Chapter III.2 The Changing Roles of Monetary and Exchange Rate Policies
- International Monetary Fund
- Published Date:
- December 1991
The introduction of economic reforms in the USSR has brought about some important changes in macroeconomic policy making. This chapter describes and analyzes the role and operation of monetary and exchange rate policies, and their implementation in the USSR before and after the reforms of 1987-88 (Sections 1 and 2). It also discusses the main points of the current proposals for further reforms in the financial sector (Section 3), with special emphasis on the issue of policy credibility for an economy in transition.
1. MONETARY POLICY BEFORE THE REFORMS
a. The role of monetary policy
The role and the instruments of monetary policy prior to the reforms of 1987-88 have to be considered in the context of the classical model of central planning that had prevailed in the USSR since the early 1930s. In that model, virtually all physical resources were allocated according to the central state plan, and the financial plan only mirrored the detailed quantitative plans for enterprise inputs and outputs. The subordination of financial planning to quantitative planning meant that real magnitudes would determine monetary aggregates, without in principle allowing for feedbacks. Planning started from the desired objective for production, which was apportioned between private consumption, public consumption, and investment. With the help of elaborate input-output models, the resulting main production objectives were translated into a detailed matrix of enterprise inputs and outputs. With prices being virtually fixed, and assuming a constant propensity to save out of disposable income, the desired (planned) stock of money in the economy could be derived. The role of monetary policy was to ensure that the liquidity injection into the economy took place in accordance with the plan.
To minimize any feedback that monetary variables might have on production and prices, the authorities pursued a policy of “dichotomized” money supply. In effect, credit to enterprises and their financial flows more generally were strictly. separated from those of households in two respects. First, within the enterprise sector, and between that sector and the budget, all financial transactions were carried out in the form of transfers of bank deposits. Cash holdings by enterprises were virtually prohibited, and currency was drawn from enterprise deposits almost exclusively for payroll purposes. While households could hold savings accounts, only currency served as their means of payment. The interchangeability of currency and deposits within the household sector was not strictly limited, although the authorities always aimed at constraining cash holdings of households to the extent possible through regulating the supply of currency. Second, direct lending between the enterprise sector and households was prohibited; households were therefore not allowed to purchase enterprise securities and consumer credit was virtually nonexistent. These regulations effectively isolated the financial behavior and flows of firms and households, contributing to the reduced liquidity or “moneyness” of the currency (see below).1
The instruments of monetary policy were administrative in nature, and differed in the two financial circuits. Financial flows of enterprises were regulated through the Credit Plan, and those of households through the Cash Plan. The Credit Plan was the financial counterpart to the production plan. It was a “micro” plan in that it was built up from the disaggregated planned demand for credit by each enterprise. The planned demand for enterprise credit was aggregated at all territorial (local, regional, and union) levels, to determine the overall quarterly credit plan. Credit extended to enterprises was mainly short-term, aimed at supplying working capital, as virtually all investment was financed through budgetary transfers to enterprises (at the same time, the bulk of their profits had to be remitted to the budget). Indeed, until the mid-1960s, long-term credit to the economy was nonexistent, and increased only slowly thereafter. Enterprises faced a soft budget constraint which implied that shortfalls from planned profits would either be supported directly from the budget through increased net transfers or by bank credits. The difference between such credits and budgetary grants was rather blurred; and debt write-offs might occur following the accumulation of payments arrears.2
The complementary Cash Plan covered all the financial flows effected in currency. The particular importance that the authorities attached to the Cash Plan can be explained by the fact that only currency was regarded as a freely available source of purchasing power. As mentioned, enterprises were not allowed to hold significant amounts of cash, and their deposits were often held jointly with the branch ministries, with their use being earmarked. Savings deposits of households, which were encouraged by the authorities, tended to be stable and therefore were implicitly regarded as direct resources of the state budget (similar to government revenue), rather than a free claim by households on goods and services.
The Cash Plan specified both the factors that contributed to an injection of currency into circulation, and those that caused it to flow into the banking system—as reflected in the so-called balance of money incomes and expenditures of the population (see Table D.2 in Appendix II-1). Increases in currency in circulation arose most notably from wage and salary payments, social money benefits, state procurement of products grown on the private plots of collective farm members, and drawdowns of household deposits. Withdrawal of currency from circulation was mainly the result of household purchases of goods and services from state or cooperative outlets and increases in saving deposits, as well as of small purchases of government bonds.3 Clearly, most of these factors were beyond the control of the banking system. Therefore, the implementation of monetary policy focused on closely monitoring the execution of the Cash Plan, and alerting the authorities when deviations occurred.4
The degree of moneyness of financial assets, and consequently the demand for money, differed substantially between the two separated financial circuits.5 Households were, in theory, free to hold financial assets to the extent desired, although the range of these assets was rather limited (namely, to currency as well as demand and savings deposits).6 Because the ownership of real assets was limited by law on ideological grounds, most household savings took the form of financial assets, almost exclusively in the form of money.
The high degree of moneyness of the available short-term financial assets of the household sector contrasted with the low degree of liquidity of the financial assets of enterprises, which had two main causes. First, as noted, the bank accounts of state enterprises were frequently jointly owned by the firms and their respective branch ministries.7 Second, the use of enterprise own funds was strictly regulated, with funds being strictly earmarked and generally not fungible. Money holdings therefore did not play a decisive role in the decision-making of enterprises. The demand of enterprises for financial assets was largely determined by three major factors: (i) the requirements of the quantitative plan; (ii) uncertainties regarding the liquidity of available deposits; and (iii) the opportunity cost of holding money in terms of inventories (in the event of chronic shortages, inventories might substitute for money as a store of value). For these reasons, and due to the lack of attractive real rates of return on financial assets,8 an enterprise may have sought to minimize its money (deposit) holdings. Over time, some of the rigidities were relaxed and, in line with the gradual decentralization of decisionmaking, enterprises gained greater freedom over the use of their accounts. However, the resulting higher degree of moneyness of enterprise accounts might not have increased the desired holding of financial assets insofar as growing liquidity was accompanied by greater shortages and possibly a heightened preference for stockbuilding.
b. Institutional features of the banking sector
Consistent with central planning and management, all central and commercial banking operations were centralized in Gosbank. A few state-owned specialized banks already existed prior to the reforms of 1987-88 (see Chapter IV.5), but they did not change the monolithic feature of the banking system because they were set up with well-defined tasks and were automatically assigned to specific enterprises; therefore, they did not compete with one another. Moreover, the banks worked under the direct control and supervision of Gosbank; one of them in fact as a Gosbank department (the Savings Bank).
The subordinated role of monetary and credit policy implied a generally passive role for Gosbank, reducing it to that of an administrative agency. Chief among its functions was to provide credit to enterprises necessary to carry out production and revenue plans. Moreover, since virtually all enterprise income and depreciation funds were transferred to the budget and branch ministries, enterprises were highly credit-dependent, giving Gosbank a considerable monitoring role over enterprise activity.9 Gosbank also played an important role in the administrative control of the economy. It signalled deviations from plan targets or inconsistencies among plan objectives, and it suppressed these imbalances through the strict separation of the financial flows of enterprises from those of households and the supervision over the earmarked use of enterprise funds. In addition, the Gosbank network also provided the only settlement and clearing mechanism for the enterprise sector. Finally, like many central banks in market economies, Gosbank functioned as fiscal agency for the Government. Budgetary financing took different forms. All increases in households’ savings deposits were made available automatically to meet planned budgetary financing needs. Moreover, indirect budget financing prevailed in the form of credit to enterprises to bridge the gap between planned and actual profits to be transferred to the budget.
c. Monetary policy before the reforms: an illustration
In a market economy, a monetary expansion that exceeds the growth of demand for money typically leads to some combination of an increase in prices and a deterioration in the balance of payments. However, in the Soviet system, where prices were controlled and foreign exchange operations restricted, excessive monetary expansion typically did not have such effects. Rather, it resulted in excess demand in the economy, which was manifested in shortages. In addressing the problem of excess demand, the authorities used administrative measures. A good example of this was the credit expansion during the first half of the 1980s. In the period 1981-1985, credit to the economy10 grew by an average of 8.7 percent per annum, significantly exceeding the average annual rate of growth of production by around 3 percentage points.11 As a counterpart, enterprise deposits also rose substantially. However, excess money supply could not manifest itself in an increase of the price level, or a spillover to the balance of payments, because of a set of administrative controls. First, excess enterprise liquidity in a particular sector was kept isolated in one product market due to the fact that deposits of enterprises were earmarked (in this case, mainly for construction purposes). Therefore, excess liquidity did not spill over to other product or factor markets. Second, in the given product market, shortages and overheating were subsequently addressed in a purely administrative manner: for example, at the end of 1986, the majority of money funds earmarked for construction were simply eliminated, and so were the corresponding credits to the construction sector.
This example highlights the reasons why the authorities did not pay particular attention to money creation in the enterprise sector. Any excess money creation was kept in isolation from other markets; and with prices in that particular market being controlled, and foreign trade operations restricted, excess liquidity was reflected in shortages which ultimately could be handled in an administrative manner. By contrast, the authorities paid close attention to money creation in the household sector, where such administrative measures were more difficult to apply. Therefore, the main source of possible excess liquidity in this sector was controlled through tight regulation of wages. Indeed, in this period, real wage increases were kept below increases in productivity (Table E.2 of Appendix II-1), and as a result, little, if any, excess liquidity emerged in the hands of the household sector.12
d. The role of the exchange rate13
Before 1987, the official exchange rate was merely used as an accounting unit and played no role in the allocation of resources. This was its traditional function in the central planning system in which foreign and domestic prices were separated through a system of variable taxes and subsidies, the so-called price equalization system. Under this mechanism, any change in the foreign currency price of imports or exports was offset by changes in taxes or subsidies and therefore had a budgetary effect but no impact on domestic prices, production or consumption.
2. MONETARY AND EXCHANGE RATE POLICY SINCE 1987-88
a. Restructuring of the banking system
In line with the general objectives of the reforms of 1987-88, i.e., to improve the efficiency of resource use and to grant more freedom of decision to economic agents, the banking system was restructured at the beginning of 1988. Given the increasing need to develop indirect levers for macroeconomic management, this restructuring was conceived as a first step in widening and strengthening the potential role for monetary policy.
Initially, the financial reforms had several objectives. First, it was intended to establish a two-tier banking system, in which all commercial bank functions would be detached from Gosbank. The new banks were to be established on the basis of full state ownership, and along sectoral lines. Assets and liabilities of the new banks were to be determined according to the deposits and indebtedness of enterprises that had been assigned to them. Second, they aimed at introducing a degree of competition among specialized banks by increasing their number. Third, increased independence was to be given to the specialized banks in credit allocation. While they were expected to continue to accommodate plan targets, they were also encouraged to extend credit within the established ceilings on the basis of risk assessment, profitability, and creditworthiness. Finally, new instruments of control were to be employed. With the dismantling of detailed quantitative planning, overall credit ceilings were to be introduced, replacing the disaggregated credit plan.
Two phases of the financial reforms can be distinguished in the process to date. During the first phase (mid-1987 to August 1988), five specialized banks were established to take over all the former commercial banking functions of Gosbank and to act as a treasurer for the Government.14 Despite these institutional changes, however, the stated objectives remained largely unfulfilled in most respects during this first phase of reform. Most importantly, despite the transfer of virtually all commercial banking functions from Gosbank to the specialized banks, and the increase in their number, competition was not strengthened. This was due to the organization of banks along strict sectoral lines. Furthermore, credit allocation remained essentially administrative, with little emphasis on profitability and creditworthiness, owing to both the aforementioned weak competition among banks, and the dependence of the specialized banks on the branch ministries. Finally, the lack of consistency in the overall reform process reduced the effectiveness of credit policy. In particular, delays in price reforms severely impaired the task of providing loans on the basis of financial criteria.
The second phase of financial reforms began in mid-1988, when the Law on Cooperatives granted cooperatives the right to establish their own banks. This reflected general expectations that the large specialized banks would decline to service the infant cooperatives, placing them in an unfavorable position relative to the state-owned sector from the very start. Soon, state enterprises were also granted the right to establish their own financial institutions. In order to slow the growing shift of household deposits away from the Savings Bank and toward the emerging commercial banks, the authorities later introduced interest rate regulations that restrict the interest rates paid by commercial and cooperative banks (CCBs) on household deposits to the same levels as offered by the Savings Bank.15 Especially in view of the implicit full government guarantee on savings deposits held at the Savings Bank, but not on those at CCBs, this measure effectively reduced competition in the financial sphere of the household sector16.
b. The main consequences of the financial reforms
The reforms initiated in 1988 had an impact in four major areas:
(1) Competition. The reforms introduced an element of competition into the financial circuits of both enterprises and households, mainly as a result of the proliferation of CCBs. However, competition is still limited because of the sectoral organization of the big specialized banks, as well as the regulation that restricts interest rates that CCBs can offer on household deposits. Moreover, specialized banks still account for 95 percent of credit activity.
(2) Liquidity of financial assets. During the reforms, increased moneyness was established through several factors. Chief among these were the monetization of various enterprise accounts through the discontinuation of their joint ownership, as well as the increased fungibility of other enterprise funds. In addition, the artificial blocking of flows between the two financial circuits was reduced, as CCBs were allowed to compete for household deposits, and as households were allowed, at least in theory, to purchase shares of private cooperatives or of CCBs, or to establish such banks.
(3) Financial intermediation. The banking sector was given a more active role in resource allocation. State specialized banks could, within their credit ceilings, extend credit on a more commercial basis, rather than according to plan targets. Commercial and cooperative banks based their credit extension primarily on profitability and creditworthiness. In addition, if only on a small scale, commercial banks have also begun to act as financial intermediaries for the household sector.
(4) Financial markets. A first rudimentary step was taken toward establishing an interbank money market. State specialized banks were now allowed, at least in principle, to lend to and borrow from each other as well as CCBs. However, there was still no market for securities.
These positive elements have to be weighed, however, against the negative aspects that emerged on account of the incompleteness and the lack of proper sequencing of the reforms, as well as the reversal of certain measures. Competition remained extremely limited, and the monopoly position of the Savings Bank was effectively re-established. In addition, the annual economic plan still played an important, although not clearly defined, role in resource allocation. Moreover, the ability of the new credit policy to be based on more commercial criteria was severely hampered by the lack of proper progress in some areas of reform. In particular, price reforms have seriously lagged behind the decentralization of decision making, hampering the efficient use of indirect monetary instruments. Similarly, little progress has been made in introducing a hard budget constraint on both enterprises and banks, which again reduces the effectiveness of indirect instruments of monetary control, such as interest rates. Finally, the incompleteness of reforms has contributed to the emergence of increasing monetary disequilibrium in the second half of the 1980s.
c. The modified role of monetary policies and instruments
During the pre-reform period, credit to the economy occasionally exceeded targets due to the lack of corrective mechanisms to address deviations from the plan. In particular, credit to enterprises might have been higher-than-planned, owing in part to the automatic financing of the gap between planned and actual profits, and in part to the fact that key enterprises could easily bargain for higher credit. The absence of mechanisms to compensate by reducing the allocation of credit to other enterprises or, more generally, to react to negative supply shocks, would lead to money creation above the plan targets. With the shift toward less detailed quantitative planning, the consequence of monetary overruns had to be increasingly taken into account. Excess demand that emerged in a specific product or factor market following deviations from plan targets could now more easily spill over, in unforeseeable ways, to other markets. Moreover, the increasing financial requirements of the budget, in part also a product of the reform process, made necessary more active monetary and credit policies.
The role of monetary policy was modified in two important respects. First, it was given a greater responsibility in the attempt to maintain macroeconomic balance. Second, credit policy was assigned, albeit still more in theory than in practice, the task of ensuring a more efficient allocation of resources. To this end, within their credit ceilings, specialized banks were encouraged to extend credit on the basis of financial criteria. The modified role of monetary policy altered the characteristics of the Credit Plan. In contrast to the pre-reform period, the Credit Plan became a “macro” plan at a global level, in that it aimed—often unsuccessfully as in 1988-89—at equalizing public sector dissaving as well as enterprise credit needs with expected saving of the rest of the economy.17
The instruments of monetary control were also altered. Before the reforms, the quantitative administration of the Credit Plan was the main instrument of control. With the reforms, new direct instruments of control were introduced, which, however, differed, according to the type of bank. For the state-owned specialized banks, two instruments of control have been used:
(1) Ceilings on credit extended by each bank are determined, within the aggregate Credit Plan, through projected demand for credit by economic sectors. However, the banking regulations effectively permitted the possibility for indefinite credit extension. In particular, to the extent that banks raised more deposits than planned, they could exceed their credit ceiling. This could lead to a situation in which overall credit creation was uncontrolled, as banks raising more resources can extend more credit, while those raising less could still fulfill their original (planned) credit ceilings.
(2) Refinancing quotas of Gosbank were determined in the light of the projected increase in each bank’s resources (chiefly deposits), the targeted increase in the bank’s total credit extension, and the maturity match between deposits and credit. Interest rates on refinancing have differed according to banks (i.e., sectors). Higher refinancing could be obtained at higher interest rates.
In contrast to the use of direct instruments for the specialized banks, monetary control over CCBs relied more on indirect instruments. Initially, there was virtually no control at all. Later, a reserve requirement of 5 percent was introduced, which was increased to 10 percent in August 1990.18 Refinancing by Gosbank was also available, although in a very limited amount. Several prudential ratios were also introduced.19
d. Monetary developments since the reforms: the “overhang” problem20
The incompleteness and sequencing of the reforms were in large part responsible for the monetary disequilibrium that developed in the second half of the 1980s. The increased autonomy that was granted to the enterprise sector shifted resources from the budget towards the enterprises. In particular, enterprises were able to retain more of their own funds (profits and depreciation allowances), while the budget continued to finance much of their investment. This asymmetric decentralization process was accompanied by the increasing fungibility of enterprises’ own funds; as a result, the effective moneyness of the resources of enterprises rose appreciably. To offset this impact, and to make room for the increased budgetary financing needs, the authorities adopted a more global monetary approach that required the tightening of credit policy toward enterprises in the second half of the 1980s. Despite an appreciable decline in credit to the enterprise sector, overall net domestic credit grew rapidly due to the rising budget deficits, which continued to be largely monetized. At the same time, rapid growth of internally generated resources of enterprises more than offset the effects of the credit crunch and led to an excess liquidity among enterprises. This enabled the management of increasingly autonomous enterprises repeatedly to raise wages at rates which outstripped the growth of real consumption possibilities and led to rising excess liquidity of the household sector as well.
More specifically, three periods can be distinguished (see Table III.2.1):
|Total bank credit1||8.7||5.2||11.2||10.5|
|Credit to the economy 1||8.7||-2.3||-4.7||4.3|
After allowance for the debt write-offs at end-1986.
After allowance for the debt write-offs at end-1986.
(1) 1986-87. This period was characterized by the attempt of the authorities to offset the rapid acceleration in bank financing of the budget—at an average annual rate of 30.4 percent—by a reduction in credit to nongovernment at a rate of 2.3 percent.21 However, already in this period the growth rate of monetary assets (M2) of both households and enterprises accelerated (to 9.6 percent per annum, or about 8 percent in real terms for households; and to 18.3 percent in both nominal and real terms for enterprises).
(2) 1988-89. With increasing bank financing of the budget, the squeeze on credit to the enterprise sector was inadequate to prevent a further acceleration in the rate of growth of the total money supply. Credit to the government rose by 39.4 percent per annum, while credit to nongovernment declined by only 4.7 percent; as a consequence, the growth rate of total bank credit accelerated to 11.2 percent per annum. Real money balances of households increased by over 10 percent per annum (13.1 percent in nominal terms); and their maturity shortened markedly. Enterprise liquidity rose at an even higher rate (18.4 percent per annum in nominal terms), while the liquidity of these funds also increased. As a result, a significant “monetary overhang” developed both in the household and enterprise sectors.22
(3) 1990. While the growth rate of credit to government was cut by more than half, as the budget deficit fell, enterprise credit was permitted to increase for the first time since 1986. The growth of overall credit thus remained roughly unchanged, at more than 10 percent. While the growth rate in M2 of households remained broadly unchanged, the growth rate of enterprise money probably expanded, partly reflecting the increased access to bank credit and, possibly, a cutback in stockbuilding of consumer goods. As a result, the overall growth rate of money (M2) accelerated slightly.
e. Developments in exchange rate policy
With the beginning of decentralization of foreign trade in 1986, the authorities decided to give exchange rate policy a somewhat more active role. This policy was geared toward the convertible currency area, while exchange rate policy vis-à-vis CMEA countries remained passive. The main measures were the introduction of so-called differentiated foreign exchange coefficients (DVKs) and the foreign exchange retention scheme in 1987, and the introduction of foreign exchange auctions in 1989. All three initiatives, however, largely failed to achieve their objective of making the traded goods sector more responsive to changes in world market conditions, partly because of the restrictions attached to the measures, and also because of the way they were implemented. More fundamentally, their impact was constrained by the fact that the measures were not accompanied by supporting domestic policies, including price liberalization or substantial changes in the central allocation system.
In 1987, the system of price equalization was partially replaced by the DVK system.23 These coefficients were set initially with a view to equating foreign and domestic prices for individual products (although some promotion of manufactured exports was also intended by setting particularly high DVKs). The coefficients not only differed by commodities, but also by countries of origin and destination. The advantage compared to the previous system was that—with fixed coefficients—changes in foreign currency prices for imports or exports would in principle be reflected in the profitability of the enterprises and thereby might make them more responsive to market conditions. However, the system was not implemented as intended. When enterprises faced pressures on their profits at the given exchange rate and DVKs, they frequently negotiated changes in the DVKs with the authorities. The DVKs were therefore often changed in an ad hoc manner, which meant increased budgetary support for the enterprises.
The foreign exchange retention scheme had limited coverage and was subject to various restrictions. Thus, until 1990, oil and other raw material exports were exempted from export retention, while retention rates varied from 0 to 100 percent for processed goods. On average, retained foreign exchange accounted for only 7-8 percent of total export earnings in convertible currencies. Moreover, retention rights were set by individual enterprise, which implied that different retention rights might apply for the same export goods produced by different enterprises. Until 1989, there were also several restrictions on the use of retained foreign exchange. It could only be spent in the year after it was received and only for imports of investment goods. These restrictions were relaxed in 1989, when also consumer goods for the benefit of workers (subject to certain limitations) could be imported in the same year as the foreign exchange was earned.
The foreign exchange auctions, which were established in November 1989, played a marginal role in exchange rate policy. During the first eleven auctions, only the equivalent of US$150 million was transacted. Therefore, the exchange rates established during the auctions, ranging from rub 9 to rub 24 per U.S. dollar, could not be considered as indicative of the market equilibrium exchange rate. Although foreign exchange retained by enterprises could be sold in the auctions, this was done only to a limited extent. This might be related to the fact that enterprises did not generally lack domestic financing but rather foreign exchange for imports, and they could not be certain that they would be in a position to purchase foreign exchange in the auctions at a later stage. Auction transactions were also initially restricted by confining participation in the foreign exchange auctions to only a few participants; subsequently, access by a broader group of enterprises and organizations was permitted, including joint ventures.
3. CURRENT REFORMS
Against this background, several proposals emerged with the aim of speeding up reforms of the financial and exchange systems.
a. The central banking law24
The central banking law that was finally approved in December 1990 focuses on the structure of the monetary system, including organizational aspects, and the role and independence of the monetary authority in shaping monetary, exchange rate, and prudential policies as well as managing international reserves. In addition, the questions of instruments of control, the types of commercial banks allowed to operate, their supervision, and competition in the banking system are determined in the new law and in the companion law on the banking system.
(1) The structure of the monetary system. The new law sets up a union reserve system, consisting of Gosbank and republican central banks. The system is based on a single currency. A board of governors, called the Central Council, will manage a unified monetary and credit policy and issue uniform prudential rules and regulations for the entire system. The republics will adopt their own banking legislation in accordance with the laws of the Union Reserve System. The Central Council will consist of twelve members: the President and the Vice President of Gosbank, to be appointed by the Soviet Supreme for six years, and ten other members appointed by the President of the USSR on a rotation basis from the presidents of the central banks or other leaders of the republics. The executive body of the Central Council will be the Monetary and Credit Council. As regards the role of the republican state banks, their activity would be subordinated to the Union Reserve System; and in terms of monetary and credit policies, their role would be limited to the implementation of policies as determined by the Central Council.
(2) Independence of the central bank.25 There are three major aspects to the independence of a central bank: independence in terms of monetary and exchange rate policy, prudential policies and bank supervision, and its financial relations with government(s). The new law gives the central bank a central, active and independent role in the areas of monetary, exchange rate and prudential policies. In particular, it will determine the main guidelines and objectives of monetary and credit policy, which will be submitted to the Supreme Soviet for approval, contemporaneously with the annual union budget.
The law provides for coordination of monetary and exchange rate policies. However, at the same time, given that a joint union-republic foreign exchange fund26 has been set up by an earlier presidential decree outside the domain of the union reserve system, it is unclear how monetary and exchange rate policies will be coordinated. A committee will be established to develop foreign exchange policy, including all-union responsibilities in this area, as well as to ensure external debt payment. Its operational features, however, including procedures for decision-making and for the implementation of agreed policies, have yet to be defined.
As regards the third aspect of central bank independence, the new law allows for bank financing of the union and republic budgets to the extent approved by the Supreme Soviet. Gosbank and the central banks of the republics are authorized to purchase government securities within these established limits. Under exceptional circumstances, which are not specified by the law, the President of the USSR can authorize short-term credits in “limited” amounts in excess of the limits determined by the Supreme Soviet.
(3) Monetary control instruments. The law provides for the use of both direct and indirect instruments, of which refinancing quotas appear to be key. In addition, reserve requirements and interest rate policy—through changing the interest rate charged on credit by the central banks—will also be applied. Quantitative credit ceilings and interest rate regulations will be allowed, but only under “exceptional” circumstances, such as an excessive increase in money supply or in inflation. Such temporary measures can be introduced within the framework of the annual presentation of the monetary policy guidelines to the Supreme Soviet, or by the Central Council. As to their duration, a limit of six months is set only for such measures taken by the Central Council which, however, can be extended by the President of the USSR indefinitely.
(4) Competition and interbank money markets. Increased competition within the banking system is sought through the breaking up of the large state-owned specialized banks into independent joint stock companies and the establishment of new commercial banks. Most of the banks will be universal and free to choose their clientele on a competitive basis; and some specialized banks, yet to be set up, will be responsible for financing major union or republic projects. Foreign participation in bank ownership is allowed. Improved payment and settlement arrangements will remove existing limitations on the movement of monetary resources within the union. The registration and supervision of banks is to be the responsibility of the republican central banks.
The law on the banking system provides a special commercial bank status for the Savings Bank in two respects. First, Gosbank is to guarantee fully household deposits held at the Savings Bank, but not those with any other bank. Second, except for the Savings Bank, all commercial banks attracting household deposits must create a special reserve fund. The size of the fund is to be determined by the respective republican central banks. These regulations appear aimed at reducing competition for household deposits, so as to maintain the pre-emption of household savings for financing of the budget.
b. Other financial and exchange rate measures
Interest rates will continue to be administratively regulated but, as of November 1, 1990, the regulations were to be more uniform across banks. Interest rates on household deposits were increased to 5-9 percent, depending on maturities. Lending rates were also raised to a maximum of 15 percent.27 The authorities have also discussed possibly indexing the savings deposits of households (principal and interest) to the price level. Such proposals have not, however, included indexation of the deposits of enterprises.
On November 1, 1990, a commercial exchange rate was introduced at a level that was two thirds depreciated in foreign currency terms compared with the official exchange rate. At the same time, the DVKs were eliminated. The commercial exchange rate will fluctuate in line with the exchange rates of the currencies in the basket to which it is pegged.28 The commercial exchange rate would apply to most trade and capital transactions. In addition, a free exchange market will be established with supplies from foreign exchange retained by enterprises and official holdings. Banks and other brokers would be direct participants in the market. A special rate would remain in force for tourist transactions. But the commercial rate and the free market rate would be the key exchange rates vis-à-vis convertible currencies. It is unclear how the commercial rate will be managed in relation to the free market rate.
c. Effectiveness of the new reforms
A central question that arises at this point is how these monetary and exchange arrangements would operate as the reforms proceed, particularly in view of the existing monetary overhang, and how they would interact in maintaining monetary “flow” equilibrium. A substantial monetary overhang is often associated with shortages and typically with a large free foreign exchange rate premium (in this case, the difference between the free and the commercial exchange rates). A large premium involves some important costs. For example, if the free rate is more depreciated than the commercial rate, there is an incentive for arbitrage and circumvention of official regulations to exploit the differences in rates. Moreover, a large free market rate differential and surrender requirements introduce an anti-export bias, as exports are being implicitly taxed.29
Preliminary indications are that the authorities intend to stabilize the level of the commercial exchange rate in terms of a basket of currencies. Such a policy would be appropriate if the commercial exchange rate was tied to a basket of currencies close to a market clearing rate, and if the underlying rate of inflation was about the same as that of foreign trading partners and competitors. But that situation is not likely to prevail immediately following price liberalization. Therefore, either a flexible exchange rate system or initial overshooting of the depreciation, followed by fixing of the exchange rate, would appear to be appropriate.
A major problem for a fixed exchange rate in the present circumstances is that the fiscal deficit is not likely to be consistent with low inflation in the near future, and credit policies with respect to the rest of the economy, even if tightened, may not be expected to offset fully the expansionary fiscal stance. Therefore, in the course of a few months or a year, the gap between the exchange rates is likely to widen once again. Persistent inflation would call for a more flexible exchange rate.
As mentioned above, interest rates have been adjusted recently, and the Government has announced that in the future it will set interest rates at more realistic levels. This is, of course, a welcome development. Interest rate policy, however, cannot be relied upon to correct misalignments between the commercial exchange rate and the domestic price level, without changes in other fundamental factors, such as the fiscal deficit. Interest rates are effective for correcting a temporary widening of the gap between the free and the commercial exchange rates by enhancing the attractiveness of domestic financial assets vis-à-vis foreign assets, thereby lowering the free market premium. However, if the premium were driven by permanent forces, attempting to lower it by resorting to high interest rates could backfire for reasons similar to those discussed above.
A regime of multiple exchange rates is incapable, per se, of providing a long-run remedy to fundamental misalignments or inconsistencies among policy targets. The additional flexibility that is obtained by the existence of several exchange rates is rather limited because, as suggested above, substantial exchange rate differentials lead to distortions, arguing for a rapid convergence to a unified exchange rate system.
Exchange rate unification is consistent with both fixed and flexible exchange rates. Under fixed exchange rates, the ability of the monetary authorities to sustain the official exchange rate depends on the adequacy of international reserves and/or lines of credit from abroad (e.g., a stabilization fund). In contrast, the feasibility of a floating exchange rate regime depends much less on the country’s reserves position. Therefore, a system of unified and floating exchange rates might be an attractive option for a country such as the USSR if it starts from a relatively low stock of international reserves and can obtain only modest amounts of international credit for stabilization purposes. A system of floating exchange rates, however, requires flexible domestic wages and prices and, given the latter, suitably tight financial policies if the exchange rate regime is not to reinforce existing inflationary pressures.
The current reforms of the financial system have been inspired by those of industrialized market economies. These systems have been designed in order to prevent political pressures from having a direct impact on the management of monetary and financial policies. In a more competitive environment, as envisioned by the new proposals, effective management of monetary policy is highly dependent on the credibility of policy announcements. The new proposals, however, fall short of ensuring policy credibility. Independence of the central bank, for example, may help to reduce outside pressures on the bank, but it does not completely eliminate the temptation to change policies in the future. Furthermore, central bank independence may easily become ineffective, since, as pointed out above, credit and monetary policy will have to be approved by the USSR Supreme Soviet simultaneously with the annual union budget.
Lack of credibility in a market environment is likely to be associated with high nominal and real market interest rates. This is so, because if the central bank is not credible, the public is likely to expect a future flare-up of inflation. In such a situation, the banking system would be forced to offer high nominal interest rates. Otherwise, depositors would prefer to hold their financial assets in the form of inventories or foreign exchange. To the extent that the central bank actually is able to persist with its intended anti-inflationary policy, the rate of inflation will tend to decline, thereby giving rise to rising real interest rates. High real interest rates, in turn, if maintained over a considerable period of time, may bring about serious disruption of the productive sector. Thus, it is very important under such a system that policy announcements become sufficiently credible within a reasonable period of time.
Credibility could be lost by faulty policy design, since the public will soon realize that policy will have to be subject to future adjustments. This points to the dangers of independent monetary and exchange rate policies, as suggested by the creation of the joint union-republic foreign exchange fund. In a well-functioning market system, monetary and exchange rate policies are intimately related. Attempts to manage them in independent ways are likely to result in exchange rate misalignments or sizable differentials between the commercial and free market exchange rates. As argued above, these phenomena bring about undesirable consequences, which eventually result in unforeseen accommodations of monetary policy to exchange rate policy, or vice versa, undermining policy credibility.
Credibility is likely to be more difficult to establish for a country such as the USSR than for the typical market economy. Soviet policy makers have not yet acquired much experience in a liberalized environment, and hence their competence and endurance are still largely unknown to the public. The presumption is that, not having had the chance to bloom under the old regime, expertise in market-oriented monetary policy may, indeed, be relatively scarce. This is an additional reason why monetary and financial policies need to be designed so as to avoid any unnecessary tension between the different policy targets. Ideally, one should aim for consistent monetary rules that operate most of the time with little human interference. Such a scheme may involve a form of exchange rate standard (e.g., anchoring to another currency), or pre-setting simple and transparent monetary rules (e.g., a pre-announced rate of increase in the money supply).
The above discussion suggests that the Soviet authorities would be well-advised to complement the new proposals with schemes that ensure a quick transition to a reasonably credible system. Policies and institutions are of the essence, but timing is too. Good policies that take long to be implemented may become ineffective because they may be overtaken by events, and hence lose their credibility. This highlights the importance of sending clear, early signals to the market about the authorities’ intention to implement consistent and non-discretionary policies.
“Moneyness” of short-term financial assets refers to the degree of their liquidity, which in turn reflects the degree of their unconditional conversion into goods, as well as the free flow of money between households and enterprises.
This occurred, for example, in 1986 and 1990.
Given the low level of direct and indirect taxation of the household sector, tax payments did not constitute a major source of cash withdrawal.
In formalized terms, the cash plan can be described as follows:
where M(h) is currency in circulation, W is the average nominal wage rate, N is the level of employment; P(a) and P(c) are the average procurement price of agricultural products sold by the population and the price of consumer goods, respectively; Q(a) and Q(c) are the quantity of goods and services purchased from farmers by the state, and the purchase of goods and services by households from the state and cooperatives, respectively; T is the net cash transfer to the household sector, C is credit to households; S(h) is household savings deposits; and Δ denotes a change in a variable.
Monitoring of the execution of the Credit and Cash Plan was based on a number of indicators (e.g., the ratio of currency to retail trade).
For a detailed discussion of the demand for money of households and enterprises, see Chapter III.3.
Purchase of long-term financial assets in the form of government bonds was negligible (and occasionally compulsory). Moreover the degree of moneyness of savings deposits was occasionally reduced by the need to queue to make withdrawals.
Joint ownership of enterprise funds not only reduced the free availability of deposits, but sometimes resulted in the cancellation of certain deposits, if they were deemed excessive. An example is the cancellation of orderer’s accounts in the context of the debt write-off operation of 1986.
Over the last three decades up to 1987/88, interest rates on enterprise deposits were fixed at 0.5 percent.
Another element of close monitoring was that, because enterprises were not allowed to hold currency in excess of a nominal amount, virtually all enterprise funds were held at Gosbank. Moreover, until recently, Gosbank was not only entitled to follow developments on enterprise accounts, but also to effect banking operations without the formal consent of an enterprise if envisaged in the plan (for example, profit transfers to the budget).
Almost exclusively credit to the enterprise sector, as credit to households was negligible.
See also Chapter II.3.
For a detailed description of the exchange rate arrangements prior to the reforms, as well as to date, see Chapter III.4.
These reforms are described in greater detail in Chapter IV.5.
Some commercial banks have succeeded in finding ways to circumvent this regulation through offering, for example, special premia on deposits, or lottery drawings for deposits (i.e., the winners are rewarded with very high—25 percent—interest rates).
In addition, although prudential in nature, another measure limited the amount of deposits to the own capital of the commercial bank.
The concept of “expected” saving used in the Credit Plan does not necessarily coincide with the desired or voluntary saving of the population.
However, at the same time, commercial banks were allowed to meet the requirement through the purchase of government bonds.
Such as the ratio of own capital to total resources, a minimum capital requirement, and a stipulated ratio for the maximum exposure to one client.
For a detailed analysis of the monetary disequilibrium, see Chapter III.3.
Taking into consideration the impact of the already mentioned write-off of construction-related credit at the end of 1986. As credit to households was very small, this decline mainly reflected the fall in credit to enterprises.
For a detailed description of this and other exchange system measures, see Chapter III.4.
The Law of the USSR on the USSR State Bank of December 11, 1990.
In the following, the proposed Union Reserve System will, for simplicity, be referred to as the central bank.
For a detailed description of the fund, see Chapter III.4.
Before this date specialized banks were not allowed to pay, on average, more than 2 to 4 percent on households deposits, depending on maturity; while for credit rates, they were given some leeway to vary rates according to the financial position of the borrower. Nevertheless, interest rates were highly regulated, as indicated by the fact that, except for the Agroprombank, bank lending rates were generally lower than the interest rate on refinancing by the Gosbank. In 1989 the average interest rate on credit and the rate on refinancing were the following, respectively. Promstroibank: 3.78 percent versus 4 percent; Agrobank: 1.77 percent versus 1.5 percent; Zhilsotsbank: 2.89 percent versus 4 percent. It has to be added, however, that some of these banks had government deposits, on which they did not pay any interest.
As regards commercial banks, they could freely determine their deposit and lending rates for all transactions until February 1990, when a regulation on interest rates was introduced, limiting interest rates that commercial banks can offer for household deposits to those offered by the Savings Bank. (Before the regulation, commercial banks offered a 6 percent interest rate on household deposits, which was 2.5 times more than the average rate in the Savings Bank.) Interest rates on credits extended varied between 5 and 60 percent, with an annual average of 9 percent.
For details see Chapter III.4.
See Chapter IV.3 for further discussions.