Monetary and exchange rate policies in Cyprus
Takis KANARIS*
During the nearly four decades of its independence Cyprus has experienced fast economic and social growth. During this period, a restructuring of the economy in favour of the services sector occurred, so that it now constitutes the most dynamic area of economic activity. Presently, Cyprus is at the doorstep of the European Union (E.U.) and the need to adjust with the E.U. acquis has speeded the process of liberalisation and deregulation of economic structures and a concomitant dismantling of the protectionist barriers.
The Cypriot financial system has been operating for a long time under a regime of widespread restrictions which have affected its efficiency and flexibility and resulted in its isolation from developments in the international financial environment. This is now changing, with the system steadily proceeding on the path of modernisation and deregulation. This adjustment process not only will align the Cypriot financial sector with the European Union acquis, but more importantly, it will enhance its competitiveness and efficiency within the context of the highly integrated European and international financial markets. It will also greatly encourage the promotion of Cyprus as a regional and international business centre.
In the above context, considerable progress has been recently made as regards the upgrading of the operational set-up of monetary policy, the reform in government securities, the liberalisation of interest rates, as well as the introduction of modern banking legislation. In parallel, there is an ongoing gradual process of dismantling the remaining restrictions on capital flows so that they will be completely eliminated by the time of entry in the EU.
1. NEW MONETARY POLICY FRAMEWORK
The transition to the new monetary policy framework that took place at the beginning of 1996 was smooth and banks have adjusted to the new environment. Under the new regime, repo/reverse repo auctions have become the Central Bank's main instrument for liquidity management, replacing the liquid asset ratio which was the main tool of monetary policy for over twenty years. Open market operations play now a core role in steering interest rates, managing liquidity in the market and signaling the stance of monetary policy. The main constituent elements of the new monetary policy framework are described below:
Minimum reserve requirement
The liquidity ratio was abolished in 1996. A proportion equal to 20 per cent of the average weekly deposits during 1995 was "frozen" as at January 1, 1996. This frozen stock consists of treasury bill holdings, which are automatically renewable and bear a fixed interest rate of 6 per cent per annum. The frozen stock of treasury bills will be phased out gradually, within a period of 7 years, commencing on January 1, 1997.
A proportion equal to 7 per cent of the average weekly deposits during the first three weeks of December 1995 was transferred to a new "Minimum Reserve Account". Deposits are subject to the new reserve requirement of 7 per cent per annum. The minimum reserve account is the only operational account of banks with the Central Bank. The average daily balances in this account up to the required proportion of 7 per cent earn interest of 6 per cent per annum, while deposits in excess of this proportion do not earn interest.
Introduction of repurchase agreements
As from January 1, 1996, repurchase / reverse repurchase transactions have replaced the liquidity ratio as the main instrument of monetary management. Operations of liquidity injection and absorption are carried out through auctions in government securities under repurchase agreements, between the Central Bank and money market participants (banks). Repurchase transactions take place whenever the Central Bank deems appropriate and their duration is up to 15 days.
Introduction of standing facilities
(a) Short-term Central Bank facility
A short-term Central Bank facility (lombard-type) was introduced as from the beginning of 1996, the interest rate of which is intended to provide the upper end of money market interest rates. A change in the interest rate of this facility signals changes in the stance of monetary policy. Credit granted to banks under the "lombard" facility is made available on an overnight basis and government securities (treasury bills) are used as collateral. The size of this facility was defined as 1 per cent of deposits at the end of the previous year.
(b) Overnight deposit facility
The Central Bank has also offered to banks an overnight deposit facility for placing their short-term surplus funds at the end of the day. The interest rate on this facility is intended to provide, in normal circumstances, the floor for short-term money market rates.
(c) Domestic Government Debt
Furthermore, as from January 1996, changes were introduced regarding the primary sales of government securities, which are now sold through auctions providing the government with market-based financing. Currently, treasury bills of 3-month and 12-month maturity are issued by auction as well as longer-term stock of 5 and 10 years maturity. With the exception of the 3-month treasury bill, these securities are tradable in the secondary market.
2. FINANCIAL LIBERALISATION AND THE CYPRUS ECONOMY
The financial sector in Cyprus is still beset by various constraints, the most important being the statutory ceiling on interest rates at 9,0 per cent. In view of the commencement of accession negotiations, Cyprus is expediting the reform of the financial sector so as to fully prepare the country for membership and to tap new resources of economic growth which would result from a better allocation of savings. The two cornerstones of the reform are:
(i) liberalisation of interest rates
(ii) liberalisation of capital flows.
A bill liberalising interest rates has been tabled before the House of Representatives in January 1999. This bill provides for the abolition of the interest rate cap which has been in existence since 1944. Furthermore, credit institutions are obliged to be transparent in relation to interest rate charged and the way interest and other charges are calculated. Additionally, the bill includes a safeguard clause which provides that debtors with existing housing loans up to the amount of £60,000 will have the choice between variable interest rates and a fixed interest rate of 9,0 per cent.
The repeal of the obsolete interest rate Law will step up the ongoing process of capital account liberalisation. Simultaneously with the liberalisation of interest rates, medium and long-term foreign borrowing will be allowed for both firms and individuals alike. This development is expected to improve substantially competitive conditions in the credit market to the benefit of the borrowers. By the time of entry into the EU all restrictions on capital flows will be abolished.
International experience has highlighted the need to establish a stable macroeconomic environment before financial markets are deregulated. Cyprus enjoys a stable macroeconomic environment, and its economy is characterised by fairly rapid economic growth, virtual full employment, modest inflation. Despite the recent weakening in the balance of payments, the external reserves and payments position remains quite strong. However, the deterioration observed in the fiscal accounts point to the need for a fiscal consolidation so as to contribute to a reduction of the current account deficit and to provide a sound basis for the financial liberalisation process.
A sound macroeconomic environment is necessary but not sufficient to ensure the success of financial liberalisation. Of equal importance are the microeconomic fundamentals. The state of the banking institutions in Cyprus in terms of soundness and profitability is considered as satisfactory in relation to its European counterparts. The solvency ratio observed by the Cypriot banking system is adequate with all banks maintaining a solvency ratio above the 8% level prescribed by the relevant EU directive, while the assets utilisation ratio compares favourably with the position in other EU countries. A number of other factors point to the fact that the Cyprus banking system is in good shape; the use of sophisticated technology; well trained and educated staff with more than one third of bank employees holding a university degree or other professional banking qualifications; the successful expansion of the largest banks in setting up branches in the UK and Greece.
A history of sound banking is, of course, no guarantee of success for the future. Financial reform entails that the banking system will be exposed to increased competition and risks. Competition in the financial sector will be enhanced by allowing, inter alia, bank customers access to foreign loans. But the further opening of the capital account requires close monitoring of the foreign exchange exposure of banks and private enterprises so that no systemic risk is introduced into the economy. Overall, banks should break off with seemingly successful past practices and monitor and evaluate credit risk more thoroughly.
It is evident from the above that the operation of banking institutions under fully liberalised conditions requires a strengthening of the regulatory and supervisory framework. Supervising authorities need to ensure that sound lending practices will be carried out and in general to secure the solvency of the banking sector. Progress has been made towards this direction with the banking law approved by Parliament in July 1997. In particular, this law provides for a minimum capital base, minimum capital adequacy ratio and minimum liquidity as well as for a deposit guarantee scheme. However, the new banking legislation is not applicable on the co-operative credit societies and saving banks which are neither supervised by the Central Bank nor are subject to the prudential regulations set for the banking sector. This is an inherent institutional weakness in the financial sector which has to be addressed imminently, if the soundness of the co-operative credit sector is to be maintained under a liberalised envi
ronment.
3. EXCHANGE RATE POLICY
During the period 1973-June 1992 the Cyprus pound was pegged to a basket comprising the currencies of its principal trading partners. This peg was abandoned in June 1992 in favour of a link to the official ECU. The margin at which the Cyprus pound would be allowed to fluctuate was limited to 2,25 per cent above/below the central rate. In view of Cyprus' application to joint the European Union, this linkage reflected the desire to integrate the Cypriot economy with that of the European Union and did not represent any significant shift in the philosophy behind the exchange rate policy of Cyprus, as its main objective of maintaining stability in the external value of the currency remained unchanged. The maintenance of a stable currency policy through the ECU link has contributed significantly in cushioning inflationary pressures, keeping confidence in the currency and enhancing credibility in the effort of achieving convergence with the EU economies.
Introduction of the Euro
In view of the positive consequences of the Cyprus pound/ecu link, it was decided to peg the Cyprus pound with the euro (the successor to ecu) from day one. The introduction of the euro on 1 January, 1999 was a historic step towards European integration and is bound to have profound impact upon the euro-area as well as the world economy in the years to come. The most important pro-growth effect of the euro will come as it spurs price competition. As prices become visible in one currency across the continent, costs and productivity will be more easily measurable.
The potential consequences on Cyprus could be positive over the longer-term given the general expectation that the creation of the EMU would most likely result in lower inflation and interest rates and stronger than otherwise output growth in EMU countries. For outside countries, particularly those with close ties to Europe like Cyprus, the impact of the unified market is likely to come through trade and financial linkages.
Cypriot enterprises can take advantage of the economies of scale by offering products across the single market and dealing in one currency. The link of the Cyprus pound to the euro, as from January 1, 1999 at the central rate of 1,7086 and a permissible range of fluctuation of 2,25% entails that trade between Cyprus and the Europe is carried out at minimum exchange rate risks. Cyprus will also benefit from the fact that the single currency zone includes some of the island's main competitors for tourism and exports. Countries such as Spain, Portugal, Italy will no longer be able to devalue their national currencies at will, as in the past, in an effort to improve competitiveness. Finally, the link of the Cyprus pound to the euro, the currency of a zone whose primary goal is price stability, underscores the commitment of the authorities to keep inflation at check, through which real competitive gains will accrue for the Cypriot products.
The creation of EMU and the launching of the euro offers greater opportunities for the Cypriot economy but also introduces new challenges. Global competition started pushing companies to restructure and euro now is forcing the pace. Cyprus, as a country aspiring to become a member of the European Union, must intensify its efforts to meet the Maastricht convergence criteria, and restructure the economy. Progress on this front is important not only for the purpose of achieving a timely adoption of the acquis communautaire but also for reasons of improving the efficiency and competitiveness of the Cypriot economy so that it will be able to meet with success the challenges of an increasingly competitive environment.
12-03-1999
* Manager Economic Research Department Central Bank of Cyprus thkanari@centralbank.gov.cy
