Former Yugoslav Republic of Macedonia: Recent Economic Developments

The economy of the Former Yugoslav Republic of Macedonia suffered a setback owing to the Kosovo crisis. The impact of the crisis, however, was less severe. Inflation remained low, the balance-of-payments position and the fiscal situation improved, and indicators of external vulnerability remained satisfactory. The National Bank of Macedonia faced contrasting challenges in the conduct of monetary policy. The pace of structural reforms picked up and a value-added tax was introduced. However, structural weaknesses in the financial system have prevented a more vigorous economic recovery.

Abstract

The economy of the Former Yugoslav Republic of Macedonia suffered a setback owing to the Kosovo crisis. The impact of the crisis, however, was less severe. Inflation remained low, the balance-of-payments position and the fiscal situation improved, and indicators of external vulnerability remained satisfactory. The National Bank of Macedonia faced contrasting challenges in the conduct of monetary policy. The pace of structural reforms picked up and a value-added tax was introduced. However, structural weaknesses in the financial system have prevented a more vigorous economic recovery.

III. Monetary Developments1

A. Recent Developments

1. FYRM has been pursuing an exchange-rate-based monetary policy since 1996. This has proved successful in reducing inflation to industrial country levels. However, structural weaknesses in the financial system have prevented a more vigorous economic recovery. Imbalances in the enterprise and banking sectors—largely reflecting delays in restructuring—have contributed to the low degree of financial intermediation and to high interest rates. In early 1999, the Kosovo crisis exposed major weaknesses in the banking sector and in the transmission mechanism of monetary policy. The rapid economic recovery in the aftermath of the crisis, as well as prospects of reforms has helped restore confidence in the banking system (Chapter IV).

2. For most of 1998 there were no significant pressures on the exchange rate, but a tightening of monetary conditions in November was needed to counter short-lived speculative pressures in the foreign exchange market. By end-year, the external reserve accumulation reached 2.1 months of imports. Money and credit growth were consistent with targets for the year, and by December, 12-month growth of denar M2 reached 11 percent, with denar private credit growth of 10 percent. NBM deposit auction rates increased to 18 percent by the end of the year, compared with a low of around 11 percent in mid-1998 (Tables 23–26).

3. With the onset of the Kosovo crisis in late-March 1999, there were withdrawal of deposits from commercial banks and delays in debt-service payment by enterprises, causing some banks to experience severe liquidity shortages. Denar deposits contracted by 4 percent in the first quarter while foreign currency deposits declined by about 20 percent. In the event, the National Bank responded by injecting liquidity while allowing the deposit auction rate to increase to 25 percent by May 1999. Also, the National Bank intervened in the foreign exchange market in April and May with net sales to counter the increasing pressure on the denar.

4. With the ending of the conflict, demand for currency in circulation normalized with impressive speed and both denar and foreign currency deposits were quickly reconstructed. The NBM intervened in the foreign exchange market to neutralize appreciation procedures. The monetary effects of these large foreign exchange purchases were partly sterilized through the unwinding of previously auctioned NBM credits along with an increased issue of NBM bills. Money increased rapidly in the second half of the year. As the liquidity position of banks improved, the money market interest rate declined to 11 percent, compared with a peak of 22 percent in May.2

5. Despite the large swings in liquidity position of commercial banks, deposit and lending interest rates of commercial banks were broadly inflexible. Deposit rates hovered around 9 percent, while lending rates remained within a broad range of 19–27 percent.

B. Instruments of Monetary Policy

6. As part of measures to create a more market-oriented and efficient financial system, the NBM is in the process of revamping its set of instruments for the conduct of monetary policy to secure a smooth transition to indirect monetary policy instruments from April 1, 2000. The NBM received technical assistance missions from the Fund’s MAE in December 1998 and December 1999. In this section, the current instruments are reviewed and a broad description of the direction of change is provided.

Credit ceilings

7. The NBM has maintained the practice of setting bank-by-bank credit ceilings since January 1994, to control the expansion of domestic credit as well as for prudential reasons. Aggregate monthly credit ceilings are allocated to banks and savings houses in proportion to their level of capital less foreign exchange position. Banks are penalized for exceeding their credit ceilings by being disallowed from granting any new credits for 30 days following the violation.

8. However, credit ceilings have become increasingly distortionary, as individual banks’ shares in total credit tend to be perpetuated without regard to their individual performance, profitability, or ability to mobilize resources. Although this distortion can be minimized by the opportunity to trade unused credit ceiling allotments, in practice the trading of credit margins by banks has been very limited. In addition, credit ceilings have become increasingly ineffective as banks’ measured credit may fall well below actual credit owing to misclassification of certain credit items as other assets.3

9. One of the measures aimed at creating a more efficient financial system is the NBM’s preparation to transform credit ceilings into selective prudential limits and to replace the current ceilings for credit control with indirect instruments of monetary policy. In line with previous MAE mission recommendations, the National Bank intends to ensure that, prior to phasing out credit ceilings, central bank bill rates will fluctuate. The NBM has started preparing a plan to develop, at an early stage, other instruments of indirect control, including repurchase operations.

Reserve requirements

10. Denar reserve requirements for commercial banks have remained unchanged since 1993, at 8 percent for sight deposits (for savings houses the equivalent rate is 4 percent) and 3.5 percent for longer-term deposits (for savings houses the equivalent rate is 1.5 percent). The remuneration paid on reserve requirements is unified. In June 1998, to help reduce the costs of intermediation and in line with MAE’s advice, the remuneration paid on reserve requirements was increased from 3.6 percent to 6.2 percent, a level closer to market rates. The higher remuneration had only a marginal impact of 0.2 percentage point on the intermediation spread. Excess reserves remain unremunerated.

11. Since June 1998, reserve requirements on foreign exchange deposits held by individuals have been lowered from a 100 percent uniform reserve requirement into six different categories: reserve requirement for sight deposits have been lowered to 70 percent; for one-month deposits, 60 percent; for three-month deposits, 50 percent; for six-month deposits, 40 percent; for deposits up to a year, 30 percent, and for deposits of more than one year, 20 percent. Foreign exchange deposits of enterprises remain subject to a 100 percent uniform reserve requirement.

12. Average reserve requirements have not been used as an active monetary policy instrument, though in the past, marginal reserve requirements have been implemented to limit the liquidity of specific banks. Because the current system is unified not on deposits—neither across currencies nor across maturities—but on remuneration only, it has a built-in impact on banks’ demand for reserve money. Changes in the composition of deposits give rise to an automatic modification in the overall level of reserve requirements. The current system also adds a wedge between long- and short-term deposit rates, implying a role for the National Bank that should be left to banks. The lowering of the reserve requirement on foreign currency deposits has helped increase the share of foreign currency credit into total credit from 21 percent (at the time of its introduction) to 23 percent as of December 1999.4

NBM credit auctions

13. Credit auctions have played an important role as a key instrument for liquidity management. The NBM has used the auctions primarily to inject liquidity according to the monetary program and also to support large distressed banks with structural liquidity needs. With the improvement in the liquidity positions of banks, the NBM has gradually moved to, de facto, phase out credit operations. At end-December 1999, the outstanding stock of deposits sold on auction declined to denar 500 million, compared with denar 2.1 billion in March 1999. Credit auctions have become a one-sided instrument and the NBM’s ability to reduce liquidity by withdrawing deposits sold at auction has been greatly diminished.

National Bank bills

14. The National Bank has managed to increase its supply of securities as banks have allocated part of their improved liquidity to central bank bills during 1999. The stock of outstanding central bank bills remained under denar 1 billion until December 1998 and increased rapidly to denar 2 billion by end-1999 (equivalent to 24 percent of reserve money, twice the share a year earlier).

15. Under the current setup, the NBM auctions bills across a range of maturities daily, announcing a maximum interest rate for each maturity and unlimited volumes. The NBM has not encountered difficulties placing bills at the current interest rates offered on various maturities (7 days, 6 percent; 14 days, 7.5 percent; 28 days, 9.5 percent; 42 days, 10 percent; 56 days, 10.5 percent; 91 days, 11 percent). However, 38 percent of all outstanding bills are held by the second largest bank, and the NBM has benefited from captive markets: the Deposit Insurance Fund holds about 14 percent of the outstanding stock of NBM bills.

16. The NBM envisages that open market operations will become the NBM’s principal monetary instrument of liquidity management in 2000. To that end, the NBM has taken a decision to allow market forces to determine the interest rate on its bills. To encourage the development of a secondary market, the NBM has decided that all bills will have unified maturity, with no possibility of repurchase before maturity, and limited amounts of bills will be offered in weekly auctions (as opposed to daily). Intra-week liquidity needs would be satisfied through repurchase agreements. Bills bought in the primary market could be used as collateral for Lombard credits.

Lombard credit facility

17. The NBM operates a Lombard credit facility to provide lender-of-last-resort funds to banks. Banks must provide collateral equivalent to twice the amount of credit desired, in the form of NBM bills, In November 1998, the NBM increased the Lombard rate to 18.5 percent from 14.4 percent. Despite the increase, the new rate was at times below the interest rate on credit auctions and the interbank market rates for long periods. The collateral required under the Lombard facility is 133 percent of the loan to be received for the use of bonds.

1

Prepared by Paulo Drummond.

2

The NBM ceased auctioning deposits in November.

3

Including receivables from payments made on behalf of banks’ clients arising from guarantees and letters of credits.

4

Although banks are not allowed to lend in foreign currency, they can lend to their customers in domestic currency with a foreign currency clause. See Chapter on Banking System Soundness for a discussions of the impact of this measure on banks’ risk and lending operations.