Lords of the Inflation. The Role of Central Banks and Governments in Securing Price Stability

On May 18-19, the annual international research conference “The role of the central bank in ensuring economic development” was held in Kyiv. Andrzej Rachko, Adviser to the President of the National Bank of Poland, analyzes the exit from the crisis of Eastern European countries outside the Eurozone.

I would like to focus on macroeconomic policies in emerging market countries, i.e. Eastern European countries which are members of the European Union but not of the Eurozone, in the aftermath of the 2008 financial crisis. I will talk about two periods – first the period of economic slowdown right after the crisis, and second – the recent period of deflation caused by the crisis.

For a better understanding of the situation in the banking sector at the time of the crisis it is important to underline the difference between banking systems in Eastern and Western Europe.

Firstly, the banking sector in Eastern Europe [before the crisis] was much less sophisticated than in the West. If you analysed the balance sheet of an Eastern European commercial bank, you would find mainly loans on the asset side and deposits of households and enterprises on the liabilities side. The bank did not use any complex instruments such as CDS, CDOs etc. So, the regulatory authorities focused on credit risks and there was no need for it to look closely at other financial risks. This was the reason behind the higher capitalization of Eastern European banks compared to their Western counterparts – everyone assumed that credit risk was higher in the Eastern part of Europe, therefore there should be more capital in the banking sector. The average capital adequacy ratio in Eastern Europe was significantly higher than in the West (especially in the terms of tier one capital).

Secondly, all the banks in Eastern Europe were functioning with significantly lower leverage – both on the micro scale (measured by assets to capital ratio of an individual bank) and on the macro scale (evaluated by assets of the banking system to GDP).

The last important aspect was the ownership of the banks. In Eastern European countries after privatization 50 to 80 per cent of the banking sector belonged to foreign banks. Hence, when the financial crisis struck in the West, economists assumed that an outflow of funding from the Eastern part of Europe was only a question of time. Central bankers were thinking about how to protect the banking sector from this risk. Firstly, central banks injected sufficient liquidity to each bank in need. Although the central European banking sectors were over liquid in domestic currency, a rapidly growing risk interrupted inter-bank money market operations and it was necessary to initiate central bank liquidity assistance. Secondly, the liquidity of the FX market was controlled by specially implemented instruments, for example, Narodowy Bank Polski used FX swaps which contained the prices of the swap market and underlined the role of the central bank as a lender of last resort in foreign currency as well. Thirdly, the European supervisors launched the so-called Vienna Initiative 1.0, which was a platform for the exchange of information and coordination of actions between financial authorities in Western and Eastern Europe. All these steps helped the Western banks to realize that financial stability was not in danger and the profitability of their subsidiaries in Eastern Europe was satisfactory even during the time of crisis.  Hence, there was no sense to rapidly curtail the size of banking business in the East. The outflow of funds from the Eastern European banking sector was stopped and was only observed on the Treasury bonds market.

The medium term negative consequences of the crisis for Eastern Europe were similar to those in the West: a slowdown of GDP growth and the problem of nonperforming loans (NPL). However, due to their high capitalization, for Eastern European banks the problem was not how to cover potential losses from NPLs but how to manage NPLs. Many commercial banks paid a lot of attention to NPL management (in terms of staff and managerial time), so they did not have sufficient time and human resources to concentrate on the core business, the creation of new loans. Therefore, it was necessary to find some financial intermediaries which would manage NPLs. This problem was discussed within Vienna Initiative 2.0, which focused on different aspects of a suitable framework. One element was linked with central bank operations: it was an issue of a temporary liquidity back stop for these financial intermediaries.

The biggest problem during the crisis was the issue of mortgages denominated in foreign currency. In my opinion this is a very good example of the consequences of a lack of macro-prudential policies. The credit bubble which was created by cheap mortgages denominated in foreign currency had undermined not only banking sector stability, but macroeconomic stability as well. Conversion of external resources from foreign currency to domestic money spurred on the appreciation of the exchange rate, which caused an abrupt increase in the current account deficit before the crisis. When the financial market sentiment was reversed due to the external crises, the exchange rate was depreciated and the cost of servicing the mortgages was increased for unhedged households. This additional and unexpected cost curtailed consumer demand, limited the lending ability of banks, and finally, slowed down GDP growth. The scale of the problem varied for different countries.

In the Polish case, the upfront prudential regulation limited lending in foreign currency only to high income households. Therefore, the significant depreciation of the Polish currency did not stimulate an increase in NPLs and did not contain private consumption growth. The opposite example was Hungary. The depreciation of the forint involved growth of NPLs by up to 20 per cent, which undermined financial stability. This was a big challenge, and the Hungarian authority had no choice other than to introduce mandatory conversion of mortgages from Swiss Francs (mainly) to forints, which was a huge problem for the banks, and for the central bank as well, which lost a substantial share of its foreign reserves.

Therefore, it is necessary to implement some upfront instruments of regulation that may support monetary policy. For example, when Poland started to fight the rapid increase in the volume of foreign-denominated mortgages in 2006-2007, Narodowy Bank Polski realized that it was not possible to stop it by using the standard monetary policy instruments. Hence, the Polish authority used prudential regulations – for example, an additional income buffer for borrowers who wanted to obtain a mortgage denominated in foreign currency.

Now I will talk about the second period, namely, deflation. About a  year ago we discussed this situation at a meeting with all the emerging market central banks at the Bank of International Settlements (BIS). A majority of the participating banks had no problems with deflation because they still had inflation.

Deflation was an issue for the Czech Republic (which is a specific case), Romania, Hungary and Poland. The representatives of these countries tried to convince our BIS colleagues that deflation is not a real problem for Central Europe.

The inflation expectations were the first argument, because they were well anchored during the whole 2.5-year period. Polish consumers and entrepreneurs did not consider deflation to be a real problem. For them, it was only a short break in a standard situation of inflation.

Secondly, other important economic indicators remained practically the same – propensity to save did not change, wages grew by 3 per cent in nominal terms and almost 5 per cent in real terms, and retail sales growth was positive during the whole period. For Narodowy Bank Polski the greatest concern was producer price index (PPI) deflation. But entrepreneurs’ response to this type of deflation was very flexible – the adjustment of firms’ prices did not reduce profitability, employment and wages.

What are the lessons from these two periods?

Firstly, the central bank’s job in emerging market countries is to contain inflation. Secondly, we need to use a very conservative approach to the instruments with which we control the situation in our banking sector, and if possible to avoid very sophisticated new instruments. The third lesson is that we need to focus on the stability of the financial sector.

A very important question is the implementation of macroprudential regulation. This regulation may have fiscal effects on the economy, therefore one needs to find a compromise between the central bank as an institution which has macro-prudential instruments in its hands and the minister of finance. In Poland authorities decided to build a special committee for macro-prudential regulation, but then the question about the vagueness of such a board arose.

Regarding FX regulation, in my opinion it is possible to use interventions even in the case of a free float regime, but only to smooth the volatility of the exchange rate, not to achieve any specific level of the exchange rate (the Czech Republic, which uses FX interventions as an instrument of monetary policy, is a special case).

And last but not least, we may use monetary policy instruments to raise  the rate of economic growth, but the efficiency of these instruments is very limited. So when we talk about any kind of stimulus for growth, we need to focus on the fiscal side – to build fiscal space, to use fiscal instruments. This is the first best choice in my opinion.