After a relatively long period of macroeconomic stabilization, Belarus faces the threat of a purposeful deviation from it. However, today there is no room for a ‘growth injection’ by means of monetary policy. Moreover, Belarus still suffers from a problem of unanchored inflation expectations. This prevents monetary policy from being effective and powerful. So, unless inflation expectations have been anchored, any discussion about reshaping monetary policy and making it ‘pro-growth’ is meaningless.
Policy Mix and Macroeconomic Landscape in Belarus
Since 2015, Belarus has considerably improved the quality of its macroeconomic policies. The country has fallen back upon a floating exchange rate, and feasible monetary and fiscal rules. This change followed a long history of voluntary expansionary policy mixes associated with numerous episodes of huge inflation, currency crises, etc.
Due to the new policy mix, the country has been displaying a movement towards macro stability in recent years. For instance, the external position is close to being balanced, the fiscal position has even become positive, while the inflation rate is at historical lows around 5%. For Belarus, these achievements are important, taking in mind a ‘fresh memory’ of price and financial instability. Hence, until recently there were no doubts in the feasibility of the commitments of Belarusian authorities to sound macroeconomic policies.
However, despite a relatively strong macroeconomic performance, the threat of a purposeful and at least temporary deviation from policy commitments seems to strengthen. What is important is that this time, popular simple explanations – e.g. political voluntarism (Belarus will have presidential elections in 2020), a naïve perception of economic policy mechanisms by authorities, etc. – are not sufficient for understanding the phenomenon. Rounds of loosening economic policies tend to be justified as ‘lesser evils’. Exploring some rationality in such a justification requires more insight into the Belarusian macroeconomic landscape.
In recent years, the lack of productivity and output growth has become more evident: in 2015-2019 the average output growth rate has been around 0. The root of the problem is the deficit in productivity and growth (Kruk & Bornukova, 2014; Kruk, 2019), while the rules-based policy mix just uncovered it.
However, this direction of causation tends to be challenged by some policy-makers. In an ’archaic’ manner, the policy mix is accused of blocking any pro-output policy discretion, even if there is a justification for it. For instance, an ‘extra’ need for a ‘growth injection’ may be justified by social challenges. Poor growth in Belarus results in a rather sensitive squeezing of relative levels of well-being in comparison to neighboring countries. Between 2012 and 2019, the well-being shrank from around 78% of the average level in 11 CEE countries down to about 63%. This intensified the labour outflow significantly, including for those employed in socially important industries, say, in healthcare. So, according to this view, the ‘growth injection’ is a lesser evil rather than systemic social threat.
A more advanced ‘accusation’ of the new policy mix assumes that it either causes a too restrictive stance of monetary policy with respect to output or that it ignores complicated transmission channels. For instance, one may argue that too much emphasis on price and financial stability can actually result in undermining them, given the huge debt burden of Belarusian firms. The quality of a considerable portion of the debts in Belarus tends to be sensitive to output growth rates. Hence, according to this argumentation, the monetary policy rule should be ‘more pro-growth’, reflecting the debt-growth-financial stability linkage inside it.
‘Translating’ this policy agenda to a research agenda results in two questions. First, is there room for a more expansionary monetary policy? Second, do financial instability risks require making the monetary policy rule ‘more pro-growth’?
The Monetary Policy Stance: Causality and Causes
Monetary policy, as a rule, aims to be counter-cyclical, i.e. generate expansionary incentives during cyclical downturns, and vice versa. In this respect, its stance should be matched to the estimate of the output gap. From this view, given dominating estimates of a near-zero output gap for 2019 in Belarus (National bank, 2019; Kruk, 2019), today’s monetary policy should be roughly neutral. However, analyzing monetary policy stance together with the estimates of the output gap is not a univocal option, especially given doubts about the consistency of any estimate of the output gap (Coibion et al., 2017).
From this point of view, a direct measurement of the monetary policy stance – matching ex-post real interest rate vs. an ex-ante one – is a worthwhile alternative. If the ex-post real interest exceeds the ex-ante rate, it means that the interest rate policy by a central bank is restrictive, while an opposite situation witnesses its expansionary stance (e.g. Gottschalk, 2001). A methodology for identifying inflation expectations by Kruk (2016) allows detecting restrictive and expansionary stances as well. Moreover, doing it in this way allows simultaneously tracing the stance of actual and expected inflation, and study its possible impact on monetary policy (Figure 1).
Figure 1. Monetary Policy Stance, Actual Inflation and Inflation Expectations in Belarus
Note: Positive sign means restrictive stance of monetary policy, while negative sign means expansionary stance.
Source: Own elaboration according to methodology in Kruk (2016) and based on data from the National Bank of Belarus.
First, this diagnostic shows that the stance of the monetary policy today is roughly neutral, which conforms to the diagnosis based on matching with the output gap. In this respect, it means that there is no room for monetary policy softening today.
However, eventually the situation may change and a need for an expansionary monetary policy may indeed arise. Can the National Bank of Belarus unconditionally satisfy such demand? Second, and the more important conclusion, is that the National Bank cannot. Figure 1 also demonstrates that the monetary policy stance in Belarus is very sensitive to the stance of inflation expectations. From this view, the restrictive monetary policy, say in 2015-2016 and 2018, reflected shocks in inflation expectations. The National Bank had to take a mark-up in the expected inflation in respect to the actual one into account and to transform it to the mark-up of the interest rate. If the National Bank ignores such shocks and nevertheless softens monetary policy, it will undermine price stability due to a powerful transmission effect from expected inflation to the actual one. Moreover, a reverse linkage from actual inflation to the expected one is likely to result in a prolonged inflationary period, causing a so-called ‘abnormal’ stance of the monetary environment (Kruk, 2016).
So, a generalized policy diagnosis for today looks as follows. Monetary policy has reached a roughly neutral level due to a considerable reduction in inflation expectations. The latter, in turn, happened due to a prolonged period of a restrictive policy stance (in 2015-2016), which suppressed actual inflation by means of sacrificing output in a sense (the period of cyclical downturn could have been shorter without such limitations in monetary policy).
Unanchored Expectations Bar a More ‘Pro-Growth’ Policy
A deeper cause of the limited room for monetary policies is unanchored inflation expectations. Statistical properties of the inflation expectations series (Kruk, 2019 and 2016), as well as the polls of households and firms by the National Bank, suggest that despite the reduction of the level of inflation expectations, the issue of it being unanchored is still on the agenda. In this respect, expected inflation in Belarus tends to be sensitive to numerous kinds of actual and information shocks, e.g. domestic and global output dynamics, interest rate levels and spreads, exchange rates, financial stability issues, etc. Hence, unless expectations have been anchored, the monetary policy would still suffer from a lack of power. This means that anchoring inflation expectations is the core precondition for normalizing the monetary environment and the power of any monetary policy.
For the monetary rule, this means that it cannot become more ‘pro-growth’, keeping in mind the risks to financial stability. Otherwise, it can spur price destabilization, which may also trigger financial instability. Hence, the logic of a ‘lesser evil’ does not work. Indeed, there are risks to financial stability stemming from poor growth. But combating them through a more ‘pro-growth’ policy will cause price instability and financial instability stemming from that. But what is more important, the logic of a ‘lesser evil’ itself is doubtful with respect to monetary policy. Recognizing the linkage between monetary policy and financial stability does not mean that risks to the latter should be directly traced by the former. Financial stability issues can and should primarily be tackled through macroprudential tools.
After a relatively long period of macroeconomic stabilization, Belarus faces some risk with respect to it. However, today’s monetary policy stance is roughly neutral in Belarus. Hence, a ‘growth injection’ may result in inflation resurgence. Moreover, even today’s near-neutral monetary policy stance is a considerable achievement, as the country still experiences the challenge of unanchored inflation expectations. This issue is a deep underlying problem, which keeps the monetary policy from being more effective and powerful. So, unless inflation expectations have been anchored, any discussion about reshaping it and making it ‘pro-growth’ is meaningless.
As for today’s justifications for monetary policy softening – poor growth and financial instability risks – they hardly relate with the monetary policy agenda. The challenge of poor growth requires thinking in terms of productivity issues, while financial stability risks in terms of macroprudential tools first.
- Coibion, O., Gorodnichenko, Y, Ulate, M. (2017). The Cyclical Sensitivity in Estimates of Potential Output, National Bureau of Economic Research, Working Paper No. 23580.
- Gottschalk, J. (2001). Monetary Conditions in the Euro Area: Useful Indicators of Aggregate Demand Conditions? Kiel Institute for the World Economy Working Paper No. 1037.
- Kruk, D. (2019). Belarusian Economy in Mid-2019: the Results of the Recovery Growth Period, BEROC Policy Paper No. 69.
- Kruk, D. (2016). SVAR Approach for Extracting Inflation Expectations Given Severe Monetary Shocks: Evidence from Belarus BEROC Working Paper No. 39.
- Kruk, D., Bornukova, K. (2014). Belarusian Economic Growth Decomposition, BEROC Working Paper No. 24.
- National Bank of the Republic Belarus (2019). Information on the Dynamics of Consumer Prices and Tariffs and Factors of Changes Therein, 2019Q3.
The Belarusian economy has given birth to a very interesting phenomenon of extremely high real interest rates in a prolonged recession. Despite an expected intuitive guess about the linkage between them (high interest rates cause recession), the reality turned out to be more difficult. The era of high real interest rates was due to past mistakes in economic policy, which undermined the credibility of the latter and gave rise to high and volatile inflation expectations. However, the adverse output path following the too high interest rates was not essential. The recession was mainly predetermined by a negative Total Factor Productivity (TFP) shock. The shock itself forms a disagreeable and contradictive environment for monetary policy. Together with unanchored inflation expectations, this makes monetary policy ineffective and too risky.
Unusually high real rates and recession
Since the painful currency crisis of 2011, the Belarusian monetary environment has become extremely vulnerable in many respects. In 2011 and early 2012, the country faced (once again) a 3-digit inflation rate. While the inflation rate later went down gradually, it was not sufficient to enhance monetary stability in a broader sense. For instance, for nominal interest rates, the level of 20% per annum was an unachievable lower bound until 2016. Moreover, in 2013—2016, upside jumps in the nominal interest rates took place regularly (see Figure 1).
Figure 1.Nominal interest and inflation rates, % per annum
Such combination of nominal interest and inflation rates has resulted in an extremely high and volatile level of real interest rates throughout the last 4 years. Real returns at the Belarusian financial market fluctuated in 2013—2016 within the range of 10-30% per annum. For instance, a median (monthly) value of the real interest rate on new loans in 2013—2016 was 17.6% per annum (in the beginning of 2017 it approached the level of 8-10% per annum). So, one may say that the real monetary conditions have been extremely tight in the last couple of years.
At the same time, in 2015—2016 Belarus has dipped into a prolonged and deep recession. During the last two years, the country has lost roughly 7% of its output. The combination of high real interest rates and a recession gave rise to a naive, but acceptable diagnosis: the excessively high interest rates caused (or at least contributed to) the recession. This view became popular in the domestic policy discussions. Furthermore, often this story transformed into a claim that ‘too tight monetary policy causes (or at least contributes to) recession’. Given this pressure, the National bank of Belarus (NBB) became accustomed to justifying its policy stance by considerations of financial stability given financial fragility. So, the economic policy discussion got into the discourse of these two extremes. Finally, it boiled down to the question whether ‘the monetary environment has stabilized enough in order to soften monetary policy’.
However, a naive story about the stance of monetary policy and the business cycle is not (fully) true in the case of Belarus in several respects.
Unanchored expectations drive interest rates
First, high interest rates at the financial market were not because of the excessively high policy rate of the NBB. It happened due to volatile, but still persistently high inflation expectations (Kruk 2017, 2016a). The latter visualized the loss of monetary-policy credibility by the general public.
Before 2016, the level of inflation expectations was persistently higher than the actual inflation, demonstrating an extremely slow (if any) convergence (see Figure 2). At the same time, the ex-ante level of real returns has remained relatively stable. When setting its policy rate, the NBB has taken into consideration existing inflation expectations, otherwise the high expected inflation would have been realized.
Figure 2. Actual and expected inflation, %
So, in the recent past, the stance of the monetary policy could hardly be accused of generating too tight monetary conditions through the setting of an improper policy rate. The problem was (is) more severe, and one can argue about the inability (and the lack of willingness) of the NBB to anchor inflation expectations.
However, in the late 2016 and early 2017, the expected and actual inflation rates converged, mainly due to a contraction of the former. This introduced more stability into the monetary environment, in a broader sense. Kruk (2017, 2016a) shows that the turn of 2016—2017 has become a breakpoint for the monetary environment to return into a ‘normal’ stance (see Figure 3).
The NBB reacted to the milder monetary environment by a number of reductions in the policy rate (from 18% since August 2016 down to 14% since April 2017). However, a shift of both expected and actual inflation into the range between 5% and 9% may be interpreted as there being room for further reductions.
Figure 3. Classification of monetary environment stance in Belarus, probability estimates
Note: Classification and the methodology for estimates are based on Kruk (2016a). ‘Normal’ regime is characterized by reasonable and relatively stable real interest rates; ‘subnormal’ – too high real interest rate due to ‘inflation expectations premium’; ‘abnormal’ extremely volatile and mainly huge negative real interest rates due to the swings of actual inflation.
Therefore, as of today, one may argue that the long-expected time for a softening of the monetary policy has come, as the ‘expectations overhang’ has disappeared. However, such a view might be too optimistic. Kruk (2017) argues that the convergence of expected and actual inflation rates might be a temporary lucky combination, as there is a lack of evidence supporting a growing credibility of monetary policy among the general public. On the contrary, inflation expectations seem to have shrunk due to a depressed domestic demand and lower consumer confidence. So, even if expectations have contracted, they have not been anchored. Hence, ‘the expectations overhang’ may resurge at any time.
Monetary softening cannot neutralize structural recession
Even if we assume that the ‘expectations overhang’ has disappeared, it would still not mean that there is room for a new monetary stimuli. A naive story about high real interest rates that cause recession glitches once again when interpreting this linkage. Most frequently, countries face a cyclical recession (i.e. caused by temporary demand fluctuations). If that is the case, a negative impact of excessively high interest rates on output path is taken for granted.
However, the Belarusian story of recession is different. Kruk and Bornukova (2014) have shown that the country faced a negative TFP shock, which determined the weakening of the long-term growth rate. Kruk (2016b) shows that due to this shock, the long-term growth rate crossed the zero level approximately at the turn of 2014—2015, and dipped into a negative range later on. Hence, the Belarusian recession that started in 2015 was a combination of a negative contribution from both the long-term dynamics and the business cycle. Furthermore, since the second half of 2016, the negative contribution of the business cycle has faded out, and the recession was determined by the negative TFP shock almost solely (Kruk, 2017) so that, by 2017, the recession has become a purely structural phenomena.
From a monetary policy stance, this gives rise to a new challenge. Although the majority of methodologies still assess the output gap to be negative (but not far away from zero), the output gap will soon be closed automatically because of continuing negative TFP shocks (Kruk, 2017). In a sense, the negative TFP shock contributes to the closing of the output gap in the same way as monetary policy does. However, it does this job in an opposite manner (i.e. by squeezing the trend growth, and not by stimulating the business cycle), it leaves almost no room for monetary policy. It creates a situation where a reasonable loosening of the monetary policy may immediately turn into an excessive one. Taking into account that the dormant inflation expectations can resurge, monetary policy decisions resembles walking on the edge.
Today’s policy discussion in Belarus is extensively concentrated around the search for the best monetary policy to fight the recession. However, this formulation of the problem is a mistake in itself. Today’s contradictions in monetary policy are simply a reflection of the bulk of accumulated structural weaknesses in the economy. Today, monetary policy can hardly do anything to stabilize output. The solutions for ending the recession, and enhancing growth should be found in structural policies, not in the sphere of monetary policy. As for monetary policy, it can, at this moment, hardly contribute to output stabilization (without challenging price stability). To do so, it has to ensure an anchoring of the inflation expectations first.
- Kruk, D. (2017). Monetary Policy and Financial Stability in Belarus: Current Stance, Challenges, and Perspectives (in Russian), BEROC Policy Paper Series, PP No.43.
- Kruk, D. (2016a). SVAR Approach for Extracting Inflation Expectations Given Severe Mnonetary Shocks: Evidence from Belarus, BEROC Working Paper Series, WP No. 39
- Kruk, D. (2016b). The Reasons and Characteristics of Recessiion in Belarus: the Role of Structural Factors (in Russian), BEROC Policy Paper Series, PP No. 42.
- Kruk, D., Bornukova,K. (2014). Belarusian Economic Growth Decomposition, BEROC Working Paper Series, WP no. 24.
Central banks affect growth in part by raising or lowering the cost of investment through their influence over local interest rates. We examine whether the ability of local firms to raise money abroad reduces the influence of local monetary policy authorities. Surprisingly, it does not. In fact, we find that firms that are able to raise equity capital from foreign investors are more responsive, not less, to local monetary policy shocks than those that raise capital only in the domestic market. These findings suggest that foreign investors confer an efficiency effect, improving the sensitivity of stock prices to local monetary policy shocks.
One means by which central banks affect economic growth is by influencing interest rates that impact the cost of financing for firms. For example, when a central bank lowers interest rates, those lower rates make new investment cheaper and more profitable. That encourages companies to invest more. Profits rise, firms hire more and we see growth in the economy as a whole.
When firms are able to raise money abroad, they are no longer as dependent on the local economy for financing. This potentially causes problems for central banks and other local monetary policy authorities who wish to influence the local economy by controlling interest rates.
This brief summarizes the results of Francis, Hunter and Kelly (2016), where we examine the extent to which monetary policy authorities’ influence differs across firms that are able to access foreign capital (also called “investable stocks”) and those that are largely dependent on the local market (also called “non-investable stocks”). Contrary to expectations, the evidence shows that firms that are able to raise foreign capital by being open to foreign equity investment are actually more sensitive to local monetary policy shocks than those that are not.
The perks and perils of financial liberalization
Over the last 30 years, the authorities in several less developed countries liberalized their domestic financial markets by allowing foreign ownership of local stocks. There are tremendous benefits for the local firms that became ‘investable’ as these countries liberalized, relative to firms that remained dependent solely on domestic stock markets. These include, inter alia, (1) being able to raise large tranches of foreign capital at lower rates than available in the domestic market, which reduces their financing constraints and increases their ability to invest, (2) substantial improvement in the liquidity of their stocks, (3) improvements in corporate governance and reporting (see Reese and Weisbach, 2002), and (4) greater efficiency with which their stocks incorporate value-relevant information.
Despite these benefits, there is widespread concern that liberalization comes with several problems. First, foreign capital flow (“hot money”) can cause excess volatility in local stock markets and exchange rates when foreign investors rapidly repatriate their funds. Second, local firms may become sensitive to foreign monetary policy shocks, and those foreign monetary shocks may be contrary to what is needed in the local economy. Third, and perhaps chief among the problems, is that if a large segment of domestic firms is able to raise capital abroad, then local monetary authorities may lose their ability to influence the domestic economy through their control of local policy interest rates. We examine this last concern in this policy brief below.
What does the research tell us?
One of the big challenges when measuring the impact of changes in monetary policy on an economy is the fact that the effects of investment started or stalled by changes in monetary policy may take months, or even years, to play out. The long time frame makes it very difficult to tell whether changes in monetary policy affect the macro economy. To solve this problem we follow in the footsteps of the former Chair of the U.S. Federal Reserve, Ben Bernanke (see Bernanke and Blinder, 1992, and Bernanke and Kuttner, 2005) and examine the impact of monetary policy shocks on stock returns. We do this because stock prices reflect anticipated changes in the economy and they are one of several channels through which monetary policy actions are transmitted to the real economy. That is, if local stock prices respond to monetary policy changes, it is likely the local economy will respond as well.
Because stock prices move in anticipation of future improvements in the economy, it is very important that we measure monetary policy surprises (also referred to as shocks) and not merely observed changes in monetary policy. To do this we model expectations about local monetary policy as a function of changes in oil price, changes in the U.S. Fed-funds rate (a proxy for changes in U.S. monetary policy), local industrial production growth, inflation rate and exchange rate changes. Details are described in the companion paper to this brief, Francis, Hunter and Kelly (2016).
We examine the impact of local monetary policy shocks on local stock returns. We find that for 17 of the 24 developing markets in our sample a one-standard-deviation surprise increase in local monetary policy interest rates results in an immediate and statistically significant 1.06% decline in the country’s overall stock market index. Interestingly, the unresponsiveness of the remaining seven stock markets to local monetary policy is not entirely due to the dominance of foreign (U.S.) monetary policy. In only four of the seven markets is foreign monetary policy simultaneously significant.
As noted above, one possible concern is that local monetary policy influences the investment and financing decisions of only non-investable firms. However, we find that firms that have access to foreign equity capital are at least as sensitive to local monetary policy shocks as are firms that are closed to foreign equity investment. In about 30 percent of our sample, Chile, Mexico, Venezuela, Jordan and Russia, firms that are open to foreign investment are even more sensitive than the ones that are closed. This evidence is consistent with the hypothesis that foreign investor participation in investable stocks improves the informational efficiency of investable firms’ stock prices, making them more sensitive to local monetary policy shocks. We call this an “efficiency” effect. This is counter to the predictions of the “integration” effect, whereby local stocks that are accessible to foreign investors are more responsive to foreign, not local, monetary policy shocks.
As an example, consider the impact of local monetary policy shocks on the returns of Brazilian stocks that are open and closed to foreigners, as depicted in Figure 1. In both panels the stock market is subjected to a one- standard-deviation surprise tightening of monetary policy, which is equivalent to 0.52% higher policy interest rates. In the top panel, the response is a statistically significant decline of 1.9% in the stock prices of firms that are open to foreign investment. In the bottom panel, the same monetary policy surprise translates into a statistically insignificant 0.9% lower prices for stocks that are closed to foreign investment. These findings are typical of the other countries in our companion study.
Figure 1. Impulse Responses of Brazilian Stock Returns to a One-Standard-Deviation Structural Shock in Local Monetary Policy
Investable stocks – open to foreign investment
Non-investable stocks – closed to foreign investment
Source: This figure reports impulse responses (center line) of investable and non-investable stock returns over 24 months in response to a one-standard-deviation structural shock in local Brazilian monetary policy. The impulse responses are obtained from a structural VAR model with eight endogenous variables: oil prices, the U.S. Fed-Funds rate, local industrial production growth, inflation, exchange rates and investable and non-investable Brazilian stocks. The left axis is in percent and the horizontal axis is months after a policy shock. The outer bands are probability bands used to determine statistical significance. The impulse response in a given period is significant, if both outer bands are on the same (lower or upper) side of the horizontal line at zero.
Ruling out alternate interpretations
One concern with the above results is that they might be driven by the simultaneous response of stock prices and monetary policy to emerging market crises that occurred during our sample period. However, the results when controlling for the Mexican and Asian currency crises are materially the same. The Russian default in 1998 is prior to the start of our data for Russia.
Additionally, one might be concerned that when we separate stocks into investable and non-investable, what we are really doing is separating firms on the sensitivity of their product markets to changes in the local economy. To examine this, we determine whether our results hold for stocks that operate in traded-goods markets and for those that operate in non-traded goods markets. We continue to find that investable stocks are more sensitive than non-investable stocks to local monetary policy in both markets.
Summary and policy implications
Our research suggests that firms that are open to foreign investment are at least as sensitive to local monetary policy as are firms that remain closed to foreign investment. These findings assuage a non-trivial concern among monetary policy authorities that while access to foreign capital has many benefits, it may come at the cost of a loss of ability to influence one’s own local economy. The primary policy implication of our work is that foreign investment in local stocks does not result in a loss of monetary policy control. In fact, our results suggest that foreign investment makes local firms more responsive to monetary policy shocks.
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.
- 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
Significant oil price fluctuations are an important factor influencing real economic variables, especially in the countries with large dependency on export of natural resources. Under such fluctuations, it is natural to consider the possibility of economic policy to fine tune the real economy, achieve inflation stability, and to weaken the negative influence of oil price shocks. In terms of monetary policy, authorities realize the existence of many channels through which oil market is related to the real sectors and inflation. The Central Bank of Russia should analyze the necessity to react to oil prices and to change the effect of them on the real economic variables.
The most typical way of reaction to oil prices in the Russian Federation is accumulation of reserves at the Reserve Fund. The Stabilization Fund (was later in 2008 separated into the Reserve Fund and the National Welfare Fund) was created in 2004 based on the initiative of Mr. Alexey Kudrin, who was a Minister of Finance at the time. The idea of the fund is to direct the revenue from oil export to the budget, but only when the price of oil does not exceed a pre-specified level, and the residual income should be accumulated in the fund.
In addition, the Central Bank of Russia may respond with its refinancing rate to the changes of the oil price via an augmented oil price Taylor rule or indirectly without inclusion of a commodity quota into the monetary policy rule.
We consider whether the Central Bank of Russia should formally establish the policy of responding to the changes of the oil price. The key evaluation criterion for selecting the optimal response is the minimization of inflation and GDP fluctuations.
Taking into account the results of an applied Dynamic Stochastic General Equilibrium model estimated for the Russian economy, we suggest that the Central Bank, optimally, should include the oil price in its interest rate Taylor monetary rule. That is, it should react to oil price quotas but only in the case of stabilization fund absence. This suggested optimal monetary policy implies a positive direct response to oil price shocks; a 1% oil price increase (decrease) should trigger CBR to raise (decrease) the refinancing rate by 0.1%. In the case of stabilization fund presence, there is no need to respond to changes in the oil price since the former stabilizes the situation when the oil price fluctuates too much.
The main potential limitation of this study is the problem of model quality against the real data. In addition, other monetary policy instruments may be tested against the reaction to changes in the oil price.
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.
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.
- 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.