Chapter

I Overview

Author(s):
Malcolm Knight
Published Date:
February 1998
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Since 1991, the 15 countries under review—the Baltic countries, Russia, and the other countries of the Former Soviet Union—have, to varying degrees, been pursuing reforms whose broad objectives have been to achieve market-based determination of interest rates and exchange rates, manage banking system liquidity through market operations with indirect instruments, and provide the institutional underpinnings for the design and implementation of macroeconomic stabilization and structural reform programs supported by the IMF. The implementation of these measures has required close coordination of associated reforms to foster interbank money markets, government securities markets, and foreign exchange markets and to strengthen other functions of central banking, including critical actions in the payments system, central bank accounting and internal audit, and banking supervision and bank restructuring.

This paper attempts to rank the progress that each of the countries has achieved in each of the main central banking areas surveyed and to distill an overall ranking for each country’s progress thus far compared with its peer group, which consists of all the aforementioned countries. Measuring progress necessarily involves qualitative assessments, and the assigned rankings must therefore be treated with appropriate caution. In particular, even those countries judged to have made substantial progress in financial system reform compared with their peer group still have further work to do before achieving international standards. Nevertheless, the rankings should be useful to the authorities in reforming their central banking functions and to the international community in drawing broad conclusions as to the effectiveness of their past efforts and the extent of further reform measures needed. The rankings contained in the sections that deal with banking supervision or restructuring and the payments system are partly based on questionnaires that were addressed to the recipient central banks. In other areas, they are based on the IMF’s ongoing contacts with the authorities.

Institutional Background

Except in Belarus and Turkmenistan, central banks in the Baltics, Russia, and the other countries of the former Soviet Union now have broad de facto autonomy to pursue price stability and to formulate and implement monetary policy accordingly. With the exception of the currency board arrangements in Estonia and Lithuania and the informal peg to the SDR in Latvia, exchange rates are flexibly managed and intervention has generally been active, sometimes reflecting the use of foreign exchange operations as a substitute for money market operations. Intervention, in some cases, has represented an attempt to smooth the exchange rate when the foreign reserve position permitted. For all practical purposes, the only countries with restrictions on external current account transactions are Belarus, Russia, Turkmenistan, and Uzbekistan, and most countries have only limited restrictions on capital movements, except for some that govern inflows of certain types of long-term capital.2

Most of the countries under review have liberalized interest rates on bank deposits and bank lending and now rely mainly on indirect instruments to control bank liquidity (except Belarus, Tajikistan, and Turkmenistan), although their reliance on market operations is often limited by shortcomings in the liquidity management framework and lingering weaknesses in market micro structure. The prospects for deepening money, securities, and foreign exchange markets—in terms of volume and type of operation—are still limited by uncertainties about the enforceability of contracts, the remaining shortcomings in the payments infrastructure for financial market transactions, and the soundness of many bank counterparties in the market. Although the regulatory frameworks within which banks function are now reasonably strong, their effectiveness in almost all countries remains severely limited by weak and uneven accounting and disclosure standards, markedly limited on-site inspection capabilities, and problems in enforcing the supervisory and intervention powers of central banks. In these circumstances, market discipline remains weak, leaving the central banks with much of the burden of ensuring orderly conditions in the banking system.

Summary of Findings in Key Functional Areas

Monetary Operations and Government Securities Markets

In general, the information assessed during the preparation of this study suggests that the 15 countries under review have made reasonably good progress in establishing market-based monetary policy instruments and procedures. Kazakhstan, the Kyrgyz Republic, Latvia, and Russia have advanced the furthest, to judge from their progress in designing and operating central bank standing and discretionary facilities, the stage of development of interbank and government debt markets, and development of the operating framework for short-term liquidity management.3 The other countries have generally established basic instruments and procedures, but operations often need streamlining (for example, full collateralization, market-related rates of charge, and conditions of access), and money and government securities markets have been slower to emerge. However, for all countries, the development and effectiveness of short-term operating frameworks are still hampered by insufficient coordination within the central banks between market desks and units managing standing facilities, and/or between central banks and treasuries, in terms of both auction schedules for issuing government paper and government cash flows.

In most countries, the development of interbank money markets has been undermined by poor counterparty information (leading to market segmentation), a lack of timely information on clearing positions at the central bank, widespread bank unsoundness, and a lack of collateral. The introduction of repurchase agreements (repos) is a way of addressing credit risk, but shortcomings in delivery-versus-payment arrangements have introduced liquidity risk that complicates the pricing and margining of such transactions. The lack of timely access to an adequate custodial system has restricted the usefulness of collateral, and uncertainties remain concerning the legal basis of repos in virtually all countries other than Moldova and Russia.

Primary auctions of treasury bills have been established—except in Estonia, Georgia, and Tajikistan—and generally function well in all countries except Turkmenistan. Outstanding stocks of treasury bills in most countries remain small. Secondary markets in government debt are well established in Kazakhstan and Russia, and to some extent in Latvia, Lithuania, Moldova, and Ukraine, in part owing to growing interest by foreign investors.

Foreign Exchange Markets

With the exception of Belarus, Turkmenistan, and Uzbekistan, foreign exchange markets appear to be the component of financial sector reform where the greatest progress has been made toward the introduction of market-based policies and procedures. Most countries have achieved current account convertibility, including the Baltics, Georgia, and the Kyrgyz Republic. This environment has been conducive to the development of foreign exchange markets beyond the early evolutionary stage of auction arrangements. With a few exceptions (Tajikistan, Turkmenistan, and Uzbekistan), the central banks’ internal organization, procedures, and staffing for conducting market operations and managing official international reserves are largely in place.

Banking Supervision and Bank Restructuring

Because central and commercial banking operations were centralized in the Soviet Gosbank and a few specialized state-owned banks before 1991, these countries started the transition in urgent need of deep structural change in their banking systems; such changes have occurred, and at an impressive rate. The commercial banking sector has developed partly from previously state-owned specialized banks, although in most countries the number of new commercial banks has also expanded rapidly. These unique circumstances, as well as the major risks and uncertainties associated with the rapid transformation of other sectors of the economy, naturally raise questions about the financial soundness of banking systems in the Baltic countries, Russia, and the other countries of the former Soviet Union. In the early 1990s, under conditions of high inflation and associated exchange rate depreciation, banks could make substantial profits from currency operations and payment float without the need to develop their normal lending business. As economic stabilization has progressed and inflation rates have come down, the need has correspondingly increased for commercial banks to strengthen balance sheets, increase provisioning for non performing loans, and strengthen markedly their credit and market risk analyses. Firm, timely, and effective bank supervision is essential if these countries are to avoid banking sector problems during this delicate transition.

Initially, the countries under review focused on putting in place the legal, regulatory, and organizational framework for bank supervision, which is now broadly satisfactory except in Tajikistan and Uzbekistan. Attention now needs to be more strongly focused on training bank inspectors, enhancing on-site inspection programs, and improving enforcement of supervisory decisions, including in the judicial system. In some cases, the courts have been reluctant to uphold supervisory decisions taken by the central bank (Moldova), and in others the implementation of decisions has been delayed unduly (Georgia, Lithuania, Russia, and Ukraine). Accounting and auditing standards and the associated rules for classifying impaired loans and for provisioning have become, more than ever, the priority in Armenia, Georgia, Moldova, and Russia now that the earlier work in establishing supervisory systems is broadly completed.

As already noted, recent progress toward inflation and exchange rate stabilization has highlighted some underlying financial difficulties associated with rapid structural changes in the banking system, giving rise to continuing concerns about recent and potential systemic banking problems. Pressing bank soundness issues that need to be addressed include impaired loan portfolios, inadequate banking skills and bank governance, overbanking at a time of economic contraction and financial disintermediation, and insufficient capital to absorb these and other adverse developments (highlighted also by the introduction of higher capital requirements and stricter provisioning standards). Some countries (Baltic countries, Georgia, Kazakhstan, Kyrgyz Republic, and Moldova) have developed a comprehensive approach to bank restructuring, including a diagnosis of the situation of banks and an institutional framework for restructuring that includes clearly specified disciplinary actions and enforcement procedures. Armenia and Azerbaijan are also making significant efforts to address revealed banking sector weaknesses. In Russia, the authorities intend to continue restructuring on a case-by-case basis; they have affirmed that neither federal government funds nor central bank funds will be used to bail out banks. A number of the larger, systemically important commercial banks have been closely monitored since August 1996. As yet, however, the Russian authorities have assessed the financial condition of a relatively small number of banks. In Tajikistan and Uzbekistan, the authorities have not yet undertaken detailed initial assessments of the banking system.

Payments System Policies

The Baltics, Belarus, the Kyrgyz Republic, and Ukraine have largely addressed the strategic issues of payments system policy. Only Tajikistan lags significantly behind in this area. In the other countries, the payment services provided by the central banks and the functionality of payments system interfaces with monetary operations and instruments and with core financial markets require further improvements. Areas where progress is needed include the centralization of commercial banks’ accounts with the central bank and the associated timely availability of banks’ account balance information (Armenia, Georgia, Kazakhstan, Russia, and Turkmenistan); better design of reserve averaging and of Lombard facilities to support the liquidity needs of the banks (Azerbaijan, Georgia, Russia, and Uzbekistan); the development of specialized systems for large-value and low-priority or high-volume payments, with clear arrangements for minimizing risks (Armenia, Azerbaijan, Georgia, Moldova, and Russia); and more flexible delivery-versus-payment arrangements for securities markets (Armenia, Georgia, and Russia). The legal frameworks underpinning netting arrangements or agency relationships continue to be unclear in a number of countries. In Russia, payments system reform was initially hampered by a lack of coordination among a number of regional initiatives, often characterized by undue emphasis on technology at the expense of payments system functionality, and sometimes by the lack of a clear strategic vision. However recent management changes in the central bank signal the potential for swift progress, and most of the above-mentioned elements will largely be in place by 1998.

Central Bank Accounting and Internal Audit

All countries except Russia, Tajikistan, and Turkmenistan are implementing a new chart of accounts for their central banks, as well as associated accounting arrangements that reflect international practice and standards. Among these, Armenia, the Baltics, and Kazakhstan can now independently consolidate central bank accounting reforms. Russia is developing a new chart of accounts that embodies some aspects of international standards, but has not yet adopted the key principle of accrual-based accounting. Internal audit reforms in the central banks continue to lag in all but a few countries (Belarus and Latvia). More progress has been registered in the external audits of the central banks: Armenia, Azerbaijan, the Baltics, Georgia, Kazakhstan, the Kyrgyz Republic, and Ukraine have completed external audits according to international standards.

Country Rankings

The 15 countries covered in this report have adopted the broad goal of fundamentally transforming their economic and financial systems over the medium term. As noted above, their progress since 1991 in the various key areas of central banking reforms has varied. To help countries determine the appropriate sequencing of further reforms and to assist both recipient and donor central banks and institutions in identifying priorities for further technical assistance, the IMF staff has attempted to rank each financial system as a whole and the progress each country has achieved thus far in each of the key sectors.

The main body of this report describes in detail the technical criteria that have been used to rank each country’s progress in monetary, exchange, and supporting reforms. To provide a broad overview of the status of reforms, these technical rankings are summarized in Table 1. Countries are divided into three groups according to progress made since the end of 1991 in implementing structural changes in each area: (I) limited progress, (II) moderate progress, and (III) substantial progress. Progress during this transition period in the various areas was measured relative to levels of development achieved by peer countries, consisting of the 15 countries that were surveyed. As noted above, measuring progress necessarily involves qualitative assessments. The assigned rankings must therefore be treated only as rough indicators of areas that each country should focus on in order to maintain the momentum of structural transformation. Furthermore, although a ranking of III implies that a country’s progress to date has been as rapid as practicable during the period given its initial circumstances, in many instances further actions will still be needed to achieve international norms of operation.

Table 1.Central Banking Reforms in the Baltics, Russia, and the Other Countries of the Former Soviet Union: Country Rankings
Monetary Operations and Government Securities MarketsForeign Exchange Operations and MarketBanking SupervisionBank RestructuringPayments SystemCentral Bank Accounting and Internal AuditOverall Ranking
ArmeniaIIIIIIIIIIIIIIIIII
AzerbaijanIIIIIIIIIIIIII
BelarusIIIIIIIIIIII
Estonia*IIIIIIIIIIIIIIIIII
GeorgiaIIIIIIIIIIIIIIII
KazakhstanIIIIIIIIIIIIIIIIIIII
Kyrgyz RepublicIIIIIIIIIIIIIIIIIIII
LatviaIIIIIIIIIIIIIIIIIIIII
Lithuania*IIIIIIIIIIIIIIIII
MoldovaIIIIIIIIIIIIIIIIIII
RussiaIIIIIIIIIIIIIIIIII
TajikistanIIIIIII
TurkmenistanIIIIIIIII
UkraineIIIIIIIIIIIII
UzbekistanIIIIIIIIII
Note: * denotes currency board arrangements; the rankings denote the following: 1—limited progress; II—moderate progress; and III—substantial progress.
Note: * denotes currency board arrangements; the rankings denote the following: 1—limited progress; II—moderate progress; and III—substantial progress.

Rankings are given for six functional areas: monetary operations and government securities markets, foreign exchange operations and official international reserve management, banking supervision, bank restructuring, payments system, and central bank accounting and internal audit. The overall ranking is an aggregate of those individual ones. Countries that have at least three ratings of III and no rating of I received an overall rating of III. Countries that have at least three ratings of I and no rating of III received an over all rating of I. The other countries received a rating of II. Each of the functional areas is given equal weight. The rankings for each country reflect the pace of structural changes toward a market-based financial system and are not intended as an assessment of countries’overall macroeconomic and financial policy stance.

1The background papers for the 1994 meeting were published as Central Banking Technical Assistance to Countries in Transition (Washington: International Monetary Fund, 1994). The background papers for the 1996 meeting were published as Central Bank Reform in the Transition Economies (Washington: Inter-national Monetary Fund, 1997).
2Although Russia accepted the obligations of Article VIII of the IMF’s Articles of Agreement in June 1996, a remaining restriction resulting from the inconvertibility of interest income on foreign holdings of government securities was scheduled to be eliminated by end-1997.
3Estonia and Lithuania are not discussed here because they have currency board arrangements.

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