The Web edition of the IMF Survey is updated several times a week, and contains a wealth of articles about topical policy and economic issues in the news. Access the latest IMF research, read interviews, and listen to podcasts given by top IMF economists on important issues in the global economy.


The Web edition of the IMF Survey is updated several times a week, and contains a wealth of articles about topical policy and economic issues in the news. Access the latest IMF research, read interviews, and listen to podcasts given by top IMF economists on important issues in the global economy.

Highlighting the Link Between Bank Soundness and Macroeconomic Policy

The banking system is an important yet vulnerable structural component of a country’s economy. Since 1980, according to an internal IMF study by the Monetary and Exchange Affairs Department, more than two thirds of IMF member countries have experienced significant banking sector problems. These experiences have underscored not only the importance of a sound banking sector for macroeconomic stability but also the influence of macroeconomic and structural policies on the soundness of the banking system.

Until recently, this two-way linkage between macroeconomic policy and the condition of the financial sector has elicited little attention at the policy level. The IMF study—part of a broader ongoing effort to explore the macroeconomic implications of banking and financial sector issues—examines how the soundness of the banking system is related to macroeconomic and structural policies and suggests ways that a strengthened focus on bank soundness issues can be incorporated into IMF surveillance, the design of IMF-supported adjustment programs, and technical assistance. The study also considers how the IMF can help promote measures to strengthen bank soundness in coordination with other international financial organizations.

Policymaking for the Banking System

Banks play a number of key roles in the economy, including mobilization of savings, intermediation, maturity transformation, facilitation of payments flows, credit allocation, and maintenance of borrower financial discipline. Even in economies with highly developed financial markets, banks remain at the center of financial and economic activity, acting as primary providers of payments services and a fulcrum for monetary policy implementation. In developing countries and in economies in transition with less fully developed financial markets, banks are typically the only institutions able to produce the information necessity for intermediation, to provide the portfolio diversification for maturity transformation and risk reduction, and to help monitor corporate governance.

Because of the central role that the banking system plays in the economy, virtually no government has permitted widespread bank failures or, in the event of systemic bank insolvencies, failed to intervene to support depositors. This different treatment of banks compared with other enterprises reflects the fact that weaknesses in the banking system, if left unattended, could pose a threat to macroeconomic stability. Policy tools used include lender-of-last-resort (LOLR) accommodation of banks and explicit and implicit government guarantees of bank liabilities.

Public policy should focus on preventing stress in the system as whole, however, rather than on supporting or rescuing individual banks, unless they pose serious systemic risks. The prescription for stress prevention in the banking system consists of well-balanced institutional structures that create proper incentives for strong internal governance and market discipline of financial institutions, combined with supportive regulatory structures and a macroeconomic policy mix that provide the stability necessary for sound banking.

Defining, Measuring, and Predicting Soundness

The definition of a sound banking system is relatively straightforward: most of the banks in the system are solvent and likely to remain solvent. Solvency—a bank’s positive net worth as measured by the difference between the value of its assets and liabilities (excluding capital and reserves)—is difficult to measure, however, and the likelihood of continued solvency is difficult to predict. Banking problems often emerge—even in the most advanced countries—with little apparent warning, owing to weaknesses in information and difficulties in prediction. Assessing bank loans requires judgments regarding the valuation of uncertain future payments. Furthermore, bank owners and managers have incentives to disguise problems in their loan portfolios. Therefore, balance sheet figures on asset value and nonperforming loans may not adequately represent a bank’s actual circumstances. If the system is viewed as a whole, aggregation across banks may mask problems—for example, a vulnerable bank that serves as a key payments center could have more significant systemic implications than an insolvent savings bank.

A variety of forces can cause banks to fail and systems to lose their soundness:

  • poor or negligent management;

  • excessive risk-taking;

  • an inadequate operating environment;

  • fraud; or

  • a sharp deterioration in the economic environment that invalidates the assumptions on which loans and investments were initially based.

The behavior of unsound banks differs from that of sound banks, according to the IMF study. Banks that have lost most of their capital or have become overburdened with nonperforming assets tend to spiral into deeper insolvency with increasing speed. Unsound banks often become willing to assume any risk in their desperate pursuit of income and will therefore be less responsive to interest rates and other market signals. Such behavior, if widespread, will have serious repercussions on the response of economic agents, the functioning of financial markets, the efficiency of financial resource use, and the transmission of monetary policy. It may also pose a threat to the well-being of sound competitors.

Macroeconomic Policy and the Banking System

Promoting a sound banking system is, by itself, a legitimate policy objective. At the same time, weaknesses in the banking system can constrain the effectiveness of macroeconomic measures in general and monetary policy in particular. In the design of policy, according to the IMF study, the severity of banking problems needs to be determined and the objectives and instruments of macroeconomic policies adapted accordingly to prevent the system from deteriorating further and to facilitate its strengthening. The IMF study focuses on several key areas where the linkage between macro-economic policy and banking system soundness may require adaptation of objectives or instruments.

Stabilization Policies. Inflation and balance of payments targets are typically pursued with monetary, exchange rate, and fiscal policies. Concern for the soundness of the banking system may occasion trade-offs in the choice of policy objectives and program targets and may influence the pace with which macro-economic objectives can be pursued.

The IMF study cautions that concerns for banking system soundness cannot be used as an excuse for postponing adjustment, since macroeconomic stability is itself crucial for bank soundness. Rather, such concerns should lead to an appropriately designed adjustment program that combines macroeconomic and structural measures at a sustainable pace of adjustment. For example, an inflation target may need to be tempered by concerns that a sharp reduction in inflation could have an adverse impact on the banking system in the short run. Monetary policy will be constrained by what the banking system is equipped to accomplish. This, in turn, depends on how sensitive banks are to interest rate signals and how effectively the banking system and the central bank can control their own balance sheets.

Exchange rate policy must take into consideration the potentially damaging effect that both changes in the exchange rate and prolonged over- or undervaluation can have on a banking system. The limitations imposed by a weak banking system on the use of interest rate policy can further constrain the scope for exchange rate management through domestic interest rates.

Monetary Instruments. A fragile banking system calls for a careful evaluation of the feasibility and implications of the instruments selected to pursue monetary targets and objectives.

Indirect instruments, such as open market operations, rely on a sound banking system for rational market responses and for transmission of policy impulses through interbank and money markets. Unsoundness can make banks unresponsive to price signals and lead to interbank market segmentation. In extreme cases, market segmentation could wholly rob indirect instruments of their effectiveness. At the same time, however, direct instruments of monetary policy such as credit ceilings cannot be relied upon to halt the growth of broad money, because insolvent banks’ losses contribute to an expansion of net domestic assets of the banking system.

For developing and transition countries seeking to develop money markets and to shift monetary intervention to market-based instruments, problems in the banking system may influence the pace of reform. According to the IMF study, the appropriate instrument mix and the phasing of new instruments will depend on the state of a country’s banking system and broader financial markets; the degree of vulnerability in the system; and the scope for fiscal, prudential, and other structural measures to strengthen bank soundness.

Most central banks operate some form of credit facility that can be used to provide liquidity and facilitate payments settlement for banks in distress. The intent of central bank LOLR facilities, the IMF study emphasizes, is not to provide resources to insolvent institutions but to provide temporary liquidity—often at penalty rates—to solvent institutions that are experiencing temporary liquidity problems. LOLR facilities need to be managed with utmost caution, relying on careful monitoring of banking soundness. However, both central banks and supervisors often find it difficult to distinguish between illiquid but solvent banks and insolvent ones. In cases of systemic unsoundness, the central bank may be called upon to lend to insolvent banks to facilitate a systemic restructuring. In such cases, the government should guarantee the credit extended and ultimately absorb the cost of restructuring.

Fiscal Balance. Because addressing banking system unsoundness often entails substantial government spending, the fiscal balance itself becomes a constraint on the type of corrective action that can be taken. According to the IMF study, the scale of government spending required is often used as an excuse to delay early action; but experience has shown that the longer a solution is delayed, the more difficult and costly the ultimate resolution becomes. It is essential for efficient resource allocation that when fiscal policy is being formulated, banking system problems not be “swept under the rug.” Both current government obligations to banks—including the servicing of securities for bank capitalization or restructuring and contingent liabilities such as loan and deposit guarantees—should be estimated as accurately as possible and brought into the budget.

Foreign Capital Flows. Managing large capital flows in a world of freer capital movements and increasingly integrated international financial markets has become a major challenge for policymakers and bank supervisors. As the financial system has become more internationalized and banks have increased their exposure to credit and market risk in the international arena, the dual relationship between macroeconomic policies and banking system weakness has become more apparent. As a result, prudential and macroeconomic policies need to be designed to take account of the banking system’s capacity to intermediate capital flows efficiently. At the same time, objectives for banking system soundness need to be considered along with monetary, exchange rate, and fiscal policy objectives in the context of an open capital account.

Banking problems must not be swept under the rug when fiscal policy is being formulated.

Structural Policies and Bank Soundness

Oversight. Of critical importance to banking system soundness is the oversight framework, consisting of internal governance, market discipline, and official supervision. According to the IMF study, the core responsibility for bank soundness lies with owners and managers; owners with their own capital at risk have incentives to operate their banks prudently. Market discipline provides further pressure and incentives for good internal governance and imposes sanctions for failures. Supervision, however, is essential to compensate for failures or inadequacies in governance and market discipline. To function properly, the supervisory agency must have sufficient authority, established by law, to carry out its duties; independence from political interference; and adequate human and financial resources to carry out its duties.

Prudential Policies. Risk is inherent in banking; but policies that restrict insider lending, monitor foreign exchange exposure, or constrain maturity mismatch can help limit credit, exchange rate, and interest rate risks and help ensure that these risks are managed properly.

Many initiatives have been put in place at the national and international levels to measure and limit specific forms of risk. According to the IMF study, the most important recent initiative to control credit risk has been the widespread implementation of minimum capital adequacy standards. In a parallel effort, a more comprehensive approach to risk management stresses internal governance and the role of market discipline. Prudential policy can support the former by ensuring that banks institute appropriate internal control procedures and can support the latter by fostering enhanced public disclosure of bank financial information.

Exit Policies. The least intrusive and most efficient way of keeping a banking system sound, according to the IMF study, is to force the early exit of nonviable banks—either by market forces or supervisory action. Strong prudential supervision that ensures timely and orderly exit or restructuring of weak banks can play a key role. A system of deposit insurance that is limited in coverage, so as to protect small depositors while still encouraging market discipline, and a lender-of-last-resort facility that discourages runs by providing liquidity to solvent banks also contribute to an effective exit policy.

Since the exit of weak banks is critical to the incentive structure of a strong banking system, orderly bank failures should not be interpreted as a failure of supervision. Rather, the closure of unsound banks reminds other banks that the market and regulatory systems work. Policies fostering an open and competitive banking market will also help create a banking system in which strong banks can thrive and no single bank is too big to fail.

Financial Sector Liberalization. In recent years, many countries have taken steps to liberalize and deregulate their financial sectors, often as part of a broader program of macroeconomic stabilization and structural reform. Deregulation allows banks to enter unfamiliar areas of business, increasing their potential exposure to credit, market, foreign exchange, and interest rate risk. Deregulation can also open the domestic banking market to other financial institutions and to foreign competition.

Because such changes in the operating environment and activities of banks may increase the turbulence of financial markets and expand banks’ opportunities to make mistakes in managing risks, the IMF study suggests that policymakers accompany liberalization with prior or concurrent measures to strengthen the oversight framework. The timely implementation of prudential and bank restructuring policies, in tandem with adequate stabilization policies, is essential to avoid major disruptions to growth and stability in the course of financial liberalization.

The IMF’s Role

In recent years, IMF surveillance, program design, and technical assistance have increasingly acknowledged the importance of a sound financial sector for the efficient functioning of an economy. But, as the IMF study notes, there is a need to address further the macroeconomic causes and consequences of banking soundness—from both a domestic and an international perspective. The dual relationship between bank soundness and macroeconomic balance suggests that while macroeconomic imbalances can lead to bank unsoundness, strategies for dealing with macroeconomic imbalances must also consider the degree of soundness of the banking system.

Surveillance. There is considerable scope to expand the breadth, rigor, and coverage of banking sector issues in IMF surveillance, according to the IMF study. As recent events in many industrial countries have shown, bank soundness problems are not limited to developing and transition economies. Treating bank soundness as a key component of surveillance, however, calls for an understanding of country-specific structural and behavioral linkages between the banking system and the macroeconomy, as well as access to information on banking and financial markets.

The IMF’s surveillance role, the IMF study stresses, is not as a banking supervisor but as an adviser on policy. IMF consultations can help focus the attention of the authorities on the adequacy of the incentive structure, the regulatory framework and its enforcement, the need for a strict exit policy for insolvent banks, and the importance of adherence to international standards and norms of cooperation on supervisory issues.

IMF-Supported Programs. A number of IMF-supported adjustment programs have incorporated banking and financial sector reforms. In many cases, progress has been slow because the reforms are complex and take several years to take effect or because of a lack of sustained effort by the authorities. The IMF study recommends several ways to improve the design of macroeconomic programs that incorporate the policy implications of banking sector problems and the structural measures to deal with those problems:

  • The focus on banking sector soundness objectives needs to be sharpened both in policy design and in the phasing of structural measures.

  • The appropriate relative weight of monetary and exchange rate and fiscal adjustment, as well as the design of specific instruments, needs to be assessed in the light of banking system soundness.

  • The costs of resolving banking system weaknesses need to be addressed more transparently and incorporated into the fiscal program.

Technical Assistance. Over the last 30 years, the IMF, through its Monetary and Exchange Affairs Department, has been providing technical assistance to strengthen banking regulation and supervision. Enhanced attention to soundness issues in the IMF’s operations would call for the greater integration of technical assistance into surveillance and program design.

Coordination with Other Institutions. A number of international and regional institutions currently address issues related to the soundness of banking systems.

According to the study, the IMF is in a unique position in that it covers virtually all countries—industrial, developing, and transition—and has access to expertise, both in-house and from member central banks, on a broad range of macroeconomic and supervisory issues. The IMF is thus well placed to advocate improved regulation, supervision, data disclosure, and resolution strategies in coordination with other agencies and to complement the work of other institutions by setting structural banking issues in a macroeconomic context.

Standard Established for Data Publication Industrial and Emerging Market Countries Agree to Adopt Data Standard

On April 22, the Interim Committee of the Board of Governors of the IMF welcomed the establishment of the special data dissemination standard (SDDS), a standard that members having or seeking access to international capital markets may subscribe to on a voluntary basis (see IMF Survey, May 6, p. 158). Early indications are that a significant number of countries, including a mix of industrial and emerging market countries, intend to subscribe to the standard.

In April 1995, the Interim Committee, in the wake of the Mexican financial crisis, called on the IMF’s Executive Board to establish standards to guide members in providing economic and financial data to the public. The Group of Seven industrial countries, which met shortly thereafter in Halifax, made a similar request. A year later, in April 1996, the IMF’s Managing Director reported to the Interim Committee that the SDDS had been established and that invitations to subscribe had been sent to members. He expressed his expectation that the SDDS would, by enhancing access to timely and comprehensive statistics, contribute both to the formulation of sound macroeconomic policies and to the improved functioning of financial markets. The IMF also made the standard available to the public.

The SDDS was developed following extensive consultations between IMF staff and official statistical agencies, users of data—especially in financial markets—and other international organizations. It prescribes a set of good practices across four dimensions of the dissemination of economic and financial data (see box on page 174):

  • the practice of disseminating a range of data needed to monitor macroeconomic performance and policy, with periodicity and timeliness that balances the needs of data users and the capabilities of producers;

  • practices that encourage ready and equal access to the data;

  • practices that help ensure the objectivity and professionalism—that is, the integrity—of the data; and

  • practices that, while not themselves guaranteeing the quality of the statistics, assist users in assessing quality for their own purposes.

The data categories to be disseminated under the SDDS are for the real, fiscal, financial, and external sectors of the economy. In most countries, the different categories are produced by a minimum of three agencies—the central bank, the finance ministry, and the national statistical office. The SDDS provides flexibility designed to take into account differences in the way national statistical systems are organized and to recognize differences in economic structures. For example, the standard does not prescribe a single, uniform practice intended to discourage undue political influence on the data but rather prescribes transparency about a data producer’s practices, whatever they may be. Also, in the list of data categories to be disseminated, several are labeled “as relevant,” so that a member that does not produce and disseminate that category would nevertheless be considered to be observing the standard.

Reflections on the New Data Dissemination Standard

Will the new data dissemination standard reduce market surprises? Will it facilitate decisions on investment in emerging market economies? Will it encourage policymakers to implement sound economic policies? How difficult will it be for emerging market economies—and even industrial countries—to meet the data demands of the markets? These questions and others on die IMF’s new data dissemination standard were tackled at an April 19 IMF Economic Forum.

John McLenaghan, Director of the IMF’s Statistics Department and one of the forum moderators, opened the discussion by suggesting that capital markets are likely to function more efficiently if key information is made regularly available in a timely fashion. In addition, he said, governments are more likely to take corrective policy actions to avert crises and a loss of confidence if they are committed to providing such information.

This market perspective was shared by John Lipsky, Chief Economist and a Managing Director of Salomon Brothers in New York. He suggested that one of the goals of the data initiative “should be to enhance the force of market discipline on policies.” He also said that the IMF’s initiative should be useful for a number of reasons:

  • In the wake of the Mexican financial crisis in late 1994, investors’ demands for higher-quality data and standards of analysis have become more exacting, in part because of die large shift in recent years toward securitized private credit as opposed to the more traditional forms of bank lending.

  • Even industrial country data can be improved in some areas.

Mehmet Kaytaz, President of the State Institute of Statistics of Turkey, offered the perspective of the data supplier. For Turkey, he said, the data initiative offers a major opportunity for the statistical agencies to upgrade the quality and integrity of their data, although doing so will require more resources at a time of tight budgets. Typically, statistical offices have not received the highest priority in government resource allocations, he said, but priorities may begin to change when governments realize that better data should help attract foreign investment. Kaytaz said that key challenges ahead will include improving coordination between the various statistical agencies and finding a balance between data quality and timeliness.

As for the electronic bulletin board to be maintained by the IMF on the Internet, Lipsky emphasized that users will want die actual data to be “hot linked” to die “metadata” (the descriptive information about the data) that will be shown on the IMF’s electronic bulletin board—a possibility the IMF is now exploring. He also cautioned that the IMF will have a difficult rime maintaining the stance that the quality of the data is ultimately the responsibility of the data supplier rather than the IMF, although the IMF will monitor observance and potentially remove users for egregious nonobservance. Ultimately, he stressed, the IMF will have to provide some sort of implicit vetting of die quality of the data. In the long run, this will be a potentially troublesome issue, he said, if the only option is removal from the bulletin board.

Carol Carson, Deputy Director of the IMF’s Statistics Department, responded that the IMF’s approach would be to help countries put their best foot forward, offering them technical assistance, if needed, to correct data quality problems. “We would hope that we would never even get to a situation where we would even have to consider removing a subscriber,” she said.

This sentiment was echoed by Jack Boorman, Director of the IMF’s Policy Development and Review Department and co-moderator of the forum. “If the countries on the bulletin board are to merit the attention and the premium that may well be there,” he said, “there has to be a separation between those that are fully meeting the standard and those that are not.” However, he said, the point was to help countries improve their data, not for the IMF to be a “schoolmarm.”

In response to a question on whether countries will not still try to hide information that could trigger dramatic market reactions, Boorman said that if the system works as intended and authorities publish release dates and adhere to periodicity, governments would not be able to manipulate their data. Moreover, he stressed that the IMF was hoping that market participants would serve on the front line in monitoring compliance: “If a central bank is supposed to release reserves data at 8:00 a.m. on a certain Tuesday, but at 8:05 a.m. somebody sitting at his screen in New York or London doesn’t see it, our hope is that he picks up the phone and calls the central bank. A few of those instances, we hope, will put a fire under the people who are supposed to release the data, so they take steps to avoid those phone calls.”

Laura Wallace

IMF External Relations Department

To make known, especially to financial market participants, which countries subscribe to the SDDS and, more important, observe the SDDS, the IMF will maintain an electronic bulletin board on the Internet. Members subscribing to the SDDS will provide information to the IMF about their dissemination practices and that information—the so-called metadata—will be posted on the bulletin board. The IMF is exploring ways to link the bulletin board to country data sites electronically. The bulletin board is expected to be accessible to the public at the end of August 1996.

A transition period will extend through the end of 1998, since most subscribers will need to make some changes in their dissemination practices. During this period, countries may subscribe to the SDDS while making the adjustments necessary to observe the standard fully. The transition period will also allow the IMF, in cooperation with members, to continue elaborating more fully certain operational aspects and to undertake reviews of the standard in the light of experience over time.

Countries that subscribe to the SDDS will be expected to observe it. Procedures to deal with the unlikely cases of nonobservance, including arrangements to draw on the advice of a panel of independent statistical experts, will be further elaborated during the transition period.

The establishment of the SDDS and the opening of subscription mark the end of one phase of work begun following the April 1995 Interim Committee’s request. Work is also under way by the IMF and all its members on a general data dissemination standard. The general standard aims to improve statistics for all IMF members; this goal will be achieved through the delivery of IMF technical assistance, training in statistical methodologies, and regular staff work. Further work on the general data dissemination standard will now assume a high priority and will concentrate on data coverage, periodicity, and timeliness. The three other dimensions of the special and general standards are expected to be the same. The Interim Committee has asked the Executive Board to establish the general standard before the end of 1996.

IMF Statistics Department and Policy Development and Review Department

The special data dissemination standard is available to the public from the IMF’s Public Affairs Division: Tel: (202) 623-7682; fax: (202) 623-6278. This information is also available on the Internet at gopher://

Summary of Special Data Dissemination Standard

Coverage, periodicity, and timeliness. The SDDS focuses on crucial basic data that shed light on economic performance and policy in the real, fiscal, financial, and external sectors. It specifies the minimum coverage necessary, but countries are encouraged to disseminate other relevant data.

Access by the public. Ready and equal access is a principal requirement for the public, including market participants. To support such access, the SDDS prescribes advance dissemination of release calendars and simultaneous release to all interested parties.

Integrity. To assist users in assessing integrity, the SDDS prescribes: dissemination of terms and conditions under which official statistics are produced, including those relating to the confidentiality of individually identifiable information; identification of internal government access to data before release; identification of ministerial commentary on the occasion of statistical release; and provision of information about revision and advance notice of major changes in methodology.

Quality. Although quality is difficult to judge, monitorable proxies, designed to focus on information the user needs to judge quality, can be useful. To assist users in assessing quality, the SDDS prescribes: dissemination of documentation on methodology and sources used in preparing statistics; and dissemination of component detail, reconciliations with related data, and statistical frameworks that support statistical cross-checks and provide assurance of reasonableness.

Japan Acts to Resolve Financial Sector Problems

The following article is based on an analysis included in the May 1996 edition of the IMF’s World Economic Outlook.

Recent developments in the Japanese financial sector have prompted a determined response by the authorities. Japan’s financial institutions have been faced with considerable asset-quality problems, arising both from the bursting of the bubble in land and equity prices since 1990 and the recent prolonged downturn in economic activity. The failure of several financial institutions in 1995, together with the lack of full disclosure of nonperforming loans and the absence of a transparent framework for disposing of failed institutions, contributed to market participants’ concern about the risk of systemic crisis. This was reflected in the emergence, in late summer 1995, of a “Japan premium”—the amount of extra interest Japanese banks had to pay to borrow funds in the global interbank market. The premium widened considerably following the delayed revelation of large trading losses at the New York branch of Daiwa Bank.

The government responded by announcing plans for liquidating the jusen (housing loan corporations), improving bank supervision, and resolving the problem of failed institutions. These plans, contained in three legislative bills, are to be decided by the Japanese Diet in June 1996. Assuming full implementation of the corrective measures and current bank profitability trends, the problems of major banks may well be on their way toward resolution.

Problem and Response

In November 1995, Japan’s Ministry of Finance released detailed estimates of problem loans in the financial sector based on a survey of individual institutions (see table). These estimates, revised slightly in December, place total problem loans at ¥38.1 trillion (equivalent to about 8 percent of GDP), of which ¥18.6 trillion is considered unrecoverable. While total problem loans may be somewhat larger, the latest estimates appear to have reduced uncertainty about the magnitude of the problem.

In December 1995, the Japanese Cabinet approved a plan to liquidate the seven insolvent jusen, following negotiations among the principal creditors. There are eight jusen, which are owned partly by banks (founding banks), insurance companies, and securities firms. The jusen were originally established to finance housing loans, but during the second half of the 1980s, they expanded their borrowing from shareholders, other financial institutions (lender banks), and agricultural cooperatives to finance fast-growing lending to real estate developers.

Estimated Problem Loans, As of End-September 1995

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Data: IMF, World Economic Outlook, May 1996

While the Diet has yet to ratify the agreement, it represents a significant step forward. The plan to wind up the jusen distributes the immediate losses associated with an estimated ¥6.4 trillion of unrecoverable assets among founding banks, other financial institutions, and agricultural cooperatives.

In addition, ¥685 billion has been earmarked in the budget for FY 1996 (April to March) to cover the balance of the losses. The remaining jusen assets (about ¥6.8 trillion) are to be transferred to a loan-collecting firm, the Jusen Resolution Corporation (JRC). The founding banks, lender banks, and agricultural cooperatives are to extend low-interest loans to the JRC to finance the cost of assets purchased. Public money will be used to cover half of the possible losses incurred by the JRC; the commercial banks are expected to cover the remainder. The commercial banks are also to provide funds for the Deposit Insurance Corporation (DIC)—about ¥1 trillion; the investment income generated from these funds will be used to make up part of the loss borne by the commercial banks.

Widespread opposition to the use of public money has put the plan in doubt. While the budget—including authorization of the appropriation of ¥685 billion for resolving the jusen—has been passed, use of public funds has been frozen until related legislation is enacted. The Financial System Stabilization Committee—set up in July 1995 to formulate a strategy for resolving the nonperforming loan problem—issued its final report at the end of 1995. The report recommended that deposit insurance premiums—currently 0.012 percent of insured deposits—be raised fourfold to recapitalize the DIC, whose funds are essentially exhausted. Moreover, financial institutions are to pay a special levy over the next five years, equal to three times the existing insurance premium, to establish “special funds” for financing the disposal of failed institutions beyond the payoff costs. To facilitate the disposal of failed credit cooperatives, the Committee recommended the establishment of the Resolution and Collection Bank—an institution similar to the Resolution Trust Corporation set up in the United States to restructure insolvent savings and loans in the late 1980s. This bank would take over failed institutions and handle their liquidation after deposit repayment and loan collection, in cases where other institutions cannot be found to take over the failed institutions. It would also serve as a bridging bank until a takeover institution could be found and would collect nonperforming loans not transferred to takeover institutions.

The major banks’ profitability improved substantially in FY 1995, with net business profits rising to a record high.

The authorities have also announced measures to improve banking inspection and supervision. To strengthen internal management controls, financial institutions will be expected to follow guidelines on in-house inspections and risk management. They will also be inspected by external auditors and the Ministry of Finance to verify compliance with these criteria. Overseas branches will be subject to greater scrutiny by the Ministry and the Bank of Japan. And the authorities plan to strengthen the exchange of information with foreign supervisory authorities, in accordance with the Basle Concordat (which sets out internationally agreed guidelines for bank supervision). Finally, the local and national supervisory authorities will step up their coordination to strengthen the supervision of credit cooperatives.

The major banks’ profitability improved substantially in FY 1995, with net business profits rising to a record high. Profits increased by about 70 percent over the previous year, reflecting a decline in short-term interest rates and an associated steepening of the yield curve. In addition, the rise in overall equity prices boosted the banks’ hidden reserves by more than 25 percent in FY 1995.

With the major banks having announced large loan-loss provisions and write-offs amounting to approximately ¥10 trillion, their average risk-weighted capital ratio is expected to decline to about 9.2 percent at the end of FY 1995, from 9.7 percent at the end of FY 1994. Total operating profits of these banks have been about ¥3 trillion in recent years. Assuming that the banks maintain this level of profitability, accumulate no further problem loans, and use all profits to write down problem loans, the difficulties of the major banks, on average, can be resolved in about three years; some of the banks, however, will require much longer. Given the uneven distribution of problem loans among smaller financial institutions, however, deposit insurance assistance or public money, or both, will likely be needed to wind up several failed institutions.

Camdessus Cites Ingredients for Success

Following are excerpts of remarks by IMF Managing Director Michel Camdessus at the Roundtable of Heads of Agencies, Ninth United Nations Conference on Trade and Development, on April 27 in South Africa. He was asked what the IMF intends to do to guarantee that structural adjustment effectively benefits all human beings.

Why is it that, in the world of today, where so many developing countries are succeeding and thereby fueling world economic expansion, some countries fail? I have posed this question to the leaders of many of the successful countries. Let me tell you what their response was.

First, these countries have discovered the necessity of getting the economic fundamentals right, beginning with restoring and maintaining financial stability, including relatively stable prices. This has become an orthodoxy. They have understood that to achieve this, fiscal deficits have to be reduced to the point that they can be financed in a noninflationary way, do not crowd out private sector activity, and remain consistent with a sustainable debt situation. They know that this requires a major effort to mobilize domestic resources—and to ensure that domestic and foreign resources are used effectively—so that there will be room in the budget for essential expenditure on health and education, agriculture, basic infrastructure, and appropriate social safety nets. Moreover, they know that prices—from the exchange rate to interest rates to the prices of individual goods and services—must be in line with market fundamentals.

Second, they have understood the need for key structural reforms—in the labor market, on trade policy, in the financial sector, agriculture, and other productive sectors of the economy—in order to improve resource allocation and expand the productive capacity of the economy. They have also understood that policies must be formulated within a medium-term strategy, and that protectionism is a no-win game.

These successful adjusters have also discovered the benefits of establishing an institutional framework in which both domestic and foreign entrepreneurs have confidence to invest. In particular, they have found that when governments concentrate on doing a few things well—notably, ensuring law and order, providing reliable public services, establishing a simple, transparent regulatory system that is equitably enforced, and providing an independent and professional judiciary—confidence improves dramatically.

Moreover, they have found that to make a decisive difference in the domestic economic climate, policies must achieve a critical mass of reform. They know that this is the only way to convince economic agents that reform is irreversible and that the country is truly integrating into the world economy. And for that they seek regional integration, compatible with the World Trade Organization, and avail themselves—with no reluctance whatsoever—of the support of our institution. And I am proud to report that today the IMF can list 76 countries with programs of this kind in place, supported by our financing, or being actively negotiated.

More and more countries are establishing the preconditions for successful structural adjustment.

Finally, these countries have understood that successful adjustment requires a domestic consensus in favor of reform—a consensus that requires domestic leadership and must be forged from within.

When these ingredients of success are in place, economies become more dynamic; they also become more resilient and better able to withstand external shocks. Moreover, as Costa Rica, Morocco, Peru, Tunisia, Uganda, Vietnam, and other successful developing countries of the world can attest, when these elements are in place, the world responds, and not just with official project loans and balance of payments support—important as these are—but with a far larger pool of resources and a potentially more powerful kind of support: private non-debt-creating capital inflows.

I believe that this success can be replicated in other countries around the world—especially if piecemeal approaches to reform are replaced with bold and comprehensive structural adjustment programs; if stop-go adjustment gives way to sustained policy reform; and if the commitment to reform is founded on a strong domestic consensus on the need for openness; stable financial policies; sound, market-oriented structural policies; and good governance.

Certainly, this is not an easy process—especially since, in many cases, it requires new thinking about the role of government and the need for domestic consensus, changes in the legal system and other domestic institutions, and a new approach to the many other factors that go into creating the kind of environment in which people have confidence to save and invest for the future. Although there is still some way to go, it is encouraging to see that more and more countries are establishing the preconditions for successful structural adjustment—and thus, for sustained, high-quality growth in today’s global economy.

From the Executive Board

Kenya: ESAF

The IMF approved a new three-year loan for Kenya under the enhanced structural adjustment facility (ESAF) equivalent to SDR 149.6 million (about $216 million). This loan will support the government’s economic reform program for 1996-98, which is built on the policy framework paper published by the Kenyan Authorities on February 16, 1996. The first annual loan in an amount equivalent to SDR 49.9 million (about $72 million) will be disbursed in two equal semiannual installments, the first of which will be available on May 15, 1996.

Kenya has achieved a major economic transformation over the last three years. Direct controls on domestic prices, internal marketing, external trade, and the exchange system have been eliminated, and the exchange rate and interest rates are now fully market determined. The government budget deficit (excluding grants) was reduced from 11.4 percent of GDP in 1992/93 to 2.5 percent in 1994/95; money supply growth was brought under control, and confidence in the banking system was restored. Real GDP, which had stagnated in 1992-93, has begun to recover, expanding by 3 percent in 1994 and by 5 percent in 1995; moreover, inflation declined from 46 percent in 1993 to 1.7 percent in 1995. The external current account was in near balance in 1993 and in 1994, but a sizable deficit re-emerged in 1995, as imports continued to grow strongly from previously depressed levels. However, the progress in economic reform slowed in 1995, and some setbacks occurred. The budgetary targets for the first half of 1995/96 were not met, mainly because of large off-budget outlays, and the restructuring of key parastatals was delayed.

Medium-Term Strategy And 1996 Program

Kenya’s economic program for 1996–98, supported by the ESAF loans, focuses on the following key areas: consolidation of the fiscal adjustment; privatization and restructuring of the parastatal sector; avoidance of the recurrent misuse of public funds; and further development of outward-looking competitive markets. The basic medium-term macroeconomic objectives are to raise the economic growth rate to about 6 percent by 1998; to maintain inflation at 5 percent throughout the period; and to lower the external current account deficit, excluding official transfers, to about 0.8 percent of GDP.

Kenya: Selected Economic Indicators

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Program projections

Data: Kenyan authorities and IMF staff estimates and projections

Within this medium-term strategy, the program for 1996 aims at achieving a real GDP growth rate of 5 percent; limiting average inflation to no more than 5 percent; reducing the external current account deficit, excluding official transfers, from 4.2 percent of GDP in 1995 to 1.3 percent of GDP; and increasing gross official reserves to 2.9 months of imports at end-1996. To achieve these objectives, the authorities will reduce the overall fiscal deficit (on a commitment basis and excluding grants) from 2.5 percent of GDP in 1994/95 to 1.9 percent in 1995/96, and further to 1.6 percent in 1996/97. Total revenue is to be reduced in relation to GDP, while the tax base will be broadened. On the expenditure side, allocations for operations and maintenance will be raised to improve the delivery of essential services; outlays for capital expenditures will also be increased. The program aims also at strengthening expenditure control and budgetary management, as well as improving tax administration. The overriding objective of monetary policy will be the pursuit of price stability.

Structural Reforms

The main objectives in 1996 will be to achieve further progress in privatization and restructuring of a number of key enterprises (for example, completion of the privatization of Kenya Airways, commercialization of the National Cereals and Produce Board, the contracting out of the management of the container terminal of the Kenya Port Authority in Mombasa, and partial privatization of the telecommunications functions of the Kenya Posts and Telecommunications Corporation); divesture of roughly one-half of the remaining nonstrategic enterprises; restructuring of the civil service; and further strengthening of the financial system, inter alia, by making the Central Bank of Kenya more independent and by converting the National Social Security Fund into an autonomous pension fund. Furthermore, the program will focus on establishing transparency and accountability in public finances, with a view to preventing the misuse of public funds and off-budget outlays. The civil service code of conduct will be enforced strictly, no budgetary expenditure commitments will be entered into without Parliamentary approval, all government procurement contracts in excess of K Sh 10 million will be awarded through public tendering, and the recovery of the misused public funds will be pursued vigorously.

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Addressing Social Costs

The government is planning to target poverty measures and to increase the poor’s access to social services. The quality and availability of health services are expected to improve, as budgetary resources are reallocated to promote a shift from hospital care to preventive and primary health care. Public resources will also be reallocated from university education toward primary and secondary education, particularly for underprivileged students.

The Challenge Ahead

The key to translating Kenya’s recent economic gains to high and sustained economic growth is to enhance the confidence of private investors. Full transparency and strict discipline in public finances must therefore be assured. The authorities are urged to address prevailing concerns of bilateral donors on broader governance issues.

Kenya joined the IMF on February 3, 1964. Its quota is SDR 199.4 million (about $288 million). Its outstanding use of IMF credit currently totals SDR 248.62 million (about $359 million).

Press Release No. 96/21, May 8


The IMF approved the third annual loan under the enhanced structural adjustment facility (ESAF) for the Lao People’s Democratic Republic in an amount equivalent to SDR 11.7 million (about $17 million) to support the government’s economic reforms in 1996. The loan is available in two equal semiannual installments, the first of which is due in mid-May.

The Lao PDR is transforming itself from a centrally planned to a market-oriented economy via a medium-term program aimed at strengthening macroeconomic stability while putting in place a wide range of structural measures to improve the efficiency of the domestic economy and to open it up through trade and tariff reform. These adjustment efforts have been supported by the IMF since 1989, and, as a result, the Lao PDR has experienced a strong expansion of private investment and rapid export growth.

Loose monetary conditions in late 1994 and early 1995, however, contributed to a period of sharply rising prices, exchange restrictions, and a weakened exchange rate. From mid-1995, the authorities tightened fiscal and monetary policies. These measures brought inflation back under control and stabilized the exchange rate, which in turn led to a subsequent elimination of exchange restrictions.

The 1996 Program

The focus of the 1996 program is to maintain macroeconomic stability through enhanced fiscal discipline and tight monetary policy. The macroeconomic objectives include maintaining real GDP growth at about 7.5 percent, reducing inflation to about 7.5 percent by end of the period, containing the external current account deficit (excluding grants) to below 14 percent of GDP, and increasing reserves to the equivalent of three months of imports by the end of the year.

To achieve these objectives, the authorities plan to continue to pursue tight fiscal and monetary policies to ensure that inflation substantially decreases and the exchange rate stabilizes. Fiscal targets for the year include an overall deficit (before grants) of 9.2 percent of GDP. Revenue is set to remain constant at 12.5 percent of GDP as a result of tighter surveillance of customs revenues, increased excise duties on cigarettes and alcohol, and adoption of a market-based exchange rate for tax valuation purposes. Current expenditure will be restrained through tight control over the wage bill and spending on material and supplies. At the same time, the implementation of a public expenditure review will assist the government in better determining the country’s expenditure needs, avoiding projects with little social or economic return, and identifying institutional constraints in the budgetary and planning process. On the monetary side, the authorities aim at containing broad money growth to 23 percent during 1996 through a combination of direct and indirect instruments.

Structural Reforms

After privatizing about 90 percent of public enterprises, the government has retained 32 strategic enterprises in the public sector but will operate them on a commercial basis. The remaining enterprises will be privatized by end-1997. A reform of the civil service will focus on retraining and reallocating staff and applying competitive entrance procedures. The management, accounting, and credit practices of state-owned banks will also be strengthened. Beginning in 1996, external audits of all commercial banks will be conducted annually by independent auditors, and, as part of the efforts to strengthen bank supervision, a set of prudential guidelines will be promulgated in the course of 1996.

Lao PDR: Selected Economic Indicators

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Data: Lao authorities and IMF staff estimates

The authorities also intend to accelerate the strengthening of the legal framework to support the ongoing structural changes in the economy. Priorities for 1996 will be to facilitate the development of a sound financial system, including legislation on negotiable instruments. The framework will also define legal rights to land use, establish parcel boundaries, and provide registration titles through a land titling project.

Addressing Social Issues

The government intends to encourage a broad geographic base for economic activity so that the benefits will be reaped by all regions of the country. These efforts would be supplemented by the improved provision of essential social and economic infrastructure to enable the poor to strengthen their earning potential. In particular, the public investment program would, in line with available resources, accord greater emphasis to strengthening social services and human resource development.

The Challenge Ahead

Prospects are good for continued growth in the Lao PDR in 1996, with a recovery in its rice production and a buoyant private sector. However, containing demand pressures and accelerating structural reforms will constitute the main challenges facing the authorities.

The Lao PDR joined the IMF on July 5, 1961, and its quota is SDR 39.1 million (about $57 million). Its outstanding use of IMF credit currently totals SDR 42 million (about $61 million).

Press Release No. 96/23, May 8

Ukraine: Stand-By

The IMF approved a nine-month standby credit for Ukraine equivalent to SDR 598.2 million (about $867 million) to support the government’s 1996 economic reform program.

Ukraine: Selected Economic Indicators

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Data: Ukrainian authorities and IMF staff estimates

In October 1994, Ukraine embarked, with IMF support, on a reform program that brought about the unification of the exchange rate, the liberalization of many features of the exchange system, the abolition of price controls, and the increase in interest rates to positive levels in real terms. In the opening months of 1995, Ukraine realized the first benefits of its new policies in the form of lower-than-expected inflation, nominal exchange rate stability, capital inflows, strong export performance, and expanded private sector activity.

However, delays and slippages in policy implementation occurred during the second half of 1995. Credit was allowed to overrun program targets, budgetary subsidies to the enterprise sector were renewed, and there were delays in privatization and export liberalization. The negative impact of these slippages was quick to emerge: the karbovanets weakened on the exchange market, inflation surged, confidence eroded, and foreign financing in support of the program virtually ceased.

Against this background, the authorities adopted several corrective measures in late 1995 and early 1996 to try to bring the program back on track. These measures helped to stabilize the financial situation, in particular, to halt the depreciation of the karbovanets, and to reduce inflationary pressures.

The 1996 Program

In recognition of the fragile state of the economy, the policies formulated for 1996 aim at resuming the stabilization and liberalization of the economy. The key policy objectives are to reduce inflation to about 1-2 percent per month by the end of the year, to limit the decline of output, and to realize the country’s economic potential.

To these ends, the program seeks to reduce the consolidated budget deficit to 3.5 percent of GDP in 1996 from 5 percent of GDP in 1995. Following reform of the tax system in 1995, most ad hoc tax exemptions will be removed, and new taxes will be levied to support the restructuring of the energy sector. On the expenditure side, the increase in budgetary wages will be regulated so that they do not exceed 80 percent of inflation; subsidies will be reduced; and several other programs will be adjusted or postponed in accordance with financial targets. Although Ukraine’s parliament adopted a budget deficit of 4 percent of GDP, the authorities are confident that they can contain public expenditure sufficiently to achieve the program’s deficit target. Control over expenditure commitments will be facilitated by a new treasury management system that will help project cash flows and manage liquid resources through centralizing paying agents’ funds. Monetary policy will be consistent with the objectives of lowering inflation and replenishing net international reserves. Ukraine’s program in 1996 is expected to be supported by external financing of official flows of about $2 billion from multilateral and bilateral creditors.

Structural Reforms

The government intends to introduce further structural reforms in 1996 to create the conditions for a sustainable recovery in output. A number of measures have been taken to accelerate the auctions of state enterprises with the aim by the end of 1996 of privatizing at least 70 percent of the shares in a total of 5,000 medium and large enterprises. These include the streamlining of preparation procedures for privatization, the circulation of new privatization certificates to boost demand at auctions, and no official intervention in price setting at these auctions.

Price liberalization will also be deepened by halving the number of goods for which advanced declarations of price increases must be submitted to the government. Competition policies for government procurement orders will be strengthened, and a land reform is expected to take place, including the introduction of a tide registration system.

Addressing Social Costs

During 1996, the authorities intend to further improve targeting of their social protection policies. To these ends, improvements to the household budget survey will be made to better identify the segments of the population with the greatest need of protection. Already, steps are being taken to improve the efficiency of the recently introduced income-based housing subsidy scheme, limited to households where housing and energy costs exceed 15 percent of total income. Efforts will also be made to strengthen the pension system to make it sustainable, affordable, and more effective in providing benefits to the large number of pensioners.

The Challenge Ahead

Although the 1996 program will help to set the stage for future recovery of economic activity, many tasks remain to transform the Ukrainian economy into a market-oriented one and to achieve sustained growth. Chief among these tasks is the widening and deepening of structural reforms.

Ukraine joined the IMF on September 3, 1992. Its quota is SDR 997.3 million (about $1.4 billion), and its outstanding use of IMF credit currently totals SDR 1.0 billion (about $1.5 billion).

Press Release No. 96/24, May 10

Currency Boards Circumscribe Discretionary Monetary Policy

On April 1, 1994, Lithuania introduced a currency board arrangement, under which the Bank of Lithuania agreed to provide U.S. dollars for domestic currency upon demand. In taking this step, the Lithuanian authorities implicitly agreed to forsake an independent monetary policy. Their overriding goal was to ensure the strength and long-term stability of the national currency, the litas. A recent IMF study evaluates both the progress and challenges posed by Lithuania’s currency board arrangement over the past two years within the general context of currency board design.

Drawing on this experience, the study concludes that under such an arrangement, the scope for discretionary monetary policy must remain sharply circumscribed.

The Prerequisites

Under a currency board arrangement, the monetary authorities agree to supply or redeem local currency bank notes and, if applicable, reserve deposits of commercial banks held with it for another currency—usually a widely traded one, such as the U.S. dollar or the deutsche mark—at an established exchange rate and without limit. The national bank is expected to refrain from trying to influence interest rates, since this is the primary mechanism through which the money and foreign exchange markets reach equilibrium under a currency board arrangement. Currency board arrangements generally require an even stricter and less forgiving attitude toward banking failure and wage and price rigidities than do exchange rate pegs.

Selected IMF Rates

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The SDR interest rate, and the rate at remuneration, are equal to a weighted average of interest rates on specified short-term domestic obligations in the money markets of the live countries whose currencies constitute the SDR valuation basket (the U.S. dollar, weighted 39 percent; deutsche mark, 21 percent; Japanese yen, 16 percent; French franc, 11 percent: and U.K. pound, 11 percent). The rate of remuneration is the rate of return on members’ remunerated reserve tranche positions. The rate of charge, a proportion (currently 109.4 percent) of the SDR Interest rate, is the cost of using the IMF’s financial resources. All three rates are computed each Friday for the following week. The basic rates of remuneration and charge are further adjusted to reflect burden-sharing arrangements. For the latest rates, call (202) 623-7171.

Data: IMF Treasurer’s Department

If the currency board arrangement is to prove durable, it must be accompanied by a very tight fiscal policy and a liberal, outward-oriented economic policy. In the case of neighboring Estonia, which introduced its own currency board in 1992, both the public and leading politicians largely accepted the necessity for the government to operate within a balanced budget. The stability of the Estonian kroon since then has reportedly boosted business confidence and the availability of consumer goods. And the introduction of a currency board in Argentina in 1991 has been accompanied by a strict monetary and fiscal policy.

Before a currency board is established, several major issues must be addressed. To which outside currency should the exchange rate be pegged and at what level? How much backing should be provided to the currency board before it begins operation, and who should have access to it? And can the government accept the constraints on borrowing that a currency board arrangement poses? For a country that can satisfactorily answer the above questions, a currency board offers a relatively effective way to manage its currency in the face of limited central banking expertise or low policy credibility.

Two main principles underlie the operation of currency boards:

  • Foreign exchange backing under a fixed rate. Holding to a fixed rate of exchange against an anchor currency provides certainty to the public that the domestic currency will retain its current value. This stipulation is especially important in countries such as Lithuania, where inconsistent government financial policy helped build support for the establishment of such arrangements, says the IMF study. The public must also be confident that the monetary authorities have the foreign exchange to redeem currency at that rate. Thus, increases in reserve money must be matched by appropriate inflows of foreign currency. Full backing for the currency on hand is not always necessary, however. For example, the Argentine currency board is permitted to use a limited amount of government securities as backing. The Lithuanian currency board likewise relies on resources borrowed from the IMF to ensure full backing for the Bank of Lithuania’s liabilities under the arrangement.

  • A ban on the printing of “fiat” money. Under the legislation that created Lithuania’s currency board arrangement, the central bank is prohibited from printing money to finance budgetary deficits. All domestic currency in circulation must accordingly be backed by gold and foreign currency reserves. If the government requires domestic financing, it must borrow from the commercial banking system.

Photo Credits: Padraic Hughes for the IMF, pages 165 and 173.

Lithuania’s Example

The introduction of Lithuania’s currency board arrangement was accompanied by a vigorous domestic discussion, says the IMF study. When the Prime Minister announced his intention to adopt such an arrangement, there was already widespread public support for a fixed exchange rate. Such support was hardly surprising: in the seven months following Lithuania’s currency reform of October 1992, the litas had fallen by over 50 percent against the U.S. dollar, only to rebound sharply in the following months.

Use of discretionary monetary policy is at odds with a currency board’s purpose of maintaining currency credibility.

Thus the domestic dialogue was not about ends but about means. It involved questions about how much discretion should be given to the Bank of Lithuania in the design of the currency board arrangement. The initial impetus came from the Prime Minister who recognized the arrangement’s potential ability to deflect strong pressures for more rapid money growth. Pointing to the success of neighboring Estonia’s currency board in bringing down inflation and restoring financial stability, he argued that Lithuania could reap similar benefits.

Not surprisingly, the initial working group, which included IMF staff, was directed to use the key provision of Estonia’s Kroon Security Law as a model. In the end, Lithuania adopted the currency board arrangement as the most viable means for attaining a strong and stable national currency.

The arrangement stipulates that the Bank of Lithuania sell and buy foreign exchange at a fixed exchange rate with no limitation on the amounts. The exchange rate of the litas was set at Lit 4 per U.S. dollar, close to the rate prevailing prior to the start of operations. Under normal circumstances, the Bank of Lithuania’s monetary operations are confined to sales and purchases of foreign exchange at the fixed exchange rate. Only licensed banks are permitted to exchange money directly with the Bank of Lithuania, thereby preserving the existing foreign exchange retail network. The government exercises some flexibility in conducting monetary affairs, including serving as a lender of last resort.

Although credit to the government is ruled out by the currency board arrangement, this had also been the case under the previous exchange rate regime. While the Bank of Lithuania provides foreign exchange backing for all litai in circulation, the currency board arrangement draws some of its backing from resources borrowed from the IMF. Because these IMF liabilities are long term, with maturities of up to ten years, they are considered a suitable source of backing for the arrangement.

Initial Difficulties. According to the IMF study, the Lithuanian currency board arrangement functioned reasonably well for the first six months of its existence. Once operational, foreign exchange began flowing into the country and continued to do so through the fall of 1994. Between April and November 1994, for example, net foreign exchange inflows to the Bank of Lithuania averaged $18.5 million a month.

Data: Lithuanian authorities and IMF staff estimates

The picture changed abruptly in December 1994, when the government attempted to “stretch the bounds” of the currency board arrangement. For example, the Bank of Agriculture, which, in exchange for a $12.5 million loan to the state energy system, received an offsetting exemption from reserve requirements. In a further compromise of the spirit of the arrangement, the government decided to borrow $30 million from a German bank, pledging foreign exchange reserves of the Bank of Lithuania as collateral. The immediate result was an outflow of foreign exchange. Aware of growing concerns about the future viability of the arrangement, the Lithuanian authorities quickly reversed course by underlining their unqualified support for it and their commitment to maintaining the value of the litas.

As a result of these steps, the currency board arrangement’s credibility was largely restored by the spring of 1995—at a price. Despite government efforts to dispel rumors about pending devaluation, rates on treasury bills nonetheless remained high throughout this period. While the authorities were sub-sequently able to halt capital outflows, the preceding period of drift resulted in a loss of policy credibility for the government.


Drawing on the Lithuanian example, the IMF study maintains that unconsidered resort to discretionary monetary policy is fundamentally at odds with the ultimate purpose of a currency board, namely, to maintain the credibility of a nation’s money. It accordingly advises that resort to such measures be sharply circumscribed and limited to smoothing fluctuations in money demand. Going beyond this point runs the risk of undermining the currency board’s capacity to enhance monetary credibility.

Discretion with Rules? Lessons from the Currency Board Arrangement in Lithuania, by Wayne Camard, is No. 96/1 in the IMF’s Papers on Policy Analysis and Assessment (PPAA) series. Copies are available for $7.00 from Publication Services, Box XS600, International Monetary Fund, Washington, DC 20431 U.S.A. Telephone: (202) 623-7430; fax (202) 623-7201; Internet:

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