What are the key areas of reform necessary for effective monetary management in centrally planned economies in transition?
As the new governments of Eastern Europe increasingly move from centrally planned to market-based systems, a wide range of reforms in central banking and monetary management, as well as in the broader financial sector, take on considerable importance for attaining macroeconomic stability. Indeed, the development of an efficient framework for monetary management—without which stabilization would be difficult to achieve—is an interactive and evolutionary process, whereby certain financial sector reforms facilitate the transformation of monetary management, and vice versa. This process involves providing greater autonomy to central banks, strengthening competition in the banking system, promoting the development of money and securities markets, streamlining the payments system, restructuring of the financial system to deal with problem loans and enterprises, and developing an effective banking supervision system.
For a detailed discussion, see “Financial Sector Reform and Central Banking in Centrally Planned Economies,” by V. Sundararajan, IMF Working Paper WP/90/120. available from the author.
While these goals are common in varying degrees to all countries seeking to reform their financial sectors, the structural features of centrally planned economies (CPEs) have posed special challenges for the design of reform measures and the sequencing of these measures in coordination with other structural and stabilization policies. This article outlines these challenges in the CPEs—based mainly on the experiences of Hungary, Poland, Czechoslovakia, and China—by presenting a conceptual framework of reforms in monetary policy framework and financial markets, within which country experiences could be interpreted and assessed.
A typical CPE has a state bank, which usually has a significant monopoly over banking and credit. Under this “monobank system,” there can exist an almost unlimited capacity to create bank deposits. In addition, specialized financial institutions often provide banking services to particular sectors, essentially channeling credit to enterprises in line with the rules specified by the central authorities.
There are two distinct and separate financial circuits. One serves the household sector, which receives personal incomes in cash, pays for consumption in cash, and deposits funds (mainly in savings accounts) with, or receives credit from, a specialized bank dealing with households. The other circuit serves enterprises, which receive credit from the monobank or other specialized banks and make payments to other enterprises and government entities via current bank accounts, while paying wages and salaries in cash. Associated with these two circuits are a “cash plan” to program currency issue and a “credit plan” that provides rules on credit allocation to meet planned output targets.
Given the reliance placed on the direct allocation of credit in a CPE, interest rates and exchange rates virtually have no role in allocating credit. Credit is usually extended to enterprises at low fixed interest rates, with no consideration to repayment risks and maturities of particular loans. In addition, interest rates offered on financial assets held by enterprises are kept at relatively low levels, and in many cases, surplus funds are siphoned off, usually by ad hoc agreements with the government and, in some instances, by high explicit tax rates. As a result, there is a strong tendency for enterprises to accumulate real assets (inventories, plant, and equipment), as opposed to acquiring financial assets.
Just as the cash plan and credit plan are formulated in the light of the physical input and output plans, so, too, are the foreign exchange and external borrowing and import plans. It is through these plans and attendant administrative controls that the economy is linked to the international economy. The exchange rate is seen mainly as an accounting device to enable conversions between foreign and domestic prices to be made consistently.
Any surplus of receipts over expenditures in the banking system is transferred to the government. Similarly, large transfers, including depreciation funds, are made by enterprises to the treasury, and the state budget is thus a major source of investment funds and subsidies, often by onlending through banks. However, the dominance of state enterprises as borrowers from the banking system obscures issues of risk and hence impinges on the efficient allocation of bank funds. Bankruptcy, while technically possible, is in practice avoided by transfers of government funds and rollover of bank credits.
Stages in the reform of monetary management and financial markets
(Arrows indicate the direction of influence)
Citation: 29, 1; 10.5089/9781451953060.022.A003
1 Includes actions to deal with fixed-rate loans, nonperforming loans, capital adequacy, and subsidized selective credits, etc.
A new banking structure
The first important step in financial sector reforms in CPEs is the transformation of the monobanking system to a two-tier banking system, in which the state or national bank assumes the traditional central banking functions, focusing on regulating overall credit and interest rates, while newly established commercial banks take on the responsibility of deposit and loan transactions with households and enterprises. Existing specialized banks are also given greater autonomy. Such a transformation took place in China in 1984, Hungary in 1987, the Union of the Soviet Socialist Republics in 1988, Poland in 1989, and Czechoslovakia in 1990.
Significant efforts have also been made in recent years to strengthen the autonomy of the central banks of Hungary, Czechoslovakia, and Poland. For example, in Hungary, a proposed law strives to strengthen the appointments and tenures of the National Bank’s board of management and set limits on central bank credit to government. Following the political changes in mid-1989, Poland implemented major legal reforms to limit central bank credit to the government, reduce the scope of the credit plan, modify the statutory objectives of the National Bank of Poland, and strengthen the Bank’s powers in controlling monetary policy. At the same time, such autonomy has to be accompanied by clear arrangements for the accountability of the central bank for the stated statutory objectives. The legal amendments to achieve these goals are still being pursued in these countries; Poland, however, has already adopted some of the needed amendments.
As regards the activities of the recently established commercial banks, their ability to compete for deposits and loans of nonbank entities are somewhat limited, owing to the dominance of specialized banks that existed prior to the reform. Although the system is still dominated by specialized banks, the regulatory environment has been liberalized to permit freedom in lending, undertake a wide range of investments and services, and create a new range of financial institutions.
The new commercial banks are technically autonomous in their loan and management decisions. But their autonomy and competitiveness is often hampered because of heavy dependence on central bank funds; extensive reliance on interest subsidies from the budget; the large share of state-directed low interest loans, particularly for housing; the dominance of large state enterprises in the loan and deposit portfolio; and finally, the state ownership of most banks. Of course, the relative importance of the above factors differs from country to country.
Reforms of monetary management
Closely associated with the banking reforms have been major changes in the mix of instruments of monetary control and in the foreign exchange system. Indeed, the reform of monetary instruments can be seen as an evolutionary process divided into several stages, and the transition from one stage to the next typically requires reforms in the other central banking functions and in the broader financial sector. Most countries are at the beginning of stage two (see box). Much progress has been made to adapt monetary control instruments to the structure of the banking industry. The detailed credit allocation process has been replaced by various direct and indirect controls, such as central bank refinancing quotas and bank-specific credit ceilings, supplemented, as needed, by reserve requirements and special deposits with the central bank. Recently, some market-based indirect instruments (e.g., treasury or central bank bill auctions) have also been introduced in Czechoslovakia, Poland, and Hungary. In addition, liberalization of current account restrictions and the unification of the exchange rate system, with some progress toward domestic markets in foreign exchange, have been prominent features of reform in Czechoslovakia and Poland.
The authorities have sought to carry out monetary policy in ways that are conducive to money market development. This has been done by gradually emphasizing operations in money market securities and by encouraging banks themselves to operate in this market. The success of such policy objectives rests on flexibility in interest rates and the implementation of various supporting reforms, such as strengthening prudential regulations, public debt management, and accounting and bank reporting systems.
The design of monetary policy instruments and the evolving structure and scope of interest rate policy have been strongly influenced by the uneven distribution of deposits and credits following banking reforms, the weaknesses in the clearing and settlement system and in money markets, as well as other structural and policy factors.
Uneven distribution of deposits and credits among banks. This resulted, in part, from the way banks were split up from the monobank and contributed to the large dependence on central bank or interbank deposits for many banks, particularly the newly formed banks. As a consequence, central bank refinance policies—the interest rates on refinance, and the methods of allocating refinancing facilities among the banks—have had a far reaching impact both on the effectiveness of monetary control and on the evolution of money and interbank markets. In most countries, the facilities for allocating financing from the central bank among individual banks, based on uniform criteria, have posed difficult technical problems. The use of uniform criteria put pressure on the nascent interbank market to redistribute a large volume of bank reserves. In order to avoid the resulting hardship to banks and enterprises, a part of central bank assistance was given out as medium-term loans and the rest of the assistance was restructured into various short-term facilities—bill discount, credit against collateral of bills and securities (Lombard credit), and current account (overdraft) credit. In Czechoslovakia, however, the dependence of deficit banks on the interbank deposits of surplus banks turned out to be so massive as to raise doubts about the degree of competition and flexibility in the money and deposit markets.
Payments systems. The clearing and settlement systems for payments are typically on a gross (item-by-item) basis, instead of a net basis (that is, net of payments to other banks). The lack of net clearing arrangements, the delays in transmitting information, inadequate rules for interbank settlements, and the preoccupation of the system with the legality of payments—more than the speed and certainty of delivery of funds—have together created large uncertainties in the amount of banks’ clearing account balances, weakened monetary control, and distorted monetary statistics and prudential returns. These inadequacies have become a significant factor in many countries, impeding the growth of money and interbank markets and the effective pursuit of indirect monetary control based on active liquidity management by the central bank and commercial banks.
Other structural and policy factors. While interest rates have been largely liberalized in Poland, different degrees of control remain in China, Czechoslovakia, and Hungary. As is to be expected, the refinance rate—the rate at which resources can be obtained from central banks—became the key interest rate influencing or guiding the deposit and lending rates in Hungary, Poland, and Czechoslovakia. As part of stabilization measures, real interest rates were increased substantially—in some countries to positive real levels. However, the effectiveness of such interest rate management has been constrained by the structure of the banking system. First, the level and structure of interest rates has been influenced by the high degree of concentration in the banking system, by the large share of loans at low and fixed interest rates in most countries, and by the massive volume of nonperforming loans in others. Second, the response of non-banks to interest rate policy has been weak, owing to lack of financial discipline and slow progress in restructuring enterprises and establishing accountability for profits. Finally, flexible management of interest rates has proved difficult largely because of the difficulties in introducing market-based instruments of monetary control, which require adequate flows of information supported by speedy and reliable accounting procedures, settlement arrangements, and policy research.
Many of these constraints to effective monetary policy are being addressed as part of the current program of banking and monetary reforms. In particular, the authorities are either implementing or considering various methods to deal with the large volume of loans at low and fixed interest rates in major financial institutions. Similar, but more complex problems, arise with regard to the large volume of nonperforming loans in all countries, particularly Czechoslovakia. In all countries, reforms of various central banking functions—notably research, accounting, and information technology—are underway in support of active monetary policy.
The sharp growth in foreign currency deposits of households (and also enterprises in some countries) in the domestic banking system has posed special challenges to the implementation of monetary policy in Poland and to some extent, in Czechoslovakia. A major problem has been the significant short-run shifts in the demand for domestic currency assets and in the national currency money multiplier, owing to changes in exchange rate expectations and the consequent substitution between domestic and foreign currency deposits. In addition, the sizable foreign currency exposure of the banking system has led to large losses or reduced profits, particularly following currency depreciation. Various approaches to dealing with these problems have figured prominently in the debate on financial sector reforms.
The introduction of banking supervision has not kept pace with the rapid developments in the banking system and the rapid growth in the number of banks in some countries. The slow progress in banking supervision reflected weaknesses in the legislation, as seen in China, protracted debates on the appropriate role and structure of banking supervision, as in Poland until mid-1989 and Czechoslovakia more recently, and limited resources devoted to supervision. The need to adapt the traditional accounting concepts to the needs of a market-oriented economy and the difficulties in building up staff with the requisite training also slowed progress in developing supervisory systems.
The application of prudential supervision has also been complicated by many macroeconomic and technical factors. These include political difficulties in restructuring banks and enterprises in order to absorb the losses due to bad loans and foreign exchange exposure, the inadequacies of loan recovery and bankruptcy laws, the dominance of large loan or deposit customers in many countries, and the limited scope for raising capital in most CPEs. The absence of adequate credit analysis and loan monitoring and internal audit systems in commercial banks also impedes the supervision process. Moreover, the lack of progress in dealing with losses due to bad loans and foreign exchange exposure has constrained the decisions on interest rate policy.
Financial sector reforms in many CPEs are being implemented in a period of significant instability in the macroeconomic environment, weakness in balance of payments, and major distortions in relative prices and investment allocation. The need to implement stabilization policies supported by financial sector reforms and other structural reforms raises complex questions regarding the appropriate sequencing of central banking and financial sector reforms and their integration with macroeconomic adjustment measures. In particular, the significance of monetary policy reforms for effective stabilization, as well as the close links between reforms of monetary policy, money markets, and the clearing and settlement system, point to the importance of parallel reforms in these areas early in the reform sequence.
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