Liberalization of the foreign investment regime involving reforms in legislative, accounting, information, and institutional framework in the context of approaching the EU.

Increased confidence in the economy with political and economic stability (reduced external debt, low inflation). Sound economic and financial policy framework, supported with CBA and structural reforms.

High lending rates with limited perception of FX risks

Rapid growth of banking sector credit financed increasingly by bank borrowing from abroad (since early 2000s).

Dominance of the banking system by foreign banks with easy access to foreign funds (including from parent banks, especially in the recent years).

Aggressive response of domestic banks to the entry of foreign banks.

Improvement in market confidence in the economy and a gradual integration of Croatia into the international financial markets.

Macroeconomic stabilization (price and exchange rate stability from 1994).

Rehabilitation of the banking system (from 1995).

Investment grade credit rating attained (in 1997).

Stable exchange rates and higher domestic interest rates (and differential with foreign interest rates).

Rapid growth of banking sector credit financed increasingly by bank borrowing from abroad (since the early 2000s).

Paris and London Club debt agreements (in 1995–96).

Arrival of foreign banks with easy access to foreign funds (including from parent banks, especially in the recent years).

FDI promotion policies after 1997.

Privatization programs.

Favorable macroeconomic performance and stability (until 1997 and after 2000) translating also into lower risk premia

High interest rate differentials.

Insufficient intermediation and supply of long-term instruments by domestic banks that contributed to a rise in direct financial credits from abroad.

Foreign investors’ convergence play on the prospects of E(M)U membership in 2001-02 and improved economic prospects associated with EU membership.

Fall in world interest rates in 1993-95, attracting foreign (mostly short term) inflows.

Macroeconomic stability and associated increase in confidence in the economy.

EU convergence issues and associated reforms with the prospect of imminent euro adoption.

Privatization/deregulation of the financial sector that drew foreign savings intermediated by reputable regional banks.

Stable/predictable exchange rate and low perception of FX risks under the currency board vis-à-vis the euro.

Low nominal interest rates (given the currency board) leading to negative real rates due to relatively high inflation, which in turn contribute to the real estate boom and rapid credit growth.

Arrival of foreign banks who have been seeking profitable opportunities and with easy access to foreign funds (including from parent banks).

Improved confidence in macroeconomic stability, performance, and prospects.

Improved credibility of the narrow exchange rate band.

High interest rate differentials owing to sterilization operations that stimulated further inflows when combined with predictable exchange rate movements within the narrow exchange rate band.

Relatively early liberalization of government securities markets attracting interest rate sensitive inflows.

Foreign investors’ convergence play on the prospects of E(M)U membership in 2001-02 and improved economic prospects associated with EU membership.

Rapid growth of banking sector credit since the early 2000s, funded partly by bank borrowing from abroad.

Fall in world interest rates, attracting foreign (mostly short term) inflows.

Arrival of foreign banks with easy access to foreign funds (including from parent banks, especially in the recent years).

Credible low inflationary policies.

High interest rate differentials with predictable exchange rate movements and intra-marginal interventions within formal bands.

Improved macroeconomic performance and prospects.

Exogenous geopolitical events (also in connection with the peace process), decreasing the country’s risk premium.

Strong economic growth and macroeconomic stability and increased confidence in the economy (per capita income in PPP terms climbed an impressive 19 percentage points in 1997–2006, among the fastest of the eight new eastern European member states (EU8) and until recently inflation performance was commendable (1.9 percent in 2002, 2.9 percent in 2003, 6.2 percent in 2004, 6.7 percent in 2005, and 6.5 percent in 2006).

EU accession and prospects of euro adoption.

Elimination of all capital controls.

Stable/predictable exchange rates and perception of low FX risks under the long-standing fixed peg regime since 1994.

Low nominal interest rates leading to negative real rates due to relatively high inflation, which in turn contributed to the real estate boom.

Arrival of foreign banks with easy access to foreign funds (including from parent banks).

The need to cofinance projects supported from EU structural funds.

Impressive growth in per capita income toward the European average underpinned by robust productivity growth, increased confidence in the economy, and improved prospects associated with EU accession, which has gained momentum from 2003.

Privatization/deregulation of banks that attracted foreign capital under a liberalized capital account.Stable/predictable exchange rates and perception of low FX risks under the currency board arrangement.

Arrival of foreign banks with easy access to foreign funds (5 of 9 banks in Lithuania are subsidiaries of foreign banks and 4 are branches of foreign banks).

The need to cofinance projects supported from EU structural funds.

Improvement in economic conditions, with greater macro-economic stability and EU accession prospects (from 1994).

Privatization and growth of the Polish capital market (from 1991).

London Club agreement (1994).

Global ample liquidity following interest rate cuts in the United States (2001–05).

Large interest rate differentials (in the 1990s, adjusted for expected exchange rate depreciation), combined with predictable exchange rate movements and intra-marginal interventions within the formal bands (1992-99).

Increasing confidence in monetary management (from 1992).

Declining corporate income tax rates (over time lower than in most EU countries) (from 1997).

First stage of privatization program.

Improved economic prospects in the context of EU accession.

Increase in capitalization of foreign companies already operating in Romania.

A surge in bank borrowing from abroad since mid-2001 in part to fund the rapid growth of banking system credit.

Speculative inflows driven by high interest rate differentials and predictable exchange rate movements until 2005.

Increasing role and share in the banking system of foreign banks with easy access to foreign funds (including from their parent banks especially in the recent years).

Prospects of EU entry (in 2000s).

High interest rate differentials.

Improved macroeconomic performance with high output growth, supported by structural reforms.

Increased credibility of monetary policy with significant disinflation and consolidation of public finances.

Abundant international liquidity and low interest rates in advanced economies in 2000s.

Hedging needs of foreign issuers (multilateral institutions, international banks, and export credit agencies) of new TL papers, following the lira’s redenomination.

Helped improve productivity and export performance.

Helped financing of CA deficits.

In the later periods, when other investment inflows caused difficulties in monetary management especially under the CBA with limited room for monetary policy maneuver and lack of traditional monetary instruments to manage liquidity (the reserve requirement as the only monetary instrument).

Helped post- post-crisis restructuring of the financial sector, through privatization.

Contributed to development of financial markets, through rising volumes of transactions.

Since early 2001, facilitated the rapid increase in credit growth with a significant FX component, which has been raising financial stability concerns associated with indirect FX exposure of banks and deterioration in banks’ risk assessment and internal control systems; some disintermediation that took place toward lending by nonbank financial institutions not subject to reserve requirements or similar supervisory scrutiny also raises stability concerns for the overall financial sector.

Associated with a widening of the CA deficit.

Associated with a rapid monetary expansion, when sterilization was complicated by a high degree of euroization and lack of appropriate monetary instruments (inflationary impact has been limited by reverse currency substitution at the earlier stages and exchange rate stability and wage moderation in the later stages).

Rapid increase in the external indebtedness of banks and the corporate sector as they borrow from abroad (banks in financing their rapid lending growth, corporates in part in response to the direct/indirect measures imposed on bank lending).

Volatile short term inflows contributed to FX market instability in 1998/99 period.

The currency mismatch (direct FX risk) in the balance sheets of commercial banks (as banks borrowed in foreign currency and lent in kuna) contributed to two banking crises (mid and late1990s).

Significant rise in recent years in foreign currency related lending to unhedged borrowers financed largely by banks’ foreign borrowing exposes the financial system to indirect FX risks and risks of a potential deterioration in asset quality if the exchange rate were to depreciate.

The measures imposed to limit credit growth or its financing in the form of bank borrowing from abroad led to some circumvention efforts in the form of switch to borrowing from less well-regulated nonbank financial institutions (e.g., leasing companies), with the associated stability risks for the overall financial sector.

Improved technological possibilities, export performance, and competitiveness.

Helped financing of CA deficits.

Led to rapid monetary expansion and large sterilization needs under the pegged exchange rate–holy trinity dilemma.

Insufficient coordination of fiscal policy with monetary policy under a fixed exchange rate required higher interest rates that helped attract further inflows.

Complications in achieving the inflation targets under the free float (causing a significant undershooting of the targets in) during 1999–2004.

Entrance of foreign banks in the form of either branches or subsidiaries had a role in developing the interbank, FX and bank-client markets, and was also an important stabilizing element in terms of managing FX risks.

Participation of foreign banks in the privatization of major state banks lead to a mixed experience as regards financial sector stability, although it overall increased the efficiency of both the banking sector, as well as (indirectly) corporate management.

Inflows intermediated through the banking system have been supporting a strong growth of banking sector credit (especially since 2002); the latter has contributed to overheating pressures in the economy:

• a sharp deterioration of the current account deficit (to an estimated 15 percent of GDP in 2006, compared with5 percent in 2001).

• the 2008 target for euro adoption pushed back (until 2011) owing to the difficulties in meeting the inflation criteria.

Growing external indebtedness (with net external liabilities (NFL) approaching 100 percent of GDP by end-2006) increased vulnerability to a sudden reversal of market sentiment for Estonia or the region.A mitigating factor is that equity investment was the main driver of the build-up of external liabilities.

Contribution to productivity and enhanced competitiveness.

Inflow of foreign savings intermediated by reputable regional banks has brought major benefits to the financial sector and underpinned economic growth, but has also supported a very rapid growth of bank credit that increased financial sector vulnerabilities:

• Concentration of bank lending in the housing and household markets subjects banks to real estate market risks (mortgages constitute more than 80 percent of household liabilities).

• Banks are significantly long in foreign currency (20 percent of GDP), but are exposed to indirect FX risks through their lending to unhedged borrowers (short FX position of nonbanks is about 57 percent of GDP, much of which is likely unhedged); the euro exposures (direct/indirect) are excluded from the prudential regulations given the currency board.

• Banks are vulnerable to liquidity and rollover risks, through funding of lending by foreign borrowing (2/3^rd of bank liabilities are debt funded). Liquidity support by parents is likely given reputational risks, but cannot be taken for granted. Mortgages loans at variable rates may mitigate interest risks.

Helped finance CA and public sector deficits.

In the early period, no significant macroeconomic effects observed in mid-1990s, in part due to sterilization efforts.

Persistent inflows complicated policy implementation as the authorities aimed at maintaining the exchange rate band while simultaneously targeting inflation: higher interest rates to counter inflation (in the absence of sufficiently tight fiscal policies and exchange rate flexibility) continued to attract inflows, as well as stimulating FX-linked lending.

Inflows intermediated through the banking system to support a rapid expansion of credit have been associated with a widening current account deficit (via higher imports and consumption), which, when combined with fiscal deficits raised concerns about currency stability.

Rapid expansion of credit made possible in part by foreign borrowing by banks contributed to financial stability concerns (after 2000): in particular rising foreign currency lending exposed the banking sector to indirect FX risks (to the extent borrowers were not hedged). There is some deterioration in banks’ lending standards given the intense competition for market shares.

Trade off between the objectives of achieving low inflation and preserving competitiveness under heavy capital inflows complicated monetary policy management; sterilizations to offset monetary expansion became costly, leading eventually to greater exchange rate flexibility.

No significant financial sector implications were observed.

Widening CA deficit (to 21 percent of GDP in 2006) more than financed by banks’ net foreign borrowing and deposit taking (22.4 percent of GDP).

FX market pressures and exchange rate risks associated with sizable external imbalances: NFL rose to 69 percent of GDP in 2006; unlike other EU8—where net equity (FDI and portfolio) accounts for the largest share of NFLs—in Latvia, more than half of NFL is in the form of net debt, which rose from 9 percent of GDP in 1999 to 43 percent in 2006.

Rising inflation pressures led to a delay in the target date of euro adoption in 2008—to at least 2012).

Inflows have been supporting a very strong growth of bank lending. Concentration of loans to households and non-tradable sectors presents an obstacle to long-term production capacity (in 2003-06, over 61 percent of new loans were used to finance residential mortgages or corporate real estate; 11 percent for other loans to households; and 6 percent to manufacturing).

While credit growth has raised well-being of households, there have been limited benefits for sectors that could generate export earnings.

With the small share of FDI directed to the manufacturing sector (14 percent in 2005—the smallest among EU8), Latvia is missing out on the productivity-enhancing benefits of FDI in export-oriented manufacturing sectors.

The persistently strong growth in bank lending financed largely by bank borrowing from abroad contributed to financial vulnerabilities:

• Reliance on foreign borrowing by banks has increased vulnerability to liquidity and rollover risks; banks account for half of Latvia’s foreign debt assets and 2/3^rd of its foreign debt liabilities.

• Banks have increasing exposure to FX-related credit and market risks via balance-sheet mis-matches of their unhedged foreign currency borrowers.

• Intensifying competition among banks for market share contributed to a softening of loan standards (e.g., an easing of mortgage origination standards).

Contribution to overheating pressures in the economy with a rising current account deficit and inflation pressures:

• Concerns about sustainability of the current account deficit with continued strength of the credit expansion financed substantially by external borrowing; the credit expansion supported domestic demand and imports; non-FDI financing component of the current account deficit has been increasing.

• The recent pick up in inflation will likely remain above the Maastricht criteria as long as demand pressures continue; target date for euro adoption moved until at least 2010.

Increasing external debt through banking sector borrowing from abroad raises vulnerability to a sudden reversal of market sentiment toward Lithuania or the region.

Foreign bank entry contributed to financial sector development: the subsidiaries of foreign banks have profited from knowledge and technology transfers, as parent banks have enforced credit management techniques in their subsidiaries similar to those in their home institutions. The subsidiaries have standing credit lines with their parent banks that may facilitate rapid access to liquidity.

At the same time, banks’ vulnerability to liquidity and rollover risks increased through rising external debt of banks (including from their parents); net foreign borrowing financed on average ½ of credit growth in 2006, compared with 1/10^th in 2005).

Financial sector vulnerabilities also rose through: some deterioration in lending standards; sectoral risk concentration (particularly in real estate and mortgage sector) and some exposure to risks of a fall in house prices; and exposure to indirect FX risks through loans to unhedged FX borrowers (to the extent that euro adoption is not imminent).

Helped improve the technological possibilities and create a competitive export sector.

Contributed to economic overheating, with stability risks.

Complicated monetary policy management through costly sterilizations, which led to step-wise increases in exchange rate flexibility to safeguard the disinflation process; the authorities eventually switched to an inflation targeting regime in 1998 with a floating exchange rate adopted in 2000.

FDI inflows to domestic financial sector contributed to an efficient and stable financial sector, as they played an instrumental role in banking privatization and in supporting private banks in distress.

Large capital flows were often associated with rapid credit growth with a rising share of irregular (often nonperforming) loans.

These loans presented a risk to financial stability in the early 1990s; the stronger supervisory system in the 1990s helped deal with the negative effects of the rapid credit growth.

Deterioration of macroeconomic balances: expansion in domestic demand, a widening CA deficit, competitiveness concerns, and a slow down in the process of disinflation.

Exacerbated the trade off between simultaneous attainment of competitiveness and inflation goals, limiting monetary policy autonomy and jeopardizing the inflation target: raising interest rates attracted further inflows and higher FX denominated lending while lowering interest rates risked credibility of the inflation target adopted in mid-2005.

Capital inflows facilitated a rapid growth of credit to the private sector with a significant FX component, exposing the banking system to indirect FX risks; some pressure on profitability has also been observed.

Appreciation pressures under a floating exchange rate have raised competitiveness concerns (and were associated with a significant widening of the CA deficit); exchange rate intervention under the floating exchange rate since 2001 aimed mainly to build a sufficient stock of reserves.

Inflows increased the premium placed on an appropriate policy mix; continuation of disinflation may require interest rates to remain high for a while, which is likely to sustain capital inflows.

Recent inflows contributed to a rising share of fixed term consumer lending, exposing the banking system to interest rate risks. On the other hand, greater reliance on (more long-term) foreign financing has served to mitigate somewhat maturity mismatches in Turkish banks, although faster credit expansion has created other vulnerabilities, including greater exposure to credit risk.

Financial sector reforms (legal and institutional framework for foreign investment made EU compatible, and strengthening the prudential and supervisory framework.

Appropriate information systems for financial flows integrating all foreign investments, statistical tools to gather information on cross-border financial flows, and reporting requirements on financial institutions, legal entities, and physical persons.

Liberalization of FX and capital account regime from 2000 and acceleration of trade liberalization from 1997.

Credible and consistent macroeconomic policy mix (including transparent monetary policy based on CBA).

Supervisory, monetary, and administrative measures to slow down the pace of rapid credit growth financed largely by inflows intermediated by the banking system (e.g., raising the level and broadening the coverage of reserve requirements to liabilities previously exempted; further tightening of prudential and supervisory regulations; moral suasion to convince banks to reduce credit growth; credit controls in the form of a nonremunerated reserve requirement on excessive credit growth) (2004–06).

Debt management measures: The authorities shifted from foreign to domestic borrowing sources; bought back outstanding Brady discount bonds; government deposits were transferred to the central bank; and the Deposit Insurance Fund was instructed to invest its cash balances and maturing repos in government debt to deal with the liquidity impact of inflows.

These measures helped in managing the capital flows, including by increasing the financial system’s absorption capacity of the inflows. In particular, it provided greater freedom to banks in managing their open foreign currency positions, including those associated with capital flows, while obligating them to develop internal risk management systems in line with best international practices.

May have helped somewhat reduce net FX inflows into the domestic economy.

Helped limit potential adverse consequences of increased inflows.

These measures were taken not to limit capital inflows per se, but to deal with their implications through expansion of credit funded by such inflows. Overall, moral suasion was ineffective (given the dominance of foreign banks operating under home country regulations); tighter reserve requirements mainly served as a warning; while the supervisory, administrative measures helped slow credit growth, they also resulted in some dis-intermediation and circumvention efforts that transferred some of the activity to potentially riskier funding of borrowers; the latter required in turn a widening of the scope of the measures and efforts to strengthen nonbank financial sector supervision.

Helped deal with the liquidity impact of the inflows.

Limited scale sterilization initially through reserve requirements and ‘obligatory’ CB bills (remunerated at above deposit rates but below standard CB bill rates), later through foreign currency denominated CB bills (at market rates).

FX market liberalization in 2001, including by allowing banks full access to the FX market (including to hold foreign currency in their accounts, and not only when justified by import needs as previously) and extension of surrender requirement period for conversion of FX receipts of the corporate sector.

Introduction of Chilean type of controls in early 1998, in the form of a requirement to deposit (in kuna) 30 percent of the short-term credits from abroad and 5 percent of longer-term credits at the CB for all financial credits taken for conversion into domestic currency; a requirement to deposit (in kuna)10 percent of the guarantees on credits for conversion into kunas; and a requirement to deposit 15 percent of foreign exchange deposits of foreign banks (in kuna) in a separate account with the CB.

Sterilization efforts have been thwarted by a high degree of euroization preventing effective development of monetary policy instruments; obligatory CB bills were introduced, because standard bills did not attract enough liquidity.

The measures have helped i) better manage corporate FX risks (by enabling companies to freely decide on the currency composition of their portfolio holdings); ii) deepen and broaden the relatively shallow foreign exchange market (in turn facilitating better management by all market participants of the risks associated with capital flows), iii) improve financial intermediation of the capital inflows (together with the efforts to strengthen the banking system following the banking crisis of 1998-2000, including through opening the sector to foreign capital and strengthening its supervision and regulation).

Initially, the controls were instrumental in decreasing the share of short-term inflows; controls on longer term financial credits and deposits were abolished soon (in late 1998 following international market turbulences).

Debt management measures: The authorities shifted from foreign to domestic borrowing sources.

Helped cope with the implications of the inflows on the liquidity of the financial system.

Fiscal adjustment and a mix of prudential, supervisory, and administrative measures to reduce capital inflows, with a view to limiting the accumulation of external debt and expansion of credit, where the exchange rate stability objective and high euroization of the economy limited the capacity to use traditional monetary instruments:

(Unremunerated) marginal reserve requirement (MRR) on banks’ new foreign borrowing (7/2004) to slowdown bank-related portion of capital inflows that has funded much of the bank credit expansion; the rate was increased several times (to 55 percent currently) and the base was broadened in 2005 (e.g., to include banks’ guarantees to companies/individuals who directly borrow from abroad, and deposits received by banks from leasing companies not related to them, and to introduce a special reserve requirement of 55 percent for issued securities for FX-related liabilities); the MRR is in addition to the overall reserve requirement (RR) of 17 percent on banks’ FX and kuna liabilities (domestically and from abroad);

Moral suasion: the HNB warned banks on a few occasions that it would relax or tighten some of its instruments depending on their foreign borrowing, and issued guidelines for management of currency induced risks and credit risk from household lending;

Supervisory and administrative measures to slow down the pace of rapid credit growth financed largely by bank borrowing from abroad (e.g., further tightening of the prudential and supervisory framework; raising risk weights on unhedged FX linked borrowing; reporting requirements for unhedged FX loans; FX liquidity requirements and broadening of their base to include FX-indexed as well as FX-denominated instruments; and credit controls in the form of obligatory purchases of low yielding HNB bills for banks extending excessive credit in 2003 and end-2006).

The prudential, supervisory, and administrative measures (including reserve requirements on bank borrowing) as a whole aimed at dealing with the external and financial sector vulnerability implications of the inflows, and have not so far had a significant impact on bank borrowing or credit growth.

• The preliminary indications suggest that banks are unwilling to raise their lending rates to offset the rising cost of lending imposed by these measures so as to keep their market shares.

• While the MRR on banks’ external borrowing seems to have resulted in some scaling down of their borrowing plans after the rate was raised to 55 percent, an upturn in borrowing has already been observed, reportedly to comply with the broadening of the FX liquidity requirements from late 2006.

• Banks also evidently seek other ways to overcome the regulations (e.g., by financing activity through retained earnings, injection of capital by, or directing clients to, parent banks, intensifying efforts to attract domestic deposits, etc).

• Moral suasion has had limited effectiveness given the significant share of foreign banks in the system.

• FX linked lending seems to have slowed down somewhat recently, reflecting the change in the 32 percent liquidity requirement (to broaden its base) as well as higher risk weights for FX lending to unhedged customers.

Banks’ circumvention efforts led to several attempts by the HNB to close loopholes by widening the scope of the existing regulations; a unified nonbank supervisory agency was also established to strengthen nonbank supervision and thereby limiting the room for circumvention by switching to borrowing from nonbank financial institutions.

Large scale sterilization through CNB bills, rising unremunerated reserve requirements (1994-1997), and automatic conversion of government privatization revenues at the CNB.

Liberalization of capital outflows (1995).

Administrative measures, such as limits on short-term open positions with nonresidents and margin fees on FX transactions with the CNB (1995).

Greater exchange rate flexibility through a widening of the exchange rate band (from 0.5 to 7.5 percent) in early 1996 followed by a forced exit to a floating regime.

Interest rate cuts, occasional interventions, and set up of a government account at the CNB for conversion of privatization proceeds under free float and IT regime after 1998.

Was moderately effective in providing some monetary policy autonomy under the pegged exchange rate in short-term, but involved substantial quasi-fiscal and real costs. Overall they were not helpful in preventing a slower disinflation process.

Arguably helped reduce net inflows.

Had only a limited effect in extending the maturity of the inflows, as they were easily circumvented.

Temporarily successful in reversing short-term flows in 1996, providing a greater room for monetary policy maneuvering by introducing a degree of exchange rate variability.

Helped reduce the appreciation pressure that was feeding into undershooting of inflation targets (especially after the 2001–0 2 appreciation episode).

Monetary measures took the form of: delays in the relaxation of the reserve requirement to the Euro area levels, and including foreign liabilities in the reserve base on gross basis while abolishing vault-cash deductibility from the base.

Fiscal measures: tightening fiscal policy further has been difficult; the authorities attempted to reduce borrowing incentives by limiting mortgage interest rate deductibility that encourages real estate related borrowing.

Prudential and supervisory measures: Given the limited monetary tools available and difficulty to influence foreign bank behavior, the authorities’ supervisory effort has been focused on risks from rapid credit growth, particularly in the real estate sector. Measures included: maintaining the higher capital adequacy requirement; increasing risk weightings of mortgage loans from 50 percent to 100 percent (March 2006); promoting better understanding of risks associated with excessive credit growth (hence to reduce lending and borrowing exuberance), especially in the mortgage loan market; and enhancing cooperation between home/host supervisors.

Communication or “moral suasion” tools: the BoE recommended that the government abolish certain tax relief and guarantee schemes in the mortgage market so as not to interfere in market developments; “moral suasion” letters were sent to banks, their Scandinavian owners, and to respective regional supervisory authorities.

Capital inflows and rapid credit growth has continued with a peak in the annual growth in real sector credit at more than 50% at the end of 2005. The measures in the last four years have not yet had any visible impact to slow down credit growth.

Government reluctance to make unpopular decisions to abolish the relevant tax reliefs and existing state guarantee schemes in the housing loan market has continued to provide incentives for rapid credit growth.

The authorities have found that the large presence of foreign banks with easy access to funds, though beneficial for many reasons, has limited their ability to influence bank behavior by regulation. Moral suasion tool has also not been helpful since foreign banks have paid more attention to instructions from parents and strong competition has prevented banks from slowing credit growth so as not to lose market share.

Large sterilized interventions, when the exchange rate band was narrow (until 2001).

Greater exchange rate flexibility through a widening of the crawling band (from ±2.25 to ±15 percent) in 2001, though intra-marginal interventions provided limited de facto flexibility.

Adjustment in exchange rate regime parameters, e.g., by reducing monthly rates of crawl to slow down the depreciation of the currency (to accommodate the appreciation pressures).

Gradual decrease in interest rates permitted by disinflation;

Cautious liberalization of the capital account (with controls on certain transactions—e.g., derivative transactions and lending to nonresidents in domestic currency maintained).

Debt management tools: Early repayment of foreign public debt through privatization receipts and shifting the denomination of the debt in favor of the domestic currency.

Moral suasion: Possibility to impose measures and controls against destabilizing capital inflows under extraordinary circumstances, as well as threats to impose stricter reserve requirements to stem the inflows and to reduce remuneration on reserve requirements if banks’ on-balance sheet open positions exceeded 30 percent of their capital (never used).

Strengthening of prudential and reporting environment to help monitor and manage risks associated with capital flows.

Risk awareness campaigns by the central bank to warn against the risks associated with unhedged FX lending of foreign borrowing by banks to borrowers with limited FX earnings and hedging against FX risks.

Not very effective.

Helped address partly the appreciation pressures on the currency.

Played a role in limiting speculation against the forint and potential adverse consequences of a reversal of the interest sensitive portfolio inflows.

Helped cope with the implications of the inflows on the liquidity of the financial system.

Possibility to impose extraordinary measures could have played a signaling effect. However, moral suasion in general had limited effectiveness in an environment of highly integrated international financial markets and in the presence of large foreign banks which have easy access to foreign funds and are supervised and regulated by parent bank supervisors.

While helpful, the effectiveness may be limited in the absence of efforts to strengthen cross-border coordination of parent and host bank supervisors.

These measures have been aimed not at limiting capital inflows per se, but at dealing with their implications for facilitating FX lending; effectiveness of these measures have been likely limited given the persistent strength of FX lending.

Sterilized interventions to defend the exchange rate band and prevent excessive appreciation that undermine competitiveness.

Large quasi-fiscal costs that forced seeking other policy options over time.

Adjustment of exchange rate band parameters and practices (e.g., abandonment of an ‘inner’ band and/or adjustment of the rate of crawl).

Greater exchange rate flexibility by widening the bands and introducing asymmetric bands.

Careful sequencing of capital account liberalization:

• Deferral of further inflow liberalization at times of strong inflows and liberalization of capital outflows;

• Liberalizing inflows and long-term flows before outflows and short-term flows, and foreigners’ and business sector flows before domestic and household sector flows;

• Continuous development of domestic money and capital markets; increased range and sophistication of monetary operations available; and strengthening bank supervision and regulation.

Provided some temporary relief from the impossible trinity dilemma by introducing more exchange rate flexibility.

Decisive factor in resolving the holy trinity dilemma by introducing two-way exchange rate risks.

Worked well in reducing the market pressure on exchange rate band limits (thereby also limiting the need to intervene and sterilize).

Helped improve the resilience of the banking system and markets to absorb and effectively manage the inflows.

Monetary measures: Increase in the main refinancing rate on several occasions to keep rates 1½ – 2 percentage points above ECB rate, phased increase in the reserve requirement (7/2004, 6/2005) and a broadening in the reserve base to include banks’ foreign liabilities with shorter maturities.

Prudential and supervisory measures: increase in supervisory reporting requirements—tightening of onsite/offsite inspections, introduction of a rating system for banks, periodic stress testing activities, increased supervision of banking groups on a consolidated basis (2004); dialog and exchange of information between home and host supervisors. The latter was seen as a way to mitigate the threat to stability that would arise from a slowdown in capital inflows from the large foreign banks. Various MoUs have been signed at the Baltic or bilateral levels.

Moral suasion: periodic consultations with individual banks and bank association; communication of BoL’s concerns about rapid credit growth to banks (through letters to and meetings with banks) and the media; efforts to raise public awareness (e.g., through conferences) have been used to raise public awareness of the risks associated with rapid credit growth and its associated risks. Administrative controls have not been used as they were seen as a step backward and a last resort.

The phased increase in reserve requirements has achieved some limited success in slowing credit growth, by tightening lats liquidity conditions which also exerted some temporary upward pressure on money market rates. Since remuneration rates are below banks’ funding costs, higher and more broadly applicable reserve requirements acted to raise bank lending rates on both lats- and euro-denominated loans. In general however, monetary measures were not sufficient to put persistent downward pressure on lending growth, which has remained very strong throughout (2002–2006), though the term structure of banks’ borrowing abroad improved. Reasons for limited effectiveness include: lack of independent monetary policy; high euroization; high foreign ownership, and hence unlimited access to funding sources; and competition and profitability in the banking sector.

The immediate impact of these measures have not yet been observed, with credit growth supported by the inflows having remained persistent. Regulatory options to contain the buildup in vulnerabilities have in general been constrained in the EU context. In a setting where banking services may be offered by local banks, foreign branches, and cross-border providers, domestic prudential regulations that are stricter than elsewhere in the EU have been viewed to be easily evaded by booking loans offshore.

Monetary measures: with limited interest rate policy under the CBA, the measures took the form of postponing the planned reduction in reserve requirements to euro zone levels.

Prudential/supervisory measures: tightening of capital adequacy requirements in 2006; continued bank monitoring measures with frequent inspections and ongoing efforts to increase information disclosure under pillar 3 of Basel II; greater cooperation with home supervisors of foreign banks to facilitate supervisory and crisis management cross-border arrangements (agreements concluded with Sweden, Latvia, and Estonia).

Moral suasion/risk awareness/market development measures: collection of comprehensive information in the credit registry for risk assessment/management; policies for better understanding of risks; moral suasion letters to banks; public statements on risks related to housing boom; talks with banks and internal ratings based risk assessment measures.

Attracting long term investments through improving business and investment climate: Lithuania’s relatively low level of FDI and its recent outflow of FDI are causes for concern. Some efforts have been put into improving the investment climate and improving climate for doing business.

Gradual increase in exchange rate flexibility and monetary policy autonomy with an eventual move to a full float (2000) and adoption of inflation targeting (1998).

Sterilized interventions and tighter monetary policy (OMOs and reserve requirements increased in the second half of the 1990s).

Administrative measures: The NBP began attracting household deposits directly to drain excess liquidity in the banking system and to encourage banks to adjust deposit rates.

Liberalization of external trade, including the abolishment of import surcharges and reduction of import tariffs (in connection with the requirements associated with WTO and EU accession), and elimination of a surrender requirement.

Possibility to impose temporary measures under special circumstances that may threaten monetary/financial stability was put in the Law after OECD related capital account liberalization (e.g., an obligation on residents or nonresidents to maintain noninterest bearing deposits in connection with their capital operations other than FDI, or obligation to resell foreign currency or obtain permit to engage in FX operations).

Delays in liberalization of the remaining capital controls at times of strong capital inflows and international financial market volatility (second half of the 1990s and early 2000s);

Mandatory liberalization of outflows (OECD obligations).

Indirect interventions: Setting up of a government account at the NBP for FX proceeds associated with privatization and Eurobond issues.

Provided time for development of other elements supporting exchange rate flexibility and their sequencing with capital account liberalization and implementation of inflation targeting.

Full monetary autonomy under a flexible exchange rate and IT finally solved the problem of costly sterilized interventions and economic overheating associated with capital flows earlier.

Not very effective in curbing domestic demand, as monetary transmission of standard instruments through fragmented and underdeveloped financial markets was limited and higher interest rates continued to attract inflows.

Improved the CB control over market rates and helped reduce overheating associated with the capital inflows in an environment with weaknesses in monetary transmission.

Limited growth of FX reserves, also through stimulating imports.

Never used. (As in the Czech and Hungarian cases, their mere presence could have acted as a deterrent to certain types of crisis prone flows)

Helped prevent contagion of Asian and Russian crises.

Possibly contributed to reducing pressure from capital inflows.

Helped reduce appreciation pressure on the zloty by reducing the net inflow of FX in the market.

Debt management measures: The authorities shifted from foreign to domestic borrowing sources; and used part of the privatization receipts to finance future debt service and buy back Brady bonds.

Gradual strengthening of bank regulation and supervision and development of markets: Prudential regulation and supervision gradually strengthened up to the level comparable and in some areas more restrictive than international standards throughout the 1990s, with tight qualification and provisioning criteria and limits on open positions since the early 1990s.

Gradual development of money/FX markets (e.g.derivatives for hedging) since mid-1990s, supported by a gradual increase in exchange rate flexibility until 2000. Effective capacity for monetary operations was also in place since the late 1990s.

Helped cope with the implications of the inflows on the liquidity of the financial system.

Helped improve the resilience of the banking system and markets to absorb and effectively manage the inflows.

Delays in liberalizing capital controls, including restrictions on nonresident purchases of government securities and other controls on short-term capital inflows until 2005.

Allowing exchange rate flexibility (abandoning the crawling band in November 2004) so as to help reduce the upward pressure on inflation by allowing the lei to appreciate under the inflation targeting regime adopted in July 2005); but reduction in interest rates to discourage capital inflows through partial sterilization of its interventions. From Late 2005, interventions were reduced and subsequently abandoned, allowing greater exchange rate flexibility and tighter monetary policy; the policy rate was tightened (early 2006), and sterilization operations intensified to reduce the policy rate gap.

Improvement in the fiscal balance (fiscal stance of broad public enterprises tightened relative to GDP).

Administrative measures: Extending and raising the reserve requirement on all foreign currency denominated liabilities successively (2004–06), with a view to curtailing strong foreign currency lending by the banking system and excessive lending to unhedged household borrowers; these measures were combined with the limits on exposures of credit institutions lending in foreign currency to borrowers without natural hedging, and refinement of loan classification and provisioning requirements to take into account FX risks.

Until 2005 interest rate sensitive inflows were limited by the controls on short-term capital inflow, allowing some degree of monetary autonomy under a de facto crawling band regime.

The policy remained under pressure from the conflicting objectives of inflation and competitiveness, which undermined monetary policy credibility at times: The NBR continued to intervene in the FX market to prevent lei appreciation and reduced its sterilization efforts (September 2005); this caused its effective interest rate (average rate at which it accepts bank deposits) to diverge from the policy rate (until early 2006), threatening the fulfillment of its inflation target.

Reduced the public debt related inflow of capital.

Strong credit growth, in particular with FX component has remained persistent throughout 2005-06. Persistent expectations of exchange rate appreciation continued to feed demand for FX-denominated loans under an open capital account. The measures to slow such loans have evidently been followed by banks raising capital rather than restructuring and reducing their FX-denominated loans, and engaging in various window-dressing activities.

Largely sterilized interventions (managing liquidity impacts of inflows) limiting the extent and speed of nominal appreciation in 2003–04 period.

Reduction in interest rates (by more than 10 basis points between early 2004 and early 2005).

Tighter fiscal policy (in response to overheating and current account concerns).

Debt management operations using capital inflows to over-borrow and move to medium- and long-term domestic borrowing using local currency instruments.

Capital inflows have continued to come, with a significant increase in equity and debt securities, as well as inflows to the banking system.

Helped cope with the implications of the inflows on the liquidity of the financial system.