Central bank policies in a very small transition economy

INSTITUTIONAL BACKGROUND

The Bank of Slovenia was established in June 1991 as the central bank of the Republic of Slovenia. In October 1991 it launched the issue of the new Slovenian currency, the tolar. The Bank's legal status is defined by the Law on the Bank of Slovenia; independence is set down by Constitution.

Independence is defined loosely to include "responsibility to Parliament". The Governor and the other ten members of the Governing Board are appointed by Parliament for overlapping periods of six years. Annual financial statements of the Bank have to be approved by Parliament. The actual independence of central bank policies has so far been safeguarded to a very large degree by the practice of engaging, into the Governing Board, the very best professional capacities of the (two) Slovenian universities and research institutes. Based mainly on this and on the performance derived from this structuring of the decision-making process, the Bank of Slovenia has for some time now been rewarded with a high public credibility rating. This has enabled smoother pursuit of policy objectives, and has also kept off possible incentives for intervention from the Government.

The Law stipulates non-involvement with Government finance with specifications that the Bank of Slovenia cannot lend to the Government for more than 5 percent of its annual budget or one-fifth of the planned deficit, and that no debt should be carried across fiscal years. In actual life the Government has never borrowed from the Bank; it is depositing operational domestic and foreign exchange surpluses with the Bank based on an agreement to coordinate liquidity management policies. These as well as some other aspects of the legal status do show, however, that a number of adjustments is still pending prior to full compliance with EU standards.

CHOICE OF OPTIONS OF CENTRAL BANK POLICIES

At the time of establishment of the central bank, Slovenia had inherited from its previous economic environment high inflation, approaching to hyperinflation, and negligible foreign reserves. This situation was an important factor for the basic choice of the monetary policy regime. Ever since establishment the exchange rate regime has been managed float, with monetary targeting as the policy "anchor". Initially base money was targeted, within a very flexible - one month ahead - time horizon. Since 1997 the Bank has been declaring one year ahead targets for the broad aggregate M3. Given the fluctuating external conditions and the domestic transitionary processes, a degree of flexibility is still retained and the annual targets are set out in a relatively wide band. For 1998 this was between 18 and 26 percent, and the outcome was a 20 percent growth; for 1999 the band has been set between 16 and 24 percent.

The other factor that has influenced the policy stance of the Bank are some specifics of the Slovenian economy, namely, its very small size and relatively high openness. The trade ratio (imports and exports of goods and services to GDP) is a high 115 percent; about two thirds of the trade are with the European Union. This means that the economy is much more susceptible to impulses from its external environment than from most domestic ones. Slovenian growth derives mainly from developments in foreign, basically European demand, and very little from trends in domestic consumption; the business cycle largely follows the central European pattern. Upshifts in domestic demand pull imports and the foreign deficit, but do not - noticeably - pull growth also, as they do in the larger size transition economies.

This bears strongly on the choice of options of monetary policy. Monetary management is not very effective only through the control of aggregate domestic demand, but has to be oriented strongly also to the cost factors of the economy. External equilibrium and elements of competitiveness are therefore considered important as monetary policy indicators, while on the other side there are very few desirable effects that the central bank could expect to achieve through monetary slackness, even in the very short run.

Considering the large weight of the tradeable sector in the economy, monetary expansion is also passed on in only a restricted manner to inflation - a larger segment of the CPI index determined more strongly by the exchange rate - so the central bank does not receive good signals from the real sector markets. Expansion will, nevertheless, generate instability in the financial, mainly the banking system; it will pass into the performance of the comparatively secluded domestic sectors and provoke general growth of wage and other costs, thus squeezing profits and survival margins of the internationally competing economy. Repercussions are delayed and less obvious, but are then so much more severe.

In a transition economy, of course, monetary strictness has to do mainly with central bank involvement in the monetary effects of foreign financial inflows. Elementary liquidity control of the banks that would push up their interest rates is most likely to result only in the substitution of domestic with foreign credit.

MODE OF OPERATIONS

In the described circumstances, the basic mode of operations of the Bank of Slovenia has been, and still is, to keep a relatively tight grip on the medium-term monetary developments and to engage actively - within this constraint - on the foreign exchange markets. For domestic monetary control, much emphasis is attached to coordination with banking supervision; Banking Supervision is a department within the Bank of Slovenia. For foreign exchange operations and sterilisation a relatively extensive set of instruments and prescriptions has been developed.

The very small size of the Slovenian market implies that there is much less incentive for foreign investors to engage in the elsewhere attractive branches supplying domestic consumption, and FDI has not been as intensive as in some other countries in the region. Given the good general parameters of the economy, there has been much more inflow through the other channels of financial investment, mainly by the way of bank loans. These inflows are very volatile for the monetary and financial sector, for which reason the Bank of Slovenia had in previous years set up a number of restrictions. Some of these still apply to the short-term markets, while recent accession to the Association Agreement with the European Union has entailed liberalisation in the other areas.

Sterilisation of foreign exchange intervention effects is carried out with the Bank's own tolar bills; the small Government deficit has prevented the formation of a sufficent market for Government securities. Bank of Slovenia tolar bills are issued in various maturities between 2 and 270 days. Most are available only to banks, and a smaller choice is offered to the general public; nonresidents are barred, and the extent of their engagement through intermediaries is not considered to be large. Due to these operations, the Bank of Slovenia has been in a net (tolar) debt position with the banking sector since the beginning of 1997, and the bills have also assumed the prevailing role among the liquidity management instruments. In 1998 the average debt on these securities was about EUR 450 million, or 15 percent against the international reserves of the Bank (another 50 percent taken up by the Bank's foreign currency bills).

The described modes and instruments of operation - as well as the underlying policy orientations - are of course considered transitionary. There is no sense to compare them directly and strictly, in form, with the operations of central banks in "steady state" economies. They are designed to function in the channels of transmission of monetary policy in the Slovenian economy. Comparison can be made only for the capacity to reach and influence in the desired manner the monetary policy end objectives.

PERFORMANCE

Regarding its basic policy objective, the Bank of Slovenia has by February 1999 already brought the annual CPI inflation rate down to 5.6 percent, while current (seasonally adjusted) dynamics in the preceeding months have been even much less. The projected introduction of VAT in July 1999 will produce some disturbance in the trend. After that the gradual lowering of the inflation rate is expected to continue and by 2002 an inflation level, close to that in the EU, should finally be reached. Depending on the delay in the converging of interest rates, the central bank will then make preparations for a tighter alignment of the tolar with the euro.

Real GDP growth in the past years has been over 4 percent on average. This is not very high, but on the other hand it is a stable growth path that is not being financed through the accumulation of deficits and can safely be considered sustainable. The Government deficit has not surpassed 1 percent of GDP and the current account even less. At the end of 1998 total foreign debt (mainly inherited from the pre-transition period) was about 25 percent to GDP and had only a very small short-term component. Coverage of the debt with foreign exchange reserves was 97 percent; foreign reserves were equivalent to 5 months of imports of goods and services.

* Governor, Central Bank of Turkey