Tag: Currency crisis
Political Responsibility for Economic Crises
This brief summarizes the results of research on the political costs of large-scale economic crises. In a large historic sample of countries, we study the impact of different types of crises, such as sovereign and domestic defaults, banking crises and economic recessions, on political turnover of top politicians: heads of the state and central bank governors. According to the findings, only default on domestic debt increases the probability of politicians’ turnover but not the default on external debt. As argued, this is due to the fact that the latter is not directly felt by the voters. In addition, we find that although currency crises increase chances of head of central bank turnover, it does not affect tenures of heads of state. Presumably, this is the case since currency crises are in the eyes of the public the responsibility of CB governors. These findings are relevant for both developed and transition economies, but are especially important for the latter as political turmoil and economic recessions are more prevalent in developing nations.
Overview and Key Findings
Large-scale economic crises are associated not only with the economic downturns, but also with political turnover. When the national economy is in a critical state, a default declaration often turns the economy back to growth as it is typically viewed as an act of acknowledging a problem and showing readiness for changes. However, politicians responsible for the economy and leaders of the states are often reluctant to declare default and try to postpone it, which worsens the situation. One of the reasons behind such unwillingness to act is a fear of a political turnover following the open acknowledgement of a problem.
This brief summarizes the findings Lvovskiy and Shakhnov (2018). We investigate the statistical evidence of political costs related to different types of economic crises.
We find that the effects of a crisis depend on the crisis type and on whether it was in the area of responsibility of a given politician. For example, external sovereign defaults have no effect on political turnover, which we interpret as external sovereign default having a small impact on the general public. On the contrary, domestic sovereign defaults have a large impact on the country population and often lead to the replacement of the top executive. In turn, banking crises are followed by the downfall of the government at the level of chief executive as well as the governor of the central bank.
While there is large literature on career concerns of politicians and political turnover, the majority of papers either focus on the regular changes through elections in democratic regimes (Treisman, 2015) or study a particular non-democratic country, like China (Li and Zhou, 2005). However, throughout history, crises have often happened in transition, non-democratic or not fully democratic countries. Furthermore, even in democratic countries many changes of government have been irregular. Since a delay in default declaration usually harms economies it is important to understand the mechanisms behind it in different institutional settings. Our paper contributes to this understanding by analyzing the impact of economic crises on political survival in a wide set of countries and regimes. Better understanding of the political costs that the top executives face while making such decisions is crucial for the prediction of these decisions as well as for international default negotiations and consultations.
Below we describe our finding in some more detail.
Statistical Analysis and Results
Our analysis consists of two main parts. We start with the political turnover for heads of state, who are in charge of the performance of the whole economy, which we measure by the GDP growth. Then, we look at central bank (CB) governors, who are in charge of the monetary policy, price stability, stability of the financial sector and banking supervision.
Table 1. Head of state changes
Table 1 presents the estimated linear probability regression models for the head of state turnover. As expected, elections have a strong impact on the probability of the turnover of the head of state. Further, as Column 1 in Table 1 shows default on external debt has no significant impact on the head of state tenure while default on domestic debt increases the yearly chances of being displaced by 34 %. This supports the idea that voters care more about their own savings than about the general situation with the state’s budget. When we look at the effect of past crises (the predictor variable in this case is whether a crisis took place last year), Column 2 coefficients for both external and domestic defaults appear to no longer be statistically significant. Instead, banking crises become significant. This situation could be due to the fact that one of the common consequences of domestic defaults is an ongoing distortion of savings which often leads to deposit runoffs, so the effect of the previous year’s domestic default now acts through a banking crisis.
Table 2. Central bank governor changes
Table 2 presents similar results but this time the left hand side variable is CB governor turnover. Similarly to the case with the head of state turnover, only default on domestic debt has a significant effect on the CB’s governor tenure and not the one on external debt. The main differences with Table 1 are that elections do not statistically predict turnover of CB heads while currency crises do. The former result is expected since in most countries there are no direct elections of central bank governors and central banks often have some degree of independence from the government. The latter result, that currency crises have a significant impact on CB governors’ tenures, implies that since currency control is one of the roles of a CB, its head is held accountable for currency crises and not the head of a state.
Conclusion
We examine the political cost of different types of economic crises, and find non-uniform effects of different types of crises on the political survival of various key officials. Domestic defaults, and recent banking crises are shown to be costly both for heads of states and central bank governors, while currency crises only have an impact on the political survival of the latter.
Interestingly and importantly, we find no evidence of the impact of (external) sovereign default on political turnover of the head of state or central bank governors. In other words, contrary to Yeyati and Panizza’s (2011) suggestion, it seems that there is no immediate political cost at the top associated with (external) sovereign default. One possible explanation is that the public does not punish a politician for defaults because by defaulting, the politician makes the optimal decision. In a modern world, many developing nations experience rapid growth of their sovereign debt. The presented evidence brings partial optimism that even if economic mistakes have already been made, top politicians would understand that acknowledging a problem and making steps toward its solution may not always be as costly for them as has previously been thought.
References
- Li, Hongbin; Li-An Zhou, 2005. “Political turnover and economic performance: the incentive role of personnel control in China,” Journal of Public Economics, 89 (9), 1743 – 1762.
- Lvovskiy, Lev; Shakhnov, Kirill, “Political Responsibility for Different Crises”, BEROC working paper #50, 2018
- Treisman, Daniel “Income, Democracy, and Leader Turnover”, American Journal of Political Science, 2015, 59 (4), 927–942.
- Yeyati, Eduardo Levy and Ugo Panizza, “The elusive costs of sovereign defaults,” Journal of Development Economics, January 2011, 94 (1), 95–105.
The Anatomy of Recession in Belarus
After impressive growth in the 2000s, Belarus’ economy has since the currency crisis of 2011 stalled. Structural issues – dominance of the state sector and directed lending practices – have made growth anemic. Recession for Belarus’ main trading partner and the decline of oil prices has aggravated the long-run problems. We perform growth diagnostics to separate the effects of total factor productivity (TFP) growth from capital accumulation over the recession. We show that, as in the 2000s, capital accumulation had the largest positive effect on growth in Belarus, but TFP gains were very low, or even negative in the years of recession.
During the 2000s, Belarus experienced extraordinarily high growth rates, despite a lack of economic reforms and low performance in the EBRD transition indicators. In Kruk and Bornukova (2014) we show that the growth was extensive in its nature, and mainly driven by capital accumulation. The total factor productivity (TFP) contribution to growth was low. After the currency crisis of 2011 in Belarus, however, growth rates have stagnated. Despite a high investment rate (which declined dramatically only after 2015) the growth rates were below 2 per cent per annum, which is a non-satisfactory performance for a developing economy (see Figure 1). In 2015, Belarus entered its first recession in the last 20 years with GDP declining by 3.9 per cent, and the recession has continued in 2016.
Figure 1. GDP Growth Rates and Investment Rates in Belarus (%), 2005-2015.
Source: Belstat
In the 2000s, the Belarusian government relied on directed-lending programs, and subsidized the interest rates for state-owned enterprises’ (SOE) loans. After the currency crisis of 2011, which many blamed on the loose monetary policies connected to directed-lending programs, the government switched to a so-called modernization policy that underlined the need to invest in new equipment and introduce new technologies. So far this policy have not bear fruits in terms of economic growth, but did it increase efficiency?
Growth Decomposition 2011-2015
Using the standard capital services approach modified for the Belarusian data in Kruk and Bornukova (2014), we decompose Belarusian economic growth in 2011-2015 into the growth of factors (capital and labor) and growth of TFP. We find that the lack of growth in TFP explains the lack of GDP growth and GDP decline over these years.
Figure 2. Gross Value Added Growth Decomposition in Belarus, 2006-2015.
Source: Author’s calculations based on Belstat data. Note: K stands for capital, L for labor, TFP for total factor productivity, and CU for capacity utilization.
A noteworthy fact about the Belarusian growth decomposition is that the direction of growth rate of capital and TFP has been persistently opposite in 2012-2015. Presumably, accelerated capital accumulation vs. stagnating/lowering TFP could be explained by initially insufficient levels of it (i.e. less than steady state). However, this explanation seems to be improper for the Belarusian path. According to our assessments, a capital stock has passed its steady state level at the turn of 2013-2014. Despite this, capital kept growing rapidly, while productivity contracted. An alternative explanation – a growth of the capital stock was secured by specific directed instruments; this artificial capital accumulation caused an endogenous contraction of TFP, as confirmed by the data.
Indeed, a TFP decline could accompany capital accumulation due to expanding allocation and technical inefficiencies. This explains the meltdown of economic growth in Belarus by 2013-2014 and its transition to the negative spectrum later on. In late 2014-2015, this was supplemented by exogenous negative shocks affecting TFP – deteriorating terms of trade and a shrinking energy subsidy from Russia – which caused a rapid dip into recession, which should be classified as structural adjustment.
In 2015-2016, lack of TFP growth and excessive capital accumulation caused further adjustments: firms reduced capital investments radically and contracted capacity utilization. These mechanisms amplified structural recession by a cyclical component.
Sectoral dimension: manufacturing
Out of all the manufacturing industries, only one – manufacturing of electrical, electronic and optical equipment – had positive TFP growth in 2011-2015. On average, manufacturing has lost 4.1% of TFP over this period, with the highest TFP losses in the industries that have always been hallmark for Belarus: manufacturing of machinery (-7.6%) and transport equipment and vehicles (-8.8%). The wood-processing industry has notoriously obtained huge financial aid during the modernization campaign (over 1 billion USD – but Belta (2015) lost 5.6% of TFP over 2011-2015.
We also find that the capital market continues to be distorted by the government interventions, leading to inefficient allocations in the sense that investment is not going to the most efficient industries. On the contrary, there is a negative relationship between the capital growth rate and the TFP growth rate in manufacturing industries. The labor market, which faces less government intervention, functions more efficiently. Labor growth is higher in the industries with higher initial labor productivity.
International comparisons
While comparing the TFPs of Belarusian industries to each other makes little sense (like comparing apples and oranges), comparing them to the TFPs of corresponding industries in other countries might shed some light on the comparative efficiency and competitiveness of the Belarusian economy. Table 1 lists the industries and sectors of the Belarusian economy that are the most and least competitive in a relative TFP sense.
Table 1. TFP winners and losers in Belarus
| 2014 TFP relative to | ||
| Czech Republic | Sweden | |
| Winners | ||
| Petroleum products | 1.98 | – |
| Transport services/communications | 1.67 | 0.70 |
| Trade and repair | 1.37 | 1.77 |
| Financial activities | 1.33 | – |
| Chemicals manufacturing | 1.17 | – |
| Losers | ||
| Transport vehicles | 0.72 | – |
| Machinery and equipment | 0.70 | 0.34 |
| Textiles | 0.68 | 0.26 |
| Woodworking | 0.56 | – |
| Electricity, gas and water | 0.41 | 0.22 |
| Agriculture | 0.40 | – |
Source: Author’s calculations.
The majority of the industries in the “winners” category are non-tradable (services like communications, finance, trade and repair). Coincidentally, trade, transport and finance also have relatively high shares of private ownership. Another group of winners are rent industries (petroleum benefitting from cheap Russian oil; and chemical industry built on potassium salts extraction).
As for the most of the manufacturing industries, where the government dominates, and where extensive financing was available at subsidized rates, TFP levels are relatively low. While the TFP performance of the manufacturing of transport vehicles, machinery and other equipment was also reported as low in 2010 (Kruk and Bornukova, 2014), the woodworking industry reached high levels of inefficiency after 2010, when the “modernization” program of this industry received a huge influx of capital.
The relative levels of TFP are good predictors of the future exports performance: higher-TFP industries are more competitive in the international markets. The current low relative TFP of the manufacturing sectors suggests that manufacturing exports will not recover in the coming years.
Conclusion
As in the 2000s, Belarus relies on capital accumulation to generate economic growth. In recent years, however, more investments have not generated growth and rather led to losses in TFP, aggravated by external factors. The current recession in Belarus is mainly a structural adjustment, driven by distortive policies of capital accumulation and allocation; and only partially driven by external shocks.
Lack of TFP growth leads to loss of international competitiveness, causing a collapse of exports. Deep structural reforms are necessary to revive growth and recuperate the lost export potential.
References
- Belta (2015) http://eng.belta.by/president/view/bellesbumprom-group-to-increase-exports-to-1.4-1.5bn-by-late-2017-2860-2014/
- Kruk, Dzmitry; and Kateryna Bornukova, 2014. “Belarusian Economic Growth Decomposition”, BEROC working paper series, WP no. 24
Liquidity and Monetary Policy in Belarus
High inflation and devaluation expectations after the 2011 currency crisis force Belarusian monetary authorities to seek non-conventional policy measures. Instead of using the refinancing rate as an instrument on the money and credit markets, the National Bank of Belarus resorts to liquidity squeezes, which drive up the rouble interbank rates. The banks have to raise deposit and loan rates in response. As a result, households continue to keep savings in the national currency deposits, while firms struggle to keep up with the payments. This situation, however, will have to end soon.
Belarusian economy is characterized by state ownership domination and various (including political) constraints. This often makes it tempting for the Belarusian authorities to resort to untraditional policy measures, or use the conventional policies in unexpected ways. A good example is Belarusian monetary policy in 2012-2013. In 2011 Belarus experienced a severe currency crisis: the exchange rate of the Belarusian rouble (BYR) crumbled from 3011 BYR per USD in January 2011 to 8470 BYR in December 2011. Prices followed the currency and doubled: in 2011 the inflation rate was 108%. Due to high government influence on the labor market and competition from the Russian labor market, real incomes quickly recuperated (Bornukova, 2012). But the owners of the deposits in Belarusian roubles took a hit – their savings lost almost a half of real value. More and more people converted their deposits into USD or other foreign currency. Inflation and devaluation expectations were soaring (Kruk, 2012).
The National Bank of Belarus clearly realized that the proper response would be to increase the interest rates: this policy measure would partially compensate the losses of rouble deposit holders, make rouble deposits attractive again and curb the growth in lending, one of the major causes of the currency crisis.
However, there is a catch. Formally, the main monetary instrument of the National bank is the refinancing rate. Yet, despite the name, this is not the rate at which the National bank is refinancing the commercial banks. Officially, it is only a “basis for setting interest rates on the operations involving liquidity provision to banks”. The problem is that most of the floating rates, especially those on concessional loans, have the refinancing rate as its basis rate. Very high refinancing rate would hurt debt-financed organizations, in particular in agriculture and construction. And the National bank found a compromise: the refinancing rate would remain relatively low; but the National bank would regulate the money market through liquidity squeezes: it would offer liquidity to the commercial banks only at a much higher collateral loan and overnight rates. The lack of liquidity due to a squeeze would drive up the interest rates on the interbank market.
Figure 1: Main interest rates in Belarus in 2012-2014
Source: The National Bank of the Republic of Belarus.
Figure 1 shows the main interest rates in Belarus in 2012-2014. The refinancing rate was steadily decreasing throughout the whole period. The overnight rate (which moves together with the collateral loan rate), also set by the National bank, for some period was almost two times higher than the refinancing rate, reaching 70 percent at its peak. The overnight rates mostly exceeded the rate set in the interbank market. The interbank rate reflects the market price of liquidity. The National bank influences this rate by offering (or not) liquidity to the state-owned commercial banks.
The National bank has successfully used liquidity squeezes as an instrument of stabilization on the currency market. As Figure 2 shows, the two major spikes in the interbank rate coincided with the higher rates of currency devaluation. The first major devaluation episode began in the autumn of 2012. At that time the market reacted to the increased lending and the news about the ban on the exports of “solvents”, which meant Belarus would have to pay back to Russia the customs duties on oil. On the other hand, the periods of high liquidity and low interbank rates were usually followed by devaluation episodes.
Figure 2: Changes in the exchange rate and the interbank rate, 2012-2014
Source: The National Bank of the Republic of Belarus.
In the summer 2013 devaluation speeded up once again, fueled by the potassium scandal. The National bank responded with lower liquidity and higher rates, which reached peak values of 50% and higher in September 2013.
Of course, this policy had other effects besides calming the currency market. As Figure 3 demonstrates, deposit and credit rates mainly reacted to the changes in the interbank rate, with peaks in the autumn of 2012 and summer-autumn of 2013. Enormously high deposit rates (often higher than 40 percent) delivered a hefty real rate of return given inflation of 22 percent in 2012 and 16 percent in 2013. Rouble deposits were growing throughout the period. But someone had to pay those rates.
Figure 3. Short-run deposit and loan rates for firms and individuals
Source: The National Bank of the Republic of Belarus.
High real rates became a burden for firms and households. The commercial banks had to stop many of their long-term individual lending programs (mainly those financing housing purchases). Instead, the banks put their efforts into the development and promotion of short-term consumer credit, which was virtually non-existent just a couple of years before. Many firms switched to cheaper loans in U.S. dollar, but the National bank quickly shut down these practices by introducing restrictions on foreign currency loans. Credit growth slowed down, and did not decline only due to the government-sponsored lending programs and a boom in consumer credit.
High loan rates together with the growing wages and low sales suffocated the firms. Average profitability across the country is declining since summer 2012, reaching the record low profit margin and negative aggregate net profits in December 2013 (see Figure 4). The lack of liquidity lead to the crisis of payments: accounts receivable and accounts payable on the 1st of February 2014 were 24.7 and 31.6 percent higher than a year before.
Figure 4. Average profit margin in Belarus, 2012-2014
Source: The National Statistical Committee of the Republic of Belarus
Today Belarus experiences high pressure for devaluation. The international currency reserves are depleted; the current account balance is in the red for a long time. The exporting enterprises quickly lose competitiveness due to low productivity. For the first time since 2009 GDP growth is virtually non-existent (and even negative in the first months of 2014). Some of the main trading partners – Russia, Ukraine and Kazakhstan – have already devaluated their currencies and face uncertain prospects for growth. It looks like the successful practice of fighting devaluation with liquidity squeezes at the cost of the real economy will have to end soon.
References
- Kateryna Bornukova, 2012. “Devaluation of 2011 and real incomes in Belarus (in Russian),” BEROC Policy Paper Series 9, Belarusian Economic Research and Outreach Center (BEROC).
- Dzmitry Kruk, 2012. “Inflation Expectations and Probable Trap for Macro Stabilization”, FREE policy brief, http://freepolicybriefs.org/2012/02/27/inflation-expectations-and-probable-trap-for-macro-stabilization/
- National Bank of the republic of Belarus, Statistics. http://nbrb.by/engl/
- The National Statistical Committee of the Republic of Belarus. http://belstat.gov.by/homep/en/main.html
Directed Lending: Is It An Efficient Tool to Modernize the Economy?
Over the last couple of years, the growth rate of potential Belarus’ GDP declined. The government intends to revive economic growth by the policy of ‘modernization’, in practice pinned down to a drastic increase in the volume of capital investment, including by the means of directed lending. As the pre-crisis macroeconomic imbalances are at least partially cured, the government seems to be eager to apply a familiar policy tool. However, the empirical analysis of the effects of directed lending on total factor productivity and economic growth casts serious doubts on the efficiency of this policy tool.
Over the last couple of years, the growth rate of potential Belarus’ GDP declined. This conclusion is robust as suggested by the application of competing methodologies to assess potential GDP. For instance, the statistical filters, including the HP-filter, the Kalman filter, and the production function approach, produce different levels of potential growth, but generate similar growth rate dynamics, particularly the downward trend. From this perspective, the tendency for high and sustainable GDP growth in Belarus is increasingly compromised.
Economic authorities seem to be aware of that fact. For instance, the Ministry of Economy stresses the need to create a new, ‘highly productive’ sector in the national economy as the new engine of growth. An ambitious plan involves expanding the size of this sector to contribute to about half of the GDP growth rate, aimed at 12 per cent per annum by 2015. The creation of this ‘highly productive sector’ falls into recent policy initiative, called ‘modernization’. Under this banner, the government plans to renovate the capital stocks (primarily machinery, equipment, and transport vehicles) of a large number of state-owned enterprises. In a nutshell, this strategy may be seen as a way to facilitate technical progress embodied in capital.
What is necessary, according to the government, is to make a spurt in capital investments, often on a case-by-case basis. The government has a pool of enterprises to be modernized. The majority of them are unable to modernize themselves – i.e. radically increase capital investments – due to the lack of internal funds and poor access to external finance. Accordingly, directed lending is considered to be a useful policy instrument of modernization. In 2013, the Development Bank plans to considerably increase its credit portfolio (by about USD 0.5 billion) by financing projects at subsidized interest rates under the ‘modernization’ program. Recently, the government compiled a list of 67 agricultural enterprises liable to have an access to cheap loans for modernization purposes from the Development Bank. In addition, state-owned banks will continue the provision of policy loans that can be considered as directed ones.
With directed loans, we mean those loans that are typically granted to selected borrowers at interest rates lower than the market interest rates. In Belarus, directed lending has been an important policy tool over the last decade. Selective credit programs have been applied to prevent underinvestment and to stimulate output growth.
According to the estimations of Fitch Ratings (2010), almost a half of the outstanding loans in the Belarusian economy by the end of 2009, were directed ones. The IMF provided a slightly smaller, but still substantial figure of 46.2 percent (IMF, 2010). According to our own calculations, by 2011, the volume of directed loans amounted to about 40 percent of the total volume of outstanding loans. These loans have been made abundant in agriculture and housing construction sectors and, to a lesser extent, in manufacturing. This massive presence of selective credit in the national economy can be seen as a large factor contributing to the currency crisis of March 2011.
Accordingly, after the crisis, and following the necessity to ‘clear up’ the assets of the national banking system, the share of directed lending was reduced. We estimate that in 2012, the ratio of directed loans in total loans dropped to roughly 30 percent. However, the recent rhetoric of the development of ‘highly productive’ sectors and modernization is indicative of the intention to find new life for this old cloth. Directed lending is expected to revitalize enfeebling growth. In 2012, real GDP growth amounted to 1.5 percent against the background of the initial government plan of 8.5 percent.
Under selective credit programs, banks have been partially deprived of their autonomy to make decisions over the provision of credit. Thus, banks’ intermediation role has been circumscribed by the authorities. In theory, directed loans may spur capital accumulation as beneficiaries of these loans have access to cheap loans and thus invest and – arguably – produce more. In Belarus, there has also been an additional incentive, i.e. the necessity to substitute depreciating and outdated capital stock, inherited from the Soviet past. At the same time, political interference into the process of credit provision suggests that loans may be allocated to lower-yielding projects, and thus dampen growth rates of factor productivity and GDP (Fry, 1995). In addition, non-favored companies – typically from the private sector – face higher interest rates as their state-owned counterparts receive substantial discounts for their use of capital.
So far, these soft budget constraints in the financial system have allowed favored companies to receive loans up to three times cheaper, if judged by the level of real effective interest rates. Although private companies tend to be more efficient than state-owned enterprises in terms of factor returns and profitability, higher interest rates may reduce the volume of outstanding market loans. Furthermore, increases in the volume of cheap residential loans, which do not contribute directly to enhancement of productive capacity of the economy, may dampen the returns on investment further.
Governments have traditionally relied on selective credit programs by stressing positive externalities and spillovers for the economy as a whole (DeLong and Summers, 1991). Commercial banks care about private returns, while governments seek to maximize social returns by financing firms, which are capable of generating positive externalities. Unfettered operations of credit allocation mechanisms minimize allocation inefficiency and induce banks to minimize the costs of financial intermediation, thereby making credit more accessible.
How do these competing forces meet in Belarus and what are the effects of their joint working? In answering those questions, we have conducted an empirical analysis of the effects of directed lending on total factor productivity dynamics. The latter is considered to be a good proxy to observe the impact of selective credit programs on the efficiency of actor use.
The results of our econometric analysis show that over the period concerned, 2000–2012, the expansion of directed lending in Belarus has negatively affected total factor productivity dynamics and, subsequently, negatively contributed to the rates of GDP growth. A positive impact on growth, stemming from additional capital accumulation might nevertheless occur, but with a substantial lag. This likely positive impact is associated with the ability of banks to increase the volume of market loans alongside with the rising volume of directed loans. The option has been made possible only due to massive liquidity injections by the government and mainly the National Bank of Belarus. However, such injections are problematic to maintain over the medium to the long run as they have severe inflationary repercussions for the economy.
The effects of individual components of directed lending are mainly the same. In particular, loans for residential construction, provided to households in need, negatively affect total factor productivity. Moreover, it is through housing loans the adverse effects of directed lending upon factor productivity are mainly realized. The interest rate spread – between preferential interest rate and market interest rate – amplifies these negative relationships. Lower preferential rates result in larger losses in total factor productivity. Loans to agricultural firms have similar impact, although it has to be emphasized that the overall impact on total factor productivity approaches zero (not negative, as in the case of housing loans).
We also find that for Belarus, an increase in the total volume of directed loans leads to an increase in the volume of market loans. Both the National Bank and, to a lesser extent, the government, strive to minimize risks in the national banking system, which provide loans with smaller returns and/or non-performing policy loans. Similar challenges have been observed in China, where the Central Bank has been forced to recapitalize domestic banks to support economic growth after the global financial crisis of 2008. In 2007–2008, Chinese growth of 8–10 percent was driven by new lending averaging 30–40 percent of GDP, of which up to a quarter of the loans might have been non-performing, amounting to losses of 6–10 percent of GDP (Das, 2012).
In Belarus, the recapitalization policy, apart from its inflationary consequences, has other important effects. In particular, it prevents a dangerous trade-off between directed loans and market loans to resurface, whereby the former crowds out the latter as banks are unable to expand their portfolios due to the liquidity constraints.
Therefore, unless the expansion of directed loans would be checked, adverse effects of selective credit programs on productivity and growth would not evaporate, with negative consequences for the whole economy. Regarding policy recommendations, we claim that there is a need to fundamentally revise directed lending policies or to even minimize it to the extremes by allowing standard market mechanism for credit allocation to prevail in the national economy. Furthermore, we argue that directed lending, even after some cosmetic changes in the system design made in 2012, is not an efficient tool for economic growth promotion.
Tentative results of growth accounting made at the level of selected important industries suggest that the downward growth dynamics is associated with weak total factor productivity growth, i.e. disembodied technical progress. Improvement of total factor productivity seems to have the biggest potential for revival of economic growth. Therefore, the use of directed lending, as a policy instrument that hampers total factor productivity dynamics, may undermine prospects for long-term economic growth in Belarus.
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References
- Das, S. (2012). “All Feasts Must Come to an End– China’s Economic Outlook”, Euro Intelligence, 11 March, viewed 12 April 2012.
- DeLong, J.B. and L.H. Summers, (1991). “Equipment Investment and Economic Growth”, Quarterly Journal of Economics 106, 2, pp. 445–502.
- Fitch Ratings, (2010). “Directed Lending: On the Up or on the Way Out?”, Belarusian Banking Sector, May.
- Fry, M.J. (1995). Money, Interest, and Banking in Economic Development (John Hopkins University Press, Baltimore and London).
- IMF (2010), “Republic of Belarus: Fourth Review under the Stand-By Arrangement”, IMF Country Report 10/89, viewed 15 July 2012.
Monetary Policy in Belarus since the Currency Crisis 2011
In the second half of 2010, the National Bank of Belarus carried out a soft monetary policy to stimulate domestic demand. Until March 2011, the country experienced strong economic growth. There was an increase in real incomes with a parallel increase in the negative trade balance and the reduction of international reserves. Stimulating policy became one of the reasons for the formation of a multiplicity of exchange rates on the foreign exchange market. Beginning of March and until the end of October 2011, there was an official and gray currency market in the country. High domestic demand and rapid devaluation processes led to the deployment of an inflationary spiral, which in turn meant a decrease in the growth of real incomes.
Inflation Expectations and Probable Trap for Macro Stabilization
As of today, a majority of the negative consequences of the deep Belarusian currency crisis of 2011 seem to have been realized. Hence, the Belarusian economy is now ‘purified’ from main macroeconomic distortions and has a chance for sustainable long-term growth. Nevertheless, there are signals that some nominal and real inertia may generate new shocks for the national economy. From this view, the money market is of great concern, while interest rates signal maintained high inflation expectations. High and unstable expectations may entrap monetary policy and generate new shocks for the Belarusian economy. In this policy brief, we deal with a visualization of inflation expectations and argue for the necessity of a new nominal anchor in order to stabilize expectations for future periods.
In 2011, Belarus experienced its highest inflation and devaluation in modern history. These were consequences of the automatic macroeconomic adjustment determined by a number of both long- and short-term distortions in the national economy. Changes in prices and exchange rate adjusted real parameters towards their long-run equilibrium level. Hence, from a long-run perspective, one may interpret these adjustments as favorable since they ‘purified’ the economy from the macroeconomic imbalances that may have hampered growth. Furthermore, shifting from exchange-rate (XR) targeting to a managed float is another essential aftermath of the currency crisis. Economic authorities had to recognize that accommodative monetary policy (MP) was not compassable with XR targeting since it resulted in a considerable overvaluation of the real XR, and correspondingly, an incredibly large current account deficit. Thus, the new exchange rate regime may be argued to be a new automatic stabilizer for Belarus, providing the level of current account balance consistent with other macroeconomic fundamentals. Overall, the current stance of the national economy might be treated as a chance to “begin again from the ground up”. In this sense, the Belarusian economy as of today is sometimes compared to the Russian economy after its crisis in 1998, which then performed particularly high growth rates.
In our opinion, realizing the opportunity for a strengthening of long-term growth through structural changes undoubtedly should become a policy priority of Belarus in the near future. However, it should be emphasized that despite “purification” from major macroeconomic imbalances, there are still a long list of short-term challenges. In particular, one may stress the risks of expansionary policy revival; increasing external debt burden; growth in non-performing loans, which may undermine the solvency of the banking system; reduction of foreign demand due to shocks in global economy. These risks are more or less observable and may be monitored. Hence, the realization of one or the other shocks from this list might not come as a surprise, and economic authorities seem to at least realize this, and when possible, take prevention measures.
At the same time, another challenge seems to be more adverse and urgent; namely, the question of inflation and devaluation expectations. In economic theory, expectations play a crucial role in affecting behavior of economic agents. Recognition of the role of expectations at the money market determined intention to “subject” and stabilize these within modern monetary policy frameworks.
In Belarus, given the recent history of high inflation and devaluation, corresponding expectations of Belarusian economic agents are likely to be rather high. Moreover, shifting from XR targeting to a managed float has not yet resulted in provision of a new nominal anchor for the public.
For instance, disinflation was declared to be a priority goal, but there are no strict commitments on its numerical value, as well as in respect to procedures and mechanisms to provide disinflation trends. As of today, the Belarusian MP regime can hardly be classified as a standard regime. The MP Guidelines for 2012 assume indicative targets on international reserves, refinancing rate and the growth rate of banks’ claims on the economy. The latter witnesses the propensity to monetary targeting. However, the instable relationship between the monetary aggregate to be targeted and the ultimate goal (inflation), as well as the indicative nature of this commitment give rise to doubts in respect to treating it as monetary targeting. Furthermore, commitment on bank claims on the economy can hardly be treated as a nominal anchor for the public. According to the taxonomy of MP regimes by Stone (2004), Belarus is currently closer to the weak anchor regime, which assumes “no operative nominal anchor…and central bank reports a low degree of commitment… and high degree of discretion”.
Thus, our hypothesis assumes that there has been an adverse shock in inflation expectations due to weak nominal anchor and recent experience of huge inflation. If that is the case, this may be an additional source of shock for the money market, which may cause a new wave of macroeconomic instability. In order to make policy recommendations, this hypothesis needs empirical support. However, it is difficult to identify expectations in empirical analyses since this variable is typically unobservable and cannot be univocally measured. Instead, expectations are most often treated indirectly through other variables. Many central banks deal with the results of sociological polls on this issue, but these approaches may suffer from different economic meanings and measurements of inflation expectations by economic agents.
An alternative approach was proposed by St-Amant (1996) and extended by Gotschalk (2001), who base on famous Fischer equation representing current nominal interest rate as the sum of ex-ante real interest rate and expected inflation. Further, based on the approach by Blanchard and Quah (1989), structural vector autoregression (SVAR) between nominal and real interest rate is identified with a number of restrictions, which allows decomposing changes in the nominal rate to those associated with ex ante real rate and inflation expectations. The latter may be used as a measure of inflation expectations. Such a measure of inflation expectations assumes explicit economic meaning referring to the money market, i.e. the rate of future inflation, which will provide the, by economic agents, expected level of interest rate. Taking the data from statistics (not polls) and international comparability of such estimates are important advantages of this approach.
We applied this methodology to Belarusian data (nominal and real interest rate on ruble households’ deposits with a term more than a year). The obtained time series measure changes in inflation expectations in the current period for a period of the next 12 months. However, our goal is to visualize the level of inflation expectation and not changes in expectation. Therefore, we use the series in levels, choosing January 2003 as the base period (when National Bank of Belarus actually shifted to XR targeting regime), and assigned a zero level (as starting one) to it. The obtained series of inflation expectations is provided in Figure 1.
Figure 1. Inflation Expectations in Belarus
The estimated series of inflation expectations show a decrease in 2003 – mid 2005, which may be explained by the effectiveness of the new nominal anchor (XR), and correspondingly the expected disinflation. The expectation of reflation in late 2005 till late 2007 may be explained by the more expansionary policy and changes in Russian preferences that took place during this period. After that, there was a period of stable expectation, which is likely to be explained by the credibility of the nominal anchor (nevertheless, there was a shock in late 2008 that is associated with the impact of the global crisis).
The most considerable shock took place in the beginning of 2010, which has a lack of intuitive explanation and might be associated with a phase of radically expansionary policy.
Finally, a new significant shock took place in late 2010 – beginning 2011 which might be associated with the visualized problems at the currency market at that time.
Currently, there is a very high level of inflation expectations and its increased volatility in the second half of 2011 seem to be of a great importance. It signals that economic agents do not treat price shocks as a single-shot, but mostly tend to consider it as a long-lasting process. Hence, the absence of a nominal anchor and the fresh memory of huge inflation seem to be responsible for the current high and instable inflation expectations.
Maintenance of high inflation expectations is a dangerous threat for the money market. Propagating inflation through expectations may be considered as a separate channel within the monetary transmission mechanism (along with interest rate, exchange rate and bank-lending channels). In other words, even without additional fundamental preconditions for inflation, inflation expectations may become a self-fulfilling prophecy.
However, during the last two months (December 2011 and January 2012) this adverse effect seems to have been suppressed by monetary authorities, as the monthly inflation rate reduced radically in comparison to average rate in May-November 2011. This is likely to be the outcome of the significant monetary policy tightening that has resulted in a sharp increase in nominal interest rates by banks. On the one hand, such nominal interest rate complies with the shocks in inflation expectations and real ex ante interest rate (the latter grew as well at the background of the crisis). In other words, current level of nominal interest rates will equalize ex post real rate with ex ante real rate if the actual inflation rate has been as high as current inflation expectations. But on the other hand, if actual inflation had been much lower than expected one (and it tends to be so, in case of keeping on conservative MP), ex post real rate would be much higher than the ex-ante one. For instance, such a situation has already been peculiar during December and January: according to our estimations, ex ante real interest rate in December was about 3.6% in annual terms (preliminary data on January shows that it in this month it is rather similar), but annualized ex post real rate for these months is about 30%.
This suggests that there is a trap for the monetary authorities. If they keep high interest rates, based on the expected inflation, the impact of expectations on actual inflation will be mitigated, but the losses, say in terms of output, will be high because of the extremely high ex post real interest rates. If the monetary authorities facilitated the rapid reduction of nominal interest rates, current nominal rates would not guarantee ex ante real interest taking into consideration the high inflation expectations, which would then constitute a severe shock for the money market. Hence, the mechanism of self-fulfilling prophecy would work.
Furthermore, the increased ex ante real rate (and high probability of even higher ex post real rate in national currency) could give speculative incentives for a number of economic agents. For example, many agents could increase the share of national currency in their savings portfolio, either avoiding buying hard currency (which took place during the peak of the currency crisis) for new deposits, or changing the nomination of their deposits to the national currency (i.e. selling the hard one). In a sense, this trend may be interpreted as the compensation of losses on ruble deposits in the last year, which is needed to revive the demand for such deposits. But in any case, these internal processes (along with restricting money supply by the National bank) influence the domestic currency market. Through this, the supply and demand are formed not only due to current and financial international flows. Hence, due to these incentives for hard currency supply and demand, the current value of the nominal rate may substantially deviate from the equilibrium rate. The latter may be defined as in Kruk (2011): the one that may clear the market immediately (given short-term trends in current account flows at the background of medium-term values of other fundamentals).
Figure 2. Actual and Equilibrium Exchange Rate
Note: For 2010Q1-2011Q1 official rate of the National bank is taken as actual nominal rate, for 2011Q2 the exchange rate at the ‘black market’ (used by internet shops), and for 2011Q3 ‘black market’ and later the exchange rate of the additional BCSE session are taken.
The assessments of the equilibrium exchange rate based on this methodology (Kruk (2011)) show that in the third quarter, the actual rate almost equals the equilibrium rate. For 2011Q4, all necessary data is not available yet, but an approximate assessment correction of the equilibrium rate of the Q3 for average inflation between Q3 and Q4 may be used (i.e. in real terms the rate should not have changed in order to sustain equilibrium). Such an assessment indicates that the actual rate in the Q4 is again overestimated by roughly 5-10% in comparison to the equilibrium rate.
At a first look, such an ‘overhang’ at the domestic currency market seems to not be a great problem. But along with the trap stemmed from the high and unstable inflation, this may contribute and propagate possible shock at the money market. Furthermore, this ‘overhang’ is due to speculative incentives, which in turn, are due to high inflation expectations. Hence, high and unstable inflation expectations are a prime cause of this ‘overhang’.
Finally, we may argue that unfavorable inflation expectations is a multidimensional problem, which generates grounds for shocks at the money market and entraps monetary policy at the current stage. Therefore, restraining inflation expectations must currently be an absolute and unconditional priority of economic policy.
This gives rise to the issue of which policy tools that are needed for solving this problem. Tight monetary policy alone may not be enough and/or its losses in terms of output may be unacceptably high, especially taking into account that keeping the Belarusian economy depressed is likely to cause huge migration and thus reducing the prospects for long-term growth.
Our view on the problem of inflation expectations supposes that they stem both from recent experience of very high inflation and the absence of nominal anchor. Inflation memory cannot easily be removed, but introducing a new nominal anchor seems to be worthwhile. Among possible options, given the desire to preserve autonomous monetary policy in Belarus, the introduction of inflation targeting (IT) is seen as inevitable. A shift to this regime is associated with plenty of obstacles and might not be realized immediately (Kruk (2008)). A gradual shift to IT through its intermediary phases (so called IT Lite) is more expedient and complies more with the requirement of obtaining new powers and capacities at the National Bank of Belarus.
Taking on more and more strict commitments in terms of inflation and implementing mechanisms and procedures peculiar for IT (the latter is even more important than commitments themselves) will increase credibility and public trust for the National bank. The other side of the coin involves decreasing and less volatile inflation expectations, which do not challenge monetary policy and facilitate low and stable inflation. Another advantage of IT is the possibility to mitigate price shocks.
Our main policy recommendation is therefore that it is necessary to shift to an IT framework as soon as possible, starting from exploiting the forms of IT Lite. The advantages of this step overweigh all the obstacles, including those associated with the reluctance of economic authorities to change institutional preconditions.
However, one important clause should be emphasized. Shifting to IT (especially gradually through IT Lite) does not guarantee that current high inflation expectations will be reduced automatically and immediately. In other words, it does not guarantee that the cost of reducing inflation in terms of output will decrease (though for the present Belarusian situation there are grounds to suspect that it would facilitate). For instance, Mishkin (2001) shows that “there appears to have been little, if any reduction, in the output loss associated with disinflation, the sacrifice ratio, among countries adopting inflation targeting… The only way to achieve disinflation is the hard way: by inducing short-run losses in output and employment in order to achieve the longer-run economic benefits of price stability”. However, an introduction of IT assumes that new shocks in inflation expectations may be prevented, and due to it, low and stable inflation will be more likely.
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References
- Blanchard, O., Quah, D. (1989). The Dynamic Effects of Aggregate Demand and Supply Disturbances, American Economic Review, Vol. 79, No.4, pp.655-673.
- St-Amant, P. (1996). Decomposing US Nominal Interest Rate into Expected Inflation and Ex Ante Real Interest Rates Using Structural VAR Methodology, Bank of Canada, Working Paper No. 96-2.
- Gottschalk, J. (2001). Measuring Expected Inflation and the Ex Ante Real Interest Rate in the Euro Area Using Structural Vector Autoregressions, Kiek Institute of World Economics, Working Paper No.1067.
- Mishkin, F. (2001). From Monetary Targeting to Inflation Targeting: Lessons from Industrialized Countries, World Bank, Policy Research Working Paper No. 2684.
- Kruk, D. (2008). Optimal Instruments of Monetary Policy under the Regime of Inflation Targeting in Belarus, National Bank of Belarus, Materials of International Conference “Efficient Monetary Policy Options in Transition Economy”, pp. 305-322.
- Kruk, D. (2011). The Mechanism of Adjustment to Changes in Exchange Rate in Belarus and its Implications for Monetary Policy, Belarusian Economic Research and Outreach Center, Policy Paper No. 004.