 CSK to 1 USD. In the circumstances, we thought it would be preferable if to err, then rather in an overshot undervaluation than the other way round. As a result, the option finally adopted was 28 CSK per USD, i.e. closer to then existing parallel market rates. Nevertheless, with the benefit of hindsight it can be claimed that the exchange rate level chosen proved to be justified in the medium run, however its depreciation could appear overshot initially. The resulting gap between the current exchange rate and PPP rate made possible for the adjustment process to materialise via continued real exchange rate appreciation, while keeping the nominal exchange rate untouched.

The calculations of a real effective exchange rate indicate a gradual, but persistent real appreciation of the Czech koruna in transition years. Between January 1990 and December 1994 the real effective exchange rate based on CPI appreciated by 20.4%, and that based on PPI by 19.5%. It follows, the extent of real exchange rate appreciation since the start of transition already significantly outweighed the competitive edge gained through initial devaluations. In accordance with the standard reasoning it implied a corresponding loss in relative competitiveness compared to the base period.

The institutional and economic environment for the exchange rate regime and policies has also been undergoing important changes. In the first transition period, dominated by macroeconomic stabilisation, the financial infrastructure and financial markets were only in their infancy. The degree of foreign exchange liberalisation and the form of introduced currency convertibility could be only partial. Since then, however, the liberalisation process has kept momentum, being extended also to capital account flows. Related to extensive microeconomic restruc-turing and financial markets' developments, capital flows diversified and gained in importance. As a result, the degree of financial openness of the Czech economy significantly advanced, not only current account's but also capital account's fundamentals increasingly matter. Those processes found their reflection in the new Foreign Exchange Act which is to enter into force in the second half of 1995 and, in accordance with its clauses, the country is heading to meet the require-ments of current account convertibility in accordance with Article VIII of the Agreements on the IMF.

At the present stage of our development diverging pressures on exchange rate have been evolving. On the one hand, massive capital inflows and the resulting stockpiling of foreign exchange reserves triggered the expectations of potential nominal exchange rate appreciation. At the same time, there is a tendency to a current account deficit which may further accelerate in connection with the expected increase in growth dynamics. Though such a constellation of foreign exchange flows could be desirable, given certain limits and pre-conditions adhered to, for the development potential of the Czech economy for some time to come, an open issue is its consistency with the existing fixed exchange rate arrangement.

As a result, the exchange rate regime is again on the agenda. The relative costs and benefits of potential options must be re-assessed with a view to the changing conditions and the increased sensitiveness of exchange rate developments to market sentiment and expectations. Fixed exchange rate regime implies that nominal exchange rate changes are, in principle, given up as an instrument of restoring external balance and international competitiveness. Due to this exchange price fixity, there is an inherent risk of a substantial deviation from an "equilibrium" rate. The resulting macroeconomic costs can therefore be avoided only to the extent in which domestic variables can adjust in a flexible way.


IN CONCLUSION

Thanks to a comprehensive and consistent macro-economic policy aiming at price and currency stability as its first priority the requirements of the transition have been successfully met and the sound foundations for sustainable recovery and growth of the Czech economy laid. Nevertheless, while much has been accomplished, the challenges of consolidation of the achieved results and of their further fostering in the changed conditions of a more mature stage of transition appear even more demanding. In coming months both external developments and intensified inflationary pressures will test our capabilities, resolution and the co-operative approach of the government and the central bank.

01-06-1995

(*) Governor of the Czech National Bank. Narodni Banka, Na prikopë 28 11003 Praha. Czech Republic.

(1) At the beginning of 1995, the newly founded Czech Export Bank was also licensed as a state-owned financial institution.

(2) Both the composition of the basket and the relative weights of individual currencies were, however. revised in the past period. As of May 2,1993 onwards the basket of the Czech koruna is confined to only DEM and USD, with the weights 65% and 35% respectively.


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