Abstract
This note compares patterns of domestic investment in Serbia with those in other central and eastern European countries, noting the relationships with external balances. The structure of participation and employment rates suggests a need for analysis of the impact of labor market institutions on youth and women. A further focus on redeployment services would be appropriate. The Serbian banking system, the implications of the structure of Serbia’s economy, the operational framework of monetary policy, and the adoption of an inflation targeting regime have been discussed.
VI. Foreign Exchange and Monetary Operations18
A. Introduction
1. This note discusses the operational framework of monetary policy in light of the envisaged gradual transition to a flexible exchange rate regime and inflation targeting. It suggests the need to adjust foreign exchange intervention policies, improve the signaling function of 2-week repo operations, and strengthen the pass-through from the repo rate to other short-term interest rates.
B. Foreign Exchange Intervention
2. Since 2000, foreign exchange intervention has played a significant role in moderating volatility in the exchange rate. Thus, the announced intention of the National Bank of Serbia (NBS) to accommodate increased volatility should be reflected in amended fx-intervention policies.
3. Four issues arise: determination and realization of long run foreign exchange reserve targets; policy regarding daily volatility in the dinar market; determination of any remaining role of fx-intervention in guiding exchange rate trends; and institutional reforms in the fx-market. These are taken in turn.
Reserve Accumulation Targets
4. The NBS will need to hold an adequate stock of international reserves. The optimal level of foreign reserves may reflect need for a buffer against external shocks with the opportunity costs of holding reserves being weighed against the probability and size of such shocks. The target level chosen may also reflect the role of foreign reserves in forestalling currency crises, including under conditions of a floating exchange rate regime.
5. Furthermore, the NBS will need to decide whether to set reserve targets in gross terms or net of commercial banks’ claims on the central bank. The former would be more appropriate if, in the event of a loss of confidence in the currency, depositor confidence in the domestic banking system is expected to be maintained. In that event, the full stock of gross reserves will be available to defend the currency should the authorities decide to do so. On the other hand, if a crisis is expected to be accompanied by a loss of confidence in banks in Serbia, a reserve target net of commercial banks’ claims would be more appropriate. This is because with the loss of confidence in banks, commercial bank deposits with the central bank—and the associated international reserves—would decline. Thus, in this case, the full stock of gross reserves would not be available to defend the currency.
6. The targets set would change over time. Most basically, they could move in line with imports to maintain an overall import coverage. And there may also be occasion to set targets taking into account particular contingencies—for example, ahead of Kosovo-related uncertainties.
7. To realize these targets, the central bank will need to intervene in forex markets. This process needs to be consistent with market determination of the exchange rate. In particular, such interventions should be conducted so as to minimize risk that they are misperceived by markets as reflecting action to achieve an exchange rate target.
8. To this end, the general policy—of interventions to meet “long-term” reserve targets—should be announced and purchases made over time. To avoid risk of misperception of the transactions, the NBS could follow the example of some central banks which preannounced a schedule for their foreign exchange purchase auctions. The transparency in this approach helps underpin market understanding of the authorities’ purposes, thereby maintaining market confidence in the authorities’ commitment to a flexible exchange rate regime.
9. Looking further ahead, structural reforms in the forex market could be considered. In particular, the NBS may want to consider eventually encouraging establishment of a broker/dealer system in the foreign exchange market to replace the current fixing sessions. Amongst other benefits, this would help to focus market attention on the regularly published reserves data, rather than on individual central bank transactions in the forex market.
Daily Dinar Volatility
10. Exchange rate volatility may be excessive in a generally thin fx-market. The NBS has the option, in this context, to allow the volatility itself to entice additional private agents into the market, thereby deepening it. Or, if that process is deemed likely to be too slow or to accommodate excessive daily volatility until it is complete, the NBS could provide the necessary smoothing by adopting a “leaning against the wind” approach to daily foreign exchange intervention to smooth daily changes.
11. If a “leaning against the wind” approach is desired, operational aspects will need to be considered. For example, the NBS could decide to intervene if the daily appreciation or depreciation exceeds a certain percentage threshold. This would help to smooth daily shocks. But, consistent with the commitment to accommodate greater exchange rate flexibility, cumulative daily appreciation or depreciation—even if sizeable—should not be resisted by foreign exchange intervention. While there may not be a need to announce the specific operational rule to execute these principles, the adopted rule should be applied consistently. This approach balances the credibility of the new regime—making clear that foreign exchange interventions are not guiding trends in the exchange rate—with the possible need for some flexibility in the specific policy rule used to “lean against the wind.”
Restructuring the Foreign Exchange Market
12. The NBS has purchased foreign exchange from the exchange offices at preferential rates. These flows largely reflect remittances and, conversion of euro-denominated “mattress money” into dinars in retail exchange offices. Given the preferential rate, the exchange offices have had no incentive to sell their receipts to commercial banks. These activities by the NBS have represented significant intervention, given that the NBS has not resold such purchases in the daily fixing sessions. Thus, these NBS purchases have been reflected in foreign reserve accumulation.
13. The NBS has reduced the preferential rates. The so-called “stimulation rate” was lowered from 1 percent to 0.9 percent on April 1 and to 0.7 percent on June 1. This marks an exit process for the NBS from these activities.
14. Looking ahead, the NBS could announce a schedule for complete elimination of the preferential rate. The process of exit should weigh two concerns: on the one hand, immediate withdrawal, while clean, might shock the foreign exchange market unduly; while, on the other hand, a general commitment to withdraw might qualify market confidence in the authorities’ commitment to terminate discretionary foreign exchange intervention. Accordingly, announcement of a schedule for elimination balances these concerns. This would signal to market participants that the NBS is firmly committed to abjuring discretionary foreign exchange intervention, while avoiding the shock of immediate withdrawal. A binding monthly schedule to reduce the stimulation rate to zero, say over a six month horizon would best be accompanied by close consultations with the banks to facilitate their preparations to take over the business of the exchange offices.
15. In the interim, the NBS should aim at reselling the foreign exchange acquired from the exchange offices. The envisaged gradual further reduction in the stimulation rate should help reduce the amounts purchased by the NBS from the exchange offices. But to minimize the impact of the remaining purchases on reserve accumulation, the NBS could consider reselling in the fixing session on a daily basis the foreign exchange acquired from the exchange offices, net of accumulation motivated by long-term reserve accumulation goals. If the NBS were to phase in such resales gradually, it will need to weigh the costs and benefits of preannouncing the schedule for such resales (e.g., to resell 20 percent through October 31, 40 percent through December 31, etc.): on the one hand, publicly announcing such a schedule would unambiguously signal the NBS’s withdrawal from discretionary foreign exchange intervention; on the other hand, as above, an overly abrupt exit may impart an unintended and undesirable shock. Balancing these concerns suggests announcement of a schedule at least several months long, while also standing ready to apply other instruments—notably adjustments in the repo rate and monetary policy transparency—to adjust to any consequent unintended and unanticipated shocks. A weaker approach—because it would send a more qualified signal of the authorities’ commitment to the new monetary policy framework—could consist of the NBS starting immediately to resell say 20 percent, while committing to assess the appropriateness of increasing this share by 20 percentage points every two months, with the presumption that these increases would go ahead in the absence of serious market disturbances.
Exchange Rate Trends
16. Reforms noted above still allow official influence on exchange rate trends. In so far as the macroeconomic objectives of the authorities carry implications for the exchange rate—for example due to its implications for inflation—they may reflect those objectives in policy towards the repo rate. This approach reconciles the aim of allowing exchange rate volatility with that of securing overall macroeconomic objectives including in respect of the exchange rate.
17. But the instinct to phase out discretionary foreign exchange intervention rather than abandon it in one step should be resisted. This instinct may be strong given familiarity with this instrument and that to some extent, the repo is not yet tried and tested. But this approach is not advised—even for only some interim period—because it may undermine the effectiveness of the repo. For example in the case of trend excess capital inflows putting upward pressure on the currency, discretionary intervention could stem the appreciation and create domestic liquidity. But if this occurred, this would displace the repo as the central monetary policy instrument. Instead of discretionary intervention in such a case, a fiscal policy response would be best. And if that is not available, then the repo rate could be lowered achieving the same effect as discretionary intervention without clouding market confidence in the authorities’ commitment to the new monetary and exchange rate regime. To the extent that instincts to persevere with discretionary intervention even for interim periods reflect doubts about the effectiveness of repo operations, those doubts should be addressed directly through appropriate reforms of repo operations, as discussed below.
C. Repo Operations
18. Repo operations can be strengthened. The NBS is currently conducting repos with two different maturities (two weeks and two months). The auction type used for both maturities is a variable interest rate tender (U.S. style). Until mid-May 2006, the tender announcement comprised a maximum bid rate. Since then, the tender announcement consists solely of the offered quantity. These arrangements have several drawbacks:
By simultaneously conducting two-week and two-month repos, while controlling interest rates for both operations, the NBS dilutes the signaling function of the two-week repo rate (Figure 1).
Despite the recently increased role of repos in the conduct of monetary policy, the two-week repo rate has assumed little, if any, prominence in the NBS publication strategy, leaving market participants unclear about the monetary framework.
The recent abolition of the maximum bid rate has undermined the signaling function of the two-week repo rate.19 In fact, market participants query if the revision in the auction mechanism was intended to yield a decline in the policy rate.
Repo Rates and Belibor
Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A006
Source: NBSRepo Rates and Belibor
Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A006
Source: NBSRepo Rates and Belibor
Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A006
Source: NBS19. To establish the two-week repo rate as the key policy rate, the role of two-month repos should deemphasized. By abandoning two-month repos operations, the NBS would establish the two-week repo rate as the sole monetary policy rate, thereby facilitating the transmission from the two-week repo rate to interbank rates. However, should the NBS wish to maintain two-month repos, the auction method for two-month repos would necessarily need to be revised: tenders should be variable rate tenders with pre-announced volume, with the NBS acting as a rate taker.20 Moreover, the volume of two-month repos should be reduced to a minor share of total repo operations. In this context, the NBS should communicate that the 2-month repo rate, by design, does not reflect the monetary policy stance.
20. In respect to the auction method for two-week repos, fixed rate tenders may be preferable at this juncture. While fixed rate and variable rate tenders should both be included as options in the operational framework, a fixed rate tender may be preferable during the transition to the revised monetary operations framework, as it could provide the least ambiguous policy signal and be easily supported by a communication strategy. Even if a variable rate tender works well and leads to only small fluctuations in the actual repo rate, such fluctuations may still cause confusion in the markets about policy intentions. Given the need to signal unambiguously commitment to the new regime and establish the central role of the 2-week repo rate within it, at this time these signaling considerations likely outweigh those tending to favor variable rate tenders.21
21. The NBS may need to complement fixed interest rate tenders with a strategy for guiding market participants with respect to the envisaged liquidity withdrawal. In the absence of such a strategy, a possible excess or shortfall of aggregate bids compared to the NBS liquidity forecast, at least if large, may induce unwarranted tensions in the interbank market, particularly given the prevailing segmentation of this market. Such guidance could be achieved through the regular publication by the NBS of its short-term (14 day) and medium-term (2 months) liquidity forecast. However, should the NBS not yet consider its liquidity forecast as sufficiently reliable or should market participants doubt the reliability of these forecasts, the NBS may wish to publish in the tender announcement the quantities that it intends to withdraw.
22. Should the NBS wish to continue with variable interest rate tenders, a return to the recently abolished practice of announcing maximum bid rates would be warranted. The significantly increased volatility of the highest accepted rate as well as the average weighted repo rate since end-May has given rise to doubts among market participants about monetary policy intentions. Therefore, the current practice is not consistent with the objective of strengthening the signaling function of the two-week repo rate.
23. The transition to a flexible exchange rate regime could at some future stage lead to need for liquidity providing repos. While the NBS is prepared for such transactions with respect to its legal framework and operational procedures, the availability of eligible assets on the side of the banks deserves further considerations. The stock of T-bills held by the banks fell sharply following the increase in the repo rate at end-2005 to the negligible amount of SRD 120 million at end-June. While T-bills could be complemented with FFCD bonds held by banks, this does not constitute a long-term solution owing to the transitory nature of these bonds. The NBS may, therefore, wish to discuss with the banks the scope for using bills of exchange as collateral, provided sufficient asset quality is secured. While foreign exchange swaps could also be considered, caution is warranted as this may give rise to the misinterpretation that the NBS is targeting a specific future exchange rate level.
24. The 2-week repo rate should assume a prominent role in the NBS public relations strategy. This implies that press statements after each Monetary Council meeting should explain the reasons for adjusting the two week repo rate or for leaving it unchanged. This explanation would have to comprise discussions of risks to the inflation objective as well as factors affecting the transmission channels from the repo rate to inflation.
25. The schedule of Monetary Council meetings could be reconsidered. To avoid problems of severe over- or under-bidding owing to market speculation about imminent repo rate changes, the NBS may wish to consider aligning the schedule of Monetary Council meetings with the reserve maintenance period.
D. Interest Rate Corridor
26. At present, there is no economically meaningful interest rate corridor. In 2005, the NBS automatically linked the interest rates of its lending facilities to the weighted monthly average interest rates of repos of all maturities and also increased the interest rate on its deposit facility to 6 percent. While steps in the right direction, these measures left the Belgrade Overnight Index Average (Beonia) effectively delinked from the two-week repo rate, diminishing its role in money markets. During the period May-July 2006 the Beonia has fluctuated between 7.3 percent and 23.8 percent, with the average rate amounting to 13½ percent (Figure 2). Within this range, changes in the Beonia are determined by shortterm liquidity conditions (i.e. amounts deposited at the NBS deposit facility and the difference between banks’ giro accounts and calculated required reserves). As a result, while changes in the repo rate affect the Beonia, the timing of the pass-through is uncertain and may occur with a significant delay. In the meantime, liquidity factors beyond the control of the NBS may move the Beonia in directions contrary to monetary policy objectives.
Beonia, Belibor, Repo Rates, and NBS Lending and Deposit Facilities
Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A006
Source: NBS.Beonia, Belibor, Repo Rates, and NBS Lending and Deposit Facilities
Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A006
Source: NBS.Beonia, Belibor, Repo Rates, and NBS Lending and Deposit Facilities
Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A006
Source: NBS.27. Thus, the NBS could consider linking the deposit facility rate to the two-week repo rate and narrowing the spread between these two rates. In determining the appropriate spread, the NBS will have to weigh effectiveness and market development arguments. While the former favor a narrow spread, the latter may suggest that an overly narrow spread could induce banks to rely overwhelmingly on the deposit facility, thereby impeding the development of the nascent interbank market. To reflect market development considerations, the interest rate corridor could be narrowed in several steps. However, establishing an economically meaningful corridor to ensure a stronger pass-through from the two-week repo rate to the Beonia, requires a sizeable first step, which could consist of raising the deposit facility rate to a level above the current Beonia average of 13½ percent.
28. In addition, the interest rates on the NBS lending facilities should be linked to the two-week repo rate. The current practice of linking these rates to the weighted monthly average of repo rates with all maturities is an impediment for the banks to use this instrument, as the actual interest rate that will be applied to the transaction is unknown in advance. Moreover, linking the NBS lending rates to the two-week repo rate would also strengthen the signaling function of the latter.
E. Transmission From the Repo Rate to the Exchange Rate
29. Recent experience suggests that the repo can already influence the exchange rate. In early 2006, and despite continued strong foreign exchange intervention, upward pressures on the dinar strengthened under the influence of the significant increase in the repo rate at the beginning of this year and a revision in March of regulations on banks’ open fx-position. The latter excluded bank capital from the calculation of the open fx-position, effectively obliging banks to invest the counter value of their capital in dinar-denominated assets. The increase in the repo volume between end-2005 and end-April 2006 (SRD 17.6 billion) corresponds to 31.3 percent of commercial banks’ net foreign borrowing during this period. With respect to the seven foreign banks that are the most active in the repo market (accounting for 88.9 percent of the total increase in the repo volume), this share amounts to 36 percent.
30. But the transmission form the repo rate to the exchange rate, even at best, will not always be smooth. The transmission has so far largely relied on a small number of foreign banks. The repo market is dominated by six foreign banks.22 Given the small number of players, a swift and smooth response of capital flows to changes in the repo rates may be hampered by exposure limits of parent banks, which could become binding constraints for additional capital inflows, most notably under circumstances of rising uncertainty and pressure on the exchange rate. In a similar vein, with banks’ foreign borrowing denominated in foreign currencies, the allowed open fx-position established a ceiling for individual banks’ additional demand for repos in the event of a repo increase.
31. Looking forward, however, the basis for the transmission from the repo rate to the exchange rate is likely to broaden. The high level of financial euroization implies that portfolio adjustments by residents can be a key determinant of exchange rate changes. Given the high level of fx-denominated deposits, this may be a powerful channel for transmitting changes in the monetary stance to the exchange rate. This channel will gain importance to the extent that sustained progress in disinflation reduces the risk premium on dinar-deposits; and banks offer sufficiently attractive deposit rates on dinar-denominated instruments. Achieving the latter also depends on the scope for banks to expand the share of non-indexed dinar-denominated loans in their loan portfolio.
32. But major policy or international shocks and the strength of medium- and longterm capital inflows will challenge monetary policy making. Investor sentiment towards the dinar is even more fragile than vis-à-vis euro-denominated claims on Serbia. Adjustments in the repo rate may, therefore, need to be large. These considerations underscore the need to stabilize the broader policy environment—including notably in respect of fiscal and structural policies—in order to support the effectiveness of the envisaged monetary and exchange rate reforms. It also strengthens the case for broadening and deepening money and financial market with a view to widen the interest rate channel of monetary policy.
Prepared by Andreas Westphal.
Since the abolishment of the maximum bid rate, the two-week repo rate declined by almost 100 basis points. This decline was not accompanied by a public statement by the NBS on its policy intentions.
With the NBS using repo rates for anchoring the formation of interbank interest rates at two different points on the yield curve, the latter does not necessarily reflect market expectations about future inflation and future interest rate conditions. Consequently, giving up this practice would provide valuable additional information for monetary policy.
At this juncture, the unambiguous signaling of fixed rate tenders may outweigh the benefits of variable interest rate tenders that primarily consist of (i) fostering market development by creating incentives for banks to improve their liquidity projections and portfolio management; and (ii) providing information to the central bank about the banks’ interest rate expectations liquidity needs. A transition from fixed rate to variable rate tenders may be warranted in the event of overbidding or underbidding, possibly resulting from expectations of interest rate adjustments.
While Komercijalna Banka also accounts for a sizeable share of the repo market, it was so far lacking the relatively easy access to foreign borrowing. However, this is about to change owing to the recent acquisition of a controlling minority stake in this bank by the EBRD.
