Negative Euro Area Interest Rates and Spillovers on Western Balkan Central Bank Policies and Instruments


International Monetary Fund
Published Date:
May 2017
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Western Balkans’ Central Banks Conference on “Negative Euro Area Interest Rates and Spillovers on Western Balkan Central Bank Policies and Instruments”

Western Balkans are an economic area of over 20 million people with six states – Albania, Bosnia and Herzegovina, FYR of Macedonia, Kosovo, Montenegro, and Serbia – which all aspire to membership in the European Union (EU) and enjoy “candidate” or “potential candidate” status in the EU accession process.

The countries in the region have a history of conflicts evidenced by the term “Balkanization,” which, based on the Balkan peninsula experience in the 19th and the beginning of the 20th century, is used to describe the process of fragmentation of a region or state into smaller regions or states that are often uncooperative with one another. Notwithstanding this past, the countries in the region share common economic objectives, challenges, and opportunities at the present.

They all aim to promote peace and prosperity in the region. They have all faced the challenge of a transition to a market economy. They all have strong economic and financial ties to the EU as a whole and to the euro area in particular via different economic, trade, financial, and monetary channels. They all have a common objective of joining the EU first and the euro area later.

They are faced with similar economic, financial stability, and monetary policy challenges. To name a few of these common challenges: despite recent growth acceleration, for the past eight years growth rates have been in low single digits at best. Supplies of foreign credit and capital from private sources – plentiful in the pre-crisis years – have largely dried up, and EU-headquartered banks, which have a large presence in the Western Balkans, are coping with a new global regulatory context in which they are encouraged to deleverage and reduce cross-country exposure. At the same time, governments face severe limits in what they can do to tackle these problems. The fiscal space for Keynesian-style public spending projects is limited, while monetary policy is naturally constrained in these small open economies, which all have a high degree of euroization.

There are several initiatives aimed at revitalizing multilateral ties throughout the Western Balkans and improving regional cooperation on the issue of economic development. Still there is scope for further initiatives to exchange views and experiences on the responses given to common challenges, enhance cooperation, and shape joint initiatives across the countries in the region. This applies to monetary policy, financial stability, and central bank policies in general.

Against this background of common objectives and similar challenges, the IMF and the Bank of Albania, with the gratefully acknowledged financial support of the Swiss Government, have organized this conference among senior central bank policymakers of Western Balkan central banks and beyond. The topic of the conference is negative euro area policy rates and, more precisely, the economic and financial consequences for the Western Balkan countries of negative euro area interest rates and the recent standard and non-standard monetary policy measures implemented by the European Central Bank (ECB). It has an ambitious agenda since it aims at discussing and analyzing the consequences of recent ECB monetary policy from three important perspectives: financial stability, reserve management, and monetary policy. The conference provides policymakers in the region and beyond with a forum for discussing recent policy challenges, the policy responses, and their effects as seen from several key dimensions. From this perspective, the ultimate aim of the conference is to identify the policy responses that can be considered relatively more effective in given circumstances.

The conference also benefits from the participation of central bankers from countries in the proximity of the euro area that have also grappled with the euro area monetary policy spillover effects and have devised a different monetary and financial stability policy response reflecting the individual characteristics of each country. It is indeed our belief that the Western Balkans can not only benefit from learning from each other, but also benefit from the experience of other countries in the EU and in its proximity. This regular exchange of experience may gradually pave the way to greater economic cooperation.

In terms of content, the conference provided several interesting and useful insights. They can be summarized as follows. While the ECB is expected to reduce in the coming months the extent of the monetary policy accommodation provided and gradually exit from its nonconventional measures, lower average interest rates throughout the economic cycle are expected to prevail in the foreseeable future. In this case, the effective lower policy rate bound may become more frequently binding.

Negative interest rates have been effective in the countries in which they have been deployed. Negative consequences did not materialize, at least to the extent initially thought. Furthermore, potential negative impacts were either outweighed by the positive contribution negative interest rates provided to inflation and inflation expectations, or they could be prevented with a few carefully designed instruments, such as the tiered reserve remuneration scheme and the dynamic exemption scheme as a function of banknote demand, as was implemented by the Swiss National Bank (SNB).

Low policy rates in the euro area and the recent package of non-standard monetary policy instruments deployed have had in general positive spillover effects in the Western Balkans, both directly and indirectly. These effects have been largely independent from the monetary policy and exchange rate regimes adopted. This is confirmed by both the econometric analysis conducted and presented by the ECB and by the anecdotal feedback from the policy-makers in the region. They benefited the countries in the area via the trade channel with a positive export shock and higher imported prices. They also benefited the countries in the region via cross border flows, lower risk premia, lower pressure on the exchange rate, and greater scope for domestic accommodative monetary policy. Furthermore, if the extent of the monetary policy accommodation had positive spillover effects, policymakers from the Western Balkans need to remain vigilant on the consequences that may derive from the forthcoming reduction in the ECB monetary policy stimulus.

The effective lower policy rate bound varies from country to country and in each country over time, as economic agents adapt to lower interest rates, as instruments are deployed to mitigate the possible negative consequences of low interest rates on financial stability risks, and depending on the availability of alternative non-standard monetary policy instruments. While the ECB and the SNB could effectively lower rates below zero, elsewhere the effective lower bound can be higher. Albania has deployed an interesting conceptual framework to analyze the effective lower bound and the scope for additional standard monetary policy accommodation. When the effective lower bound is reached, if additional accommodation is needed in the pursuit of the price stability mandate, nonstandard measures need to be deployed. The most effective non standard measures vary depending on the economic and financial system characteristics of each country. Therefore, if countries like Switzerland and the Czech Republic were effective with the implementation of an exchange rate floor to prevent destabilizing exchange rate appreciation, in others, like Hungary, a different set of instruments has been considered more effective.

As regards financial stability, low ECB policy rates and the package of nonstandard measures do not seem to be fueling any large-scale asset bubble in the countries in the region. Banks are still coping with a high level of non-performing loans (NPLs), are still in general applying tighter lending standards, and are in a deleveraging mode also as a consequence of the new global and EU regulatory frameworks. Credit growth remains in general subdued, banks are trying to transition toward a self-funded business model relying to a much smaller extent on funding from the EU parent, and EU banks have undertaken a general reassessment of their engagement in the region. If these factors may have helped containing financial stability risks, they also represent a challenge going forward to undertake financial system reforms to diversify the funding sources available and reduce the reliance on the banking system. Such a general picture hides, however, some heterogeneity across countries, with some countries requiring closer vigilance than others.

Excessive euroization is the single most important structural financial stability risk with which countries in the region that are not de facto fully euroized, like Kosovo and Montenegro, are confronted. Low euro area interest rates and lower domestic policy rates in the Western Balkans provide both opportunities and challenges to address high euroization levels. They compress interest rate differentials, making, on the one hand, loans in foreign currency less financially advantageous than domestic loans, but they also lower the premium paid on domestic deposits, thereby reducing the opportunity costs of foreign currency deposits. Countries in the region need a medium-to long-term strategy to cope with this phenomenon. Such a strategy would need to define the policy instruments to be deployed over an appropriate time horizon, to lower euroization levels, contain the financial stability risks it induces, and enhance the effectiveness of monetary policy.

As regards reserve management, negative euro area interest rates have made it increasingly difficult to achieve positive returns in a negative interest rate environment for countries that need to hold a sizeable part of their foreign exchane (FX) reserves in euro due to the trade and financial links to the euro area. Negative euro area interest rates have challenged the traditional optimization model with which FX reserve portfolio composition was defined, that is, maximize expected portfolio returns under the constraint that the portfolio should not have a negative return based on a predefined, high confidence level. Negative interest rates mean that if negative returns should be avoided, reserve managers need to take up greater FX, interest rate, and credit risk, thereby increasing the risk of negative returns, in a tail scenario while if risks are minimized, portfolio returns are more likely to be negative. These problems are accentuated by two factors. First, the sizeable reserves held by the countries in the region also as a safeguard against financial stability risk. Second, the importance of FX reserve revenues from a central bank profitability perspective, which is perceived in several countries as a guarantee of independence.

Countries in the region and beyond have in general responded to these reserve management challenges via two radically different strategies. Some countries like Romania and Albania have prioritized safety and liquidity in the management of their reserves to serve the insurance purpose for which reserves are held. However, they have seen FX reserve income decline and may be confronted with marginally negative returns in 2017. Other countries have more aggressively pursued yield-enhancing strategies in pursuit of higher returns and to avoid negative returns on FX reserve holdings. These strategies have encompassed currency diversification, the addition of new asset classes, longer duration, and extra credit risk. These strategies seem to have paid off under the prevailing benign financial market conditions. However, when it comes to core reserves, as defined by their reserve adequacy target, it is of fundamental importance that they are managed with a risk tolerance that is consistent with the contingent macro risks that they are designed to cover. These strategies should therefore also prove to be resilient during more turbulent market times and the expected ECB exit from the current high level of monetary accommodation.

These considerations are elaborated in the transcript of the conference speeches included in this publication. They are underpinned and corroborated by facts and figures. Country-specific considerations are discussed in greater details in the policymakers’ speeches included, whereas keynote addresses, with which each session is introduced, provide a more general, cross-country analytical, and conceptual framework to interpret individual countries’ experiences.

The highly distinguished speakers, whose interesting presentations held during the conference are included in this publication, and the feedback received during and after the event, confirm the great interest elicited by the conference.

There seems to be, therefore, a case for considering such a conference not as a one-off event but, in line with the auspices of several participants, to turn it into a recurrent event. This would provide a forum for senior central bankers and policy officers in the region to regularly exchange experiences of the common challenges faced and their responses. The events would support cooperation among the countries in the region that is expected to become closer and more fruitful in the years ahead.

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