Monetary Policy Challenges Under High Euroization SEE after EU Enlargement and before Accession April 4-5, 2005 Budapest Boris Vujčić Deputy Governor Croatian National Bank

The degree of dollarization in transition economies Source: Feige, E. (2002)

The degree of dollarization in transition economies Source: Feige, E. (2002)

Foreign currency deposits as a % of total deposits in banking system Source: CNB

Foreign currency deposits as a % of M4 Source: CNB

Foreign & domestic currency in circulation (EUR mio)

Why foreign currency? long history of macroeconomic instability dating back to ex-Yugoslavia: high inflation, frequent devaluations, partial foreign exchange deposit expropriations financial markets might not have a long memory, but citizens do large diaspora, tourism simple inertia

Interest rates on long-term domestic and foreign currency deposits

Consequences of de facto euroization: structure of bank lending, 2004

Balance sheet effect: Banks hedge exchange rate risk with euro- clause in their loan contracts only an imperfect hedge - transforms exchange rate risk into the credit risk most borrowers have kuna denominated receipts

High degree of euroization – high liquidity and solvency risks CNB requires banks to keep 35% of the amount of their foreign exchange liabilities in liquid foreign currency instruments together with the central bank reserves: required liquidity buffer for the financial system high-cost insurance

Consequences of de facto euroization: quasi currency-board monetary policy CNB International reserves Base money

Quasy currency-board monetary policy: ER stability, but no commitment from the central bank trying to get the best of both worlds: credibility associated with the ER stability and low inflation keep two-way risk in order to discourage speculative capital and make speculation more difficult, as well as to allow the ER to reflect changes in fundamentals, although maybe in a limited way difficult game to play

What helps: low degree of integration into the international financial markets capital controls: explicit as in ‘98, or implicit like n regional political instability n lack of EU integration n banking problems n or a two way risk in the ER market

What makes it difficult? Lukewarm capital: reacts to bad news and exchange rate movements domestic instead of foreign players many instead of few elements of herd behavior, but different animal than institutional investors like pension funds, investment banks or hedge funds

Foreign currency reserves of the CB relative to base money and M1 Source: CNB

Average monthly exchange rate Source: CNB

Leaning against the wind in a highly euroized economy Source: CNB

Foreign exchange interventions vs. change of the exchange rate Source: CNB

Foreign exchange interventions vs. the level of exchange rate Source: CNB

A problem…? (enterprises fx deposits after and prior to the liberalization of the fx market) FX liberalization

…and an unorthodox solution! 42% of RR on foreign currency deposits has to be held in local currency weapon of detterance mismatch in banks’ balance sheets regulation allows banks to have non-zero net foreign currency position of up to 20% of liable capital

Reserve requirement monthly rate and volume

Prudential regulation has an impact on monetary policy coverage of foreign exchange liabilities by foreign exchange claims: minimum 35% –in effect limits the growth of domestic credits net foreign currency exposure: maximum 20% of the risk-based capital –banks grant kuna credits indexed in f/c => fx risk transformed into credit risk

What cannot be done? use of nominal depreciation for competitiveness improvement quick portfolio shift from a local currency rising interest rates (procyclical monetary policy) possible pass-through on inflation “original sin” - domestic agents are not able to transfer exchange rate risk (balance sheet effect)

Impact of ER movements and banking problems on the flow of bank deposits

What cannot be done? - cont. irreversibility of euroization dollarization hysteresis arising from inflation/depreciation expectations inertia network externalities in the use of foreign currency

What are the options? unilateral euroization  not acceptable continue with de facto euroized financial system  until euro is introduced de jure upon entry into the EMU  only then balance sheet risk will be removed from the system