- Susana Almuina, Ian McCarthy, Gabriel Sensenbrenner, and Justin Zulu
- Published Date:
- December 1995
As the head of the IMF department with responsibility for macroeconomic policies in the Baltic countries, Russia, and other countries of the former Soviet Union, I am particularly pleased to be with you today. The central bankers of these countries, Russia, and other countries of the former Soviet Union, together with their collaborating counterparts from coordinating central banks, have created in the short span of two years the institutions and tools that set the stage for executing market-based monetary policy. In so doing, the central banks of these countries have developed quickly from regional branches of Gosbank to their appropriate positions as one of a market economy’s twin pillars of macroeconomic management. They have adapted to their role as policy leaders by taking on—with no little success—functions that used to be solely carried out by Gosbank headquarters.
The point that I want to make today is that, now that the institutions have been put in place, the new central banks must make clear what their role in a market-oriented economy is to be and then work steadfastly to establish and legitimize that role. In our view, the key element of the job of any new central bank is to successfully protect the value of the currency—and consequently the value of the incomes and wealth of the nation; and the sooner it convinces savers, investors, and the international community that it will not waiver from that objective, the easier it will be to attain that aim. At the same time, the central banks must play a key part in the further development of a vibrant and market-oriented commercial banking system.
In all of our technical assistance and policy discussions, we have tried to impart our belief that the most important contribution a central bank can make to a country’s long-term prosperity is the creation of an atmosphere of price stability and confidence, rather than the direct accommodation of enterprises’ demands for production financing (as was the role of the central banks of the Baltic countries, Russia, and other countries of the former Soviet Union when they were Gosbank branches). I know that many central banks continue to be pressured by governments, parliaments, and enterprises to return to the old days of fully accommodating credit policy. But such a policy is not appropriate in a market economy, where the defining role of the central bank should be to protect the value of the national currency by acting as a check on the financial demands of all other sectors.
Practically all of the central bank reforms discussed during these meetings have as their ultimate goal the provision of powers and tools to the central bank so that it can achieve financial stabilization. Achievements so far include the introduction by almost all countries of their own currency, which has allowed central banks to take charge of their own monetary policy; the increase of interest rates to positive real levels in many countries; the widespread licensing of commercial banks, which has allowed central banks to withdraw from day-to-day financial intermediation, and provide instead only the needed regulatory framework and freedoms; improvements in the payments system which have taken place in almost all countries, with the result that scarce financing is moving faster and more efficiently between enterprises; and the announcement of measures to liberalize rules for the purchase and sale of foreign currencies and the development of foreign exchange markets. Together, these measures provide an objective mechanism for valuing a currency and give investors the guarantees of reversibility that give them the confidence to hold it.
Where these achievements have taken place, central banks have built the institutional framework for controlling inflation. But further progress will be important on several fronts if these new institutions are to become legitimate, effective, and permanent. I would like to dwell in particular on the currency regime, control of credit growth, the exchange system, and the development of exchange markets.
As regards the choice of currency or currency area, I cannot stress too strongly the importance of establishing confidence in its sustainability. Unless savers and investors believe that the regime that has been chosen is permanent, they will protect themselves against expected changes by speculation and capital flight. These, in turn, will make stabilization impossible, which will further undermine the sustainability of the regime and make it more likely to collapse. Some of the stagnation in economic activity since 1991 is certainly due to uncertainties about the future value of monetary assets. In particular, the protracted discussions about a possible return to a mini-ruble area last year damaged the economies of the countries concerned: not knowing what the outcome would be, people hoarded cash, rubles, and dollars, and postponed domestic saving and investment. At the same time, the uncertainty regarding currency arrangements made it very difficult for policymakers to introduce serious stabilization policies.
A country’s choice of currency is a sovereign decision and should not be made by outsiders. But we stress that decisions need to be made, and then adhered to, so that the return to stability and growth is postponed no longer than is necessary. We have, I hope, been properly neutral about the currency decision, while pressing for some decision to be made. But increasingly—certainly since the Tashkent meeting of May 1992—it has become clear that the cooperation required for a stable ruble area is unlikely to be politically acceptable in many countries. This is why we supported the introduction of independent currencies with technical assistance and (where macroeconomic policies were appropriate) with financial backing.
Control of Credit Growth
An independent currency is important because it gives a central bank the power to take charge of monetary policy, but it is not in itself a solution to high inflation and balance of payments problems. The disappointing number of countries where inflation has continued to escalate since the introduction of a new currency illustrates the difficulties of taking control of the financial situation, especially when government and enterprises continue to overspend. It is clear that failure to contain credit growth—and therefore inflation—is the foremost threat to the credibility of central bankers of the Baltic countries, Russia, and other countries of the former Soviet Union at present.
It is critical that central banks insulate themselves from political pressures to relax credit ceilings by confining their role to the determination of the overall limits on credit that are necessary to bring down inflation, and by refusing to get involved in individual cases. The allocation of credit to enterprises is the responsibility of commercial banks, and the subsidization of priority sectors is the responsibility of the budget. If central banks involve themselves in these tasks, it only jeopardizes the fulfillment of their own: thus we believe it is important for central banks to stop lending to enterprises and to insist that any support for priority sectors be covered under the global allocation for budgetary credit.
As regards enterprises, pressures to finance them are likely to increase rather than decline in the coming year, as a new round of arrears has to be dealt with, as some enterprises begin to fail, and as imprudent commercial banks become insolvent. But bailouts cannot solve the arrears problem; they just keep debtor enterprises in business so that they can participate in a further round of financing through arrears. Each time their expectation that the central bank will bail them out is realized, their ability to buy and sell at higher and higher prices is reconfirmed. Why should they cooperate in negotiating for lower prices if they can get subsidized central bank credit to cover their losses? Only a clear statement from the central bank that bailouts will no longer take place will succeed in stopping the arrears spiral and the inflation that accompanies the arrears.
Likewise, central banks need to establish their independence by refusing to give in to unexpected demands for financing from the budget. Revisions in budgetary credit allocations during the year relieve politicians of their responsibility to budget prudently and avoid inflationary waste.
In our view, central banks do no favor to either enterprises or the budget by postponing their shift to a hard budget constraint. If inflation is to fall and economic growth to resume, enterprises, banks, and politicians need to know the rules; central bankers need to take responsibility for setting them.
The choice of exchange system is an important element in the choice of monetary regime, though, like the choice of currency, it does not by itself determine inflation performance. In our opinion, the sustainability and predictability of the system are at least as important as the way in which the exchange rate is determined.
There is much to be said for fixing the exchange rate and thereby using it as a nominal anchor, or guidepost, for policies. The maintenance of the peg imposes discipline on domestic financial authorities, which in turn slows inflation and increases the predictability of future returns to trade and investment. The increase in the credibility of the policy regime is the main benefit of a fixed-rate system. However, the converse is equally true: failure to hold the fixed rate is a public demonstration of policymakers’ failure to manage the economy as promised, and usually leads to a crisis of confidence and a flight from the currency. It is therefore imperative that the supporting fiscal and credit policies be in place (and that a country has adequate reserves) before the exchange rate is fixed. A central banker contemplating a fixed-rate system needs to ask himself if he can keep credit growth sufficiently low to ensure that inflation is in line with inflation in the country whose currency he wants to peg to.
Thus, given the financial uncertainties that now prevail in many countries, a flexible exchange regime may offer advantages, at least in the near term. It can prevent slow-to-fall fiscal deficits from worsening the balance of payments and draining scarce reserves. Also it will help spread the cost of adjusting to the unavoidable terms of trade shocks being experienced across the economies of many of these countries, as energy prices move to world market levels.
Our advice to the Baltic countries, Russia, and other countries of the former Soviet Union has been that the choice between a fixed and floating exchange regime is not an absolute, but rather it depends on the specific situation. A fixed rate can be better, but only if it is sustainable; because of the discipline entailed, it requires a bigger commitment, which may be neither financially nor politically feasible. A floating rate system which works is better than a fixed rate system which does not: Latvia, for instance, has stabilized as well with a floating exchange rate as has Estonia, where the rate has been fixed with a currency board.
Development of Exchange Markets
The relinquishing of microeconomic controls on exchange markets is a further important element of establishing confidence in the monetary system. I mentioned above the guarantee of reversibility that is so crucial for making investors willing to hold a currency. While the introduction of exchange auctions and the announcement of convertibility have been among the most impressive achievements of the Baltic countries, Russia, and other countries of the former Soviet Union in recent months, the actual implementation of the new systems has fallen regrettably short of expectations.
Several artifacts of planning continue to compromise the integrity of the systems, including:
The widespread existence of surrender requirements at nonmarket exchange rates, which impose penal taxes on what should be the most dynamic sectors of the economy.
The reluctance of government agencies to participate in the auctions, relying instead on the state foreign exchange fund. We take the view that government should not be given preferential treatment over the private sector in external activities.
Continued restrictions on trading in hard currencies and the currencies of the Baltic countries, Russia, and other countries of the former Soviet Union, as well as various payments restrictions.
All of these distortions limit the power of these exchange markets to provide a fair reflection of the relative value of the currencies of these countries. Since a primary mandate of the IMF is to facilitate their integration into the international community, I lay particular stress on the elimination of these impediments.
In sum, our joint work is now moving into a more mature phase. Since 1991, everyone here—both the recipients and providers of technical assistance—has put Trojan efforts into building the institutions appropriate to a market economy. What must come next is the demonstration and reinforcement of the durability of these hard-won institutions, through perseverance, prudence, and consistency in the execution of monetary policy.