Since 1992, the central banks of the Baltic states and the Commonwealth of Independent States (CIS) have undertaken to various degrees comprehensive reform of their monetary and exchange arrangements in support of their stabilization efforts.⁵ The objective has been to achieve market-based determination of interest rates and exchange rates, control of banking system liquidity through indirect instruments, and, pari passu, to enhance the use of markets for transmitting monetary policy signals.

This volume provides a review of the first four years of structural reforms in the monetary and exchange areas and identifies priorities for the deepening of reforms. The exercise is designed to highlight linkages among the reform components, the coordination of these components to support market-based arrangements for monetary control, and the main obstacles on the road ahead.

The implementation of market-based arrangements for monetary control has required careful coordination of concomitant reforms to foster money and foreign exchange markets and strengthen key functions of central banking, including critical actions in the payment system, accounting, and banking supervision and restructuring areas. The scope and depth of the reforms required the unparalleled commitment of the central banks and the political authorities at large. In this regard, reforms were designed to be consistent with and supportive of macroeconomic stabilization, as shown by the emphasis on structural actions in the monetary, exchange, and banking areas that are contained in Fund-supported adjustment programs.

Significant progress has been made by most countries in introducing market-based instruments of monetary and exchange management and in fostering development of the money and exchange markets. Nonetheless, further progress is needed in these areas to consolidate the gains in stabilization and structural reforms. Such progress will require continued and well-coordinated efforts to implement concomitant reforms in (1) restructuring the banking system to ensure its soundness; (2) developing a comprehensive strategy for public debt management; (3) establishing appropriate microstructures of secondary markets; and (4) bringing about closer coordination of different monetary instruments and exchange market operations.

The divergences in the pace of central banking reforms over the past four years and, to some extent, variations in the availability of skills in managing the requisite organizational and institutional changes have led to considerable diversity of country situations. The following is a broad-brush characterization of the current institutional and policy-setting parameters.

In most countries, following the introduction of central bank laws, the central bank has de jure independence from political authorities in pursuing the primary objective of price stability; it has authority to formulate and implement monetary policy and authority to implement foreign exchange policy—the exchange system frequently being decided by the government. With the exception of the currency board of Lithuania and Estonia, and the informal peg of Latvia to the SDR, exchange rates are formally flexibly managed by the central banks, in some cases within a large corridor (e.g., preannounced exchange rate band in Russia). Most countries have liberalized deposits and lending interest rates and rely mainly on indirect instruments, even though the effectiveness of market-based instruments is still limited. In the case of Fund-supported adjustment programs, management of interest rates and the exchange rate has been typically governed by a ceiling on net domestic assets of the central bank (usually including a subceiling on net credit to government) and a floor on net international reserves; to the extent that these targets are met with the periodicity specified in the program, the authorities enjoy some scope for managing the path of reserve money and therefore of the exchange rate. In some countries Fund-supported programs specify indicative limits on reserve money growth.

For all practical purposes, there are no restrictions on current account transactions, and in one-third of the countries, there are few or no restrictions on capital flows; in most other cases, there remain limited formal restrictions on long-term inward capital flows (e.g., industrial property or real estate). While development of the money, securities, and foreign exchange markets has been impressive in many countries, further development in terms of volume and type of operation suffers from uncertainty regarding the enforceability of legal contracts arising from, for example, operations with collateral, netting arrangements, or agency relationships, and by weaknesses in the banking system that have become more apparent as stabilization takes hold.

Further progress in financial stabilization and financial market development, and the increased interest rate and exchange rate flexibility that is needed for these purposes, is often constrained by widespread portfolio weaknesses in the banking sector. This has been occasionally reflected in outright banking crises in several countries. Difficulties in the banking system have been exacerbated by initially lax licensing policies of the authorities, ineffective enforcement of prudential standards on banks and of hard-budget constraints on borrowers, poor financial data and bank governance, inadequate legal frameworks for bank conservation or liquidation, and poor enforcement powers of the supervisory authorities, including in the lack of cooperation from the courts.

While good progress has now been made in strengthening bank licensing and supervision, these weaknesses influence the pace of systemic bank restructuring that is needed to restore banking soundness and remove constraints on interest rate flexibility. As a result, consequences of banking soundness for policy effectiveness and risks of policy reversals have become sources of concern.

Macroeconomic Developments

Since early 1995, the threat of hyperinflation has been receding rapidly in almost all of the transition economies. In many cases, inflation rates have now reached manageable levels, although further improvements are both desirable and possible. The transitional recessions have bottomed out in several countries, and growth has resumed in some. Policies to reduce inflation and the concomitant market reforms and economic restructuring, when pursued consistently, have improved growth prospects. For a number of countries, the external situation has considerably improved, reflecting both positive trade developments and a strengthening of the capital account of the balance of payments.

The observed progress in stabilization reflects the pursuit of stricter financial policies. Most CIS countries reduced the deficit of the general government substantially in 1995—for example, to below 6 percent of GDP in many cases, with the Baltic countries maintaining close to overall balance. Growth of central bank credit to government declined sharply, owing to both fiscal adjustment and development of a government securities market. Remarkably, virtually all central banks have dramatically curtailed their financing of commercial banks in comparison with very high levels in earlier years. Interest rates rose to positive real levels in most countries, while exchange rates remained generally stable in 1995 and 1996. Tighter policies have, however, exposed, and at times exacerbated, weaknesses in bank portfolios, and these weaknesses in banking, unless addressed quickly, could threaten stability.

With the authorities broadly committed to fiscal and monetary restraint, the effectiveness of stabilization policies has been increasingly complemented by medium-term structural and institutional reforms. In particular, structural reforms in the monetary, exchange, and banking areas have been designed, and their implementation coordinated, to ensure close support for stabilization objectives, and steady progress toward market-based monetary and exchange management. Operational and institutional requirements of stabilization policies, as well as technical linkages among structural measures, together have influenced priorities among specific financial sector reforms. For instance, the establishment of an interbank money and government securities market has been supported by introducing indirect instruments to implement monetary policy. At the same time, other structural reforms—for instance, in payment and accounting systems, or in banking system structures—have been used to support indirectly the design and implementation of stabilization policies by permitting more effective operation of policy instruments and more efficient transmission of policy decisions.

Design of Bank-Restructuring Strategies: Main Issues and Challenges

Many of the transition economies are currently considering or embarking on bank-restructuring strategies with technical assistance from the World Bank, the IMF, and bilateral agencies. For most, the overall financial situation is currently fraught with the close danger of a banking crisis. As of 1995, the ratio of nonperforming loans to total loans varied from 14 percent to 63 percent. In most of the CIS countries, the five largest banks accounted for most of the total nonperforming loans; it may be inferred that many of these banks are insolvent. Problems in the banking sectors in the CIS countries can, in most cases, be considered systemic in nature. At the same time, the share of the banking sector in real economic activity has declined sharply, and the intermediation role of the banking sector has become extremely limited. Even the Baltic states, which were able to contain inflation by early 1993 and establish monetary control relatively quickly, continue to be characterized by low intermediation ratios.

While the household deposit base is still small in most of these countries, and the banking sector’s total assets are smaller relative to GDP than in Eastern European transition economies, a systemic crisis would nonetheless lead to a further deterioration of confidence in the banking system and jeopardize monetary stability. Risk of crisis aside, the poor health of the banking system is a major constraint on the recovery of the real sector, which will ultimately need the medium-term financing of banks.

Large changes in the economic environment, insufficient institutional development in banking, and inadequate banking practices are or have been ongoing causes of financial distress in the CIS countries. All three factors will need to be addressed to increase the prospects for successful bank restructuring in the long term. In this framework, a comprehensive program of bank restructuring should include measures that encompass (1) the future structure and performance of the banking system, including the policy framework to ensure a competitive and profitable system; (2) strict exit policy; (3) the treatment of loss sharing among involved parties, such as depositors and other creditors, borrowers, and shareholders, with particular emphasis on avoiding moral hazard problems in the design of the strategy; (4) institutional arrangements for loan recovery and loan workout; (5) the minimization of current and future use of public funds and the conditionality measures associated with such use, including a phasing of measures to achieve compliance with prudential standards and supervisory requirements; and (6) in some cases, transitional arrangements to ensure that basic financial services can be provided to the economy.

In most of the CIS countries, banking sector problems have been dealt with as and when they surfaced, and a systemic approach to bank restructuring has not yet emerged. Currently, in most cases, restructuring measures mainly consist of license withdrawals and liquidation procedures directed at small banks. Only 2 of the 12 CIS countries, namely, Kazakstan and the Kyrgyz Republic, have embarked on a systemic restructuring strategy, which includes also extensive measures to deal with the formerly specialized banks. Each of these countries has made progress in enterprise sector reform. Most other countries appear reluctant to close or rehabilitate the large banks, and restructure the enterprise sector.

Interestingly, Georgia has adopted a more “market-based” approach to restructure its banking system. A key element is the implementation of a bank certification program where failure to gain certification will be accompanied by strict limitations on balance sheet growth. Moldova has had a similar program.

Several countries have implemented a package of short-term stopgap measures. These include curbing the activities of problem banks, as in Georgia, and limiting ad hoc injections of funds by the authorities.

The development and implementation of a comprehensive strategy will require a well-defined institutional setting. Depending on the scale of the problem, existing institutions may take the lead or a special agency or task force for bank rehabilitation may need to be formed. Guided by the budgetary resources available for bank rehabilitation and the implementation capacity of the restructuring institution, it will then be critical to reach consensus, especially with the government, on the various components of a restructuring strategy. As a first step, most countries are beginning with a diagnostic review to establish the magnitude and the nature of the problems in the banking sector. Progress has been made also in improving the legal framework; however, much work still needs to be done in this area to establish the framework for facilitating effective restructuring of the banking system. Fewer than half of the countries have initiated formal deposit insurance schemes, although in many countries there seems to be an implicit government guarantee on deposits of large banks. Generally, the introduction of deposit insurance is not advisable before the banking sector has been restructured and is profitable. So far, only Kazakstan has established an adequate institutional framework to recover nonperforming loans.

The strategy should include concomitant reforms to create the environment and incentives for the efficient working of the financial system, as well as the establishment of a robust mechanism to minimize the recurrence of banking-system distress. First, it is necessary to ensure that banks operate on commercial principles and have strong management and internal control, supported by adequate official oversight. Privatization and participation of foreign banks could be an important method of achieving these objectives. Second, banking-system restructuring will need to go hand in hand with enterprise restructuring and measures to strengthen the legal and regulatory framework for banking and loan recovery. Otherwise, as shown by the experience of Eastern European countries, the success of bank restructuring will likely remain limited.

Monetary Operations and Public Debt Management

Monetary management is primarily exercised through reserve requirements, refinance facilities, and intervention in the foreign exchange market, and, to a limited extent, through auctions of treasury bills and central bank paper. In most countries, central bank financing of the banking system is provided on market-related terms, mostly through credit auctions that are increasingly collateralized. A Lombard facility with well-defined rules of access has often been introduced as a short-term lender-of-last-resort facility in support of the operation of the payments system. There are adequate procedures for adjusting rates on standing facilities in line with market conditions. Direct central bank credit to the government is decreasing, although it still remains high in some countries, representing an important source of reserve money creation. Treasury bill auctions are under development in most countries, and a few have experimented with open market operations in the secondary market, but outstanding volumes remain small. Liquidity absorption is mainly conducted through a combination of foreign exchange sales, outright sale of treasury bills, deposit auctions, and increases in reserve requirements; an issue in some countries remains the costs of sterilizing capital inflows. Fairly high and unremunerated reserves continue to be the norm.

In spite of significant progress registered in most cases, much remains to be done to bring monetary operations and instruments in many of the CIS countries to modern market standards. Countries need to strengthen information systems for the conduct of monetary operations and enhance coordination with foreign exchange operations. Given the structural and liquidity problems in the banking system, central banks need to design lender-of-last-resort facilities under well-defined rules of access; this could be complemented with reserve averaging to some degree. In addition, central banks need to enhance the efficiency of existing monetary instruments by ensuring compliance with reserve requirements, and generalizing the use and improving the quality of collateral in central bank operations. As well, adequate arrangements need to be in place to ensure that sterilization costs are transferred to the budget. As markets develop, central banks need to prepare the ground for repurchase operations. Further, strengthening banking supervision, dealing with problem banks, and improving the payments system are necessary to enhance banks’ efficient liquidity management and the effective implementation of monetary policy.

Foreign Exchange Operations and Reserve Management

With a few exceptions, the transition economies have moved substantially toward unification of the exchange rate at a market-determined level in a setting of a liberal exchange system. Most current account transactions have been liberalized and progress has been made toward liberalizing capital flows; seven countries have accepted the obligations of Article VIII of the Fund’s Articles of Agreement (Estonia, Georgia, Kazakstan, Kyrgyz Republic, Latvia, Lithuania, and Russia).

Exchange rates are, in most cases, determined in an interbank auction arrangement. Interbank trading outside the auctions is generally allowed and is gaining increasing prominence, as banks learn to appreciate the flexibility afforded by continuous markets. After an initial sharp depreciation of their currencies, countries with strong adjustment programs and generally open exchange systems have experienced a relative stabilization of the exchange rate—and strong appreciation in real terms—and strengthening of foreign reserve positions.

Reform priorities include the development of the interbank foreign exchange market to permit the transition from the centralized auction market to a continuous dealer-based system. Further progress toward exchange system liberalization is also required, and monetary and exchange operations at the central bank must be better coordinated to avoid conflict between exchange rate stability and monetary stability. Strengthening of the interbank market will include the drawing up, or strengthening of, codes of conduct and the design and enforcement of adequate prudential and informational measures.

In most cases, the management of international reserves has been consolidated under central bank management. International reserve management will need to be improved through the development of appropriate investment guidelines and internal controls.

Payments System

Progress in payments system reform has varied markedly among the transition economies. In all countries, central banks dominate the provision of basic clearing and settlement systems for payments and have streamlined these systems to meet the needs of users of the payments system at this stage of countries’ financial development. Clearing times are still slow and unpredictable in more than half of the countries. In others, initial reforms based on readily available technology have helped stabilize clearing times and thereby reduced or stabilized credit float that contributed to weak monetary control. Most countries are replacing automatic overdrafts with Lombard facilities to limit risks assumed by the central bank in payment settlements. To help banks’ liquidity management, several countries have centralized their settlement account structures and others are in the process of doing so. Only a few have introduced clearing houses based on netting for low-value payments, and none of the countries is yet operating a specialized large-value transfer system (LVTS). Some of the countries, however, are operating electronic systems or pilot projects that carry the bulk of their high-value payments, and most countries are well advanced in their plans for LVTS, with real time gross settlement.

Reform priorities are to expedite further work on a specialized interbank funds transfer system for priority payments with guaranteed same-day or real-time settlement, and its interface with securities and foreign exchange markets; the provision of timely account information to banks to enable funding of debits on the interbank market; and proper risk management in netting arrangements. Other important reform elements include the implementation of private sector netting arrangements, including through pricing of central bank payment services, and a further streamlining of the legal and regulatory frameworks. In many cases, a vision of the central bank’s role in the future payments system and systematic planning and implementation of the ensuing policy framework remains elusive.

Central Bank Accounting

Most countries have made good progress toward completing the first stage of designing a new chart of accounts and the associated organizational changes, and some have proceeded beyond this stage. For most, the current accounting system can now provide a range of accounting services to support market-based policy actions, albeit with varying degrees of sophistication. In particular, accounting systems are generally able to support day-to-day operations, through the provision of timely account information to banks, availability of transaction and balance information to support short-term liquidity forecasting, and detailed recording to support monetary and exchange operations.

Many countries still fall short of internationally accepted standards, however, and a comprehensive training program is required to consolidate the progress achieved. New accounting policies are needed in many areas, in particular as concerns accrual versus cash basis, valuation of foreign exchange operations, and generally market-based valuation of assets. Work on internal audit generally has been limited to introductory and strategic issues.

Important accounting issues, which remain to be addressed by some countries, include the adoption of national accounting standards that are consistent with international standards (particularly when the adoption of accrual accounting and market-based valuation policies are concerned), appropriate format and additional disclosures for financial statements, recognition and distribution issues of central bank profits and losses, and the development of effective and efficient internal audit arrangements.