Monetary policy of Narodowy Bank Polski: Experience and likely evolution in the short-medium term

Hanna Gronkiewicz - Waltz (*)

1. INSTITUTIONAL FRAMEWORK

When Poland was a centrally-planned economy, Narodowy Bank Polski acted both as a central bank of the state and as a commercial bank responsible for the financing of a state-owned industry. A financial reform was launched in 1989 with the enacting of a new Banking Law providing the legal framework for a commercial banking sector and for pure central banking activity of the NBP. The major changes in role of the NBP introduced in 1989 and further amendments include:

(i) establishment of a two-tier banking system with the NBP as a central bank;

(ii) strengthening of the NBP's independence resulting, inter alia, from:

(iii) introduction of modern monetary policy instruments.

At present NBP's major responsibilities are similar to those of central banks of developed market economy countries and include monetary and exchange rate policy, issue of the currency and banking supervision. It should be stressed that new regulations introduced by the NBP are required to be consistent with the European Union Directives and Regulations as well as international practices (e.g. Basle Committee super-visory rules).

Various steps were also taken to broaden and strengthen the financial system. The financial institutions, non-existent under central planning system but indispensable in the market economy, have been created or re-established, the most important of which includes capital market institutions such as Warsaw Stock Exchange and Securities Commission.


2. MONETARY POLICY

The economic reform in Poland initiated in 1990 directly followed the period of hyperinflation of the late eighties, and the fight against inflation was one the objectives of the reform implemented with both fiscal and monetary policies tools. To meet this challenge, a set of modern monetary policy instruments was introduced. At present the following monetary policy instruments are applied by the NBP.

(i) central bank interest rate.

The NBP has at its disposal three forms of credits to provide to the banking system. Rediscount credit is granted to the banks to refinance banks' credits to the corporate sector and individuals secured with bills of exchange. The lombard credit is made available against Treasury securities as collateral. The characteristics and conditions of these credits are typical of market economy countries. The third form of NBP credits, the so-called refinance credit is mainly granted to finance the limited number of government sponsored infrastructure projects initiated in the 1970's or early 80's. This kind of a credit will to be phased out with completion of these projects and finally eliminated.

The rediscount rate is considered as the NBP base rate. The borrowing ceilings for banks from the NBP for both rediscount and lombard credits are linked to banks' capital.

In the 1990's, the central bank interest rates were following the trends of inflation. In January 1990 the refinancing credit rate was set at 40% per month. Gradually the rates were lowered, following the downward trend in inflation, to the current annual level of 27% (rediscount) to 31% (refinancing). Generally speaking, the NBP policy was to ensure positive real interest rates.

With time, the effective role of NBP's interest rates as a monetary policy instrument has been diminishing in favour of open market operations as a result of the increasing liquidity of the banking system and smaller use of NBP's credits. The NBP rates are still important as a reference rate used by banks to define their variable deposit and lending rates. They are also thought to be an important signal as to the direction of monetary policy.

(ii) obligatory reserves.

Obligatory reserves were introduced in 1990. They are considered as a longer term monetary policy instrument. At the beginning of 1990 the ratio of obligatory reserves for sight deposits was set at the level of the legal maximum of 30%. The current rates are 20% and 9% respectively for sight and term deposits in the domestic currency. For deposits in foreign exchange there is a uniform rate of 1% applied for both sight and term deposits.

(iii) open market operations.

Open market operations were formally introduced in late 1992. However, already in 1990 NBP's bills were offered to the banks as a form of liquidity control in the period when Treasury securities were not available. These bills were discontinued in 1991 and reintroduced in 1994 to absorb excess liquidity of the banking system. At present five types of open market operations are used: repo, reverse repo and outright sales, purchase of Treasury bills and bonds and issuance of NBP's bills. Open market operations constitute the major monetary policy instrument with steadily growing importance of repo and reverse repo interest rates.

(iv) credit ceilings.

In the years 1990 - 1992 credit ceilings were used as a tool to control banking sector liquidity. Pursuant to the law, the NBP may still impose credit ceilings but since 1992 this form of credit control has been discontinued.

The economic reform in Poland directly followed the period of hyperinflation of the late eighties and the fight against inflation constituted a major objective of the reform. Inflationary pressure in the initial period of the reform originated mostly from high inflationary expectations, high budget deficit (except for 1990) and its partial financing by the NBP, and market imperfections. Since 1994, in addition to the budget deficit, other main sources of inflation have been the monetary consequences of accumulation of foreign exchange official reserves, pressure on food prices resulting from drought and protection of the internal market. A relatively high rate of GDP growth, especially in 1994 and 1995 should also be taken into consideration.

One of the main objectives of the NBP monetary policy throughout the 1990's. Positive real interest rates and market equilibrium on the internal market have led to the weakening of the expectations but they still play a significant role. At the beginning of the 90's, monetary policy was strongly supported by restrictive fiscal and wage policies. It was possible to bring the rate of inflation down from 586% in 1990 to 70% in 1991. Fiscal and wage policies were somewhat relaxed later on. Nevertheless, it was possible to reduce inflation further to 43% in 1992. Throughout the period, the budget deficit, and its partial financing by the central bank, may be considered as a major source of inflationary pressure.

In 1992 the economy started to recover at an accelerated rate. In 1994 a growth rate of 5% was achieved and a strong upward trend is expected to continue in the coming years. Since 1994, new inflationary sources have emerged making the conduct of monetary policy more difficult. The lack of any wage control, drought, protection of the domestic agricultural market and a high rate of accumulation of foreign exchange official reserves have added to inflationary pressures.

The downward trend of inflation weakened in 1994, while in the first months of 1995 the rate of inflation was substantially higher than expected (4.1% in January alone). At the same time banks started to lower their deposit rates mostly in reaction to falling yields on Treasury bills. As a result in February 1995 the NBP decided, for the first time since 1990, to rise its lending rates by 2-3 percentage points and overnight deposit rate by 2 percentage points. At the same time the NBP took steps to sterilise the excess liquidity of the banking system mostly through open market operations. Since mid-1994 the NBP has been entering the market practically every day offering reverse purchases and outright sales from its portfolio of T-bills. As the stock of NBP's holdings turned out to be insufficient, NBP bills were reintroduced in the second half of 1994.

Consequently, the process of lowering, by banks, of interest rates on deposits has been stopped. Following the slowdown of inflation and introduction of a new foreign exchange rate mechanism NBP interest rates were reduced in May slightly below the February levels. It seems that it is still feasible to achieve inflation of about 20-23 per cent, i.e. lower than 29.5% recorded in 1994, but higher than 17% assumed in Budget Law.


3. EXCHANGE RATE POLICY

At the beginning of the economic reform, the exchange rate was treated as one of the nominal anchors of the reform and remained fixed to the US dollar from the beginning of 1990 until May 1991. It was then devalued by 16.8% and remained at this level till October when a preannounced crawling peg mechanism was introduced. In the new system the domestic currency was pegged to a basket of five currencies including the US dollar (45% of the basket), German Mark (35%), Pound Sterling (10%), French Franc (5%) and Swiss Franc (5%). Initially, the rate of devaluation was set at 1.8% per month, falling with the rate of inflation to 1.2% per month at the beginning of 1995.

Since mid-1994, Poland has started to record a very fast increase in foreign official reserves. In 1995 the rate of accumulation of official reserves even accelerated leading to inflationary pressure. In the period January - May 1995, official reserves increased from 6.0 to 10.0 billion USD. The major sources of this increase included non-recorded crossborder trade, exports, foreign investments and insubstantial inflow of short term capital.

Increased money supply could hardly be curbed by existing monetary policy instruments. The crawling peg mechanism turned to be unable to ease this pressure. As a result, since May 16 this year a new foreign exchange mechanism has been introduced. It took the form of a crawling band with +/- 7% permitted fluctuations around the central rate calculated as previously against the same basket of currencies. In the new system the NBP has ceased to quote its rate, but can intervene on the foreign exchange market to maintain the market rate at the desirable level. The daily rate is set in the form of fixing. As a result the domestic currency appreciated by about 5% against the central rate. Despite this, the reserves have continued to accumulate although at a much lower rate.

The new mechanism has added much flexibility to the system and closer coordination of the monetary and exchange rate policies has become possible. The foreign exchange market has easily adapted to the new system.

Since January 1990, most current account transactions have been permitted. After the approval of the new foreign exchange law on June 1, 1995, Poland officially declared convertibility of the zloty according to the Article VIII of the IMF Articles of Agreement.


4. EVALUATION AND PROSPECTS

Throughout the 1990's it has been possible to maintain a clear downward trend of inflation while at the same time providing the conditions of recovery of the economy since mid 1992. A relatively strong growth tendency of 5.0-5.5%, was recorded in 1994 and expected for 1995.

The major challenge that the NBP faces in the short and medium run relates to pressures in the foreign exchange area creating serious dilemma for exchange rate and interest rate policy. The policy mix in the short- medium- term will depend on reaction of the economy to appreciation of the zloty after modifying the exchange rate mechanism which will show actual strength of the economy. Additional factors that the NBP will have to take into account will relate to government actions in the area of fiscal, public debt management and trade policies strongly affecting efficiency of monetary policy.

Longer term targets in the area of specific monetary instruments are not changing. A long-term interest rate will be applied and refinancing policy will be conducted in a way that stimulates increase in demand for money, but obviously the effect on short-term capital flows must be taken into consideration. As further pressures in the foreign exchange market can still be expected, open market operations will be ready to sterilise banking system liquidity, using both short term (reverse repo) and long term (outright sale of T-bills from the NBP portfolio and the NBP bills sale operations) instruments. The system of obligatory reserves is not expected to be changed, nevertheless the rates, still at a high level, will be adjusted downwards if tensions in the foreign market ease.

29-06-1995

(*) President of the National Bank of Poland/Narodowy Bank Polski. Ul Swietorkrzyska 11/21 Pob 1011 - 0950 Warsaw Poland.
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