Chapter I. Coping with Capital Flows under an Inflation Targeting Regime: Lessons for Poland1
1. As the global financial crisis wanes, with declining risk aversion, Poland could be affected disproportionally by a rebound in capital flows to Emerging Europe. As the only EU economy to avoid outright recession during the crisis, Poland is likely to attract renewed risk appetite. In particular, as investors begin to differentiate across the region, Poland could become one of the main recipients of capital inflows. This could lead to excessive exchange-rate appreciation, which would undermine competitiveness. Moreover, rapid capital inflows, especially when associated with a domestic credit boom, can create the conditions for overheating of the economy. The recent global crisis shows that such risks should not be underestimated and suggests the need to be prepared to adopt policies to stem excessive inflows.
2. The policy response to excessive capital inflows can be multidimensional. While fiscal tightening is generally seen as a useful policy response, in practice it has been used only to a limited extent.2 The conventional wisdom in the literature and among policymakers points to exchange rate flexibility as an appropriate response to capital inflows.3 Indeed, Poland’s adoption of inflation targeting in 1998, concurrent with the introduction of a free-floating exchange rate regime, was in part motivated by the rapid capital inflows in the late 1990s.4 However, persistent exchange rate appreciation, especially if not justified by the underlying fundamentals, can lead to overshooting and attendant macroeconomic instability. Indeed, past experience suggests that there is scope for a less-conventional response, including through foreign-exchange intervention and macro-prudential regulations.
3. Purchases of foreign-exchange (FX) can help dampen exchange-rate appreciation, while boosting official reserves. Under certain circumstances, intervention in the foreign exchange market can be a prudent strategy to resist unwarranted appreciation. The recent Israeli experience with reserves accumulation provides an example of an intervention strategy that was successful both in stemming rapid exchange rate appreciation and maintaining a credible inflation-targeting framework.
4. Targeted macro-prudential regulation can help stem capital inflows, while strengthening the financial sector. While the main objective of such policies is not to curb capital inflows or reduce upward pressure on the exchange rate per se, macro-prudential measures have shown to be effective in mitigating the risk of rapid credit growth and credit fuelled bubbles in asset markets. Similarly; under certain conditions, targeted prudential measures can be effective in mitigating vulnerabilities created by foreign-currency denominated lending.
5. The structure of the paper is as follows. Section II provides some stylized facts on past and recent capital inflows to Poland. Section III discusses potential policy responses to capital inflows by analyzing the role of three broad intervention strategies, foreign-exchange reserves accumulation, macro-prudential regulations and capital controls. Section IV draws initial lessons for Poland and section V concludes.
B. Stylized Facts on Capital Flows to Poland and Emerging Europe
6. Capital flows to Poland were smaller and less volatile than in other Emerging European countries (Figure 1). On the whole, capital inflows to Emerging Europe were justified by a real convergence process. But, in certain countries, these inflows became excessive and concentrated in non-tradable sectors, mostly real estate, banking and other services. The resulting absorption boom led to the build-up of substantial external imbalances and, in some cases, abrupt capital flow reversals during the crisis. While Poland experienced a decline in flows, the magnitude was relatively small. Indeed, the volatility of capital flows into Poland has been lower during both the boom and crisis periods, in part due to timely introduction in the boom period of counter-cyclical macro-prudential measures—notably on FX mortgages. More recently, Poland has outpaced the region in both gross and net capital inflows, due to renewed risk appetite for strong emerging markets.
Figure 1.Poland: The Boom Years, Cross Country Comparison
Sources: IMF, World Economic Outlook; IMF, International Financial Statistics; and IMF staff calculations.
C. Policy Response to Capital Inflows
Foreign-Exchange Market Strategy
Intervention in the foreign-exchange market can be a prudent strategy to resist appreciation, once the REER rises beyond what is justified by fundamentals—with implications for competitiveness and medium-term growth—and if the authorities see scope for building up foreign reserves. In this context, the recent Israeli experience provides a useful illustration of a successful example of intervention policy aimed at building adequate precautionary reserves in the face of strong capital inflows and exchange rate appreciation, while preserving the credibility of the inflation targeting regime. Moreover, the relatively similar Colombian experience highlights the need for a systematic approach to be timed appropriately with the country’s cyclical position.
7. In the absence of inflationary pressures, purchases of foreign exchange can complement interest-rate cuts in stemming capital inflows. Under such conditions, loose monetary policy and purchases of foreign exchange, with minimal sterilization, can stem capital inflows in a manner consistent with the inflation targeting objective. However, under a rising (positive) output gap and overheating economy, attaining the inflation target and stemming capital inflows may give rise to conflicting objectives. Specifically, in the presence of rising inflationary pressures, tighter domestic interest rates will only tend to induce further capital inflows, which would undermine the desired effect of intervention. At the same time, any purchases of foreign exchange would need to be fully sterilized to support tighter monetary conditions, which could be costly.
8. A broader assessment of the costs and benefits of building up reserves needs to be considered as well. While an increase in reserves creates precautionary balances to address potential current and capital account shocks, the benefits need to be weighed against the costs arising from an excessive build-up of reserves. These costs arise from the opportunity cost of foregone consumption and investment—generally proxied by the spread between the interest paid on the country debt and the risk-free return of reserves.5
The Israeli Experience
9. The recent Israeli experience provides an example of successful foreign reserves management consistent with an inflation targeting mandate. In March 2008, in the face of sustained capital inflows and upward pressure on the shekel, and relatively low levels of foreign exchange reserves, the Bank of Israel (BoI) initiated a two-year $10 billion foreign-exchange accumulation program. Following a review of its reserves management, the BoI had identified a target range of $35-40 billion in foreign exchange reserves as being appropriate to the needs of the rapidly growing Israeli economy and its increasing integration into the global economy. In order to avoid an undesirable impact on the exchange rate and to minimize interference with the market mechanism, the purchase of foreign exchange by the BoI was conducted in pre-announced daily operations. At $25 million per day, the initial purchases were quite small relative to average daily volume in the Israeli foreign exchange market, which at the time was over $2 billion. By mid 2008, the daily intervention size increased to $100 million. In late 2008, following a reassessment of its FX reserve adequacy level, the BoI raised its targeted range to $40-44 billion.
Israel: Foreign Exchange Reserves, billions USD
10. The intervention strategy has been in line with the announced objectives. The BoI’s revised target was reached by early 2009, a year earlier than initially planned, but the central bank maintained its pre-announced reserve accumulation program until August. Since then, the BoI discontinued its program of daily FX purchases of $100 million, albeit said that it will continue to intervene on a discretionary basis “in the event of unusual movements in the exchange rate which are inconsistent with underlying economic conditions, or when conditions in the foreign exchange market are disorderly.”6
11. In measuring the success of this program, the Israeli authorities point to meeting two key objectives: (i) achieving FX reserves adequacy level and (ii) implementing a transparent and credible strategy so as to preserve the inflation targeting framework. The first objective was clearly met, notwithstanding that the targeted level was exceeded substantially.7 The second objective appears to have also been met, as long-term inflationary expectations were continuously anchored within the targeting range. However, the recent shift to a less-transparent discretionary intervention has raised questions among market participants about the credibility of the inflation-targeting regime in the years ahead. While the authorities view the shift to discretionary intervention as a transitional step back towards a free floating exchange rate regime, the IMF has since reclassified Israel’s exchange rate regime from “free floating” to “floating.”8
12. While not explicitly stated as an objective, the reserves accumulation strategy appears to have been also effective in stemming the rapid appreciation of the shekel. Between December-2007 and July-2008, Israel’s real effective exchange rate rose by close to 20 percent.9 Over this short period, on a nominal basis, the shekel appreciated by about 25 percent against the US dollar and 12 percent against the euro. Since the intervention program was put in place, notwithstanding global developments, the shekel reversed course and, through end-2009, has depreciated by about 15 percent and 10 percent against the US dollar and euro, respectively.
Israel: Real Effective Exchange Rate, CPI-base
The Colombia Experience
13. The Colombia’s Central Bank intervention strategy between 2004 and 2007 offers further insights on the need to time foreign exchange intervention correctly with the economic cycle. In the context of an inflation-targeting and a flexible-exchange-rate regime, in 2004, the Banco de la Republica (BdR) of Colombia made use of both rule-based auctions of foreign currency swaps as well as direct and discretionary interventions in the spot market. This move was consistent with its foreign exchange strategy which aims, within a floating regime, at maintaining an adequate level of reserves, limiting excessive volatility at short horizons, and moderating excessive exchange rate movements that endanger the attainment of inflation targets and financial and external stability.
14. The intervention strategy aimed at addressing persistent and mounting peso appreciation. Between end-2003 and end-2004, the Colombian peso appreciated by close to 20 percent against the US dollar, which led to expectations that inflation would fall well below its target coupled with adverse effects on external competitiveness.
15. However, empirical evidence suggests that only the early intervention period was successful in stemming excessive currency appreciation.10 Initially, the intervention was based on pre-determined auctions, supported by policy rate reductions given that the economy was still operating below potential. However, as difficulties to contain the exchange rate appreciation in an overheating economy mounted, dollar purchases occurred in parallel with tightening monetary policy. As a result, by mid-2007, the BdR sent conflicting and ineffective signals to the markets by using the policy rate as instrument to target inflation, and foreign currency intervention to target the exchange rate.
16. Moreover, the pursuit of inconsistent policies and the commitment to the inflation target gave rise to the build-up of offsetting financial derivatives positions as investors started betting on a peso appreciation. The one-sided, protracted discretionary intervention by the central bank exposed the peso to speculative appreciation pressures as a consequence of leveraged one-way bets in the derivatives market by investors expecting BdR to remain committed to its price-stability objective.
17. The Colombia experience exemplifies the need for a credible intervention strategy and the risks to financial stability arising from conflicting goals. Sterilization of foreign reserve accumulation is unsustainable in the presence of rising output gaps. Therefore, the country cyclical position is a key consideration in any FX strategy to ensure stable inflation and avoid external imbalances.
A strong macro-prudential framework can be a key element in the overall policy approach to capital inflows. The primary objective of macro-prudential policies is not to stem capital inflows or reduce upward pressure on the exchange rate per se. Instead, it is to protect the banking system from a reversal of boom-like macro-economic conditions that may be characterized by strong capital inflows, rapid credit growth and credit-fuelled bubbles in asset markets. Measures aimed at increasing the resilience of the banking system may indirectly discourage an overly rapid growth in credit and reduce the build-up of foreign exchange denominated exposures.
18. To be effective, a strong macro-prudential framework needs to combine a range of interlocking measures. A prudential approach that focuses on a single measure, such as the Basel capital adequacy ratio, can encourage a build-up of risks that are inadequately captured, as banks increase those risks that are not monitored effectively and arbitrage existing prudential requirements. Indeed, cross-country evidence suggests that the introduction of prudential measures, sometimes supported by monetary measures, appears to have contributed, on average, to some, at least temporary, containment of lending booms, especially when the prudential approach relied on a range of measures.11
19. The monitoring and control of liquidity risks needs to be a key element of the macro-prudential approach. The global financial crisis has shown up inadequate control of liquidity risks that arise from an overreliance on short-term funding markets.12 Such funding has typically been sourced in international wholesale markets and the embedded currency mismatches have further increased banks’ vulnerability. In response, the Basel Committee issued a consultation paper that envisages an international requirement for banks to hold highly liquid assets against funding sources that are subject to roll-over risks. The paper also emphasizes the need to contain currency mismatches in banks’ liquidity positions.13
20. A macro-prudential approach requires the build-up of buffers in good times that can be drawn upon in bad times. The framework likely to be adopted in the EU combines dynamic provisioning and time-varying capital buffers.14 A dynamic provisioning framework, such as the one operated in Spain since 2000, requires banks to set aside general provisions against loan losses that are expected to occur over a full economic cycle. When the credit cycle turns and loan losses are realized, the general provisions are released and replaced by specific provision for losses incurred, avoiding the cyclicality in provisions that may otherwise undermine capital positions in recessions. In addition, the authorities can take measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress. Such a countercyclical capital framework contributes to a more stable banking system, by smoothing the impact of economic and financial shocks arising from volatility in capital flows. Central bank imposed controls on the growth of credit, such as used in Croatia from 2007, are an alternative that could also be considered (discussed below).
21. Measures directed at banks’ balance sheets are usefully complemented by close supervision of lending standards. Poland, for example, recently adopted new regulations, known as Recommendation T, intended to enhance banks’ appraisal of credit risks for consumer loans, including through the introduction of maximum loan-to-income (LTI) and loan-to value (LTV) ratios.
22. The risk of a build-up of foreign exchange denominated exposures requires special attention. Across central and eastern Europe (CEE), since the late 1990s a rising share of household loans, mortgages in particular, was denominated in foreign currency, especially euro and swiss franc.15 In the process, households took on substantial unhedged foreign exchange (FX) liabilities, creating balance sheet vulnerabilities and significantly complicating policy responses across the region. In countries with flexible exchange rates, the depreciation of local currencies in late 2008 and early 2009 led to increases in debt servicing costs, depressing disposable income and consumption. In countries with fixed exchange rates, devaluation was feared to unduly stress household balance sheets, even though it was felt that this could have helped restore competitiveness.
23. Foreign-exchange denominated exposures may also create significant vulnerabilities for the banking sector. A depreciation of the local currency can lead to a reduced ability of households to repay their loan, implying a higher probability of default (PD). When the collateral backing the loan (e.g. a local house) is priced in local currency, depreciation also leads to an erosion of collateral value relative to the loan amount and increases the loss given default (LGD). 16 Depreciation finally leads to an expansion of (risk-weighted) assets when loan amounts are converted into local currency on banks’ balance sheets. Since the offsetting unrealized capital gain is not usually allowed to count towards regulatory capital, this puts pressure on capital ratios and can lead to a capital crunch.
24. Further vulnerabilities can arise depending on the way foreign exchange denominated exposures are funded and hedged. Short-term foreign funding may be subject to sudden reversals, exposing banks to roll-over risks. Such funding can also lead to a squeeze of net interest income, when margins over variable rates are fixed under the long-term mortgage contract, but vary on interest paid depending on market conditions. Experience across the region has shown that when funding is raised domestically, but hedged through short-term currency swaps this can likewise create important vulnerabilities. Depreciation increases the cost of rolling over the hedge. Moreover, in stressed conditions, banks may be unable to roll over the hedge in private markets, forcing recourse to central bank provided currency swaps. Box 1 provides more detail on vulnerabilities arising on the funding side.
25. A range of prudential measures can be taken to address the risks arising from foreign exchange denominated mortgages. In a number of countries, Poland included, prudent loan-to-value (LTV) ratios have helped limit household sector vulnerabilities from foreign exchange denominated mortgages. In addition, the liquidity framework can be enhanced by prescribing that long-term foreign exchange denominated exposures are funded and hedged on a long term basis. Finally, capital requirements can be raised to reflect increased credit and valuation risks associated with FX exposures. Such measures can increase the resilience of the banking sector but will also raise the cost of offering foreign exchange denominated mortgages, potentially cooling capital inflows associated with funding these exposures. However, increased capital requirements can be more effective if this measure is coordinated with the home country supervisors of parent banks, since there is a risk otherwise that foreign exchange denominated mortgages are provided directly by parent institutions.17
26. Ultimately, an effective macro-prudential framework needs be based on close cooperation between national authorities and can be strengthened by multilateral action. Cooperation between the central bank and the supervisory authority needs to extend both to the analysis of threats to financial stability arising from inflows and the coordination and timing of new measures. Attention needs to be given to avoid pro-cyclicality and excessive rigidity in the system, with adverse effects on the health of the banking system and access to credit on the part of households and enterprises. Moreover, the crisis has shown that national approaches to mitigate cross-border flows face important limitations. The approach to capital inflows in the EU is likely therefore to benefit from multilateral action that could be taken under the auspices of the new European authorities, such as the European Banking Authority (EBA) and European Systemic Risk Board (ESRB).
Box 1.Funding Foreign Exchange Denominated Mortgages: Risks and Flows
Over and above the vulnerabilities arising on the asset side of banks’ balance sheet, additional vulnerabilities can arise from the way banks fund FX loans. When the loan is funded long-term in foreign currency, e.g. through a long-term FX bond, this creates a foreign capital inflow which tends to create upward pressure on the local currency. However, the flow is not vulnerable to a sudden reversal that could put pressure on the banking system.
When the loan is funded short-term in foreign currency, e.g. through FX deposits, sourced in wholesale markets, or—more often—from a foreign parent bank, there is again a capital inflow and an effect on the exchange rate when the funding is first initiated. In addition, the capital inflow is vulnerable to a sudden reversal, creating an acute risk for the banking system if banks are unable to roll-over their short-term foreign funding.
Under a third common funding model, the loan is funded short-term in domestic currency, but the foreign exchange risk inherent in such funding is hedged through a short term swap.1 The swap does not create a net capital inflow in itself.2 However, since the domestic bank will sell the foreign currency received under the swap contract in the spot market, in order to create a net short FX position, a capital inflow and upward pressure on the exchange rate still arise.
This funding model also creates vulnerabilities that relate to the local bank’s ability to roll-over the hedge. A shortage of foreign currency in international markets (as observed for dollars, euros and swiss francs during the crisis) and increased perceptions of counterparty credit risk may increase the cost of rolling over the hedge. Indeed, the experience during the crisis has been that private swap markets broke down from 2008Q4 across the region, forcing recourse to central bank provided currency swaps.3
Even when private swap markets remain open, a depreciation of the local currency will tend to lead to margin calls and increase the cost of rolling over the hedge in local currency terms. This may in turn create a liquidity squeeze in local interbank markets.
Capital controls may help counter strong temporary surges in capital inflows and reduce pressure on the exchange rate. They can also alter the composition of flows and reduce macro-financial vulnerabilities associated with rapid inflows. Capital controls can be administered by the government (often the fiscal authorities) or the central bank. Both unremunerated reserve requirements (URRs) and taxes on capital inflows have been used widely in the past, especially in emerging markets. However, they impose an administrative burden and can be circumvented.
27. The use of unremunerated reserve requirements and taxes on capital inflows both reduce the attractiveness of inflows, but work in different ways.
URRs—which entail a mandatory deposit of a portion of short-term foreign currency debt for a specific period without remuneration—involve a relatively straightforward change in the central bank’s operational framework, typically augmenting preexisting reserves requirements imposed on the domestic banking system. While the evidence on the effect of URRs on the volume of inflows is mixed they have proved effective in protecting the banking system by altering the composition of inflows towards longer maturity, notably in the cases of Columbia, Chile and Croatia. The case of Croatia is a good example of how the monetary measures can be effective, especially when they are combined with a range of prudential measures (Box 2). However, URRs imposed on domestic banks can push business offshore or into the non-bank financial sector. They also impose an administrative burden on the banking system, which increases with repeated changes in coverage and terms. Their design is constrained by the EU Treaty and other regulations and must not involve discrimination between foreign and domestic providers of funds.
A tax on inflows aims at discouraging the targeted financial transactions by reducing the rate of return to non-resident investors on domestic assets. The recent case of Brazil has highlighted the limited impact of these measures if applied to specific transactions. While a broad tax on capital inflows can help avoid tax evasion and possibly have countercyclical effects in terms of revenues, there are high costs associated with building the administrative capacity required to impose a broad-based tax, and even where the necessary apparatus already exists, enforcement and collection issues can be a constraint. Taxes that discriminate between foreign and domestic residents within the EU are in any case likely to be inconsistent with the EU Treaty (Box 3).
Box 2.The Experience of Croatia18
From 2004 the Croatian National Bank (CNB) took a number of steps to reduce macro-financial vulnerabilities associated with strong capital inflows and rapid credit growth. These included a marginal reserves requirement (MRR) on foreign borrowing (from 2004), which was combined with direct measures to control the growth of credit (2003 and 2007) and a number of prudential requirements. Together, these measures were successful in slowing the growth of bank credit and increasing banks’ awareness of risks, especially regarding FX lending. They also altered the composition of banks’ funding. In response to the measures, foreign borrowing declined and banks intensified their efforts to attract domestic deposits to fund their activities. Capital adequacy also increased, in part because foreign-owned banks have found it cheaper to raise capital from their parents rather than rely on foreign borrowing subject to CNB measures.
At the same time, the measures had some undesirable implications. Most obviously, the measures tend to raise spreads and may have reduced access to credit for small and medium-sized enterprises. Moreover, in the presence of effective credit limits, foreign banks helped arrange direct cross-border borrowing for their clients, typically for the most creditworthy large corporates, leaving the Croatian banks mostly with customers with no other sources of financing. In addition, regulatory arbitrage led to unwelcome developments in the non-bank financial sector, with leasing companies extending credit. Finally, the measures had administrative costs for banks and the CNB, as attempts to circumvent the regulations prompted successive adjustments in their scope.
Marginal reserve requirement (MRR) on banks’ new foreign borrowing: introduced in mid-2004 at a rate of 24 percent, subsequently increased in steps to 55 percent; loopholes in the base closed.
Special reserve requirement, SRR (2006): set at 55 percent on banks’ liabilities arising from issued securities to close a loophole for the MRR. The reserve base is any increase in the balance of issued securities in a specific period of time compared with the average balance of the issued securities in January 2006.
Credit controls were reintroduced in 2007; (last applied in 2003); banks were required to purchase low-yielding CNB bills for 50 percent of the amount by which their credit growth exceeded a ceiling, which is consistent with 12 percent credit growth for the full year (“12 percent rule”). Since their introduction, the CNB modified controls several times, tightening conditions, closing loopholes and introducing monthly sublimits.
Foreign-currency liquid asset requirement (the “32 percent rule”) (2003) (the base was broadened in late 2006 to include indexed instruments).
Requirement to set aside provisions for general banking risks for banks with asset growth above specific threshold (2004, modified in 2006)
Increased risk weights on unhedged FX loans (2006, raised further in late 2007);
Issuance of guidelines for banks on managing risks of FX/ household loans (2006).
Minimum required capital linked to credit growth and funding sources (2007)
Cross-border supervisory coordination intensified.
Box 3.EU and OECD Regulation on Capital Controls
EU: Article 56(1) of the EU Treaty prohibits capital controls, stating that “all restrictions on the movement of capital between Member States and between Member States and third countries shall be prohibited.” Nevertheless, the prohibition needs to remain consistent with the member’s right “to take all requisite measures to prevent infringements of national laws and regulations, in particular in the field of taxation and the prudential supervision of financial institutions, or to lay down procedures for the declaration of capital movements for purposes of administrative or statistical information, or to take measures which are justified on grounds of public policy or public security” (Article 58(1)). Although this leaves a certain margin of discretion, the Treaty clarifies that the above measures and procedures cannot constitute “a means of arbitrary discrimination or a disguised restriction on the free movement of capital and payments” (Article 58(3)). Ultimately, the Court of Justice of the European Communities is responsible for judging which measures are compatible with the rules of the Treaty.
OECD: The OECD Code of Liberalization of Capital Movements and Code of Liberalization of Current Invisible Operations prescribes to its members the full liberalization of all current and capital transactions and the related payments and transfers. Temporary reservations to liberalize specific transactions are accepted to allow the needed sequencing. However, new restrictions—defined as any discrimination in transactions between residents and non-residents—can be introduced only under specific conditions (that is if (i) free capital flows have resulted in serious economic and financial disturbances or (ii) in the case of serious balance of payments difficulties for a limited time) or if the latter does not apply for specific transactions (mainly short-term and real estate-related).
WTO: As the EU has accepted specific WTO commitments concerning trade in banking services, General Agreement on Trade in Services (GATS) provisions introduce WTO jurisdiction over the capital flows associated with these banking services. While there is exclusion for prudential measures, capital controls are subject to a WTO dispute panel.
D. What Are the Lessons for Poland?
28. Poland’s Central Bank Act stipulates that its key objective is to maintain price stability. However, while the National Bank of Poland’s (NBP) mandate focuses on the inflation target, it allows for the use of multiple instruments to achieve it. For example, the mandate considers foreign exchange intervention as an appropriate monetary policy instrument. Specifically, in the event that exchange rate fluctuations exert a considerable impact on macroeconomic and financial stability, which in turn endangers the attainment of the inflation target, the NBP has in its discretion to intervene directly in the foreign-exchange market.19
29. Intervention in the form of FX reserves management can provide a line of defense to a potential resurgence in capital inflows. As highlighted by the recent Israeli experience, a systematic and transparent foreign exchange strategy can smooth excessive exchange rate appreciation and enable the build-up of reserves, while remaining consistent with the inflation targeting objective. However, the correct timing of the intervention policy, consistent with the economic cycle, is essential to achieve these objectives. For Poland, the strategy seems justified by the state of the cycle, with the economy not expected to reach potential until 2011 and a stable inflationary environment (Figure 2). Additionally, a case for building up reserves for precautionary purposes can also be made. For example, measured against standard reserves adequacy metrics, Poland’s reserves coverage, while improving, remains relatively low (Figure 3). In particular, in order to satisfy an adequacy rule ala Guidotti-Greenspan—that is, 100 percent coverage of gross financing requirements (short-term debt at remaining maturity plus the current account balance)—the authorities would need to target $20-25 billion in additional FX reserves, albeit access to the IMF’s Flexible Credit Line provides another potential source of FX liquidity to meet this target level or possible tail risks.
Figure 2.Poland’s Cyclical Position, 2004Q1-2009Q4 Figure 3.Poland: REER and Reserves Position, 2000-09
30. However, a reserves accumulation strategy would ultimately represent a short-term solution. While intervention when output is still below potential tends to be consistent with the inflation target objective, its effectiveness is hampered once the macroeconomic cycle calls for tightening of monetary policy. In this case, intervention cannot help deal with the inflationary impact of capital inflows as higher interest rates would only trigger further inflows, potentially leading to a vicious cycle.
31. A strong macro-prudential framework can also help stem flows while strengthening the financial sector. The Polish financial authorities have already put in place a set of regulatory and supervisory measures that helped mitigate a surge in financial sector flows seen elsewhere in the region during the boom period. The 2006 introduction of Recommendation S by NBP’s Banking Supervision has helped strengthen risk management in the mortgage sector and limit household sector vulnerabilities from foreign currency mortgages.20 Furthermore, the authorities recently approved Recommendation T that aims to strengthen what were perceived to be uneven lending standards for consumer loans, including through the introduction of new maximum debt to income ratios. To further strengthen the macro-prudential approach, the authorities may consider introducing countercyclical capital buffers and provisions and reviewing the strength of existing liquidity standards in light of international proposals.
32. Specific vulnerabilities created by FX mortgages call for further targeted intervention. A first useful step is the development of a liquidity regime that ensures that FX mortgages are funded and hedged on a long-term basis. In addition, increased risk weights on foreign currency exposures could be introduced to reflect greater credit and valuation risks associated with these exposures. Such measures may also increase the costs to banks of offering foreign currency denominated mortgages and cool capital inflows associated with funding FX exposures. However, these measures can be more effective if implemented in cooperation with the home authorities of parent banks. Otherwise, there is a risk that FX mortgages will be provided by parent institutions, sidestepping local regulations.
33. Monetary controls on capital inflows could also be considered in case of rising pressures. Even when their effect on the volume of flows is limited, monetary controls can help increase buffers and improve the resilience of the financial system to volatile capital flows. Croatia’s relatively successful experience with URRs on banks’ new foreign borrowing had resulted in temporary reduction in such borrowing. This example also shows that monetary controls work best when supported by a range of prudential measures. However, due attention needs to be given to the risk of discouraging financial intermediation and shifting activity offshore to circumvent domestic regulations. Moreover, in the case of Poland, the design of URRs would be constrained by the EU Treaty and OECD regulations.
34. As capital inflows return to Poland, policy makers should not underestimate the potential need to stem excessive inflows. Poland managed to largely escape the most recent boom-bust episode and, in the early quarters of the global recovery, Poland has outpaced the region in renewed capital inflows. As investors become increasingly more differentiating, Poland is likely to remain a key recipient of capital reflows to Emerging Europe and could see sustained upward pressure on its exchange rate in the years ahead.
35. While the flexible exchange-rate policy remains the main defense against a sustained surge in capital inflows, there is scope for additional policy tools. In order to avoid the prospect of an overshoot and sharp reversal, an effective policy response may require early intervention in the foreign exchange market and/or enhanced macro-prudential measures. Indeed, under certain conditions, the NBP could consider temporarily undertaking limited foreign-exchange intervention. Such intervention should be transparent and well-communicated, particularly if implemented along the lines of the recent Israeli experience, so as not to compromise the integrity of the inflation-targeting framework. Moreover, careful application of a strong macro-prudential framework can also help stem flows while strengthening the financial sector. Finally, limitations on foreign-currency lending recommended for prudential reasons could have the added benefit of slowing the resurgence in capital inflows.
Borio, C. and I.Shim (2007), “What can (Macro–) Prudential Policy Do to Support Monetary Policy?”BIS Working Paper No. 242.
Chang, R. (2008), “Inflation Targeting, reserves Accumulation, and Exchange Rate Management in Latin America,” Borradores de Economia 487, Banco de al Republica de Colombia.
Freedman, C., and I.Otker-Robe (2009), “Country Experiences with the Introduction and Implementation of Inflation Targeting,”IMF Working Paper 09/161.
Kamil, H. (2008), “Is Central Bank Intervention Effective Under Inflation Targeting Regimes? The Case of Colombia,”IMF Working Paper 08/88.
Kim, J., (2008), “Sudden Stops and Optimal Self-Insurance,”IMF Working Paper No.08/144.
Ostry, J.D., A. R.Ghosh, K.Habermeier, M.Chamon, M.S.Qureshi, and D.B.S.Reinhardt (2010), “Capital Inflows: The Role of Controls”, IMF Staff Position Note SPN/10/04.
Otker-Robe, I., Z.Polanski, B.Topf, and D.Vara (2007), “Coping with Capital Inflows: Experiences of Selected European Countries,”IMF Working Paper 07/190.
Ratnovski, L. and R.Huang (2009), “Why Are Canadian Banks More Resilient?”, IMF Working Paper 09/152.
Ricci, L., 2004, “Can Higher Reserves Help Reduce Exchange Rate Volatility?”IMF Working Paper No. 04/189.
Prepared by Natan Epstein, Manuela Goretti, and Erlend Nier, with research assistance from David Velazquez-Romero.
Evidence from emerging markets suggests that the growth in real government expenditure tends to rise strongly during periods of large net private capital inflows (see WEO, Fall 2007).
See Ostry et al. (2010).
See Freedman and Otker-Robe (2009).
Bank of Israel, Press Statement (August 3, 2009), http://www.boi.gov.il/press/eng/090803/090803f.htm.
At end-July, FX reserves reached $52 billion; at end-2009, reserves were at $60.6 billion, albeit reflecting SDR allocation of $1.2 billion. The reserves coverage of imports rose from 4 ½ months to 12 months over this period.
The reclassification was triggered after three consecutive discretionary FX purchases.
While at end-2007, IMF estimates pointed to shekel undervaluation, it was only in the order of about 5 percent (see IMF Country Report No. 08/63).
Empirical evidence confirms that a high share of wholesale funding has been a key predictor of bank failures during the global financial crisis. See Ratnovski and Huang (2009).
The European Commission has in 2009 started a consultation with a view to adopt dynamic provisioning across the EU. Separately, the Basel Committee is currently consulting on a set of reform proposals to strengthen the resilience of the banking system, including countercyclical capital buffers, http://www.bis.org/publ/bcbs164.htm.
While these loans are denominated in foreign currency, they are often settled in domestic currency. In the case of an FX mortgage denominated in swiss francs or yen, for example, the borrower receives local currency—equivalent to the contracted FX loan amount—and uses local currency to purchase a local home. Interest payments and repayment of the principal are also settled in local currency, at the prevailing exchange rate. However, in some countries in the region, such as Romania and Bulgaria, a high degree of “euroization” allows both the purchase of residential real estate and euro-denominated loans to be settled in euros,
This effect may be absent in countries where residential real estate is quoted in euros, rather than local currency.
A recent proposal by the European Commission envisages higher capital requirements for foreign currency mortgages across the European Union.
See Republic of Croatia: Financial Stability Assessment - Update, IMF, Washington D.C., 2008.
See National Bank of Poland - Monetary Policy Council - Monetary Policy Guidelines for 2010: http://www.nbp.pl/homen.aspx?f=/en/publikacje/o_polityce_pienieznej/zalozenia.html
Following the merger of banking supervision into the Polish FSA (KNF), an enhanced Recommendation S (II) was introduced in 2008.