Lithuania's monetary and exchange rate policy
at the arrival of the euro
1. ORIGINS AND ROLE OF CURRENCY BOARD ARRANGEMENT.
Lithuania's transitional currency the talonas was introduced in October 1992. However, it was difficult for the currency to gain public confidence amid the very high inflation that was typical for transitional economies at that time. Actions by the Bank of Lithuania to curb inflation were showing signs of success by the middle of 1993 and this laid the foundation for the successful re-introduction of the litas, Lithuania's inter-war currency, in June of that year. The exchange rate for the litas was originally set at LTL4.50 to USD 1.00, but it immediately began to appreciate as confidence in the currency surged.
The Law on the Credibility of the Litas went into effect in Lithuania on April 1, 1994 pegging the litas to the USD at the exchange rate of one litas for 0.25 USD. This law provided the framework for the modified currency board arrangement. Unlike other nations that have adopted currency boards in recent years, Lithuania was not pushed into this by a loss of public confidence in its currency. The Bank of Lithuania had embarked on a very restrictive monetary policy early in 1993. By the start of the following year, the Bank had succeeded in keeping the value of the litas relatively stable and had brought about a substantial decline in the average pace of monthly inflation. Foreign exchange reserves had risen significantly, the fiscal situation of the nation was strong and privatisation efforts were going forward quickly. At the same time, there was a growing political pressure on the central bank to provide direct credit to the government, which would have caused the government's commitment to stabilis
ation policies to weaken.
While the Bank of Lithuania believed that the situation could be handled by relying on the traditional tools of monetary policy, the view that prevailed was one that favoured the introduction of the currency board. It was believed that an institutional anchoring of fiscal and monetary restraint - basically tying the hands of the policy authorities - would buttress public confidence in the economic stabilisation programme. A modified currency board arrangement was worked out, one that provided some room for the Bank of Lithuania to act as a lender of last resort and, potentially, to make use of some of the traditional instruments available to central banks.
Under the currency board arrangement, the quantity of reserve money is strictly limited by the gold and foreign exchange holdings of the Bank of Lithuania. The Law provides for 100% backing by stating that "The Bank of Lithuania may change the total amount of the litas in circulation only by changing gold and foreign exchange reserves respectively". At present, the above backing arrangement serves as an instrument for achieving price stability, and also as an anchor for structural economic programmes. Annual inflation has dropped sharply from 188.7% in 1993 to 2.4% in 1998.
2. MONETARY POLICY PROGRAMME FOR 1997-1999.
Early in 1997, the Bank of Lithuania adopted a monetary policy programme for 1997-1999 that was designed to accomplish its exit from the currency board. This strategy for dismantling the arrangement, as well as a commitment to maintain the fixed exchange rate regime, has been well received in international financial markets. It has gained the support of investors in addition to the multilateral organisations. The strategic target of the programme was to be better prepared for integration to the EU and the goals of the programme were:
1) creation of a modern central bank with the ability to formulate and conduct an independent monetary policy,
2) facilitate the development of monetary policy instruments and to create preconditions to comply with the EU membership requirements,
3) provide a means for reorienting the exchange rate of the litas, so that at the appropriate time it can be pegged to the euro.
The Programme is divided into three stages:
· in the first stage, the main task of the Bank of Lithuania was to start applying modern monetary policy instruments. The Bank of Lithuania commenced this stage in January 1997 and implemented the principal objectives of this stage by the end of that year. By applying open market operations and other monetary policy instruments the Bank of Lithuania succeeded in exerting influence on the banking system liquidity fluctuations and interest rates in the money market;
· in the second stage, on partial amendment of the Law on the Credibility of the Litas, it is envisaged to establish legal conditions for the start of conducting tight though flexible monetary policy.
· the objectives of the third stage are: to change the anchor currency pegging the litas to the euro and the US dollar and encouraging the convergence of Lithuania's basic macroeconomic indicators with the European Union member state requirements, to prepare for integration into the European System of Central Banks and to harmonise the national monetary policy with the requirements imposed by the European Central Bank.
The programme was designed to create opportunities for the bank to encourage the development of more liquid financial markets in Lithuania and to be consistent with maintenance of free and open capital markets. The programme also provides the priority to the external stability of the litas and price stability as the primary objective after the implementation of the programme.
Open market operations implemented by the Bank of Lithuania are used to dampen the excess volatility in short-term interest rates due to temporary or seasonal variations.
3. EXCHANGE RATE POLICY
During the third stage of the programme exchange rate policy reorientation towards the euro is foreseen. The reorientation most probably will happen in the year 2000. The preconditions for the reorientation are that the financial and money markets should enjoy relative stability, corporate and individual deposits at banks should show steady growth, and inflation for at least six previous months should not be in excess of 0.5 - 0.8 per cent. An additional condition is stability and calm in global financial markets. The Bank of Lithuania is committed to maintaining the external value of the litas in changing the exchange rate peg. It has also promised to announce its plans at least six months in advance.
In order to take a decision concerning the change of the orientation, Lithuania's foreign trade structure by countries, currency structure of the assets and liabilities of economic agents, banks and the country will have to be taken into account. In the opinion of the Bank of Lithuania, during the transitional period, until Lithuanian monetary and financial policy reaches full compliance with EMU requirements, an intermediary peg to the basket of the euro and the US dollar, each making up 50 per cent, should be adopted. First, such a basket structure is close to the Lithuanian foreign trade currency structure. Second, the peg of the litas to a basket would reduce the effects of the anchor currency exchange rate movements. A fixed exchange rate of the litas against a balanced euro and US dollar basket would reduce the fluctuations of the inflation rate in Lithuania due to external factors that are very important to a country with a small open economy. Moreover, a peg of the litas to a basket would make
the
Lithuanian financial markets less attractive to speculative capital that would not be insured against exchange rate risk (additional measures would have to be taken to hedge against the euro/dollar rate fluctuations).
On the other hand, a fixed exchange rate of the litas against the euro and the dollar would mean that the rate of the litas is not completely fixed against any single currency, yet its fluctuations would be very limited.
It should be noted that the Bank of Lithuania, while preparing for EU membership and pegging its currency to the said basket, is committed not to devalue the litas.
Reorientation of the exchange rate policy will have an impact on the foreign exchange regime and the market in Lithuania. According to the Litas Credibility Law, the Bank of Lithuania buys and sells US dollars against litas at a fixed price at commercial bank requests. Commercial banks are obliged to buy and sell litas against the dollar from customers charging commission fees not higher than 0.25% on non-cash and 2% on cash deals.
Other market of other currencies in Lithuania is insignificant and comprises only about 15% of the turnover. Within the framework of new monetary arrangements when the litas is pegged to a basket of currencies the share of foreign exchange operations in the euro is likely to increase substantially, as well as foreign trade payments with the EU and EU orientated countries due to the reduction of foreign exchange risk and lower transaction costs.
Before the introduction of the euro the use of legacy currencies even with the EMU countries was comparatively small. For example, only 7.9% of Lithuania's exports and 46.8% of imports with Italy where settled in legacy currencies.
4. MONETARY POLICY INSTRUMENTS
The Bank of Lithuania started to re-establish the functions of a modern central bank with a wide range of indirect monetary policy instruments in the first stage of its Monetary Policy Programme. The Bank of Lithuania has already implemented the instruments that are provided in the central banks of the EMU countries and are essentially in compliance with the provisions of the document of the ECB published on 18 September 1998 "The Single Monetary Policy in Stage Three: General documentation on ESCB monetary policy instruments and procedures". Consistently implementing the Monetary Policy Programme, the Bank of Lithuania:
· has introduced two types of open market operations: repo and time deposit auctions at the Bank of Lithuania. In organising repo auctions, the Bank of Lithuania encourages the development of the national money market and enhances the attractiveness of the national Government securities market. These operations were introduced in the second half of 1997. The present Bank of Lithuania strategy for open market operations is directed towards smoothing the short-term interest rate fluctuations in the money market;
· has created a short-term (overnight) Lombard loan system that was introduced in the summer of 1998. The interest rate on Lombard loans was fixed at 13 per cent. The automatic Lombard credit collateralised with the government securities by the bank when there are insufficient funds in the correspondent accounts, together with the special liquidity loans facility from the Bank of Lithuania, performs the lender of last resort function;
· with a view on tight monetary policy provisions and Lithuanian macroeconomic tendencies, implements an appropriate policy of required reserves by establishing reserve requirements for bank liabilities; however, in order to encourage the growth of long-term credit resources in the banking system, no reserve requirements are applied to bank deposits with the term of over one year. Currently the reserve requirement applied to domestic and foreign banks operating in Lithuania is 10 per cent.
Required reserves for foreign liabilities are held in USD or EUR on special accounts of the Bank of Lithuania without paying interest.
Taken into account the disturbances in the international financial markets and the widening current account deficit, the Bank of Lithuania changed the rules for calculating reserve requirements: now they are applied also to liabilities of commercial banks to foreign banks and other non-resident credit institutions. The purpose of the amendment is to limit domestic consumption and avoid overheating.
The Bank of Lithuania is seeking to implement the so-called interest rate "corridor", where the role of the "ceiling" is performed by the interest rate for overnight loans with a pledge of securities (Lombard loans), while the "floor" is the interest rate on short-term deposits at the Bank of Lithuania. The money market rates can fluctuate freely within the established corridor depending on supply and demand, but the Bank of Lithuania influences this process by using open market operations - repurchase agreements (repo) and deposit auctions. As a matter of fact, a similar interest rate regulation mechanism is provided in the activities of the European Central Bank.
Certainly, a country which opts for a fixed exchange rate system has relatively little room for an independent interest rate policy, since it automatically imports the interest rates of the country of the anchor currency. However, the central bank can smooth sudden interest rate fluctuations that destabilise the money market. The best indicator for the interest rate dynamics is the interest rates on short-term Government securities and in the inter-bank market.
Preconditions for the efficiency of monetary policy and stability are also created by the measures taken to strengthen the market infrastructure (improving the bank supervision system, the payment system, etc.), favourable macroeconomic tendencies and scientific research capacities.
The role of the banking system is particularly important for central bank monetary policy operations. Even though the Lithuanian banking sector is still quite small in relation to the size of our economy (banks' total assets make up 24.7% of country's GDP), banks, especially our private banks have expanded fairly rapidly in recent years. This will continue as we approach the greater degree of financial intermediation seen in industrialised nations.
The quality of banking supervision has improved noticeably during the last several years. The Bank of Lithuania applies EU directives and globally accepted prudential requirements that are sometimes even tighter than those used in common practice. The financial statements by all banks are drawn on the basis of International Accounting Standards and are regularly audited which makes it easier for domestic banks to work with foreign banks - their counterparts.
Full liberalisation of the financial market in Lithuania via the implementation of rights of establishment and cross-border services and equal treatment of institutions dealing with the central bank enhances free competition. Within the framework of currency board arrangement the principles of prohibition of direct financing of the public sector and prohibition of privileged access of public authorities to credit institutions was "de facto" implemented. These measures and tendencies create a favourable environment for the development of the money market and for the Bank of Lithuania's monetary policy operations.
5. TECHNICAL ASPECTS OF THE PREPARATION FOR THE EURO
In the process of preparation for the introduction of the euro in EMU member states the Bank of Lithuania has issued a letter explaining the main features of the euro and certain regulations. Regulation with the obligation for commercial banks to use the same conversion principles when performing operations in the euro and the legacy currencies as those defined in EU regulation No 1103/97 "On certain provisions relating to the introduction of the euro" was adopted.
The Bank of Lithuania recommended commercial banks not to apply conversion fees in respect to legacy currency and euro operations.
From the day of the introduction f the euro the Bank of Lithuania announces the official exchange rate of the litas (LTL) against the euro (EUR) and has discontinued to announce the official exchange rate of the litas against legacy currencies.
Amounts denominated in legacy currencies therefore shall firstly be converted to the euro using irrevocable fixed exchange rates of the legacy currencies against the euro and then converted to the litas using the official EUR/LTL exchange rate.
Also, required reserves of commercial banks kept with the Bank of Lithuania in DEM, where converted to the euro on 1 January 1999. Because of the elimination of currency risk between the legacy currencies and the euro the Bank of Lithuania has changed a regulation concerning the open currency position. These measures facilitated better preparation for the introduction of the euro within the banks and companies.
6. PRIVATE USE OF THE EURO
Lithuanian economy has been to a great extent integrated into the EU already through the implementation of the European (Association) Agreement, liberalisation of trade, current and capital accounts transactions. Nevertheless it is worth to note that the effect of the introduction of the euro will be enhanced by two other simultaneous factors: 1) Lithuania's preparation for EU membership and 2) situation in Russia. Both factors will force closer economic relations with the EU which, being the area of stability, will serve as anchor and principal benchmark of economic, fiscal and monetary policies. Lithuanian economy has been in the process of transformation for nearly a decade. From the very beginning this process has been based on a wide range of market economy principles. Now the establishment of the EMU clearly specifies the way and the rules to be followed.
Due to the turbulence in Russia the share of Lithuania's trade with Russia can be expected do decrease and that will force companies to reorient their policy toward the EU and other markets.
The share of trade with EU countries has increased substantially already in the year 1998. EU now is the major Lithuanian trading partner accounting for 36% of exports and about a half of imports. The trade turnover with the EU account to more than 40% of Lithuania's GDP.
Due to the different factors and also due to the fact that the litas is pegged to the US dollar, the latter is still the dominant international currency in Lithuania, although its role has gradually decreased over the past few years. There are several reasons for "dollarization". During the pre-independence period (1945-1989) the dollar, together with gold, served as the store of value in Lithuania because areas of private ownership were strictly limited, high inflation and a few soviet monetary system reforms undermined the confidence in domestic money. The dollar became a symbol of stability. In addition it is worth to mention that the biggest part of emigration consisting almost of one third of Lithuania's population was concentrated in North America and were regularly supporting their relatives by payments nominated in US dollars.
Lithuania is a small country with a very liberal economy and diversified trade. Only a few years ago the main trading area was the CIS with the prevailing settlements in US dollars, particularly for raw materials.
In 1998 55% of Lithuania's imports were settled in USD, compared to 33% in legacy currencies. Outstanding loans of private sector borrowing from non-residents in legacy currencies consisted of only about 19% compared to 76% in USD. We can expect that the share of the euro will gradually increase during the transition period when the litas is reoriented to the basket of currencies and the country's reserves and debt composition is adjusted. As the first experience of the private use of the euro shows, a more substantial increase of the role of the euro can be expected after the final phase of the euro introduction when euro notes and coins are introduced. The psychological aspect of new money is very important in Lithuania because during a short period of time people had different experience with different money (the rouble, the interim national currency talonas and, later, the litas). Therefore one can expect that cash expansion of the euro will be the main factor for its wider private use.
Taking into account that most of foreign exchange deals in Lithuania are between USD and legacy currencies but not between the legacy currencies, revenues from forex deals are not expected to shrink during the transition period.
Successful introduction of the euro will cause a certain positive effect on Lithuania's financial sector already in the near future. This first of all includes lowering of currency and credit risks as well as currency transfer expenses, expansion of trade, etc. Lithuanian banks and enterprises are already benefiting from the increased competition in Europe, since services offered by correspondent banks are cheaper whereas their quality is much higher.
However the benefit of the introduction of the euro has so for "stayed" within the banking sector and has not been transferred to economic agents - the companies and the public because domestic banks have not lowered service fees; nevertheless the situation in expected to change considerably in the nearest future.
With increased risks, the incentives to invest in emerging economies on a short-term trade-related basis have declined. However, growing competition makes European banks look for the possibilities to enlarge their market share. They are actively considering possibilities for long-term strategic investment, including such markets as Lithuania. Long-term strategic objectives are "insensitive" to short-term results of the crisis in emerging economies, while the declining prices of equity capital in the wake of the financial crisis in the East is a good precondition for new strategic investors to start their activities in Lithuania.
The growing presence of the European banks in Lithuania will accelerate the introduction of new banking products, renovation of information technologies and the quality of euro services, and promote the use of the euro in our economy.
CONCLUSION
The functioning of the currency board arrangement introduced in Lithuania on 1 April 1994 by adopting the Law on the Credibility of the Litas served well as an anchor for macroeconomic stabilisation and structural economic reforms and as an instrument for achieving price stability. However during the process of integration into EU and economic reforms in the country it is necessary to adjust monetary arrangements in order to facilitate the functioning of market economy, harmonise monetary policy within the EU and reorient the exchange rate towards the euro.
Measures provided in the Monetary Policy Programme and implemented by the Bank of Lithuania during the years 1997-1999 created the environment for monetary policy operations and the reorientation of foreign exchange policy towards a basket of currencies which most probably will happen not earlier than the year 2000.
Despite the wide private use of the US dollar as an international currency in Lithuania the role of legacy currencies has been increasing. Further increase of private use of the euro in the medium term perspective will be facilitated by the reorientation of foreign exchange policy, the increasing share of foreign trade with the EU countries, subsequent adjustment of country's foreign borrowing strategy, composition of the country's official reserves and finally, by the final stage of the introduction of the euro when euro notes and coins are issued.
10-03-1999
* * Director of The International Relations Department, Member of The Board, Bank of Lithuania skropas@mail.lbank.lt
