Presentation by M Singer ed€¦ · • Four big state-owned banks: ownership was untransparent and diluted; state control was inefficient (“banking socialism”); profitability

M. Singer: Twin crisis in the Czech Republic 1

Twin crisis in the Czech Republic: Twin crisis in the Czech Republic: Causes, Consequences and LessonsCauses, Consequences and Lessons

KIMEP, Almaty23 November 2006

Miroslav Miroslav SingerSingerViceVice--Governor, Czech National BankGovernor, Czech National Bank


ContentContent

• Introduction – heritage from the CPE• Macroeconomic, monetary and banking sector

developments in the pre-crisis period (1990-1996) • Main interactions during currency and banking

sector crises (1997-1999) and policy responses • Consequences and costs of the twin crisis• Lessons

The Czech Republic is almost a text-book example of a twin crisis


Heritage from centrally planned economy Heritage from centrally planned economy (where we were in 1990)(where we were in 1990)

• Industrialised country (long tradition)• Stubborn regime of central planning (according to USSR model) • Population appreciated governments which guaranteed monetary

stability → relatively small “monetary overhang”• Negligible share of private ownership• Almost exclusive orientation to Eastern European (soft) markets • Relatively balanced macroeconomic development• Low foreign indebtedness• Relatively skilled and educated labour (though insufficient work

habits due to high social security)

The Czech Republic had relatively good starting conditionsIntroduction


Macroeconomic, monetary and Macroeconomic, monetary and banking sector developments banking sector developments

in the prein the pre--crisis periodcrisis period(1990(1990--1996)1996)

Banking sector developments


BBankinganking sectorsector developmentdevelopmentss: : introductory remarksintroductory remarks

• In the Czech Republic, banks are the backbone of the financial sector 75% of assets (simplification: financial sector = banking sector)

• Banking sector development reflected (mirrored) economic transformation with all its strengths and weaknesses

Banking sector development


Restructuring of the banking sector:Restructuring of the banking sector:main stagesmain stages

• In 1990, the banking sector started from scratch• Split of the “monobank” (1990) “two-tier” system • Inherited deficiencies (under-capitalisation, bad loans, shortage

of long-term funds, inexperienced staff, legal loop-holes, non-existent risk management)

• Consolidation Programme I (clean-up of balance sheets of Komerční banka, Česká spořitelna, Investiční banka; establishment of Konsolidační banka in 1991 as a major vehicle for takeover of bad loans) (overall costs = 7% of 1995 GDP)

• Entry of small banks (13 in 1990, 13 in 1991, 17 in 1992, 10 in 1993 and 4 in 1994) (under-capitalised, unsound development strategies, often fraudulent behaviour, !benign licensing policy!)



• Consolidation Programme II (1996) (purpose: to prevent a domino effect within the small bank sub-sector; of a total of 18 banks, 15 were treated under CP II) (costs: similar to CP I)

• Stabilisation Programme (adopted in 1996) (was intended for 13 small banks; 6 banks joined but 5 were excluded stabilisation programme turned out to be unsuccessful)

• Four big state-owned banks: ownership was untransparent and diluted; state control was inefficient (“banking socialism”); profitability and competitiveness were low and worsened in the 2nd half of the 1990s

Restructuring of the banking sector:Restructuring of the banking sector:main stages main stages -- continuedcontinued

By 1996, the Czech banking sector was witnessing many unfavourable developments



Anatomy of banking sector crisisAnatomy of banking sector crisis

Bad loanaccumulation

Capital inflow Political pressures

Insufficient banking

supervision

Real estate-and capital

market bubbles

Fraudulent behaviour

Economic recession

Insufficient risk assessment

High lending



Implications of the bad loan Implications of the bad loan accumulationaccumulation

• Vulnerable banks • Underperforming credit channel of monetary policy• High fiscal costs of keeping the banking sector alive

(instead of having the budget revenue)

Around 1996, the banking sector was a serious bottleneck (Achilles heel) of the Czech economy



Banking sector performance: 1994Banking sector performance: 1994--19961996

-600

-400

-200

0

200

400

600

800

1 000

1 200

1 400

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 05H1

in 1

000

CZK

0

5

10

15

20

25

30

in %

Net profit per empolyee (left scale)Non-performing loans (as % of total loans) (right scale)

Non-performing loans hovered around 25% of the total and profitability was virtually zero

Source: CNB



Macroeconomic and monetary developments


GDP in the Czech RepublicGDP in the Czech Republic

The economy overheated in 1995

2,2

6,9

4

-0,7 -0,8

1,3

3,6

2,51,9

3,64,2

6,16,6

-2

-1

0

1

2

3

4

5

6

7

8

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006H1

y-on

-y c

hang

e in

%

Macroeconomic & monetary development


Overheating in midOverheating in mid--1990s: causes1990s: causes

• Strong demandHigh growth of wages (much higher than productivity growth)High growth of private and public investment (infrastructure)Strong credit growth (partly due to “banking socialism”) Strong capital inflow (high interest rate differential) → sterilisation

• Weak supply side (under-developed markets, badly-defined property rights, malfunctioning legal and institutional framework, etc.)

Emergence of external imbalance

In 1996-97 the overheating started to become unsustainable: the situation required adjustment and policy responses



Real wages and labour productivityReal wages and labour productivity

Wage-productivity mismatch peaked in 1995 and was still significant in 1996

-4

-2

0

2

4

6

8

10

12

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

y-o-

y ch

ange

s in

%

Real wages

Labour productivity



Gross fixed capital formation/GDPGross fixed capital formation/GDP31,5

32,1

29,9

28,2

27

28 2827,5

26,726,2

25,5

20

22

24

26

28

30

32

34

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

in %

, nom

inal

term

s

Investment was very high in 1995 and peaked in 1996



External imbalance External imbalance

Current account deficit reached 6.6% and 6.2% of GDP in 1996 and 1997 respectively – thus exceeding the critical level (5%)

-10

-8

-6

-4

-2

0

2

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

as %

of G

DP

Trade balance/GDPCurrent account balance/GDP



Monetary policy frameworkMonetary policy framework• Fixed exchange rate since 1991

(different baskets: initially to five currencies; later on to DEM and USD)• Monetary targeting:

Operational target: monetary base Medium-term target: M2

• Capital account liberalisation (basically finished in 1995) (driven by entry into the OECD)

• Emergence of “Impossible Trinity” = parallel existence of: a) free capital flows b) fixed exchange rate, c) independent monetary policy

Capital account liberalisation eroded the monetary frameworkMacroeconomic & monetary development


Vicious circle of monetary policyVicious circle of monetary policyHigher domestic

interest rates

Capital inflow

Appreciation pressures

Interventions: purchase of

foreign currencies

Pressures: increase of

monetary base and monetary aggregates

Sterilisation: sales of securities to

domestic banks

Pressures: increase of

domestic interest rates



Main interactions during the Main interactions during the currency and banking crises currency and banking crises

(199(19977--19919999) ) and policy responsesand policy responses


Towards a speculative attack Towards a speculative attack

• To deal with imbalances some policy actions were adopted: Increase in interest rates (beginning of 1996) Widening of the koruna fluctuation band (end of February 1996 ± 7.5 %)1st stabilisation package in April 1997

However: this was not enough to calm the markets!→ speculative attack (in May 1997) → abandonment of the peg → managed float → depreciation of koruna → inflationary expectations → inflation

Impossible Trinity was not addressed sufficientlymarkets penalised



Loss of the nominal anchor in 1997Loss of the nominal anchor in 1997

-10

-5

0

5

10

15

%

Level of official exchange rate Fluctuation band - appreciation Fluctuation band - depreciation

Septem ber 27, 1992Sett ing of the band f or the f luc tuation of the exchange rate of koruna +/-0,5%

April 24, 1995Sett ing of the spread +/- 0,25%

February 28, 1996F luctuat ion band ex tended to +/- 7,5%

May 27, 1997C ancelation of the f luc tuat ion band

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000



After speculative attack After speculative attack

• 2nd stabilisation package in June 1997:Macroeconomic measures: fiscal tightening, wage freeze, import deposits (acted rapidly)Microeconomic measures: legal and institutional reforms (were more time-consuming)

• Adoption of inflation targeting (in January 1998) – unilateral decision by CNB

Macroeconomic stabilisation started to exert the intended effects in 2H1997



Anatomy of currency crisis Anatomy of currency crisis

Capital inflow

Liberalisation of capital account

Interest rate differential

Vicious circle

Appreciation of currency

Deterioration of price competitiveness

Overheated economy

External imbalance

Fiscal imbalance

Bad assessment of economy by

markets

Speculative attack

Change of exchange

rate regime

Devaluation and

depreciation


Preliminary data


Measurement errors and preliminary Measurement errors and preliminary data may have been crucialdata may have been crucial

-6

-4

-2

0

2

4

6

8

95/I II III IV 96/I II III IV 97/I II III IV 98/I II III IV 99/I II III IV

y-o-

y ch

ange

in %

Data from 4Q/98

Data from 4Q/99

Deceleration was steeper

Depression instead of growth

Actual growth was faster

More precise and timely statistics would probably have implied less strict stabilisation policies



Measurement errors and preliminary Measurement errors and preliminary data may have been crucial data may have been crucial

Would the less acute external imbalance in 1996 have triggered a speculative attack?

-8,0

-10,6

-6,6

-9,2

-12

-10

-8

-6

-4

-2

0Current account balance/GDP Trade balance/GDP

as %

of G

DP

Preliminary data

Final data



Anatomy of currency crisis Anatomy of currency crisis –– contcont..

High interest rates

Recession Unemployment

Devaluation and

depreciation

Inflation

Fiscal and monetary tightening

Drop in profitability of enterprises

Expenditure cuts



Anatomy of twin crisisAnatomy of twin crisis

Recession

Drop in profitability of enterprises

Bad loansaccumulation

Drop in profitability of banks

Bank failures

Fiscal costs Distrust of financial sector

Multiple economic and institutional adjustments

Macroeconomic & banking development



-600

-400

-200

0

200

400

600

800

1 000

1 200

1 400

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 05H1

in 1

000

CZK

0

5

10

15

20

25

30

in %


Economic

recession

Recession brought an increase in non-performing loans and negative profitability of banks

Source: CNB

Profitabilityplummeted



Privatisation of big banksPrivatisation of big banks

• The big state-owned banks were an impediment to the smooth functioning of the banking sector

• Privatisation of: IPB (Nomura) 1998 Agrobanka (GE) 1998 CSOB (KBC) 1999 CS (Erste Bank) 2000 KB (Societe General) 2001

• Privatisation costs during 1996-2004: ≈ 10% of GDP




-600

-400

-200

0

200

400

600

800

1 000

1 200

1 400

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 05H1

in 1

000

CZK

0

5

10

15

20

25

30

in %


Economic

recession

Privati-

sation

The clean-up of banks and their privatisation launched the banking sector on the path to success

Source: CNB

Profitabilityplummeted

Clean-up of CS and KB



Consequences of the twin crisis Consequences of the twin crisis and costsand costs


Macroeconomic consequencesMacroeconomic consequences

• Exchange rate depreciation + increased ER volatility• High inflation expectations → increased inflation + increased

volatility of inflation • Fuzzy monetary framework (discretionary decision-making) in 97• Political crisis (fall of government in November 1997) • Increasing problems in enterprise sector (low or negative

profitability, inter-enterprise arrears, lower budget revenue)• Macroeconomic restriction (possibly too strong and too long)

negative growth in 1997 and 1998 (not seen elsewhere) and emergence of output gap (trend rise in unemployment)

The economy slipped into recession with many negative implications for the banking sector

Consequences & costs


GDP in the Czech RepublicGDP in the Czech Republic

The economy plunged into recession during 1997-98 …

2,2

6,9

4

-0,7 -0,8

1,3

3,6

2,51,9

3,64,2

6,16,6

-2

-1

0

1

2

3

4

5

6

7

8

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006H1

y-on

-y c

hang

e in

%



Output gapOutput gap

-5

-4

-3

-2

-1

0

1

2

3

1996

Q119

96Q3

1997

Q119

97Q3

1998

Q119

98Q3

1999

Q119

99Q3

2000

Q120

00Q3

2001

Q120

01Q3

2002

Q120

02Q3

2003

Q120

03Q3

2004

Q120

04Q3

2005

Q1A

s %

of G

DP

… and the cost of stabilisation was far from negligible



FollowFollow--up adjustments and policiesup adjustments and policies

• Substantial reduction of external imbalance in 1998 and 1999

• Establishment of consistent monetary framework (inflation targeting + managed float) since 1998

• Macroeconomic stabilisation • Accelerated microeconomic restructuring

(stronger competition, institutional and legal progress, etc.)• Privatisation + clean-up Banking sector restructuring• acceleration of growth of potential output

The economy embarked on a sustainable growth path



External imbalance External imbalance

The trade deficit was close to 2% of GDP in 1998 and the current account deficit about 3% of GDP in 1999

-10

-8

-6

-4

-2

0

2

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

as %

of G

DP

Trade balance/GDPCurrent account balance/GDP



Potential output in the Czech Rep.Potential output in the Czech Rep.

0

1

2

3

4

5

6

96/I III 97/I III 98/I III 99/I III 00/I III 01/I III 02/I III 03/I III 04/I III 05/I III 06/I

y-o-

y ch

ange

in %

Production function (CNB)

Kalman filter

Production function (MF)

Growth of potential output was slow during 1996-1999 but accelerated after 2000



Banking sector restructuring costs: Banking sector restructuring costs: volume volume (as % of 1995 GDP)(as % of 1995 GDP)

9,7

2,2

-0,4 -0,4

0,2

1,4

4,2

1,5 1,6

0,9

2,8

1,6

-1,0

-2

0

2

4

6

8

10

12

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

as %

of G

DP

(cur

rent

pric

es)

Total accumulated restructuring costs were substantial: 24% of GDP

Source: Ministry of Finance, CNB



Restructuring costs: structureRestructuring costs: structure

-4 0

-2 0

0

2 0

4 0

6 0

8 0

100

1 992 1 993 1 994 19 95 1996 19 97 1 998 1 999 200 0 2001 20 02 20 03 2 004

in b

n C

ZK

C onso lida tion and s tab ilisa tion o f banksP re-priva tisa tion ass is tanceR e la ted to centra lly p lanned econom y

CPE-related consolidation and stabilisation pre-privatisationSource: Ministry of Finance, CNB



The banking sector nowThe banking sector now

• Currently the banking sector in the Czech Republic is stabilised, produces healthy financial results, and has sufficient equity to cover the risks it undertakes

• 36 banks (27 foreign owned)• 4 big banks: 62% of total assets • Banks are fully integrated into the European financial system • No significant foreign exchange or country risk

Banking sector restructuring contributed significantly to the emergence of a market economy and to GDP growth



Ethical practices in bankingEthical practices in banking• As mentioned earlier – fraudulent behaviour was one of

the reasons of the bank failures during the 1990s:“Unfettered capitalism” and state ownership of major banksUnder-performing legal framework Misbehaviour was rarely penalised at the time

• Huge progress since then:Much tighter competition highly selective implications Dominant foreign (private) ownership of banks EU membership (since 2004)Enhanced incentives towards “self-regulation” of banks

The learning process: misbehaviour is more costly than obeying laws and following good practices



Ethical practices in bankingEthical practices in banking -- continuedcontinued

• Czech Banking Association: Banking Activities Standards (2005): Customer care and satisfaction is one of the major pillars of banks’business strategiesA relationship based on mutual trust and collaboration between the bank and its client is a core motive of banks’ activitiesClearly defined rules for establishing, maintaining and eventually terminating relationships … serving as a framework on which a solid, certain and mutually beneficial foundation can be built Banks are aware that clients may lack specific knowledge of banking and financial services

banks are ready to support the professional education of the public in the banking area

Banks are now customer-oriented



LessonsLessons


Lessons Lessons

• The economy paid the price for: Inconsistent policies (Impossible Trinity) Too relaxed a macroeconomic framework and external imbalanceAn unconsolidated banking sector (partly due to the heritage of central planning) The hesitation of policy-makers to act decisively in certain cases and at certain times

The problems were home-made and to a large extent avoidable!

Lessons


What would have been advisable? What would have been advisable? • Earlier exit from the exchange rate peg (to avoid the

Impossible Trinity)• Appropriately tight macroeconomic policies (to deal

with the overheating)• Substantially better banking supervision (to mitigate

banking sector under-performance)• Much earlier privatisation of big state-owned banks

(to avoid inefficiency) • More appropriate (less misleading) statistical data

The Czech twin crisis provides very useful guidance as to how some things should not be done and how costly some mistakes can be

Lessons


Thank youThank you

Miroslav SingerČeská národní banka

Na příkopě 28115 03 Praha 1

[email protected]: 2 2441 2008

Documents

Presentation by M Singer ed€¦ · • Four big state-owned banks: ownership was untransparent and diluted; state control was inefficient (“banking socialism”); profitability