Monetary and Financial Sector Policies

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This chapter discusses recent developments inmonetary and financial sector policies in thecountries in transition, with a focus on the evolvingchallenges faced by their monetary authorities. Theprogress that has been made toward macroeconomicstabilization in most countries in transition haschanged the short-term objectives and role of mone-tary policy and has, at the same time, laid the founda-tion for the resumption and maintenance of growth.By the middle of 1997, the 12-month rate of inflationwas in the single digits in 11 out of 27 transitioneconomies, and above 25 percent in only 8 of them;the trend decline in inflation is expected to continue inthe period ahead, assuming the continued implementa-tion of disciplined policies.117 With generally goodprogress toward stabilization following the initialchallenges of high inflation, the focus of monetarypolicy has shifted to the need to maintain gradualprogress toward the low single-digit inflation ratesseen in the advanced economies. However, financialcrises in Albania, Bulgaria, and Romania in the pastyear have demonstrated that macroeconomic stabilityis still fragile and can easily be reversed, while ex-change market pressures in the Czech and SlovakRepublics and in Poland illustrate again how externalconsiderations may impose constraints on monetarypolicy.

Monetary authorities in the countries in transitionface challenges not only in formulating monetary pol-icy but also in establishing the framework of instru-ments and institutions through which monetary policycan be effectively implemented in a market economy.Furthermore, they face the challenge of fostering theestablishment of sound financial systems that meet theneeds of a market economy after decades of state mo-nopoly banking.

Following an overview of the recent conduct ofmonetary policy, this chapter discusses what further

progress is needed in two key areas of structural re-form: the introduction of market-based monetary pol-icy instruments and the development of sound bankingsystems. The chapter then reviews a number of addi-tional challenges that reflect a combination of macro-economic and structural issues and analyzes the choice

of nominal anchor and the appropriate pace of furtherreductions in inflation. Throughout the chapter, recentcountry experiences are reviewed to illustrate how therole of monetary policy is evolving as stabilization isachieved and financial sector reform proceeds.

Recent Conduct of Monetary Policy

During 1996 and the first half of 1997, the countriesmore advanced in transition continued broadly to pur-

sue relatively tight monetary policies, and they weregenerally successful in further reducing inflation. Atthe same time, significant differences in individualcountry experiences were evident, related partly to dif-ferences in exchange rate regimes and monetary pol-icy instruments and targets. After more accommoda-tive policies earlier in the year, monetary authorities inthe Slovak Republic tightened the monetary stance inthe second half of 1996 in the face of a deterioratingexternal balance. In the Czech Republic, monetarypolicies were tightened in June 1996, in response toconcerns about a worsening of the trade balance andthe lack of progress in reducing inflation below the810 percent range. More recently, monetary authori-ties in the Czech and Slovak Republics have sought todefend the external value of their currencies in the faceof exchange market pressures; in the Czech case, asseen in Chapter II, these pressures led to a change inthe exchange rate regime. Monetary policy develop-ments in 1996 and the first half of 1997 were smootherin Croatia, Hungary, Latvia, and Slovenia, as authori-ties maintained generally tight policy stances, whilegradually reducing interest rates broadly in line withinflation and attempting to offset the monetary impactof capital inflows. In Croatia and Hungary, the inflowswere partly sterilized, while in Slovenia more empha-sis was placed on reserve requirements and regulationson foreign exchange deposits as means of control.Estonia and Lithuania continued to rely on currencyboard arrangements, thus refraining from active mon-etary policy (see Tables 2022 and Figure 30).

In countries less advanced in transition, strict fi-nancial policies were maintained in Russia, and alsoin Armenia, Azerbaijan, Georgia, Kazakhstan, theKyrgyz Republic, Moldova, and Ukraine, resulting inimpressive declines in inflation from early 1996 on,with the average 12-month inflation rate in this group

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VMonetary and Financial Sector Policies inTransition Countries

117The inflation numbers for Bosnia and Herzegovina are basedupon data for the federation.

1997 International Monetary Fund


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Table 20. Countries in Transition: Exchange Rate Regime and Monetary Policy Instruments, August 1997

Exchange Rate Focus of ExchangeRegime Rate Policy Monetary Framework Monetary Policy Instruments

Currency board

Bosnia and Herzegovina Deutsche mark Currency board Reserve and liquidity requirements

Bulgaria Deutsche mark Currency board Reserve requirements

Estonia Deutsche mark Currency board Certificates of deposit (CDs)

Lithuania Dollar Currency board Uniform reserve requirement

Targeted exchange rate

Croatia De facto target band vis--vis Exchange rate target Central bank bill auctionsdeutsche mark

Hungary Crawling band vis--vis dollar Exchange rate target Repurchase, open market operationsdeutsche mark basket, 2.25%

Latvia Peg to SDR Exchange rate target Exchange rate window

Macedonia, former De facto peg to deutsche mark Exchange rate target Reserve requirements, creditYugoslav Rep. of ceilings, central bank deposit

auctions

Poland Crawling band vis--vis currency Exchange rate target, monitoring Repurchase, open marketbasket, 7% of credit expansion and money operations, reserve requirements

growth

Russia Crawling band vis--vis dollar, 5% Exchange rate target Credit and deposit auctions,primary and secondarytreasury bill markets

Slovak Republic Target band vis--vis dollardeutsche Exchange rate target Repurchase operations, reservemark basket, 7% requirements, suasion

Ukraine Target band of 1.7 to 1.9 hryvnia Exchange rate target Credit auctions, repurchasevis--vis the dollar operations, foreign exchange sales

Managed floating rate

Belarus Ad hoc pegs to various currencies Monitoring inflation and Credit auctions, treasury bill marketexchange rates

Czech Republic Ad hoc intervention to limit Money growth target Open market operations,fluctuations against the deutsche mark reserve requirements

Georgia Broad stability vis--vis dollar Monitoring of credit growth Credit to government, credit

auctions, foreign exchange sales

Kyrgyz Republic Ad hoc peg to the dollar Monitoring of money growth Treasury bill auctions, foreignexchange auctions

Slovenia Ad hoc intervention Reserve money target Repurchase operations, windowfinancing, central bank bills,foreign exchange operations

Turkmenistan Multiple rates Liquidity targets Credit auctions

Uzbekistan Multiple rates Monitoring of money growth Credit and CD auctions

Floating rate

Albania . . . Money growth target Reserve and liquidity requirements,treasury bill auctions

Armenia . . . Money growth target Credit and deposit auctions,repos and reverse repos

Azerbaijan . . . Money growth target Credit auctions, directed credits,foreign exchange sales

Kazakhstan . . . Reserve money target Open market operations, foreignexchange sales

Moldova . . . Reserve money target Credit auctions, small treasuryoperations

Mongolia . . . Real interest rate target Credit auctions

Romania . . . Money growth target Credit auctions

Tajikistan . . . Bank credit ceilings No market-based instruments


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V MONETARY AND FINANCIAL SECTOR POLICIES IN TRANSITION COUNTRIES

of eight countries falling from around 41 percent inJune 1996 to less than 15 percent in June 1997. InRussia, the monetary tightening initiated in 1995 wasmaintained throughout 1996 and early 1997; against

the background of a general decline in inflation and in-terest rates, the Central Bank of Russia reduced its re-finance rate from 80 percent a year (noncompoundedbasis) in September 1996 to 24 percent in June

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Table 21. Countries in Transition: Annual Growth Rates of Broad Money and of Domestic Credit(In percent)

1991 1992 1993 1994 1995 1996

Growth rate of broad money1

Albania . . . . . . . . . . . . 51.8 43.8Armenia . . . 74.9 2,302.7 684.2 68.7 35.1

Azerbaijan . . . 266.0 821.4 1,114.1 24.0 18.9Belarus . . . 508.2 928.3 1,936.7 167.0 52.4Bulgaria . . . 50.4 53.5 77.9 39.6 124.3Croatia . . . . . . . . . 74.9 39.3 49.1Czech Republic . . . . . . . . . 19.9 19.8 9.2Estonia . . . 68.0 57.8 29.6 31.3 36.8Georgia . . . 428.0 4,319.0 2,229.5 146.5 41.9Hungary 29.4 27.3 16.8 13.0 18.5 20.9Kazakhstan . . . 497.0 843.6 615.3 71.3 13.8Kyrgyz Republic . . . 428.4 179.7 119.2 75.8 23.2Latvia . . . . . . 84.2 49.1 24.0 19.9Lithuania . . . . . . 99.0 64.8 29.8 1.8Macedonia, former Yugoslav Rep. of . . . . . . 560.8 31.9 0.3 0.5Moldova . . . 366.0 311.3 115.6 65.2 15.3Mongolia . . . 61.0 192.1 81.0 30.5 33.0Poland 37.0 57.4 35.9 38.3 34.7 29.3Romania 101.2 79.6 141.0 138.1 71.6 66.0

Russia . . . 779.9 317.6 200.7 102.8 33.6Slovak Republic . . . . . . . . . 17.4 18.4 16.2Slovenia . . . 123.6 62.0 43.9 29.3 21.3Tajikistan . . . 513.8 1,587.4 156.3 616.4 142.6Turkmenistan . . . 1,110.0 792.6 1,156.7 375.2 225.5Ukraine . . . 858.9 1,778.1 573.0 117.4 35.1Uzbekistan . . . . . . 784.7 680.4 158.1 100.1

Growth rate of domestic credit2

Albania . . . . . . . . . . . . 9.6 47.9Armenia . . . 266.0 733.5 1,549.1 68.3 30.1Azerbaijan . . . 1,011.4 455.4 841.0 110.9 16.7Belarus . . . . . . 578.3 2,143.0 164.4 59.1Bulgaria . . . 52.5 61.3 47.3 16.0 217.5Croatia . . . . . . . . . 8.6 12.5 1.0Czech Republic . . . . . . . . . 16.8 13.2 10.6Estonia . . . 22.1 71.6 39.8 63.1 98.2

Georgia . . . 509.6 1,927.2 3,208.3 84.7 59.5Hungary 8.0 10.3 16.8 15.2 0.8 27.6Kazakhstan . . . 1,500.4 547.7 755.5 22.5 12.4Kyrgyz Republic . . . 760.1 595.2 36.9 58.9 18.3Latvia . . . . . . 145.8 68.3 26.0 3.4Lithuania . . . . . . . . . . . . 26.1 2.8Macedonia, former Yugoslav Rep. of . . . . . . 67.5 22.3 3.9Moldova . . . 570.1 333.8 116.5 55.9 18.5Mongolia . . . 60.2 51.9 79.0 26.1 89.7Poland 158.7 55.6 44.2 30.1 20.1 29.7Romania 101.1 39.0 122.6 115.8 85.4 84.7Russia . . . 747.7 501.6 297.6 77.3 44.1Slovak Republic . . . . . . . . . 18.5 21.2 15.7Slovenia . . . 80.0 108.0 21.9 37.2 11.2Tajikistan . . . 1,241.4 1,068.0 125.1 484.8 208.5Turkmenistan . . . 782.7 1,812.7 1,066.5 385.9 1,541.8Ukraine . . . 1,566.7 1,133.2 583.2 166.0 38.0

Uzbekistan . . . 1.4 854.4 239.0 58.2 252.81Broad money (currency outside banks, demand deposits, and time and savings deposits) including foreign currency deposits.2Domestic credit comprises banking sector claims on the domestic public and private nonbank sectors.


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1997.118 In 1996, Ukraine implemented tight monetarypolicies for the first time since the beginning of thetransition, as the authorities sought to create a stable fi-nancial environment for the successful introduction ofthe countrys permanent currency, the hryvnia, whichwas launched in September 1996. More recently, how-ever, the National Bank of Ukraine has successfully re-sisted increasing pressures to loosen monetary policyand extend additional credit to agriculture and industry.Armenia, Azerbaijan, Georgia, Kazakhstan, the KyrgyzRepublic, and Moldova continued to restrain monetarygrowth, with occasional slippages.119

In a number of other countries less advanced in tran-

sition, monetary policies were relaxed or remained


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Table 22. Countries in Transition:Real Interest Rates1

(In percent a month)

1992 1993 1994 1995 1996

Albania 4.3 1.1 1.61 1.61 0.5Armenia . . . 8.2 14.4 19.9 5.4

Azerbaijan . . . 12.2 6.8 9.4 2.9Belarus . . . 13.8 4.6 4.1 1.5Bulgaria 0.6 0.2 0.7 1.8 0.9Croatia . . . . . . 0.7 0.4 0.4Czech Republic . . . 0.5 0.1 0.1 0.2Estonia . . . 1.8 1.9 1.4 0.4Georgia2 . . . . . . . . . . . . 2.7Hungary 0.1 0.2 0.4 0.3 0.7Kazakhstan . . . . . . 3.6 2.5 1.1Kyrgyz Republic . . . . . . . . . 2.7 1.6Latvia . . . 2.9 0.3 0.4 0.3Lithuania . . . 1.4 2.8 0.2 0.9Macedonia, former

Yugoslav Rep. of . . . . . . 5.5 1.0 0.9Moldova . . . . . . . . . 1.1 0.7Mongolia . . . . . . . . . 10.2 5.8Poland 0.1 0.2 0.2 0.7 0.5

Romania . . . . . . 1.6 1.5 0.5Russia . . . 5.0 5.4 8.0 6.8Slovak Republic . . . 0.8 0.1 0.3 0.1Slovenia . . . . . . 0.1 0.3 0.1Tajikistan . . . . . . . . . 2.8 16.2Turkmenistan . . . . . . . . . 10.5 1.4Ukraine . . . 13.2 8.8 1.8 2.3Uzbekistan . . . 10.7 5.7 13.4 5.0

1Computed as the 12-month average of [(1 + r)/(1 + ) 1] 100where ris the central bank interest rate on a monthly basis (100)and is the percent change of the consumer price index in the samemonth from the preceding month. This is approximately equal tothe difference between the interest rate and the inflation rate, forsmall rand .

2Based on the interbank credit auction rate.

118Russia also introduced a change in its exchange rate policy: thefixed (and adjustable every six months) fluctuation band of the rublevis--vis the U.S. dollar was replaced in the middle of 1996 by acrawling band with a preannounced rate of crawl, a 4 percent de-preciation being set for 1997.

119In the Kyrgyz Republic, for instance, money growth suddenlyincreased in the fourth quarter of 1996 as the government used itsdeposits with the central bank to pay budget arrears.

Figure 30. Selected Countries in Transition:

Inflation

0

20

40

60

0

20

40

60

0

20

40

60

0

20

40

60Lithuania

Latvia

Estonia

Slovak Republic

Czech Republic

Slovenia

Croatia

Hungary

Poland

1994 95 96 Jul.97

1994 95 96 Jul.97

1994 95 96 Jul.97

1994 95 96 Jul.97

Countries More Advanced: Annual Inflation(Twelve-month percent change in the consumer price index)

20

0

20

40

60

80

20

0

20

40

60

80

20

0

20

40

60

80

20

0

20

40

60

80

KyrgyzRepublic

Ukraine

Russia

Georgia

Tajikistan

Turkmenistan

Belarus

Armenia

Kazakhstan

Bulgaria

Romania

Albania

1994 95 96 Jul.97

1994 95 96 Jul.97

1994 95 96 Jul.97

1994 95 96 Jul.97

Countries Less Advanced: Monthly Inflation(Monthly percent change in the consumer price index)

In countries more advanced in transition, inflation has come downsteadily. In those less advanced in transition, inflation has beenreduced in the countries that have maintained tight financial policies.


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loose. In Albania, Bulgaria, and Romania, the relaxationof monetary policies from late 1995 contributed togrowing financial imbalances that culminated in thecrises of early 1997. In Albania, a main impetus to in-creased monetary growth was the financing of the fiscaldeficit. Accelerating official credits to banks fueledmonetary expansion in Bulgaria, while agriculturalcredit refinancing and lending to enterprises in poor fi-nancial condition led to loose monetary policy inRomania; as monetary policies in these two countrieswere relaxed, central bank interest rates in real termsturned negative. In Mongolia, monetary developmentsin 1996 were dominated by excessive central bankcredit expansion to a weakening banking sector and alsoto the government to finance a higher fiscal deficit;monetary policy was tightened in the spring of 1997,following the initiation of a bank-restructuring pro-gram. Some initial progress toward stabilization inUzbekistan was reversed as the central bank started toextend large credits to the agricultural sector in mid-1996. Belarus and Turkmenistan have not yet introducedcomprehensive stabilization programs and have contin-ued to extend directed credits at below-market rates.

While moderate, and even single-digit, year-on-yearrates of inflation have been achieved or are withinreach in almost all countries in transition, the conse-quences of the high inflation during the period preced-ing stabilization are still being felt. The intensity andduration of the inflation process during this period ledto substantial demonetization and erosion of bankingsector intermediation. In the Czech and SlovakRepublics, countries that were able to avoid protractedhigh inflation, the income velocity of broad money didnot increase above 2, a level close to that in the ad-vanced economies, and the share of cash and foreigncurrency deposits in broad money remained below20 percent. In hyperinflation-stricken Armenia andGeorgia, in contrast, velocity surged to more than 15and domestic currency cash and foreign currency de-posits peaked at 8085 percent of broad money hold-ings in 199495. The legacy of high inflation duringthe period before stabilization continues to have an im-portant influence on the financial environment and toaffect monetary policies today (see Tables 23 and 24).For example, despite the sharp reductions in inflationin the Baltics, Russia, and the other countries of theformer Soviet Union, their average velocity in 1996still exceeded 10, their money multipliers were low,and in the middle of 1997 the share of cash and foreigncurrency deposits in broad money was still around

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Table 23. Countries in Transition: IncomeVelocity of Broad Money1

1991 1992 1993 1994 1995 1996

Albania 1.4 1.8 2.5 2.7 2.1 2.1Armenia . . . 2.9 3.7 10.4 15.5 14.3Azerbaijan . . . 4.5 3.6 5.7 9.1 10.8Belarus . . . 5.1 5.5 6.2 8.5 7.7Bulgaria . . . 1.4 1.3 1.2 1.5 2.4Croatia . . . 2.9 3.9 4.5 3.9 2.8Czech Republic . . . . . . 1.4 1.3 1.3 1.3Estonia . . . 4.0 4.7 4.3 4.5 4.0Georgia . . . 2.7 15.5 32.8 39.2 26.0Hungary 2.1 1.9 2.0 2.2 2.4 2.3Kazakhstan . . . 4.9 4.6 7.9 11.3 11.8Kyrgyz Republic . . . 5.7 9.5 10.1 7.2 7.3Latvia . . . 5.6 4.0 3.5 3.8 4.9Lithuania . . . 4.8 6.4 6.1 6.1 7.6Macedonia, former

Yugoslav Rep. of2 4.1 5.6 5.3 7.9 7.9 7.2Moldova . . . 4.4 10.2 9.6 7.8 6.5Mongolia 1.8 2.9 3.9 3.7 4.2 5.2Poland 3.1 2.8 2.8 2.7 2.8 2.7Romania 2.1 3.3 4.5 4.7 4.0 5.1Russia . . . 3.6 5.6 7.4 11.2 10.5Slovak Republic . . . . . . 1.5 1.5 1.5 1.4Slovenia 2.9 3.8 3.3 3.0 2.8 2.6Tajikistan . . . 3.5 2.4 2.2 10.3 15.6Turkmenistan . . . 5.6 6.0 11.5 14.6 15.7Ukraine . . . 4.1 6.3 6.7 9.4 10.6Uzbekistan . . . . . . 3.7 5.8 5.7 5.1

MemorandumGermany 1.8 1.8 1.7 1.6 1.7 1.6Japan 0.9 0.9 0.9 0.9 0.9 0.9United States 1.5 1.6 1.7 1.7 1.8 1.7

1Velocity is the ratio of annual nominal GDP to the average of end-of-quarter broad money stocks, including foreign currency deposits.

2Computed on the basis of nongovernment broad money.

Table 24. Countries in Transition:Money Multipliers1

1991 1992 1993 1994 1995 1996

Armenia . . . 1.8 1.9 1.6 1.4 1.4Azerbaijan . . . 3.1 2.0 3.2 1.4 1.4Belarus . . . . . . . . . 3.8 2.6 2.3

Bulgaria 3.4 3.3 4.2 4.8 4.5 5.3Croatia . . . . . . 4.5 3.7 3.6 4.2Czech Republic . . . . . . 4.2 3.8 2.6 3.1Estonia 3.2 2.1 1.6 1.9 2.0 2.3Georgia . . . . . . . . . 1.9 1.2 1.2Hungary 1.5 1.7 1.7 1.7 1.6 1.7Kazakhstan 5.9 3.4 2.1 2.1 1.8 1.7Kyrgyz Republic . . . . . . 1.3 1.4 1.3 1.3Latvia . . . . . . 2.1 2.6 2.0 1.9Lithuania . . . . . . . . . 2.4 2.3 2.2Macedonia, former

Yugoslav Rep. of2 . . . 2.1 4.0 3.2 3.6 3.2Moldova 2.4 1.7 1.4 1.4 1.6 1.7Mongolia 5.0 3.1 3.4 3.0 3.0 3.0Poland 2.6 3.0 3.5 3.9 3.7 3.9Romania 2.6 3.1 3.5 3.3 3.9 3.9Russia . . . . . . 2.7 2.8 2.6 2.3

Slovak Republic . . . . . . 6.4 6.1 4.6 4.9Slovenia 7.5 7.2 8.4 7.7 8.0 8.4Tajikistan . . . . . . . . . . . . 1.1 1.4Turkmenistan . . . . . . 1.7 1.6 1.6 1.1Ukraine . . . 1.4 1.6 2.1 1.9 1.9Uzbekistan . . . . . . . . . 1.8 1.4 1.5

1Ratio of broad money, including foreign currency deposits, toreserve money.

2Computed on the basis of nongovernment broad money.


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70 percent. The low degree of intermediation in manycountries in transition significantly affects the conductof monetary policy, as the banking system is the pri-mary transmission channel for monetary policy. At thesame time, low intermediation reduces the opportuni-ties for growth, since a fully operative banking systemimproves risk sharing, and thereby promotes efficient

resource allocation and stimulates investment.120

Development of Market-Based Instrumentsfor Monetary Policy

The transition countries inherited only rudimentarytools of monetary control from the system of centralplanning, where directed credits were the main finan-cial instrument. As part of the transformation strategy,these countries have started to introduce new mone-tary policy instruments, with the broad aim of devel-oping a range of market-oriented or indirect means ofmonetary control. Speedy adoption of indirect instru-

ments has, however, been hindered by inadequate fi-nancial market infrastructure, banking sector weak-nesses, lack of enterprise reform, and until recently,general macroeconomic instability. In these circum-stances, authorities had to choose the pace and se-quencing of monetary reform, in the broader contextof banking and enterprise reform and stabilization.

The adoption of indirect instruments of monetarypolicy is an appropriate objective for countries in tran-sition, as it is more generally for countries that lackthem.121 Indirect instruments, such as refinance anddiscount facilities, open market operations, and re-serve requirements are used to influence overall mon-etary and credit conditions by affecting the supply anddemand for liquidity, working through markets and thegeneral level of interest rates. In contrast, direct in-struments such as directed credits, credit ceilings, andinterest rate controls regulate the price or the quantityof credit, substituting for market forces in the alloca-tion of financial resources. The appeal of direct instru-ments, including in advanced economies, has gener-ally been that they appear to offer monetary controlwithout unwelcome increases in interest rates.Experience has shown, however, that direct instru-ments foster less efficient financial intermediation andare prone to abuse, since they typically depend on dis-cretionary power. Moreover, such instruments can becircumvented and over time lose their effectiveness,

partly through disintermediationthe emergence ofnew channels of credit outside the regulated bankingand financial system.

Given the initial absence in the transition countriesof market-oriented financial institutions and the unsta-ble macroeconomic environment, the objective of in-direct monetary control could only be attained gradu-

ally and progress has varied considerably. Mostcentral and eastern European countries and the Baltics,which quickly adopted tight monetary policies follow-ing the breakdown of central planning, began to intro-duce market-oriented instruments early in the transi-tion; these countries typically also made progress earlyon in other areas of market reform. In countries lessadvanced in transition, progress toward the introduc-tion of indirect instruments has been slower and morepiecemeal, but this has not necessarily been an imped-iment to bringing down inflation rates into themoderate range. Albania, the Kyrgyz Republic, andMoldova, for example, adopted tight monetary poli-cies early on in the transition, even though the move

toward indirect monetary control and broader marketreforms had not progressed far. But while the lack ofindirect monetary instruments did not prevent theelimination of very high inflation, the costs of usingdirect instruments were presumably higher.

The countries more advanced in transition had al-most entirely switched to market-oriented instrumentsby the end of 1994.122 Efforts in more recent yearshave been aimed at the need to strengthen money mar-kets, foster secondary markets in government securi-ties, improve the interbank settlement system, and re-fine open market operations. In Poland, for example,the development of the interbank market has enabledthe national bank to use open market operations as themain instrument of monetary policy. Further progresstoward financial market development and indirectmonetary control in these countries will depend upona number of considerations. These include exchangerate arrangements. Currency board arrangements inEstonia and Lithuania restrict the active use of market-oriented instruments; these arrangements allow a uni-form reserve requirement, while other instruments canbe used and central bank credit can be extended tobanks only to the extent that foreign exchange reservesexceed the backing required for base money (seeBox 5 in Chapter IV). Policies to defend the exchangerate may slow down the further development of finan-cial markets. In the Czech and Slovak Republics, forexample, money market liquidity has been sharply cutby the authorities in recent months in response to ex-change rate pressures. While money market conditions

Development of Market-Based Instruments for Monetary Policy

103

120For an overview of how financial sector development can beimportant for growth, see Ross Levine, Financial Functions,Institutions, and Growth, in Sequencing? Financial Strategies for

Developing Countries, ed. by Alison Harwood and Bruce Smith(Washington: Brookings Institution, 1997), pp. 1731.

121See William E. Alexander, Toms J.T. Balio, and CharlesEnoch, The Adoption of Indirect Instruments of Monetary Policy ,IMF Occasional Paper No. 126 (1995).

122Progress toward indirect monetary control is extensively docu-mented and analyzed in Martha de Melo and Cevdet Denizer,Monetary Policy During Transition: An Overview, World BankPolicy Research Working Paper No. 1706 (Washington: WorldBank, January 1997).


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are easing again in the Czech Republic following thefloating of the exchange rate in late May, they remainvery tight in the Slovak Republic.

Recently adopted stabilization programs in Bulgariaand Romania, supported by IMF financing, seek toeliminate remaining non-market-based instruments ofmonetary policy. In Bulgaria, the move to indirect in-struments was largely completed by the end of 1994,but financially distressed banks ended up in chronicviolation of reserve requirements, and from late 1995on, this situation led the Bulgarian National Bank toextend increasing amounts of unsecured refinancecredit. In preparation for the currency board arrange-ment adopted at the beginning of July, active monetarypolicies were abandoned altogether, and open marketoperations that supported these policies have beenphased out. Romania has lagged behind other centraland eastern European countries in monetary policy re-form. Until the introduction of the stabilization pro-gram this year, the National Bank of Romania ad-vanced directed credits to state-owned banks atbelow-market interest rates, did not conduct open mar-ket operations, and did not have instruments for ab-

sorbing liquidity. Directed credits accounted for some7090 percent of total central bank credit in recentyears and, following the increase in inflation in thesecond half of 1996, real interest rates on such creditsturned negative. The National Bank of Romania isnow committed to ending the provision of directedcredits and to allocating credit primarily through auc-tions at market-determined interest rates.

Russia and most other countries of the former SovietUnion have made substantial progress in moving to-ward indirect monetary control, although much re-mains to be done to bring monetary operations to mod-ern standards.123 Among these countries, Kazakhstanand Russia have advanced most in developing financial

104

Table 25. Russia and the Other Countries of the Former Soviet Union:Rankings of Progress with Establishment of Market-Based MonetaryOperations and Government Securities Markets1

I II IIILimited Progress Moderate Progress Substantial Progress

Central bank facilities

Standing (Lombard, refinance, Belarus Armenia Kazakhstanoverdraft) and discretionary Georgia Azerbaijan Kyrgyz Republic(open market operations, Tajikistan Moldova Russiacredit and deposit auctions) Turkmenistan Ukraine

Uzbekistan

Operating frameworkUse of short-term liquidity Georgia Armenia Belarus

forecasting and availability of Tajikistan Azerbaijan Kyrgyz Republica domestic debt forecasting Turkmenistan Kazakhstan Russiaprogram such as treasury bill Uzbekistan Moldovaauction calendar Ukraine

Market development

Interbank money market and Armenia Belarus Kazakhstansecondary market for Azerbaijan Kyrgyz Republic Russiagovernment securities Georgia Ukraine

Moldova

TajikistanTurkmenistanUzbekistan

Overall ranking Georgia Armenia KazakhstanTajikistan Azerbaijan Kyrgyz RepublicTurkmenistan Belarus RussiaUzbekistan Moldova

Ukraine

Source: Status of Market-Based Central Banking Reforms in the Baltics, Russia, and the Other Countriesof the Former Soviet Union (IMF, forthcoming). The rankings refer to an IMF staff assessment of theprogress made by each country in the relevant area over the period from the beginning of 1992 until mid-1997. Because of the diversity of country conditions and the complexity and complementarity of reforms,these rankings, while a convenient reference, can provide only an approximate indication of progress made.

1Within each ranking, countries are listed alphabetically.

123For a description of monetary policy instruments in the Baltics,Russia, and the other countries of the former Soviet Union at the endof 1995, see Lorena Zamalloa, Monetary Operations, MoneyMarkets, and Public Debt Management, in Central Bank Reform inthe Transition Economies, ed. by V. Sundararajan, Arne Petersen,and Gabriel Sensenbrenner (Washington: IMF, 1997), pp. 6298;see also Status of Market-Based Central Banking Reforms in theBaltics, Russia, and the Other Countries of the Former SovietUnion (IMF, forthcoming).


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markets and introducing indirect monetary policy in-struments. Interbank money markets and both the pri-mary and secondary treasury bill markets are activeand liquid, and open market operations are the maininstrument. The Central Bank of Russia has recentlyfurther improved its ability to influence monetary con-ditions through measures such as the introduction of a

Lombard facility, a repurchase facility, and a primarydealer system for government securities.124 In othercountries, monetary control is primarily exercisedthrough reserve requirements, refinance facilities thatare mainly market-based and, to a limited extent, auc-tions of treasury bills or central bank debt instruments.Only Belarus, Tajikistan, and Turkmenistan continueto rely mainly on direct instruments, including di-rected credits. Most countries have established inter-bank money markets; these operate freely but theirrole in redistributing bank liquidity is still limited (seeTable 25).

Development of Efficient Banking Systems

The countries in transition inherited financial sys-tems composed of a central bank and a number offunctionally specialized state-owned banks. As thesecountries embarked on market reforms, the specializedbanks were commercialized and assigned new tasks,while in many countries a number of new privatebanks emerged. But transforming the old institutionsand allowing new entry were not enough to establishefficient banking systems based on market principles.In addition, practically the entire institutional and op-erational framework required to enable commercialbanks to function effectively under market conditionshad to be created; shortcomings in legislation, pruden-tial norms, and accounting frameworks, and the gen-eral lack of adequate supervisory capacity were partic-ularly acute. Moreover, both old and new banks oftenaccumulated significant amounts of nonperformingloans and did not strengthen their banking skills in theearly years of the transformation. In many cases, theformer specialized banks acted as the main channel in

a subsidy chain from government to loss-making en-terprises by extending unrecoverable loans at below-market interest rates, while many new private banksengaged in aggressive lending to enterprises withwhich they were associated through ownership orother ties. High real interest rates in the immediate af-termath of successful stabilizations exacerbated banks

stock (outstanding bad loans) and flow (operationalinefficiencies) problems.

The absence of a well-functioning, market-basedbanking system and the persistence of prudential prob-lems have necessarily complicated the conduct ofmonetary policy.125 Weaknesses in the banking systemdistort the transmission mechanism of monetary pol-icy because banks that are less able to control theirbalance sheets will be less responsive to changes in re-serve money or interest rates. Moreover, bankingproblems may lead to pressure on the central bank toextend credit to bail out ailing banks, reduce the scopefor tightening liquidity and credit conditions and rais-ing interest rates, and thereby undermine monetary

control. Recent episodes of banking sector problemsin transition countries illustrate how such difficultiescan affect the conduct of monetary policy (see Box 7).In addition, bad loan problems distort credit allocationand thereby impede structural adjustment, as well-runbanks try to protect their assets by shifting their port-folios toward holdings of less risky government secu-rities and by widening spreads. In countries such asKazakhstan, the Kyrgyz Republic, and Lithuania, theshare of credit to the public sector in total bank creditrose around threefold in the wake of banking sectorproblems. While spreads between domestic bank lend-ing and deposit rates in the countries more advanced intransition are now below 10 percentage points a year,they remain in the 2050 percentage point range incountries less advanced in transition that still face sys-temic bank weaknesses (see Table 26). Finally, dealingwith problem banks usually entails significant govern-ment financial assistance, which has fiscal and there-fore broader macroeconomic implications.126 At thesame time, fiscal policy is likely to need to compen-sate if monetary policy is incapacitated by bankingsector problems from playing its role in stabilizingdemand.

Banking sector weaknesses may also complicate theintroduction of indirect instruments of monetary pol-icy. In the presence of insolvent banks, introducing acredit auction or similar market-based facilities may


105

124The Lombard facility, introduced in April 1996, allows thecentral bank to provide refinance credit on a continuous basis forbanks in good standing vis--vis prudential requirements, subject toa weekly aggregate limit. In addition, since October 1996, the cen-tral bank has offered two-day repurchase agreements (repos) withprimary dealers in the government securities market. Finally, thereis also an end-of-day overnight settlement facility for selected banks(at 1.3 times the refinance rate) to ensure the smooth functioning ofthe payments system. These instruments supplement open marketoperations in government securities and foreign exchange marketintervention as means whereby the central bank can add liquidity tothe banking system. The central bank has the capacity to removeliquidity from the system via open market operations and throughdeposit auctions. It also plans to introduce reverse repos with pri-mary dealers as a means of withdrawing liquidity from the bankingsystem.

125For a general discussion of these issues see Carl-JohanLindgren, Gillian Garcia, and Matthew Saal, Bank Soundness and

Macroeconomic Policy (Washington: IMF, 1996).126For example, in Hungary, the government issued debt equiva-

lent to about 9 percent of GDP to recapitalize the state banking sys-tem, while the fiscal cost of bank-restructuring schemes in theSlovak Republic is estimated to exceed 10 percent of GDP. On theseissues, see James A. Daniel, Fiscal Aspects of Bank Restructuring,IMF Working Paper 97/52 (April 1997).


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106

In recent years, countries in transition have been con-fronted with a range of financial sector problems, whichhave had important implications for the conduct of mone-tary policy. This may be illustrated by an overview of se-

lected country experiences during the past three years.The intensity of the financial sector problems experiencedhas varied quite widely. In a number of countries, prob-lems have been concentrated in individual institutionswith no significant repercussions for the wider financialsystem and monetary policy. Russia, other countries of theformer Soviet Union (excluding the Baltic countries), andMongolia have been facing systemic banking sector weak-nesses that have constrained monetary policy, but thesecountries have avoided large-scale banking crises. In theBaltics, however, bank failures did develop into full-scalebanking crises and strongly affected the conduct of mone-tary policy. In southeastern Europe, financial sector prob-lems were a key element of widespread macroeconomicinstability that developed in 1996 and peaked in early

1997 in Bulgaria and Romania, and also exacerbated theeconomic and financial breakdown in Albania in early1997.

Countries that have been able to avoid contagion ef-fects within their financial systems include the CzechRepublic, Estonia, Hungary, and the former YugoslavRepublic of Macedonia. In the summer of 1996, bankingproblems emerged in the Czech Republic in connectionwith the failure of a small bank and spillover effects on amedium-sized bank. The two banks, together with someother small banks, were put under temporary forced ad-ministration by the national bank, which also arrangedfor liquidity credits. The problems led the national bankto introduce a comprehensive consolidation program forsmall banks. The countrys four major banks were unaf-fected. In March 1995, Estonias second largest bank,which accounted for 15 percent of total banking systemassets at the end of 1993, was closed following protractedliquidity and solvency problems. None of the banks li-quidity problems spread through the payments system orthe interbank money market. The conduct of monetarypolicy was not adversely affected, but Bank of Estoniasupport, which reached 6 percent of base money, waslargely unrecoverable. In March 1997, the National Bankof Hungary reacted to a run on the countrys secondlargest bank for small depositors by providing a tempo-rary exemption from reserve requirements; the runquickly subsided and most deposits returned to the bank-ing system. Also in the spring of 1997, the operations ofthe largest saving house in the former Yugoslav Republicof Macedonia were suspended when sizable unreported

deposits were discovered. Some banks suffered modestnet withdrawals of deposits and there were limited capi-tal outflows following the suspension, but there were nofurther significant effects on economic or financialactivity.

In Russia, other countries of the former Soviet Union(excluding the Baltic countries), and Mongolia, financialsector problems have at no time reached the stage of cri-sis. However, the overall financial situation has generally

remained fragile, with large fractions of nonperformingloans, and banking sector difficulties have constrainedthe conduct of monetary policy in several countries, asthe following examples illustrate.1

In Russia, weaknesses in segments of the banking sys-tem and concerns about counterparty soundness con-tributed to a temporary collapse of the interbank marketin August 1995, requiring the central bank to inject liq-uidity temporarily through large-scale purchases of trea-sury bills.2 In Kazakhstan, a number of large banks raninto serious difficulties in 1996; the fourth largest bankwas closed in October, and two other major banks wereput under conservatorship and merged. Reflecting theloss of confidence in the banking sector, the demand forbank deposits, particularly foreign currency deposits, de-

clined as money holders shifted into cash. During 1996,the income velocity of money increased by about 5 per-cent, despite a steady decline in inflation, and the cur-rency-to-deposit ratio increased by around 26 percent;banking system credit to the private sector declined asbanks preferred to hold excess reserves rather than toextend new lending. In the Kyrgyz Republic, amid risingconcerns about the solvency of the banking system in1995, supervision was strengthened and a comprehensiverestructuring plan for the financial sector was introduced,resulting in the closure of the two largest, formerly spe-cialized, banks and a number of smaller banks. As wasthe case in Kazakhstan, these banking sector problemsresulted in an increase in the currency-to-deposit ratioand a drop in bank lending to the private sector in realterms. At the same time, the National Bank of the KyrgyzRepublic created a special facility to provide liquidityto problem banks, reducing its ability to use indirectinstruments.

In Mongolia, commercial banks, burdened with largenonperforming loans, became increasingly illiquid in1996 and confidence in the banking system waned. Theincome velocity of money increased by almost 25 percent,and the share of currency in broad money rose from 25

Box 7. Financial Sector Problems and Monetary Policy in Countries in Transition

1In Russia and other countries of the former Soviet Union(excluding the Baltic countries), the bulk of bad loans is typi-cally concentrated in the five largest banks, often the formerlystate-owned specialized banks, which continue to account for amajor share of total banking system assets (on average around

70 percent).2Temporary liquidity injections are usually associated withrepurchase agreements rather than outright purchases of trea-sury bills, since the former are self-reversing. However, repur-chase agreements were introduced in Russia only in October1996.


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107

percent to 33 percent during the year. The authorities firstadopted a policy of supporting weak banks by providingthem with ready access to central bank credit. Net creditto banks doubled, and much of the credit was provided on

concessional terms outside the regular central bank lend-ing facilities. Because of the relaxation of monetary pol-icy that this support entailed, inflation started to acceler-ate and the exchange rate rapidly depreciated. In late1996, the authorities decided to end the policy of open-ended accommodation and began implementing a com-prehensive bank-restructuring strategy, including the clo-sure of two large insolvent banks and the establishment ofan asset-recovery agency. This strategy has made it possi-ble for monetary policy to focus on macroeconomic stabi-lization rather than being diverted by support to banks.

Growing distress in the Latvian and Lithuanian bank-ing systems turned into full-fledged crises in 1995. Thecrisis in Latvia erupted in April after the failure of somebanks to complete audited reports for 1994 and the sub-

sequent closure of the countrys largest commercial bank.The crisis damaged public confidence in the banking sec-tor, with total deposits, excluding deposits blocked in in-solvent institutions, falling by 35 percent in the first halfof 1995. The banking crisis induced large capital out-flows and forced the Bank of Latvia to intervene in theforeign exchange market. The Lithuanian crisis was trig-gered in December 1995 by the publication of on-site in-spection results for the largest and third largest privatebanks, and the subsequent suspension of these banks op-erations. Immediately following the closure of thesebanks, widespread and steady deposit withdrawals tookplace from the remaining banks, with large outflows offoreign exchange through the currency board. While thebanking crises in Latvia and Lithuania did not lead towidespread macroeconomic instability, they increasedthe volatility of the demand for money and the moneymultiplier, thereby complicating the conduct of monetarypolicy, and reversed much of the financial deepeningachieved in the early years of the transition. The defla-tionary impact of the Baltic banking crises was less se-vere than suggested by the sharp contractions in domes-tic liquidity, mostly because of the still rather limited roleof bank intermediation before the crises and the high de-gree of dollarization. However, in both countries, themoney multiplier remains lower and the currency-to-de-posit ratio higher than before the crisis, and bank lendingto the private sector as a share of total credit has not re-covered, with banks preferring to hold less risky govern-ment securities.3

In Bulgaria, bank liquidity problems emerged in late1995 in the wake of public recognition that several bankshad become insolvent as a result of the accumulation ofbad loans. By that time, the net worth of the banking

system was negative to the tune of about 10 percent ofGDP, with 70 percent of loans classified as nonperform-ing and 25 percent as uncollectible. Confidence in thebanking system started to decline, it weakened furtherwith the subsequent closure of several banks, and towardmid-1996 there was a run on the entire banking system,4

coupled with a simultaneous run on the currency. Thecrisis forced the Bulgarian National Bank to providesubstantial liquidity support to the state banks undergreatest pressure, and to initiate liquidation proceduresagainst an additional number of banks. By the middle of1997, 4 of the original 10 state banks and 14 of the orig-inal domestic private banks had been closed; these bankshad accounted for around one-third of total deposits be-fore the crisis. In Romania, faced with a surge in non-

performing loans, the national bank, after having failedto take timely regulatory actions, was forced in 1996 toact as lender of last resort and extend large emergencycredits to two ailing private banks. The liquidity supportto these banks was an important contributor to the banksloss of control over reserve money in the second half of1996 and contributed to a renewed acceleration in infla-tion toward the end of the year. Finally, in Albania,pyramid investment schemes attracted funds estimatedat up to 50 percent of GDP during 199496 by exploit-ing loopholes in the existing legal and regulatory frame-work. The schemes collapsed in early 1997, as several ofthe larger companies involved were unable to continueattracting enough new deposits to cover interest pay-ments as interest rates had been driven up to very highlevels.

These experiences show that financial sector prob-lems have remained widespread among the transitioncountries, and they illustrate one of their main negativeconsequences, a reduction in the effectiveness of mone-tary policy. The experiences also demonstrate thatpolicies to support insolvent banks by extending cheapcentral bank credit are counterproductive and typicallyresult in higher inflation and exchange rate deprecia-tion. They show too how important it is that transitioncountries maintain efforts to reform and strengthen theirfinancial systems, in particular when they still sufferfrom systemic stress that may develop into liquiditycrises.

3For a detailed analysis of these issues, see Marta de CastelloBranco, Alfred Kammer, and Effie Psalida, Financial SectorReform and Banking Crises in the Baltic Countries, IMFWorking Paper 96/134 (December 1996).

4Between December 1995 and December 1996, lev depositsas a percentage of GDP were halved, while foreign currency de-posit withdrawals totaled almost $900 million, or about 40 per-cent of deposits outstanding.


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induce adverse selection and moral hazard effects,since these banks may be willing to borrow at veryhigh cost to avoid illiquidity. These problems are besthandled by introducing appropriately designed mar-ket-based monetary instruments, such as collateralizedtransactions. In addition, the careful design and se-quencing of specific supervisory policies and bank-re-structuring schemes can support the adoption of indi-rect monetary policy instruments in the presence ofbank weaknesses.127

Many transition countries have made good progressin introducing efficient, market-based financial sys-tems in general and in dealing with banking sectorproblems in particular. It appears that the institutionalcapacity of the financial system in transition countrieshas generally improved faster when a new or parallelprivate banking system has been allowed to emergethan it has when the government has tried simply to re-form existing state-owned banks.128 Country experi-ence indicates that successful bank restructuring re-quires a comprehensive approach addressing not onlythe immediate stock and flow problems of weak andinsolvent banks, but also correcting shortcomings inthe accounting, legal, and regulatory framework andimproving supervision. Privatization of formerly spe-

cialized and still state-owned banks, and firm exitpolicies, allowing in particular the closure of smallprivate banks established in the initial transition years,are also part of best practice.129 At the same time, ad-ditional financial sector reform measures are needed.While a fair number of countries are already imple-menting comprehensive financial sector adjustment

programs, in othersRussia and some other countriesof the former Soviet Union, for exampleauthoritiesare still assessing the magnitude and nature of bankingsector problems and are concentrating their efforts onenhancing banking supervision and on identifying andclosing individual insolvent banks.130 Given the sys-temic nature of the problem, additional efforts areneeded to formulate a more comprehensive restructur-ing strategy, to further develop regulation, prudentialnorms, supervisory capacity, and accounting frame-works, and to address the lack of basic financial skillson the part of bank management.

Other Factors Affecting Conduct andTransmission of Monetary Policy

In addition to having to maintain efforts to improvemonetary policy instruments and strengthen the fi-nancial system, monetary authorities face a number ofadditional challenges, such as those involved inrelative price adjustment, dollarization, and capitalinflows. These phenomena reflect both continuingcorrections of distortions inherited from central plan-ning and responses to more recent developments inthe macroeconomic environment and in financialpolicies.

Relative Price Adjustment

The price mechanism did not have a significant al-locative role in centrally planned economies, and thestructure of relative prices in these economies wasvastly different from that in market economies.Relative prices have changed substantially since thebeginning of the transformation, moving closer tothose prevailing in advanced market economies.131

108

Table 26. Selected Countries in Transition:Interest Rate Spreads1

(In percent)

1991 1992 1993 1994 1995 1996

Armenia . . . . . . . . . . . . 182.3 58.8Belarus . . . . . . . . . 58.9 74.2 28.5

Bulgaria 9.9 11.7 16.9 21.4 23.0 48.8Croatia . . . . . . . . . 16.4 14.7 16.9Czech Republic . . . . . . 7.1 6.0 5.8 5.7Estonia . . . . . . 20.7 14.3 9.6 6.2Georgia . . . . . . . . . . . . . . . 45.2Hungary 4.7 8.6 9.8 7.1 6.5 5.2Latvia . . . . . . 38.0 28.2 23.0 14.3Lithuania . . . . . . 43.2 34.9 18.2 15.9Moldova . . . . . . . . . . . . . . . 19.0Mongolia . . . . . . 174.8 132.5 54.8 55.5Poland . . . . . . . . . . . . 6.7 6.1Romania 102.2 15.0 78.0 21.0 22.0 25.0Russia . . . . . . . . . . . . 73.4 54.4Slovak Republic . . . . . . 6.4 5.2 6.6 7.0Slovenia . . . 52.3 17.0 11.5 9.5 8.7Ukraine . . . . . . 24.2 41.7 60.6 46.3

1Defined as the difference between the domestic currency short-term bank lending and deposit rates at the end of the year.

127See V. Sundararajan, The Role of Prudential Supervision andFinancial Restructuring of Banks During Transition to IndirectInstruments of Monetary Control, IMF Working Paper 96/128(November 1996).

128Stijn Claessens, Banking Reform in Transition Countries,World Bank Policy Research Working Paper No. 1642 (Washington:World Bank, August 1996).

129Michael S. Borish, Millard F. Long, and Michel Nol, BankingReform in Transition Economies, Finance & Development, Vol. 32(September 1995), pp. 2326.

130For an analysis of banking sector reform in the Baltics, Russia,and the other countries of the former Soviet Union, see CeylaPazarbas log-lu and Jan Willem van der Vossen, Main Issues andChallenges in Designing Bank-Restructuring Strategies, in Central

Bank Reform in the Transition Countries, ed. by V. Sundararajan,Arne Petersen, and Gabriel Sensenbrenner (Washington: IMF,1997); and Status of Market-Based Central Banking Reforms in theBaltics, Russia, and the Other Countries of the Former SovietUnion (IMF, forthcoming).

131See Vincent Koen and Paula De Masi, Prices in the Transition:Ten Stylized Facts, Staff Studies for the World Economic Outlook(IMF, forthcoming).


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Overall price levels, measured in a common currency,have also started to converge to market economy lev-els (see Box 8). Notwithstanding this progress, evenin the most advanced transition countries, such asPoland, the structure of relative prices remains quitedifferent from that in neighboring market economies.Substantial differences in absolute price levels across

the transition countries and between the transition andthe advanced economies remain as well.

The adjustment of relative prices has implicationsfor the inflation process in countries in transition.Adjustments in relative prices to a market-determinedstructure can lead to upward pressure on overallinflation if price rigidities are present or when uncer-tainty increases. Statistical analysis confirms thatrelative price changes, as reflected in relative pricevariability, have contributed to inflation, with thecontribution having been most significant duringthe early phases of the transition, and in Russia andthe other countries of the former Soviet Union.132

Increases in relative prices of capital-intensive ser-

vices such as housing, utilities, and transportationmay be an important factor influencing currentinflation rates. After having lagged other pricesduring the early years of the transformation, theseprices have more recently been increasing in relativeterms on a sustained basis. In 1996, services priceswere the fastest rising component of the consumerprice index in most countries in transition (see Table27). Notable exceptions were Belarus, where therehas been little progress with market-oriented reforms,and Bulgaria and Romania, where price increaseswere fueled across-the-board last year by lax financialpolicies.

In view of its effect on overall inflation, the processof relative price adjustment has implications for thedesign and implementation of monetary policy.133 Therelative price effect on inflation has to be consideredwhen choosing the pace at which inflation is broughtdown from moderate to low single-digit rates since itmay add to the short-term output costs of tighteningmonetary policy. Efforts to avoid these additionalcosts and achieve lower inflation targets by postpon-ing the adjustment of public service prices are likely tobe counterproductive, as the realignment of prices isneeded to make the provision of public services moreefficient and cost effective, which in turn contributesto lower future inflation. The size of the effect of rela-tive price adjustment on inflation varies with circum-stances across countries and time periods, so that the

implications for inflation targets and nominal anchorsmust be assessed case by case.

Dollarization

The use of foreign currency assets as money and theholding by domestic residents of foreign currency andforeign-currency-denominated deposits at domesticbanksso-called dollarizationhave been wide-spread in countries in transition in recent years andcontinue to pose challenges for the conduct of mone-tary policy. Foreign currency holdings by domesticresidents were typically restricted during the prere-form period, and the supply of foreign exchange forinternational transactions was centrally allocated andcontrolled.134 With the advent of wholesale market-oriented reforms, a combination of institutional factorsand macroeconomic instability brought about rapiddollarization. At the start of the reform programs, for-eign exchange regimes were substantially liberalized,while domestic financial market reform, including theintroduction of financial instruments denominated indomestic currency and interest rate liberalization, pro-ceeded far more slowly. At the same time, high infla-tion and lack of confidence in the exchange rate, asso-

Other Factors Affecting Conduct and Transmission of Monetary Policy

109

Table 27. Countries in Transition: Changes inConsumer Prices, December 1995December 1996(In percent)

NonfuelTotal Food Goods Services

Armenia 5.6 1.7 5.7 21.3

Azerbaijan 6.8 0.2 9.8 104.3Belarus 39.1 43.6 30.2 29.7Bulgaria 311.1 303.7 329.1 306.7Croatia 3.4 5.6 1.0 8.7Czech Republic 8.7 7.9 7.5 11.3Estonia 14.9 13.1 13.0 16.8Hungary 20.0 17.7 20.9 22.3Latvia 13.2 7.7 17.4 18.6Lithuania 13.1 13.6 10.9 16.1Kazakhstan 28.6 16.4 7.4 139.3Kyrgyz Republic 35.0 39.1 20.0 46.6Moldova 15.1 11.7 14.6 29.8Mongolia 58.8 52.1 52.0 81.8Poland 18.5 19.0 17.6 19.5Romania 56.8 55.2 60.3 53.6Russia 21.8 17.7 17.8 48.4Slovak Republic 5.5 3.4 6.6 5.1

Slovenia 8.8 12.9 7.0 12.9Tajikistan 40.6 34.9 41.2 80.0Ukraine 39.7 17.4 18.8 112.7Uzbekistan 64.4 63.2 55.5 71.1

Source: United Nations Economic Commission for Europe; andIMF staff.

132See Sharmini A. Coorey, Mauro Mecagni, and Erik Offerdal,Disinflation in Transition Economies: The Role of Relative PriceAdjustment, IMF Working Paper 96/138 (December 1996).

133See Sharmini A. Coorey, Mauro Mecagni, and Erik Offerdal,Designing Disinflation Programs in Transition Economies: TheImplications of Relative Price Adjustment, IMF Paper on PolicyAnalysis and Assessment 97/1 (February 1997).

134Nevertheless, in countries such as Hungary, Poland, and theformer Yugoslavia, dollarization was already significant and offi-cially accepted in the prereform period, while foreign currency cashwas part of the unofficial economy in other countries.


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110

The structure of relative prices in the transition econ-omies at the onset of the transformation was vastly differ-ent from that in the advanced market economies. Overallprice levels, as measured in a common currency, were also

widely divergent from the range of price levels prevailingamong advanced economies. These differences in relativeprices and price levels reflected two main factors. First,prices were heavily distorted under the system of centralplanning. Second, even undistorted prices would havebeen different as real per capita income levels in the tran-sition economies were significantly lower than those inadvanced economies. Both price structures and nationalprice levels are highly correlated with purchasing-power-parity-adjusted income per capita.1 For example, esti-mates by the World Bank indicate that in 1995, the pricelevel in the United States was about three times higherthan that prevailing on average in developing countries, inU.S. dollar terms. Price comparisons between transitioneconomies and market economies therefore have to take

into account differences in real GDP per capita.In the course of the transition, prices have started to con-verge to market economy levels in different dimensions.2

The structure of domestic prices has moved closer to thatprevailing in advanced market economies. Overall pricelevels have started to converge toward market economylevels as well. Moreover, prices have been convergingacross regions and alternative distribution channels withincountries in transition, while overall price levels havebeen coming closer together across these countries. Theadjustment of prices has proceeded in two broad phasesfollowing initial price liberalization: first, prices of trad-able goods moved toward those on international markets;more recently, services prices have been brought moreclosely into line with market economy comparators, andprice level convergence has gained momentum.

In most transition countries, relative price adjustmentstarted in earnest with the liberalization of a substantialproportion of prices at the outset of the transformationprocess. This allowed the prices of a large range of con-sumer items to become market-determined, often withthe exception of staples and many services, particularlyhousing and utilities. These measures translated into asurge in the overall price level that was typically manytimes larger than prior and subsequent price level in-creases and was related to the size of the initial monetaryoverhang. At the same time, reflecting an even more pro-nounced decline in the exchange value of the nationalcurrency, price levels in many transition countries, ex-pressed in a common currency, fell farther below marketeconomy comparators. The further price level divergence

mainly reflected initial undervaluation of the domestic

currency following devaluation in the context of a stabi-lization program or the introduction of a new currency.

Following the initial wave of price liberalization andthe introduction of market-based exchange rates, the

forces of international competition started to drive theprices of tradables toward those prevailing on interna-tional markets. Within a few years, a substantial degree ofconvergence of tradables prices was achieved. For exam-ple, tax-adjusted gasoline prices in the Czech and SlovakRepublics and in Hungary had approached Austrian lev-els by 1993.3 Relative price changes during the earlyyears of the transformation also reflected the piecemealliberalization of prices that had not been freed initiallyand the periodical adjustment of prices that remainedcontrolled, primarily prices of services. On the whole, ad-ministered prices were often adjusted by less than wasneeded to keep up with the increases in market-basedprices. As a result, prices of services, which typicallywere the most distorted prices under central planning, de-

viated even further from market levels during this period.With adjustments in tradables prices being partly offsetby lagging services prices, progress in price level con-vergence was limited. Thus in 1993, price levels in south-eastern Europe, the Baltics, Russia, and other countries ofthe former Soviet Union were 20 percent or less of theAustrian benchmark level.

In more recent years, relative price adjustment has con-tinued at a slower pace, reflecting the convergence ofprice structures that had occurred earlier. At the sametime, the nature of the adjustment process has changed,with increases in services prices, administered prices forgovernment-provided services in particular, now beingthe main driving force. The convergence of overall pricelevels toward those prevailing in comparable marketeconomies has also gained momentum. The unweightedaverage consumer price level ratio vis--vis Austria for asample of 15 transition countries rose from one-fourth in1993 to over one-third in 1996, with particularly rapid in-creases in the Baltics, Russia, and Ukraine.

Adjustments of relative prices can affect the overall in-flationary process. Such adjustments will lead to higherinflation in the presence of downward price rigidities orother frictions in relative price adjustment and loose mon-etary policy. An initial price increase for a particular goodor service can have a large inflationary impact if the rela-tive price increase involved is subsequently partly undoneby upward adjustments in other prices, provided theseadjustments are accommodated by money growth.Relative price adjustments can contribute to overall infla-tion in other ways too. For instance, relative price changes

may increase uncertainty. In the presence of adjustment(menu) costs, price setters (firms and, in the case of ad-ministered prices, government agencies) will changeprices only at certain intervals in response to changes inthe economic environment. More uncertainty then reduces

Box 8. Relative Price Adjustment and Price Convergence in Transition Countries

1For evidence on the relationship between price structures andincome levels, see Daniel A. Nuxoll, The Convergence of PriceStructures and Economic Growth (unpublished; Blacksburg:Virginia Polytechnic Institute, 1996).

2See the more detailed analysis in Vincent Koen and Paula DeMasi, Prices in the Transition: Ten Stylized Facts, Staff Studies

for the World Economic Outlook(IMF, forthcoming).

3Austria is the comparator country in the price level compar-isons carried out by the Organization for Economic Cooperationand Development.


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111

the optimal interval between price changes. More frequentprice changes in turn make monetary expansion translatemore fully and more rapidly into overall price increases.

An analysis of a panel of 21 transition economies dur-

ing 199195 indicates that relative price variability indeedhad a statistically significant and fairly important effect onoverall inflation.4 The contribution varied by region andover the sample period and depended on the extent to whichrelative price adjustments were accompanied by nominalwage increases and accommodated by money growth.Causality is hard to establish, but a more detailed study ofthree Baltic countries during 199396 indicates thatcausality ran from relative price adjustment to inflation.5

The process of relative price adjustment and price levelconvergence also has implications for the behavior of realexchange rates. Real exchange rates can be defined in anumber of ways. Real exchange rate changes are some-times calculated as changes in the ratio of the domesticprice of nontraded goods to the domestic price of traded

goods or as changes in the ratio of consumer prices in thehome country to consumer prices in its trading partners,expressed in a common currency. According to either de-finition, the price adjustments in transition countries en-tail real appreciation of the domestic currency. The recentrise in the relative price of services constitutes an in-crease in the relative price of nontraded goods, while theconvergence of overall price levels represents an increasein consumer prices relative to trading partners. A gradualreal exchange rate appreciation that reflects price conver-gence during transition is thus an equilibrium adjustmentphenomenon, which does not involve an unwarrantedloss of competitiveness.

The price adjustment process and the associated appre-ciation of the real exchange rate are expected to continuein the years ahead. While the distortions inherited fromcentral planning have been mostly eliminated and the ini-tial price level gaps between transition countries and mar-ket economies with comparable levels of real per capitaincome have been largely closed, substantial gaps remainvis--vis the advanced economies (see figure). Price struc-tures may be expected to become more similar and pricelevels to converge as productivity improvements narrowincome differentials. Full convergence of real income andprice levels on those in advanced economies can be ex-pected only in the long run, however. At the same time,the prices of many capital-intensive services in transitioncountries (housing, utilities, transportation) are still belowcost-recovery levels and will need to adjust further in rel-ative terms. According to the so-called cost-recovery hy-pothesis, this adjustment need not take place in the short

run.6 The production of services in transition countries is

based on an inherited capital stock that appears to be toolarge when compared with other countries that have sim-ilar income levels, and there is room for downsizing thiscapital stock. Services prices will therefore have to riseonly gradually to cover maintenance cost and eventuallynew investment while the excess capital stock is beingconsumed. To the extent the cost-recovery hypothesis ap-plies, the price level in transition countries will remainlower than in market economies with similar real per

capita income but may be expected to rise more rapidly asreal income in both groups of countries converges on thatin the advanced economies.

4See Sharmini Coorey, Mauro Mecagni, and Erik Offerdal,Disinflation in Transition Economies: The Role of RelativePrice Adjustment, IMF Working Paper 96/138 (December 1996).

5See Krajnyk and Klingen, Price Adjustment and Inflationin the Baltics, 199396, IMF Working Paper (forthcoming).

6See Basil Zavoico, ABrief Note on the Inflationary Processin Transition Economies (unpublished; IMF, 1995). The cost-

recovery effect has to be distinguished from the so-calledBalassa-Samuelson effect, according to which the relative priceof nontradable services will gradually increase as real per capitaincome rises because of slower trend productivity growth in theproduction of services than in that of tradable commodities.

Countries in Transition:

Overall Price Level Gaps, 1996

(In percent)

020406080100120140160

180200

Slovenia

Croatia

Russia

Bulgaria

Latvia

Poland

Hungary

Estonia

Lithuania

Georgia

SlovakRepublic

CzechRepublic

Kazakhstan

Armenia

Belarus

Uzbekistan

Ukraine

Azerbaijan

Romania

KyrgyzRepublic

Moldova

Slovenia

Croatia

Russia

Bulgaria

Latvia

Poland

Hungary

Estonia

Lithuania

Georgia

SlovakRepublic

CzechRepublic

Kazakhstan

Armenia

Belarus

Uzbekistan

Ukraine

Azerbaijan

Romania

KyrgyzRepublic

Moldova

020406080100

Vis--Vis Turkey

Vis--Vis Austria

Source: Vincent Koen and Paula De Masi, Prices in the Transition:

Ten Stylized Facts, Staff Studies for the World Economic Outlook

(IMF, forthcoming).


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ciated with lax financial policies, made holding do-mestic currency particularly unattractive (see also Box6 in Chapter IV).135

Dollarization has now leveled off in most countries

in transition and started to decline in some, as suc-cessful stabilization programs and progress with fi-nancial sector reform have led to declines in inflationand to a strengthening of public confidence in domes-tic currencies and banking systems, and made avail-able assets denominated in domestic currency with at-tractive real rates of return. In countries such as theCzech and Slovak Republics, Estonia, the KyrgyzRepublic, and Moldova, the dollarization ratio (theratio of foreign currency deposits to broad money)currently stands at around 10 percent, while in mostother countries in transition the ratio ranges between15 and 25 percent (see Table 28).136 The use of foreign

currency assets as a store of value may be expected tobe a more permanent phenomenon, being to a signifi-cant extent a natural outcome of portfolio diversifica-tion following financial liberalization and integrationwith international financial markets. It poses a numberof challenges for the conduct of monetary policy andraises a number of broader policy issues.

Dollarization raises the question of which assetsshould be included in the monetary aggregates that areused by monetary authorities as indicator or targetvariables. Aggregates including foreign currency cashand deposits are relevant if the use of foreign currencyas a medium of exchange weakens the relationship be-tween domestic money and inflation. There may beless reason to consider such aggregates if dollarizationrepresents asset diversification, with little significancefor aggregate demand and inflation. Since in practicedollarization is likely to reflect some combination ofboth motives, there is a case for considering aggre-gates both including and excluding foreign currencydeposits when assessing monetary conditions. Dollari-

zation raises a number of additional issues. It involvesa loss of seigniorage, as the demand for domestic basemoney is lower than otherwise, and may affect thecredibility of the central bank and the costs of infla-tion.137 Dollarization also affects the choice of cur-rency arrangement, as discussed in Box 6 in ChapterIV. Perhaps most important, an increase in foreign cur-rency deposits with the domestic banking system in-creases the vulnerability of the banking sector, officialforeign exchange reserves, and the exchange rate to re-versals in market sentiment and capital flight, as illus-trated by the recent Bulgarian experience. Althoughdollarization may have negative consequences, restric-tions designed to reduce the holding of foreign assetsare likely to prove even more detrimental. Dollariza-tion in excess of normal portfolio diversificationshould be seen as a symptom and not a cause of un-derlying financial weaknesses.

Capital Inflows

A number of countries in transition have experi-enced increasing and substantial capital inflows. Such

112

Table 28. Countries in Transition:Dollarization Ratios1

1991 1992 1993 1994 1995 1996

Albania 1.3 23.6 20.2 18.8 18.7 21.0Armenia 0.2 19.2 44.7 41.7 20.4 21.0Azerbaijan . . . 0.1 14.8 58.9 26.3 22.1Belarus 0.5 4.8 37.7 56.5 30.7 24.2Bulgaria 33.4 23.4 20.3 32.6 27.2 50.5Croatia 36.0 35.2 45.8 48.4 57.4 59.6Czech Republic 7.9 9.3 8.1 7.2 6.4 7.6Estonia 56.3 22.9 4.6 11.1 10.9 10.8Georgia . . . 2.2 42.9 51.1 12.7 14.9Hungary 16.5 14.3 18.7 20.4 26.6 24.2Kazakstan . . . 2.5 14.7 16.9 21.4 16.5Kyrgyz Republic . . . 5.8 10.3 6.4 7.8 8.3Lithuania . . . 46.6 25.7 27.0 25.8 25.5Latvia . . . 35.1 26.2 27.6 29.5 30.7Macedonia, former

Yugoslav Rep. of . . . . . . 32.4 18.5 18.1 16.3Moldova . . . 2.1 15.2 10.3 11.0 9.9Mongolia 5.9 5.9 29.3 17.1 18.3 19.1Poland 24.7 24.8 28.8 28.6 20.4 17.3Romania 3.9 17.9 29.0 22.1 22.6 23.4Russia 16.8 42.7 27.0 27.9 19.0 19.0Slovakia 3.1 6.3 11.5 13.0 11.1 10.0Slovenia 48.4 44.4 45.5 38.0 39.3 38.5Tajikistan . . . . . . 1.8 1.9 33.7 14.9Turkmenistan . . . 12.4 4.6 17.6 5.0 52.1Ukraine . . . 8.6 19.4 32.0 22.8 18.3Uzbekistan . . . 22.7 5.1 22.5 15.5 15.1

1The dollarization ratio is the ratio of foreign exchange depositsto broad money, including foreign currency deposits.

135For a detailed analysis of the dollarization in the early years ofthe transition, see Ratna Sahay and Carlos Vgh, Dollarization inTransition Economies: Evidence and Policy Implications, in The

Macroeconomics of International Currencies, ed. by Paul Mizenand Eric Pentecost (Aldershot: Edward Elgar, 1997), pp. 193224.

136The dollarization ratio is, however, only an approximate mea-sure of dollarization. Three types of foreign currency assets are rel-evant: foreign currency deposits in the domestic banking system,such deposits held at banks abroad, and foreign currency cashheld within the domestic economy. Only the first is included in the

dollarization ratio, which therefore understates the magnitude of thephenomenon. Foreign currency cash held outside the banking sys-tem has been particularly important in Russia. It is estimated thatRussian enterprises and households acquired the equivalent ofaround $8.5 billion in foreign currency cash in 1996 alone, equal tomore than 75 percent of the foreign currency deposits outstanding atthe end of that year. A substantial portion of these cash flows inRussia originates in the shuttle trade.

137See Alberto Giovannini and Bart Turtelboom, CurrencySubstitution, in The Handbook of International Macroeconomics,ed. by Frederick Van Der Ploeg (Oxford: Basil Blackwell, 1994), pp.390436; and Guillermo Calvo and Carlos Vgh, From CurrencySubstitution to Dollarization and Beyond: Analytical and PolicyIssues, in Money, Exchange Rates and Output, ed. by GuillermoCalvo (Cambridge, Massachusetts: MIT Press, 1996), pp. 15375.


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inflows can be highly beneficial as they may con-tribute to the financing both of additional investmentto replace obsolete and inefficient capital stocks, andof increased consumption that may allow the currentgeneration not to bear the full one-time costs of transi-tion. At the same time, however, capital inflows tendto put upward pressure on the exchange value of the

domestic currency and lead to real exchange rate ap-preciation, through either growth in monetary aggre-gates and higher inflation under a pegged exchangerate regime or to nominal appreciation in a flexibleregime. Moreover, capital inflows may threaten thesoundness and resilience of the financial system to theextent that inflows involve an increase in bank de-posits that induces an unwarranted expansion of bankcredit.

Several countries in central and eastern Europe andthe Baltics began to receive substantial capital inflowsfrom 1992 to 93 on, when macroeconomic stabiliza-tion was being consolidated.138 Capital inflows tothese countries peaked in 1995 at around 8 percent of

GDP for the region as a whole, with particularly largeinflows, equal to around 18 and 17 percent of GDP re-spectively, into the Czech Republic and Hungary. Netcapital inflows slowed in 1996, and Estonia and theSlovak Republic moved ahead of the Czech Republicand Hungary as main recipients, in relation to GDP.Not only the size, but also the causes and nature of theinflows have differed from country to country, as in-flows have in some cases been a response to high do-mestic nominal interest rates in the presence of re-duced exchange rate risk (Slovenia in 1994), butelsewhere a reflection of foreign borrowing by enter-prises facing high domestic borrowing costs (theCzech Republic), or partly a consequence of the saleof state enterprises to foreign investors (Hungary) orforeign direct investment (Estonia).

Countries less advanced in transition have alsostarted to receive short-term capital inflows. Thesehave generally been attracted by a combination of highdomestic interest rates and stabilized exchange ratesthat translate into high returns in terms of foreign cur-rency. Such inflows occurred in Bulgaria in 199394and in Kazakhstan and Russia in 1995, where the in-flows appear to have been primarily the result of fi-nancial operations by residents.139 Short-term capital

inflows into Russia and some other countries of theformer Soviet Union resumed in 1996 and continuedin the first half of 1997 following the gradual openingup of local treasury bill markets to foreign investors.Treasury bills in these countries offered high returns inforeign currency terms that were no longer available inthe more advanced countries in central and easternEurope (see Table 29). Nonresidents are estimated tohave purchased more than $10 billion in Russian trea-sury bills since they gained market access in early1996. More recently, as Russian interest rates havefallen, nonresident investors have diversified into theKazak and Ukrainian treasury bill markets.

In many countries more advanced in transition, mostnotably Croatia, the Czech and Slovak Republics,Hungary, and Poland, there have been sizable opera-tions to sterilize the capital inflows. These operationshave involved substantial fiscal costs arising fromwide differentials between the interest rates paid ondomestic debt held by the monetary authorities and theyields earned on foreign reserves. Moreover, in somecountries they were only partially effective in contain-ing monetary expansion, with effectiveness erodingas the sterilization continued. Other responses haveincluded the introduction of inflow controls in theCzech Republic and Slovenia in 1995, and changes inthe exchange rate regimes in Poland in 1995 and inthe Czech and Slovak Republics in 1996; these in-volved widening of the fluctuation bands around thecentral rates, to increase the degree of two-way risk inthe foreign exchange markets and discourage spec-ulative inflows. In the Baltic countries, the main pol-icy response to the sizable capital inflows during199296 was unsterilized intervention, although inLatvia there was some limited use of sterilization mea-


113

Table 29. Selected Countries in Transition:Net Capital Inflows1

(In percent of GDP)

1992 1993 1994 1995 1996

Bulgaria 5.7 2.5 1.1 3.9 8.9Croatia . . . 1.1 2.2 9.9 8.8

Czech Republic 1.3 6.8 6.1 17.8 6.6Estonia 5.0 13.4 7.6 7.1 13.3Hungary 1.2 15.7 8.2 17.3 0.5Kazakhstan . . . . . . . . . 3.8 4.0Latvia 5.6 8.6 7.5 1.7 8.0Lithuania 4.8 7.5 3.6 4.7 3.3Poland 1.7 0.9 0.6 4.1 2.3Romania . . . 5.8 4.3 3.7 4.3Russia2 . . . . . . 5.9 0.2 2.6Slovak Republic 5.0 2.0 7.4 6.7 7.4Slovenia 2.4 0.7 0.7 1.5 3.0Ukraine . . . . . . 0.4 10.8 5.3

1Net capital inflows are defined as the balance on financial ac-count in the balance of payments, excluding changes in internationalreserves, plus net errors and omissions.

2On a cash basis, excluding the impact of debt rescheduling.

138For an analysis of capital inflows into central and eastern Europeuntil 1995, see David Begg, Monetary Policy in Central and EasternEurope: Lessons After Half a Decade of Transition, IMF WorkingPaper 96/108 (September 1996); and Guillermo Calvo, Ratna Sahay,and Carlos Vgh, Capital Flows in Central and Eastern Europe:Evidence and Policy Options, in Private Capital Flows to Emerging

Markets After the Mexican Crisis, ed. by Guillermo Calvo, MorrisGoldstein, and Eduard Hochreiter (Washington: Institute forInternational Economics, 1996), pp. 5790.

139See Alain Ize, Capital Inflows in the Baltic Countries, Russia,and Other Countries of the Former Soviet Union: Monetary andPrudential Issues, IMF Working Paper 96/22 (February 1996).


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sures.140 Monetary authorities in most countries lessadvanced in transition have allowed the first wave ofshort-term capital inflows to increase the money sup-ply and induce a real exchange rate appreciationthrough inflation. This response has also reflected thelimited scope for market-based sterilization in the ab-sence of well-developed financial markets and indirect

monetary instruments. More recent capital inflowsinto countries such as Russia and Ukraine have to asignificant extent been sterilized by the monetaryauthorities.

The economic impact of capital inflows in transitioncountries and the appropriate policy response dependon a number of factors, including whether the inflowsare temporary or more sustained, the causes behindthem, the exchange rate regime, and the degree of do-mestic financial imbalance.141 For example, inflowsattracted by increased domestic productivity are mostnaturally accommodated by real appreciation, al-though policymakers still must choose whether thereal appreciation should be brought about throughnominal appreciation or through inflation. On theother hand, in the case of a temporary increase in cap-ital inflows resulting from a change in foreign interestrates, sterilization that limits its impact on the domes-tic economy may be the most appropriate response tothe extent that this is feasible. In countries where highdomestic interest rates due to a mix of loose fiscal andtight monetary policies attract short-term inflows, acorrection of the underlying policy imbalance is gen-erally the best response. As the origin of the inflowsand their likely degree of persistence are key elementsin designing an appropriate policy response, authori-ties need to monitor a wide range of variables, includ-ing asset prices, monetary and credit aggregates, bal-ance of payments data, the asset-liability structure ofcommercial banks, and key international variablessuch as interest rates.

Other Factors and the Velocity Issue

Monetary authorities in countries in transition face anumber of additional challenges. In Russia andthe other countries of the former Soviet Union, sub-stantial interenterprise payment arrears require specialattention. The stock of arrears in Russia may be aslarge as the stock of broad money, and it is evenhigher (in relation to the broad money stock) in

Belarus, Kazakhstan, Moldova, and Turkmenistan.Interenterprise arrears affect the timing of receipts andpayments and hence money demand, obscuring mone-

tary conditions. Arrears also impede monetary control,as they may increase endogenously when monetarypolicy is tightened, and they aggravate bad debt prob-lems for banks. While interenterprise arrears compli-cate the conduct of monetary policy, they should notbe dealt with directly by monetary policy actions.142

Netting-out exercises that value all debt at par or credit

injection operations in countries such as Belarus,Bulgaria, Kazakhstan, Romania, and Ukraine havetypically resulted primarily in higher inflation and ex-change rate depreciations; in contrast, arrears subsidedin the countries more advanced in transition once sta-bilization became more firmly rooted.143

From an operational perspective, the various factorsthat affect the conduct of monetary policy in countriesin transition can be seen as weakening the link, at leastin the short run, between the growth of monetary ag-gregates, and aggregate demand and inflation. A use-ful summary indicator measuring the strength of thislink is the variability of the income velocity of money,since more volatile velocity translates into a less well-

defined short-term link between money growth andnominal income. Short-run volatility of velocity is tobe expected in the presence of adjustments in admin-istered prices, shifts between domestic and foreign as-sets, and temporary capital inflows; quarterly data onvelocity in a number of transition countries indeedshow substantial short-term fluctuations.144 In addi-tion to requiring monetary authorities to consider awider range of informational variables, shifts in veloc-ity have broader implications for the choice of opera-tional guidelines for monetary policy.

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