EFFICIENT MONETARY POLICY OPTIONS IN TRANSITION ECONOMY

Transcription

1 NATIONAL BANK OF THE REPUBLIC OF BELARUS EFFICIENT MONETARY POLICY OPTIONS IN TRANSITION ECONOMY COLLECTION OF REPORTS Second Inernaional Scienific and Pracical Conference May 19 20, 2008 Minsk 2008

2 Ediional Board: PhD in Economics Pavel V. KALLAUR; Docor of Economics Anaoly O. TIKHONOV; PhD in Economics Yury P. VLASKIN; Docor of Economics Аlexey Е. DAJNEKO; Docor of Mahemaics Мikhail M. KOVALEV; Docor of Economics Vasily N. KOMKOV; PhD in Economics Nikolai V. LUZGIN; Docor of Economics Irina V. NOVIKOVA; Docor of Economics Vladimir I. TARASOV; Docor of Economics Yury М. YASINSKY. Referees: Docor of Economics Anaoly O. TIKHONOV; Docor of Economics Vasilij N. KOMKOV; PhD in Economics Alexandr V. LOBANOV; PhD in Economics Naalya L. MIRONCHIK. Efficien Moneary Policy Opions in Transiion Economy: Collecion of Repors of Second Inernaional Scienific and Pracical Conference, Minsk, May 19 20, 2008 / Ediional Board: P.Kallaur, A.Tihonov, Y.Vlaskin e al. Minsk: NBRB, p. The purpose of he Conference is o share recommendaions wih respec o improving developmen and implemenaion of he moneary policy, and exend inernaional relaions and cooperaion beween he praciioners and research workers in he moneary sphere. Naional Bank of he Republic of Belarus Address 20, Nezavisimosy Ave., Minsk, Belarus. Telephone Inerne hp:// Fax All righs reserved. Reproducion for educaional and non-commercial purposes is permied provided ha he source is acknowledged. The views expressed in hese papers do no necessarily reflec hose of he Naional Bank of he Republic of Belarus. This collecion of repors can be downloaded from sie of he Naional Bank of he Republic of Belarus.

3 Conen 3 Yury Alymov Macroeconomic Condiions and Peculiar Feaures of he Republic of Belarus Moneary Policy Implemenaion a Curren Sage 5 Alexandr Lobanov Analysis of Moneary Mechanism Funcioning in Belarus 12 Anaoly Tikhonov Informaion Efficiency of Financial Marke: Theoreical Concep and Insiuional Srucure 25 Vasilij Komkov, Mikhail Demidenko Impac of he Exchange Rae Facor on he Secors of he Belarusian Economy 32 Naalya Mironchik, Mikhail Demidenko The Role of he Quarerly Projecion Model in Moneary Policy of he Republic of Belarus 39 Anne-Marie Gulde Exchange Rae Regimes for Transiion Economies: Were Currency Boards an Efficien Choice? 51 David G Mayes Alernaive Roues o Price Sabiliy 67 Franz Seiz Ineres Rae Seing, Money and he Role of he Oupu Gap 78 Daniyar Akishev On Moneary Policy of he Naional Bank of Kazakhsan in Condiions if Financial Insabiliy 90 Nikolaychuk Sergei Deerminaion of Inflaion Targes for Ukraine 96 Alexandr Borodin, Elena Gorbova, Sergey Plonikov, Yulia Plushchevskaya Anca Adriana Gălățescu, Esimaing Poenial Oupu and Oher Unobservable Variables Using Moneary Policy Transmission Model (he Case of Russia) 105 Bogdan Rădulescu, Mihai Copaciu Poenial GDP Esimaion for Romania 126 Aleksejs Meļihovs, Gundars Dāvidsons The Role of Producion Progress and Human Capial in he Economic Growh of Lavia 147 Oxana Babeskaia- Kukharchuk Transmission of Exchange Rae Shocks ino Domesic Inflaion: The Case of he Czech Republic 160 Conference May 19-20, 2008, Minsk

4 4 Michał Brzoza- Brzezina, Tomasz Chmielewski, Joanna Niedźwiedzińska Subsiuion beween domesic and foreign currency loans in Cenral Europe. Do cenral banks maer? 182 Omar A. Mendoza Lugo The Differenial Impac of Real Ineres Raes and Credi Availabiliy on Privae Invesmen:Evidence from Venezuela 199 Azer Aleskerov Opimal Moneary Policy Sraegy During he Huge Foreign Exchange Inflows 229 Musafo Niyozov Feaures of Moneary Programs in Small Economies 233 Vladimir Tarasov Theoreical Aspecs of Currency Regulaion, Balance of Paymens and Ani-Inflaion Policy Saus 239 Vladimir Usosky Resricions o Moneary Policy Choice in Belarusian Economy 250 Sergey Kalechis, Naalya Koloonchik Improving Moneary Policy in he Economies in Transiion: Making Choices abou Effecive Regime or Enhancing he Efficiency of he Chosen Regime? 266 Ryzhkovskaya Oksana Approaches o he Regime Choice and Crieria of he Opimal Moneary Policy of he Transiion Period 272 Lepushynskyy Volodymyr Lines of Moneary Transmission Opimizaion under Condiions of Transiion Economy 280 Anaoly Belzesky Shaping and Funcioning of he Corporae Bonds Marke in Condiions of Transiion Economy 288 Dmiry Kruk Opimal Insrumens of Moneary Policy Under he Regime of Inflaion Targeing In Belarus 305 Naalia Lazareva The Developmen of Morgage Lending Marke in a Transiion Economy: Problems and Perspecives 323 Naional Bank of he Republic of Belarus

5 Yury Alymov 1 5 Macroeconomic Condiions and Peculiar Feaures of he Republic of Belarus Moneary Policy Implemenaion a Curren Sage The Republic of Belarus is a dynamic open economy. Over he pas few years, he counry has been ensuring high economic growh raes and has been dynamically increasing invesmens. A he same ime, some curren problems and macroeconomic risks in he economy pose challenges whose ackling will be faciliaed by improving condiions for economic performance and by providing simuli o he business iniiaive. In such circumsances moneary policy mus be aimed a promoing economic growh, above all, by delivering sabiliy of he naional currency and ensuring moneary insrumens adequae response o he changes in he environmen and inernal macroeconomic condiions. The process of economic ransformaion in he Republic of Belarus is heading in he same direcion as in oher economies in ransiion. Therefore, he main characerisics of is moneary policy and curren asks are, basically, much he same as moneary policy orienaion in oher counries which find hemselves a differen sages of he ransformaion period. A he same ime, a number of peculiar feaures of he Belarusian economy and he specific characer of cerain approaches o he paradigm of social and economic developmen have deermined he specific characer of he ransmission mechanism funcioning and, accordingly, some aspecs of moneary policy developmen and implemenaion. On he whole, he Belarusian economy can be characerized as a small open economy. Under he geographical division of labor which emerged during he Sovie era, i specialized, above all, in he assembling and processing indusries and funcioned as par of a single complex. This deermined he srucure of he economy inheried by Belarus which is based on large enerprises currenly dominaing engineering, oil processing, perochemical, and chemical indusries. Such srucure of he economy, considering he exising echnologies, makes i possible o ensure he compeiiveness of domesic indusries in a number of exernal markes. The counry s major foreign rade parners are Russia, he Neherlands, Ukraine, Germany, Poland, and he UК. The Russian Federaion is he main rading parner in erms of boh expors and impors. I should be noed ha srong posiions of he Belarusian goods in he Russian marke made a significan posiive impac on he economic growh raes in he Republic of Belarus. This was due o he fac ha high growh raes of energy prices which have been observed over he pas few years consiued a srong simulus o he economic growh in he Russian Federaion and resuled in an increase in he domesic demand in he Russian economy. This se precondiions for he expansion of Belarusian expors o Russia and, accordingly, became a significan facor behind he economic growh in our counry. GDP growh raes in exceeded 109% a year, on average. During , capial invesmens ino fixed capial grew by nearly 120% amouning o 131.5% in Beginning in 2001, he GDP volume in dollar erms grew more han 3.5 imes, while capial invesmens ino fixed capial more han 6 imes. 1 Firs Depuy Chairman of he Board, Naional Bank of he Republic of Belarus Conference May 19-20, 2008, Minsk

6 6 Mainaining aained high raes of economic growh is he mos imporan ask because i is a prerequisie for he promoion of he Belarusian economy s compeiiveness in he inernaional arena and, in he long run, he improvemen of he counry s living sandards. I s worh menioning ha despie dynamic developmen of he Belarusian economy here are sill some problems ha have no been ackled, namely: 1. Heavy ax burden which curbs economic and invesmen aciviy of enerprises, privae secor developmen, and he compeiiveness of Belarusian goods in he domesic and exernal markes. In 2007, he income/gdp raio was 50%; 2. High depreciaion of he acive par of fixed asses which has an adverse impac on he producion compeiiveness and efficiency; 3. Underdevelopmen of small and medium-size business; 4. Resriced growh raes of he financial marke; 5. Demographic rends owards he ageing of he populaion which will subsanially increase, in he fuure, he load no only on he pension sysem bu on healh care as well; 6. The economy s vulnerabiliy wih respec o exernal influence owing o poor diversificaion of expors and impors, on he one hand, fuel and energy balance, high consumpion of energy and maerials, and dependence on he prices for impored fuel and energy, on he oher; 7. Scarciy of invesmens o modernize fixed asses; 8. Inadequae innovaive aciviies and lack of he mechanism o ransfer new knowledge and echnologies from abroad, including by means of he foreign invesmens aracion; and 9. Banking risks resuling, above all, from he financial sanding of enerprises as well as adminisraive regulaion. As a resul, hese problems give rise o a number of asks whose ackling is deemed necessary a he sae level and is mandaed by he Program of Socio-economic Developmen of he Republic of Belarus for The enire governmen economic policy of he Republic of Belarus is aimed a he implemenaion of his Program, including moneary policy as is inegral par. The five-year Program idenified he following prioriies for he economic developmen: all-ou harmonious developmen of man on he basis of raising real moneary incomes and qualiaive improvemens in educaion, healh care, culure, physical raining and spors, and housing as well as oher service indusries; innovaive developmen of he naional economy; augmenaion of expors poenial on he basis of enhancing he compeiiveness of he naional economy; developmen of he agro-indusrial complex and social developmen of he rural area; conservaion of energy and resources; and developmen of small and medium-size owns. As a resul of implemenaion of measures sipulaed by he Program he oupu in 2010 will noiceably grow compared wih 2005: Naional Bank of he Republic of Belarus GDP by %; indusrial oupu by %; agriculural oupu by %; capial invesmens by %; producion of consumer goods by %; and foreign rade in goods and services by %, including expors by % and impors by %.

7 GDP energy inensiy is planned o fall by %. Housing provision funded from all sources is o increase by %. 7 Mainaining sabiliy of he naional moneary uni is deemed o be he mos imporan moneary policy conribuion o he aainmen of high raes of economic growh. Imporanly, during negaive economic rends of he 1990s caused by he budge imbalance and sizeable credi emission were reversed. The eliminaion of he exchange rae mulipliciy in Sepember 2000 made i possible o pursue more effecive exchange rae policy. The implemenaion of he mechanism of moneary policy based, above all, on he use of he naional currency exchange rae as a nominal anchor was conducive o curbing inflaionary and devaluaion processes as well as moneary sabilizaion. Where in 2001 inflaion rae measured by he CPI growh amouned o 46.1%, in 2006 i was down o 6.6%. While in 2001 he nominal exchange rae of he Belarusian ruble agains he US dollar devalued by 33.9%, 2006 saw is revaluaion by 0.6%. Slowing inflaionary and devaluaion processes o a sufficienly low level was he mos imporan oucome of moneary policy implemenaion creaing a favorable background for he aainmen of high economic growh raes. A he same ime, he Belarusian economy was facing in 2007 a number of new processes and facors, above all, in he economy s exernal secor which had a significan impac on moneary policy implemenaion and se a series of new asks requiring he moneary auhoriy o neuralize adverse effecs. Among such facors which brough abou a change in he exernal condiions of he Belarusian economy performance are, firs and foremos, he following: changes in he erms of Russian energy supplies, including a wofold increase in prices for naural gas; increasing volailiy of he exchange raes of he main world currencies as well as he of he naional currencies of he saes - foreign rade parners of he Republic of Belarus; rising prices for cereal and oil crops in he global markes (mainly because of he decrease in crop yields) as well as for milk and dairy producs owing o he falling volume of milk producion, increasing demand for dairy producs, and he removal of farm subsidies on milk producion in he EU counries; he US sub-prime morgage crisis which hi a number of markes, including ha of Wesern Europe; and acceleraion of inflaionary processes in he neighboring counries conneced, somehow, wih he above facors. Changing erms of Russian energy supplies is he mos significan facor as regards he scope of impac on he economy of our counry. Taking ino consideraion heavy dependence of domesic enerprises on Russian energy supplies which is condiioned, on he one hand, by insufficien diversificaion of energy impors and, on he oher hand, by relaively high energy inensiy of producion as well as a large share of expors of refined producs in oal expors of he Republic of Belarus, his facor enailed a number of consequences, such as: growing producion coss of enerprises which resuled in a greaer srain on heir financial sanding as well as cerain reducion in heir invesmen opporuniies; increasing price volumes of impors and corresponding deerioraion of he counry s balance of rade; growing inflaionary and devaluaion expecaions which resuled in an increasing demand for foreign currency in he domesic foreign exchange marke in he early 2007; and Conference May 19-20, 2008, Minsk

8 8 increasing inflaionary pressure which manifesed iself, above all, in he early 2007, in he acceleraion of growh raes of he PPI for indusrial producs. Oher above-menioned facors which emerged in he global markes also conribued o higher inflaionary pressure in he Belarusian consumer s marke. The naional economy suffered from he shorage of liquidiy in he global financial markes leas of all. This was due o he fac ha he volume of exernal borrowings by he Belarusian banking secor is no large because he banking secor s susainabiliy does no depend, in large measure, on he access o exernal resources. Deerioraing macroeconomic condiions of moneary policy implemenaion and, above all, he exernal environmen required a number of acical measures. The prioriy ask was o normalize he siuaion in he foreign exchange marke which was aained hanks o he implemenaion of a number of arrangemens. These included an increase in he refinance rae by one percenage poin, a more significan growh of raes (up o 20%) on refinancing operaions carried ou by he Naional Bank, as well as an absolue mainenance of he Belarusian ruble exchange rae a he prescribed level. This made i possible o preserve he confidence of he households and enerprises in he naional currency, o diver households moneary funds from he foreign exchange marke ino deposis in Belarusian rubles, and o preserve he resource base of he banking secor. Exchange rae policy mainaining he exchange rae of he Belarusian ruble agains he US dollar wihin he band se by he Republic of Belarus Moneary Policy Guidelines for 2007 played an essenial role in ani-inflaionary policy over he enire year. As he Russian ruble is becoming increasingly sronger agains he US dollar, he efficiency of he simulaneous use of wo exchange rae arges agains he US dollar and he Russian ruble - significanly decreased. Because of his, he exchange rae of he Belarusian ruble agains he US dollar as he main currency of he domesic foreign exchange marke, households foreign exchange savings, as well as foreign rade selemens, including he Russian Federaion, was acually used as a prioriy exchange rae arge. A he same ime, he US dollar dynamics wih respec o major global currencies was conducive o decreasing he real effecive exchange rae of he naional currency and, accordingly, mainaining price compeiiveness of he Belarusian expors. I is worh noing ha ani-inflaionary measures of moneary policy combined he impac of boh exchange rae policy and ineres rae policy which was aimed a ensuring a balance beween money demand and supply in he economy. The dynamics of ineres raes during he year made i possible o avoid addiional shocks which could deeriorae he financial sanding of enerprises in he nonfinancial secor of he economy as well as adversely affec he susainabiliy of he financial secor. Boh he opporuniy for credi suppor of enerprises and high growh raes of invesmens in fixed capial required o coninue he economy s modernizaion wih a view o ensuring is compeiiveness were mainained. A he same ime, ineres raes faciliaed coninued growh of he raio of he banking secor s resources and he scale of is operaions o GDP. Also, growh raes of he moneary aggregaes subsanially slowed wih respec o he previous year which was one of he facors curbing inflaion. For example, he acive ruble money supply (M1) increased over he year by 24.4% (in 2006 M1 grew by 42%). The ruble money supply (M2) increased by 29.2% (in 2006 M2 grew by 44.5%). Naional Bank of he Republic of Belarus A he same ime, he oaliy of he above-menioned adverse facors deermined subsanially higher, compared wih he forecas, inflaion raes. In he whole of 2007, he CPI grew by 12.1%, he forecas being 6 8%. However, sufficienly high raes of economic growh were mainained. GDP increased by 8.2% agains he previous year which allows us o view, on he whole, he resuls of moneary and general economic policy implemenaion favorably.

9 The Republic of Belarus Moneary Policy Guidelines for 2008 are aimed a mainaining and consolidaing posiive rends in he economy. Preserving major approaches and principles ha have proven o be posiive, curren moneary policy measures ake ino accoun he experience of neuralizing he impac of adverse environmenal rends gained in The moneary policy objecive in 2008 is o proec and ensure he Belarusian ruble sabiliy, including is purchasing power and he exchange rae agains foreign currencies. The main means o aain his objecive will be mainaining he Belarusian ruble sabiliy agains he US dollar. The exchange rae is sipulaed o flucuae wihin he plus-minus 2.5% band wih respec o he exchange rae as a he beginning of he curren year, i.e. wihin he year he exchange rae will be approximaely in he range of 2,100-2,200 Belarusian rubles versus he US dollar. I is planned o coninue o increase he role of he ineres rae as a moneary insrumen and enhance he efficiency of ineres rae policy. In doing so, he principles of ineres rae policy ha proved o be posiive in he pas few years will be preserved, firs of all, he mainenance of ineres raes a he level which is conducive o he growh of savings in he naional currency and he expansion of credi availabiliy for economic agens. The overall dynamics of ineres raes will be defined by he refinance rae. Based on he assessmen of key macroeconomic indicaors, he projeced inflaion rae being 6-8%, a reducion in he annual refinance rae o 7 9% by he end of 2008 is deemed possible. By he end of 2008, ineres raes on new erm deposis and on bank loans o enerprises and households may amoun o 7-10% and 10 12%, respecively. Wih he demand for banking services from he non-financial secor of he economy and households growing, furher enhancemen of banking secor susainabiliy in 2008 will be a prioriy. In building up banks capial, i will be necessary o ake ino accoun he need for boh ensuring heir susainabiliy and mainaining invesmen araciveness of he banking secor. Banks capial is esimaed o grow by 21% and reurn on capial o exceed 8%. Enhancing efficiency and funcional relevance of he banking secor will manifes iself in coninued faser growh of banks asses compared wih GDP. For example, he banking secor s asses and he resource base of he banks are forecased o grow by 37%, wih he banks asses/gdp raio increasing up o 47.8% by he end of The volume of households deposis wih he banks is projeced o increase over he year by 3.7 rillion Belarusian rubles. This forecas is based on he increase in he households moneary incomes and he srucure of prospecive spending, he decrease in he inflaion rae, and he expansion of he lis of banking operaions and services along wih heir qualiy improvemen. In addiion, by he end of 2008 he legal persons deposis wih he banks will grow by 3.4 rillion Belarusian rubles. The major facors of heir growh will be as follows: growing sales of producs, goods, works, and services owing o he oupu growh and he reducion of he sock of finished goods in indusry o he branch levels, he sock of commodiies in rade, and consrucion in progress; growing moneary share in he oal proceeds from he sale of producs, goods, works, and services arising from he reducion in he share of non-moneary forms of selemens and unpaid proceeds; growing profiabiliy semming from he reducion of maerials, energy, and labor inensiy in he producion of producs, works, and services; Conference May 19-20, 2008, Minsk

10 10 reducion of loss-making organizaions by means of enhancing heir efficiency; and ax burden reducion. Sipulaed volumes of lending represen an increase in he scope of banks paricipaion in he developmen of he economy s real secor and he ackling of social problems. Bank loans will play an increasing role in GDP formaion and naional wealh growh. Banks claims on he economy will increase by 41% amouning o 35.8% of GDP. Invesmen lending in 2008 is projeced o amoun o 5.7 rillion Belarusian rubles. Banks will mainain high qualiy of heir asses. The share of problem asses in he asses subjec o credi risk will no exceed 4%, he share of cliens and banks problem indebedness on credi operaions 2%. A he same ime, as experience of many economies in ransiion shows, he implemenaion of moneary measures alone canno assure he success of ani-inflaionary policy in he long run. The resrucuring which provides inernal simuli for he growh of producion and invesmens as well as promoes he growh of foreign direc invesmens is insrumenal a he ime of economic changes. The work o review legislaion regulaing he erms of economic aciviies sared by he Governmen and he Naional Bank in 2007 is par of effors o provide a more favorable economic environmen. This work is designed o drasically improve business climae in he counry which will enable he Republic of Belarus o rank among 25 global economies wih he mos favorable business environmen. I is well known ha a presen, according o he annual repor Doing business by he World Bank and IFC, he Republic of Belarus ranks 110 h among 178 counries covered by he survey. Of course, he mehodological basis of his survey and he correcness of individual conclusions can be debaed, however one canno bu agree ha measures designed o subsanially change business climae in he counry are well-imed and necessary, and fully correspond o he general rend se forh in he Program of Social and Economic Developmen of he Republic of Belarus for Business climae in he Republic of Belarus is expeced o be radically improved, above all, hanks o: subsanial reducion of procedures and ime required for incorporaing a company, licensing, propery regisering, formalizing inernaional ransacions, and closing a company; gradual reducion in ax burden and sreamlining he axaion sysem; and legislaive and judicial proecion of invesors and he sreamlining of conrac implemenaion procedures. Furher ransformaion of ownership righs will be faciliaed by: cancelling he insiuion of Golden share in he Republic of Belarus; phasing ou limiaions o he alienaion of socks (shares) in he auhorized capial of commercial organizaions esablished in he process of denaionalizaion or privaizaion; and reamlining procedures for he making decisions regarding he disposal of sae-owned propery, including land. Creaion of relevan financial insrumens, insiuions, and mechanisms for heir funcioning would faciliae he formaion of an efficien domesic financial marke, above all, by means of: Naional Bank of he Republic of Belarus cuing axaion on corporae securiies operaions; lising and selling blocks of shares in Belarusian enerprises, including large enerprises; creaing equal condiions of operaion for privae and sae-owned insurance organizaions; and

11 creaing efficien invesmen funds and oher non-bank financial insiuions. 11 Oher areas of he invesmen climae improvemen include: creaing he mos favorable condiions for foreign invesors in small selemens, including in erms of ax reducion, adminisraive conrol, proecion guaranees agains adverse changes in legislaion during five years, and he righ o have foreign insurers insure heir propery ineress; improving condiions for he esablishmen and operaion of residens of free economic zones; and encouraging he developmen of innovaive producion, also wih he paricipaion of foreign invesors, including a complex of organizaional, fiscal, and oher measures aimed a acceleraing innovaive aciviies. A series of decrees and edics of he Presiden of he Republic of Belarus providing new simuli for business and invesmen aciviies have already been adoped as par of hese measures, oher regulaory acs being in he process of preparaion. An improvemen in business climae may prove o be, in our opinion, a significan facor in mainaining high raes of economic growh and aaining arges of social and economic developmen in Belarus. This will favorably affec he process of furher srenghening of he counry s banking secor and increasing is funcional significance in he economy. Maximal assisance for he processes of economic growh, above all, by ensuring inernal and exernal sabiliy of he naional moneary uni is he ask of moneary policy under hese circumsances. To his end, he coninuaion of he evoluionary developmen of he hierarchy of moneary objecives and inermediae arges, he sreamlining of he sysem of moneary policy insrumens, he sudy of he ransmission mechanism in he economy of he Republic of Belarus, and he developmen of he mahemaical modeling of economic processes mus be ensured. Conference May 19-20, 2008, Minsk

12 12 Alexandr Lobanov 1 Analysis of Moneary Mechanism Funcioning in Belarus One popular American exbook conains a phrase mean o make an example: "The main ask of he FRS /he Federal Reserve Sysem he Cenral Bank of he USA/ is o lay down a firm foundaion of moneary policy in order o ensure a high and sable level of producion of goods and services" (Miller, 2001). I appears o be fair for each counry because he moneary secor is par and parcel of he economic sysem of a sae. Therefore, he moneary policy mechanism mus also be considered as par of a single economic mechanism ha is implemening sable exended reproducion. Accordingly, a sysemaic analysis of he moneary mechanism reflecing inerrelaion of he moneary secor wih oher secors of he economy, as well as coordinaion of objecives and insrumens of moneary, fiscal, foreign economic, and producion regulaion would enhance moneary policy effeciveness. In he Republic of Belarus, consideraion and esimaion of a variey of moneary mechanism channels as well as he adverse effec of macroeconomic measures on he moneary secor are considered, above all, from he organizaional and mehodical poin of view. Organizaion of Moneary Policy Developmen and Implemenaion Aricle 4 of he Banking Code of he Republic of Belarus prescribes ha moneary policy is a componen par of a single sae economic policy. A he same ime, Aricle 24 specifies ha he Naional Bank is independen in is operaion. In accordance wih hese principles, moneary policy is formulaed and implemened as par of a single process of developing and implemening moneary policy sraegy and acics. In doing so, inernal coordinaion of arrangemens aimed a developing he moneary secor as well as exernal coordinaion hereof wih he direcions of evoluion of oher economy secors are ensured. Therefore, hree key sages of moneary policy developmen and implemenaion could be idenified in he sysem conex (figure 1). Sage 1. Defining sraegic macroeconomic and moneary objecives, mehods and means of heir achievemen. This sage includes he design of long- and medium-erm programs. In accordance wih he world pracice and economic conceps he said programs consiue a sraegic basis for jusifying he implemenaion mechanism of boh macroeconomic and moneary policies. The programs define parameers of major objecives; direcions of macroeconomic developmen of he sae and is moneary secor; fundamenal principles and means of he achievemen hereof, he main objecives being he achievemen of susainable economic growh; high employmen level; price sabilizaion; foreign economic balance; and, based hereon, improvemen of living sandards. Forecass are based on he analysis of social, economic, populaion, and ecological environmen, scienific, echnological and producion capaciies of he counry, exernal condiions, naural resources and prospecs of changes of he said facors. Besides, forecass are made in several varians, aking ino consideraion probabilisic changes and he exen of influence of inernal and exernal economic and oher reasons. Naional Bank of he Republic of Belarus 1 Naional Bank of he Republic of Belarus, Ph. D. of Economics.

13 Figure 1: Scheme of moneary policy developmen and implemenaion 1. Developmen of sraegic macroeconomic and moneary objecives, as well as mehods and means of heir achievemen 1.1. The naional sraegy of susainable social and economic developmen for a 15-year period; 1.2. The main direcions of social and economic developmen for a 10-year period; 1.3. Medium-erm programs of social and economic developmen; 1.4. Programs of long- and medium-erm developmen of individual secors and indusries of he economy and regions; 13 Program of Developmen of he Banking Secor of he Economy of he Republic of Belarus for ; 1.5. Conceps of developmen and fundamenals of mechanisms of moneary insrumens 2. Coordinaed developmen of acical social, economic and moneary programs for he subsequen year 2.1. Economic and social developmen forecas; 2.2. Forecas of he balance of paymens; 2.3. Sae budge; 2.4. Moneary policy guidelines; 2.5. Secoral and regional social and economic programs; 2.6. Join plan of acion of he Council of Minisers and he Naional Bank designed o achieve he parameers of social and economic developmen, budge, and moneary policy guidelines 3. Implemenaion of moneary policy measures during he year 3.1. Moneary operaions quarerly macroeconomic and moneary forecass, adjusing operaional asks and insrumens; monhly seing moneary arges, esimaing he refinance rae; analyzing he parameers of banking secor and paymen sysem developmen; weekly banking secor's liquidiy forecas, making moneary operaions plan; esimaion of fixed ineres raes of he Naional Bank of he Republic of Belarus; promp analysis of he banking secor and paymen sysem performance; daily а) coninuous collecion and analysis of informaion: promp forecass of banks' liquidiy; analysis of banks' bids; agreeing he lis and parameers of operaions; б) conducing moneary operaions; 3.2. Regulaory and organizaional insrumens aking, if necessary, decisions regarding regulaions governing he banking secor and he paymen sysem, as well as regarding organizaional aciviies in accordance wih he funcions of he Naional Bank of he Republic of Belarus Conference May 19-20, 2008, Minsk

14 14 In accordance wih he Law "On Sae Forecasing and Programs of Social and Economic Developmen of he Republic of Belarus", wo major long-erm documens he naional sraegy of susainable social and economic developmen and guidelines of social and economic developmen for 15- and 10-year periods, respecively, are o be developed. Medium-erm social and economic developmen programs, in urn, are designed o ensure coninuiy of a long-erm economic sraegy. These 5-year programs are considered o be he mos significan documen ha deermines he developmen of he counry's economy in he foreseeable fuure. A he same ime, economic sabilizaion, accumulaion of he domesic and world heoreical and pracical experience, and, accordingly, he expansion of he possibiliy of real esimaion of he consequences of srucural and insiuional changes resuled in an increase in he imporance of medium-erm programs. A he same ime, in long- and medium-erm programs, moneary policy which is aimed a he achievemen of common sraegic objecives by means of ensuring he soundness of he naional currency, increasing banking sysem liquidiy and soundness of he banking sysem, and ensuring he effecive and secure funcioning of he paymen sysem, sands ou agains oher significan means and financial and economic mechanisms. Besides, i is imporan o noe ha condiions of implemenaion and parameers of macroeconomic programs serve as a basis for preparing relevan forecass and programs of developmen of virually all secors of he economy and regions of Belarus. To assis in he implemenaion of social and economic developmen of he counry, and as par of meeing he arges and parameers, he 5-year Program of developmen of he banking secor of he economy of he Republic of Belarus for is being implemened. This program deermines he following objecives of banking secor developmen: firs, enhancing sabiliy and effeciveness of he banking secor; and, second, improving and updaing he lis of banking insrumens in line wih he increasing needs of he economy and households. I is worh noing ha, based on he sraegic objecives, asks, means, and mechanisms of moneary policy deermined wihin he framework of said programs, he concepual direcions of he developmen of insrumens of he Naional Bank as well as basic regulaions regarding heir implemenaion and funcioning are devised a he Naional Bank. These include: he Concep for developing he naional paymen sysem of he Republic of Belarus unil 2010 which akes accoun of he world rends, he Concep for developing he sysem of non-cash selemens of reail paymens unil 2010; he Principles of foreign exchange reserves managemen by he Naional Bank of he Republic of Belarus; he Principles of regulaion of he banking sysem's curren liquidiy by he Naional Bank of he Republic of Belarus, and ohers. Overall, he Republic of Belarus has esablished quie clear procedures, which are in line wih he world experience, for he design of long- and medium-erm macroeconomic and moneary programs. Sill, i is necessary o srenghen he financial par of he programs, and ake ino accoun more foreign economic facors, which, in addiion o he developmen of he mehodological and informaion mechanism, implies amending he Law "On Sae Forecasing and Programs of Social and Economic Developmen of he Republic of Belarus". Naional Bank of he Republic of Belarus There is a need for he developmen of shor-erm acical objecives and measures (hey are being developed a presen), wih a view o meeing he sraegic objecives esablished a he curren sage, as well as ensuring he relevan forecas rends and srucural changes. Sage 2. Coordinaed developmen of acical social, economic, and moneary programs for he subsequen year.

15 This sage implies coordinaed analyical and forecas work primarily aimed a preparing key documens: forecas of economic and social developmen of he counry, including is balance of paymens; sae budge; and moneary policy guidelines. They also serve as a basis for devising secoral and regional programs. 15 Imporanly, he parameers of social and economic developmen forecas form he basis for drafing he republican and local budges and moneary policy guidelines. A he same ime, he financial and moneary proporions, worked ou on heir basis, migh necessiae cerain adjusmens of he iniial arge esimaion of macroeconomic indicaors. Therefore, he procedure for preparing said hree documens is ieraive. In accordance wih he Banking Code, moneary policy guidelines are considered o be a legal framework of moneary policy of he Republic of Belarus. They include key parameers of moneary sphere developmen, deermine objecives, asks, and prioriies of sae moneary policy, and provide for a complex of aciviies and regulaion and conrol mechanisms aimed a ensuring heir implemenaion. In addiion, he qualiaive srucure of he Republic of Belarus Moneary Policy Guidelines akes accoun of he necessiy of coordinaed aainmen of moneary and macroeconomic objecives and herefore includes: brief characerisic of he economic siuaion of he counry; esimaion and analysis of implemenaion of key parameers and usage of he moneary policy insrumens in he curren year; key parameers of he forecas of social and economic developmen of he Republic of Belarus for each subsequen year, including he forecas of he main indicaors of he balance of paymens; key parameers and insrumens of moneary policy of he Republic of Belarus for each subsequen year; and aciviies aimed a he improvemen of he banking sysem, banking supervision, financial markes, and he paymen sysem of he Republic of Belarus. A he same ime, aking ino consideraion he increasing imporance of medium-erm macroeconomic and moneary forecass a a ime of sabilizaion and accumulaion of domesic and world heoreical and pracical experience is sabilized and accumulaed, i is possible o consider expanding he ime period of he Republic of Belarus Moneary Policy Guidelines, specifying he Banking Code provisions, in paricular, Aricle 4. I should o be noed ha he forecas moneary documens similar o he Republic of Belarus Moneary Policy Guidelines, are prepared and implemened by he cenral banks of a significan number of counries, hough he saus, form, and ime period of forecass vary due o differen economic and moneary regulaion sysems of he counries. A he same ime, we can single ou he rend of developmen of he Naional Bank's objecives and means as par of he processes of harmonizaion of aciviies of CIS cenral banks, EurAsEC (EuroAsian Economic Communiy), and oher inegraion srucures. Besides, he world moneary experience, including ha of he neighboring counries, is widely used. Yearly (saring from 2004) preparaion of a consolidaed documen, which combines he aciviies aimed a he achievemen of objecives of he developmen of all secors of he economy Join Plan of Acion of he Council of Minisers and he Naional Bank Aimed a Meeing he Targes of Social and Economic Developmen, he Budge, and Moneary Policy Guidelines for he Subsequen Year may be regarded as a logic compleion of he developmen of a single sae economic policy Conference May 19-20, 2008, Minsk

16 16 of he Republic of Belarus. I includes primarily measures ha, in order o be adequaely implemened, require coordinaed and quie long preparaion work, as well as exchange of informaion or consideraion when he Governmen and he Naional Bank carry ou paricular aciviies independenly. Sage 3. Implemenaion of moneary policy measures during he year aking ino consideraion exising economic and moneary rends. This sage reflecs aciviies required of all he services of he Naional Bank for he subsequen year. The dynamics during he year ha akes ino consideraion forecas economic rends and makes i possible o use a sysemic approach o prepare and implemen he enire se of moneary insrumens, is esimaed for he key moneary parameers. A he same ime, real changes in he economic and financial siuaion deermine he need for he coordinaion and adjusmen of he moneary insrumens on an ongoing basis. Therefore, moneary policy implemenaion, especially in he sphere of moneary operaions, includes gradual sages of preparaion of inerrelaed quarerly, monhly, weekly, and daily forecass and decisions during he year. They, accordingly, jusify and deermine condiions for conducing paricular moneary operaions, as well as applying regulaory means and carrying ou organizaional aciviies (Lobanov, 2006). Virually all he insrumens of he Naional Bank are aimed a he economic regulaion of he banking secor which provides he non-financial secor of he economy wih direc moneary suppor, conducing necessary asses, liabiliies, and agency operaions. Therefore, i would be appropriae o say ha i is banks ha form he insiuional foundaion of he moneary mechanism. However, as all financial marke segmens develop, he number of subjecs of he moneary mechanism should expand. The following hree groups of he Naional Bank inerrelaion wih he banks may be singled ou: moneary relaions; relaions in he course of banks' performance regulaion (direcly regulaory) ha are conneced primarily wih he sae regisraion of banks and licensing of banking aciviy, regulaion of and supervision over banks' aciviy regarding safe and liquid performance hereof, esablishmen of rules and procedures for banks' operaion, and coordinaion of cerain aciviies hereof; and relaions in he course of ensuring he funcioning of he paymen sysem, ha also affec banks' aciviy; Besides, addiional informaion relaions of he cenral bank wih he banking secor emerge deriving from hem. Eigh major forms can be idenified in he srucure of moneary relaions of he Naional Bank wih banks (figure 2). They reflec he funcional srucure of operaions of he cenral bank wih residen banks. The lis of operaions shows ha he Naional Bank and banks are he acive operaors in he moneary and foreign exchange markes, as well as in he securiies marke. Naional Bank of he Republic of Belarus

17 Figure 2: Major forms of moneary relaions of he Naional Bank wih banks Refinancing operaions: 1.1 Lombard credi: aucion; a fixed raes 1.2 Purchase of Governmen securiies: REPO; o mauriy 1.3 Forward purchase of foreign exchange (SWAP) 1.4 Inraday credi (overnigh) 2. Aracion of resources: 2.1 Banks' required reserves 2.2 Sale of Governmen securiies: (REPO); o mauriy 2.3 Taking money ino deposis: aucion; a fixed raes 2.4 Issue of securiies of he Naional Bank 3. Purchase and sale of foreign currency (in he segmens of he open foreign exchange marke for regulaion of he foreign exchange rae) 4. Purchase and sale of precious meals and precious sones 5. Purchase and sale of cash (o ensure cash circulaion) 6. Regulaion of marke prices (hrough prices of he Naional Bank operaions) 6.1 refinance rae raes of he Naional Bank operaions 6.2 official exchange rae 6.3 prices for precious meals and precious sones 7. Paricipaion in he auhorized capial 8. Agency operaions: 8.1 operaion of corresponden and oher bank accouns 8.2 hrough accouns of he Treasury of he Minisry of Finance wih he Naional Bank a) ransfer of he Treasury's funds o banks b) ransfer of banks' funds o he Treasury Each operaion of he cenral bank wih Tier 2 banks has he main arge purpose, which o some exen becomes clear from he name of operaion. A he same ime, all operaions in he aggregae have a significan effec on he financial sabiliy of he banking secor, foreign exchange marke, and consolidaed moneary parameers. Therefore, hey mus be forecased and conduced wihin he framework of coordinaed echnology. In he oaliy of he Naional Bank s insrumens, he refinancing operaions and operaions aimed a he aracion of banks' resources fulfill a sor of balancing funcion. They ensure he mainenance of banking secor liquidiy banks' abiliy o mee heir obligaions in due ime a a reasonable level. These operaions are par of he sysem regulaing he moneary sphere and herefore hey are subordinae o he common objecives of he cenral bank of he counry, i.e. proecion and sabiliy of he Belarusian ruble, assurance of paymen sysem funcioning, and he developmen and srenghening of he banking sysem. The mos developing among hem are aucion operaions of refinancing and aucion operaions designed o arac banks' resources. The policy of curren liquidiy regulaion, on he whole, is based on he following underlying principles: argeed orienaion, marke relaions wih banks, securiy, ransparency, efficiency, accessibiliy, and flexibiliy. Refinancing of banks is a form of providing moneary funds on he condiions of collecabiliy and repayabiliy on he par of he Naional Bank. I is one of he funcions of he Naional Bank, he lender of las resor (boh in respec of banks and he majoriy of cenral banks of oher counries). Bu since he refinancing operaions are one of he money issue channels, heir volumes and principles hereof are deermined wihin he framework of he overall moneary program. Purchase and sale of foreign exchange is carried ou by he Naional Bank in all foreign exchange marke segmens, primarily in order o regulae he exchange rae of he Belarusian ruble and smoohen is flucuaions ha are no desirable for he foreign exchange marke. A he same ime, purchase (sale) of foreign exchange causes an increase (a decrease) in he foreign exchange reserves Conference May 19-20, 2008, Minsk

18 18 of he Naional Bank as well as changes in banks' resources in he naional currency, which ough o be aken ino accoun in he sysem of liquidiy regulaion of he Belarusian banking sysem. Purchase and sale of precious meals and precious sones is conduced by he Naional Bank primarily for he purposes of seing up a fund of precious meals and precious sones, as well as of operaional managemen hereof wihin is compeence. Besides, said operaions faciliae he developmen of he precious meals and precious sones marke, which is necessary in order o expand he sphere of he commodiy-money relaions and, accordingly, increase he level of he economy s moneizaion. Imporanly, precious meals and precious sones are purchased more acively for Belarusian rubles which makes i possible o improve he balance of commodiy-money proporions in he domesic consumer marke and hus enhance he sabiliy of he naional currency. Cash operaions are carried ou by he Naional Bank o ensure he funcioning of cash money circulaion in he counry. Such operaions resul in he relevan changes in cash and non-cash money a he cenral bank and banks, which affecs banks' resources and requires ha i be aken ino accoun in he sysem of liquidiy regulaion of he banking sysem. Paricipaion in he building up of banks' auhorized capial is considered an inerim measure of he cenral bank ha is deermined by he need o suppor he resource base of individual banks. A presen, he Naional Bank owns shares of four banks. A he same ime, he downside of is paricipaion in he banking capial is, firs, he issuing characer of such financing and, second, he collision of ineress of he cenral bank as an owner and a supervisory body. Therefore, he sraegic objecive of he Naional Bank is he reducion of is paricipaion in he auhorized capial of he counry's banks. Prices in he money marke are regulaed via wo major channels. Firsly, hrough conducing operaions, on a sysemaic basis and in significan volumes, for paymen charged, depending on he insrumen, in he form of ineres and discoun raes, ariffs, or difference in exchange raes. This deermines he price for he common moneary resources of banks and oher marke paricipans and, accordingly, prices when hey conduc asses operaions hereafer. This channel is used primarily o conduc operaions of banks' liquidiy regulaion, as well as foreign exchange rading operaions, which are significan in volumes and are conduced on a regular basis. Secondly, price arges announced by he Naional Bank (above all, he refinance rae and he official exchange rae of he Belarusian ruble) are, o a grea exen, direcly considered by banks and oher financial marke operaors when forecasing and seing heir prices. Obviously, he significance of he second price channel depends on he sysemaic confirmaion of he acualiy of he cenral bank's arges. Corresponden and oher bank accouns are operaed primarily o ensure uninerruped and secure banks' selemens wih heir cliens and fulfill moneary obligaions o he sae and oher banks. In he Republic of Belarus, he mechanism of effecing inerbank selemens via he single corresponden accoun of a bank opened wih he Naional Bank was inroduced in January Is inroducion made i possible o enhance he effeciveness of he paymen sysem, ensure conrol over banks' corresponden accouns, and regulae bank liquidiy on he basis of sep-by-sep developmen of moneary insrumens. Naional Bank of he Republic of Belarus Operaions conduced when he Naional Bank provides services o he Governmen in differen segmens of he financial marke are also conneced wih he Naional Bank's moneary relaions wih commercial banks. Said operaions ensure selemen and cash servicing of Governmen insiuions; agency services provided o place Governmen securiies; and he servicing of he sae deb. Accordingly, significan moneary funds do no jus move wihin he accouns of he Treasury of he Minisry of Finance opened wih he Naional Bank, bu are also ransferred o banks or, vice-versa, are ransferred by banks o hese accouns. Therefore, he cenral bank is required boh

19 o organize he selemen and paymen process and carry ou he aciviies agreed wih he Minisry of Finance, ha are aimed o sreamline said money flows and regulae banking secor liquidiy wih a view o solving he asks of a single economic policy of he counry. 19 Thus, pracical implemenaion of moneary policy by means of purposeful implemenaion of moneary insrumens is he resul of mulisage and coordinaed echnology of funcioning of he moneary regulaion sysem as par of he overall and developing economic regulaion sysem of Belarus. Moneary Forecasing Mehods Ensuring moneary policy effeciveness implies also he need for he design of scenarios of forecass and decisions made by he cenral bank based on models and mehods ha ake ino consideraion he oaliy of he channels of moneary policy influence on he economy. Basic forecas calculaions of moneary indicaors are based primarily on he sysem of economeric models (SEM MP 2) which includes hree inerconneced blocks: 1) ineres rae channel; 2) exchange rae channel; and 3) he balance of money supply, he economy's demand for money, and prices. SEM includes four main models: consumer price index model; money supply model; model of he Belarusian ruble exchange rae; and ineres rae model. The main inerrelaions of moneary and macroeconomic indicaors of his sysem are shown in figure 3. The sysem of SEM MP-2 is designed o solve he asks of formulaing moneary policy of he Republic of Belarus (MP): 1) analyzing and forecasing moneary indicaors on he basis of scenario calculaions and 2) defining he required level of influence on he par of he MP insrumens and exogenous variables which would make i possible o reach permissible values of inermediae and arge indicaors. The logic of is consrucion reflecs he process of MP formulaion which is based on he descripion of communicaion channels beween he insrumens ha are under he direc conrol of he cenral bank and he final objecives of he counry. There are hree major sages of MP formulaion: 1) seing sraegic (final) objecives, 2) defining inermediae objecives, and 3) choosing moneary insrumens. The echnology of scenario forecasing using his sysem makes i possible o ake ino accoun he complexiy of macroeconomic relaions when choosing moneary insrumens (he ruble money base, he refinance rae, he raio of he required and excess reserves o deposis, and he Belarusian ruble-us dollar official exchange rae). This is refleced in he fac ha, firsly, forecas developmen akes ino consideraion foreign economic rends, and, secondly, he calculaions are coordinaed wih he forecas parameers of he non-financial secor of he economy. Besides, o obain alernaive varians of forecass, he Naional Bank uses he Quarerly Projecion Model (QPM) which is based on he New Keynesian concep (Mironchik, 2006). The model describes inerrelaions beween he main macroeconomic variables: inflaion, GDP in erms of he aggregae demand of he economy, exchange rae, and ineres rae (figure 4). I makes i possible o make forecass for a period when he effec of moneary impulses generaed by he Naional Bank by means of ineres and exchange raes regulaion, on he aggregae demand and inflaion (up o 12 quarers) is mos effecive. The calculaions made as par of said basic models, he esimaion and deailed descripion hereof are supplemened wih he forecass of foreign exchange receips on he basis of he balance of paymens, price indices, he economy's demand for money, households' moneary incomes and expenses, as well as a number of oher economic and moneary indicaors. The calculaions are made using a se of differen mehods, including he equaion of exchange, purchasing power pariy, uncovered ineres rae pariy, equaions of money muliplicaion, VAR, simple regression models, and ohers. Conference May 19-20, 2008, Minsk

20 20 Figure 3: Srucure of he Sysem of SEM MP-2 Exchange rae channel Ineres rae channel RUR/USD cross-rae Inflaion in Russia Ineres raes on newly araced erm Refinance rae BYR/RUR nominal exchange rae BYR/RUR real exchange rae Gap of BYR/RUR real exchange rae Inerbank rae Shor-erm deviaions from longerm inerrelaions of prices and BYR/USD exchange rae BYR/USD nominal exchange rae Inflaion in USA Demand for money Inflaion Gap М2* Money supply Rae on newly graned credis in he naional currency Real GDP Moneary Moneary muliplier Rae on newly graned credis in hard currency Bank prime loan rae in USA Balance of money supply, he economy's demand for money, and prices The significance of influence of moneary mechanism channels on he economic variables is moniored on a regular basis. This makes i possible o idenify moneary policy prioriies and esimae he effeciveness of is regime. For example, modern esimaions on he basis of SEM-MP-2 ha, in principle, coincide wih he resuls of he analysis carried ou using VAR, sugges ha changes in he exchange rae of he Belarusian ruble agains he US dollar deermine he inflaionary processes in Belarus. Naional Bank of he Republic of Belarus This is explained by a significan share of he US dollar in he domesic foreign exchange marke, in he srucure of foreign exchange savings of households, as well as in he foreign rade operaions selemens. Accordingly, he mos effecive channel of moneary policy influence on he domesic and exernal susainabiliy of he Belarusian ruble is he mainenance of sabiliy of he exchange rae of he Be-

21 larusian ruble agains he US dollar. Therefore, he Belarusian ruble exchange rae is used as a moneary arge. 21 In 2008, he Naional Bank plans o keep he flucuaions of he official exchange rae of he Belarusian ruble agains he US dollar wihin he +/- 2.5% band compared wih he exchange rae as a he beginning of 2008, allowing for a gradual increase in he exchange rae flucuaions wihin he esablished band wih a view o ensuring a more flexible response o he changes in he demand and supply in he foreign exchange marke Figure 4: Scheme of inerrelaions in Quarerly Projecion Model (QPM) Ineres Rae on Credis Inflaionary Expecaions Refinance Rae Aggregae Demand Oupu Gap Inflaion Official Exchange Rae Exchange Rae Ineres Rae on US Dollars in he Inernaional Marke Exernal Demand Inflaion in Counries-Trade Parners Prices for Oil and Gas Seing parameers for changing he exchange rae of he Belarusian ruble wih respec o he US dollar would make i possible o influence he lowering of inflaionary and devaluaion expecaions ha deermine, o a grea exen, he behavior of he economic agens, hereby sabilizing he price level and exchange rae dynamics. Given ransparency of he Belarusian economy, he exchange rae may also be used as an insrumen of influencing he dynamics of domesic prices by curbing prices for impored goods. Resraining he growh of he ruble equivalen of he prices for impored raw and oher maerials and componens will make i possible o reduce coss growh raes and, accordingly, domesic prices for he Belarusian producs. Bu, given world rends of muual dynamics of he world currencies exchange raes, his exchange rae policy will no be conducive o srenghening he real exchange rae o he exen ha could adversely affec price compeiiveness of he domesic producers. A he same ime, he esimaions show quie high significance of he credi channel in he moneary ransmission mechanism of he Republic of Belarus which principally reflecs he following inerrelaions: money supply deposis credis invesmens oupu (figure 5). Therefore, he Naional Bank does no abandon monioring he dynamics of parameers of he banking sysem s moneary survey aking ino accoun is influence on he enire complex of economic indicaors, including boh inflaion growh raes and producion volumes. Conference May 19-20, 2008, Minsk

22 22 Response of GAP_GDP3 o Cholesky One S.D. D3M1_SA Innovaion Figure 5: Response funcion of GDP gap o money supply Besides, sysemaic esimaions show he significance of he ineres rae channel of he moneary mechanism in he Republic of Belarus. Figure 6 shows a VAR-based char ha describes impulse response funcion of inflaion o he changes in he real ineres rae on credis. I suggess ha here is significan negaive response wih a lag of up o 12 monhs, while he maximal effec will be fel in 6-10 monhs which, on he whole, corresponds o he naure of he inflaionary processes ha have a sicky characer, i.e. hey are persisen and gradually adjus o heir arge. Therefore, he Naional Bank pays significan aenion o he ineres rae policy when accomplishing moneary and macroeconomic objecives. Naional Bank of he Republic of Belarus Figure 6: Funcion of inflaion response o ineres raes

23 A he same ime, mainaining ineres raes a he level faciliaing boh he growh of savings in he naional currency and he expansion of credi availabiliy o he economic agens is considered o be a basic principle of ineres rae policy. Ensuring aracive erms for savings in he naional currency promoes he aainmen of he moneary policy objecives of curbing inflaionary and devaluaion processes, while expanding he availabiliy of credi resources acs as a simulus o economic growh. 23 The overall dynamics of ineres raes on he Naional Bank s operaions is deermined by he refinance rae which ses he minimal level of ineres raes on aucion operaions designed o provide banks wih liquidiy and he maximal level of ineres raes on aucion operaions designed o wihdraw liquidiy. In pursuing moneary policy, he Naional Bank gives prioriy o he ineres rae as he main operaional insrumen for exering influence on he moneary sphere. The inraday inerbank credi rae in he naional currency is an operaional objecive. The range of is flucuaions is deermined by he raes on sanard faciliies (overnigh credi, SWAP operaions, and fixed ineres rae deposis wih he Naional Bank). A he same ime, he raes on he Naional Bank operaions in he financial marke are designed o ensure he movemen of he rae of inraday inerbank credi in he naional currency wihin he required range/band while reducing is daily flucuaions. Thus, he models and mehods ha are used as par of said echnology make i possible o ake ino accoun and esimae he versaile characer of macroeconomic inerrelaions and creae scenarios of moneary parameers forecass wih a view o making decisions in he fuure regarding he specific usage of moneary insrumens of he Naional Bank. * * * On he whole, i may be noed ha a sable moneary mechanism ha saisfies he needs of he secors of he counry's economy is in place in he Republic of Belarus. Operaion of he Naional Bank and banks is coordinaed wihin he framework of he wo-ier banking sysem. The aainmen of moneary policy objecives and he developmen of he banking secor consiue par of a single complex of he sae economic policy, are based on he srenghening of he poenial of indusries of he naional economy, and simulae, in urn, he dynamics of heir growh and living sandards. A he same ime, ensuring long-erm social and economic developmen of he counry and he evoluion of domesic and foreign economic relaions require he improvemen, on an ongoing basis, of he moneary regulaion sysem and he overall sysem of economic regulaion. Taking ino consideraion specific feaures of he sae and developmen of he economy, he pursued moneary regime should be adequaely modified o ensure he effeciveness of moneary policy in meeing he prioriies of social and economic developmen. Furher increase of moneary policy effeciveness will be simulaed by: a sysemaic exended analysis of he moneary ransmission mechanism ha reflecs qualiaive and quaniaive inerrelaions beween he moneary secor and oher secors of he economy. This will make i possible o imely modify he lis of moneary arges and moneary policy regime as a whole; coordinaion of he objecives and mechanisms of moneary, fiscal, foreign, economic, and producion regulaion. I would be also advisable o srenghen he financial par herein, and o ake ino accoun more foreign economic facors; an increase in he moneary mechanism of he significance of ineres raes as a moneary regulaion insrumen on he basis of financial marke developmen; and argeed developmen of moneary insrumens and coordinaed echnology of applicaion hereof. Conference May 19-20, 2008, Minsk

24 24 As par of mehodology, he developmen of model insrumens is considered as an urgen issue wih a view o: aking ino accoun he producion funcions in order o show more exended economic mechanism inerrelaions; and expanding he forecas horizon, which is advisable for aking ino accoun cycles of macroeconomic and moneary processes. On he whole, improving he moneary policy mechanism as par of macroeconomic policy of he counry should faciliae he aciviies aimed a ensuring he macroeconomic balance ha implies an inernal and exernal balance of he economy, opimal combinaion of economic growh parameers, employmen, prices for goods and services, and he balance of paymens of he counry. References Miller R.L., Van Hoose D.D. Modern Money and Banking Translaed from English M. INFRA-M, 2000 p Lobanov A., Moneary Policy Mechanism of he Republic of Belarus // Banking Bullein No. 26. pp MironchikN.L., Demidenko M.V., Tsukarev T.V., A New Keynesian Approach o Moneary Policy Analysis. Naional Bank of he Republic of Belarus

25 Anaoly Tikhonov 1 25 Informaion Efficiency of Financial Marke: Theoreical Concep and Insiuional Srucure Financial sysem is, in addiion, a kind of informaion brain of economy. I is jus financiers who decide whereo he invesmens will be allocaed (or will no be allocaed), wha branches and secors will be developed and which will no be developed. Failure o choose he righ prioriies may cos one dear. Thus, for example, in he XIX cenury he Governmen of France decided o develop sailing flee. They made serious effors and spen a lo of funds. As a resul, France acually has developed he mos powerful sailing flee while he oher counries have already buil seamships. Thus i is no by chance ha Holland came o he fron line in he XVII cenury which ook place o a grea exen due o he mos developed financial sysem. I also played significan role in indusrial revoluion in England in he XVIII cenury. J.Schumpeer whose ideas had grealy conribued o developmen of he economic heory of he XX cenury considered credi as he inegral par of innovaive enrepreneurship wihou which i is impossible. He wroe, The banker is no so much a mediaor in he commodiy rade purchasing power as he producer of his commodiy He is beween hose who wish o exercise he new combinaions and he owner of means of producion 2 The above-menioned aspecs esify ha o overcome uncerainy is he mos urgen problem for financial sphere boh in he inner and ouer aspecs. In he former case i means ha each subjec of he financial sphere (professional or unprofessional )is facing he same problem; in he laer case i means ha is efficiency influences in many respecs he way of solving informaion problems in he economy in whole. In his aspec one should ake ino consideraion he problem of heoreical developmen of he concep of informaion. J.Sigliz and J.Akelrof have proved ha economic informaion is endogenous, i is being generaed only in he course of communicaion and ineracion beween economic eniies 3. Hence, valid informaion is no being disseminaed auomaically, and his is conneced no only wih weakness of organizaion of infrasrucure of marke relaions bu also wih he fac ha eniies can inerpre signals in a wrong way and/or inadequaely ransmi signals ouside ( deliberaely or indeliberaely). A ha some individuals ac so as o hand over cerain informaion (if hey are concerned o ac like his), he res srive for keeping i in secre or for disclosing i parially or presening i in a cerain way so ha o improve or a leas no o worsen heir sae of affairs. 4 This resuls in change of marke funcioning paern. As J.Sigliz accenuaed, acions (including choice) hand over informaion, marke paricipans know abou his, and his affecs heir beha- 1 Academy of Managemen under he Presiden of he Republic of Belarus. Professor, Docor of Economic Science. 2 J.Schumpeer, Theory of Economic Developmen. M.: Progress, 1983 p Probably such inerpreaion does no sui for physical or chemical informaion bu i reflecs he specific characer of economic informaion which direcly affecs he ineress of he eniies. 4 Le us noe ha reasoning of ha kind fully complie wih he spiri of economic imperialism (see, for example, A.Neserenko Wha has William Baumol failed o ell : Conribuion of he 20 h cenury o he philosophy of economic aciviy Economic Maers No.7). Conference May 19-20, 2008, Minsk

26 26 viour. 1 Therefore asymmery of informaion is being caused by he acions of he paricipans of marke relaions. If his is he case, a number of heoreic and applied problems arise: if informaion is imperfec, is asymmery is being caused by he marke paricipans hemselves which means informaional ransparency of he financial sysem; wha should be undersood as reliable informaion ; wha should be an insiuional organizaion of a successfully funcioning marke as a whole and financial marke in paricular? Effecs of Informaion Asymmery Effecs of informaion asymmery (EIA) are divided ino wo groups 2 : 1) he effecs which ake place ex ane 3 which are usually called risk of adverse choice or adverse selecion and hey are caused by misakes in evaluaion of he qualiy of goods or services; 2) he effecs which ake place ex pos which are usually called moral hazard, and hey are caused by he siuaion ha he mere fac of ransacion may resul in change of behaviour of one of he paries (for example, insurance companies have long ago noiced ha once he car has been insured, is owner may ake less care o preven hi-jacking). The mos famous paper in which EIA have been described for he firs ime belongs o J.Akelrof. 4 The paper describes he marke of used cars ( he marke of lemons 5 ). In general, he following process akes place in such marke. I is difficul o esablish he qualiy of he cars being sold. Therefore mos par of high qualiy cars are being sold a undersaed prices whereas low qualiy cars are being overcharged. Theoreically his resuls in he siuaion when high qualiy cars eiher compleely disappear from he marke or here will be very few of hem (as compared wih he normal informaion-neural sae). This kinds of markes are very common, especially in he developing counries. They are noed for dull economic aciviies, relaively low qualiy of he goods being sold. They repor abou he cases when unconrolled effecs of informaion asymmery resuled in almos enire collapse of he marke 6. I should be noed ha EIAs ac no only in he commodiy markes bu in oher markes as well: in labour-marke hey show hemselves as follows: since each firm srives o recrui he mos skilled and hones workers, he acual wages being offered by employers are above marke wages (he reverse side of such overesimaion is cerain level of unemploymen); in he credi marke hey show hemselves as follows: he crediors undersand ha high bank raes can scare away mainly he conservaive and hones borrowers raher han swindlers, ha is why ineres raes being offered by bankers are below balance raes (hence here is a cerain defici of borrowed funds) 7. And EIA are mos srong in he financial marke. Since any marke ransacion assumes ex ane exchange of informaion, he saemen of is aribuive imperfecion seems o undermine he basis of balance paradigm. Alernaively, we consid- 1 Sigliz J.E. Informaion and he Change in he Paradigm in Economics, Les Prix Nobel Refer o: Mishkin F. The Economic Theory of Money, Banking and Financial Markes: Manual for Higher Educaional Insiuions/ Translaed from English by D.V.Vinogradova, edied by M.E.Doroshenko. M.: Aspec Press, 1999, pp ex ane (La.) means ha he effec appears before ransacion, ex pos afer ransacion. 4 G.A.Akerlof. The Marke for Lemons : Qualiaive Uncerainy and he Marke mechanism/ Quarerly Journal of Economics. Augus 1970, p To swallow a lemon means o buy he inferior goods. Naional Bank of he Republic of Belarus 6 This ook place in he expor marke of Brasilian melons. The more deailed informaion of his follows. 7 Refer o: Sigliz J.E., Weiss A. Credi Raion in Markes wih Imperfec Informaion. American Economic Review.- Vo. 71/3. p ; Akerlof G.A., Yellen J.L. Efficiency Wages Model of he Labor Marke. New York: Cambridge Universiy Press, 1986, and oher.

27 er ha informaion should be included in he model of marke balance bu no as exogenous facor (which is ypical for poins of view of G.Sigler and R.Kaose) bu as endogenous facor. Moreover, his can be achieved on he basis of he concep of informaion efficiency of he marke which reflecs is insiuional srucure which deermines he direcion of marke balance shif due o naural asymmery of economic informaion. 27 Informaion Consisency of he Marke Informaion (a leas economic informaion) depends on he behaviour i.e. he acions (which are a he same ime he signals) and purposes of economic agens. They in many respecs are being deermined by he insiuions which assign possible schemes and sereoypes of implemenaion of he ineress of eniies. Hence, he sae of he marke depends no only on expenses and pracicaliy of benefis and oher economic facors which are he basis of any equilibrium (and nonequilibrium) models bu on he insiuional srucure of he economy which deermines he sereoypes of behaviour of he eniies and he naure of heir informaion/communicaion ineracion. The modern heory assumes ha he effecs of informaion asymmery in he commodiy marke resul in negaive endencies. The sellers of high qualiy goods eiher bear losses or leave he marke. Hence, he governmen policy shall be aimed a ensuring (direcly or indirecly) formaion of an insiuional srucure which enables o overcome informaion asymmery. According o he common poin of view, acion of he said effecs in he labour and credi markes is being manifesed in he fac ha an acual level of wages and ineres raes correspondingly is beyond and below of he equilibrium ones. These conclusions can no be considered illogical, bu neverheless hey fail o describe fully he resuls of he effecs of informaion asymmery in differen markes. The hing is ha informaion asymmery is being displayed in he acions of marke paricipans in wo ways. Firs of all, his means a deliberae price shif (ineres rae or wages) from equilibrium level. Secondly, his means an undersaemen (or raioning) of supply (of high-qualiy cars in he commodiy marke, loan funds or work places in he credi marke and labour marke respecively). These phenomena have been fully described by he classical auhors of informaion behavioural paradigm. However, he problem which of he following effecs are sronger is sill uninvesigaed: deliberae price deviaion from heir equilibrium level (so as o neuralize he effecs of adverse choice) or raioning of supply. We believe ha depending on he level of informaion sufficiency of he marke 1 here may be relaively more significan he rends conneced wih raioning (of credi, work places ec.) or sipulaed by deviaion of he efficien prices (ineres raes, wages level) from he equilibrium ones. We deermine he concep of informaion consisency (IC) of he marke as such sae when insiuional organizaion hinders collecing ren from asymmery of informaion since he losses from he acions aimed a derivaion of his ren exceed he laer greaely. This is being achieved boh a he cos of direc acions of a counerpar (penalies, alienaion of securiy ec.) as well as wihou hem when he agen gains bad repuaion, loses cusomers or he source of income. The indispensable condiion of informaion efficiency of he marke is no only comparabiliy of he consequences of responses wih he probable benefis obained due o deliberae generaion and/or use of informaion asymmery, bu also awareness of he agen of he possibiliy and realiy of such acions. In he main, his is he mos principal condiion. Even 1 This concep has been iniially inroduced in he paper by Yasinsky Yu., Tikhonov A. Informaion-behavioural paradigm: The End of Equilibrium Theory or is Second Breah?/ Economic Maers No.7, p Conference May 19-20, 2008, Minsk

28 28 if he response mechanisms do no funcion in realiy, bu he agens believe in he opposie, his is sufficien for hem o ac correspondingly. Alhough such siuaion is fairly dangerous. Belief should be confirmed from ime o ime, oherwise i can dissapear, and if his akes place quickly enough, he crisis may ake place. High informaion consisency of he marke is also being manifesed in he fac ha agens are well aware abou he acual coss of all alernaive possibiliies, he behaviour of he sellers (goods, manpower or financial obligaions) is direced o disclosure of informaion. There is insiuionally proeced sysem of valid signals in he marke. This resuls in increase of he quaniy of ransacions in he marke, coincidence of he maxima of privae and public benefis. To he conrary, wih he informaion inconsisency of he marke, ransacions are few, he funcions of privae and public reurn do no coincide. Under condiions of high informaion consisency of he marke he mos skilled and hones agens of marke relaions will enjoy he advanages. Therefore public benefis from he effecs of informaion asymmery exceed he expenses associaed wih hem. Oherwise he expenses of he effecs of informaion asymmery are very significan for he sociey. The insiuional srucure which provides for informaion consisency includes: 1) The sysem of objecivizaion and verificaion of informaion of he qualiy of producs and he repuaion of manufacurers (hese are he sandards, he regulaions specifying he requiremens o specific ypes of producs, raings, cerificaes of qualiy, such as ISO-9000); 2) proecion and disinc personificaion of proprieary auhoriies (including indusrial and inellecual propery) and he sysem of ensuring of conrac obligaions execuion; 3) The rules of financial reporing and informaion disclosure; 4) The Sae banks and non-governmenal banks and daa bases (including he Naional Credi Hisory Agency, for example). If he above-menioned elemens of infrasrucure are no developed, he marke is informaionally inconsisen, and favorable condiions appear for receip of a ren from informaion asymmery. The effecs of asymmery are refleced in desrucive rends. Types of Biased Markes Each acual marke ransacion is characerized by he fac ha he cerain pary bears he increased risk conneced wih informaion imperfecion. This is raher conradicory o he radiional heory of conracs which disinguishes beween he conrac for employmen (where he principal bears increased risk as compared wih he agen) and he sales conrac (where boh paries bear equal risk). Therefore, we will disinguish beween a quasi-principal (even if i is he case of relaionships beween he credior and he borrower where he former is a pure principal) and a quasi-agen (analogue o he classical agen). The examples of such pairs are presened in Table 1. Table 1: Quasi- Principal and Quasi- Agen Type of Marke Quasi-principal Quasi-agen Commodiy Buyer Seller Loan Lender Borrower Job Employer Employee Naional Bank of he Republic of Belarus Under condiions of informaion inconsisency of he marke he Seller of he Goods (manpower, an applican for loan) volanarily or no srives o use asymmery of informaion in such a way as o receive a ren. The Buyer (employer or credior) should naurally sand on he defensive by decreasing demand (by excessive cauion in he course of hiring or by credi raioning). In any case

29 under condiions of informaion inconsisency he burden of effecs of asymmery is being borne by he Buyer and he sociey as a whole, since excep for he ren which is being received by he Seller he volumes of consumpion, crediing and employmen are being decreased. 29 If he marke is informaionally inconsisen, a quasi-agen (QA) can no give he valid signal (which is he problem for hones and skilled QAs), and he quasi-principal (QP) is obliged o defend himself. Under condiions of informaion inconsisency QAs can send signals. This requires cerain expenses. However, if he benefi from qualiy or reliabiliy for QP exceeds he said expenses, QA is ready o pay hem as he efficien ineres rae which is lower han he marke rae, or as he efficien wages which exceeds he equilibrium marke wages (credi marke and labourmarke correspondingly), higher prices of he brand producs (including bonus for qualiy). Under condiions of informaionally consisen marke he Seller is obliged o overcome informaion uncerainy by sending signals. As M.Spence 1 has demonsraed, he major condiion for he signal o be valid is ha i is difficul o falsify. This means ha he signal should be such ha is simple imiaion should be oo expensive for imiaor. I is unlikely ha anyone can ensure a signal o be valid and hard o falsify 2, and hus Buyer of he Goods (employer, credior) pays a kind of bonus o he Seller who succeeds in his respec. I should be noed ha he sae of informaionally consisen markes is far more preferred no only over as compared wih he informaionallyinconsisen markes bu relaive o he marke assumed by he radiional heory of equilibrium of he marke as a reference one wih eviden or implici assumpion on is informaional neuraliy. Thus we can disingwish beween wo alernaive ypes of biased markes (or biased equilibria): he favorable which corresponds o informaionally consisen marke, and unfavorable which is characerisic of informaionally inconsisen marke. Dynamics of LoanMarke Depending on he Level of is Informaion Consisency If he loan marke is informaionally inconsisen, he scope of credi raioning is very imporan 3. I is difficul for he crediors o esimae he acual solvency of he cusomers as well as o esimae reliabiliy and efficiency of he projecs being offered for financing. Therefore he curve of loan offers is shifed o he lef (Figure 1b). The greaer porion of bank asses is allocaed o shor-erm speculaive rading. A ha if privae commercial banks dominae in capaciy of crediors, for which difference beween profi and losses has no only accouning significance, he gap beween poenial and acual volume of credis widens wih decrease of he level of informaion consisency of he marke. The said gap influences he marke ineres raes by increasing hem. Thus, in spie of he fac ha efficien raes are lower han he marke raes (which is presened wih red line in he Figure), hey are sill higher as compared wih he iniial equilibrium level (poin a in Figure 1), i.e. he raes associaed wih he classic marke equilibrium (i* is higher han ie, Figure 1b). This is a kind of divaricaion of endencies.loan funds are being reduced in view of he fac ha banks srive o lower he average credi risk, bu as soon as he credi is in defici, he raes are being oversaed which hus increases he risk on he projecs o be financed. Thus endency of each individual bank o reduce risks on he projecs being acceped for financing has he opposie effec for he economy and banking sysem as a whole. In he unorganized, shadow and half-legal markes 1 E.g. see: Spence M. Marke Signaling Informaion Transfer in Hiring and Relaed Processes. Cambridge, Harvard Universiy Press, Among such signals are, for example, a fairly long-erm guaranee period for durable goods, graning of liquid securiy on credis, higher educaion diploma during employmen ec. 3 Credi raioning also akes place in he informaionally consisen financial marke. In his case, however, i is weaker and is hen naural consequence of underesimaion of efficien raes as compared wih heir marke level (Figure 1а). Conference May 19-20, 2008, Minsk

30 30 efficien raes are much higher han equilibrium raes since hey are obviously characerized by high risk, he necessiy of paymen of specific services. However, i is possible ha in his case he informal sysem of guaraneeing of credis will be creaed (raher rigid and in is way efficien ). Bu such sysem will make he public mechanism nonransparen, and he informaion field will be sicky and nonransparen. Informaion problems will no be solved bu will be raher hidden. In view of increased risk of ransacions in shadow marke he value of he loan funds can be increased many imes bu no by several percenage poins 1. i i ie i* a i* a ie b Figure 1a: Informaionally consisen marke for loan resources k Figure 1b: Informaionally inconsisen marke for loan resources k Under condiions of informaion consisency acion of he effecs of informaion asymmery will lead o absoluely differen resuls. In his case ineres raes will be esablish a he level below he marke level, he negaive aspec of which is heir cerain defici (see Figure 1а). Bu he laer is no persisen however since he borrower has an opporuniy o signal of high qualiy of his projec (if any). The same defici enables he lender o carry ou selecion (oherwise he borrower relucan o pass hrough he process of selecion could appeal o oher bank and receive credi). Thus he marke promoes he economy and innovaions. Speculaive rading bear subordinae characer and conribue o sabiliy of he marke a he cos of arbiraion and wide opporuniies for risk hedging. The exising moderae defici of credi resources is he facor which enables he lenders o carry ou more horough examinaion of he projecs, and acually performs a consrucive funcion. As a resul hones borrowers generally receive credis a he raes lower han equilibrium raes. Aainmen of Informaion Consisency of he Marke I is impossible o provide for high informaion consisency of he financial marke ignoring he economy a large. The appropriae measures should cover all branches and secors. The basic componens of he insiuional infrasrucure which ensures informaion efficiency of he economy are as follows: Naional Bank of he Republic of Belarus 1 In Chamber, one of hemos prosperous rade areas of Pakisan, he borrowers wihou credi hisories» and liquidsecuriies are forced o borrow from moneylenders. Ineres raes on such loans amoun in average o abou 80 per cen per annum (and vary beween 18 and 200 per cen per annum), and commercial banks lend money a ineres rae of 12% per annum on he average. Wha is mos surprising, however, is ha if one excudes from he ineres yields of moneylenders heir expenses on collecion of informaionabou borrowers, monioring and supervision over purposeoriened use of he graned resources heir ineres rae will be approximaely equal o he bank raes. This means ha helender should use more han 80 % of his yields for soluion of he informaion problems. This is in his case he price of informaion inconsisency of he marke (See: Knowledge for Developmen. World Developmen Repor. 1998/1999. М.: Publishing House «Ves Mir», World Bank. p. 99).

31 1. Insiuions which provide for acual possibiliy of objecivaion of informaion of he qualiy of he goods and services of consumer and indusrial markes. The hing is ha informaion on he qualiy of he producs and services can no be always reduced o a se of well-defined invarian daa. In some cases in order o ensure validiy of informaion of he value and he marke prices of he Goods, i is sufficien ha free and liquid marke operae. Bu ofen his condiion urn o be insufficien. There is need of sandards, specificaions, sysems of cerificaion of he producs and qualiy, raing esimaion ec. I is necessary o emphasize in his connecion ha i is beer o have non-high raing of he repuable agency han o have no raing. Moreover, effors should be aken for inroducing he inernaional sandards of financial accouning no only in he bank sphere bu in he economy as a whole Proecion of Inellecual and Indusrial Propery. The Governmen should creae an insiuional and legal environmen, including proecion of rade marks and brands which could conribue o esablishmen of he sandards by he marke paricipans hemselves. Manufacurers of many producs which qualiy can no be fully esimaed a he ime of purchase (from he new brands of sof drinks o cars or compuer programs) can use brands for creaion of repuaion of high qualiy. This will allow hem o collec an exra charge for qualiy hus creaing ineres in selling of exacly high-qualiy goods and wide opporuniies for dynamic developmen. 3. The mos imporan elemens of he insiuional srucure of informaion consisency is he sysem of proecion and disinc idenificaion of proprieary warrans as well as conrol over proper execuion of conracual obligaions. From he poin of view of modern economic heory propery righs are he mos imporan insiues which enable o overcome informaion uncerainy arising in he course of ineracion beween economic eniies. For ensuring high level of execuion of conracual obligaion a well-developed sysem of legislaion and economic cours is required. 4. Achievemen of informaion consisency presumes a high level of compeiiveness and meacompeiiveness of he marke. The former concep is well- known in he economic heory. As for he laer concep, we define i as he sae of he marke when nobody is proeced agains liquidaion (even in case of monopolisic marke). The monopolis may be siuiaed in he sphere of meacompeiiveness unless he is proeced agains bankrupcy. On he oher hand, here can be eniies on he compeiive marke who are no afraid of heir fuure, who enjoy he governmenal suppor and are well aware of he fac ha heir losses will be wrien down in any case. If hey are few, here is nohing o be afraid of, oherwise no penalies for receip of ren from informaion asymmery will be efficien, and he marke will be pracically doomed o informaion inconsisency. 5. The following componen of insiuional infrasrucure of informaionally consisen economy is he nework of he sae and non-governmenal daabases of echnical and commercial informaion as well as he cenres of generaion and disribuion of informaion. The problem consiss in he fac ha for formaion of he daabases of commercial informaion of he borrowers, cliens of insurance companies ec. I is necessary o provide for efficien funcioning of he insiue of proecion of rade secre and privae informaion. The scandal conneced wih leakage of informaion from he bank of credi hisories which ook place in Russia in 2007 suis only for he persons who are no concerned in creaion of credi bureaus. In conclusion we shall noe ha he problem of achieving of high informaion consisency is raher urgen no only for Belarus and many counries of he former USSR and Easern Europe. The crisis in Argenine which ook place in 2002 is he mos prominen evidence of his. Conference May 19-20, 2008, Minsk

32 32 Vasilij Komkov 1, Mikhail Demidenko 2 Impac of he Exchange Rae Facor on he Secors of he Belarusian Economy The Belarusian economy is an open sysem where volumes of foreign rade urnover are commensurae wih he GDP volume. In urn, he inensiy of foreign economic relaions depends o a large exen on he foreign exchange rae realignmen. Therefore, an assessmen of he impac of he exchange rae facor on he mos imporan macroeconomic indicaors as well as indicaors for he developmen of individual secors of he economy s real secor is of pracical ineres o our counry. Such assessmens can be made only on he basis of special economic and mahemaical models. Two ypes of models can be used wih his end in view: economeric models which ake ino consideraion curren rends in he dynamics of relaionships beween economic indicaors as well as balance models whose equaions represen he producion cos paern in individual secors of he economy. Those balance models which are buil on he basis of he inersecoral balance mehodology offer he sronges possibiliies for he analysis of negaive and posiive impacs of he foreign exchange rae realignmen. The use of such models makes i possible o assess no only immediae and direc effecs of changes in differen elemens of coss in individual secors of he economy bu also indirec and long-erm consequences and effecs which follow he chains of inersecoral relaions. The dynamic price model which has been buil on he basis of daa from he inersecoral producion and produc disribuion balance shee compiled by he Minisry of Saisics and Analysis of he Republic of Belarus, was used in his research wih a view o assessing he impac of he exchange rae facor on indicaors for he developmen of individual indusries of he economy s real secor. The informaion suppor required o build such model has subsanially improved in he pas few years because he Minisry of Saisics and Analysis sared o compile inersecoral balance on a new mehodological basis involving a wider range of daa. In paricular, inersecoral supply of domesic producs as well as flows of impors wihin he same secoral srucure formed separae par in he cos paern of each indusry s inermediae maerial consumpion. This provides new opporuniies for assessing he impac of he exchange rae facor on secoral coss by aking ino consideraion heir changes semming from he appreciaion/depreciaion of impored goods consumed in he process of producion and in he fuure, also, changes in he cos of hose elemens of maerial coss of domesic producion in whose producion impored raw maerials and componen pars were used. Naional Bank of he Republic of Belarus I is well known ha he impac of he exchange rae facor on he producion efficiency is highly ambiguous posiive and negaive shor-erm effecs of he foreign exchange rae realignmen exering differenly direced influence on he compeiiveness of he oupu can ofen balance ou. The oucome is deermined, o a large degree, by specific feaures of secoral producion, and, above all, by he cos paern and he paern of demand for he oupu. In paricular, he devaluaion of he naional currency can promoe he compeiiveness of domesic produc as regards he price facor boh in exernal markes and in he domesic marke as i enails he possibiliy of making i cheaper wih respec o he prices of foreign compeing enerprises. This effec can be exered, o a larger exen, in expor oriened secors of he economy whose expenses relaing o he maerials of home manufacure as well as salaries and wages prevail in he producion cos. 1 Belarusian sae economic universiy, Professor, Docor of Economics. 2 Naional bank of he Republic of Belarus.

33 On he oher hand, prices for impored raw maerials and componen pars grow as a resul of decline in he exchange rae of he naional currency wha provokes, wihou doub, an increase in oal producion cos of domesic enerprises, hereby weakening heir compeiive posiions in exernal markes. Those indusries which are mainly oriened o he domesic marke and have a significan share of impored raw maerials and energy supplies in heir expenses paern are he firs o suffer from oal negaive effec of he devaluaion. However, adverse implicaions of he decline in he foreign exchange rae are no confined o he growh of maerial coss which is observed in he secors of he economy consuming impors. For beer assessmen of such implicaions, i is necessary o ake ino consideraion indirec impac of he devaluaion on he expenses of hose producers in whose maerial coss domesic goods manufacured by enerprises wih high impors consumpion (e.g., producers consuming a lo of oil producs made by domesic refineries ou of impored crude oil) accoun for a major share. 33 Indirec implicaions of he foreign exchange rae realignmen ransmied via he inersecoral relaionships sysem can be aken ino consideraion wih he help of he aforemenioned price model. The disincive feaure of his model is ha i is realized in he dynamic form, i.e. includes raes of changes in economic indicaors as is variables. If raes also ac, in he process of calculaions based on he model, as exogenous variables, esimaed daa obained wih he help of he model ake he form of elasiciy coefficiens which characerize he impac of assigned exogenous facors on he enire sysem of endogenous indicaors. I was calculaed on he basis of his model how nominal volumes of inermediae maerial consumpion in each secor of he economy increase if he exchange rae of he Belarusian ruble is down 1%, given he cos of impored goods and services varies in proporion o he growh of he foreign exchange rae. In addiion, i was assumed ha real secoral producion volumes remain invariable as well as nominal volumes of he added value in all secors of he economy also remain unchanged, i.e. he growh of producion cos and, accordingly, he growh of secoral prices is aained only a he expense of maerial coss appreciaion which is iniiaed by he ruble devaluaion a he beginning of inersecoral relaionship chains and laer on is ransmied o new levels of producion cooperaion ogeher wih inersecoral supplies of domesic produc. Calculaed relaive changes in nominal secoral volumes of he inermediae maerial consumpion characerizing heir elasiciy wih respec o he exchange rae realignmen are shown in Table 1. The Table also conains daa obained by his elasiciy calculaion of average secoral prices which show he exen of heir change (percenage change) resuling from 1% realignmen of he foreign exchange rae under curren srucure of he economy. I should be noed ha hese assessmens of price elasiciy are characerisic of minimum inflaionary implicaions of he Belarusian ruble devaluaion calculaed on he assumpion ha secoral prices will change only a he expense of he maerial coss appreciaion due o his devaluaion given ha volumes of he added value in he secors of he economy will remain unchanged. The above changes in secoral prices may be deemed he producers firs naural reacion in response o he appreciaion of impored raw maerials and componen pars which are purchased by hem. Table 1 also shows absolue nominal incremens in he inermediae maerial consumpion which are linked wih an increase in expenses caused by he ruble devaluaion (as calculaions were made on he basis of he laes currenly available inersecoral balance shee, which refers o he year 2005, assessmens in his Table are characerisic of he condiions for his year). Conference May 19-20, 2008, Minsk

34 34 Naional Bank of he Republic of Belarus Table 1: Effec of 1% foreign exchange rae devaluaion Incremen in inermediae maerial consumpion, billion Belarusian rubles. Incremen in expors of goods and services, billion Belarusian rubles Gain (+), losses (-), billion Belarusian rubles. 1 Elecric power and hermal power Peroleum indusry producs Gas indusry producs Coal, oil shale, and pea Ferrous and non-ferrous meals Chemical and perochemical indusry producs Machinery and equipmen, and mealworking indusry producs Timber, woodworking, and pulp and paper indusry producs Consrucion maerials (including glass and porcelain indusry producs) Ligh indusry producs Food indusry producs Oher indusrial producs Consrucion producs Agriculural producs, services provided o agriculure, and foresry producs Transpor services Communicaion services Trade and inermediary services (including caering services) Geology services, prospecing, and oher aciviies producs Housing and communal services, and non-producive ypes of household services Healh care, physical raining, and social services Educaion, ar and humaniies, science services Financial inermediaion and insurance services Governance, defense, and nongovernmenal organizaions services Toal The above daa show he scale of secoral losses resuling from he devaluaion which have a negaive impac on he producion efficiency and produc compeiiveness. For he purpose of comparing hem wih a posiive effec of he devaluaion, Table 1 also shows absolue nominal incremens in he volumes of expor proceeds denominaed in rubles which can be generaed by he secors of he economy given ha volumes of foreign exchange proceeds remain unchanged and he naional currency exchange rae is 1% down (his calculaion also refers o he condiions for 2005).

35 The difference beween exra incomes received by he secors of he economy as a resul of an increase in he ruble equivalen of foreign exchange proceeds and exra expendiures on he purchase of more expensive raw maerials and componen pars may serve as an adequae assessmen of an overall effec of he Belarusian ruble devaluaion on each secor of he economy. The sign of his assessmen makes i possible o judge wheher compeiiveness of he economy s secors in he marke becomes higher or, conversely, lower while is value characerizes he scale of an increase or decrease in secoral incomes resuling from he naional currency devaluaion. 35 Daa in Table 1 indicae ha he devaluaion incurs he bigges losses o such secors of he Belarusian economy as consrucion, agriculure and foresry, power indusry and hea-and-power engineering, rade and caering, as well as food indusry. Also, i should be noed ha he ruble devaluaion has a negaive impac on all branches of domesic service indusry because heir dependence on impors is significanly higher han heir expor poenial. Expor oriened secors of he economy gain from he devaluaion mos of all, namely: chemical and perochemical indusry, peroleum indusry, ranspor, foresry, woodworking, and pulp and paper indusry, meallurgy, and mechanical engineering and mealworking. Paricular emphasis should be placed on high favorable assessmen of he gain from he devaluaion in such indusries as peroleum, as well as chemical and perochemical. For he economy which impors large volumes of crude oil his fac which seems o be, a firs glance, unexpeced is no a surprise in an environmen of he Belarusian economy which received underpriced Russian crude oil and earned, owing o his, exra income from reexporing hereof o he hird counries, as well as from selling abroad producs of processing. The above assessmens of exra incomes in expor oriened secors of he economy were made on he assumpion ha heir real producion volumes remain unchanged. However, i is obvious ha hese secors of he economy gained addiional compeiive advanages in exernal markes as a resul of he ruble devaluaion and could make use of hem in order o increase expors of heir produc. The economeric modeling of he secoral expors dynamics of hose secors of he economy which, according o Table 1, mus gain from he devaluaion showed ha hey reaced fairly adequaely o he realignmen of he Belarusian ruble real exchange rae which can resul, in he shor run, from he realignmen of is nominal exchange rae. In economeric models ha have been buil real GDP of Russia and changes in rade condiions for he Republic of Belarus, along wih he real exchange rae of he Belarusian ruble, were also aken ino consideraion as facors of changes in volumes of secoral expors. The raio of expor and impor prices was aken ino accoun as an indicaor characerizing he impac of he laer facor. In some models, changes in energy prices (crude oil and naural gas) which have a significan impac on producion cos in individual secors of he Belarusian economy were aken ino accoun addiionally. The growh of real GDP in he Russian Federaion major foreign rade parner of our counry creaing precondiions for he growh of aggregae demand herein, including demand for impored producs, simulaes wihou doub an increase in physical quaniy and value of Belarus s expors. Preliminary saisic analysis showed ha inensive developmen of he Russian economy in recen years was conducive o he significan growh of Belarusian enerprises expors which was, in urn, one of he facors in he GDP growh in our counry. Economic implicaions of changes in foreign rade condiions viewed from he sandpoin of changes in he compeiiveness of domesic produc in exernal markes are similar, in many respecs, o he effecs resuling from he realignmen of he ruble real exchange rae, hough in one case hey can be caused by price flucuaions in he unsable global marke of naural resources and in anoher case by he exchange rae facor. An increase in expor prices for domesic produc, all Conference May 19-20, 2008, Minsk

36 36 oher condiions being equal, resuls in he falling demand for i because consumers abroad prefer o buy cheaper goods of own producion or similar produc from hird counries. The reducion in impor prices for he produc of foreign firms compeing wih Belarusian producers resuls in similar effec. Therefore, growing indicaor for changes in rade condiions which akes ino consideraion he dynamics of expor/impor prices raio in respec of compeing goods, all oher condiions being equal, may serve he facor which has a negaive effec on expors of Belarusian enerprises. Changes in impor prices for non-compeiive indusrial goods resul in opposie effec. Their growh, increasing producion cos of domesic enerprises, hurs abiliy of produc o compee and herefore can lead o he reducion in is expors, whils heir decrease, conversely, simulaes he growh of expors. I is for his reason ha indicaors for he change in prices for major impored raw maerials crude oil and naural gas which can, increasing or decreasing producion cos, significanly influence he compeiiveness of domesic produc even in cases where real foreign exchange rae remains unchanged were included ino individual economeric models as independen expor facors. Expors of he secors of he Belarusian economy were modeled on he basis of monhly saisics daa. Time series of benchmark saisics were ransformed ino logarihmic form o avoid heeroscedasiciy problems and were subjeced, where necessary, o he seasonal adjusmen procedure (seasonal adjusmen was carried ou wih he help of Cesus X11 implemened in E-Views). Preliminary saionariy analysis of variable models was carried ou in order o reduce he risk of false regression. Uni roo analysis of daa (presence of non-saionariy) was made wih he help ADF, PP, as well as KPSS ess. The resuls of esing showed ha all variables used in he models are non-saionary and are firs order inegraed. The resuls of esing underlie he choice of he ype and specificaion of economeric models which were used hereafer o assess he impac of he foreign exchange rae on secoral volumes of expors. Expors modeling was carried ou on he basis of Johancen coinegraion analysis (since he use of radiional mehods of regression analysis is inappropriae in cases where variables are nonsaionary). Three specificaions of economeric model were buil and analyzed in order o obain he mos complee picure of he impac exered by differen facors on he dynamics of secoral volumes of expors for each of addressed expor oriened secors of he Belarusian economy: The resuls of esing underlie he choice of he ype and specificaion of economeric models which were used hereafer o assess he impac of he foreign exchange rae on secoral volumes of expors. Expors modeling was carried ou on he basis of Johancen coinegraion analysis (since he use of radiional mehods of regression analysis is inappropriae in cases where variables are nonsaionary). Three specificaions of economeric model were buil and analyzed in order o obain he mos complee picure of he impac exered by differen facors on he dynamics of secoral volumes of expors for each of addressed expor oriened secors of he Belarusian economy: EX RUS = β 0 + β1gdp + β 2ERER + ε, (1) EX RUS = β 0 + β 2GDP + β 3ERER + β 4TT + ε, (2) Naional Bank of he Republic of Belarus where EX RUS = α 0 + α 1GDP + α 2 ERER + α 3 POIL + α 4 PGAS + ε, (3)

37 EX indicaor for secoral expors; 37 RUS GDP indicaor for real GDP in he Russian Federaion; ERER index of he effecive real exchange rae of he Belarusian ruble; TT index of changes in rade condiions; and POIL and PGAS accordingly, indices of changes in dollar prices for crude oil and naural gas impored o he Republic of Belarus. Model (2), of hree models in quesion, showed he mos advanageous resuls in erms of is saisical characerisics as well as in erms of he quaniy of saisically significan assessmens. Table 2 shows long-erm elasiciy coefficiens of changes in expors wih respec o changes in he real exchange rae of he Belarusian ruble, Russia s GDP, and foreign rade condiions for six expor oriened secors of Belarusian indusry assessed via Johancen mehod on he basis of his model which, according o Table 1, mus gain from he devaluaion (symbol*, in assessing elasiciy coefficiens in his able, shows heir saisical significance, i.e. saes ha null hypohesis abou insignificance of hese parameers is rejeced a 5% level). Daa in Table 2 indicae ha resuls of coinegraion analysis obained wih he help of model (2) correspond, on he whole, o heoreical conceps of he impac of individual facors on he dynamics of expors. An increase in exernal demand, due o he growh in revenues of our main foreign rade parner, is he mos conribuing, posiive, and saisically significan facor in he growh of Belarusian expors. All addressed secors of he economy, in an appropriae response o he surge of Russia s exernal demand, increase supply of heir produc o his counry wih very high significan elasiciy which can be apparenly explained by he scope of he Russian economy sanding head and shoulders above he Belarusian economy in erms of producion volumes. Table 2: Elasiciy assessmens resuling from he facor analysis of he dynamics of secoral volumes of expors in he Republic of Belarus. Indusries Elasiciy assessmens of facors: Russia s GDP Real exchange rae of he Belarusian ruble Trade condiions Peroleum 5.6* Chemical and perochemical 2.0* Meallurgy 4.5* * Mechanical engineering and mealworking 2.6* -0.6* -0.9* Foresry and woodworking 3.2* -0.4* -1.7* Ligh 1.6* -0.5* -1.4* A negaive and saisically significan response of expors of mos addressed secors of he Belarusian economy o changes in foreign rade condiions was also revealed as a resul of he analysis. Assessmens of corresponding elasiciy made wih he help of model (2) are significanly negaive and basically exceed 1 in erms of absolue value. Excepions are wo indusries, peroleum as well as chemical and perochemical, for which expors elasiciy assessmens wih respec o rade condiions urned ou o be posiive hough saisically insignifican. Moreover, model (3) which addiionally akes ino consideraion expors dependence on changes in he prices for major impored energies showed ha crude oil appreciaion has a posiive and saisically significan impac on Conference May 19-20, 2008, Minsk

38 38 expors of wo above-menioned secors of he economy. This fac can be obviously explained by special condiions for crude oil impor from Russia which is purchased, as i was menioned earlier, a prices ha differ from inernaional. The resuls of he analysis made on he basis of model specificaion (2) also show ha expors of all addressed secors of he economy respond o changes in he real foreign exchange rae of he Belarusian ruble wih negaive elasiciy. However, for such indusries as peroleum, chemical and perochemical, as well as meallurgy received assessmens urned ou o be insignifican. For he firs wo indusries i is he resul of inconsisency in he impac exered by he foreign exchange rae realignmen and he price for he crude oil impored from Russia on he compeiiveness hereof. The insignificance of he meallurgy expors elasiciy assessmen in erms of he exchange rae facor is obviously explained by he fac ha considerable price flucuaions in he global meal marke had a decisive impac on he compeiiveness of his indusry which is confirmed, incidenally, by very high saisically significan assessmen of is expors elasiciy wih respec o changes in foreign rade condiions. So, on compleion of he analysis i is possible o sae ha he exchange rae facor has an ambiguous impac on he open Belarusian economy owing o a complex ineracion of differenly direced effecs changes in proceeds from he sale of expored produc and changes in he producion cos resuling from he appreciaion/depreciaion of indusrial impors as well as domesic goods wih high impors share. In individual secors of he economy cumulaive effecs of he Belarusian ruble depreciaion differ grealy boh in value and in sign owing o secoral peculiariies of he producion paern and he paern of demand for he oupu. Mos secors in he Belarusian economy represened in he srucure of he inersecoral balance shee compiled by he Minisry of Saisics and Analysis of he Republic of Belarus, including consrucion and agriculure, as well as all branches of he service indusry, bear losses from he devaluaion because heir dependence on impors is far greaer han heir expor poenial. Firs and foremos, major secors of he Belarusian economy which generae large share of expor revenue, such as chemical and perochemical, perol, foresry, woodworking and pulp and paper, meallurgy, and mechanical engineering and mealworking make significan cumulaive gain from he devaluaion. The facor analysis of he dynamics of hese indusries expors made on he basis of Johancen coinegraion analysis showed ha hey avail hemselves, fairly effecively, of addiional compeiive advanages resuling from he devaluaion of he ruble increasing supply of heir produc o he exernal marke. The resuls of he same analysis indicae ha expors of aforemenioned secors of he economy respond, in a saisically significan manner, wih high posiive elasiciy o he real GDP growh of he main rading parner of our counry he Russian Federaion as well as wih negaive significan elasiciy, bu no for all indusries, o changes in foreign rade condiions. Naional Bank of he Republic of Belarus

39 Naalya Mironchik, 1 Mikhail Demidenko 2 39 The Role of he Quarerly Projecion Model in Moneary Policy of he Republic of Belarus In recen years he Naional Bank of he Republic of Belarus (he Naional Bank) is acively involved in examining he issue of he moneary policy regime improvemen, including evaluaion of he expediency of he gradual ransiion o he inflaion argeing (Lobanov and Kalechis, 2004), Naional Bank of he Republic of Belarus, 2007). This regime gave a raher good accoun of iself during he recen years in a number of counries in view of inflaionary expecaions sabilizaion and enhancing moneary policy ransparency and accuracy. Moreover, he successful funcioning of he regime was regisered no only in he counries wih he developed marke economy, bu also in he counries whose marke is under developmen (Baini, e al., 2005). Bu, wih a view o ransiing o he inflaion argeing regime a number of pracical issues should be ackled, including, significan lowering of adminisraive inervenion in price-seing; assuring availabiliy of he sable foreign economic secor and developed financial marke; eliminaion of fiscal dominaion over moneary policy; and esablishing reliable analyical insrumens for he comprehensive reflecion of he moneary policy ransmission mechanism. All hese issues are criical for achieving successful resuls on pracice. The aricle dwells on he individually aken aspec of he implemenaion of he developed program of ransiion o he inflaion argeing, namely, creaion of he corresponding sysem of analysis and projecion of moneary policy of he Republic of Belarus. I. Main Characerisics of he Moneary Policy Analysis and Projecion Benchmark Sysem During he las 50 years moneary economiss developed a number of scienific principles on he basis of he accumulaed heoreical and pracical experience which are a presen he basis for he aciviies of he majoriy of cenral banks. The key principles are: (1) inflaion, wih regard o he susainable growh of prices, is always and everywhere a moneary phenomenon; (2) price sabiliy has imporan advanages: a low and sable inflaion level conribues o he more efficien use of he producion resources in he economy; (3) here is no a compromise choice beween he level of unemploymen and inflaion in he long-run: in he long-run he Phillips Curve is verical, i.e., a definie naural level of unemploymen is inheren in he economy which does no depend on he level of inflaion and all he aemps of he moneary auhoriies o keep he unemploymen a he level which is lower han he naural one cause an even higher inflaion raher han he increase in employmen; (4) expecaions are one of he main facors of inflaion and play an imporan role in he moneary policy ransmission mechanism; (5) when he level of inflaion is growing i is necessary o increase he real ineres raes, i.e., o comply he Taylor Principle; (6) he imeinconsisency problem (problem wih economic agens confidence in he cenral bank, namely, wih a cenral bank s abiliy o follow he announced policy) is peculiar o discreionary moneary policy; (7) he cenral bank s independence, mainly, in he choice of moneary policy insrumens conribues o he increase in is efficiency; (8) he adherence o he sabiliy of a nominal anchor (inflaion, money supply, or exchange rae) plays an imporan role in he aainmen of good moneary policy oucomes by he cenral bank; (9) he sabiliy of he financial sysem is imporan for he mainenance of sable economic growh raes (Mishkin, 2007). 1 Naional bank of he Republic of Belarus, Ph.D. of economics. 2 Naional bank of he Republic of Belarus. Conference May 19-20, 2008, Minsk

40 40 In order ha above-menioned scienific principles have applied characer cenral banks, wih he acive use of economeric models, develop and apply specific algorihms, mehods, analysis, projecion and implemenaion sysems of moneary policy. A cerain progress in his field was achieved during he las en years. The cenral banks ha swiched o he inflaion argeing and popularized developmen of he forecasing and policy analysis sysem (FPAS) based on he neo-keynesian paradigm (Blach, Laxon, e al., 1994), Black, Cassino, e al., 1997), and CNB (2003) conribued o his progress. Laxon and Sco (2006) disinguish he following main feaures of he FPAS benchmark for inflaion argeing: 1. The reporing, daabase and near-erm forecasing sysem is based on he use of he limied in number bu major in naure macroeconomic variables ha enables each new person involved in he forecasing and developing moneary policy process o use he same daa. 2. Daabase updaing, monioring and preparaion of repors should be performed on he imely (weekly) basis. Tha is why all he persons ha are involved in moneary policy forecasing and developing mus be informed on he permanen basis abou he manner in which he new high frequency daa influence he near-erm inflaion forecas (and how hey may influence he long-erm inflaion oulook). 3. The availabiliy of he simple quarerly projecion model (QPM) which reflecs he Moneary Policy Commiee s (MPC) poin of view wih respec o he moneary policy ransmission mechanism and he sandard se of shocks ha affec he economy. A he beginning, he model may be raher simple. The main hing is o sar formalizing he mechanism in which, from he MPC s poin of view, he key macroeconomic variables respond o moneary policy insrumens. The model mus be exended as may be necessary based on he pracical needs. A ha, i should no be oo complicaed and urned ino he black box. 4. The quarerly developmen of he consisen medium-erm forecas using QPM. This work presumes he assessmen of risks o he baseline forecas and making, on his basis, proposals on amending he official baseline forecas. 5. Developmen measures of uncerainy in he forecas, for example, confidence inervals ha may be useful o characerize he forecas accuracy. 6. Examinaion of specific risks relaed o he fulfillmen of he baseline forecas and developmen of he coningency policy alernaives. I is necessary o examine he scenarios of he cenral bank s reacion on new informaion ha may appear during he period beween official forecass. Naional Bank of he Republic of Belarus Laxon and Sco (2006) poin ou he benefis ha are ensured by such srucured forecasing and policy analysis sysem. Firs, i faciliaes communicaion beween he people ha are involved in he forecas and he policy debae and leads o he imporan muual aciviies and seady improvemen of qualiy of muual analyical work. Second, i assures more srucured debaes abou he risks in he forecas faciliaing he idenificaion and discussion of problems relaed o he key policy issues. Third, i assures he daabase developmen ha makes i possible o assess he previous forecass informing saff abou he required new invesigaions. Forh, i conribues o he developmen of he highly-specialized human capial. Fifh, i faciliaes he developmen of insiuional knowledge on he moneary ransmission mechanism and he effecs of differen shocks on he economy. Sixh, is ensures a higher degree of ransparency of he moneary policy sysemic componen and forecass developmen process because he managers saemens and official repors on cenral banks moneary policy no only incorporae he forecas of ineres raes, bu also provide a comprehensive and convincing for he public reasoning of he forecas. I is grounded by he need o increase and mainain confidence in moneary policy. In his

41 case, he models make i possible o form he well-grounded and coordinaed hisory of he economy developmen and progress. 41 As a rule, wo problems are defined among he main facors ha hinder or impede he FPAS developmen. Firs, he desire o obain he perfec FPAS in he shores possible ime wihou ensuring of he minimal accepable qualiy of he near-erm analysis and forecasing and, secondly, he effecive FPAS requires significan inegraion of all is consiuen elemens: he reporing sysem, human capial, informaion echnologies, daabases, ec. For example, unil he creaion of he efficien daabase and availabiliy of he corresponding inellecual and reporing sysem required o suppor monioring and near-erm forecasing i will be unimely o spend significan resources for developing a perfec model of he economy. Besides, he pracice proved ha he peculiariies and developmen of he FPAS depend, o a grea exen, on he moneary policy regime and he degree of he cenral bank s independence (Laxon and Sco, 2006). II. Developmen of he Forecasing and Moneary Policy Analysis Sysem in he Republic of Belarus The developmen of he forecasing and policy analysis sysem a he Naional Bank is inseparably linked o he evoluion of he moneary sphere of our counry and developmen of such fields of economic science as Moneary economics and Economerics. I is considered ha he carrying ou of independen moneary policy commenced in 1994 when he Belarusian ruble was approved as a single legal ender in he Republic of Belarus. The period was difficul for he moneary sysem of he Republic of Belarus because he counry overcame he crisis which was caused by he general economic recession afer he collapse of he Sovie Union. Significan volumes of credi emission were ransferred o he economy o keep sae enerprises afloa and cover budge defici. In he condiions of limied general economic and srucural reforms as well as he low level of gold and foreign exchange reserves he high raes of money supply growh resuled in he muliple exchange raes in he foreign exchange marke, significan devaluaion of he Belarusian ruble versus foreign currencies, and drasic inflaion growh, whose raes in 1999 amouned o 251.2%. Several years earlier, in 1991, Money circulaion and credi and Economerics were professed in he Republic of Belarus for he firs ime. During he firs years he inroducory courses o cerain branches of Economerics and Money circulaion and credi ha were radiional in were augh. Correspondingly, he indicaed period was characerized by applicaion, mainly, of he simples approaches, moneary policy analysis and projecion mehods, based on he well-known equaion of exchange, money muliplier formula, and basic macroeconomic ideniies (Komkov, 1996). As saisical daa were accumulaed, modeling skills were developed, and scienific saffing was formed he firs invesigaions of he Belarusian economiss were carried ou ha involved he analysis and modeling of processes in he moneary sphere, including, wih applicaion of economeric models. Rusakevich (1998) developed he generalized economeric model of he moneary sysem of he Republic of Belarus ha combined he blocks of he basic macroeconomic ideniies and moneary ideniies, as well as he regression models of he money supply and money demand. The auhor used logarihmical-linear regression equaions o describe he behavioral dependencies. During , he use of regression analysis was fully jusified and adequae due o he high elasiciy of consumer prices wih respec o he money aggregae M1 (1.0) and exchange rae BYR/USD (0.7). In 2000, significan posiive changes in he moneary sphere go under way, namely, he sysem of muliple exchange raes was liquidaed, a single exchange rae was inroduced, he raes of he credi emission were reduced, and ineres raes were mainained on he posiive, in real erms, level. Wih a view o aaining he key moneary policy arge he Naional Bank sared o use he ex- Conference May 19-20, 2008, Minsk

42 42 change rae as an inermediae arge, aemping o assure predicable dynamics of he Belarusian ruble exchange rae versus he US dollar and preven significan appreciaion of he real effecive exchange rae of he Belarusian ruble in he condiions of he foreign rade defici. As a resul, in , he raes of he devaluaion of he official exchange rae of he Belarusian ruble versus he US dollar dropped from 33.9% in 2001 o 0.5% in A ha, in 2005 and 2006, he nominal exchange rae appreciaed by 0.8 and 0.5%, respecively. The decrease in he raes of devaluaion of he Belarusian ruble along wih he oher economic and moneary measures conribued o he gradual disinflaion and business acivizaion in he counry. Inflaion which was measured by he CPI growh decreased from 46.1% in 2001 o 6.6% in 2006; he average rae of he real GDP growh amouned o 8% during The achieved relaive macroeconomic sabilizaion in he counry on he background of foreign and naional scienific invesigaions developmen in he field of economic and mahemaical modeling and he inernaional experience of he pracical use of economeric models wih a view o ackling moneary policy asks conribued o he successful developmen of he VAR-models and ECMmodels by he Naional Bank s specialiss (Kallaur, Komkov and Chernookiy, 2005). Thus, Chernookiy (2004) in his paper considered modeling differen inflaion indicaors involving he ECMmodels. Based on monhly daa Malugin, Pranovich e al. (2005) developed he sysem of error correcion models for moneary policy arges (Firs Economeric Models Sysem for Moneary Policy (EMS MP-1) designed o analyze, forecas and evaluae moneary policy opions in he Republic of Belarus. In he modified version of his sysem (Second Economeric Models Sysem for Moneary Policy (EMS MP-2) economeric models are inegraed and inerrelaed by he guided exogenous variables (moneary policy insrumens: refinance rae and reserve money) and general exogenous variables (oupu, inflaion arge and exernal facors) as well as endogenous variables (inermediae moneary policy arges: exchange rae, money supply, and long-erm ineres raes). The EMS MP-2 serves as one of he basic insrumens of forecasing moneary proporions and a core model of he forecasing and policy analysis sysem of he Republic of Belarus (Belarusian Sae Universiy, 2007). For he ime being, he EMS MP-2 complies, o he greaes degree, wih he legally prescribed procedures of moneary policy developmen and implemenaion in he counry. Firs, i akes ino accoun he pracice of he coordinaed developmen of he general economic and moneary forecass and measures for he nex year: he parameers of he annual forecas of he social and economic developmen are he saring basis for drafing he Moneary Policy Guidelines of he Republic of Belarus. Second, i covers he enire sysem of inermediae moneary policy arges, including he exchange rae arge and indicaive parameers of erm deposi raes, credis o he real secor and ruble money supply. Naional Bank of he Republic of Belarus Nowihsanding a cerain progress in he economeric modeling and examinaion of he moneary policy ransmission mechanism he analyical insrumens used in remained limied. The models were developed, mainly, on he basis of monhly daa, evaluaed separaely and presened, mosly, for he purpose of he shor-erm forecasing. Besides, he exension of he lag of he moneary policy impac on prices, increased imporance of he non-moneary facors of inflaion and considerable changes of he foreign economic environmen sared o hinder, o an increasing exen, forecasing and meeing he exchange rae arge. The uncerainy of quaniaive assessmens of money velociy and he insabiliy of he money demand funcion did no allow o rely compleely on he growh raes of he moneary aggregaes only. All hese facs simulaed debaes on he expediency of changing he sysem of inermediae moneary policy arges and swiching o he inflaion argeing regime. Therefore, in 2005, he Naional Bank of he Republic of Belarus in order o improve mehodological condiions of moneary policy and wih he echnical assisance of he IMF and he Naional Bank of he Czech Republic sared o sudy he neo-keynesian approach

43 o he analysis and projecion of moneary policy (Clarida, Gali and Gerler, 1999), (Walsh, 2003), (Woodford, 2003), which is mainly used in condiions of he inflaion argeing. This projec conribued, o a grea exen, o he undersanding of he moneary policy ransmission mechanism funcioning, developmen of he approaches o moneary policy of he Republic of Belarus analysis and projecion wih accoun of he world experience, and comprehensive use of he sysem of models and exper judgemens of he Naional Bank s saff. 43 III. The Experience in he Field of Developmen and Use of he Small Semisrucural Quarerly Projecion Model for Medium-erm Forecasing and Moneary Policy Projecing a he Naional Bank The semi-srucural QPM for analysis, medium-erm forecasing and moneary policy projecing which was developed for he Republic of Belarus is a simple model of he firs generaion in which he indicaors of deviaion of he real economic variables from heir equilibrium rends are used. The model was developed on he basis of quarerly daa obained since he beginning of 2002, i.e., from he momen when he level of inflaion amouned o less han 35% per annum, and includes a sandard se of he aggregaed behavior equaions: he inflaion equaion, which represens a dynamic equaion of he aggregae supply, is based on he modified Phillips Curve (Gali and Gerler, 1999) and describes inerrelaions beween inflaion, persisence in inflaion (auoregressive inflaion variable), inflaion expecaions, impored inflaion (including changes of prices for power supplies), and marginal producion coss ha are approximaed by he oupu gap indicaor; he oal demand equaion according o which he oupu gap is deermined by he persisence ypical o he oupu gaps, real moneary condiions (deviaion of he real ineres rae and real exchange raes from heir equilibrium levels) and exernal demand (he oupu gap in Russia); he ineres rae equaion which is represened in he form of he modified version of he Taylor rule (Rudebusch, 2001); he exchange rae equaion according o which he exchange rae dynamics is deermined by he Purchasing Power Pariy (PPP) in he long-run, he Uncovered Ineres Raes Pariy (UIP) in he medium- and shor-run, and Naional Bank s inervenions in he foreign exchange marke. Taking ino accoun nuances of he ransiion period of he Belarusian economy developmen his model was adaped o he sae pricing policy peculiariies and Naional Bank s moneary policy. This was refleced in he specifics of modeling inflaion, exchange rae, ineres rae and oher variables. Le s ake a deailed look a his aspecs. Inflaion. The Phillips Curve equaion was developed no for core inflaion ha complies wih he sandard pracice of is modeling, bu for overall CPI inflaion. I is explained by he fac ha despie he officially declared 30% share of he adminisrae regulaed prices in he consumer baske a more wide conrol over he price changes is used in he Republic of Belarus. I is exercised hrough he direc price- and ariff-seing for cerain ypes of goods (some baked goods, cerain mea and milk producs, obacco goods, vodka, and cerain medicines) and services (housing and communal services, ranspor, infan school services, ec.) by he corresponding bodies of sae adminisraion; prescribing he maximum level of prices (ariffs), he maximum rade markup (discoun) o he prices, and he maximum profiabiliy rae for enerprises and organizaions; as well as hrough seing he maximum growh rae of sale prices (ariffs), pracically, for all he economic eniies. A he same ime, as i follows from he experience, he adminisraive regulaion is characerized by he non-sric conrol of he fulfillmen of he prescribed resricions by he regulaory bodies. Such siuaion is imposed by he objecive circumsances and conclusions made on he basis of he price regulaion pracice in he previous years, namely, he inefficiency of mainenance of he significan deviaion of prices from he naural for he economy level (Sae Scienific Insiuion Insiue of Economy of he Naional Academy of Sciences of he Republic of Belarus, 2003). I was also con- Conference May 19-20, 2008, Minsk

44 44 firmed in he year 2007, when impored gas prices increased by more han 2.1 imes, ha resuled in he deerioraion of he financial posiion of a grea number of enerprises and organizaions, and forced o raise prices for households for he elecriciy and gas by 20% and heaing by 12%, prices for firms for gas by 88.9%, for elecriciy by 21.2%, and for heaing by 40%, ha, naurally, caused he growh in he CPI. Besides, he inensive growh of prices for foodsuffs in he world marke, including Russia, resuled in 2007 in he dispariy of prices for he individual foodsuffs in he Russian and Belarusian markes and, as a resul, in he quick re-orienaion of he naional producers owards he foreign markes. In such a siuaion he increase in domesic prices was unavoidable for he purpose of simulaing he delivery of goods o he domesic marke by he producers, ha also made an impac on he dynamics of he CPI. As a resul, in 2007 he growh of he CPI amouned o 12.1% and exceeded he upper border of he inflaion arge by 1.5 imes. The adminisraive price regulaion in he Republic of Belarus has one more disincive feaure: in he condiions of he limis prescribed by he sae individual enerprises ac like monopoliss. They are no afraid of domesic compeiion and decrease of demand for heir producs in he condiions when all he producers increase he prices and very ofen increase heir prices ogeher wih oher enerprises (even if i is no necessary) and lobby he increase in prices in he governmen bodies grounding i by he increase in he coss of producion and decrease in he profiabiliy (Sae Scienific Insiuion Insiue of Economy of he Naional Academy of Sciences of he Republic of Belarus, 2003). Thus, modeling he modified Phillips curve for overall CPI inflaion is, and he research resuls confirm i, an approach quie adequae for he Republic of Belarus. Exchange rae. Under he inflaion argeing regime and floaing exchange rae cenral banks of small and open economies generally describe he dynamics of he naional currency exchange rae versus he currency of he counry-he main rading parner relying on he PPP subjec o he Balassa-Samuelson effec and UIP: where s * eq * ls = χ 0 E[ s+ 1] + (1 χ0)( s 1 + 2( π π + z ) / 4 + ( r r pr ) / 4 + ε, (1) π is domesic inflaion; * π is foreign inflaion; s is he nominal exchange rae of he foreign currency versus he naional currency; eq z is he equilibrium real exchange rae of he naional currency; r is he domesic nominal ineres rae; * r is he foreign nominal ineres rae; and pr is he risk-premium of foreign invesors. Naional Bank of he Republic of Belarus So far he Naional Bank mainains he regime of sof pegging of he exchange rae of he Belarusian ruble o he US dollar, i.e. o he currency of he counry ha is no is main rading parner wha is due o he considerable weigh of he US dollar in he domesic foreign exchange marke and in he srucure of he households foreign exchange savings, as well as is large share in he selemens of foreign rade operaions. Therefore, he descripion in he model of he change in he BYR/USD exchange rae arge is based on he condiion of gradual adjusmen of he nominal exchange rae o he level of is fundamenal equilibrium which depends on he process of real convergence of he developing Belarusian economy wih he level of developed counries, including he USA:

45 ls _ usd ar = θ ε, ar SS ar 0 ls _ usd 1 + (1 θ0)( us _ pie pie + lz _ usd ) + ar ls _ usd (2) 45 where ar ls _ usd SS us _ pie is he nominal USD/BYR exchange rae arge; is inflaion in he USA in he long-run in a seady sae; ar pie is he medium-run inflaion arge in he Republic of Belarus; and lz_ usd is he real BYR/USD exchange rae. For example, if he long-run inflaion arge in he USA is 2% and in Belarus 5%, given he rend of he produciviy growh of he Belarusian economy is 3 percenage poins higher han he same indicaor for he USA, here s no reason o expec a change in he nominal BYR/USD exchange rae in he long-run. The nominal exchange rae may diverge, in he medium- and shor-run, from is fundamenal equilibrium level under he impac of he change in he difference beween domesic and foreign ineres raes in accordance wih he UIP. ls _ usd = λ + + ε, (3) ar eq 0 ls _ usd + (1 λ0 )[ ls _ usd 1 + ( rn us _ rn us _ prem ) / 4] ls _ usd where rn is he nominal ineres rae on new bank credis in he naional currency o firms (excluding inerbank credis and lax credis); us_ rn is he nominal ineres rae on new credis in US dollars o firms; and eq us _ prem is he equilibrium risk-premium of foreign invesors on BYR/USD operaions. Thus, if LIBOR in USD for one year is 3% and he marke ineres rae on new credis in Belarusian rubles is 13%, given he difference beween he ineres rae on credis in US dollars o firms and LIBOR (risk-premium) amouns o 8 percenage poins on average, all oher condiions being equal, i is reasonable o anicipae in he shor-run (for example, in he neares quarer) he appreciaion pressure on he BYR/USD exchange rae corresponding o he appreciaion of he nominal exchange rae by 0.5% per quarer. A he same ime, given he fac ha Russia is he main rading parner of he Republic of Belarus and, accordingly, economic processes in Russia have he sronges effec on socioeconomic developmen in Belarus, he dynamics of he BYR/RUR exchange rae which is auomaically defined on he basis of RUR o USD cross-rae is aken ino consideraion in inflaion and oupu gap modeling. Ineres Rae. The hird peculiar feaure of he model is he absence of he yield curve equaion which shows relaionship beween shor-erm and long-erm ineres raes in he marke economy relying on he expecaions hypohesis subjec o he risk-premium facor. In he Republic of Belarus ineres raes on ruble-denominaed credis o firms whose share in he oal volume of he banks ruble-denominaed claims on he economy accouns for more han 70% are suscepible o adminisraive conrol, i.e. ineres raes on new credis mus no exceed he refinance rae subjec o 3% margin in order o make he banks credi resources accessible o he enerprises. However, in case of exigency his limiaion can be removed, as i happened, for example in he firs quarer of 2007, for he purpose of promoing he sabilizaion of economic agens devaluaion expecaions and reducing he demand for foreign exchange which sharply increased afer a more han wofold increase in prices for naural gas impored from Russia o Belarus and subsanial change in he erms of oil producs supply. Neverheless, a a ime when an acive conrol over he level of ineres raes in he economy is reained here is no sense hus far in Conference May 19-20, 2008, Minsk

46 46 modeling he relaionship he Naional Bank refinance rae banks long-erm ineres raes on credis. Therefore, he Taylor rule is represened in he model as an equaion for he ineres rae on new ruble-denominaed credis o firms: rn eq ar gap rn = δ 0 rn 1 + ( 1 δ 0 )[( rr + pie3+ 2 ) + δ1( pie3+ 2 pie3+ 2 ) + δ 2lgdp ] + ε, (4) where eq rr is he equilibrium real ineres rae in he Republic of Belarus; pie 3 +2 is he prediced value of hree-quarer CPI inflaion (over he curren and he nex wo quarers); pie3 + 2 is he arge of hree-quarer inflaion (over he curren and he nex wo quarers). ar In he fuure, if he margin is cancelled or he share of credis wih adminisraively conrolled ineres rae is subsanially reduced he model will possibly be exended by he yield curve equaion. In 2008, we ried one more experimen seing he value of δ 1 coefficien in equaion (4) equal o zero. As a resul, he opimal level of he nominal ineres rae on new ruble-denominaed credis o firms in he model was brough in conformiy wih he neural level of his rae (he equilibrium level of he real rae plus an anicipaed inflaion rae) adjused for he reacion of he Naional Bank o he oupu deviaion from is poenial level. I is assumed ha he excess demand in he economy necessiaes ineres rae policy ighening, and, conversely, he negaive oupu gap requires ha he ineres rae be reduced, hereby faciliaing, by means of moneary policy measures, he mainenance of susainable growh raes of oupu in he economy. Such modificaion of he ineres rae equaion (he lack of he Naional Bank s reacion o he divergence of inflaion from he arge) is due o he fac ha he dynamics of inflaion in he Republic of Belarus nowadays is defined, in many respecs, by non-moneary facors, i.e. he adminisraive conrol of prices, he srucure and level of coss in he real secor of he economy, he dynamics of foreign prices for inermediae and mainline impors, policy on household money income, and fiscal policy. Anoher disincive feaure of he Naional Bank s new se of models which disinguishes i from similar models of oher cenral banks is deermining, wih he help of he Kalman Filer, he deviaion of he indicaor for real volumes of he banking secor s lending o he economy from is equilibrium level. There were several reasons behind i: in he firs place, popular poin of view ha he credi channel is more effecive han he ineres rae channel and, accordingly, managemen s wishes o allow for his fac, where possible, in he model; and in he second place, an addiional opporuniy o analyze he relaionship beween he oupu gap and he banking secor s credis denominaed no only in rubles bu in foreign exchange whose role in mainaining high growh raes of he economy increased significanly beginning in In 2007, he Naional Bank sared he approbaion and pracical use of his model, as well as began o develop FPAS on is basis so ha o bring he laer closer o he benchmark. New insrumen showed immediaely ha i is in demand because afer he hike in he prices for naural gas impored from Russia o Belarus and he change in he erms of crude oil supply auhoriies began o pay more aenion on he risk assessmen and effecs of unfavourable exernal shocks on he economy of our counry, as well as he analysis of he Naional Bank s reacion o hese effecs. An ad hoc forecasing eam (FT) consising of he eam manager, modeler and model operaor, as well as expers in differen secors of he economy makes all model calculaions and descripions hereof. Naional Bank of he Republic of Belarus Today, he imeable for calculaions involving QPM model depends on he curren pracice of holding quarerly meeings of he Board of he Naional Bank and weekly meeings of he MPC. Preparing he firs (preliminary) forecas sars approximaely on he10h day of he las monh in he reporing quar-

47 er and akes abou 5-7 working days. An assessmen of he economy s curren sae, major inflaion risks, and real moneary condiions is he main ask of he forecas, having regard o acual daa for he pas wo monhs and near-erm forecas for he las monh in he reporing quarer. The descripion of he forecas resuls and presenaion hereof are brough up for discussion a one of he las meeings of he Moneary Policy Commiee preceding he meeing of he Board of he Naional Bank where he forecas of major moneary indicaors for he nex quarer is considered and approved. 47 Following he publicaion of acual daa for he quarer, i.e. approximaely on he10h day of he firs monh in he quarer which follows he reporing quarer, he FT sars o develop he second (more accurae) forecas which is aken ino consideraion in analyzing moneary policy scenarios produced on he basis of alernaive mehods and models. A fairly shor experience of using his model by he Naional Bank showed ha i is definiely useful for he purposes of moneary policy in an environmen of he ransiion economy and he exchange rae argeing regime despie he problems basically confroning he developmen and applicaion of any oher model. In he firs place, his is an addiional insrumen for sudying he moneary policy ransmission mechanism and idenifying opical issues of he research as well as areas of improvemens o saisics. For example, he shorcomings of he CPI calculaion mehod which was in use in 2007 were revealed in he course of using he model, namely he calculaion of he price for heaing. The price for his service depends on he norm for hermal energy consumpion which was generally revised wo imes a year: a sharp downward adjusmen in May and upward adjusmen a he end of he year. As a resul of such correcions flucuaions of seasonally adjused quarer inflaion (in annual raes) amouned o ± 2 percenage poins. New procedures for calculaing his norm as well as he norm for he consumpion of hermal energy o hea waer were adoped in 2008 ha assume heir recalculaion once a year, in May and Sepember (respecively), wha is sill inconsisen wih he inernaional experience as he pracice of muliple changing he srucure of he consumer baske wihin a year is coninued. Also, he need for furher improvemens in he approaches o he analysis and forecas of moneary and non-moneary inflaion facors requires exracing energy goods iems from consumer baske and creaing a subgroup index wihin he CPI which would make i possible o analyze he dynamics of he aggregaed index of energy prices (prices for oil producs, naural gas, coal, and elecric energy). In he second place, his is an efficien insrumen for explaining, spreading, and popularizing new knowledge abou he moneary economy among boh expers of he Naional Bank and academic economiss of he counry because he QPM as a brief descripion of he ransmission mechanism of Belarus s moneary policy and relaionships beween major macroeconomic variables gives no only quaniaive assessmens, bu, a he same ime, an explanaion hereof. The model is simple o use and undersand wha is provided by a small number of equaions developed on he aggregaed level. In he hird place, his is an addiional alernaive insrumen for assessing curren sae of he economy and analyzing moneary policy. In he fourh place, his is a fairly powerful analyical sysem for medium-erm forecasing of major macroeconomic indicaors which combines hisorical daa, he near-erm forecas, and exper judgmens and makes i possible o calculae alernaive moneary policy scenarios subjec o uncerainy. And in he fifh place, his is a good means of verifying he consisency beween forecasing and analysis of economy, hough he lis of macroeconomic variables calculaed by he model is limied. I is naural ha he pracice of he model use and FPAS operaion in he Naional Bank hus far differs subsanially from he benchmark. Above all, his is due o he difficulies in adaping new mehods for moneary policy analysis and projecing o he erms of he exchange rae argeing regime and he ime required o cope wih hem and o raise confidence in he resuls of model calculaions. Even if he analysis is based on he modern economic heory employing advanced ma- Conference May 19-20, 2008, Minsk

48 48 hemaical insrumens, all he same, i is necessary o acknowledge ha here is an uncerainy in he change of observed variables. Exper assumpions of he saff as well as forecass abou he dynamics of exogenous variables which are highly uncerain exer significan influence on he resuls of model calculaions. This aspec of he problem is of op prioriy for he Belarusian economy which currenly undergoes major srucural changes defining, o a large exen, he fuure dynamics of equilibrium rends. Besides, difficulies for geing reliable resuls are deermined by he use of relaively shor ime series buil on quarerly daa for ha is conneced wih greaer insabiliy of economic processes which ook place in he developmen of he counry in pas years. Currenly, he use of he above-menioned model in he process of moneary policy projecing in a small and open ransiion economy also becomes more complicaed under he impac of exernal facors. One should ake i ino consideraion ha he rend owards significan acceleraion of inflaionary developmens became visible laely in many counries around he globe resuling from sharp increase in he world demand a a ime when raw maerials and labor force are limied. Borio and Filardo (2007) believe ha as he dynamics of domesic prices becomes increasingly dependen on global facors (wha is peculiar o he Republic of Belarus), he efficiency of domesic moneary policy on conrol he excess demand and inflaion in he shor-run decreases and imporance of aking global measures aimed a limiing he excess demand in he world as a whole increases. IV. Areas of Furher Developmen of FPAS in he Naional Bank High qualiy FPAS is very helpful in making informed decisions in he moneary policy sphere, in an environmen of he ransiion economy in paricular, which is characerized by frequen and subsanial srucural changes. Therefore, he Naional Bank aaches special imporance o he ask of coninuous and all-round developmen of is analyical and forecasing insrumens. In connecion wih his, we would like o place emphasis on a number of areas of furher developmen of FPAS which are of high prioriy o us. Currenly, he Concep of he Financial Marke Developmen is implemened in he Republic of Belarus and a number of regulaory acs simulaing he developmen of business environmen as well as he inflow of foreign invesmens have been adoped. Accordingly, condiions for pursuing more flexible exchange rae policy and increasing he role of ineres rae in regulaing economic processes are oulined. Therefore, in cases where significan changes in he condiions for he implemenaion of moneary policy pursued by he Naional Bank occur high emphasis should be placed on he imely adjusmens of he QPM specificaion. Coninuous and susainable developmen of all oher elemens of FPAS wih a view o gradual bringing he laer closer o he benchmark is also imporan. We hink i is expedien o sar o develop he dynamic general equilibrium model (DGEM). In conras wih he QPM, his model offers significan advanage, i.e. he coverage of all secors of he economy and he descripion of relaionships beween indicaors of flows and socks. Building such kind of he model would make i possible o subsanially improve, a his sage, saff s knowledge of economic processes and of how hese processes affec he choice of moneary policy measures in he ransmission mechanism, would help o find ou wha is he subjec o furher research, and would faciliae he developmen of more consisen macroeconomic forecass. Naional Bank of he Republic of Belarus Assessing and forecasing equilibrium rends in he dynamics of real economic variables, applicaion of he business cycles heory for he purposes of macroeconomic analysis and projecion, price and wage rigidiy, assessmen of inflaion expecaions and heir impac on he price level, as well as aggregaion of individual behavior and use of he represenaive agen model all hese issues are quie new for he Republic of Belarus and are poorly covered in he domesic academic and eco-

49 nomic lieraure. This makes pracical use of he new kind of model raher complicaed and requires furher deep heoreical and applied research, including wih he help of alernaive approaches and by involving all scienific insiuions of he counry which specialize in moneary economics. This would make i possible no only simulae new scienific debaes on opical aspecs of moneary regulaion, bu would be conducive o furher improvemen in he principles of Belarus s moneary policy developmen and implemenaion. 49 In consideraion of he foregoing, as well as in view of growing insabiliy in inernaional financial markes, he ask of incorporaing he imperfecions of he banking sysem and financial marke of he Republic of Belarus ino srucural model of he economy and business cycles developmen model is he prioriy for he Naional Bank. Ensuring sabiliy of he financial and banking sysem is one of he main asks of he Naional Bank oday. References Belarusian Sae Universiy (2007). Research repor Developmen and Perfecion of he Economeric Models Sysem for he Purpose of Developing Moneary Policy Implemenaion Scenarios. Sage 4 (final): Developmen and Perfecion of he Economeric Models Sysem for he Purpose of Developing Moneary Policy Implemenaion Scenarios. Minsk: BSU, 2007 p.58. Sae Scienific Insiuion The Insiue of Economics of he Naional Academy of Sciences of Belarus (2003). Research repor Analysis of he Republic of Belarus Moneary Policy and is Impac on he Real Secor of he Belarusian Economy Using he Sysem of Economic and Mahemaical Models. Sage 3: Research ino Inflaion Facors, Modeling he Inflaion Dependence on Exchange Rae Changes, Coming up wih Recommendaions o Resrain Inflaion and Devaluaion Processes in he Counry. Kallaur P., Komkov V., Chernookiy V. (2005). Moneary Policy Transmission Mechanizm in he Economy of he Republic of Belarus. Belarusian Economic Journal No. 3 pp Komkov V. On Forecasing and Regulaing he Economy s Financial Equilibrium. Theory and Pracice Issues of Saisics in Transiion Period: Theses of he Repor a he Scienific and Pracical Conference, Minsk, March 27-29, 1996, Minisry of Saisics and Analysis of he Republic of Belarus, Belarusian Sae Economics Universiy, and Research Insiue for Saisics. Minsk, 1996 pp Lobanov A. and Kalechiz S. (2004). Naional Currency Sabiliy Assurance Mechanizm. Bankovskiy Vesnik No. 34 pp hp:// Maliugin V., Pranovich M., Moorin D., and Kalechiz D. (2005). Economeric Models Sysem for he Analysis, Forecasing, and Assessmen of Moneary Policy Varians. Bank s Research No. 2 p.41. hp:// Mironchik N., Demidenko M., Tsukarev T. A New Keynesian Approach o Moneary Policy Analysis and Forecasing. Belarusian Economic Journal No. 1. pp The Naional Bank of he Republic of Belarus (2007). The Developmen Program for he Banking Secor of he Belarusian Economy for Minsk pp Rusakevich I. (1998). Analysis and Forecasing in he Cenral Bank Bankovskiy Vesnik No. 11. pp Chernookiy V. (2004). The Inflaion Processes Model in he Republic of Belarus. Bank s Research No.1. The Naional Bank of he Republic of Belarus p.38. hp:// Baini, N., Kuner, K. and Laxson, D. Does Inflaion Targeing Work in Emerging markes. IMF. World Economic Oulook. Sepember Chaper 4, Blach, R., Laxon, D., Rose, D., Telow R. (1994). The Bank of Canada s New Quarerly Projecion Model. November p. hp:// Black, R., Cassino, V., Drew, А., Hansen, E., Hun, B., Rose, D. and Sco, A. (1997). The Forecasing and Policy Sysem: he core model. Research paper No. 43. Reserve Bank of New Zealand. Augus p. hp:// Borio, C., Filardo, A. (2007). Globalizaion and inflaion: new cross counry evidence on he global deerminans of domesic inflaion. 13h Dubrovnik Economic Conference, 29 June, Clarida,R., Gali,J., Gerler,M. The Science of Moneary Policy: A New Keynesian Perspecive. NBER Working Paper No Cambridge. May p. hp:// CNB (2003). The Czech Naional Bank s Forecasing and Policy Analysis Sysem. Czech Naional Bank. Prague. 142 р. Galí, J. and Gerler, M. (1999) Inflaion dynamics: a srucural economeric analysis. Journal of Moneary Economics, No 44. P Laxon, D. and Sco, A. (2006). On Developing a Srucured Forecasing and Policy Analysis Sysem Designed o Suppor Inflaion-Forecas Targeing. Conference on Inflaion Targeing: Performance and Challenges.. Cenral Bank of Turkey, İsanbul, 19 January Conference May 19-20, 2008, Minsk

50 50 Mishkin, F. (2007). Will Moneary Policy Become More of a Science? Presened a he Deusche Bundesbank conference Fify Years, held in Frankfur am Main, Germany, Sepember 21, Rudebusch, G. (2001) Term srucure evidence on ineres rae smoohing and moneary policy ineria. Federal Reserve Bank of San Francisco. Working Paper No 2. Walsh, Carl E. Moneary heory and policy. The MIT Press Woodford, M. Ineres and Prices. Princeon Universiy Press Naional Bank of he Republic of Belarus

51 Anne-Marie Gulde Exchange Rae Regimes for Transiion Economies: Were Currency Boards an Efficien Choice? 3 Exchange rae regime choice ofen implies a rade-off beween credibiliy and flexibiliy. This paper argues ha ransiion economies faced paricularly difficul choices; he desire o signal reliabiliy of new insiuions and ensuring sufficien flexibiliy for he reorienaion of producion were boh imporan, bu called for opposie regime ypes. The choice of a currency board he hardes peg possible by some ransiion economies was herefore highly conroversial, wih criics suggesing ha a hard regime would sifle economic developmen and leave economies prone o financial crises. Based on economic performance, his paper argues ha currency boards can be seen as an efficien choice nowihsanding early concerns abou heir inflexibiliy. Ye, emerging pressure poins also imply ha serious effors may now be needed o ensure coninued susainabiliy. I. Inroducion Few issues in economics are debaed in as conroversial manner as he choice of he exchange rae regime and he aendan role of moneary policy. In he 1990s, when mos Easern European counries embarked on he ransiion from plan o marke economies, hey were herefore confroned wih a range of opions and rade-offs, and no single regime or even unique crieria for regime choice emerged. Consequenly counries acual choices differed, even in cases were iniial condiions were similar. Since he sar of he ransiions process economic performance differed bu mos counries have made significan progress, wih some having already achieved EU membership and in one case he inroducion of he euro. Has one ype of regime performed beer han ohers? Wih he benefi of hindsigh, his paper reviews he experiences of ransiion economies in choosing exchange rae and moneary regimes. I focuses in paricular on a group of four counries ha favored currency boards in he hope o (re)gain credibiliy, comparing hem agains he ohers ha oped for more flexible exchange rae regimes, and swiched regimes when his was seen as beneficial. Like he iniial choices, he resuls of our review do no allow for fully conclusive answers. However, he iniial concern ha currency board counries would necessarily rade off growh for sabiliy does no seem confirmed. However, here are concerns, ha he sysem may now require more pronounced policy effors han oher regimes o achieve a sof landing following a period of rapid capial inflows. 1 Inernaional Moneary Fund 2 This paper was wrien during he auhor s sudy leave a he Join Vienna Insiue. I would like o hank Aish Ghosh and Holger Wolf, my co-auhors on earlier relaed work. Kalin Tinchev and Harald Andersen of he IMF kindly provided daa on FSIs and exchange rae regimes All remaining errors are he responsibiliy of he auhor. 3 The opinions expressed in his paper are hose of he auhor and should no be aribued o he Inernaional Moneary Fund or he Join Vienna Insiue. Conference May 19-20, 2008, Minsk

52 52 Box 1: Classifying Exchange Rae Regimes Exchange rae sysems can be classified in differen ways. The de jure classificaion repors he regime ha is being announced as a counry s official policy in a law, regulaion, or circular. Noing ha acual exchange rae managemen ofen differ from he declared (de jure) sysem, many researchers now use a de faco classificaion, which draws inferences from he acual oucomes and he observed behavior by cenral banks on he exchange rae regime in place. 1 Among regimes, simple classificaions rely on wheher or no he rae can move and usually only propose a hree way classificaion fixed, inermediae, or floaing regimes. This classificaion is useful in paricular in comparing regimes across counries and over longer periods. More deailed classificaions aemp o add addiional informaion on rules and resricions ha impac on he acual exchange rae oucomes. These sysems herefore allow a much finer disincion among he policy implicaions of individual regimes, including he needed radeoffs in case of conflics beween differen goals. An example of a fine regime classificaion is given by he caegories used in he IMF s Annual Repor on Exchange Arrangemens and Exchange Resricions: Naional Bank of he Republic of Belarus Exchange arrangemen wih no separae legal ender: Counries are eiher members of a moneary union, or are dollarized, i.e. use anoher counries currency. Currency board arrangemen: Sricly fixed (hard) exchange rae regime, level and key feaures (mos imporan he degree o which a moneary aggregae has o be covered by foreign exchange reserves) se ou in a law or oher legal ex and can no be changed. Reserve coverage requiremen implies sric limis on money creaion. Convenional pegged arrangemen: Currency pegged o anoher single currency a a fixed rae. In case of severe economic disequilibria, he peg can be changed (revaluaion or devaluaion). Convenional peg o a baske: Currency pegged o a baske of currencies, of wo or more counries. Weighs are generally chosen depending on he srengh of he economic relaions wih he differen counries. Pegged exchange rae wihin horizonal bands: The exchange rae is se boh by marke forces and inervenion. I can flucuae wihin a horizonal bank, bu should marke forces push i oward eiher side of he limi of he band he cenral bank will inervene o keep he rae wihin he band. Crawling peg: The currency is auomaically devalued/revalued based on a formula, generally using inflaion differenials as guidelines. Crawling band: The currency is free o move wihin a band. However he limis of he band on eiher side are se based on a rule (generally in reference o inflaion differenials). Should he exchange rae flucuae oo sharply and reach he bank, he cenral bank will inervene. Managed floaing wih no predeermined pah for he exchange rae: The exchange rae is marke deermined. However he cenral bank inervenes a is discreion wih a view o influencing he rae. Independenly floaing: The exchange rae is deermined in he foreign exchange marke. The cenral bank does no have any exchange rae arge and does no inervene wih he inenion o influence he rae. 1 For more deail see Ghosh, Gulde and Wolf (2003) Alernaive classificaions are, among ohers, proposed by Reinhard and Rogoff (2004), and Levy-Yeyai and Surzenegger (2005). Since 1998, he IMF uses a de-faco classificaion.

53 II. Opions and Issues in Selecing an Exchange Rae Regime 53 A. General Principles The debae on opimal exchange rae and moneary regimes daes back a leas o 1973, when in he afermah of he breakdown of he Breon Woods regime of fixed exchange raes counries were, for he firs ime, able o op for financial regime ha would allow acive moneary policy in he conex of a flexible exchange rae regime. However nowihsanding an iniial opimism and enhusiasm abou he new policy ool, many counries were in pracice relucan o abandon fixed exchange raes alogeher, ciing boh heoreical reasons and concerns abou difficulies in he implemenaion of flexible regimes. By he early 1990s, he ime economic ransiion sared for many formerly socialis counries, he issue of he opimal exchange rae regime remained largely unseled. By ha ime seminal heoreical work had helped develop crieria o guide counries choice of exchange rae regimes. Specifically, he lieraure developed crieria ha relaed o he underlying economic srucure of counries. I suggesed ha counries ha are subjec o real shocks for example raw maerials exporers would benefi from flexible exchange raes, which could faciliae real economic adjusmens ha migh be necessary o mainain compeiiveness as exernal condiions change. Likewise, counries ha were seen as prone o nominal shocks, for example unsable moneary condiions, would benefi from he credibiliy accorded by fixed exchange raes (Melvin, 1985). Given he sark rade-offs beween fixed and floaing here were also aemps o find middle ground. Specifically, boh he academic lieraure and pracical policy making aemped design inermediae regimes ha could combine he sabiliy advanages of fixed raes wih he flexibiliy benefis of flexible sysems (Box 1). In pracice, counries implemened a wide range of moneary and exchange rae regimes. In he acual choice heoreical consideraions of an opimal regime were ofen only one inpu in he acual choice, which ofen was also or predominanly guided by hisorical preferences, issues of pracicaliy, as well as he desire for economic inegraion. B. Consideraions for Transiion Economies When formerly socialis counries embarked on heir ransiion o marke economies he choice of he exchange rae regime became an imporan inpu in overall economic policy making. A he ime, many expers noed ha he opimal choice of an exchange rae regime in a ransiion economy presened paricularly difficul problems (see Box 1). According o he sandard heory of exchange rae regime choice, he need for flexibiliy in he resrucuring of economic sysems would favor flexible raes. On he oher hands, mos flexible raes sysems are more complex o implemen, in paricular in siuaions where he necessary money and foreign exchange markes remained o be esablished or are shallow. 1 A separae and inense debae emerged on he bes regime ha would ensure credibiliy of moneary and exchange rae policies in ransiion economies. In his debae he need and desire o gain credibiliy and send srong signals of an ani-inflaionary sance was seen as a srong argumen in favor of no only fixed, bu possibly very hard exchange rae regimes. Proponens of his view argued ha ransiion economies and heir unesed insiuions would gain mos credibiliy benefis if exchange raes were no only fixed, bu fixed in perpeuiy. Willful mischief or simple policy mis- 1 Foreign exchange aucions have been advocaed and used as a relaively simple way of implemening a flexible exchange rae regime when underlying markes are missing. However aucions generally only work if here are surrender requiremens o he cenral bank, and he amouns brough by he cenral bank o aucion ends o have a significan influence on he rae. They are herefore no a longer-erm opion. Conference May 19-20, 2008, Minsk

54 54 akes would be eliminaed by puing moneary and exchange rae policies firmly under sric rules. The regimes in quesion ofen also called hard regimes would include currency boards, ourigh dollarizaion, or joining an currency union. In pracice, currency boards were he mos seriously debaed opion. (Box 2). Box 2: Wha is a Currency Board? Currency Boards are moneary regimes ha were iniially popular in colonial imes. They allowed colonies he have heir own currency, albei subjec o sric rules ha linked currency issue o balance of paymens surpluses. When hese erriories became independen saes, mos oped o ransform heir boards ino full fledged cenral banks and abandon he sric rules. In he 1970s only a few boards remained. Since hen, several counries have resored o implemening currency boards, all in imes when i was imporan o achieve credibiliy for new or crisis shaken moneary arrangemens. They include Hong- Kong (1983), Argenina ( ) and four ransiion economies Esonia (1992), Lihuania (1994), Bulgaria (1997) and Bosnia and Herzegovina(1997). While he design of individual boards differs in some deails, all modern currency boards share inend o signal sric limiaions on he cenral bank s abiliy o generae inflaion. This is achieved hrough he following characerisics: 1) Exchange rae fixed in a visible manner o an anchor currency : he par value of he naional currency agains an inernaional currency is se eiher by law or binding regulaion. Legal obsacles o change in he pariy are pu in place o signal he permanence of he arrangemen. 2) Coverage requiremen conrols he expansion of money supply: The rules of a currency board specify ha a moneary aggregae (usually reserve money) has o be covered by foreign exchange reserves. Unless a currency board has more reserves han wha is needed o cover he moneary aggregae, i can no influence changes in money supply. 3) No exi mechanism: Currency boards derive a large par of heir credibiliy by no specifying exi opions or exi condiions. The underlying premise is ha currency boards will have o conduc economic policies, including fiscal policy, in all cases consisen wih he mainenance of he peg and he coverage rules. To dae only one modern currency board (Argenina, 2002) has been abandoned, all ohers remain in place. While no clear exi dae exiss, i is expeced hough ha he Easern European currency boards will say in place unil he counries will adhere o he euro. Table 1 summarizes he full se of issues faced by ransiion economies a he ouse of he regime choice. As discussed earlier, he crieria do mosly no lead o a single firs-bes choice, bu in many cases require imporan rade-offs by policy makers. In paricular, he need for economic flexibiliy, including he necessary changes in relaive prices ha could faciliae he adjusmen o a new producion srucure, sands in sark conras o he need o esablish a rack record of ani-inflaionary policies. This ension is a fac of life for all counries, bu in he conex of newly inroduced currencies and newly mined cenral bankers gaining credibiliy may require significanly more effor. Therefore, ying cenral bankers hands in he conex of a sric rules-based regime has been advocaed o visibly avoid any moneary mischief. Naional Bank of he Republic of Belarus

55 Table 1: Exchange Rae Regime Choice for Transiion Economies: Objecives and Trade-Offs Main Policy Objecive Economic Flexibiliy Gain Credibiliy Rapid Economic Inegraion 55 Iniial recommended regime choice Main rade-offs Consrains Revised recommended regime choice Revised recommended regime choice Revised recommended regime choice Flexible rae Difficul o anchor inflaion expecaions Hard regime (currency board) or dollarizaion (use of a neighboring currency) Real exchange rae appreciaion, loss of compeiiveness, lower growh. No lender of las resor, higher risk of financial crises Fixed rae (or hard regime) anchored o currency of he desired inegraion area Real exchange rae appreciaion, loss of compeiiveness, lower growh. No lender of las resor, higher risk of financial crises infrasrucure Flexible raes difficul; fixed rae regime a leas during a period where money and foreign exchange markes are being designed and inroduced. Desire o reorien economic linkages Flexible raes would auomaically adjus as rade paern evolve Small marke Small marke Small marke Flexible raes in shallow In very small markes, In very small markes markes could be ourigh dollarizaion cos of hedging high, highly volaile. Crawling migh reduce operaing hence dollarizaion or baske peg coss migh safe coss for im- could ensure some porers/exporers and flexibiliy bu limi faciliae inegraion volailiy Lacking financial Lacking financial infra- Lacking financial infra- srucure Infrasrucure needs more limied han for flexible raes, hard regimes possible. Desire o reorien economic linkages Choose an anchor currency one of he big inernaional currencies. srucure Infrasrucure needs more limied han for flexible raes, fixed raes possible. Desire o reorien economic linkages Choose anchor currency in a forward looking manner, pegging o he rae of he (desired) fuure inegraion area. The choice of he exchange rae regime is also he single mos imporan deerminan of a counry s moneary independence and he ypes of moneary regimes a counry can implemen. Ye for any given exchange rae regime, he degree of moneary independence also varies depending on srucural characerisics such as he capial accoun regime, he size of he economy, and he deph of financial markes. Given he inerrelaions beween choice and rade-offs among exchange rae and moneary regimes, he selecion of he exchange rae and moneary sysem is in pracice always a join decision. Mos srikingly, as se ou in able 2, he choice of a hard regime (dollarizaion or currency board) requires he full and absolue subordinaion of liquidiy developmens in he home counry o he mainenance of he peg. Wih his choice policy makers also have o be aware ha a hard regime generally leaves no moneary policy opions, even if an increasingly open capial accoun leads o rapid (and possibly disrupive) changes in domesic liquidiy. 1 1 In pracice, mos modern currency boards have prudenial policy insrumens in place, ha policy makers have, a imes, used as a las resor o seer liquidiy. Examples include in paricular reserve requiremens, which are seen as a prudenial ool o ensure bank liquidiy, bu which have been used in Bulgaria and oher currency board counries, o address he liquidiy effecs of capial inflows. However, even where such an opion exiss, he moneary effecs can only be limied and emporary. Conference May 19-20, 2008, Minsk

56 56 Table 2: Moneary Regime Choice for Transiion Economies Exchange rae regime Marke characerisics Capial flows resriced Hard Peg Oher peg Inermediae Regimes No moneary independence Some moneary independence Some moneary independence Floaing Raes Moneary independence Capial accoun liberalized No moneary independence Temporary/limied moneary independence if large amoun of reserves available Some moneary independence, if reserves available Moneary independence, bu real effec may be limied due o rapid price adjusmen Small/hin markes No moneary independence Any possible independence more limied Any possible independence more limied Moneary independence, bu price adjusmen likely o be very fas Moneary policy No independen moneary policy Moneary managemen can supplemen peg, bu exchange rae goal dominaes in case of conflic. Marke characerisics may se addiional limis Exchange rae arge is a key assumpion in moneary program. In case of deviaions poliical choice which arge o lif. Moneary policy possible, bu needs a credible anchor and ake expecaions ino accoun. As se ou in able 2 only counries wih a floaing rae and relaively developed financial markes do have a realisic chance a a degree of moneary independence. In he absence of an exchange rae link o guide moneary inervenions, his regime requires however ha he auhoriies have a heir disposal an alernaive anchor, ha is boh visible and credible, and able o signal he qualiy of moneary policy o financial markes. In he early phases of ransiion, many counries have followed a simple moneary program, based on argeing a moneary aggregae. In he conex of financial deepening and rapidly developing financial markes, underlying relaions were however no always sable and he implicaions for moneary policy unclear. Transiion economies wih flexible exchange raes herefore increasingly view inflaion argeing as he mos appropriae moneary regime. Under his regime he cenral bank commis iself o mainaining inflaion wihin a predeermined range, wihou any explici arges for moneary aggregaes, ineres or exchange raes. Inflaion argeing however requires excellen saisical daa and economeric analysis, so ha he cenral bank can very quickly deermine he naure and exen of price pressures. In addiion, he cenral bank mus be sufficienly independen and credible so ha markes believe ha i will counerac he price developmens, and ha he cenral bank s acions no be subjec o poliical pressure. In view of he sringen requiremens, inflaion argeing o dae is largely limied o advanced indusrial counries, and only few ransiion economies can ye be seen as good candidaes. Naional Bank of he Republic of Belarus

57 57 С. Revealed Preferences: Acual Regime Choice of Transiion Economies 1 Figure 1: Exchange Rae Regimes in Transiion Economies: Summary Classificaion Given differen iniial condiions, he imporan rade-offs discussed above, and divergen poliical preferences, acual regime choice among ransiion economies varied across counries 10 (Figures 1 and 2). In many cases, Hard regimes 8 even counries wih highly similar Oher pegs 6 basic economic characerisics did Inermediae 4 choose differen regimes based on Floaing 2 policy preferences and perceived differences 0 in he srengh of he rade offs. Examples include, early in he ransiion experience, he hree Balic counries which iniially oped for hree differen exchange rae regimes, bu also he counries in cenral and Souhern Europe where no uniform paern emerged. 2 Figure 2: Exchange Rae Regimes in Transiion Economies: Deailed Classificaion No legal ender 2 Currency board 3 Convenional peg 4 Baske peg 5 Horizonal band 6 Crawling peg 7 Crawling band2 8 Managed floaing 9 Independen floa 1 No legal ender 2 Currency board 3 Convenional peg 4 Baske peg 5 Horizonal band 6 Crawling peg 7 Crawling band2 8 Managed floaing 9 Independen floa 1 Daa for exchange and moneary regimes are from he Annual Repor of Exchange Arrangemens and Resricions (Daabase mainained by he IMF). 2 Esonia had adoped a currency board from he sar of he ransiion period, while Lavia and Lihuania iniially followed a moneary arge and had floaing exchange rae regimes. Lihuania laer adoped a currency board, while Laiva swiched o an SDR peg. Conference May 19-20, 2008, Minsk

58 58 The fac ha many ransiion economies changed heir exchange rae re- Figure 3: Exchange Rae Regime Swiches in Transiion Economies, gime over he course of he ransiion 14 process (Figures 3) is anoher indicaor Move o a harder regime for he difficulies (and he rade-offs) 12 Move o more flexibliy involved in exchange rae regime 10 choice. A review shows ha such 8 changes were frequen and some counries changed more han once. In addi- 6 4 ion he moves were also no unidirecional, bu counries moved in nearly 2 equal numbers from pegs o more flexible rae regimes and vice versa. A hol- 0 lowing ou rend, meaning ha counries would find i increasingly difficul o operae inermediae regimes and insead op o corner soluions (eiher fully flexible raes or hard regimes) is for his counry group no obvious from he daa. 1 An imporan excepion from he paern of changing regime lies wih currency boards: In fac, once inroduced, none of he currency board regimes in ransiion economies was replaced by anoher sysem, nowihsanding he someimes difficul economic challenges faced by he counries. Difficulies included, for example, banking and financial crises in he early and mid-1990s in he wo Balic currency board counries, he Russian crisis of 1998, and, more recenly, massive capial inflows and rapid credi growh in Esonia, Lihuania and Bulgaria. The sole significan change was a prevenive adjusmen of he Lihuanian currency board: reflecing he increasing inegraion wih Europe Lihuania successfully changed in 2002 he anchor currency o which is currency board was pegged from he US dollar o he euro. 2 Taken ogeher, he hard regimes, pegs and rules based inermediae regimes form he majoriy of exchange rae sysems in Easern European Transiion Economies. Accordingly, he IMF has classified all hese counries as using an exchange rae anchor o guide moneary policy (Figure 4). While many of hem also formulae indicaive moneary programs, he credibiliy of he exchange rae anchor will require ha in case of a conflic, he exchange rae rule prevails. A smaller bu sill significan group of counries followed a moneary arge. Only wo Figure 4: Moneary Anchors in Transiion Economies Moneary Targe Exchange Rae Anchor Inflaion Targe Naional Bank of he Republic of Belarus 1 The hollowing ou hypohesis was firs proposed among ohers Sanley Fischer (2001) and suggess ha wih more open capial accouns, inermediae regimes and convenial pegs would increasingly subjec o speculaive pressures and herefore would disappear as viable exchange rae regimes. 2 The move had been carefully prepared and communicaed o he public in advance o allow asse holders a reallocaion of heir porfolios o avoid any losses.

59 counries have he insiuional and implemenaion capaciy necessary o be able o move o an explici inflaion argeing framework. 59 D. Economic Impac: Were Currency Boards an Efficien Choice? The choice of a currency board for ransiion counries was conroversial among academics, wih many suggesing ha he inflexibiliy of he sysem was likely o lead o lower growh and more vulnerable financial sysems (see e.g. Roubini, 1999). Policy makers in he counries noed ha hese risks were real. They neverheless oped for currency boards because hey fel ha he advanages of a more credible sysem would more han ouweigh any poenial coss. They also argued ha srucural feaures of heir economies such as a high level of fiscal and wage flexibiliy would allow for alernaive adjusmen mechanisms. Wih more han a decade of experience, i may now be possible o examine he raionaliy of he choice. A firs indicaion of success of currency board counries could be he fac ha since incepion, none of he currency boards in ransiion economies has been abandoned, nowihsanding imporan ess. Such early ess include, for example in Esonia and Lihuania imporan banking secor problems which, o a lesser exen, were also a concern in Bulgaria. 1 Oher challenges included he Asian and Russian crises of he lae 1990s, wih in paricular he fall-ou from he Russian crisis leading o measurable feed-back effecs in he Easern European ransiion economies. To an exen he demise of he ine currency board also can be considered a es, since some had feared ha here migh be conagion and loss of credibiliy for currency boards more general. in percen Figure 5: Easern European Transiion Counries: Real GDP Growh In addiion o he persisence, 0 he remainder of his secion will examine policy oucomes Average CBA Average Non CBA Average Non CBA Conrol o see wheher here is any visible and measurable difference in macroeconomic performance, and or financials secor developmen and sabiliy among ransiion economies. For reasons of comparision he group of non-currency boards is presened once as a full group (non CBA) bu also as a smaller group (non CBA conrol) comprising four non-cba counries wih oherwise similar feaures han hose of he CBA counries Bulgaria s banking crisis largely predaed he currency board. In designing he currency board, special effors were included o limi any lae effecs of remaining banking secor weaknesses on he new regime. Gulde (1999) and Enoch, Gulde and Hardy (2002). 2 Counry groups are: CBA: Bulgaria, Bosnia-Herzegovina, Esonia, and Lihuania. Non-CBA: Albania, Belarus, Croaia, Czech Republic, Hungary, Lavia, FYR Macedonia, Moldova, Poland, Romania, Russia, Serbia, Slovak Republic, Slovenia, Ukraine. Non-CBA conrol: Lavia, FYR Macedonia, Romania, Slovenia. 3 Daa are aggregaed using simple averages. While for oher purpose weighed averages migh be appropriae, he fac ha we are ineresed in he poenial effec of he exchange rae regime on macroeconomic aggregaes suggess simple averages as preferable. Conference May 19-20, 2008, Minsk

60 60 Macroeconomic Performance 1 annual average, in percen Figure 6: Easern European Transiion Counries: Inflaion Performance Average CBA Average Non CBA Average Non CBA Conrol Macroeconomic performance of currency board counries appears largely in line wih comparaor counries, even hough more recenly some pressure poins are emerging. Growh he mos criical concern of hose who iniially quesioned he suiabiliy of currency boards for ransiion economies in CBA counries was a par or beer han in boh he larger and narrower comparaor groups. (Figure 5). 2 Growh performance of course reflecs a broad range of facors, however i remains ineresing o noe ha economic sysems in CBA counries in paricular labor markes mus have been sufficienly flexible o allow oupu growh wihou recourse o nominal exchange rae changes. As expeced, currency board counries ouperformed comparaors on inflaion, wih raes of price increase in he earlier years much lower han comparaor counries (Figure 6). More recenly hough, non CBA ransiion economies have achieved lower inflaion in he conex of heir differen moneary regimes, possibly reflecing boh underlying macroeconomic policies bu also he increased credibiliy for heir cenral banks from years of experience, and improved echnical capabiliies of he cenral bank. A he same ime he CBA group has seen a boos in inflaion resuling largely from capial inflows and demand pressures. Curren accoun balances of ransiion economies wih CBA were hisorically higher han comparaor counries, bu have in he mos recen pas soared o levels ha could undermine sabiliy of he regime. 0-2 Figure 7: Easern European Transiion Economies: Curren Accoun Balances Ye, hisorically he period since he sar of economic ransiion is shor, and he group of ransiion economies having chosen currency boards as an exchange rae and moneary regime is small. Ghosh, Gulde and Wolf (2008) herefore argue ha more reliable inferences of he longer erm issues involved in regime choice may be gained by broader a comparison of he ma- in percen of GDP Average CBA Average Non CBA Average Non CBA Conrol Naional Bank of he Republic of Belarus 1 Macroeconomic daa are from Inernaional Financial Saisics (IFS) and from he World Economic Oulook (WEO) daabases. 2 We concenrae on developmens since 2000 o ake since wo of he CBAs were only inroduced in he lae 1990s.

61 croeconomic economic impac of exchange rae regimes including a long sample of mos IMF member counries Sylized facs for his larger and world-wide group confirm he ani-inflaionary bias of currency board regimes. Average inflaion raes have indeed been much lower under currency boards: Agains a sample average of 18,7 percen per year for all regimes and 14,6 percen per year for radiional pegs, he average inflaion rae for currency boards comes in a 5,7 percen per year. Economeric analysis confirms ha he ani-inflaionary benefis from a currency board regime derive from boh a lower increase in money supply, and for any given money supply a higher level of money demand (an effec ha could be ermed confidence benefi of a currency board. The broader analysis in Ghosh, Gulde and Wolf also can no find a negaive effec on growh; for heir sample, average annual per capia oupu growh under currency boards sood a 2,7 percen per year and subsanially exceeded ha under oher pegged regimes (1 percen) and under floas (1,8 percen). While no addressing causaliy he addiional growh may in par reflec boh greaer rade openness and higher invesmen raes. 2 Financial Sabiliy and Financial Secor Developmen The choice of a currency board has poenially imporan implicaions for financial sabiliy, given ha under a currency board he cenral bank has only very limied or no opions o ac as a lender of las resor. Those criical of currency board regimes argue ha he financial risks are higher, and currency board counries are herefore subjec o poenially more frequen and more severe banking crises han counries wih less hard exchange rae regimes. Ohers have argued ha more sringen financial secor regulaion migh help o ensure financial sabiliy under a currency board, bu ha financial secor developmen migh suffer from heavy regulaion. Financial secor issues were considered when Easern European Transiion counries conemplaed he adopion of currency boards. For example, specific design modificaions were made in some counries: in Bulgaria here was an explici se-aside of some funds for lender of las resor funcions (he so called banking fund ). Bulgaria also allowed averaging of required reserves o provide commercial banks wih some liquidiy cushion. In Esonia excess coverage could provide a limied degree of inervenion room. Lihuania had relaively few specific adapaions of he prudenial framework. 3 All CBA counries modernized heir prudenial rules and oped for minimum capial raios exceeding he 8 percen Basel minimum, and imporanly all choose o open heir financial markes o foreign compeiion. This hey hoped, would help foser financial secor developmen, while giving he banking secor access o foreign finance (from moher banks) and hus also alleviaing some of he financial sabiliy concerns. 4 The implemenaion of financial secor policies early in he currency board periods added o he credibiliy of he sysem. A he ime of he incepion of mos Easern European currency boards, banking sysems in all fuure currency board counries were eiher sill in crisis or had jus emerged form severe difficulies (Enoch, Gulde, and Hardy, 2002). In none of he CBA counries, bank privaizaion was 1 The empirical analysis is based on a daase of macroeconomic variables drawn primarily from he Inernaional Moneary Fund s World Economic Oulook daabase. The sample covers 147 counries (a subse of he 165 counries for which he exchange rae regime is available) over he period See Ghosh, Gulde and Wolf (2008) for deails. The repor ha rade openness and invesmen are 3 o 4 percenage poins of GDP higher in he currency board group han under oher regimes, consisen wih he view ha currency boards resul in lower real ineres raes hrough reduced risk premia. 3 In Lihuania he limiaions of he role of he cenral bank during a crisis became eviden during he banking problems of 1994/1995. The resoluion also showed he relaively more pronounced role of he governmen in resolving a financial crisis. 4 In paricular, i was hoped ha banks wih foreign paricipaion/parens would have access o alernaive liquidiy sources abroad in case of a liquidiy squeeze, and herefore he absence of a lender-of-las resor would be less severe. Conference May 19-20, 2008, Minsk

62 62 complee. In resolving acue and lingering financial secor problems early afer hey had chosen currency boards, all four counries avoided bank financing from he cenral bank and, o he exen banks received suppor, relied on fiscal conribuions, including for (limied) deposior proecion. The longer-erm experience of he Easern European currency board counries shows ha financial secor sabiliy and developmen can be achieved in he conex of a CBA. Indicaors such as porfolio qualiy, profiabiliy, soundness, and financial developmen he experiences of Easern European CBAs are mosly in line wih or beer han comparaor counries, albei some of he differences may also reflec he underlying financial secor srucure in paricular he high degree of foreign ownership, which however, as noed before, has also been a conscious choice of he CBA counries. In percen of oal loans Figure 8: Easern European Transiion Economies: Non-Performing Loans CBA Non CBA Non CBA Conrol In percen of NPLs Figure 9: Easern European Transiion Economies: Provisions Agains NPLs CBA Non CBA Non CBA Conrol Porfolio qualiy: Porfolio qualiy in CBA counries is significanly beer han in comparaor groups. This is shown by a much lower share of non performing loans in oal loans (Figure 8), wih he raio being close o he shares of NPLs in counries wih advanced financial markes. By conras, while NPLs in he comparaor groups have come down, hey remain comparaively high. In addiion, porfolio qualiy in CBA counries also benefis from much higher provisions compared o heir peers (Figure 9). Naional Bank of he Republic of Belarus Profiabiliy: Banking secors in CBA counries have become more profiable over he las years (Figure 10). Profiabiliy was iniially mos likely as a resul of remaining clean ups of he lingering financial secor problems lower han ha in comparaor counries. Over he pas years hough CBA counries saw banking secor profis increase, wih reurns on equiy now beer han in comparaor counries, and significanly higher han in mos advanced economies. Bank Soundness: Following he banking crises ha emerged in many ransiion economies in In percen of equiy Figure 10: Easern European Transiion Economies: Reurn on Equiy CBA Non CBA Non CBA Conrol

63 he early years of he ransiion process, bank soundness has been an imporan concern. Figures 11 and 12 show ha banking sysems in boh CBA and comparaor counries have high capial raios and are liquid. The somewha lower levels of capial and liquidiy of banking sysems in CBA counries compared o hose in non-cba counries should no be inerpreed necessarily o mean ha sysems are weaker. In fac, expers have argued ha he lower capial and liquidiy levels which however are well wihin prudenial norms show ha CBA banking sysems are profi oriened, 63 and aemp o minimize he cosly holding of excess capial and liquidiy Figure 11: Easern European Transiion Economies: Toal Regulaory Capial of he Banking Secor 60 Figure 12: Easern European Transiion Economies:Liquid Asses in percen of risk weighed asses in percen of oal asses CBA Non CBA Non CBA Conrol CBA Non CBA Non CBA Conrol Financial secor developmen: All Easern European counries have successfully privaized all or a large share of heir financial markes and seen financial deepening. Ineresingly, early concerns ha he need o mainain sabiliy would hinder rapid financial deepening in CBA counries has no played ou in realiy. In fac, using he raio of broad money (M2) o GDP a commonly used measure for he deph of financial sysems currency board counries have been in line wih comparaor counries, and more recenly seem o have a faser momenum in gaining financial deph (Figure 13). Anoher ineresing measure relaed o he currency composiion of financial asses and liabiliies. Currency boards show a relaively higher degree of dollarizaion han comparaor counries (Figures 14 and 15), nowihsanding he fac ha a credible fixed exchange rae regime could be expeced o promoe financial deepening in he home currency. While a complee analysis of he many causes of dollarizaion in Easern Europe is beyond he scope of his paper, i In percen Figure 13: Easern European Transiion Economies: M2 o GDP CBA Non CBA Non CBA Conrol 1 However, in he conex of he absence of a lender of las resor, banking supervision will need o be especially vigilan o ensure ha profi oriened behavior by he banking sysem remains consisen wih necessary norms. Conference May 19-20, 2008, Minsk

64 64 remains ineresing ha CBA counries are globally among he mos highly dollarized economies. Hence, while financial developmen did ake place, he goal of creaing deep financial markes in local currency has no been fully achieved. 70 Figure 14: Easern European Transiion Economies: Share of Foreign Currency Denominaed Liabiliies of Banks 70 Figure 15: Easern European Transiion Economies: Share of Foreign Currency Denominaed Loans in percen of oal liabiliies in percen of oal loans CBA Non CBA Non CBA Conrol CBA Non CBA Non CBA Conrol E. The Way Forward To dae, he empirical experience shows ha Easern European counries wih currency boards have by and large managed he ransiion process well. However, by iself his is no enough o conclude ha hey were necessarily an efficien choice: many of he issues involved in he regime choice may only now come he forefron given ha sysems have been in place for en years or more, and inflexibiliies could have buil up. In addiion here are imporan challenges relaed o macroeconomic managemen ha resul from EU accession of some currency board counries and increasing financial globalizaion. Only if hese challenges can also be masered, he regime choice will have proven righ. Agains his background, Easern European currency board counries face several imporan challenges which hey mus address if hey are o remain a sable and viable moneary regime. Mainaining Growh: While he growh difference is impressive a firs sigh suggesing a win-win scenario of adoping CBA some cauion is warraned. Many boards were adoped in he mids of economic crises, given he shor duraion of mos modern boards, heir growh records may o a degree reflec he bounce-back o rend oupu following successful sabilizaion raher han a higher susainable growh rae of rend oupu iself. To mainain he growh momenum, i is imperaive ha he economies mainain compeiiveness, by among oher issues avoiding excessive real appreciaion. Naional Bank of he Republic of Belarus Effecive responses o capial inflows: Global increases in capial flows along wih flows generaed by he convergence wih he EU have led o rapid capial inflows in mos Easern European counries. For he currency board counries macroeconomic responses have been difficul, given he lack of moneary policy. The challenge for policy makers will be o use a combinaion of fiscal adjusmen, sric(er) applicaion of prudenial rules, and possibly moral suasion o avoid an overheaing of he economies and excessive asse price inflaion. Indicaions are ha he currency board counries have recognized he paricular challenges in managing he credi boom, bu coninued vigilance is necessary. Mainaining financial sabiliy: Financial deepening and financial secor challenge: Counries ha implemened currency board regimes have benefied from rapid finan-

65 cial developmen, ofen driven by foreign owned insiuions. Ye i remains a sriking facor ha in spie of credible CBAs ha dollarizaion of financial sysems has increased and mos posiions are unhedged. In he conex of macroeconomic sress facors, such as high curren accoun deficis, inflaion, and possible global liquidiy pressures he susainabiliy of he peg remains anamoun o financial sabiliy. Hence, achieving a sof landing from curren macroeconomic imbalances, along wih in he fuure more pruden managemen of foreign exchange exposures will be needed o mainain financial sabiliy. 65 Achieving a smooh exi hrough euro adopion: Wih increasing inegraion of he CBA counries ino he EU, adopion of he common currency is he naural exi for CBAs. Given he sill uncerain ime frame wih one of he CBA counries (Bosnia and Herzegovina) no ye even an EU member all face challenges o mainain macroeconomic and srucural policies consisen wih he requiremens of he CBA and in line wih he convergence process. Curren imbalances in some of he counries may need o be addressed as a maer of urgency, also because he failure of one CBA would, mos likely, lead o a loss in he credibiliy of he ohers. References Alonso-Gamo, Paricia, Sefania Fabrizio, Viali Karmarenko and Qing Wang 2002, Lihuania: Hisory and Fuure of he Currency Board, IMF Working Paper 02/127. Benne, Adam 1992, The Operaion of he Esonian Currency Board, IMF Saff Papers, 40 2, June, pp Burgess, Rober, Sefania Fabrizio and Yuan Xiao, 2003, Compeiiveness in he Balics in he Run-Up o EU-Accession, April, IMF Counry Repor 03/114, a hp:// Chobanov, Dimiar and Piria Sorsa 2004, Compeiiveness in Bulgaria: An Assessmen of he Real Exchange Rae, IMF WP/ 04/37 Corker, Rober, Craig Beaumon, Rachel van Elkan and Dora Iakova, 2000, Exchange Rae Regimes in Seleced Advanced Transiion Economies, IMF Policy Discussion Paper No. PDP/00/3, April, Washingon, DC. Enoch, Charles and Anne Marie Gulde 1998, Currency Boards: A Cure for a All Moneary Problems? Finance and Developmen, December. Enoch, Charles and Anne-Marie Gulde 2000, Making a Currency Board Operaional, IMF Paper on Policy Analysis and Assessmen, 97/10. Enoch, Charles, Anne-Marie Gulde, and Daniel Hardy, 2002, Banking Crisis and Bank Resoluion: Experiences in Some Transiion Economies, IMF Working Paper WP/02/56. Fischer, Sanley, 2001a, Exchange Rae Regimes: Is he Bipolar View Correc?, Journal of Economic Perspecives, Vol. 15, No. 2, pp Ghosh, Aish, Anne-Marie Gulde, and Holger Wolf 2003, Exchange Rae Regimes: Choices and Consequences, MIT Press. Ghosh, Aish, Anne-Marie Gulde, and Holger Wolf 2000, Currency Boards: More Than a Quick Fix?, Economic Policy, Vol. 15, No. 31 (Oc., 2000), pp Gulde, Anne-Marie 1999, The Role of he Currency Board in Bulgaria s Sabilizaion, IMF, Policy Discussion Paper, PDP 99/3. Levy-Yeyai, Eduardo and Frederico Surzenegger 2003, Dollarizaion: A Primer, in: Eduardo Levy -Yeyai and Frederico Surzenegger eds., Dollarizaion: Debaes and Policy Alernaives, Cambridge, MA: The MIT Press. Levy-Yeyai, Eduardo and Frederico Surzenegger 2005, Classifying Exchange Rae Regimes: Deeds Versus Words, in European Economic Review,, 49, No. 6, Melvin, Michael, 1985, Choice of an Exchange Rae Regime and Macroeconomic Sabiliy, in Journal of Money, Credi and Banking, 17:468-78,. Nenovsky, Nikolay and Kalin Hrisov 2002, The New Currency Boards and Discreion: Empirical Evidence from Bulgaria, Economic Sysems, 26, No. 1,:[55]-72, April Nicholl, Peer, 2001, Perspecives on Moneary Policy in Bosnia and Herzegovina, BIS Review 51/2001, p. 1-5 Pauola, Niina and Peer Backé 1998, Currency Boards in Cenral and Easern Europe: Pas Experience and Fuure Perspecives, Focus on Transiion, 1, Online a hp:// Reinhar, Carmen and Kenneh S. Rogoff, The Modern Hisory of Exchange Rae Arrangemens: a Reappraisal, in Quarerly Journal of Economics, 119, No 1, Roubini, Nouriel 1999, The Case Agains Currency Boards: Debunking 10 Myhs Abou he Benefis of Currency Boards, Mimeo, NYU. Conference May 19-20, 2008, Minsk

66 66 Sepp, Urmas and Mari Randveer 2002, Aspecs of he Susainabiliy of he Esonian Currency Board Arrangemen, Working Papers of Eesi Pank, 5. Williamson, John 1995, Wha Role for Currency Boards?, Washingon Insiue for Inernaional Economics. Wolf, Holger, Aish Ghosh, Helge Berger and Anne-Marie Gulde (2008, forhcoming), Euro-Based Currency Boards, Cambridge, he MIT Press. Naional Bank of he Republic of Belarus

67 David G Mayes 1 67 Alernaive Roues o Price Sabiliy This paper considers he differen roues available for mainaining price sabiliy in he smaller ransiion economies in he conex of he wide changes in he value of he US dollar and commodiy prices in recen years. I explores he experience in boh srongly fixed exchange rae regimes, going as far as euroisaion, and also he experience of inflaion argeing regimes, showing ha even Ausralia, Canada and New Zealand have experienced problems. I suggess ha hese wo poles are likely o offer he mos credible roues forward, even hough adopion of all he requiremens for a successful modern moneary policy will ake ime and financial developmen. The normal advice abou having he condiions for credibiliy apply and inermediae regimes where policy is unclear are likely o be more difficul o susain. The ransformaion of he ransiion economies over he las weny years has gone hrough a leas hree phases he iniial collapse, he reorganisaion, he recovery and more recenly rapid growh. Tha rapid growh may be apering off in some counries his year, he Balic Saes for example, bu hey sill seem se o grow faser and hence coninue caching up wih he more advanced counries. These changes in phase have also been accompanied by changes in moneary policy sraegy. The iniial problem was o conrol rapid inflaion and inroduce price sabiliy a price levels ha were clearly compeiive in inernaional erms and allowed he economies he opporuniy o develop new indusries boh for domesic consumpion and expor. In he inervening years sabiliy was increased and he economies brough ino beer balance. The fas growh of recen years has however brough a number of furher difficulies. Firs of all i has been accompanied by a relaive fall in he US dollar and secondly by srong increases in commodiy prices, paricularly oil. These changes have placed pressures on moneary policy. Those counries ha have decided o mainain sabiliy hrough inflaion argeing have found ha relaively high ineres raes were required leading o an appreciaion of he exchange rae. Those counries ha have effecively pegged heir exchange raes or formed currency boards have also encounered problems. Those ha pegged o he euro have seen considerable increases in heir real exchange raes as heir inflaion has exceeded ha in he euro area iself and widening rade deficis, offse by FDI and in some cases remiance income from hose who have sough more rapid increases in income by working abroad, even if emporarily. Pegging o he US dollar or he Russian rouble has no proved o be an easy sraegy as i oo has seen some rise in inflaion. This aricle considers he opions for he way forward mainaining price sabiliy ye enjoying he faser rae of growh and convergence owards he sandards of living of he more advanced counries. General advice in recen years has been o choose one of he polar regimes, eiher a nominal exchange rae firmly fixed o a sable currency in which a significan proporion of ransacions are underaken and asses held or aim direcly a price sabiliy, frequenly by argeing inflaion. The laer case implies a freely floaing exchange rae. However, neiher of hese may urn ou o be ideal. The currency o which he exchange rae is pegged may urn ou o be less sable han hoped and no responsive o imporan shocks ha affec he counry. A direc inflaion arge may also prove difficul if local pressures are raher a odds wih he world cycle and hence require raher high ineres raes o hold inflaion down. This has led some counries o choose or conemplae inermediae sraegies ha involve some consrain on boh exchange rae and price flucuaion. A common choice is o choose some progressive rae of exchange rae change such ha real exchange rae flucuaions are limied and inflaion conrolled. A second alernaive is o follow a sable in- 1 Universiy of Auckland. Conference May 19-20, 2008, Minsk

68 68 srumen role, such as an IMF programme, where conrolled expansions in moneary aggregaes limi he scope for inflaion in condiions of fiscal responsibiliy. This aricle herefore begins by considering he wo polar cases, beginning wih exchange rae fixiy in Secion 1, followed by inflaion argeing in Secion 2, before moving on o consider oher regimes in Secion 3 and concluding. 1. Fixing he Exchange Rae The ransiion counries are faced by four simple choices in rying o peg heir currency o ha of a more sable neighbour wih whom hey have exensive economic and financial links. The simples is o adop heir currency: - dollarisaion, rubleisaion or even euroisaion as in he case of Monenegro, for example. This of course involves no simply giving up independen moneary policy bu also giving up seignorage (alhough a sharing agreemen could be negoiaed if he currency counry is willing o do so). A lile less drasic, and reaining some say in policy would be o ener ino a currency union alhough here is no opporuniy in he main for he ransiion counries o do so in a manner ha does no involve heir being dominaed by heir parners. This applies even o hose ha have joined he EU and hence expec o join he euro area. Even if such an agreemen canno be reached i is possible o form a clear unilaeral peg o he oher currency by forming a currency board. In hese circumsances he domesic currency is mainained bu i is backed enirely by holdings of he oher currency. Leas drasic is a formal fixed peg, where here is no 100% backing bu simply reserves held of he oher currency ha are hough sufficien o cope wih any mismaches or speculaive aacks agains he currency. Wihou such full backing any peg will ineviably be somewha less credible and counries will be open o speculaive aack. If a counry has a wholeheared commimen o a fixed exchange rae peg hen i is a lile difficul o see why i does no follow one of he more credible arrangemens. On he whole counries ha op for a fixed peg simply backed up by reserves wish o allow hemselves he opporuniy o change he pariy a some laer sage. Of course his in iself gives a reasonable basis for speculaion. Usually such counries have a degree of capial conrols o enable hem o manage he exchange rae more closely. However, such arrangemens are no impossible. Denmark for example has a very close peg o he euro, permiing very lile variaion. To all inens and purposes i operaes as if i were a member of he euro area. One obvious difficuly is a lack of he necessary foreign currency o use as backing for is own currency. However, given he srong euroisaion, dollarisaion or rublisaion of he ransiion counries his is a lile more difficul o subsaniae. I may mean ha while a currency board is more difficul o implemen, moving direc o moneary union migh be possible. Clearly he naure of he discussion depends on he saring poin. If a counry is already following a weaker peg hen he exen of he change required o adop a harder peg is likely o be quie small in economic erms bu much harder in poliical erms as i involves some explici degree. Moneary policy will already have been heavily dicaed by ha of he currency o which i is pegged. 1 There are wo quesions ha need o be addressed in assessing he economic conex for moneary union. The firs is applies o all of he fixed rae arrangemens namely, wheher he loss of he nominal exchange rae as an adjusmen mechanism is likely o impose significan coss on a counry. These derive from a combinaion of wheher he counry is likely o be exposed o differen shocks from he un- Naional Bank of he Republic of Belarus 1 There is one imporan excepion here, if like Lavia, he peg is o a currency baske, in his case he SDR, raher han o a single currency. The relaive values of he oher currencies will be deermined by inernaional financial markes, wha will maer is he weighs. If he baske is fixed, as in he Lavian case, hen moneary policy will need in effec also o be an average of he weighs. If he weighs are rade deermined and are reappraised on a regular basis hen arrangemen will be a lile more complex.

69 ion as a whole, o which moneary policy responds and he way in which he counry is likely o respond o shocks when inside he union. The second is he exen of he possible gains from inegraion. 69 Boh hese assessmens have o be forward-looking. This pus hem a odds wih he sandard opimal currency area (OCA) and relaed crieria, such as he convergence crieria laid down in he Maasrich Treay for membership of he euro area, as hese end o be backward-looking (Schelkle, 2001). Experience in he EU (Hughes-Halle and Richer, 2006) suggess ha a backward-looking assessmen ends o underesimae he degree of fuure convergence and reducion in he asymmery of shocks in behaviour and heir impac. For he ransiion counries, here are largely only wo realisic direcions o look for exernal moneary sabiliy he euro and he Russian ruble. There are some cases where he US dollar offers a possibiliy (he Asian ransiion counries are no considered in his analysis bu some of hem have indeed focused on he US dollar, reflecing he currency of invoicing composiion of heir rade and he exchange rae policy of heir main compeiors and neighbours). To quie some exen he choice of which way o look is as much poliical as economic. The counries of he Balkans, Ukraine and even Moldova have a realisic chance of joining he EU in he foreseeable fuure, Belarus oo if here were a major poliical change bu beyond ha i becomes more difficul o be obviously saisfying he crieria of Europeanness, alhough boh Georgia and Armenia would no doub feel hey had a srong case. However, only he economic issue is pursued here. In Mayes and Korhonen (2007) we assessed he suiabiliy of Belarus, Kazakhsan, he Russian Federaion and Ukraine for a moneary union. This is he only union ha has been mooed in any deail and alhough he chances may no seem raher remoe, even for such a union beween Russia and Belarus i is worhwhile exploring he economic suiabiliy, if only for illusraive purposes for oher CIS counries. The aricle sars wih a backward looking assessmen using boh he normal OCA crieria and he Maasrich crieria for membership of sage 3 of EMU. There is no single acceped lis of he OCA crieria following Mundell s (1961) exposiion and views of heir naure and impac have evolved considerably (Grubel, 2005). We herefore followed he lis of 10 crieria se ou by Edwards (2006), as his is one of he broader and mos recen consideraions. This does no imply suppor for any paricular lis. Opimal Currency Area Crieria (Edwards, 2006) Facor mobiliy, paricularly labour, across he union High level of rade across he union Differen/diversified composiion of oupu and rade across counries Price and wage flexibiliy across members of he union Similar inflaion raes across counries Financial markes inegraed across counries No fiscal dominance in he individual counries Low and similar levels of public deb in he differen counries Counries exposed o similar or synchronised exernal shocks Poliical co-ordinaion across counries However, hese crieria are only a guide. They are no of equal imporance and forming an overall assessmen involves a raher arbirary aggregaion. Their applicabiliy also depends on wha he ouside opion is. The scope for furher gain may be small if much of he ingrediens of a union are already in Conference May 19-20, 2008, Minsk

70 70 place (as for counries such as Esonia ha are operaing a long-sanding currency board backed by he euro inside he EU). The likelihood of any such union aking place or being susained is much more a poliical concern and we address ha in a laer secion of he paper. Mayes and Korhonen (2007) simply ran hrough he economic characerisics of he four counries in his conex. A second paper ha looks a he OCA crieria from he poin of view of he asymmery of srucure and shocks among he four counries (Chaplygin e al., 2006) is raher less promising in is conclusions. They have a srong focus on wha hey see as coss a currency union is likely o be expensive in erms of increased insabiliy and los performance. (p.64). They are concerned ha he Russian Federaion is likely o be a source of supply shocks and ha because of is dominan posiion he oher hree counries will have o adjus. They argue (p.63) ha for he coss of forming a moneary union o be small, he wihin group cyclical correlaions mus approach uniy and he shocks mus have roughly equal variances. They are very clearly far from his and hence he auhors conclude ha he coss for each counry will be a leas one sandard deviaion larger han he adjusmen coss which ha counry would have faced wih floaing exchange raes. A currency union will no come cheap. (p.64). We found ha many of he OCA and Maasrich crieria were reasonably well me paricularly he deb crierion, which was a major worry in he iniial formaion of EMU - bu he key issue was dispariy in size. The Russian Federaion is no only wice as large as is prospecive parners in erms of populaion (145 million compared o 75 million Belarus 10, Kazakhsan, 17, Ukraine, 48) bu i has a much higher GDP per head, nearly double ha of Belarus and geing on for hree imes ha of Ukraine, if we ake US dollar nominal values, and 40 o 50% higher even if we consider GDP per capia based on purchasingpower-pariy. Kazakhsan is growing more rapidly so he gap is closing. Despie he fac ha he Russian Federaion iself has been growing by over six percen a year recenly, he oher counries have been ouperforming i, wih he excepion of Ukraine in Thus he relaionship among he parners will be raher differen from ha in a modern currency union and would be somewha more akin o early colonial currency unions, where he home counry was dominan. Indeed in many respecs i would be similar o rubleisaion wih an agreemen o share seignorage. Given he lack of wish o recreae hisory, clearly a new union would have o be raher more sensiive o he posiion of he smaller counries as independen sovereign eniies, which may no be likely. Naional Bank of he Republic of Belarus One serious worry in he background mus be ha because of he 1998 problems iner alia, he ruble sill appears o be undervalued (IMF, 2005a) despie subsequen appreciaion agains he US dollar. This implies ha, as ime passes, he base for all of he counries wih respec o hird currencies will end o rise his would be in addiion o he general rise in he price level ha can be expeced as income per head rises relaive o ha in he more advanced counries. Neverheless, such undervaluaions (and overvaluaions for ha maer) can be very persisen and while he ruble is owards he edge of he disribuion, oher ransiion counries, such as he Czech Republic, are similarly below he average relaionship (IMF, 2005a, Box 2). This would imply ha he region could suffer from he Duch disease, alhough he exensive reinvesmen of oil income in a fund, like ha in Norway, helps reduce he pressure. The Russian oil price sabilisaion fund, se up in 2004, will probably do he same and hereby go some way o sabilising he impac on he oher counries. However, he IMF (2005b) also believes he hryvnia o be undervalued so he major quesion may relae o real exchange rae beween he Russian federaion and is parners. In he case of Kazakhsan, here appears o be lile worry (IMF, 2006) as he enge is in he view of he IMF even more undervalued and likely o coninue o appreciae. Indeed he issue is wheher here would be sufficien appreciaion before any permanen fixing o he ruble. Any problems of overvaluaion are hus more likely in he fuure han in he presen, unlike he case when counries, such as he UK, ried o rejoin he gold sandard afer he firs world war.

71 I is very easy o agree wih he conclusion in Gulde e al. (2004, p.29) The long-run ne economic effec[s] of a proposed currency union beween Belarus and Russia is no clear. Odling-Smee (2003, p.1) pus i on economic grounds alone i is no really possible o say wheher Belarus will benefi from moneary union. Indeed ha remark could be applied o a lo of moneary unions, since he oucome depends on how he members choose o reac boh in erms of public policy and in he privae secor. I represens a regime change. The ingrediens for success and failure, loss and gain are all presen. All one can readily do is lis hem and perhaps assign some enaive probabiliies. However, he auhors go furher and sugges ha eiher Belarus effecively has o rubleise and adjus iself o he moneary policy of he Russian Federaion or ha he Russian Federaion has o view he process of inegraion as somehing more comprehensive and be prepared o assis in he developmen of Belarus, including he use of fiscal ransfers o offse some of he coss of change in a more federal approach. Anyhing in he middle is bound o fail. 71 Gulde e al. (2004) argue ha joining he moneary union and he knowledge ha i is going o happen could ac as shock herapy o ensure ha he necessary changes are made in he consiuen member saes o enable hem o compee. This argumen was advanced in he case of Finnish membership of he euro area (see Pekkarinen e al.(1997) for he governmen sponsored repor) and appears o have been he case in subsequen behaviour (Mayes and Suvano, 2002, 2007). However, his view is no universally shared ex ane. Sweden, which in many respecs was likely o be a beer case for euro zone membership in erms of he OCA crieria laid ou in Secion 2, came o he opposie conclusion in is repor on he likely coss and benefis (Calmfors e al., 1996). They argued ha here was a danger ha Sweden would no only ge locked in o is hen high rae of unemploymen bu ha he process of inegraion migh make i worse. Hence adjusmen should occur firs and membership second. I is also worh noing ha such perfecly sensible economic reasons for iming ge readily wrapped up in he poliical decision making (Mayes and Suvano, 2007). Moneary union for Sweden is now well over he poliical horizon afer membership was rejeced in a referendum in 2004, despie he fac ha he economic concerns had by hen been answered. Adoping currency boards seems o have worked well for he ransiion counries ha have followed i: Bulgaria, Esonia and Lihuania. I brough inflaion down quickly and has kep under subsanial conrol subsequenly. Since all hese counries had EU membership in mind, which enails paricipaion in Sage 3 of EMU and hence adopion of he euro, having a currency board backed by he euro simply has he effec of bringing forward effecive euro area membership. However as ime has passed he needs of price sabiliy have enailed finer uning. The wo Balic Saes, for example, have found ha hey canno readily mee he Maasrich convergence crieria for EU membership because hey lack he ools o conrol inflaion sufficienly narrowly o ensure ha hey are wihin 1.5% of he average of he lowes hree inflaing counries in he EU. Wih 27 member saes i is no difficul o find wo or hree ha are facing abnormal condiions ha lead o low inflaion. Wihou an independen moneary policy i is no possible o fine une inflaion wihou using deflaionary fiscal policy or one off measures ha will reduce measured inflaion such as a swich from indirec o direc axaion. Coupled wih he fac ha he ransiion counries end o have undervalued price levels, he faser growh in he process of real convergence is likely o lead o raher higher inflaion ha in res of he EU o which hey converging. Slowing growh simply o join he euro area seems a raher perverse sraegy, which Esonia in paricular has explicily rejeced. However, his paricular problem of adjusmen is simply a quirk of he raher unusual way he EU has chosen o define convergence insead of following some form of he OCA crieria. From a purely economic poin of view he ineres of a joining counry would be simply in erms of wha likely inflaion would be under membership, as indeed i would be for he exising members. Clearly if new members Conference May 19-20, 2008, Minsk

72 72 end o have above average inflaion raes afer joining, policy will have o somewha igher han i would oherwise have been if inflaion overall is o be kep under he same degree of conrol. An alernaive line of argumen would of course be ha if he exising members were happy wih heir inflaion levels before enlargemen hen hey should be happy wih he same levels subsequenly even hough ha implied a higher value for he enlarged area. Such nuances are no available and hence i is likely ha furher enlargemen will come piecemeal or a imes of low growh. This will only be a problem for he ransiion counries if heir curren moneary policy regimes are hemselves no susainable wihou he proximae likelihood of EMU membership. Srains have emerged, in boh he Czech Republic and Hungary for example bu hese have a presen appeared purely emporary. In he same way fiscal srains have grown and hose in urn will need o be correced if hey oo are no o lead o problems for moneary policy. Figure 1: Esonian inflaion and he Maasrich Crierion 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 2000m m m m m m m01 Esonian inflaion (12 monh average) Esonian inflaion (y-o-y growh rae) MIC eurozone inflaion (y-o-y growh rae) Figure 2 The prospec for EMU enry for Esonia 10% 8% 6% 4% 2% 0% Esonian HICP (12M moving average) MC crierion forecas (Commission oc 2005) Naional Bank of he Republic of Belarus

73 The experience of Esonia is illusraed in Figure 1. On he whole inflaion has been above he Maasrich crierion (MIC) bu if suiabiliy for membership had been assessed on he basis of experience of he previous year as soon as Esonia joined he EU in May 2004 i would have been able o join. The Maasrich crierion has been fairly close o average inflaion in he euro area over he period bu on he whole slighly higher. Thus if counries could mainain heir behaviour when qualifying aferwards hey would presen lile of a problem o he exising members. The picure is analising. Unil he recen increases in commodiy prices, paricularly oil and he very rapid growh i looked as if Esonia migh again have a chance of qualifying (Figure 2) Following an Inflaion Targe Targeing inflaion direcly is an obvious roue o success ha has been adoped by several of he ransiion counries. In some cases his seems o have been highly successful even wih few of he recommended ools in place as in Albania. There has been clear cauion in many quarers, paricularly in he IMF, see Sone (2003) for example, abou recommending he adopion of inflaion argeing. The major worry is ha counries will adop he regime in name bu wihou he key ingrediens ha will make i credible and successful (inflaion argeing lie, as Sone describes i). Clearly if here is fiscal dominance or a weak abiliy o influence inflaion, i is going o be hard o make any moneary policy succeed in mainaining price sabiliy. However, i is easy o exaggerae he essenial requiremens for successful inflaion argeing. Ideally one would like o have good and comprehensive daa, good and reliable forecasing models, and financially deep economy, so ha here was a srong a predicable linkage beween he cenral bank s moneary insrumens and inflaion and he real economy. However, such requiremens are no realisic for many of he ransiion counries. Early successful adopers, such as he Czech Republic, have buil up heir daa, models and financial economy progressively. Even, New Zealand, he iniiaor of inflaion argeing, sared from a far from ideal posiion. No only was he daabase far from ideal bu he economy had gone hrough a major period of ransformaion such ha he Reserve Bank s models were found o be uninformaive. A new model ha was hough saisfacory was no implemened unil eigh years afer inflaion argeing sared (Driessen and Mayes, 2005) and even hen his formed raher less han is now hough desirable by Norges Bank and Sveriges Riksbank. As a resul, policy making was boh relaively sraighforward, concenraing on geing he direcion of change righ and being prepared o correc in he ligh of experience, bu i was also relaively shor run, focusing jus a year ahead in he early years (Mayes and Razzak, 1998; Mayes and Riches, 1996). Neverheless, such robus policy was successful, and has been emulaed in oher counries where he knowledge and echnical ools available were a lo less han ideal (Angerez and Aresis, 2007). The principal concern is wheher his approach o policy is going o be worse han he obvious alernaives, given he curren circumsances, no wheher i is going o be opimal, were all he desirable condiions o be fulfilled. This hen reurns o he issue of wheher flucuaions in he nominal exchange rae are likely o help or hinder he mainenance of price sabiliy. 2 Of course, if a counry sicks o a robus inermediae arge, such as an IMF moneary programme, hen i may be able o mainain general sabiliy wihou moving o eiher polar regime. However, hese moneary programmes are hemselves simple ools, designed o keep inflaion wihin olerable bounds and sabilise he economy in he early years. They may be inefficien a achieving price sabiliy once he laer phases of ransiion have been reached. 1 HICP is he Harmonised Index of Consumer Prices used in he EU for measuring inflaion in his conex. 2 As Angerez and Aresis (2007) poin ou, oher ransiion counries ha chose differen moneary policies have also been successful in sabilizing inflaion over he same period. Conference May 19-20, 2008, Minsk

74 74 Inflaion argeing is normally viewed as he anihesis o fixed exchange rae arrangemens he exchange rae is allowed o flucuae as an imporan par of he adjusmen needed o mainain overall price sabiliy. I is hus regarded as a shock absorber. However, experience in recen years seems o be somewha differen as many counries have seen heir exchange raes move subsanially in recen years. This is no jus a phenomenon experienced by he ransiion counries bu seems o reflec a problem wih inflaion argeing iself or possibly simply wih any independen moneary policy. This is illusraed for example by he experience of Ausralia, Canada and New Zealand, hree of he mos experienced and mos credible inflaion argeers. The nominal effecive exchange rae in Canada rose by 20% beween mid-2004 and mid-2006 and has remained around ha higher level since. The Ausralian rade weighed index (TWI) rose by 20% during he course of 2003 and by April 2007 had increased a furher 10%, reaching levels no seen since However, New Zealand has seen he greaes flucuaion and in June 2007 he TWI reached 74, is highes value since he New Zealand dollar was floaed in 1985 and 45% higher han he low poin in February This promped he firs inervenion in foreign exchange markes since he floaing of he dollar. 1 Like he RBNZ, he Bank of Canada has allowed a free floa since 1998 (excep he co-ordinaed inervenion in suppor of he euro in Sepember 2000), bu he RBA has inervened quie frequenly (Edison e al, 2003). However, Canada has a curren accoun surplus so he exchange rae is no an immediae source of concern. The defici has risen in Ausralia o 6% of GDP in he December 2006 quarer bu he increase in commodiy prices means ha he rade defici is only 1½% of GDP. The problem case is hus New Zealand, where, like Ausralia, he main source of he defici is ne income and no rade, bu in he year o December 2006, he defici was 9% of GDP. When a small counry is ou of phase wih much of he res of he world, i no only has o change ineres raes subsanially o have an effec bu ha difference in ineres raes draws in foreign exchange. Foreign eniies, paricularly Japanese, issued New Zealand dollar bonds (uridashis) wih a value ousanding equivalen o over 30% of GDP in early Wih he flucuaions in he US dollar over he las few years many counries have seen major flucuaions in exchange raes, so he problem is no unique o inflaion argeing counries. The euro for example rose by over 60% compared o he US dollar beween June 2001 and Ocober The euro area also found he exen of exchange rae flucuaion oo large o olerae and he Eurosysem inervened when i hough raes had become oo low, in par in concer wih he oher major cenral banks. Tha appeared o work and he fall in he euro was arresed. There has been increasing discomfor in New Zealand wih high exchange raes during periods of srong moneary policy pressure o conain inflaion. This conribued o he decision, by he governmen, o raise he ceiling for he inflaion arge in The Reserve Bank has looked a he opions since hen and indeed organised a conference on he opic in The problem is greaes for small developed counry economies which do no have an obvious alernaive roue o price sabiliy hrough pegging o a major rading parner ha iself sands a good prospec of price sabiliy and mees a considerable proporion of he requiremens for he creaion of an opimal currency area. The RBNZ underook an exensive programme of inernal and exernal research on he advanages of a currency union (principally wih Ausralia) from which i concluded ha here was no srong economic case ha could be made (and here has been no grea poliical appeie o do so in eiher counry). Naional Bank of he Republic of Belarus 1 Alhough he exchange rae did rise a lile furher i has since remained around 2-4% lower, alhough in common wih oher currencies, he US dollar exchange rae has fallen furher.

75 In 2004, i also changed is view on he subjec of inervenion in he foreign exchange marke (RBNZ, 2005). Previously inervenion had only been hough o be necessary in periods of considerable marke urbulence (disorderly markes) and normally wih he approval of he miniser of finance. Then i suggesed ha inervenion would be appropriae o influence 'he level of he exchange rae o reduce cyclical exchange variabiliy when he rae is excepionally and unjusifiably high or low' unjusifiably in erms of 'economic fundamenals'. Is remarks abou he appropriae circumsances and wha can be achieved are very guarded 'when here is a maerial prospec of influencing he exchange rae and in ways ha seek o avoid giving rise o desabilising inervenion'. Neverheless, June 2007 saw jus such an inervenion, when he overnigh cash rae was raised o 8%. 75 Inervenion is normally viewed unenhusiasically especially when i is serilised, as mos cenral banks are small relaive o heir markes. Bu on occasion his appears o have been successful in Canada Siklos and Weymark (2006) poin o an example in And in Ausralia i is argued ha even hough he RBA may have had limied success in 'leaning agains he wind', inervenion has been a profiable sraegy by buying foreign currency when he dollar was high and selling i when i was low (Kim and Sheen, 2002). However, i may increase volailiy raher han smooh i (Edison e al., 2003). Wha his episode emphasises is ha for even he mos commied inflaion argeers here are occasions when he impac on he real economy will ake precedence. The challenge for inflaion argeing is hus more one of a challenge for all moneary policies in small open economies. They are oo small o move markes much. Should hey herefore sofen he focus on overall inflaion and place some limis on how far hey are prepared o le he exchange rae move away from 'equilibrium' along he way? If hey permi such shor erm deviaions will his harm credibiliy and make inflaion conrol more cosly over he longer erm? For he ransiion counries he choice is raher harder. In inernaional markes heir credibiliy is likely o be limied and hence any deviaion will be inerpreed as confirmaion and risk premiums will remain high. However, a home heir credibiliy is likely o be considerably higher. Cenral banks are respeced insiuions, as par of rying o pu he expeced insiuional arrangemens in place for inflaion argeing hey will have and will have demonsraed a measure of independence. They will also have been relaively successful in keeping inflaion low. Thus despie shorer run pressures and coninuing imbalances, expecaions may well be quie firmly anchored on price sabiliy. There may herefore be a empaion, especially since he pressure on exchange raes comes from exernal acion he major imbalances and sweeping policy moves in he Unied Saes and he ramping up of commodiy prices, paricularly oil as worldwide demand moves ahead rapidly. 3 Opions and Reflecions The economeric evidence ha cenral banks can have a srong influence over inflaion in he ransiion counries has been slow in appearing. Models esimaed for Belarus and Armenia for example show a relaively limied channel for he influence of ineres raes on real behaviour (Pelipas, 2006; Dabla-Norris and Floerkemeier, 2006). However, hese esimaes suffer from wo drawbacks, firs of all hey necessarily use informaion drawn from a rapidly changing pas when he concern for policy is over wha will happen in he fuure. Secondly hey end o underesimae he role of expecaions. Cenral banks and governmens have a range of insrumens hey can use o bear on inflaion, even if hey are no as direcly effecive as ineres raes in developed counry markes. Neverheless hey are sufficien o bring inflaion under conrol. As people know his, as long as heir use is expeced, hen expecaions will hemselves ac direcly o conrol inflaion. Price seers will ac in he belief ha inflaion will no ge ou of hand and ha in iself will help conrol inflaion. Conference May 19-20, 2008, Minsk

76 76 Hence while i may no be possible o adop all of he faces of a modern developed economy moneary policy regime, i may be possible for he ransiion counries o adop enough of hem for he policy o work effecively, as Dabla-Norris e al. (2007) argue for Armenia and Georgia for example. Furhermore, he exchange rae channel normally operaes in all small counries (Przysupa, 2002). The flow from exernal prices o inernal prices, miigaed by he exchange rae is a relaively predicable mechanism, cerainly one where here is no doub abou he sign, alhough is effec can vary over he course of he economic cycle and wih expecaions abou how permanen any exchange rae change is likely o be. The exchange rae channel is also likely o have a porfolio componen (Drew and Sehi, 2006) which will be imporan in ransiion counries where here is subsanial dollarisaion or oher foreign currency holding. I is also emphasised when remiances form an imporan par of incomes. In hese cases he impac of he exchange rae channel is enhanced. Wih a depreciaion, no only is here a direc inflaionary impac from higher impor prices bu remiances increase heir purchasing power. Similarly if he exchange appreciaes here are wo roues by which inflaion is pushed downwards. Thus, in he earlier sages of moneary policy in he ransiion counries, he exchange rae is likely o play a considerable role and may effecively be an inermediae arge for moneary policy even in an inflaion argeing regime (Bernanke e al, 1999). Chile, Israel and Kazakhsan have each used his approach. One of he advanages is ha he immediae impac is quie rapid, affecing inflaion wihin hree monhs, wih much of he effec coming hrough in he firs year (Mayes and Viren, 2000, explore he relaive size and speed of impac of he exchange rae and ineres rae channels in he EU counries). Whaever he choice of regime i is clear ha here are common elemens o be developed, saring wih a good informaion base. The cenral bank has a forward looking ineres in he economy, which is no necessarily shared by he saisical auhoriies, so he cenral bank will wan o develop is own leading indicaors and surveys of inenions and expecaions. The cenral bank will wan o develop a good undersanding of he economy and communicae i o he res of he economy boh governmen and privae secors hrough a high qualiy review, probably in he form of an Inflaion Repor, a regular inervals. The basic condiions for credibiliy of independence, a lack of fiscal dominance, ransparency and accounabiliy also apply. The increasing financial deepening of he economy will come wih ime, alhough here is much he cenral bank can do o encourage i by ensuring high qualiy supervision and compeiion, so ha he public has confidence in boh he currency and he financial sysem. Naional Bank of he Republic of Belarus For hose counries hinking of joining he euro area here is a choice of pah o adopion of he single currency. While i is possible o sar by having fixiy, ulimaely o he full exen of adoping he euro iself as in Monenegro, or hrough a currency board, anoher roue is o focus direcly on domesic price sabiliy iniially and only when ha has sabilised and he counry become much more closely aligned o he euro area o approach a fixed exchange rae. For hose wihou such an explici goal, he iniial seps will be of indefinie lengh. The problem hen is o provide credible evidence of heir durabiliy. This is more readily demonsrable wih he exremes of exchange rae fixiy and inflaion argeing. Neverheless inerim less ransparen regimes have worked as Slovenia s successful accession o he euro area shows. The euro is no he only currency wih which o achieve igh fixiy bu i is currenly he only common currency available. The ohers are paricular counries currencies and hese are run o he ineres of hose counries. This makes adopion a more difficul decision. The fac ha here is an exi roue, as Argenina has demonsraed is a mixed blessing. The irrevocable naure of euro membership, alhough no sricly rue, and is ineviabiliy for all counries excep he UK and Denmark under he presen reay makes i a very srong anchor. Wihou such srong poliical commimens economic argumens will always be less credible and provide difficulies for small open economies, as he experience of Ausralia, Canada and New Zealand discussed here demonsraes.

77 References 77 Angerez, A and Aresis, P (2007) Assessing he Performance of he Inflaion Targeing Lie Counries, World Economy, vol. 30(11), pp Bernanke, B, Laubach, T, Mishkin, F and Posen, A (1999) Inflaion Targeing, Princeon: Princeon Universiy Press. Calmfors, L, Flam, H, Gofries, N, Malary, J H, Jerneck, M, Lindahl, R, Bernsson, C N, Rabinowicz, E and Vredin, A, EMU A Swedish Perspecive, Dordrech: Kluwer. Chaplygin, V, Hughes-Halle, A and Richer, C. (2006). Moneary Inegraion in he ex-sovie Union: a Union of Four, Economics of Transiion, vol.14(1), pp Dabla-Norris, E., and Floerkemeier, H. (2006). Transmission Mechanisms of Moneary Policy in Armenia: Evidence from VAR Analysis, IMF Working Paper No. 06/248 Dabla-Norris, E, Kim, D, Zermeno, M, Billmeier, A and Kramerenko, V (2007), Modaliies for Inflaion Targeing in Armenia and Georgia, IMF Working paper WP/07/133. Drew, A and Sehi, R (2006) The ransmission mechanism of New Zealand moneary policy, Reserve Bank of New Zealand Bullein, vol.70(2), pp Driessen, K and Mayes, D G (2005) A Robus Approach o Moneary Policy: Moneary Policy for he EU s New Neighbours, UACES conference on Eurioepean Union Pas and Fuure Enlargemens, Zagreb, Sepember, IMF Working Paper, forhcoming. Edison, H, Cashin, P. and Liang, H. (2003). 'Foreign Exchange Inervenion and he Ausralian Dollar: Has i Maered?', IMF Working Paper 03/99. Edwards, S. (2006). Moneary Unions, Exernal Shocks and Economic Performance: a Lain American Perspecive, NBER Working Paper 12229, May. Grubel, H. (2005). New Crieria for Opimum Currency Areas, in (Sisiar Jayasuriya, ed.) Trade Policy Reforms and Developmen: Essays in Honour or Peer Lloyd, Volume II, pp , Chelenham: Edward Elgar. Gulde, A-M, Jafarov, E and Prokopenko, V, A Common Currency for Belarus and Russia?, IMF Working Paper WP/04/228, also version in Vinhas de Souza, and De Lombaerde (2006). IMF (2005a). Russian Federaion Saff Repor for he 2005 Aricle IV Consulaion, Augus, Washingon DC. IMF (2005b) Ukraine - Saff Repor for he 2005 Aricle IV Consulaion, November, Washingon DC. IMF (2006). Kazakhsan - Saff Repor for he 2006 Aricle IV Consulaion, June, Washingon DC. Kim, S-J. and Sheen, J. (2002) 'The Deerminans of foreign Exchange Inervenion by Cenral Banks: Evidence from Ausralia', Journal of Inernaional Money and Finance, vol.21, pp Mayes, D. G and Riches, B (1996). 'The Effeciveness of Moneary Policy in New Zealand in Conference on Moneary Policy, B Noron, ed, pp.2-42, Macquarie Universiy and Reserve Bank Bullein, vol.59 (1), 1996 Mayes, D.G. and Razzak, W. (1998) Transparency and Accounabiliy: Empirical Models and Policy Making a he Reserve Bank of New Zealand Economic Modelling, 1998, revised version reprined in M Morgan and F den Buer Empirical Models and Policy Making, Rouledge, ch.7, pp Mayes, D and Suvano, A. (2002). Beyond he Fringe: Finland and he Choice of Currency, Journal of Public Policy, vol.22, pp Mayes, D and Suvano, A. (2007). Meeing he Challenge of Moneary Union: Lessons from he Finnish Experience, Bank i Kredy, vol. 38 (październik), pp.3-14 Mayes, D G and Viren, M (2000) The Exchange Rae and Moneary Condiions in he Euro Area, Welwirschafliches Archiv, vol. 136 (2), pp Mundell, R. (1961). A Theory of Opimum Currency Areas, American Economic Review, vol. 51, pp Odling-Smee, J, Moneary Union Beween Belarus and Russia: An IMF Perspecive, Belarusian Sae Universiy, Sepember, available a hp:// Pekkarinen, J, Moneary Union and Finland: EMU Exper Group, Helsinki: Publicaions of he Prime Minisers Office. Pelipas, I (2006) Money Demand and Inflaion in Belarus: Evidence from Coinegraed VAR, Research in Inernaional Business and Finance, vol. 20(2), pp Przysupa, J (2002) The exchange rae in he moneary ransmission mechanism Naonal Bank of Poland Working Paper 25. RBNZ (2005) 'Briefing on he Reserve Bank', Ocober, also available from hp:// Siklos, P. and Weymark, D. (2006). 'Measuring he Impac of Inervenion on Exchange Marke Pressure', mimeo, Wilfrid Laurier Universiy, December. Sone, M (2003) Inflaion Targeing Lie, IMF Working Paper, 03/12. Vinhas de Souza, L and De Lombaerde, P, The Periphery of he Euro Moneary and Exchange Rae Policy in CIS Counries, Aldersho: Ashgae. Conference May 19-20, 2008, Minsk

78 78 Franz Seiz 1 Ineres Rae Seing, Money and he Role of he Oupu Gap 2 The paper shows ha a robus and successful moneary policy implies an ineres rae response o deviaions of he inflaion rae from arge, o he change in he oupu gap, o a money gap and o he lagged ineres rae. These elemens of he reacion funcion are also he necessary consequence of assigning money a prominen role in he moneary policy sraegy. As a drawback, his orienaion inroduces reacions o money demand shocks. On he oher hand, such an inerial policy rule is robus o he use of real-ime or ex pos daa, a poin which is especially imporan for ransiion counries like Belarus. In a second sep, we compare his rule wih ohers under a welfare-heoreic perspecive. We find ha ineres rae rules which include a response o money growh ouperform boh Taylor-ype rules and speed limi policies once real-ime oupu gap uncerainy is accouned for. One reason is ha argeing money growh inroduces hisory dependence ino he policy rule which is desirable when privae agens are forward-looking. The second reason is ha money growh conains informaion on he rue growh rae of oupu which can only be measured imperfecly. 1. Inroducion Gerberding e al. (2004, 2005) have shown ha he use of real-ime daa for Germany considerably changes he assessmen of he Bundesbank s moneary policy reacion funcion. According o ha analysis, he Bundesbank did no respond o he level of he oupu gap as suggesed by he Taylor (1993) rule, bu raher o he change in he oupu gap as well as o deviaions of (expeced) inflaion and money growh from heir respecive arge values. Furhermore, he resuls sugges ha he moneary policy of he Bundesbank was characerised by a high degree of ineres rae ineria. This is ineresing for oher cenral banks, oo, as he Bundesbank is usually judged o have been one of he mos successful cenral banks. Ineresingly, argeing he rae of change raher han he level of he oupu gap has recenly been advocaed by a number of auhors, such as Orphanides (2003a) and Walsh (2003, 2004). One argumen in favour of such an approach is ha esimaes of he level of he oupu gap are subjec o much greaer uncerainy han esimaes of is change. Anoher advanage is ha argeing he change in he oupu gap makes moneary policy more hisory-dependen, which is an imporan elemen of an opimal commimen policy in forward-looking models. Real-ime daa uncerainy is an inernaional phenomenon (see Gerberding e al. (2005) for Germany, Gerdesmeier and Roffia (2005) for he Euro Area, Kamada (2004) for Japan, Nelson and Nikolov (2001) for he UK and Orphanides (2001) for he USA) and is especially imporan and severe for ransiion counries like Belarus (see also figure 1 for Germany). One common characerisic of he real-ime daa ses which exis is ha he measuremen errors regarding he change in he oupu gap were much smaller and much less persisen han he measuremen errors regarding he level of he oupu gap. For he purpose of pracical moneary policy, i seems essenial o base ineres rae seing on variables which are exposed o measuremen error only o a comparaively small exen. The purpose of he presen paper is o derive such ineres rae feedback rules and o answer he quesion wha role money plays in such a rule. Naional Bank of he Republic of Belarus 1 Universiy of Applied Sciences Amberg Weiden and WSB Poznan, Poland 2 This paper draws on join work ogeher wih C. Gerberding, M. Scharnagl and A. Worms from he Deusche Bundesbank. Neverheless, he views expressed in he paper should no be inerpreed as hose of he Deusche Bundesbank.

79 A robus moneary policy rule Wih forward-looking price seing and a shor-run oupu inflaion rade-off, here are gains for moneary policy makers from commimen o a policy rule. Under commimen, he cenral bank akes he effecs of is own acions on privae secor expecaions ino accoun. As a consequence, opimal policy is no purely forward-looking, bu hisory-dependen in he sense ha i implies sysemaic responses o lagged variables of ineres. Choosing he commimen soluion ha is opimal from a imeless perspecive, he ineres rae rule akes he form 79 i ρ i ρ i ρ i φ p p φ y y, (1) * = (1 1) * ( T p ) + y( ) where i is a shor erm ineres rae, i* is is long-run equilibrium level (which is equal o he sum of he long-run equilibrium real rae of ineres plus he rend rae of inflaion). The parameers ρ, φ p and φ y capure he degree of ineres rae smoohing and he srengh of he ineres rae response o he inflaion gap ( p- p T ) and he change in he oupu gap ( y- y*), respecively. is he difference operaor and T is a arge value. All decisions have o be based on informaion available a ime. Gerberding e al. (2007) have shown ha using money as an indicaor variable resuls in a feedback rule of he form ( ) * T *, es ( 1 ) ( ) ( ) i = ρ i + φ p p + λ γ y y + λ ε λ η + ρ i + ν, (2) p wih λ1 > λ2 0 and where ε capures shor-run dynamics as well as flucuaions of money demand and η sands for measuremen errors in money growh 1 (ν is an error erm). A posiive value of λ 2 would eiher indicae ha he saff made sysemaic misakes in esimaing he long-run relaionships or ha, despie he medium-erm orienaion of heir approach, policymakers sill showed some response o shor-run flucuaions in money demand (even if hese were correcly idenified). Thus, he opimal ime-invarian policy rule (1) under commimen shares many feaures wih he ineres rae represenaion of, as we call i, flexible moneary argeing (2). The difference beween (1) and (2) is ha a) money inroduces measuremen errors in money growh, η, ino he policy rule and b) money implies a policy response o ε. The laer is usually seen as he principal drawback of a moneary orienaion. However, a cenral bank should be aware of his problem and ry o idenify and filer ou special facors which only influence money demand in he shor run bu do no have any repercussions on he long-run relaionships, especially on rend inflaion and on inflaion expecaions (see in he case of he Bundesbank Balensperger, 1998; Deusche Bundesbank, 1998, 36f.). In erms of Eq. (2), his pracice of filering acual money growh figures implies ha he coefficien on ε (λ 2 ) should be smaller han λ 1 or may even be zero. A firs sigh, Eq. (2) also looks raher similar o he well-known forward-looking Taylor-ype rule in ha i includes he rae of inflaion, he oupu gap and he lagged ineres rae as feedback variables. However, a closer inspecion reveals some imporan differences: 1 In he case of Germany or he euro area he laer are pracically non-exisen. Conference May 19-20, 2008, Minsk

80 80 (a) Using money as an indicaor implies a policy response o he difference beween he growh rae of acual oupu and he (esimaed) growh rae of poenial oupu growh (i. e. he change in he oupu gap) whereas he Taylor rule includes a response o he esimaed level of he oupu gap. Hence, money inroduces hisory dependence ino he policy rule which is an imporan componen of an opimal commimen policy when agens have forward-looking expecaions (b) Moneary orienaion implies a response o he rue values of p and y (which deermine money demand) while a he same ime inroducing measuremen errors in money growh, η, ino he policy rule. By conras, ineres rae rules wih a direc feedback from prices and oupu - such as Taylor-ype rules or nominal income argeing - are vulnerable o measuremen errors in hese variables, bu do no suffer from measuremen errors in money growh. The relaive performance of hese rules compared o moneary argeing herefore crucially depends on he magniude of he respecive measuremen errors. (c) Money inroduces addiional ineria ino he policy rule even if here is no ineres rae smoohing moive a priori as ρ > 0 as long as he ineres rae response o he money growh gap and he ineres elasiciy of money demand differ from zero. (d) According o (2), a moneary pillar implies a response o he conemporaneous rae of inflaion whereas he forward-looking varian of he Taylor rule allows for values of n greaer han zero. (e) Eq. (2) implies a policy response o ε. (f) Eq. (2) also shows ha simply amending a Taylor rule by a money (growh) gap in order o check wheher moneary policy acually reaced o moneary aggregaes (see, e.g., Clarida e al., 1998) does no do jusice o he medium-erm naure of moneary argeing. One poenial advanage of money growh argeing over oher moneary policy sraegies is ha money growh may conain useful informaion on he unobserved rue value of curren oupu (growh) whereas cenral banks which arge oupu (growh) direcly have o rely on noisy esimaes of his variable. Of course, his advanage hinges criically on he relaive magniude of he measuremen errors in money and oupu daa as well as on he cenral bank s abiliy o idenify money demand shocks in real ime and o separae shor-run from long-run influences on money demand (see Coenen e al., 2005). 3. Esimaion and inerpreaion Which moneary policy sraegy a cenral bank really follows can obviously only be esed empirically by esimaing a reacion funcion which conains all poenially relevan argumens, especially he level and he change in he oupu gap as well as a money gap. More generally, nesing he ingrediens of he forward-looking Taylor rule and he feedback variables implied by Eq. (2) ino one model leads o he following ineres-rae rule (3). By allowing he horizon of he inflaion gap, n, o vary from zero o six, he wo variables measuring curren and fuure price pressure can be subsumed ino one error erm µ. Naional Bank of he Republic of Belarus ( i p E p p E y y T T * = (1 ρ ') α + + n + φ p (( + n + n) Ω ) + φ y (( ) Ω ) * * + φ y E (( y y ) Ω ) + φm E (( m m ) Ω + ρ ' i 1 + µ ), (3)

81 where he measuremen error in money growh, η, has been se equal o zero. Furhermore, i * has been T replaced by he sum of a consan and he price arge, p + n. Ω is he informaion se available in and E is he expecaion operaor. An imporan issue is he mehod used o generae he forecass. Since we do no know policymakers rue forecass of inflaion, he oupu gap and he change in he oupu gap, we follow he sandard pracice of using he realized values as proxies. Therefore, he error erm µ is a linear combinaion of he forecas errors of inflaion and oupu and he exogenous disurbance erm ν. 81 In order o avoid simulaneiy problems, he RHS-variables are insrumened by a vecor of variables I which belong o he cenral bank s informaion se a he ime i ses ineres raes and which are orhogonal o µ. As we use end-of-quarer values of he dependen variable, we include he conemporary values of hose RHS variables which were known o policymakers a he end of quarer (ha is, inflaion, he price assumpion, he money growh arge) as well as wo lags of each RHS variable in he insrumen se (see he noes o able 1 for more deails). Table 1 summarizes he resuls of esimaing (3) on ex pos and real-ime German daa for differen forecas horizons n. Several observaions are in order. Firs, in all cases, he J-saisic confirms he validiy of he over-idenifying resricions. Second, he coefficien of he inflaion gap, φ p, is significanly posiive for all values of n. Third, he coefficien of he level of he oupu gap, φ y, is significanly posiive only for n=0 in he ex-pos seup, suggesing ha in his case, he oupu gap acs as an indicaor of fuure inflaion raher han as an independen feedback variable. Fourh, he coefficiens of he oupu growh gap, φ y, and of he money growh gap, φ m, are significanly posiive for all values of n. Fifh, wih esimaed values of ρ beween 0.80 and 0.92, he rule exhibis a high degree of ineres rae smoohing. However, wha is perhaps mos surprising is ha he resuls based on real-ime daa differ only slighly from he resuls in he ex-pos seing. An obvious explanaion for his congruence is ha (in conras o oher cenral banks) policymakers a he Bundesbank focussed heir aenion on indicaor variables which were exposed o measuremen error only o a comparaively small exen. Figure 1 illusraes ha his was indeed he case. Firs of all, he measuremen errors regarding he change in he oupu gap were much smaller and much less persisen han he measuremen errors regarding he level of he oupu gap. Moreover, revisions in consumer prices and in money growh were even smaller in size hroughou he sample period, wih money growh figures being hardly ever revised a all. While his may no be rue for oher counries over differen sample periods, Coenen e al. (2005) reach very similar conclusions wih respec o euro-area daa since These resuls prove o be quie robus o changes in he forecas horizon n (1 n 6), he exac iming of he inflaion and oupu variables, he concree specificaion of he money gap (annual growh raes, annualised 6-monh growh raes, level specificaions), and o he choice of alernaive proxies for he unobserved forecass of inflaion (consumer prices, oupu deflaor, consensus forecass). Obviously, he Bundesbank did no follow a Taylor rule since he level of he oupu gap urns ou o be insignifican in almos all regressions. Insead, he significan and sizable response o boh, inflaion and he oupu growh gap as well as he high degree of ineres rae smoohing sugges ha he Bundesbank ook is money growh arges seriously. However, here are also wo aspecs in which he resuls deviae from he money based ineres rae rule derived in Secion 2. Firs, by responding o expeced fuure inflaion raher han o curren inflaion, policymakers a he Bundesbank seem o have been more forward-looking han implied by he ineres rae rule (2). Second, beyond he feedback from he variables implied by moneary argeing, here seems o have been an addiional, independen response o money growh. Taken lierally, our model of moneary argeing implies an ineres rae response o deviaions of curren inflaion from arge. And in fac, for n=0, our esimaes of he feedback coefficiens corres- Conference May 19-20, 2008, Minsk

82 82 pond well wih he predicions of he heoreical model, paricularly in he real-ime seup. However, increasing he forecas horizon of he inflaion gap lowers he sandard error of he regression even furher unil i reaches is minimum a a forecas horizon of hree quarers. In order o beer undersand his resul, recall ha he Bundesbank ried o idenify and filer ou shor-run flucuaions in money demand which did no have any repercussions on he long-run relaionships, especially on rend inflaion and on inflaion expecaions. Such flucuaions migh no only be caused by shocks o real money demand (as capured by he variable ε ), bu also by he effecs of price shocks on nominal money demand. Viewed from his perspecive, increasing he ime horizon of he inflaion variable may improve he fi of he model because expeced fuure inflaion is a beer proxy for medium-erm price developmens han he curren rae of inflaion which is driven by emporary price shocks as well as longer-erm rends. Finally, we sill have o explain he role of he explici money growh gap in he Bundesbank s reacion funcion. Firs of all, noe ha increasing he horizon of he inflaion gap from zero o hree quarers (in he case of φ y = 0, see ables 1b and 2b in Gerberding e al., 2007) lowers he coefficien of he money growh gap from 0.98 o 0.29 in he ex pos seup and from 1.05 o 0.30 in he realime seup jus o increase again for n > 3. As regards he esimaes based on real-ime daa, he remaining response o he money growh gap a n=3 migh be explained by is role as an indicaor of he "rue" growh rae of real oupu. More generally, he significan reacion o money growh in boh scenarios may reflec an insurance scheme o policymakers agains measuremen errors in oupu growh of unknown size a he ime decisions were made. Apar from ha, φ m may capure a remaining influence of shor-run dynamics and money demand shocks on he Bundesbank s ineres rae decisions. This may simply reflec misakes, possibly due o difficulies in idenifying shocks in real ime. Bu i may also indicae a conscious decision by policymakers o show some response o obvious deviaions of money growh from arge, even if hey were believed o be caused by shocks and herefore no o feed ino prices in he medium o long run (e.g. for credibiliy reasons). 1 Normaive Aspecs From a normaive perspecive, i is ineresing o know wheher adding money o an ineres rae rule ha already includes a response o boh inflaion and he oupu (growh) gap yields any exra benefis. On he one hand, augmening a sandard Taylor rule wih a money growh arge may be advanageous because i inroduces ineria and hisory-dependence ino he policy rule. On he oher hand, his can also be achieved by including he lagged ineres rae and oupu growh direcly among he feedback variables (as in Sracca, 2007). However, even in his case, an addiional response o money growh may be beneficial because money growh may conain informaion abou he rue rae of oupu growh which can only be measured imperfecly. Naional Bank of he Republic of Belarus To gauge he relevance of hese argumens for he euro area, we exend he se of simple rules analysed by Sracca (2007) o include varians of he Taylor rule and he speed limi rule which feaure an addiional response o money growh. We hen go on o calculae he opimal feedback coefficiens and o compare he performance of he opimised simple rules in a small esimaed model of he euro-area. The seup ha we use is a version of he canonical New Keynesian model which has been proposed by Rudebusch (2002) and esimaed on euro-area daa by Sracca (2007). To capure he implicaions of oupu gap uncerainy, we assume ha policymakers observe only noisy measures of he oupu gap and of he change in he oupu gap. Moreover, we assume ha he observed uncerain variables ener he policy rule direcly. The model is described in deail in Scharnagl e al. (2007). 1 Addiional reasons why i migh be helpful for policymakers o look a money are discussed in Gerberding e al. (2004), secion 5.

83 As noed, our analysis akes place in a simple rules framework and focuses on he relaive performance of several varians of he basic Taylor rule, aking ino accoun ha policymakers observe only a noisy measure of he oupu gap. These rules are simple because hey model he ineres rae as a funcion of a limied se of sae variables while he fully opimal rule would involve all sae variables of he model. Given he consrain on he number of feedback variables, he feedback coefficiens are chosen so as o minimise policymakers expeced loss. A poenial advanage of simple rules is ha hey are easier o undersand and monior for he public han he (complex) opimal commimen soluion. Furhermore, simple rules may be more robus o model uncerainy. 83 The firs simple rule ha we consider is a Taylor rule wih ineres rae smoohing: iˆ = φ iˆ + φ ( π π ) + φ x, (TR) * where x is he oupu gap, π is he inflaion rae, î is he deviaion of he nominal ineres rae from is seady sae value and he subscrip indicaes he informaion on he conemporaneous value of a specific variable available a ime. The second rule is a simple growh rae argeing or speed limi rule of he kind advocaed by Orphanides (2003b) and Walsh (2003) which involves a response o he change raher han o he level of he oupu gap: i ˆ = φ i ˆ + φ ( π π ) + φ ( x x ), (SPL) * However, cenral banks need no be limied o a discree choice among hese wo simple rules. Especially wih oupu gap uncerainy, i may be advanageous o respond o he level as well as o he change in he oupu gap (see Rudebusch, 2002). Hence, we also consider a hybrid rule which ness boh cases: i ˆ = φ i ˆ + φ ( π π ) + φ x + φ ( x x ), (TRSPL) * Finally, we consider a varian of he Taylor rule and a varian of he speed limi rule wih an addiional response o money growh: iˆ = φ iˆ + φ ( π π ) + φ x + φ ( m m ), (TRM) * * i ˆ = φ i ˆ + φ ( π π ) + φ ( x x ) + φ ( m m ), (SPLM) * * Table 2 gives an overview of he whole model. Deriving he opimal feedback coefficiens requires an objecive funcion, and we use a fairly sandard one in which he cenral bank is assumed o minimize he variaion in inflaion around is arge (which is normalized o zero), in he oupu gap, and in he change in he ineres rae: 1 * = 0 ( ) + x + i( 1) = 0 L E ß w π π w x w i i, π (4) where he parameers ω π, ω x and ω i are he relaive weighs on he hree elemens of he loss funcion L. 1 The arge for oupu is assumed o be equal o he naural rae, so he arge for he oupu gap is also zero. Conference May 19-20, 2008, Minsk

84 84 As a firs sep, we use he model summarized in Table 2 o compare he relaive performance of he five rules defined above under differen degrees of oupu gap uncerainy (no uncerainy, low uncerainy, baseline uncerainy, high uncerainy). We assume ha he cenral bank minimises Equaion (4) subjec o he rule in quesion and he model, while aking ino accoun ha is esimae of he oupu gap is imperfec. Furhermore, we assume ha he policy rule is perfecly credible, so agens know he rule and assume (correcly) ha i will be followed. In order o gain a beer undersanding of he role of oupu gap uncerainy, we firs consider he hypoheical case of perfecly observable oupu gaps. Here, our resuls regarding he Taylor rule (TR) and he speed limi rule (SPL) closely resemble he ones presened by Sracca (2007) despie he fac ha we use a slighly differen objecive funcion. In paricular, he opimal Taylor rule is found o have a very low degree of ineria, while he opimal speed limi rule is found o be very persisen (in fac, i is idenical o a firs difference rule). Sracca argues ha he difference beween he values of φ1 is likely o reflec he fac ha he Taylor rule feeds back srongly from he highly persisen level of he oupu gap, while he SPL rule reacs (again srongly) o he less persisen change in he oupu gap. Anoher ineresing resul is ha he reacion o he oupu variable is much sronger han he response o curren inflaion, especially as regards he SPL rule. Again, his makes sense, since in an environmen characerised by ransmission lags and a low degree of inflaion ineria, demand shocks which affec curren oupu are much more relevan for fuure inflaion han cos-push shocks which maer only for curren inflaion. Allowing for an addiional response o money growh somewha changes he opimal coefficiens of he Taylor rule, bu he associaed reducion in he overall loss is fairly limied. Augmening he speed limi rule by a response o he oupu gap (TRSPL) or o money growh (SPLM) has even less impac on he opimal coefficiens and on he overall losses. Allowing for measuremen error in he oupu gap drasically changes hese resuls in several direcions. Firs of all, oupu gap uncerainy aenuaes he opimal response o he oupu gap and o he oupu growh gap across all policy rules. The inuiion for his resul is sraighforward: as he reliabiliy of an indicaor is reduced, one should place less emphasis on he informaion i conveys. Second, he opimal reacion o inflaion increases wih he degree of oupu gap uncerainy. While his resul is in line wih he lieraure on he consequences of oupu gap uncerainy in an opimal argeing rules framework (see Swanson, 2004), Rudebusch (2001) and Smes (2002) find ha higher oupu gap uncerainy moderaes he reacion o he inflaion rae in he opimal simple rules hey consider. As poined ou by Leiemo and Lonning (2006), his apparen conradicion can be explained by he presence of wo counervailing effecs. On he one hand, in he case of a demand shock, a sronger policy reacion o he inflaion rae can subsiue for a reacion o an imprecisely measured oupu gap. Ceeris paribus, his effec will increase he opimal coefficien on inflaion. On he oher hand, in he presence of cos-push shocks, a sronger reacion o inflaion will desabilize he oupu gap even furher. Hence, wih increasing oupu gap uncerainy, i will be opimal for he cenral bank o reduce is response o boh he oupu gap and inflaion. Apparenly, in he model considered here, he firs effec dominaes. A hird imporan resul is ha oupu gap uncerainy generaes a non-rivial role for money growh as a feedback variable. Allowing for oupu gap uncerainy significanly increases he opimal coefficien on money growh, φ 5, in boh he money-augmened Taylor rule and he money-augmened speed limi rule. A baseline (high) levels of uncerainy, φ5 reaches a value of 1.42 (1.56) in he TRM rule and of Naional Bank of he Republic of Belarus 1.08 (1.20) in he SPLM rule. More imporanly, even a a low degree of uncerainy, he addiional response o money growh reduces he loss by 4.6% relaive o he sandard Taylor rule and by 3.9% relaive o he sandard speed limi rule (wihou money). Under baseline (wors case) assumpions abou

85 oupu gap uncerainy, he welfare gain increases o 6.4% (8.0%) for he Taylor rule and o 6.2% (6.4%) for he speed limi rule. One explanaion for he welfare gain compared o he sandard rules is ha responding o money growh allows he cenral bank o reduce is response o inflaion in boh he TRM and he SPLM rule, hus enabling i o avoid inefficien reacions o cos push shocks. By conras, augmening he speed limi rule wih a response o he oupu gap (TRSPL) reduces he loss relaive o he sandard SPL rule only marginally. 85 We now carry ou some sensiiviy analysis. In paricular, we ry o find ou wheher he superior performance of he money-augmened speed limi rule is robus o changes in he parameers of he cenral bank loss funcion and o variaions in key coefficiens of he underlying model. We find ha he resuls (ranking of he policy rules) are independen of wheher he increased uncerainy sems from higher persisence or higher shock variabiliy, he money-augmened speed limi rule leads o lower variabiliy in boh he oupu gap and inflaion for any choice of he relaive weighs in he objecive funcion, increasing he sandard error of he money demand shock reduces he coefficien of he money growh gap, i is beer o overesimae he level of uncerainy (o choose he coefficiens opimized for a higher degree of uncerainy), he ranking of he policy rules is robus o he choice of he relaive weigh on oupu gap versus inflaion, he ranking of he policy rules is robus o changes in he model coefficiens (degree of backward-lookingness of he Phillips curve / IS curve, ineres rae elasiciy, oupu-gap elasiciy, sandard deviaion of he cos-push shock, of he IS-shock), he ranking of he policy rules is robus o mispercepions abou he degree of inflaion ineria and mispercepions abou he rue level of oupu-gap uncerainy Summary, conclusions In he presen paper, we have shown ha a moneary pillar aken seriously implies an ineres rae response o deviaions of inflaion from arge, o he change in he oupu gap, o he lagged ineres rae and o deviaions of money demand from long-run equilibrium. The laer is usually seen as he principal drawback of moneary indicaors. However, we have argued ha a cenral bank wih a focus on money will be aware of his problem and, depending on he saff s success in idenifying shocks o money demand, he ineres rae response o such shocks will be mued or even non-exisen. Wih heir implied response o he lagged ineres rae and o he change in he oupu gap, money growh arges inroduce ineria and hisory-dependence ino moneary policy. As shown by Giannoni and Woodford (2003), boh feaures are imporan componens of opimal moneary policy in sandard New-Keynesian models wih forward-looking expecaions. In addiion, responding o he change in he oupu gap raher han o is level may be advanageous when he laer is subjec o large and persisen measuremen errors as has hisorically been he case. Furhermore, as poined ou by Nelson (2003), beyond he sabilisaion concerns capured by shor-run models, cenral banks have o be concerned wih pinning down he seady-sae rae of inflaion, and his should be he main moivaion behind a cenral bank s commimen o a moneary indicaor approach. Hence, he available empirical evidence suggess ha he lessons from German daa, ogeher wih he insighs from recen research on opimal moneary policy under commimen and welfare- Conference May 19-20, 2008, Minsk

86 86 heoreical consideraions, are more relevan for he euro area han he lessons from US daa presened by Rudebusch and Svensson (2002). Having said his and agains he background of he increased uncerainy moneary policy makers in EMU are confroned wih, he Eurosysem s prominen role for money seems o be a sensible approach. Taken seriously, his orienaion inroduces he necessary ingrediens of a robus and inerial moneary policy rule. This should be he more rue for he even higher uncerainy case in ransiion counries. References Balensperger, E. (1998), Moneary Policy under Condiions of Increasing Inegraion ( ), in: Deusche Bundesbank (ed.), 50 Years of he Deusche Mark, Clarendon Press, Clarida, R., Galí, J. and M. Gerler (1998), Moneary policy rules in pracice, Some inernaional evidence, European Economic Review 42, Coenen, G., Levin, A. and V. Wieland (2005), Daa uncerainy and he role of money as an informaion variable for moneary policy, European Economic Review 49, Deusche Bundesbank (1998), Moneary Policy Sraegies in he Counries of he European Union, Monhly Repor January, Gerberding, C., Seiz, F. and A. Worms (2004), How he Bundesbank really conduced moneary policy, An analysis based on real-ime daa, Deusche Bundesbank Discussion Paper Series 1, No 25/2004. Gerberding, C., Seiz, F. and A. Worms (2005), How he Bundesbank really conduced moneary policy, Norh American Journal of Economics and Finance 16, Gerberding, C., Seiz, F. and A. Worms (2007), Money-Based Ineres Rules, Lessons from German Daa, Deusche Bundesbank, Discussion Paper, Series 1, No. 06/2007. Gerdesmeier, D. & Roffia, B. (2004), Taylor Rules for he Euro Area: The Issue of Real-Time Daa, Deusche Bundesbank Discussion Paper Series 1, No 37/2004. Giannoni, M. and M. Woodford (2003), Opimal Ineres Rae Rules: I. Theory, NBER Working Paper Kamada, K. (2004), Real-Time Esimaion of he Oupu Gap in Japan and is Usefulness for Inflaion Forecasing and Policymaking, Deusche Bundesbank Discussion Paper Series 1, No 14/2004. Leiemo, K. and I. Lonning (2006), Simple Moneary Policymaking wihou he Oupu Gap, Journal of Money, Credi and Banking 38, Nelson, E. (2003), The Fuure of Moneary Aggregaes in Moneary Policy Analysis, Journal of Moneary Economics, 50(5), Nelson, E. and K. Nikolov (2001), A Real-Time Oupu Gap Series for he Unied Kingdom, , Consrucion, Analysis and Implicaions for Inflaion, CEPR Discussion Paper No Orphanides, A. (2001), Moneary Policy Rules Based on Real-Time Daa, American Economic Review 91, Orphanides, A. (2003a), The Ques for Prosperiy wihou Inflaion, Journal of Moneary Economics 50, Orphanides, A. (2003b), Hisorical Moneary Policy Analysis and he Taylor Rule, Journal of Moneary Economics 50, Rudebusch, G. (2001), Is he Fed oo Timid? Moneary Policy in an Uncerain World, Review of Economics and Saisics 83, Rudebusch, G. (2002), Assessing Nominal Income Rules for Moneary Policy wih Model and Daa Uncerainy, Economic Journal 112, Rudebusch, G. and L. Svensson (2002), Eurosysem Moneary Targeing, Lessons from U. S. Daa, European Economic Review 46, Scharnagl, M., C. Gerberding and F. Seiz (2007), Simple Ineres Rae Rules wih a Role for Money, Deusche Bundesbank, Discussion Paper, Series 1, No. 31/2007. Smes, F. (2002), Oupu Gap Uncerain: Does i Maer for he Taylor Rule?, Empirical Economics 27, Sracca, L. (2007), A Speed Limi Moneary Policy Rule for he Euro Area, Inernaional Finance 10, Swanson, E. (2004), On Signal Exracion and Non-Cerainy-Equivalence in Opimal Moneary Policy Rules, Macroeconomic Dynamics 8, Taylor, J. (1993), Discreion versus Moneary Policy Rules in Pracice, in, Carnegie Rocheser Conference Series on Public Policy 39, Naional Bank of he Republic of Belarus Walsh, C. (2002), Speed Limi Policies: The Oupu Gap and Opimal Moneary Policy, manuscrip, July 2002.; a shorer version was published in he American Economic Review 93 (1), Walsh, C. (2004), Implicaions of a Changing Economic Srucure for he Sraegy of Moneary Policy, in: Moneary Policy and Uncerainy, Jackson Hole Symposium 2003, Federal Reserve Bank of Kansas Ciy,

87 Figure 1: Measuremen errors in key moneary policy indicaors, O up u gap * Change in oupu gap (f-q)* R eal oupu grow h (f-q) P oenial oupu grow h (f-q)* CPI (rae of change, f-q) M oney sock (rae of change, f-q) * The calculaion is based on Bundesbank esimaes of poenial oupu. 1 The measuremen errors are defined as he differences beween he ex pos figures (March 1999 vinages) and he iniial figures. Conference May 19-20, 2008, Minsk

88 88 Table 1: Ex-pos and real-ime esimaes of (3) n=0 n=1 n=2 n=3 n=4 n=5 n=6 ex-pos φ p 1.03** (0.41) 1.43*** (0.42) 1.71*** (0.60) 2.92*** (0.77) 2.37** (1.02) 2.41** (1.17) 2.99** (1.39) φ y 0.55** (0.23) φ y 1.25** (0.53) φ m 0.54*** (0.19) ρˆ 0.83*** (0.04) 0.30 (0.18) 1.04** (0.40) 0.46*** (0.16) 0.80*** (0.05) 0.24 (0.30) 1.34** (0.54) 0.49** (0.20) 0.84*** (0.05) (0.27) 1.33*** (0.41) 0.25* (0.15) 0.85*** (0.03) 0.19 (0.38) 1.74** (0.68) 0.40** (0.18) 0.88*** (0.03) 0.41 (0.44) 2.08** (0.92) 0.52** (0.23) 0.90*** (0.03) 0.44 (0.46) 2.33** (1.06) 0.61** (0.27) 0.91*** (0.03) R² SEE JB J-sa real-ime φ p 2.17*** (0.48) φ y 0.06 (0.18) φ y 2.41*** (0.77) φ m 0.98*** (0.31) ρˆ 0.84*** (0.04) 2.19*** (0.36) 0.01 (0.14) 1.79*** (0.53) 0.61*** (0.21) 0.82*** (0.04) 2.43*** (0.33) (0.11) 1.53*** (0.43) 0.39** (0.16) 0.82*** (0.04) 3.05*** (0.45) -0.31** (0.15) 1.72*** (0.48) 0.17 (0.15) 0.85*** (0.03) 2.64*** (0.71) 0.00 (0.23) 2.57*** (0.87) 0.60** (0.23) 0.89*** (0.02) 2.73*** (0.81) 0.04 (0.25) 3.01*** (1.11) 0.80*** (0.30) 0.91*** (0.02) 3.56*** (1.07) (0.31) 3.57*** (1.19) 0.91*** (0.34) 0.92*** (0.02) R² SEE JB J-sa ***(**/*) denoes significance a he 1% (5%/10%) level. Esimaion period: 1979Q1 o 1998Q4,: esimaion mehod: GMM; HAC-robus sandard errors in parenheses; for furher noes see able 1. Ex-pos series as of March Variables: lef-hand-side variable: 3-monh money marke rae (end-of-quarer); righ -hand-side variables: inflaion gap according o cpi; level and change in he oupu gap wih Bundesbank's own esimaes of producion poenial. For furher deails on he daa see Gerberding e al (2004). The insrumen se includes he conemporary values of inflaion and he price assumpion (which were known o policy makers a he end of each quarer) as well as wo lags of each explanaory variable. Preesing suggess ha his insrumen srucure is sufficien. R²: adjused coefficien of deerminaion; SEE: sandard error of he regression; J-sa: p-value of he J-saisic on he validiy of overidenifying resricions ; JB: p-value of he Jarque Bera es of he normaliy of residuals. Naional Bank of he Republic of Belarus

89 89 Table 2: Overview of he model (1) Aggregae demand x = ( ) + x α x α x σ i E π r ε benchmark values: α 1 =1.47; α 2 =-0.53 σ=0.17; σ x 2=0.20 π (2) Aggregae supply π = γπ 1+ (1 γ) E 1π+ 3 + kx 1+ ε benchmark values: γ=0.20; k=0.31; σ π 2=0.94 r r r m m = κ m ( m 1 κ q q 1 + κ ii 1) + κ1 m 1 + κ q q + ε (3) Money demand benchmark values: κ m =0.15; κ q =1.20; κ i =0.80; κ 1 =0.40; κ q =0.10; σ m 2=0.20 (4) Oupu gap and poenial oupu (5) Policy rules (6) Oupu gap uncerainy q x = q q * * qq 1 = ρ * + ε benchmark values: ρ=0.95; σ q* 2=0.13 ˆ ˆ * i = i + ( ) + x φ φ π π φ (TR) i ˆ = φ i ˆ + φ ( π π ) + φ ( x x ) (SPL) * i ˆ = φ i ˆ + φ ( π π ) + φ x + φ ( x x ) (TRSPL) * iˆ= φ iˆ + φ ( π π ) + φ x + φ ( m m ) (TRM) * * i ˆ = φ i ˆ + φ ( π π ) + φ ( x x ) + φ ( m m ) * * q (SPLM) x% = x η ; x% = x η η = ρηη 1 + η benchmark values: ρ η =0.89; σ η2 =0.98 ε Conference May 19-20, 2008, Minsk

90 90 Daniyar Akishev 1 On Moneary Policy of he Naional Bank of Kazakhsan in Condiions if Financial Insabiliy In he years of independence, economic reforms aimed a he developmen of marke relaions were carried ou in Kazakhsan. Privaizaion processes, reforms of he sae finance and financial secor, as well as a reiremen pension reforms were carried ou in ha period. The rae of economic growh esifies o he efficiency of hose reforms. Ten years ago GDP per capia oaled slighly more han 700USD, whereas a he end of 2004 i reached 2,700USD and as of 2007 i was expeced o increase up o 7,000USD. According o he World Bank raing Kazakhsan (wih is per capia income oaling $3,771) in 2005 was referred o a group of counries where he income was above he average world level. The moneary policy of he Naional Bank of he Republic of Kazakhsan (hereinafer he Naional Bank) is one of he consiuens of he Kazakh economy s success. Kazakhsan obained a possibiliy of conducing is own moneary policy wih he inroducion of he naional currency, enge, in The Naional Bank s moneary policy for more han a half of is 15-year-long enge hisory has been conduced in condiions of financial insabiliy. The aricle feaures he Naional Bank s moneary policy conduced in condiions of financial insabiliy. Le us firs give a definiion o he erm financial insabiliy Financial sabiliy probably means complee fulfillmen by he financial sysem of is direc asks, i.e. successfully carrying ou invesmen projecs and efficienly evening jumps in he consumpion of resources. Moneary sabiliy, marke agens confidence in financial insiuions and markes, absence of abrup flucuaions of price of real or financial asses are he consiuens of financial seadiness. From his poin of view, beginning from he inroducion of he enge, he periods of financial insabiliy were he periods beween November 1993 and 1999 and beween Augus 2007 and he presen momen. Le us describe he moneary policy in each of hese periods. November (period of fighing wih hyper inflaion). By he inroducion of he enge, Kazakhsan s economy had been in very difficul siuaion. In 1993 inflaion rae oaled 2,265 percen and he producion oupu decreased by nearly 50 percen in In order o sop he producion oupu decline, which sared jus afer he collapse of he Sovie Union and he break-up of iner-counry economic links, he Naional Bank in fac fulfilled he funcions of commercial banks, issuing loans o enerprises direcly and covering he sae defici direcly. In hese condiions, he reducion of he inflaion rae and he suspension of he producion drop became he prioriy asks for he Governmen of he Republic of Kazakhsan (hereinafer he Governmen) and he Naional Bank. To address hese problems i was decided o conduc ough macroeconomic policy, which included a considerable reducion in he budge gap and he resricion of he credi expansion. Naional Bank of he Republic of Belarus In 1994 he Naional Bank sopped he pracice of issuing loans on easy erms as well as issuing loans direcly o enerprises. The Governmen was allowed o obain loans o cover he budge gap for a fee. In 1995 he Naional Bank ceased o issue loans o economy according o he Govern- 1 Depuy governor of he Naional bank of Kazakhsan.

91 men s direcive. The banks refinancing mechanism considerably changed: he Naional Bank sared placing credi resources by means of credi aucions on he lombard basis. In 1995 he Naional Bank Law was adoped where he Naional Bank independence was esablished and he main objecive was defined as o ensure he inernal and exernal sabiliy of he naional currency. 91 Afer ransferring he funcions of crediing economy o he second ier banks and obaining independence wihin he framework of is powers, he Naional Bank coninued o work on he creaion of modern banking sysem based on marke principles and efficien banking conrol. Anoher imporan ask facing he Naional Bank was he developmen and conducion of he moneary policy aimed o he reducion of he inflaion rae. In ha period in addiion o he refinance rae and minimal reserve requiremens new insrumens were inroduced, in paricular operaions on he domesic foreign exchange marke, lombard loans and shor-erm noes of he Naional Bank. In inflaion rae decreased from 2,165 percen o 60 percen. However, he oupu coninued o fall down and on average oupu fall was more han 10 percen a period (see Figure 1). Inflaion Figure 1: Real GDP growh and inflaion 2165,0% 1158,3% 60,3% ,2-12,6-8,2 Real GDP growh,% Wih he ask of achieving he price sabiliy, issues regarding he esablishmen of he young naional currency were seled. Originally he enge was inroduced as a currency converible in curren accoun operaions. As for he converibiliy of he enge in capial accoun operaions, since he inroducion of he enge operaions of he ransiion of he capial from residens o non-residens were o be licensed, whereas capial inflow was o be regisered only for he purposes of saisics. I was sipulaed by a considerable shorage of inernal sources of foreign exchange supply. In order o increase he supply of he foreign exchange a he inernal marke compulsory sales of 50 percen of expor proceeds was inroduced as a emporary measure (period of achieving macroeconomic sabiliy). In January 1998, he Naional Bank sopped direc financing of he republic budge defici (he ban was legally pu ino force in 2004). The budge defici was financed by means of issuing securiies, which led o he sock marke developmen. I was a period of posiive changes for he enire economy. Inflaion coninued o go down and decreased from 60,3 percen in 1995 o 1,9 percen in The producion decrease considerably slowed down respecively. In he producion fell by 10 percen a year on he average, whereas in here was an annual average 0,75-percen rise (see Figure 2). In he period under review, ough moneary policy was coninued o be conduced, moneary policy insrumens were developed and improved. In paricular, operaions, such as Repo and Overnigh, were inroduced. A he end of his period, financial crisis in he Souh-Easern Asia and a decrease in he world oil prices became a cerain endurance es for he young naional currency. As a resul of a considerable depreciaion of naional currencies in a number of counries ha were Kazakhsan s rade parners and as a resul of global changes on he world financial markes, he Kazakh naional currency was under exremely srong depreciaion pressure and he inflaion rae rose o 17,8 percen in Conference May 19-20, 2008, Minsk

92 92 This esablished an exreme siuaion for he moneary policy. In April 1999, freely floaing enge exchange rae was inroduced in order o resore he enge s compeiiveness. The choice of he ime period for such a sep was no incidenal. I was a ime of he financial sabilizaion in Russia and a reducion of depreciaion expecaions in Kazakhsan. The measures aken o mainain he foreign exchange marke (emporary inroducion of compulsory sales of 50 percen of expor proceeds, lowering of reserve requiremens) le he banking sysem and he iner-bank marke o coninue funcion seadily. Measures o proec individuals deposis and deposis of legal eniies in banks and o provide for social proecion helped he banking sysem o avoid he loss of cliens and o preserve is susainabiliy. The enge exchange rae sabilized afer a few days. Figure 2: Macroeconomic indicaors of Kazakhsan in real GDP growh, % inflaion, % -4 Real GDP growh, % Inflaion % (period of financial sabiliy and rapid economic developmen). Saring 2000, sabilizaion a he world financial markes, favorable price rends a he world commodiy markes and economic recovery produced a posiive effec on he macroeconomic siuaion in Kazakhsan. During his 7-year period, he counry s financial sysem boosed. In paricular, a fund guaraneeing individuals deposis, a sysem of morgage lending in he sphere of housing consrucion were founded, insurance and sock markes were developing and promissory noe program was launched. The economy was characerized by a considerable capial inflow, large increase in individuals deposis wih banks and bank loans. During he enire period, inflaion rae sayed a he level beween 6,4 percen and 8,4 percen and he average annual GDP growh was 10,3 percen (Figure 2). Naional Bank of he Republic of Belarus In he sphere of developmen of he moneary policy iself, an imporan role belongs o he esablishmen of he Republic of Kazakhsan s Agency on he Regulaion and Supervision of he Financial Marke and Financial Organizaions (hereinafer he Agency) and he delegaion of he appropriae powers of he Naional Bank. This made i possible o declare ha he primary objecive of he Naional Bank was price sabiliy. Among he asks ha helped o mee he objecive were he ones ha were aimed a developing and implemening he sae moneary policy, providing for he operaion of he paymen sysem, esablishing currency regulaion and conrol and conribuing o he sabiliy of he financial sysem.

93 The year 2007 was a period of financial unseadiness. Despie an economic boos a he beginning of he curren cenury, here was an upward rend in inflaion pressure in 2006, which can be linked o a large foreign capial inflow, liquidiy surplus on he domesic financial marke and a rise in governmen budge expendiures. In 2006 he inflaion rae exceeded 8 percen for he firs ime since To deec financial problems a early sages, in 2006 he Naional Bank wih he Supervision Agency began o publish annual repors on financial sabiliy. The 2006 repor named an increase in he banks foreign borrowing among he mos considerable facors of he financial sysem s vulnerabiliy. 93 Kazakhsan s economic developmen in 2007 can be divided ino wo sages. The firs half of he year was characerized by posiive rends of previous years (highly developing indusry, insurance marke, consrucion, rade and banking services marke). In he firs half of 2007, credis o economy increased by nearly 47 percen and residens deposis in he banking sysem rose by 24 percen. In Augus 2007, he crisis on he US morgage marke, which arose in he beginning of 2007, urned from local ino global, hus having a considerable effec on he siuaion a he world financial markes. The world markes experienced lack of liquidiy and a number of cenral banks, in paricular, he Federal Reserve Sysem and he European Cenral Bank, conduced credi inervenions o mainain heir counries banks. Under hese condiions ineres raes in world markes increased. Porfolio invesors began o wihdraw capial from developing markes. As a resul, access o foreign borrowing was almos closed for mos developing markes. Those Kazakh banks ha had made considerable foreign borrowings in he previous years experienced some difficulies. However, access was mainly closed o borrowings a he markes of unprofessional invesors, i.e. by means of issuing bonds and conducing IPO, whereas a possibiliy of aracing of professional invesors syndicaed loans was preserved. However, despie a cerain decrease in he growh of he banking secor (a sligh flow-ou of deposis, an increase in he ineres rae on loans) he local banks did no sop issuing loans o economy. The economic developmen, especially in spheres, such as consrucion and financial aciviies, is expeced o slowdown in he following years because of uncerainy in he prospecs for he developmen of he world financial and commodiy markes. The growh in he consrucion sphere will be hampered due o he lack of credis, and he developmen of he financial secor will slow down due o resriced access o foreign borrowings. In 2007 he world food markes disurbances also affeced he Kazakh economy in a negaive way. For insance, poor harves in he counries ha are major grain producers and a rise in he world producion of alernaive fuel from vegeable raw maerials (bioehanol) resuled in increase in prices of whea and oil. All hese facors led o he rise in he inflaion pressure in he counry. So, in 2007 we could observe boh he lack of bank liquidiy and growh in inflaion pressure. In such condiions, he Naional Bank faced he need o choose a prioriy beween mainaining he sabiliy of he banking sysem and measures o mainain price sabiliy. The problem was ha hose measures conradiced o each oher. In order o mainain he sabiliy of he banking sysem here was a need in he liquidiy inflow and o reduce he inflaion pressure i was necessary o absorb i. In ha siuaion, he Naional Bank chose he sabiliy of he banking sysem as a main prioriy for is policy. I was aken ino consideraion ha he insabiliy of he banking sysem migh resul in he banking panic, non-paymen crisis, deposiors escape, as well as have a negaive impac on he seadiness of oher segmens of he financial marke, which is liable o sysem crisis due o he fac ha a number of financial insiuions are banks subsidiaries or are pars of bank conglomeraes. Pension funds are mos likely o be affeced as a resul of a considerable share of banks financial insrumens in he invesmen porfolio of he pension fund. Conference May 19-20, 2008, Minsk

94 94 During 2007, wih he change in he financial siuaion he moneary policy has undergone changes as well. In paricular, in he firs seven monhs of 2007, moneary policy aimed a absorbing of excess liquidiy in he second ier banks was conduced, whereas in he second half of 2007, here was a downward rend in he absorbing of excess liquidiy by means of issuing fewer noes and heir early redempion. Since Augus 2007, he Naional Bank has increased providing banks liquidiy hrough operaions of reverse repo and swap operaions. Apar from ha, a new ype of refinance loans was inroduced, namely loans secured by banks corresponden accoun balances wihin he Naional Bank. The inroducion of he changes in he reserves requiremens ha were adoped in he firs half of 2007 and were aimed o absorbing of excessive liquidiy of banks was posponed ill Moreover, saring Ocober 9, 2007, a new mechanism of minimal reserve requiremens aimed a reducing he base of reserve requiremens and broadening he srucure of reserve asses was inroduced. In 2007 an agreemen on cooperaion and ineracion in issuing bank loans was signed by he Naional Bank, he AFN (he Financial Supervision Agency) and second-ier banks. According o he Agreemen banks volunarily consen o resric he rise of heir foreign asses and exernal liabiliies and o conduc conservaive credi and moderae deposi policy. As for he refinance rae, policy of expensive money was conduced during he enire year. In January- November 2007, he official refinance rae was kep a he level of 9 percen and saring December 1, 2007, i was raised o 11 percen. This opened he desired corridor of marke raes (see Figurere 3) wih he upper limi defined by he rae on credi (equaling o he refinance rae) and he lower limi defined by he rae on deposis ha were drawn (1/2 of he refinance rae). The rae on noes is aimed o seing a more precise posiioning of he marke rae inside he corridor. The weighed average of his rae increased from 4,69 percen in December 2006 o 5,64 percen in December Figure 3: Ineres rae policy of NBK Credi rae (upper limi of he corridor) percen Deposi rae (lower limi of he corridor) Shor erm noes rae Weighed average inerbank REPO rae On he whole, a complicaed macroeconomic siuaion and he sabiliy of he banking sysem insead of price sabiliy as a prioriy direcion resuled in he siuaion where, despie measures o reduce he inflaion rae ha were aken, he inflaion rae did no mee he arge in The annual inflaion rae averaged ou a 10,8 percen in 2007, whereas he forecased corridor corresponding o he high oil price scenario defined in Moneary Policy Guidelines on oaled 8,2 o 9,2 percen. Naional Bank of he Republic of Belarus The annual inflaion rae is expeced o decrease in he nex years provided ha here are no shock facors.

95 The Naional Bank of he Republic of Kazakhsan has se he conducing of he moneary policy aimed a keeping he inflaion rae low and he mainaining of he sable funcioning of he financial sysem as prioriies in is aciviy in The official refinance rae will be se wih regard o he siuaion a he money marke and he inflaion rae so ha he refinance rae say posiive in real erms and be he upper limi of raes a he shor-erm money currency marke. To improve he mechanism of liquidiy a he inernal marke and aking ino accoun rising ineres of he second ier banks in swap operaions a possibiliy of conducing discoun operaions of currency swap will be considered. Analyical approaches will be improved in he framework of he Financial Sabiliy Repor and Developmen of Early Warning Sysem of financial crises. The Naional Bank will coninue carrying ou regular inspecions of banks, which i began doing in 2007 o analyze qualiaive characerisics and facors of he loan marke developmen. Conclusion Kazakhsan s success in he sphere of economic developmen is o a grea exen conneced o he Naional Bank s aciviy in he sphere of developing he financial secor, wih he moneary policy aimed a sabilizing prices, in paricular. The moneary policy in Kazakhsan is no a mechanism, which is se forever. I is consanly improving. In various periods, he nominal exchange rae and moneary aggregaes were he anchor of he moneary policy. Since 2004 he moneary policy has been aimed a providing price sabiliy. The main asks facing he Naional Bank are o develop and conduc he sae moneary policy, provide for he funcioning of paymen sysems, conduc currency regulaion and currency conrol and conribue o he sabiliy of he financial sysem. The Naional Bank lays special emphasis on he sabiliy of he financial sysem because a crisis in he banking sysem may lead o a crisis in he enire financial secor. Conference May 19-20, 2008, Minsk

96 96 Nikolaychuk Sergei 1 Deerminaion of Inflaion Targes for Ukraine This paper discusses deerminaion of inflaion arges during he ransiion from exchange rae peg o inflaion argeing. The long-erm objecive for moneary policy of cenral bank is achieving price sabiliy ha in pracice is associaed wih definie low bu no a zero rae of inflaion. The necessiy for mainaining low inflaion may be aribued o a number of facors such as asymmeric nominal rigidiies, saisical bias in measuring consumer price index, risk of deflaion and liquidiy rap. In he medium erm, inflaion arges should primarily rely on he macroeconomic forecas, assessmen of probable disinflaion coss and he need for enhancing confidence in cenral bank. The paper argues for an opimal rae of inflaion for Ukraine ha would have been corresponding o he price sabiliy concep and may serve as a long- erm guide for he Naional Bank of Ukraine in ransiion o inflaion argeing framework. Also he paper offers he mediumerm rajecory of inflaion arges o achieve he long-erm objecive. Inroducion The general approach o moneary policy has changed significanly over he recen weny years. Price sabiliy as an objecive of moneary policy is increasingly popular in he world pracice. This may be primarily aribued o he belief ha inflaion involves a decline in he social welfare. The major social and economic implicaions of inflaion are redisribuion of income, reducion in real purchasing power of privae savings, fall in he real ineres raes, growing uncerainy in decision-making by economic agens. As a consequence, he propensiy o save and hence he capial accumulaion rae he parameers ha deermine long-erm economic growh come down. None of he counries, however, uses zero rae of inflaion as arge. The necessiy for mainaining low (near zero) rae of inflaion may be aribued o a number of facors such as asymmeric nominal rigidiies of prices and wages, risk of deflaion, requisie posiive nominal ineres raes and saisical bias in assessmen consumer price indices used for inflaion measuremen. The problem of finding a long-erm opimal level of inflaion is associaed wih he necessiy o choose he minimum possible level of inflaion ha would have given an opporuniy o avoid he negaive effecs of exremely low inflaion. A he same ime, counries experiencing high inflaion have o address he issue of idenifying he rend o reducing he inflaion o he long-erm arge ha is associaed boh wih shor- and medium-erm losses for he economy semming from resricive policy measures, and wih poenial benefis from lower inflaion in he long run. This paper is an aemp o find he answers o he above quesions for Ukraine. Deerminaion of he Opimal Long-Term Rae of Inflaion Cenral banks make use of differen approaches o deerminaion of price sabiliy. Counries like USA and Japan ha do no use explici inflaion argeing apply a general deerminaion of price sabiliy wihou specific numerical value of inflaion associaed wih i. Naional Bank of he Republic of Belarus Generally, cenral banks ha have shifed o explici inflaion argeing make use of quaniaively explici and ransparen o he public definiion of price sabiliy or inflaion arge. In mos cases inflaion arges reduced o a range of 0 4 percen over he recen decade (see Table 1). 1 Naional Bank of Ukraine

97 Table 1: Long-Term Inflaion Targes by Counry Developed counries Inflaion arge, percen Ausralia 2 3 Grea Briain 2 Island 2.5 Canada 1 3 New Zealand 1 3 Norway 2.5 Swizerland <2 Sweden 2(±1) Developing counries Hungary 3 Israel 1 3 Colombia 2 4 Korea 3 (±0.5) Mexico 3(±1) Peru 2(±1) Poland 2.5 (±1) Slovakia <2 Thailand Turkey 4 Philippines 4(±1) Czech Rep. 3(±1) Chile 2 4 Souh Africa Source: cenral banks websies Despie he fac ha quaniaive objecives are counry specific, here is a common incenive o use inflaion expecaions as a nominal anchor. In paricular, he mos widely used definiion of price sabiliy in he lieraure is ha of Alan Greenspan, former Chairman of FRS: Price sabiliy is he sae in which expeced changes in he general price level do no effecively aler business or household decisions (Greenspan (1996)). The corresponding level ha permis he households and enerprises o neglec fuure changes in prices mees he annual rae of inflaion beween 0 and 3 percen ha is he range usually assumed as a quaniaive long-erm arge for developed counries (Mankiw (1985)). Many developing economies also shifed o long-erm inflaion arges ha for he mos par are slighly higher 2 o 4 percen (due o accouning for expeced changes in relaive prices). Hence, price sabiliy is usually deermined as a possibiliy of achieving low, bu non-zero rae of inflaion. The main reasons of non-zero inflaion are asymmeric price and wage rigidiies, he zero bound of nominal ineres raes, he risk of deflaion, and saisical measuremen bias in he CPI. When analyzing poenial advanages associaed wih inflaion we idenify he level below which inflaion may have a posiive effec on oupu growh in he long-run. Accordingly o he mos commonly used argumen, inflaion conribues o more flexible price and wage adjusmen wih he lack of heir downward flexibiliy. Negaive shocks o demand or oupu Conference May 19-20, 2008, Minsk

98 98 induce he companies o cu eiher prices or wages. If prices and/or nominal wages lack downward flexibiliy wih he price level argeing, i is no possible o reduce relaive prices or real wages o resore he balance. In he consequence he companies are induced o reduce oupu and hence employmen hereby adversely affecing he economy. Thus wih asymmeric nominal rigidiies, zero inflaion may involve difficulies in he efficien allocaion of resources and higher level of naural unemploymen. A low inflaion, wages and individual prices may fall in real erms wihou any reducion in heir nominal values. Generally, oo low inflaion may give rise o long-erm rade-off beween inflaion and oupu. In his case inflaion has a grease effec and conribues o an increase in he volume of poenial oupu and o decrease in is volailiy. As appears from he above discussions, he opimal inflaion level in any economy depends on nominal rigidiies and ypes of shock. Le us consider now he effec of asymmeric nominal rigidiies on he requisie minimum inflaion level in Ukraine. As follows from previous research, he hypohesis on asymmeric nominal rigidiies of prices in Ukraine can neiher be fully proved nor rejeced (Peryk and Nikolaychuk (2007)). Accordingly, a quaniaive esimae of he grease effec is based on assumpion ha radable inflaion in Ukraine shall no be lower han ha of is rade parners (as an approximaion we use he changes in expor prices of Germany 1 wih average inflaion amouned o 0.9 percen per year in recen years) (Fig. 1). Therefore we assume ha he Naional Bank of Ukraine may se an inflaion arge of 1 percen for radables and succeed in is achievemen. This level which is slighly higher han he equivalen indicaor for Hungary, Czech Rep. and Poland (Kiss and Kreko (2004)) will make i possible for inflaion o ac as grease for radables. Figure 1: Dependence of prices in radable secor on German expor prices and nominal hryvnia/euro exchange rae Prices of radables, annual changes, % Expor prices in Germany, annual changes, % UAH/EUR, annual changes, %" Furher calculaions will be based on he fac ha in he long-run he inflaion differenial in radable and nonradable secors is deermined by difference in he produciviy in hese sec ors. Acually, here exis oher facors (for example, erms of rade in he world markes) effecing relaive prices in boh secors. We assume, however, ha heir aggregae effec is zero in he long-run. Naional Bank of he Republic of Belarus 1 Euroarea producs accoun for he major share of consumer impors in Ukraine. We have used in our paper he expor prices of Germany as an proxy of consumer impors prices due o heir accessibiliy

99 Hence he inflaion equaion may be wrien as: 99 N T T N T π = απ + (1 α) π = π + α( π π ), (1) T π N π where π is overall inflaion; and is inflaion of radable and nonradable componens, respecively; α is he share of nonradables in he CPI baske. Hence we can derive he opimal inflaion level from he formula: o π * = π + α( π π ), (2) T N T * T where π is he opimal inflaion rae of radables; ( π N π T ) is he changes in relaive prices (radables/nonradables inflaion raio). The key poin in he esimaion of opimal inflaion level shall be calculaion of he gap in produciviy level of differen secors which deermines he equilibrium differenial beween inflaion of radable and nonradable componens of CPI. The size of gap depends on he rae of Ukraine s progress owards he developmen level of is rading parners (paricularly, in Euroarea). Hence we need o esimae he acual convergence rae. We will use for our purposes he average value of his indicaor for he period of as a proxy of equilibrium inflaion differenial beween radable and nonradable componens of CPI. According o our esimaes, he level amouned o 4.2% (as compared o 5.6% for Hungary and 4.2% for Porugal (Kiss e al., 2004)) 1. On hese assumpions hen he opimal inflaion rae for Ukraine is: o π = 1 % + 0,66 4,2% = 3,6%. For Ukraine, grease effec of inflaion ha is required due o expeced differenial of inflaion in he secors of radables and nonradables exceeds he same number for he developed counries as resul of higher produciviy growh-raes which in urn are governed by acual convergence processes. Moreover, high inflaion may be explained as follows: during convergence a lower level of prices corresponds o he sage of economic developmen compared o developed counries. Thus a price convergence rae and hence an inflaion level needed o grease he wheels ulimaely depends on he speed of real convergence. Anoher basic argumen agains he use of zero inflaion arge is ha zero inflaion has by far he greaer poenial for he economy o shif o deflaion. There is a fairly widespread consensus ha he losses of public welfare from deflaion should prevail he losses from inflaion due o: deb deflaion. Unexpeced fall in prices involves a decrease in he collaeral value hereby deerioraing he crediworhiness of debors, and of companies, in paricular. This increases he probabiliy of bankrupcy and adversely affecs fixed invesmen, ha is involves reducion in aggregae demand; delayed consumpion. Households waiing for reducion in prices pospone he purchase of cerain goods hereby causing addiional reducion in aggregae demand. Since he nominal ineres rae canno be lower han zero (economic agens can always hold heir asses in cash), exremely low inflaion places a consrain on he possibiliy of real ineres rae reducion ha would have simulaed he aggregae demand. In case of negaive demand shock 1 In our opinion, a higher esimae for Hungary may be aribued o he esimaion period ( ), i.e. he period of drasic srucural changes and significan produciviy gap beween he radable and nonradable secors a he beginning of ransiion period Conference May 19-20, 2008, Minsk

100 100 when deflaionary expecaions are realized, he real ineres rae may be very high despie zero nominal ineres rae, and such expecaions canno be reduced by ineres policy, i.e. a deflaionary spiral may arise (he siuaion is frequenly referred o as "liquidiy rap" in he lieraure) hereby involving simulaneous fall in aggregae demand and prices. Accordingly, he effecs of moneary policy are no symmeric in he inflaionary and deflaionary environmens. Due o necessiy o preven deflaion and "liquidiy rap", he opimal inflaion level depends on: 1) he probabiliy of deflaion and zero level of nominal ineres raes; 2) losses resuling from he siuaion Higher growh raes in ransiion economies as compared o hese in he developed economies shall be refleced in higher real reurns on capial employed, which for a closed economy means higher real ineres raes, i.e. he probabiliy for nominal ineres raes o approach zero level is low. However, he siuaion may be quie differen in he economy wih compeiive capial marke since he real ineres rae depends on he uncovered ineres pariy in real erms: usd usd r = r rer + rp, (3) where r is a shor-erm real ineres rae (for overnigh loans in he inerbank money marke); is a real ineres rae in US dollars; is a risk premium. usd rer usd r is changes in real hryvnia/usd exchange rae; and rp As follows from our esimaes of equilibrium values of macroeconomic variables obained by using he Kalman filer (Nikolaychuk and Mariyko (2007)), he rend of real ineres rae in USD is 3%, and he risk premium is 2% for he Ukrainian economy. We esimae ha he rend o srenghening he real rae of hryvnia o USD will be abou 7% a year as a resul of real convergence processes (Peryk and Nikolaychuk (2007)). Then he equilibrium level of shor-erm real ineres rae in hryvnia will be: r = 3% 7% + 2% = 2%. On he assumpion ha he minimum equilibrium level of nominal ineres rae required o simulae he economy in case of negaive real shocks is 2 percen, we can derive he value of inflaion arge level prevening he nominal rae from cuing o zero level: usd usd r = r rer + rp. When idenifying an opimal inflaion level in he conex of deflaion prevenion, le us firs of all discuss he accumulaed experience of oher counries in his field. As follows from he resuls of some papers, deflaion can be avoided wih he inflaion rae arge of 2 percen (Krugman (1999), Orphanides and Wieland (1998)), ohers papers sugges ha an inflaion of 1 percen can also be a sufficien insurance agains deflaion and liquidiy rap (Bernanke e al. (1998), Mishkin (2000)). The hisory of shocks in European counries evidences ha he probabiliy of ineres rae fall o zero is low, and a 1-per cen inflaion arge can preven he occurrence (Vinals (2000)). There is a widespread consensus on he sufficiency of 1 2 percen consumer inflaion o preven he likelihood of deflaion. Moreover, we believe i highly improbable ha deflaionary expecaions will arise in Ukraine due o a long hisory of high inflaion. Naional Bank of he Republic of Belarus I should furher be noed ha in he conex of small open economy, he possibiliy of exchange rae devaluaion serves as an efficien insrumen of avering deflaion and liquidiy rap. Under condiions of Ukraine his measure would be a fairly powerful proinflaionary insrumen in case of necessiy.

101 Saisical problems associaed wih inflaion measuremen serve as an addiional argumen for inflaion. According o a widespread view, he Consumer Price Index (CPI) is frequenly higher han acual changes in he cos of living. This may be aribued o he following: 101 produc subsiuion. CPI canno ake ino accoun produc subsiuion since he weighs for consumpion baske componens shall be calculaed in advance, i.e. CPI does no reflec he abiliy of consumers o subsiue away from produc whose relaive price has increased o he one of lower price. As a resul, he cos of living is growing slower han CPI; changes in qualiy. When he qualiy of any produc improves, only a cerain par of is price growh may be aribued o he growh of he cos of living. Generally, special adapaions are used o ake ino accoun he effec of changes in qualiy a CPI measuremen. However, i is hardly possible o esimae he changes in qualiy in full; changes in disribuion. The growing share of large disribuion ceners ha have an opporuniy o apply lower rade margins (for example, hypermarkes) may, all oher facors equal, reduce he cos of living. This, however, is no fully refleced in he CPI, because new oules are included in he observaion programs wih a cerain delay. new producs. Due o failure or lag in new producs inclusion in he consumer baske, CPI can represen he growh of consumer welfare associaed wih new goods. For a few of reasons, CPI measure is generally upward biased more in ransiion economies raher han in developed ones. The firs and seemingly main reason is ha qualiy improvemen and inroducion of new producs is a sronger facor in he economies moving hough he period of convergence o more developed economies. Secondly, he growing share of hypermarkes and big shopping ceners supposes Figure 2: Share of Tradables in Consumer Baske (Source: Sae Commiee of Saisics of Ukraine, own esimaes) 27% 29% 31% 33% ha he changes in disribuion condiions also exceed he level admissible for developed economies. Moreover, some auhors surmise ha oversaemen is more significan for ransiion economies due o change in relaive prices (e.g. see Filer e al. (2002) for Czech Rep.). In Ukraine, we can also observe a seadily increasing endency for consumpion of radable goods, in paricular, due o reducion in heir relaive price by he Balassa- Samuelson effec (Fig. 2). However, an opposie effec is frequenly observed in ransiion economies: despie he increase in relaive prices of nonradables heir share in he consumer baske rises as well. For example, similar effec has been observed in Hungary and his involved underesimaion of CPI hough he uncerainies in measuremen are saisically negligible (Kiss e al. (2004)). 35% For lack of repors on accuracy of CPI measuremen in Ukraine, reference should be made o some foreign sources on he subjec (Table 2). The mos comprehensive and exensive invesigaion was conduced in USA and presened in a widely-known Boskin s Repor (Boskin e al. (1996)). According o he repor, CPI oversaes he acual cos of living in USA by percenage poins per annum (he mos precise esimae is 1.1 percenage poins) a inflaion of abou 3%. Among he invesigaions of ransiion economies, i is worhy o noice a repor on Czech Rep.: in he period of , a an annual inflaion of 8.5 percen CPI was oversaed by approximaely 3 percen- Conference May 19-20, 2008, Minsk

102 102 age poins of which 1.5 percenage poins are associaed wih he effec of new producs and change in qualiy (Filer e al. (2002)). I should be noed ha hese findings are specific o he early sage of ransiion o marke economy. The accuracy is enhanced in he process of convergence and wih he use of more advanced mehods of CPI calculaion adjusmen. Table 2: CPI Bias by Counry USA Germany UK Canada Porugal Czech Hungary Producs subsiuion Changes in qualiy Changes in disribuion < New producs < Toal 1.1 ( ) 0.75 ( ) Source Воskin e al. (1996) Hoffman (1998) Cunningham (1996) Crawford e al. (1997) Covas e al. (2001) Filer e al. (2002) Kiss e al. (2004) In our opinion, CPI bias in Ukraine should no exceed 1 percenage poin, i.e. ha of developed counries. Considering he necessiy of selecing a minimum inflaion level ha would have helped o ge rid of all he above-menioned negaive effecs produced by oo low inflaion arge, he opimal inflaion arge shall be deermined as he maximum of calculaed esimaes. As follows from our findings, opimal inflaion level (4%) is primarily deermined by grease effec required o accoun of change in relaive prices, and by ensuring he nominal ineres level sufficien for prevening a liquidiy rap. Deerminaion of Disinflaion Trend Naional Bank of he Republic of Belarus I should be noed ha he opimal inflaion level we calculaed relaes o he concep of long-erm inflaion wherefrom i may deviae in he shor-run and medium-run in accord wih changes in exernal condiions and business aciviy cycle. Thus he disinflaion rend o long-erm inflaion arge shall be based on he analysis of macroeconomic condiions and admissibiliy of disinflaion losses a any seleced insan of ime. In our opinion, useful example in his conex could be he experience of he Naional Bank of Poland ha adoped he Medium-Term Sraegy of Moneary Policy ( ) in 1999, which se a medium-erm inflaion rae arge for he year 2003 o be below 4% and adjused he nex year arge wih accoun of he curren macroeconomic condiions and he necessiy of reaching he medium-rae inflaion arge in 2003 (Naional Bank of Poland, 1998). This approach makes i possible o aain a defined objecive in he medium run (5 o 6 years) while allowing some flexibiliy in deerminaion of shor-erm (one-year) inflaion arges. We believe i imporan ha an implici disinflaion rajecory is deermined bu no disclosed o he public due o he likelihoods of a siuaion when macroeconomic condiions would have forced o revise he nex-year arges hereby undermining he confidence in he policy of he Naional Bank of Ukraine and complicae conrol over inflaion expecaions.

103 annual changes, % Figure 3: Consumer Price Index and Inflaion Targes (Source: Sae Commiee of Saisics of Ukraine, own esimaes) Any nex-year arge shall be based on an unbiased analysis of he curren siuaion and macroeconomic forecas. A he curren sage i would be reasonable o deermine a disinflaion rend, which migh look as he one of Fig. 3 wih rejeced exchange rae peg and ransiion o inflaion argeing. This rend has been developed on he basis of medium-erm macroeconomic forecas for Ukraine generaed using Quarerly Projecion Model (Peryk and Nikolaychuk (2006)). High inflaion figures in are primarily aribued o he effec of supply-side facors (increase in prices of agriculural producs and energy producs such as oil and naural gas). From he comparison of program scenario, ha is based on his disinflaion rend and an assumpion of all possible moneary measures implemenaion by he Naional Bank of Ukraine, wih a basiline scenario, ha is based on unchanged policy of exchange rae peg, is eviden ha he cos of achieving 4 percen inflaion arge by he economy would amoun o approximaely from 2 o 2.5 percen of annual GDP (wih accoun of he real discoun rae of 5 percen, he value will amoun o 2.3 percen of GDP in 2008). I is a maer of policymakers o decide wheher he coss are high or low, and how hey are comparable o he long-erm benefis of sable and low inflaion is a debaing poin a presen. Bu mos researchers agree ha losses from inflaion are oo high and, hence, any disinflaion losses will be negligible as compared o hem Table 3: Comparison of Projecion Scenarios Baseline scenario Inflaion, % 14,8 10,7 8,6 7,2 6,1 5,6 5,7 GDP, % 6,5 5,5 2,8 4,8 4,8 5,3 5,5 Ineres rae, % 3,4 4,7 5,7 6,3 6,7 7,0 7,0 Exchange rae, UAH/USD 505,0 505,0 505,0 505,0 505,0 505,0 505,0 Program scenario (inflaion argeing) Inflaion, % 14,5 9,7 7,5 5,9 4,7 4,1 4,0 GDP, % 6,1 4,7 3,4 5,1 5,0 5,5 5,5 Ineres rae, % 9,8 8,3 7,0 5,9 5,5 4,5 4,5 Exchange rae, UAH/USD 505,0 505,0 500,5 496,2 487,1 479,5 467,2 Conclusions To summarize, i may be noed ha mos cenral banks consider price sabiliy as a primary objecive of heir moneary policy o avoid public welfare losses due o inflaion. However, price sabiliy is deermined as low raher han zero inflaion level. I may be explained by he fac ha exremely low inflaion raes also involve losses in public welfare due o downward price rigidiies, risk of deflaion, zero bound on nominal ineres raes and saisical bias in CPI measuremen. I is almos impossible o find examples of long-erm inflaion arges over 4 percen for developing counries (and developed counries eiher). We do no mean medium-erm arges a disinflaion 1 See he repor of Peryk and Nikolaychuk (2007) for lieraure review Conference May 19-20, 2008, Minsk

104 104 process when cenral bank is gradually cuing he arge hroughou a definie ransiion period. This can be aribued o a leas hree facors. Firsly, experience has shown ha inflaion exceeding a definie low level adversely affec he long-erm growh raes. Secondly, i is radiionally considered ha a long-erm arge over 4% may undermine confidence in he cenral bank and lead o insabiliy of inflaion expecaions especially in developing counries where repuaion of moneary auhoriies is no solid enough. Thirdly, considering he link beween inflaion level and inflaion volailiy, inflaion arges over 4% will have adverse consequences due o higher inflaion volailiy, which, in urn, may neuralize one of he mos imporan moives for price sabiliy mainenance, namely minimizaion of inflaion volailiy, which is required for predicabiliy of price behavior as precondiion for sable economic growh. Consequenly, in our opinion, an inflaion level abou 4% is opimal for Ukraine in long-run. This level is higher han ha for developed counries and mos developing counries due o a higher poenial of produciviy growh in Ukraine as compared o more wealhy counries and, hence, higher difference in relaive prices. This inflaion level shall minimize inflaion-generaed losses, on he one hand, and be adequae o preven losses from oo low inflaion. Disinflaion rend associaed wih he sraegy of ransiion o low inflaion arge and more flexible exchange rae shall be implicily deermined for a medium-erm period (5 6 years), bu shorerm arges shall be deermined in compliance wih he curren macroeconomic condiions and forecas for each following year. References Nikolaychuk S., Mariyko E. Esimaion of equilibrium and cyclic componens of macroeconomic indicaors by he Kalman filer// Herald of he Naional Bank of Ukraine, 2007, No.5, pp (in Ukrainian). Peryk O., Nikolaychuk S. Srucural model of he ransmission mechanism of moneary policy in Ukraine // Herald of he Naional Bank of Ukraine, 2006, No.3, pp (in Ukrainian). Peryk O., Nikolaychuk S. Deerminaion of an opimal inflaion level for Ukraine // Bullein of he Naional Bank of Ukraine, 2007, No.6, pp (in Ukrainian). Bernanke, Ben S., Laubach, T., Mishkin, F.S. and Posen, A.S. (1998) Inflaion Targeing: Lessons from he Inernaional Experience Princeon, NJ: Princeon Universiy Press. Boskin, Michael J., Dulberger, Ellen R., Gordon, Rober J., Griliches, Zvi and Jorgenson, Dale W. (1996): Toward a more accurae measure of he cos of living. Final Repor o he Senae Finance Commiee from he Advisory Commission o Sudy he Consumer Price Index Covas, F. and Silva, J.S. (2001), Oule Subsiuion Bias, Economic Bullein, Sepember 1999, Banko de Porugal. Crawford, J., Fillion F. and Lafleche, T. (1997): Is he CPI a suiable measure defining price sabiliy? In: Price Sabiliy, Inflaion Targes, and Moneary Policy, Bank of Canada. Cunningham, A.W.F. (1996): Measuremen bias in price indices: an applicaion o he UK s RPI Bank of England, Working Paper. Filer, R.K. and Hanousek, J. (2002): Evaluaing imperfecions and biases in price indices during ransiion CERGE-EI Working Paper, 189 Greenspan, Alan, 1996, Opening Remarks, in Achieving Price Sabiliy, a Symposium Sponsored by he Federal Reserve Bank of Kansas Ciy, Jackson Hole, Wyoming Augus Hoffman J. (1998), Problems of inflaion measuremen in Germany, Discussion Paper 1/98, Economic Research Group of he Deusche Bundesbank. Kiss, G. and J.Kreko (2004) The Opimal Rae Of Inflaion In Hungary, MNB Background Sudies, No. 1/2004. Krugman, P. (1999): The reurn of depression economics W.W. Noron and Co., New York, 1999 Mankiw, G. (1985), Small Menu Coss and Large Business Cycles: A Macroeconomic Model of Monopoly, Quarerly Journal of Economics, 100, Medium-Term Sraegy of Moneary Policy ( ) // Naional Bank of Poland (Sepember 1998) Mishkin, Frederic S. (2000): Inflaion argeing in emerging marke counries American Economic Review (May 2000), Vol. 90 Naional Bank of he Republic of Belarus Orphanides, A., Wieland, V. (1998): Price sabiliy and moneary policy effeciveness when nominal ineres raes are bounded a zero, Federal Reserve Board Finance and Economics Discussion Series No. 35 Vinals, J. (2000) Moneary policy issues in a low inflaion environmen, paper prepared for he Cenral Banking Conference Why price sabiliy? organized by ECB in Frankfur, November 2 3, 2000.

105 Alexandr Borodin, Elena Gorbova, Sergey Plonikov, Yulia Plushchevskaya Esimaing Poenial Oupu and Oher Unobservable Variables Using Moneary Policy Transmission Model (he Case of Russia) Inroducion 2 Preparaions o inroduce inflaion argeing regime (IT) are being made in he Bank of Russia, including effors o build a forecasing and moneary policy analysis sysem and specifically, a moneary policy ransmission model as is key elemen. The model is an ad hoc dynamic sochasic general equilibrium (DSGE) one. Similar models play a role of working horses in many inflaion argeing cenral banks in heir decision-making processes. In hese models macroeconomic variables are represened as a difference beween heir acual and equilibrium levels, i.e. as gaps. Such an approach is based on a reamen, generally adoped by modern macroeconomics, of equilibrium levels as inflaion neural, i.e. non-acceleraing or non-deceleraing inflaion relaive o is arge level. For insance, if inflaion is above is arge, ha can be viewed as a resul of excess demand measured by posiive oupu gap, which in urn can be an oucome of loose moneary condiions (when ineres and exchange raes 3 are below heir equilibrium levels). Bu, while inflaion arge is explicily se by moneary auhoriies, oher macroeconomic variables equilibrium levels are unobservable and hence are subjec o esimaion. Thus esimaion procedures become crucial as unobservable variables pahs play a key role in seing a model s dynamics which is essenial for making projecions and hus for decision-making process in a cenral bank. Wihin DSGE models unobservables pahs are esimaed by mulivariae Kalman filer echniques, and hey are model-dependen. A a forecasing horizon he equilibrium pahs depend also on exogenously se seady-sae parameers, o which an economy converges heoreically and by he model se-up. Thus hese parameers are very imporan for forecass, bu heir choice is a separae problem which won be covered here. The paper presens esimaes of key macroeconomic unobservable variables for Russia in wihin a preliminary version of Russian moneary ransmission model. The chosen period covers more or less homogeneous processes in he economy and is choice was also driven by daa availabiliy. The paper s srucure is as follows. Secion 1 discusses specific feaures of he model as hey are crucial for resuls of assessing unobservable variables. Secion 2 sudies wheher he esimaed unobservables pahs are consisen wih Russian economic developmens in Secion 3 provides a comparison of he model s unobservables assessmens wih hose obained by using oher mehods. The general conclusion is made regarding consisency of he model unobservables esimaes for making projecions. 1 Bank of Russia. 2 Argumens and conclusions presened in he paper reflec he auhors own opinion and do no necessarily represen he poin of view of he Bank of Russia. 3 Measured as price of a uni of naional currency. Conference May 19-20, 2008, Minsk

106 Brief descripion of he Quarerly Projecion Model (QPM) of he Bank of Russia 1 The model is being buil in Research and Informaion Deparmen of he Bank of Russia since 2007 wih he IMF echnical assisance. Is basic elemen is a so called small ad hoc ransmission model based on New Keynesian heoreical backgrounds. Such models are widely used by inflaion argeing cenral banks. The essence of he model is represened by four behavioral equaions describing: aggregae demand (IS curve); aggregae supply (expecaions-augmened New Keynesian Phillips curve); arbirage condiion in an open economy (uncovered ineres pariy condiion); moneary policy rule (reacion funcion). The ousanding feaure of his kind of models is he presence of he reacion funcion which reflecs he moneary policy acive role in changing moneary condiions in an open economy o affec aggregae demand and supply in order o bring inflaion o arge. Therefore main effors in building he counry-specific version of a baseline sandard model have been concenraed on capuring specific feaures of Russian ransmission mechanism. Is ongoing developmen accompanied by srucural changes in he economy makes he ask even more complicaed Moneary policy ransmission mechanism (TM) The QPM reflecs main moneary ransmission channels. In he radiional classificaion here are four of hose: exchange rae, ineres rae, credi and expecaions channels. Ineres rae channel is represened by a link beween inerbank raes (levels of which are influenced by moneary auhoriies acions) and bank loan raes which affec aggregae demand sance refleced by oupu gap. Exchange rae channel describes a direc exchange-rae pass-hrough on inflaion (via impored goods price inflaion), as well as indirec effecs of changes in an exchange rae on aggregae demand. Expecaions channel is refleced by lags and leads in each of he behavioural equaions. Credi channel, which is ighly inerconneced wih he ineres rae one, isn formally included ino he model. Though a quaniy variable (i.e. money or credi aggregaes) is absen, here is an implici linkage beween nominal moneary and macroeconomic variables. I s provided by an ineres rae, which represens he cos of money and, as implied by heory, deermines quaniy of money in he economy. Nowadays he link beween he ineres rae and quaniy of money is raher weak in Russia, bu he evidence of growing imporance of he ineres rae channel, along wih real ineres raes becoming posiive, will ensure an increasing role of he link. In general we believe ha moneary condiions in Russian economy are reasonably well described by exchange and ineres raes. In recen years he dominan TM channel in Russia was he exchange rae one, reducing he role of ineres rae channel which is usually considered o play he major role wihin he New Keynesian TM modelling framework. In conras o he radiional mechanism where changes in exchange rae are induced by ineres raes in Russian economy he process is reversed ineres raes were affeced by he exchange rae dynamics under he regime of managed floaing of ruble relaive o a bicurrency baske (since 2005; o US$ before) 2. Naional Bank of he Republic of Belarus 1 Preliminary version. 2 The Bank of Russia in 2006 coninued o use he ruble value of he bicurrency baske, comprised of he dollar and he euro, as an operaional benchmark when conducing currency inervenions. This allowed i o flexibly and sensibly respond

107 The policy was aimed a resraining real ruble appreciaion driven by fundamenal facors in order o suppor domesic compeiiveness 1. The main of hose fundamenals were a consan rise in world prices of commodiies (primarily oil) which consiue a major par of Russian expors, as well as increase in produciviy in he counry s radable secor exceeding ha in rade parners (Balassa-Samuelson effec) 2. Resraining real ruble appreciaion was achieved hrough conrolling nominal exchange rae movemens in presence of price rigidiies. This lead o shor-erm slowing down in real appreciaion raes and, equivalenly, o addiional, unearned nominal revenues by commodiies exporers. Thus an addiional nominal demand was creaed which was no compaible wih he economy s capaciy o mach i by increase in producion, which lead o acceleraing inflaion 3. This in urn resuled in speeding up real appreciaion rae o he fundamenal level. 107 Wihin he framework of he ough managed floaing regime, here was lile room for conducing moneary policy by changing ineres raes. For insance, increase in ineres raes would mean widening ineres-raes differenial and hus an undesirable capial inflow (wih capial flows being increasingly deregulaed). One more facor of he cauious approach o managing ineres raes was a desire o mainain he banking secor sabiliy. Besides, unil recenly he moneary policy operaional procedure was based on regulaing base money and foreign exchange marke inervenions aimed a mainaining sable nominal value of a bicurrency baske, which per se made an effecive ineres rae policy impossible. I should be also menioned ha a weakness of ineres rae ransmission channel was ineviable in a siuaion of underdeveloped financial markes in Russia and heir high segmenaion. Thus he Bank of Russia had o use a se of insrumens wih disinc rae for each raher han a universal one which mean an absence of a base rae. In general, given he policy of raher ough managed floaing and liberalising capial flows compleed by he middle of 2006, i was pracically impossible o conduc moneary policy, a leas he one aimed a bringing inflaion o arge and anchoring inflaion expecaions in he medium and long-run 4. Neverheless posiive curren accoun balance has been seadily decreasing, capial inflows have been moderaing since he second half of 2007, hence pressures owards ruble appreciaion have been weakening. So conducing an independen ineres raes policy is becoming more and more feasible. Ongoing changes in forming marke liquidiy signal abou a growing imporance of he domesic sources of he banking sysem s refinancing and consequenly, of he Bank s of Russia lending raes, firs of all, of a REPO rae. These developmens as well as he Bank s inenion o gradually proceed o a more free floaing (and, respecively, o diminish inervenions a he forex marke) and hus o managing ineres raes, allowed us o specify an ineres rae as a policy insrumen in moneary policy rule. The choice of a reacion funcion (i.e. moneary policy rule) was one of he mos essenial problems in building he model. A compromise should be achieved beween he curren and a fuure sance of o he euro/dollar flucuaions in implemening is exchange rae policy, and o cushion he flucuaions in he nominal effecive rae of he ruble. The Bank of Russia. Annual 2006 Repor., p.57. hp:// 1 The main ask for he Bank of Russia in conaining he ruble s growh caused by fundamenal economic facors was o le domesic producers adap o he changing condiions of compeiion. The Bank of Russia. Annual 2006 Repor., p.57 hp:// 2 For assessmens of facors of ruble real equilibrium appreciaion see: K.A. Sosunov, A.V. Shumilov. Assessing Russian ruble real exchange rae.// Economics Journal of HSE. Vol.9 2, 2005; Spaafora N., Savrev E. The Equilibrium Real Exchange Rae in a Commodiy Exporing Counry: The Case of Russia. // IMF Working Paper No. 03/93 3 In erms of money supply he same process can be described as an injecion of excess liquidiy o he economy via foreign exchange inervenions by he Bank of Russia in order o consrain nominal ruble appreciaion. 4 This is a well known in inernaional economic hypohesis if impossible riniy saying ha i is impossible o have all hree of he following a he same ime: a fixed exchange rae, free capial movemen and an independen moneary policy; a counry mus pick wo ou of hree. Conference May 19-20, 2008, Minsk

108 108 he ransmission mechanism in Russia. According o inernaional pracices an inerbank ineres rae has been chosen as a policy rae in he curren version of he model, presuming ha i is (or will be) being affeced by he Bank of Russia s operaions. This choice was also affeced by an absence of a single base rae of he Bank. Exchange rae in he model is represened by he bicurrency baske ruble exchange rae (composed of US$ wih he curren share of 0.55 and euro) which plays he role of he operaional arge of he Bank s of Russia exchange rae policy. Along wih he moneary policy rule specificaion, essenial feaures of Russian TM and economy were capured by he model s paramerizaion 1. Among hem are he following: moderae (no aggressive) moneary policy reacion o deviaions of a projeced inflaion from arge and smoohing ou he dynamics of ineres raes; weak linkages beween policy (here money marke) ineres rae and banking sysem ineres raes; high ineria in economic processes (GDP dynamics, inflaion) responsible for a long period of convergence o a seady sae; low ineres-raes elasiciy of oupu; higher exchange-rae elasiciy of oupu; moderae exchange rae o inflaion pass-hrough. In general, he essenial par of he model can be summarized by four equaions supplemened wih necessary ideniies and exogenous processes Equaions Basic equaions Phillips curve: IS curve: y for eq gap (1) ( α α ) ( ls + π lz ) + α y ε π + = α1 π α2 π marke marke eq gap gap for (2) ( rr rr ) + β lz + β y ε gap gap gap = β 1 y β2 y 1 β Uncovered ineres pariy condiion: Moneary policy rule: rs ls Exogenous processes Inflaion arge: eq for (3) ( δ ) ( ls + ls 4) ( rs rs ρ ) ε = δ 1 ls neural ar gap (4) ( γ ) ( rs + γ ( π π ) + γ y ) ε = γ 1 rs ar ar (1) 1 η π = π +. Naional Bank of he Republic of Belarus 1 According o inernaional pracices calibraion was used o assign parameers o he model. This mehod is considered o be he bes choice a he curren sage of he model building, aking ino accoun a limied abiliy o use saisical and economeric mehods coming from shor ime series, acive srucural changes in he economy, evoluion on moneary policy regime. Besides, cerain parameers are no subjec o esimaion. Esimaes derived from VAR-models of Russian moneary ransmission and from oher empirical approaches were aken ino consideraion.

109 Equilibrium oupu growh: 109 eq Nominal ineres rae on banks loans: rs eq (2) ( χ) y η eq ss y = χ y +. marke (3) ( + ρ ) η ( ξ ) ( rs + rs + rs + rs ) marke marke = ξ rs Real equilibrium l ineres rae on banks loans: Term premium: rr marke eq marke Real equilibrium exchange rae depreciaion: Risk premium: Foreign oupu gap: marke eq (4) ( ζ ) rr η marke eq 2 rr ss = ζ +. marke (5) ( κ ) ρ η marke ss ρ = κ ρ +. eq eq (6) ( ζ ) lz η eq 1 lz ss lz = ζ +. (7) ( ζ ) ρ η ρ = ζ ρ ss Foreign nominal ineres rae: y gap for gap for (8) 0.85 y 1 + η =. Foreign inflaion: rs for for (9) 0.85 rs 1 + η =. for for (10) 0.85 π 1 η π = Ideniies Year-on year inflaion: Oupu: ( π + π + π π ) 4 π. 4 = Equilibrium oupu: Nominal policy neural ineres rae: y y = y + y. eq eq gap eq eq = y + y 4. 1 Real policy ineres rae: rs rr ρ π. neural marke eq marke = Conference May 19-20, 2008, Minsk

110 110 rr π. = rs +1 Real ineres rae on banks loans: marke marke = rs 4 +4 rr π. Nominal exchange rae depreciaion: ( ls ls ) ls =. 4 1 Nominal equilibrium exchange rae depreciaion in 2 quarers: Real exchange rae: Real equilibrium exchange rae: Real exchange rae gap: eq for for 2ls = + π + 1 π π eq π lz. 1 for ( ls π + π ) 4 lz = lz +. lz eq eq 1 = lz + lz 4. eq Foreign real ineres rae: lz gap eq = lz lz. for for for + rr = rs π Noaions x x ss eq x x gap x for x value of domesic variable x in period seady sae value of x equilibrium value of x in period annualized % change in x since ime period 1 o difference beween acual and equilibrium values of x in period value of a foreign variable x in period Basic counry-specific parameers of he model are given in Table 1. Pahs of poenial oupu, real equilibrium ruble exchange rae o bicurrency baske, real ineres rae on loans were obained wihin his model framework. Besides, for he period of a arge pah was also esimaed by Kalman filer as an unobservable. The reasons were as follows. Naional Bank of he Republic of Belarus De-jure he governmen and he Bank of Russia se an inflaion goal for each forhcoming year. I s imporan o sress ha under igh managing of an exchange rae is level is acually predeermined by changes in real equilibrium exchange rae and inflaion in rade parners. Bu his wasn aken ino accoun while assigning he goal. More han ha, as i was already menioned de-faco igh managed floaing made achievemen of inflaion arge impossible. In such a siuaion he Bank of Russia made hard effors o resolve his difficul rade-off beween argeing exchange rae level and inflaion.

111 Based on hese wo circumsances, he hisorical inflaion arge pah was se as a random walk meaning ha de-faco i was absen in he IT framework sense. For he years of inflaion goals declared in he relevan annual Guidelines for he Single Sae Moneary Policy were used. This raher arificial design aimed a making he arge pah o converge smoohly o is fuure values which are presumed o be se under he modelled IT regime. I s worh menioning ha inflaion arge pah is crucial for all unobservable variables as well as for making projecions because equilibrium values are defined as inflaion neural, i.e. consisen wih argeed inflaion. Thus one should be careful in inerpreing he model s resuls for given he above menioned assumpions. 111 Table 1: Major parameers of he small ad hoc Russia s moneary ransmission model Equaion Parameer Economic sense/ Characerisics of he value adoped for Russia Value Inerval given by inernaional pracices Phillips curve α1 Forward-looking componen (raionaliy) of expecaions / Moderae 0,45 from 0 o 1 Phillips curve α2 Inflaion ineria / Relaively high 0,45 Phillips curve 1 α1 α2 Phillips curve α3 Exchange rae elasiciy of inflaion (pass-hrough effec) / Low Oupu gap elasiciy of inflaion (effec of demand sance on inflaion, sacrifice raio) / Low 0,1 0,23 from 0,25 o 0,5 1 IS curve β2 Oupu gap ineria / Low 0,3 from 0,5 o 0,9 IS curve β3 IS curve β4 Effec of moneary condiions (on he par of ineres rae) on oupu gap (excess demand /supply) / Low Effec of moneary condiions (on he par of exchange rae) on oupu gap (excess demand /supply) / Somewha higher han ha of ineres rae 0,1 0,2 in sum from 0,1 o 0,3 Moneary policy γ rule 1 Smoohing of policy rae / Moderae 0,4 Nominal ineres rae on bank loans ξ Loan rae ineria / High 0,7 1 ξ Dependence of loan rae on policy ineres rae / Low 0,3 1 The inervals are very approximae and migh change dependen on a model specificaion. Conference May 19-20, 2008, Minsk

112 Esimaes of he key unobservable variables Figure 1: Implici inflaion arge Figure 2а: Acual and poenial oupu Naional Bank of he Republic of Belarus

113 113 Figure 2b: Oupu gap Figure 3a: Acual and equillibrium real ruble exchange rae Conference May 19-20, 2008, Minsk

114 114 Figure 3b: Real ruble exchange rae gap Figure 4a: Acual and equillibrium real bank loans ineres rae Naional Bank of he Republic of Belarus

115 115 Figure 4b: Real bank loans ineres rae gap 2. Consisency of he sory old by he unobservable variables wih sylized facs of Russian economy in The main means o judge wheher unobservables pahs obained wihin a model are righ or accepable is o check wheher a sory old by hem suis well acual macroeconomic processes and moneary policy sance a a qualiaive level. Neverheless i s difficul o inerpre hisorical resuls of he model describing an acive role of moneary policy in bringing inflaion o arge in he Russian case, because IT wasn in place. Therefore we concenraed our judgemens on general macroeconomic sory. The key feaure of Russian economic developmens afer 1998 financial crisis was raher rapid economic growh (a abou 7% on average in ) along wih slowing down inflaion (from 36.5% in December, 1999 (m-o-m) o 9% in December, 2006). In 2007 price growh acceleraed o 11.9%. To cerain exen his acceleraion refleced a sharp rise in world food prices. Russia depends on impors of individual food iems (see Table 2). Apar from his, he counry is one of he world larges grain exporers and hus he domesic marke is exposed o he world marke developmens. Bu in 2007 no only consumer prices bu also indusrial producer prices as well as prices in consrucion acceleraed oo. Thus one could speak abou general price level upward movemen in Russia which was caused no only by exernal shocks bu by domesic inflaionary pressures as well. Our judgemen on he reliabiliy of he model s oucomes will be based on heir abiliy o capure hese sylized facs of recen Russian economic developmens Oupu gap New Keynesian macroeconomics paradigm supposes ha one of he mos imporan asks of moneary policy is o properly and in ime deec a general economic sance, i.e. o wha exen oupu deviaes from is long-run rend (or a cerain equilibrium level). One of he mos popular meas- Conference May 19-20, 2008, Minsk

116 116 ures of he economic sance is GDP (or oupu) gap which is a difference beween is acual and poenial levels. This indicaor is widely used by inflaion argeing cenral banks as a general measure of inflaionary pressures in he economy 1. Table 2: Impors and expors shares in resources and use of cerain food iems in 2006, % Impors shares in resources of cerain food iems, % Expors shares in use of cerain food iems, % mea and poulry milk and diary of which buer fa cheeses (including sheep's milk cheese) flour cereals pasa vegeable oils vegeables, waer-melon, melon and gourd Source: Rossa Predominanly in acual GDP, regardless is high growh raes, didn exceed is poenial level which corresponds o slowing down inflaion. Consequenly, he poenial also sood a a high level which means ha producion capaciies in Russian economy grew inensively. Does his hypohesis mach he daa? In producion grew fas driven by acive impors subsiuion (afer deep ruble depreciaion in 1998) suppored by subsanial amoun of free producion capaciies. When his source of growh became exhaused (in when acual oupu reached he poenial one) inensive facors of economic growh sared o play a greaer role (Table 3). Fixed capial invesmens increased fas, producion modernisaion and fixed asses renovaion ook place, hus creaing a basis for produciviy growh. Uni coss were diminishing. Bu as can be seen from persisen growh in ear and wear of fixed asses, invesmens were insufficien, and his pu limis o non-inflaionary growh. Resuls of surveys 2 show ha since 1999 average capaciy uilizaion rae has been growing. Saring from low levels of less han 40% i exceeded 70% on indusrial aciviies and almos reached his level in consrucion. In agriculure where capaciy consrains (for insance, produciviy of soil, heads of livesock) canno be removed fas, growh raes didn exceed 3.6%, which is, in paricular, much lower han growh in final consumpion expendiures by households. I ough o be menioned ha in Russia where living sandards of he mos par of he populaion are no high 3, increase in incomes ranslaes mainly o consumpion, of which o a grea exen o consumpion of food. 1 Oher indicaors of business aciviy condiions could also be used such as unemploymen gap, real marginal coss. Naional Bank of he Republic of Belarus 2 Cener of Economic Conjuncure, Governmen of Russian Federaion. Bullein of business aciviy in Russia (surveys daa). 3 (31), In 2007, monhly income of 63.4% of he populaion was below rubles, or abou US$ 470. In he 3 quarer of 2007 incomes of 13.3% of Russian ciizens were below subsisence minimum.

117 Table 3: Russian economy indicaors in GDP, % o previous year Fixed capial invesmens, % o previous year Expendiures on echnological innovaions, bln.rub., consan 2000 prices Puing new fixed asses ino operaion (wihou livesock), % of fixed asses value, end of period Coss per 1 ruble of goods and services, % * Tear and wear of fixed asses, beginning of period, % Final consumpion expendiures by households, % o previous year Source: Rossa * In January-Sepember During he period under consideraion unemploymen decreased from 10.5 o 6.1%. In general, signs of growing discrepancies beween demand and producion capaciies (despie he growh in he laer) and hus of he economy s overheaing became more and more apparen. This is refleced by oupu gap becoming posiive (as for he esimaes, in 2006) Real exchange rae gap Real equilibrium exchange rae pah and deviaions of he acual exchange rae from i, i.e. exchange rae gap, wihin he model framework are consisen wih inflaion and oupu gap. Besides, real equilibrium exchange rae pah also reflecs persisen ruble appreciaion based on fundamenal facors. High inflaion in as an oucome of 1998 crisis was refleced by high real ruble appreciaion. According o he esimaes, in real erms ruble appreciaed more han a inflaion neural raes (which corresponds o negaive real exchange rae gap) which in line wih negaive oupu gap promoed fas decline in inflaion. In as oupu was approaching he poenial level as a resul of exhausing impor subsiuion, real appreciaion became more inflaion neural oo and in some episodes even pro-inflaionary (which can be seen as posiive exchange rae gap). In 2004 inflaion acceleraed. Then in growh in produciviy lead o excess supply and hus falling inflaion raes. The negaive real exchange rae gap corresponded o hese developmens. Since he end of 2005 inflaionary pressures (excess demand) have been building up which resuled in posiive oupu gap and growing ruble undervaluaion (he drif of he exchange rae gap o posiive area) Real loans ineres rae gap The model reflecs our assumpions abou weakness of ineres raes channel, on one hand, and low influence on he economy of ineres raes on loans o privae secor, on he oher. Real ineres raes were predominanly negaive during he period under consideraion and so hey could no play a role of an efficien insrumen of managing credi aciviy which implies weakness of ineres raes channel. One of he main reasons was a long-lasing srucural liquidiy surplus in he banking secor. In such a siuaion i s obvious ha bank raes sood a a below-equilibrium level. Nega- Conference May 19-20, 2008, Minsk

118 118 ive ineres raes gap according o heory means loose, pro-inflaionary moneary policy which in he shor run pus upward pressures on oupu gap. I s imporan o sress ha negaive real ineres gap is a facor of high availabiliy of credis and a credi boom. For insance, growh in consumer credis and he relaed increase in consumpion srenghened inflaionary pressures in However, his effec wasn oo srong given a sill small share of credis in households consumpion financing. This applies also o non-financial enerprises: high profiabiliy in producion aciviies which make a major par of fixed capial invesmens (mining, ransporaion, communicaions) allows hem o finance almos a half of he invesmens by own resources. A share of loans from domesic and foreign banks in 2007 was only 9.4%. Neverheless is growh from 2.9% in 2000 winesses increasing availabiliy of he banking financing. Bu in general credi condiions didn pu significan limiaions o non-inflaionary growh during he mos par of he period under discussion Conclusions The unobservables' pahs esimaed wihin he described framework by Kalman filer could be considered o be appropriae as hey allow o produce a sory consisen wih acual economic developmens in Russia in The mos imporan are he esimaes preceding a projecion period as hey consiue a par of iniial condiions. To our mind, he gaps esimaes for he end of 2007 mach Russian economic siuaion characerized by signs of overheaing, or excess demand, semming from increase in demand under he consrains from he supply side (posiive oupu gap). I was promoed by loose enough exchange rae policy and low real ineres raes. The general conclusion is ha he model could be used for medium-erm forecasing under a ransiion o IT implemenaion. Though, o suppor he inference i would be useful o compare he given above esimaes of unobservable variables wih hose derived from alernaive mehods. 3. Alernaive mehods of oupu gap esimaion I was menioned earlier ha for he purposes of he model we define poenial oupu as he level of oupu ha generaes no inflaionary pressure in a given economy (neiher acceleraing nor deceleraing inflaion). In his case one can inerpre oupu gap as a general indicaor of demand о supply raio, in a sense ha, oher hings being equal, a posiive gap would mean excess demand and hus simulaion of an increase of prices. Firs models ha allowed obaining esimaions of he gap in he sense menioned above were based on purely saisical univariae echniques, wihou any addiional srucural assumpions. There are several such echniques, ha decompose a ime series ino a rend and cycle componens. In such a decomposiion a (sochasic) rend is considered a supply-side componen (a poenial oupu): any shocks in is level or slope are permanen, influencing all of is fuure values. Transiory cyclical deviaions of observed values from rend (gaps) correspond o a demand componen effecs Mulivariae models based on he Hodrick-Presco filer Naional Bank of he Republic of Belarus Several approaches o augmening he filer proposed by Hodrick and Presco (hereafer he HP filer) were used o obain alernaive esimaions of oupu gap. Univariae HP filer has several drawbacks. Is basic specificaion and main poins of criique are menioned in Appendix B. Laxon

119 and Telow (1992) showed ha properies of an HP filer can be significanly improved by using addiional informaion abou variables ha are relaed o oupu in New Keynesian economic paradigm, namely unemploymen level and inflaion. Thus, residuals from he Phillips curve and Okun law can ener he filer s opimizaion funcion Mulivariae filering was carried ou using wo differen approaches o augmening he HP filer Approach 1 The firs approach is based on he represenaion of HP filer in he form of an unobserved componens model wih common cyclical componen for oupu and unemploymen. Univariae specificaion was expanded wih an auoregressive process for he cyclical componen of oupu ϕ ; a similar process was included o describe unemploymen. According o Okun law, equilibrium unemploymen level µ u was specified, while cyclical deviaions of unemploymen from µ u were relaed o oupu gap flucuaions: y E 2 = µ + ϕ + ε, ( ε ) = 0, var( ε ) = σ ε µ = 2 = µ 1 + β 1 + η, E( η ) = 0, var( η ) σ η β = 2 = β 1 + ζ, E( ζ ) = 0, var( ζ ) σ ζ ϕ = 2 = c( L) ϕ 1 + ν E( ν ) = 0, var( ν ) σ ν u = µ + d = u u u 2 ( L) ϕ + ε, E( ε ) = 0, var( ε u ) σ εu µ = u u u u u u 2 = µ 1 + β 1 + η, E( η ) = 0, var( η ) σ ηu β = =. u u u u u 2 β 1 + ζ, E( ζ ) = 0, var( ζ ) σ ζu Maximum number of lags in c(l) and d(l) was se o 4 o allow for effecs of flucuaions wihin a single year. Kalman filering allows o ge ML esimaions of he parameers of he model, using which i is possible o obain pahs for poenial oupu and equilibrium unemploymen Approach 2 The second approach is o augmen he loss funcion of a sandard HP filer. Economic heory suggess ha oupu gap is relaed o inflaion and unemploymen dynamics (Laxon, Telow, 1992). This informaion can be formalized o improve filer s esimaes by adding he residuals from corresponding equaions, expressed in erms of oupu gap, in he loss funcion: L = T y T T u T ( + (( ) ( )) = µ ) λ( µ = = + 1 µ µ 0 µ 1 α1 ε α 0 2 = ε π 0 u π Here ε sand for Okun law residuals, ε are residuals from Phillips curve, α1 and α 2 coefficiens represening significance of unemploymen and inflaion flucuaions compared o flucuaions of oupu gap. 1 Also in some papers (Conway, Hun 1997; Claus 2000) capaciy uilizaion measure is used for he same purposes. Conference May 19-20, 2008, Minsk

120 120 Okun law is given by: u u ( u µ ) = k( y µ ) + ε, u where u is he level of unemploymen, µ equilibrium unemploymen, esimaed by a simple HP filer. The following equaion was esimaed o obain Phillips curve: e π π = π + a ( L)( y µ ) + ε. Inflaion expecaions were composed of several lagged levels of inflaion and consensus forecas, compued using he daa of Developmen Cener 1 ; sum of coefficiens of hese variables was resriced o Parameerizaion To iniiae filraion for an unobserved componens model, iniial values of parameers were needed. Those were chosen so ha in he iniial period, prior o he firs observaion, all variables were supposed o be on heir poenial levels, equal o he values of he firs observaions. α1 and α2 are he coefficiens responsible for comparaive imporance of Phillips curve and Okun law residuals and oupu variaion. Laxon and Telow used equal weighs for all hree. In a laer paper by he researchers from he Bank of New Zealand α1 and α2 were boh se o 2. We also used his approach for such values provide he mos sensible esimaion of he gap. Coefficien k in Okun law equaion was se a 0.3, implying approximaely 1% decrease in unemploymen for every 3% of increase in oupu. Such value corresponds o modern pracice 2 ; also i is in line wih he esimaion derived from unobserved componen model (he sum of coefficiens d 1,,d 4, divided by 100 o conver from percenage difference, equals -0.22). Ieraive naure of he esimaion of Phillips curve needs furher noice. Values of Phillips curve residuals (and hus, overall calculaed poenial oupu) depend on he srucure of polynomials ha ener ino he equaion. In urn, ha srucure is esimaed on he basis on some iniial oupu gap levels. Phillips curve esimaion had hus o be carried ou in he following way. On sep 1, poenial oupu from a simple HP filer was used o calculae iniial values of oupu gap. Given hose esimaes, coefficiens of gap and inflaion expecaions polynomials were esimaed, using a simple OLS o eliminae auocorrelaion in he residuals. Obained coefficiens were used o acquire an expression of Phillips curve residuals in erms of poenial and acual oupu. These expressions, along wih expressions for Okun law residuals, were hen plugged ino augmened PC filer loss funcion. Then numerical opimizaion yielded new esimaes of poenial oupu, and used o calculae iniial values of oupu gap for sep 2. The process coninued unil here was lile change in Phillips curve coefficiens beween wo las seps Resuls and conclusions The main resuls are presened on Figure 5. QPM gap esimaes are also ploed on ha figure for comparison. Naional Bank of he Republic of Belarus 1 Quarerly daa of polls are available on he Inerne a hp://dcener.ru. 2 Iniially an esimae of was obained by Okun himself (Okun 1962). In he laer papers esimaes of his coefficien varied for differen counries from 0.12 (Japan) o 0.54 (Grea Briain) (see Blanchard 2006; Abel, Bernanke 2005).

121 121 Figure 5: Oupu gap esimaes Comparing obained esimaes wih hose of QPM and inuiion concerning oupu dynamics, presened in Secion 2.1., i can be seen ha he main difference is lower range of flucuaions and a posiive values of gap in One of possible explanaions for ha is unreliabiliy of HP filer based esimaes on he ends of sample. Inclusion of addiional variables in he model of he filer was supposed o reduce his effec, bu obviously, i is impossible o fully solve he problem. A he same ime, posiive oupu gap a he beginning of he period corresponds o inflaion dynamics. Tha is no he case for QPM, possibly because an increase of inflaion in 2000 is due o facors no relaed o oupu; models presened in his secion do no include hese facors (mainly exchange and ineres rae dynamics). Since he middle of 2001 he obained esimaes generally correspond o inuiive view of oupu dynamics. Boh models, along wih QPM, idenify he peak of economic aciviy in 2004 (in he beginning of he year according o QPM and unobserved componens models, closer o he end of he year according o mulivariae HP esimaes), demonsrae he consequen reducion of he gap, which migh be explained by an increase in invesmen growh raes, and finally, anoher increase of he gap in , presumably due o he surpassing growh of demand given he lack of invesmens in capial modernizaion and resource limiaions. Esimaes of he gap from he unobserved componens model only marginally differ from simple HP filer esimaes, bu have several significan disincions from mulivariae HP filer. One of he main advanages of he laer is ha hey beer correspond o he macroeconomic definiion of he gap ha is o say, hey can be more clearly inerpreed as a measure of inflaionary pressures in he economy. As i can be seen on Figure 6, periods of posiive oupu gap (grey areas) almos perfecly correspond o he periods when (annualized quarerly) inflaion raes increased. Thus, he rajecory of he gap obained wih mulivariae HP filer migh be used as he baseline case for he analysis and inerpreaion of filering resuls of more complicaed srucural models. I is obvious, hough, ha he capaciy of his model for forecasing and possible moneary policy consequences analysis is severely limied, for survey daa on inflaion expecaions is used in esimaion, and here is no way o forecas evoluion of such daa. Conference May 19-20, 2008, Minsk

122 122 Figure 6: Oupu gap and inflaion dynamics Conclusion. In his paper we described he resuls of esimaion of unobserved variables rajecories in he moneary policy ransmission mechanism model ha forms he basis for he ongoing process of he forecasing and policy analysis sysem developmen in he Bank of Russia. Dynamics of oupu gap, equilibrium exchange rae and real ineres rae generaed by he model is compared o he main endencies of economic developmen in Russia in The resuls speak in favor of adequacy of QPM esimaes and he possibiliy o use he model in ransmission mechanism analysis and supporing decision-making process in moneary policy. I should be poined ou, however, ha he esimaes of unobserved variables are raher sensiive o parameerizaion. Therefore we used several mehods, based on HP filer, o obain alernaive esimaes of oupu gap. Those esimaes qualiaively correspond o QPM for he mos par of he period sudied; all hree esimaes confirm an increase in inflaionary pressures during he las wo years, hough hey are slighly differen in magniude. A he same ime, here are several discrepancies beween he esimaes, especially a he beginning of he analyzed period. Uncovering he reason for hese discrepancies will be he subjec of furher sudy. Appendix A. Technical feaures of using he Kalman filer o esimae rajecories of unobserved variables in srucural models. As i was menioned earlier, using he Kalman filer is dicaed by he need o combine he economic heory, refleced in he srucure of equaions of he model of general equilibrium, wih exper judgmens abou he dynamics of unobserved variables as well as wih observed saisics. Naional Bank of he Republic of Belarus Kalman filering allows consrucing rajecories for unobserved variables aking ino accoun he srucure of he model and saisical daa. The resuls should be viewed as descripion of he daa hrough he prism of simple non-conradicory saemens concerning he principles of he func-

123 ioning of he economy. Adequacy of such descripion is checked by comparing he obained hisory wih generally acceped inerpreaion of acual economic dynamics. 123 In order o improve he resuls of filering (obain more adequae rajecories) and o avoid siuaions where Kalman filer is no applicable, in is imporan o keep in mind various peculiariies of is echnical realizaion. Main problems ha arise during he filering can be divided in wo ypes: srucural, when i is impossible o iniiae Kalman filering o resolve such issue i is generally required o add, delee of aler some of he model s equaions. parameric, when filering can be successfully carried ou, bu is resuls do no correspond o realiy ha requires more aenion o he parameerizaion of he model. Below are some common examples, which he auhors encounered. Srucural problems arise mos ofen in he beginning of filering. One example is impossibiliy of esimaion of iniial condiions needed o begin he filering process. Exisence of leads in a model is only possible if appropriae number of non-saionary variables is presen in he model (Blanchard-Kahn condiion). Thus, simple esimaion of iniial condiions (expeced values of he variables and heir variances), as in case of saionary models, is ofen impossible. Soluion for his problem is he use of diffuse iniial condiions algorihm, when addiional filering procedure is used o esimae iniial condiions for non-saionary variables 1. The following sysem is a simple example of impossibiliy of iniial condiions esimaion: lcpi = π 4 + lcpi π = π 1 + ε. If π (growh rae of lcpi) is he only observable variable, hen i is obviously impossible o esimae iniial value of lcpi, for no informaion abou iniial price levels can be exraced from growh raes. The problem can be eliminaed eiher by choosing lcpi o be observable or, if i is impossible, by excluding his variable from he model and rewriing he equaions ha conain i erms of growh raes. Undersanding he naure of parameric problems is no less complicaed. The mos complicaed issue here is usually calibraion of sandard errors of equaions residuals which characerize deviaions of acual daa from ha calculaed in he model. From he filering poin of view, he magniudes of sandard errors of residuals also characerize explanaory power of unobserved variables ha are included in a given equaion: he more is he residual s sandard error, he less variaion is explained by he unobserved variables in he equaion. Obaining esimaes of sandard errors of he residuals based on he resuls of filering can also conribue o undersanding hose resuls. For example, if hose esimaes exceed a priori values of he sandard errors, hen explanaory power of corresponding unobserved variables migh be overvalued. 1, B. Univariae HP filer Among he echniques commonly used for univariae filering here are HP and Baxer-King filers, Beveridge-Nelson decomposiion, Markov chains based mehods and some oher 2. These mehods allow o obain esimaes for poenial oupu and oupu gap, hough reliabiliy of he esimaes is quesioned by many researchers. To review he main poins of he criique i is useful o presen HP filer in form of a local linear rend model. 1 Deailed descripion of he main mehods of esimaion of diffuse iniial condiions can be found in Harvey (1989). 2 A review of papers on many of hose can be found, for example, in Canova Conference May 19-20, 2008, Minsk

124 124 According o sandard definiion HP filer is a series ha minimizes he loss funcion: 1( ( µ µ ) ( µ )) 2 T 2 T ( y ) + ( = 0 λ = L = µ µ, where y sands for observed series. Thus for GDP series µ can be regarded as poenial oupu, ( y µ ) as oupu gap. In a more general framework, i can be presened as a local linear rend model: y = µ + e = 2, E( e ) = 0, var( e ) σ e µ = 2 = µ 1 + β 1 + η, E( η ) = 0, var( η ) ση β E =. 2 = β 1 + ζ, ( ζ ) = 0, var( ζ ) σ ζ This is an unobserved componens model ha can be used o decompose y ino poenial oupu rend µ and residual componen e. Trend is supposed o be a random walk process wih drif β, which is, in urn, a random walk iself. HP filer esimaes can be presened in form of his model 2 wih σ η =0 (Harvey, Jaeger 1993). The only parameer of he filer, λ, is hen given by a raio of wo 2 remaining error erms variances 1 : λ = σ e 2. σ ζ The model can be furher expanded by decomposing residual erm ino cyclical componen φ, which would behave according o some inuiive percepions regarding he gap dynamics, and a compleely random residual: y E 2 = µ + ϕ + ε, ( ε ) = 0, var( ε ) = σ ε Addiional assumpion of cyclical behavior of φ can be formalized, for example, wih an auoregressive process ha has some limiaions on coefficiens and variance of residual (Guay, S-Aman 1996) 2. One can obain poenial oupu esimaes by using Kalman filer and maximum likelihood. Also, esimaion provides anoher crierion for HP filer applicabiliy: esing σ =0. One of he main direcions of criicism is ha such a hypohesis is ofen rejeced. Harvey and Jaeger (1993) esed his hypohesis on he GDP daa for various counries, and concluded ha i holds only for USA, which allowed hem o say ha HP filer was ailored o exrac informaion abou business cycles from US GDP. Anoher significan drawback of HP filer is he so-called end poin problem. Due o he fac ha he filer is acually a wo-sided moving average 3, esimaes of decomposiion in curren period (he 2 η 1 In his paper abou parameerizaion of he filer Presco explained his choice of λ=1600 for quarerly daa by he fac ha such value resuled in periodic cycles wih he period of 32 quarers, which he considered a good approximaion of realiy (Presco, 1986). 2 Alernaively, one can use a widespread approach of modeling cyclical behavior wih sochasic sinusoids (Harvey,1989): ϕ = ρ cos λ ϕ ~ ϕ = ρ sin λ ϕ c 1 c 1 + ρ sin λ ~ ϕ c 1 + ρ cos λ ~ ϕ c 1 + ψ, + ~ ψ, E( ψ ) = 0, E( ψ~ ) = 0, 2 var( ψ ) = σ ψ var( ~ ψ ) = σ 2 ψ Naional Bank of he Republic of Belarus Such form provides clear inerpreaion for he parameers. Here ρ deermines he ampliude of cycles, and λс is frequency of a cycle in radians. Simple HP filer can also be hough of in erms of his model wih ρ=0 and/or σ = 0. 2 ψ 3 Two-sided in a sense ha i uses boh pas and fuure values of he observed series o derive he esimaes of decomposiion.

125 las observaion in a sample) are unreliable in a sense ha hey are subjec o possible significan revisions afer new daa is added and he esimaion is carried ou over he exended sample. This flaw reduces he appeal of using HP filer for making moneary policy decisions, for i is he esimaion of he curren sae of economy ha is imporan in ha area Finally, he resuls of Mone-Carlo based experimens sugges ha he accuracy of decomposiion srongly depends upon he characerisics of he daa generaing process. Guay and S-Aman (1996) showed ha he resricions under which he HP filer wih λ =1600 will yield accurae decomposiion, can hardly be aribued o acual GNP series. References Корищенко К.Н. Проблемы перехода к инфляционному таргетированию в России. Спб.: Изд-во СПбГУЭФ, Петрик А., Николайчук С. Структурная модель трансмиссионного механизма монетарной политики в Украине // Вестник НБУ С Улюкаев А.В., Замулин О.А., Куликов М.В. Предпосылки и последствия внедрения таргетирования инфляции в России. Экономическая политика ( 3). A. Berg, P. Karam, D. Laxon. A Pracical Model-Based Approach o Moneary Policy Analysis Overview. IMF, WP/06/80. A. Berg, P. Karam, D. Laxon. A Pracical Model-Based Approach o Moneary Policy Analysis A How-o Guide. IMF, WP/06/81. Abel, A B and Bernanke, B S (2005). Macroeconomics (5h ed.). Pearson Addison Wesley. Arus, J R (1977), Measures of poenial oupu in manufacuring for eigh indusrial counries, , IMF Saff Papers 24, Baxer, M and R King (1995), Measuring business cycles: approximae band-pass filers for economic ime series, NBER Working Paper No Blanchard, O (2006). Macroeconomics (4h ed.). Pearson Prenice Hall. Buler, L (1996), A semi-srucural mehod o esimae poenial oupu: combining economic heory wih a ime-series filer, Bank of Canada Technical Repor No. 76. Canova F (1999) Does Derending Maer for he Deerminaion of he Reference Cycle and he Selecion of Turning Poins? The Economic Journal, Vol. 109, No (Jan., 1999), pp Claus, I (2000), Esimaing poenial oupu: a srucural VAR approach, Reserve Bank of New Zealand Discussion Paper DP2000/03. Claus, I, Conway, P and A Sco (2000) The oupu gap: measuremen, comparisons and assessmen, Reserve Bank of New Zealand Research Paper #44. Fisher, I (1933), The deb-deflaion heory of grea depressions, Economerica 1, Guay, A and P S-Aman (1996) Do mechanical filers provide a good approximaion of business cycles? Bank of Canada Technical Repor No. 78. Harvey, A C (1989), Forecasing, Srucural Time Series Models and he Kalman Filer, Cambridge Universiy Press. Harvey, A C and A Jaeger (1993), Derending, sylized facs and he business cycle, Journal of Applied Economerics 8, Hodrick, R J and E C Presco (1997), Pos-war US business cycles: an empirical invesigaion, Journal of Money, Credi and Banking 29, Laxon, D and Telow, R A simple mulivariae filer for he measuremen of poenial oupu, Bank of Canada echnical repor No 59. Okun, A (1962), Poenial GNP: is measuremen and significance, In Proceedings of he Business and Economics Secion, American Saisical Associaion, Presco, E C (1986), Theory ahead of business cycle measuremen, Quarerly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages The Czech Naional Bank s Forecasing and Policy Analysis Sysem. Ed. by W. Coas, D.Laxon, D. Rose. 1 Buler (1996) suggesed one of he ways o solve he problem exending he loss funcion o include a penaly for he deviaion of poenial oupu from some fixed long-run growh rae during he las several periods (usually 12 periods, for Baxer and King showed (Baxer, King 1995) ha HP filer is subjec o significan end-poin revisions during 12 firs and 12 las periods. Conference May 19-20, 2008, Minsk

126 126 Anca Adriana Gălăţescu, Bogdan Rădulescu, Mihai Copaciu, Poenial GDP Esimaion for Romania 1 The paper s objecive is o esimae he growh raes of poenial GDP for Romania. To his end, we presen and implemen several univariae and mulivariae mehods for he measuremen of poenial GDP growh: producion funcion, filers wih unobservable componens, srucural vecor auoregressions. The resuls are robus o changing approaches and specificaions, poining o an acceleraion in he annual growh rae of poenial GDP from an average of 3-4 percen beween o values around 6 percen in he recen period. INTRODUCTION Economic growh displays irregular flucuaions along business cycles, periods of economic expansion alernaing wih hose of sagnaion. The fac ha economies have a cenral long-erm growh endency has promped economiss o formulae he concep of poenial GDP, whose long-erm growh rae is he resul of fundamenal facors: he srucure of he economy, is producive capaciy deermined by echnology, demographic and educaional facors which influence he labor force, and ohers. This concep corresponds o he seady-sae growh rae feaured in neoclassical models and i generally changes over relaively long ime spans only as a resul of significan and lasing changes in economic fundamenals. In order o be empirically idenifiable, he concep of poenial GDP has received various definiions in lieraure (for a presenaion of alernaive or complemenary definiions see Benk, Jakab and Vadas, 2005). In his paper we define poenial GDP as he level of real GDP which he economy can produce wihou generaing inflaionary pressures. In his framework, he medium-erm growh rae may vary, emporarily deviaing from is long-run equilibrium value. The GDP gap (excess demand) is he difference, expressed in percenage poins, beween acual real GDP and poenial GDP, represening a synheic aggregae indicaor of inflaionary pressures. Consequenly, excess demand is a variable ha carries a lo of relevance for esablishing he moneary policy sance, which is aimed a bringing inflaion o he announced arge over he relevan horizon by managing aggregae demand. This paper presens a series of univariae and mulivariae mehods for deermining he growh rae of Romania s poenial GDP: producion funcions, filers wih unobserved componens, srucural vecor auoregressions. The resuls are robus o differen specificaions and mehods, indicaing an acceleraing annual poenial GDP growh rae from an average of 3-4 percen in o values of around 6 percen in more recen years. The paper is srucured as follows: secion one briefly surveys he exising esimaes of Romania s poenial GDP from oher empirical sudies, secion wo deails he mehods used o deermine he poenial GDP and he resuling esimaes, while secion hree concludes. Naional Bank of he Republic of Belarus 1 The auhors wish o hank Cezar Boțel for his suggesions and commens based on early drafs of his paper, as well as Nicolae Alexandru Chideşciuc and Răzvan Sanca for compuing and adjusing some of he ime series used in he paper.

127 EMPIRICAL STUDIES ESTIMATING ROMANIA S POTENTIAL GDP In conras o oher Cenral and Easern European counries for which here are boh panel and individual counry sudies, empirical resuls regarding he evoluion of poenial GDP in Romania are scarce. One possible cause is he relaively shor ime span covered by he relevan daa. Denis e al. (2006) 1 are he firs o include a deailed assessmen of Romania s poenial GDP. Their esimaes for EU27 are made wihin a comparable framework using he producion funcion approach. The growh raes of real and poenial GDP for 8 member counries, including Romania, are shown for comparison in Figure 1. In Romania s case, he auhors poin o an average annual growh rae of poenial GDP for he period of 3.2 percen. The las years display higher values, he average for being 5.6 percen. Romania s long-erm GDP growh rae is also menioned in he IMF Repor on Aricle IV Consulaion wih Romania, IMF (2006a). In he original model, IMF (2006b), on he basis of which he resuls were obained, he derivaion of he efficien level of producion implies an opimal uilizaion of resources and exising echnologies. The sample used for he panel esimaes includes 145 counries. Toal facor produciviy growh, one of he main sources of poenial GDP growh, reflecs differences in he efficiency of using he facors, and no differences semming from access o echnology, which is assumed equal for all counries under review. In he case of Romania, he projeced pahs of economic growh in he nex decade are based on hree differen scenarios for he auhoriies capaciy o absorb EU funds and successfully implemen an insiuional and srucural reform program. The baseline scenario is conservaive, in he sense ha auhoriies do no fully implemen he reform program, and public invesmens proceed a a low rae. This scenario yields a susainable long-erm growh rae of real GDP of 5 percen on average for he period In he opimisic scenario he susainable economic growh rae is 7.5 percen for he same period, while in he pessimisic one i drops o 3 percen. Dobrescu (2004) idenifies he oupu gap variaions for he period beween 1991Q1 2002Q4 by compleing he previously-menioned definiion wih an addiional consrain. Thus, poenial GDP is also linked o he exisence of a consan share of ne expors in GDP. The evoluion of poenial GDP hus defined shows wide annual variaions. 2. ESTIMATING POTENTIAL GDP Given ha poenial GDP is a variable which canno be direcly observed from saisical daa (unobservable), he ask of measuring i is no a rivial exercise. The mehods used for esimaing he poenial GDP can be divided ino univariae mehods, which only analyze he evoluion of real GDP, and mulivariae mehods, which simulaneously ake ino accoun several macroeconomic variables. Each of hese mehods comes wih advanages and disadvanages. Because of he fac ha he level of poenial GDP is no direcly observable from saisical daa, here are several problems common o all he mehods employed in is esimaion. One of hem is he very shor sample of usable daa for Romania, which probably does no cover an enire business cycle. Due o he frequen srucural changes which ook place in he economy in he period under scruiny, i is possible ha, regardless of he chosen mehod, he idenified rends do no correcly reflec hese changes. Anoher issue is he fac ha official saisical GDP daa is published wih a 1 The paper was iniially published during 2006 wihou any reference o Romania. When updaing he resuls, he auhors included for he firs ime in heir sample daa relaive o Romania and Bulgaria. These esimaes, which are also included in he European Commission forecas repor (2006), are available a: hp://forum.europa.eu.in/public/irc/ecfin/ougaps/library?1=/2006_auumn_forecas/auumn_2006 resuls/auumn_2006 principal&vm=deailed&sb=tile. Conference May 19-20, 2008, Minsk

128 128 lag, being subse quenly subjeced o revisions. These circumsances increase he uncerainy of real-ime esimaes for poenial GDP and excess demand, requiring revisions as new informaion becomes available. Figure 1. Growh raes of acual and poenial real GDP for eigh counries 8 4 Romania: Spain: % 0 % Grow h rae of real GDP Grow h rae of poenial GDP Grow h rae of real GDP Grow h rae of poenial GDP 8 Greece: Ireland: % Grow h rae of real GDP Grow h rae of poenial GDP % Grow h rae of real GDP Grow h rae of poenial GDP 9 Poland: Hungary: % 3 % Grow h rae of real GDP Grow h rae of poenial GDP Grow h rae of real GDP Grow h rae of poenial GDP Slovakia: Es onia: % 3 % Naional Bank of he Republic of Belarus Source: Denis e al. (2006) Grow h rae of real GDP Grow h rae of poenial GDP Grow h rae of real GDP Grow h rae of poenial GDP

129 129 These aspecs jusify he applicaion of alernaive mehods o idenify he evoluion of poenial GDP in his paper. This approach allows an assessmen of he robusness of resuls, given ha each separae esimae has a relaively high degree of uncerainy. However, i mus be noed ha he mehods used do no correspond sricly o he specific definiion chosen for poenial GDP in he paper. In his paper we have used saisical daa for he 1998Q1 2006Q2 period. The daa sources are publicaions of he Naional Insiue of Saisics, of he Naional Bank of Romania and daa provided by he General Adminisraion of Cusoms, he European Cenral Bank and he US Bureau of Labor Saisics. Deails regarding he source of each ime series, as well as he ransformaions applied o he daa can be found in Appendix Univariae mehods Univariae mehods decompose real GDP ino poenial GDP and excess demand by way of a purely saisical analysis of he pas behavior of he ime series, based on a se of assumpions regarding he dynamics of he rend and he gap. The advanages of univariae mehods reside in he fac ha hey do no rely on he implicaions of any paricular economic heory (so he relevance of he resuls does no depend on he assumpions of he heory) and he fac ha hey can be easily implemened. The disadvanages are a direc consequence of heir univariae characer, he possible ineracions wih oher macroeconomic variables hus being disregarded. In addiion, he oupu of hese mehods does no sricly correspond o a precise economic definiion of poenial GDP or of excess demand. The univariae mehods used in his paper for measuring he growh rae of poenial GDP are he Hodrick-Presco filer, he band-pass filer and wo univariae models wih unobserved componens based on he Kalman filer 1. Averaging he resuls, hese mehods indicae an acceleraion of he average annual growh rae of poenial GDP from 3.6 percen in he 2000Q1 2002Q4 inerval o 6 percen in he 2003Q1 2006Q2 inerval, wih values varying in a range beween percen in he laer period (Table 1). Figure 2: Annual growh raes of poenial GDP univariae filers Mulivariae mehods When decomposing real GDP, 6 mulivariae mehods also use informaion conained in oher macroeconomic variables, 4 aking ino accoun he crossdependencies beween hese 2 and real GDP. The mos frequenly used mulivariae 0 mehods of esimaing poenial GDP are producion func Q1 00Q3 01Q1 01Q3 02Q1 02Q3 03Q1 03Q3 04Q1 04Q3 05Q1 05Q3 06Q1 ions, mulivariae unobserved componens models HP BP UV1 UV2 and srucural vecor auoregression models. The main advanage of hese mehods is ha hey benefi from a larger informaion se, informaion which is hen inerpreed hrough he relaions beween variables suggesed by he economic heory. The main disadvanage is ha hey require longer ime-series han univariae mehods. 1 General aspecs regarding he Kalman filer can be found in Appendix 2, and specific deails regarding univariae filers in Appendix 3. Conference May 19-20, 2008, Minsk

130 The producion funcion approach The producion funcion approach has he advanage of reflecing he supply side of he economy. The main drawback is he resriciveness of he assumpions regarding he funcional form and he uilizaion of producion facors. The mehod was applied using quarerly daa covering he 1998Q1 2006Q2 period for he labor force 1, GDP and gross fixed capial formaion (he laer wo in real erms). Given he shor ime span for which daa is available and he lack of oher necessary parameers, he Cobb-Douglas producion funcion was chosen as a funcional form. The capial and labor weighs were assumed o be 0.33 and , respecively. Compuaion of he capial sock is he main challenge of his mehod. Given he very large variaions in he annual fixed capial sock 3, caused by including frequen reevaluaions in he series provided by he Naional Insiue of Saisics, he use of his series would seriously damage he relevance of he esimaes. The lack of an adequae daa series for his indicaor also precludes he use of gross fixed capial formaion for deermining a variable depreciaion rae. Taking all of hese ino accoun, he chosen annual depreciaion rae was similar o he one generally used in he lieraure, namely 5 percen (implying a quarerly rae of 1.23 percen). To overcome hese consrains, he soluion was o deermine firs he iniial capial sock and subsequenly, using he accumulaion equaion presened below and he daa on gross fixed capial formaion and he depreciaion rae, o ieraively generae he capial sock series. Two mehods were used for deermining he iniial capial sock: he firs one, similar o he approach of Bergoeing e al. (2002) for annual daa, has assumed ha he raio of he capial sock values in he firs wo periods is equal o he geomeric average of he raios in he firs welve quarers 4. he second one, similar o he approach of Harberger (1978), assumes a capial growh rae equal o he average growh rae of real GDP for he analyzed period 5. The wo resuling capial sock series are presened in Figure 3. I has o be poined ou ha he wo mehods have generaed differen dynamics and levels of he capial sock. Once he capial sock is deermined, oal facor produciviy was compued as a residual of he producion funcion; he level of poenial GDP was arrived a by aggregaing he rends of he componens hus idenified. The growh raes compued from he level of poenial GDP hus measured display increasing dynamics, reaching almos 6 percen a he end of he sample, as can be seen from Figure 4. Looking a he 2003Q1-2006Q2 period, he resuls indicae an annual average growh rae of poenial GDP of 5.7 percen for he firs approach, and 6.0 percen for he second, while he growh raes for he enire sample are lower (Table 1). 1 The average number of hours worked per day is assumed o be 8. 2 For deails, see Appendix 4. 3 For example, he raio of he fixed capial sock a he end of 2003 and he one exising a year-end 2002 is 2.35, mainly due o he evoluion of he majoriy sae-owned capial sock (NIS, Romania s Saisical Yearbook: 2005 ). Naional Bank of he Republic of Belarus 4 K T + 1 K T / 12 = ( ) K T K T 5 K The capial accumulaion equaion can be rewrien as: + 1, where δ is he depreciaion rae. K K = δ + Assuming ha he capial growh rae is equal o he average growh rae of real GDP (g in he equaion), we have he following formula for deermining he iniial capial sock: I K = ( g + δ ) I K

131 131 Figure 3. The capial sock (RON billion, 2003 consan prices, seasonally adjused) Q1 2000Q1 2002Q1 2004Q1 2006Q1 0 Capial sock - 2nd mehod (lef scale) Capial sock-1s mehod (righ scale) Mulivariae filers wih unobserved componens The measuremen of poenial GDP using mulivariae filers wih unobserved componens 1 makes use of he informaion conained in oher macroeconomic variables, inerpreed hrough he relaions among he variables implied by he economic heory. In order o decompose he real GDP series, hese models generally use he ineracions wih he real ineres rae and he real exchange rae (hrough he aggregae demand curve equaion), wih he unemploymen rae (hrough Okun s law ) and wih he inflaion rae (hrough he Phillips curve equaion). The advanages of his approach are: he use of a large informaion se in he deerminaion of poenial GDP and excess demand; i is compaible wih economic heory; he approach follows closely he definiion of poenial GDP as he level of GDP which does no generae inflaionary pressures; he esimaes regarding he curren period are updaed in he following quarers by incorporaing new informaion. The disadvanage of he mehod is ha i is relaively difficul o be implemened in pracice since i requires several assumpions (for example, regarding he relaive volailiy of he rend and gap). To esimae Romania s poenial GDP we have used four versions of he mulivariae filer wih unobserved componens. Deails regarding he equaions of each model and he resuls can be found in Appendix 5. The average annual growh rae of poenial GDP in he four versions of he mulivariae filer for he 2003Q1 2006Q2 inerval ranges beween 5.4 and 6.1 percen (Table 1). The growh raes of poenial GDP given by he four versions for he 1999Q4 2006Q2 period are presened in Figure Srucural vecor auoregression (SVAR) The quanificaion of he evoluion of poenial GDP hrough he srucural vecor auoregression (SVAR) mehod is based on esimaing he relaionship beween real GDP growh and oher macroeconomic variables in order o idenify he permanen and emporary shocks o which he economy was subjeced 2. The main advanages of he mehod are: he possibiliy of a beer economic inerpreaion of poenial GDP variaions; he gradual ransmission of a permanen shock o poenial GDP and he fac ha all he resuls are based on economeric esimaes, wihou he arbi- 1 See Appendix 2 for deails on he Kalman filer. 2 See Appendix 6 for deails on using he SVAR model for measuring poenial GDP. Conference May 19-20, 2008, Minsk

132 132 rary seing of parameer values. Among he disadvanages are: higher daa requiremens compared o oher mehods and he risk of obaining a poenial GDP series which closely resembles he acual GDP series when he correlaion beween GDP and he oher variables is weak. Figure 4. Annual growh raes of poenial GDP mulivariae filers (MV) and producion funcion (PF) Q1 00Q3 01Q1 01Q3 02Q1 02Q3 03Q1 03Q3 04Q1 04Q3 05Q1 05Q3 06Q1 MV 1 MV2 MV 3 MV 4 FP1 FP2 SVARs wih wo and hree variables were esimaed for he period 1998Q1 2006Q2, including, alongside real GDP, oher relevan macroeconomic variables: CPI inflaion, CORE2 inflaion, real gross wage, employmen, he regisered unemploymen rae, indusrial producion and he real effecive exchange rae. 9 Figure 5. Annual growh raes of poenial GDP - SVAR Q1 00Q3 01Q1 01Q3 02Q1 02Q3 03Q1 03Q3 04Q1 04Q3 05Q1 05Q3 06Q1 Annual growh rae of real GDP Annual growh rae of poenial GDP (SVAR average) Naional Bank of he Republic of Belarus Noe: The growh rae of annual poenial GDP is he mean of he growh raes resuled from he esimaed SVAR models. The inerval (wih black doed lines) is given by he minima, respecively maxima of he esimaed growh raes of poenial GDP.

133 133 The esimaed SVARs indicae 1 an acceleraion of he average annual growh rae of poenial GDP from 3.3 percen in he 2000Q1 2002Q4 inerval o 6.1 percen in 2003Q1 2006Q2. The values obained from he SVAR models for he average annual growh rae of poenial GDP in he 2003Q1 2006Q2 period range beween 6 and 6.4 percen. The average of he poenial GDP growh raes is presened in Figure 5; in order o assess he variabiliy of he resuls beween he SVAR models, he average growh rae is presened along wih he minimum and maximum growh rae obained for each period wih differen models. In periods in which he real GDP growh rae exceeds ha of he poenial GDP here is an increase in excess demand (a widening of he posiive oupu gap or a closing of a negaive gap), and in periods in which i is lower han he growh rae of poenial GDP here is a decrease in excess demand. 3. CONCLUSIONS This paper presens he resuls of esimaing Romania s poenial GDP growh rae wih several differen mehods. These resuls should be inerpreed wih cauion since hey carry a high degree of uncerainy due o he unobservable naure of he measured variables and he raher small available daa sample. In spie of his, he esimaes arrived a wih differen mehods and specificaions offer similar conclusions, giving ou a uniary message regarding he dynamics and approximae values of poenial GDP growh raes in he period under scruiny. Table 1. Esimaion resuls for he growh rae of annual poenial GDP Approach Model Lags Average 2000Q1-2002Q4 Average 2003Q1-2006Q2 Average 2000Q1-2006Q2 SVAR Regisered unemploymen rae CORE2 inflaion CPI inflaion Employmen + CPI inflaion Employmen + CORE2 inflaion Real effecive exch. rae + CPI inflaion Real effecive exch. rae + CORE2 inflaion Real gross wage + CORE2 inflaion Indusrial producion index + CPI inflaion Average Producion 1 s version funcion 2 nd version Average Univariae filers Hodrick-Presco Band-pass Model UV Model UV Average Mulivariae filers Model MV wih unobserved Model MV componens Model MV Model MV Average The resuls indicae an increasing annual poenial GDP growh rae, from an average of 3-4 percen in he period o values of around 6 percen in recen periods. Thus, Romania s poenial GDP has grown a raes significanly above hose regisered by new EU Cenral and Easern 1 The values presened are he average of he 9 esimaed SVAR models. The resuls of each SVAR model are presened in Table 1. Conference May 19-20, 2008, Minsk

134 134 European member saes and Souh European saes in heir periods of high growh; 1 he magniude of Romania s growh raes is comparable o ha of growh raes in he Balic counries, being exceeded only by he size of growh raes esimaed for Ireland and Lavia. REFERENCES Apel, M. and Jansson P. (1998) A Theory-Consisen Sysem Approach for Esimaing Poenial Oupu and he NAIRU, Economic Leers, vol. 64(3), p Naional Bank of Romania (2002) Inflaion Repor 1/2002 Naional Bank of Romania (2005) Inflaion Repor Augus 2005 Benes, J. and N Diaye P. (2004) A Mulivariae Filer for Measuring Poenial Oupu and he NAIRU: Applicaion o The Czech Republic, IMF Working Paper WP/04/45 Benk, S., Jakab Z. and Vadas G. (2005) Poenial Oupu Esimaions for Hungary: A Survey of Differen Approach, Magyar Nemzei Bank Occasional Paper No. 43 Bergoeing, R., Kehoe, P., Kehoe, T. and Soo, R. (2002) A Decade Los and Found: Mexico and Chile in he 1980s, Review of Economic Dynamics, vol. 5, p Bjornland, H., Brubakk L. and Jore, A. (2006) Forecasing Inflaion wih an Uncerain Oupu Gap, Norges Bank Working Paper 2006/2 Blanchard, O.J. and Quah D. (1989) The Dynamic Effecs of Aggregae Demand and Supply Disurbances, American Economic Review, vol. 79(4), p Cerra, V. and Saxena, S. (2000) Alernaive Mehods of Esimaing Poenial Oupu and he Oupu Gap: An Applicaion o Sweden, IMF Working Paper WP/00/59 Clark, T. and Kozicki, S. (2004) Esimaing Equilibrium Real Ineres Rae in Real-Time, Deusche Bundesbank Discussion Paper Series 1 No. 32/2004 Crespo-Cuaresma, J., Gnan E. and Rizberger-Gruenwald, D. (2003) Searching for he Naural Rae of Ineres: A Euro- Area Perspecive, Oeserreichische Naionalbank Working Paper No. 84 Chrisiano, L. and Fizgerald, T. J. (2003) The band-pass filer, Inernaional Economic Review, 44(2), p Darvas, Z. and Vadas, G. (2003) Univariae Poenial Oupu Esimaions for Hungary, Magyar Nemzei Bank Working Paper 2003/8 Denis, C., Grenouilleau, D., Mc Morrow, K. and Röger, W. (2006) Calculaing poenial growh raes and oupu gaps - A revised producion funcion approach, European Commission Economic Papers No 247 DeSerres, A. and Guay A. (1995) Selecion of he Truncaion Lag in Srucural VARs (or VECMs) wih Long-Run Resricions, Economerics Dobrescu, E. (2004) Double Condiioned Poenial Oupu, paper presened a The 28h General Conference of The Inernaional Associaion for Research in Income and Wealh, Cork, Ireland, Augus 22 28, 2004 Dobrescu, E. (2006). Inegraion of Macroeconomic Behavioural Relaionships and he Inpu-Oupu Block (Romanian Modelling Experience), paper presened a Inernaional Conference on Policy Modelling, Hong Kong European Commission (2006) Economic Forecass Auumn 2006, European Economy 5/2006, forhcoming Faal, E. (2005) GDP Growh, Poenial Oupu, and Oupu Gaps in Mexico, IMF Working Paper WP/05/93 Fabiani, S. and Mesre, R. (2001) A Sysem Approach for Measuring he Euro Area NAIRU, European Cenral Bank Working Paper No. 65 Garnier, J. and Wilhelmsen, B. (2005) The Naural Real Ineres Rae and he Oupu Gap in he Euro Area, European Cenral Bank Working Paper No. 546 Gordon, R.J. (1997) The Time-Varying NAIRU and is Implicaions for Economic Policy, The Journal of Economic Perspecives vol. 11(1), p Greenslade, J., Pierse, R. and Salaheen, J. (2003) A Kalman Filer Approach o Esimaing he UK NAIRU, Bank of England Working Paper No. 179 Guarda, P. (2002) Poenial Oupu and he Oupu Gap in Luxemburg: Some Alernaive Mehods, Banque Cenrale du Luxembourg Working Paper No. 4 Hamilon, J. (1994) Time Series Analysis, Princeon Universiy Press, Princeon, New Jersey Harberger, A. (1978) Perspecives on Capial and Technology in Less Developed Counries, Conemporary Economic Analysis Harvey A. (2001) Forecasing, srucural ime series models and he Kalman filer, Cambridge Universiy Press Naional Bank of he Republic of Belarus 1 According o he resuls of Denis e al. (2006), mos of hese counries regisered poenial GDP growh raes ranging beween 3 and 5 percen.

135 135 Harvey A. and Jaeger A. (1993) Derending, Sylied Facs and he Business Cycle, Journal of Applied Economerics, vol. 8(3), p Hodrick, R. J. and Presco, E. C. (1997) Poswar US Business Cycles: An Empirical Invesigaion, Journal of Money Credi and Banking, vol. 29(1), p.1-16 Hoffmann, M. (2001) Long run recursive VAR models and QR decomposiions, Economics Leers, vol. 73(1), p Naional Insiue of Saisics (2005) Anuarul Saisic al României ( Romania s Saisical Yearbook ) IMF (2006a) Romania: 2006 Aricle IV Consulaion - Saff Repor; Saff Saemen; Public Informaion Noice on he Execuive Board Discussion; and Saemen by he Execuive Direcor for Romania, IMF Counry Repor No. 06/168 IMF (2006b) Ukraine: Seleced Issues, IMF Counry Repor No. 05/416 Larsen, J. and McKeown, J. (2004) The Informaional Conen of Empirical Measures of Real Ineres Rae and Oupu Gaps for he Unied Kingdom, Bank of England Working Paper No. 224 Laubach, T. and Williams, J. (2001) Measuring he Naural Rae of Ineres, FEDS Working Paper No Llosa, G. and Miller, S. (2005) Using Addiional Informaion in Esimaing he Oupu Gap in Peru: A Mulivariae Unobserved Componen Approach, Banco Cenral de Reserva del Peru Working Paper Lukepohl, H. (2005) New Inroducion o Muliple Time Series Analysis, Springer Manrique, M. and Marques, J. (2004) An Empirical Approximaion of he Naural Rae of Ineres and Poenial Growh, Banco de Espana Working Paper No Appendices Appendix 1. Daa sources 1 Quarerly real GDP for he period 1998Q1-2006Q2 was compued saring from he consan price GDP (2003 average price) published by he Naional Insiue of Saisics (NIS) for 2005, expanded based on he quarerly year-on-year growh raes of real GDP published in NIS bulleins saring from 1999Q1. Real gross fixed capial formaion, used in consrucing he fixed capial series, was compued in a way similar o he one described above for real GDP. Daa on employmen has been published by he NIS in Labor Force in Romania: Employmen and Unemploymen bullein. Daa regarding he indusrial producion index is aken from he Indusry Saisical Bullein of he NIS, daa on he regisered unemploymen rae, he number of employees and he gross wage economy-wide from he Monhly Saisical Bullein released by he NIS, while consumer price index (CPI) daa from he Prices Saisical Bullein, published by he NIS. CORE2 inflaion daa (CPI excluding adminisered prices, fuel prices and volaile food prices) 2 are compued by he NBR based on he disaggregaed CPI daa provided by he NIS. Average RON/EUR and RON/USD exchange rae daa, used in consrucing he effecive exchange rae are published in he NBR monhly bullein, while he currency srucure of foreign rade is aken from he Naional Cusoms Auhoriy. Price indices for Euro Area (HICP) and USA (US CPI) are aken from ECB and he Bureau of Labor Saisics. Real GDP and real gross fixed capial formaion daa series were seasonally adjused using Demera, while he unemploymen rae, number of employees, gross wage and indusrial producion index daa were seasonally adjused using he X12-ARIMA procedure. The regisered unemploymen rae series spiked by more han 3 percenage poins in January 2002, breaking he downward rend regisered in he previous quarers 3. The implemenaion of Law 416/2001 regarding he guaraneed minimum income generaed his increase as suddenly a large number of people regisered as unemployed alhough hey were no fulfilling he necessary condiion of acively searching for a job. In he following monhs, while hese persons were eliminaed from he saisics of he Naional Employmen Agency, he above menioned effec dissipaed, he unemploymen rae reurning o is previous values by June Taking ino accoun he arificial characer and he high ampliude of his emporary increase, he unem- 1 Daa used are available upon reques ([email protected]). 2 See Box 1 from Inflaion Repor, Augus 2005, page See Inflaion Repor, I/2002 (former series). Conference May 19-20, 2008, Minsk

136 136 ploymen rae daa series was adjused by eliminaing he effec from he firs and second quarers of Furhermore, he employmen daa series suffered major changes in he firs quarer of 2002 owing o a change in NIS mehodology. The series was adjused by assuming zero growh beween 2001Q4-2002Q1, and he daa prior o 2001Q4 was recursively correced using he quarerly differences aken from he daa based on he previous mehodology. Appendix 2. The Kalman filer Unobserved componens models can be represened in sae space form 1. This represenaion assumes ha he dynamics of a (p 1) vecor y wih observable variables can be described wih he help of a (m 1) vecor α of unobservable componens. The sae space represenaion is in he form of he following sysem: α +1 = Tα + Rη y = Z α + ε, where T, Z and R are parameer marices wih dimensions (m m), (p m) and (m r). The firs equaion is known as he sae (ransiion) equaion while he second one is he measuremen (observaion) equaion. Vecors η and ε (dimensions (r 1) and (p 1)) are normally disribued η ~N(0, Q ), and ε ~N(0, H ), where Q and H are covariance marices (dimensions (r r) and (p p)). I is assumed ha he error vecors η and ε are uncorrelaed for all lags, E ( η ε τ ) =0 for any and τ. Le a 1/ α +1 + = E ( +1 Y ) α and + 1 Var α +1 Y, be he condiional mean and condiional variance of using informaion up o momen, where Y = { y 1, y 2,..., y } represens he informaion se. P = ( ) The recursive equaions for deermining he condiional mean and he condiional variance of he sae variables are: a +1 = a T + K v şi P + 1 = T P L + R Q R, for =1,...,n, where K = T P Z F 1, v = y - Z a, F = Z P ZT + H, L = T - K Z. This sysem of equaions is known as he Kalman filer. Le a / = E ( ) α Y and P = Var ( ) using informaion up o dae, where α Y be he condiional mean and he condiional variance of α Y = { y y,..., } 1, 2 y is he informaion se up o he curren momen. The conemporaneous filraion equaions are given by: a +1 = T a / and P + 1 = T P L R Q R, for = 1,...,n, where / + a / = a + M F 1 v, P / = P - M F M 1 and F = Z P ZT + H, M = P, Z v = y - Z a, Naional Bank of he Republic of Belarus 1 Exensive deails regarding he design and esimaion of sae space models and Kalman filer are presened in Hamilon (1994), chaper 13, or Harvey (2001).

137 137 The parameers are esimaed hrough maximum likelihood. The iniial sae vecor α1 is normally disribued α 1 ~N( a 1, P 1 ) and assumed o be known. Taking logs of he likelihood funcion gives he following expression: n np 1 1 L = log 2 [ log F + v F v ] log ( y) 2 π, where he F marix is non singular. 2 = 1 v and F are compued wih he help of he Kalman filer, using he equaions above. Appendix 3. Univariae filers In esimaing poenial GDP, hree ypes of univariae filers were used for he period 1998Q1 2006Q2. The Hodrick-Presco filer (HP Hodrick and Presco, 1997) is he mos common univariae mehod used in he esimaion of poenial GDP in applied economic research. The filer deermines he rend of a ime series (poenial level for he real GDP case) by simulaneously minimizing boh he variance of he daa around he rend (gap volailiy) and he variance of he growh rae of he rend. The rade-off beween he wo generally conflicing objecives is solved hrough a muliplier, λ, seing heir relaive weighs. For deermining poenial GDP, we used λ = 1600, which is he recommended value for quarerly daa. The band-pass filer (BP), inroduced by Chrisiano and Fizgerald (1995), decomposes he ime series in componens wih periodical flucuaions, each of he componens corresponding o a cerain frequency/periodiciy. For example, flucuaions occurring a a four-quarer period are idenified wih he seasonal componens, while hose occurring a a 6-32-quarer inerval are usually associaed wih business cycles flucuaions. Poenial GDP was compued by eliminaing from he real GDP series he componens wih periodiciy shorer han 32 quarers. Each of he above-menioned filers are paricular cases of univariae unobserved componens models, for which he Kalman filer is used o ge he soluion. The univariae unobserved componens models decompose ime series in a permanen componen (rend), a cyclical componen and a residual erm, each having a law of moion. This srucural decomposiion is proposed by Harvey and Jaeger (1993), being used in resriced or unresriced forms in oher papers like Bjornland, Brubakk and Jore (2006), Cerra and Saxena (2000), Darvas and Vadas (2003), Faal (2005) and Guarda (2002). The firs univariae unobserved componens model (Model UV1) decomposes he observable series (real GDP) in hree componens: poenial GDP, excess demand and a residual erm. Laws of moion are specified for each of hese componens. Namely, he growh rae of poenial GDP is assumed o follow a random walk process, while for he excess demand (GDP gap) a second order auoregressive process is assumed. The random walk specificaion is preferred for he growh rae of poenial GDP considering ha daa is available only for a shor sample wih imporan srucural breaks. Model equaions are presened below (sandard errors in brackes): y P = y + y _ gap + ε y ( y ), Var ε =0.01 (1.75) y P P = y 1 + y P / 4 y = y 1 + ε ( P ), Var P P P ε =0.83 (3.38) Conference May 19-20, 2008, Minsk

138 138 y _ gap = 0.81y _ gap y _ gap 2 ( C ), Var ε C + ε =2.85 (0.18) (0.11) (3.37) where y is log of real GDP, P y log of poenial GDP, P y is he growh rae of poenial GDP and y _ gap he GDP gap in percenage poins. Error erms are idenically and independenly disribued (i.i.d.) and pairwise uncorrelaed. As in he firs model, he second one (Model UV2) decomposes he real GDP series in hree pars: poenial GDP, excess demand and a residual erm. While excess demand is sill specified as a second order auoregression, in UV2 he level of poenial GDP (as opposed o he growh rae in he previous model) follows a random walk process. The model s equaions are presened below (sandard errors in brackes), wih variables having he same meaning as in he firs model. Also in his case, error erms are i.i.d. and pairwise uncorrelaed. y y y P P = y + y _ gap P P + ε y = y 1 + ε ( ) P, Var gap ε ( ) y, Var ε =0.00 (0.29) =1.01 (0.22) ( ) C _, Var ε = 0.91y _ gap y _ gap 2 + ε C =0.50 (0.41) (0.27) (0.50) The annual growh raes of poenial GDP resuled from applying he four univariae filers presened in his appendix are shown in Table 1. The average annual growh rae of poenial GDP for he 2000Q1-2006Q2 period is 4.85%, while i is higher, namely 5.99% if only he period 2000Q1-2006Q2 is aken ino accoun. Appendix 4. Producion funcion For using he producion funcion approach in esimaing poenial GDP, we used quarerly daa for employmen 1, GDP and gross fixed capial formaion, he laer wo in real erms, for he period 1998Q1-2006Q2. The ypes of producion funcions used in he lieraure are paricular forms of he consan elasiciy of subsiuion (CES) funcion, wih he following general form in he case of wo producion facors 2 : where: γ γ 1 ( αk + ( 1 α ) L ) γ Y = A (*) Y is oupu, A is oal facor produciviy, K is he capial sock and L represens he labor force. Alpha ( α ) is he capial s conribuion o oupu formaion, while γ deermines he degree of subsiuion beween he wo facors. Regarding he las parameer, he following relaion is valid in connecion wih he elasiciy of subsiuion: σ 1 γ =. σ In he paricular case of uni elasiciy of subsiuion, ( σ = 1, equivalen wih γ = 0 ), he relaion (*) presened above becomes Y = AK L α 1 α, namely a Cobb-Douglas producion funcion. Naional Bank of he Republic of Belarus 1 An average of 8 hours per day was aken ino accoun for working hours. 2 Alhough here can be oher ways in which oal facor produciviy is incorporaed.

139 139 Alhough he uni elasiciy of subsiuion is a srong assumpion, no imposing i would mean separaely esimaing is value or adoping a value used in similar sudies, he laer approach being followed for example by Benk, Jakab and Vadas (2005) for Hungary 1. Considering he lack of necessary daa for esimaing he elasiciy of subsiuion parameer (usually a panel daa approach is needed wih deailed daa for each firm), he lack of a sudy on Romania which could sugges values for he parameer and he large scale uilizaion in he lieraure of he Cobb-Douglas producion funcion, his specificaion was also adoped for his paper. Furhermore, rying o esimae capial and labor conribuions o he oupu in he Cobb-Douglas producion funcion did no yield economically meaningful resuls. On he oher hand, small variaions in hese conribuions (e.g. 0.7 for labor and 0.3 for capial) produce similar resuls. The assumed parameer values (0.67 for labor and 0.33 for capial) are also close o he ones of Dobrescu (2006), who finds a value of approximaely 0.65 for he weigh of labor in he producion funcion. The annual depreciaion rae is assumed o be similar wih he one used in mos oher sudies, 5% (yielding a quarerly rae of 1.23%). A higher depreciaion rae would be jusified for he beginning of he ransiion period, bu aking ino accoun he ime elapsed and he presumably higher weigh of buildings in he capial sock, he value menioned above is a reasonable one. The resuls are presened in Subsecion of he paper. Appendix 5. Mulivariae filers wih unobserved componens The mulivariae Kalman filer wih unobserved componens was used o esimae several models for he 1998Q1-2006Q2 period. The firs model (Model MV1) has wo main equaions: a Phillips curve and a law of moion for he oupu gap. Equaions are presened below (sandard errors in brackes). π =.40π + (1 0.40) π y _ gap + ε 0 1, Var ( ) e π π (0.00) (0.01) (0.00) ygap ygap = 0.81y _ gap y _ gap 2 + ε (0.01) (0.01) (0.00) ε =1.00 (5.1) y _ gap, Var ( ε ) =0.01 (5.2) y = y 1 + ε ( ) yp, Var P P P yp y = y + y _ gap + ε y ε =0.00 (5.3) (0.00) ( ) y, Var ε =0.01 (5.4) (0.00) e π is CORE2 inflaion and π represens a measure of inflaion expecaions. The inflaion expecaions were approximaed by an equally weighed average of CPI inflaion for he previous, curren P and following wo quarers. As in he case of univariae filers, y is he log of real GDP, y log of P poenial GDP, y poenial GDP growh rae and y _ gap Error erms are i.i.d. and pairwise uncorrelaed. is he GDP gap in percenage poins. Equaion (5.1) shows he dynamics of curren inflaion as a funcion of pas inflaion, inflaion expecaions and excess demand. We impose he sandard homogeneiy resricion of he coefficiens on pas inflaion and inflaion expecaions summing o 1. Equaion (5.4) is an ideniy where he real GDP level is decomposed in a poenial level, deviaion from rend and a residual erm. These componens have 1 Even in his case he auhors emphasize he high uncerainy degree of he esimaed parameer. Conference May 19-20, 2008, Minsk

140 140 he following laws of moion: a second order auoregressive process in he case of he deviaion from rend (equaion 5.2) and a random walk process for he growh rae of poenial GDP (equaion 5.3). The average annual growh rae of poenial GDP is 5.86% for he 2003Q1-2006Q2 period. The simulaneous esimaion of poenial GDP and NAIRU Wih he second mulivariae model wih unobserved componens (model MV2) he poenial GDP and he non-acceleraing inflaion rae of unemploymen (NAIRU) are simulaneously idenified. These ypes of models usually include an inflaion equaion, an Okun s law and equaions describing he dynamics of poenial GDP and NAIRU. There are differen approaches o he specificaion of he inflaion equaion, which depends on is own ineria, inflaion expecaions, excess demand and on various supply facors. Some auhors, such as Apel and Jansson (1998), Cerra and Saxena (2000), Fabiani and Mesre (2001), Greenslade, Pierse and Salaheen (2003), esimae a version of he Phillips curve called he riangle Phillips curve, wih a variable NAIRU, an approach firs inroduced by Gordon (1997). They use as dependen variable he firs difference of he inflaion rae, hus imposing a homogeneiy condiion, according o which, in he long run, here is no link beween inflaion and excess demand. Oher auhors, such as Benes and N Diaye (2004), Bjornland, Brubakk and Jore (2006), use as dependen variable he level of he inflaion rae and he homogeneiy resricion is ha he sum of coefficiens on pas inflaion raes and on inflaion expecaions equal 1. Likewise, here are differen approaches regarding he laws of moion of NAIRU and growh rae of poenial GDP. Namely, he assumed processes depend on he order of inegraion of he series and srucural changes ha ook place in he economy hroughou he analyzed period. Furhermore, Okun s law can be specified in a differen manner depending on he causaliy relaion beween he cyclical componens of unemploymen and GDP. Therefore, depending on he characerisics of each economy, he auhors consider as dependen variable in Okun s law eiher he oupu gap, or he deviaion of he unemploymen rae from is rend. The esimaed model has hree equaions: a Phillips curve, Okun s law and a law of moion for he deviaion of he unemploymen rae from is rend 1. Sandard errors are in brackes. π e π π =.24π 1 + (1 0.24) π y _ gap 1 + ε (0.07) (0.04) (0.62) 0, Var ( ) ygap ygap = 0.22u _ gap u _ gap 2 + ε (0.65) (0.61) (0.71) ε =5.77 (5.5) y _ gap, Var ( ε ) =1.29 (5.6) u _ gap P ugap = 0.85u _ gap u _ gap 2 + ε (0.19) (0.23) (0.59) y = y 1 + ε ( ) yp, Var u P yp * * u* u 1 ε = + δ + ε ( ) u*, Var ε ( ) ugap, Var ε =0.35 (5.7) =1.85 (5.8) (2.29) =0.00 (5.9) (0.86) Naional Bank of he Republic of Belarus 1 Two oher versions of his model have been esimaed. The firs one reverses causaliy beween he cyclical componen of unemploymen and GDP (equaion 5.6), and he GDP gap appears conemporaneously in he inflaion equaion. For he period 2003Q1-2006Q2 he average growh rae of poenial GDP is 6.01% per year. In he second version, he Phillips curve is specified having as dependen variable he firs difference of CORE2 inflaion, while he independen variables in he unemploymen gap equaion are he pas values of he GDP gap. In his case, he average growh rae of poenial GDP is 6.20% per year for he period 2003Q1-2006Q2.

141 δ δ = δ + ε ( ) δ 1, Var ε =0.05 (5.10) (0.15) 141 y = y + y _ gap, (5.11) P u = u u _ gap, (5.12) * + Variables have he same inerpreaion as in he firs model. Addiionally, u is he regisered un- * employmen rae, u is is rend and u _ gap erms are i.i.d. and pairwise uncorrelaed. is he deviaion from he rend. Also in his case, error Equaion (5.5) shows he dynamics of he curren inflaion rae, as a funcion of pas inflaion, inflaion expecaions and excess demand. The coefficiens on pas inflaion and on inflaion expecaions, respecively, sum o 1. This resricion is imposed because, in he long run, here is no link beween he cyclical componen of GDP and inflaion. Equaion (5.6) represens Okun s law, a relaion beween he unemploymen rae gap and he oupu gap. Equaion (5.7) is a second order auoregressive process for he unemploymen gap. In addiion, here is an equaion for he growh rae of poenial GDP, as a random walk process (5.8). The equaions (5.9) and (5.10) describe a random walk wih drif for he unemploymen rend, ( δ in urn, is a random walk process). The average growh rae of poenial GDP was 6.08 percen per year for he 2003Q1 2006Q2 period and 4.72 percen per year for he 2000Q1 2006Q2 period. Simulaneous idenificaion of he poenial GDP and he neural ineres rae The simulaneous idenificaion of he naural ineres rae (he neural ineres rae or he ineres rae rend) and he growh rae of poenial GDP using Kalman filer was inroduced by Laubach and Williams (2001). In his conex, he naural ineres rae is defined as he level of he ineres rae consisen wih GDP saying a is poenial level, respecively he level of GDP which does no pu pressure on inflaion. The same mehod was laer also applied by Clark and Kozicki (2004), Crespo-Cuaresma, Gnan and Rizberger-Gruenwald (2003), Garnier and Wilhelmsen (2005), Larsen and McKeown (2004), Llosa and Miller (2006), Manrique and Marques (2004). Laubach and Williams (2001) specify he Phillips curve wih core inflaion as he dependen variable, as a funcion of is own lags, he oupu gap and he deviaion of relaive prices (such as impor prices or he oil price) from core inflaion. The aggregae demand equaion includes lags of he oupu gap and of he real ineres rae gap. The neural ineres rae is specified as a funcion of poenial GDP growh and a erm embedding oher fundamenal deerminans of he neural ineres rae (such as he households rae of ime preference). The hird mulivariae model wih unobservable componens (Model MV3) esimaed in his paper consiss of a Phillips curve, an equaion for aggregae demand and laws of moion for he real ineres rae gap, he neural ineres rae and he growh rae of poenial GDP. δ π =.48π + (1 0.48) π y _ gap + ε 0 1, Var ( ) e π π (0.40) (0.63) (10.75) ε =20.53 (5.13) Conference May 19-20, 2008, Minsk

142 142 y _ gap ygap Var ( ) = 0.93y _ gap y _ gap r _ gap r _ gap 2 (1.09) (0.44) (0.27) (0.26) ε =13.92 (5.14) (26.93) r _ gap, Var ( ε ) =29.39 (5.15) rgap rgap = 0.55r _ gap r _ gap 2 + ε (0.63) (0.57) (17.94) + ε ygap The variables have he same significance as in he firs model. Addiionally, he ineres rae considered in he model, r, is he average ineres rae on NBR s serilizaion operaions (one-monh deposi-aking operaions, hree-monh cerificaes of deposi and he deposi faciliy). The real ineres rae is compued ex ane using as an approximaion for inflaion expecaions a simple arihmeic average of CPI inflaion raes for he previous wo quarers, he curren and he following quarer. r * sands for he neural ineres rae, and r _ gap error erms π ε, ygap ε, rgap ε, yp ε, y ε and r* ε are i.i.d. wih no cross-correlaion. is he real ineres rae gap. The Equaion (5.13) ses ineres rae as a funcion of is persisence, inflaion expecaions and excess demand. In he aggregae demand equaion (5.14) he oupu gap is a funcion of is own lags and he lags of he real ineres rae gap. (5.15) is a second order auoregressive process for he real ineres rae gap. (5.16) and (5.17) are ideniies for he componens of GDP and he real ineres rae. Equaions (5.18) and (5.19) are laws of moion for he growh rae of poenial GDP and he real ineres rae rend. P y y y = y + y _ gap + ε, Var ( ε ) =0.03 (5.16) (7.13) r = r r _ gap, (5.17) * + P P yp yp y = y 1 + ε, Var ( ε ) =0.07 (5.18) (0.82) r r* = + ε, Var ( ε ) =3.68 (5.19) * * r* r 1 (4.15) The resuls poin o an average growh rae of poenial GDP of 5.37 percen over 2003Q1-2006Q2. The fourh mulivariae model wih unobservable componens (Model MV4) has four main equaions: a Phillips curve, an aggregae demand equaion, a law of moion for he real ineres rae gap and an equaion for he deviaion of he real exchange rae of he domesic currency from is rend. e nd π =.83*(0.34π + (1 0.34) π ) y _ gap + (1 0.83)( π _ pm z ) + ε 0 1 (0.06) (0.14) (0.10) π Var ( ε ) =6.11 (5.20) (0.67) π Naional Bank of he Republic of Belarus y _ gap + ε, ygap Var ( ) = 0.66 y _ gap r _ gap z _ gap 1 (0.05) (0.04) (0.04) ε =0.93 (5.21) (0.19) ygap

143 143 The variables have he same significance as in he firs model. Addiionally, z sands for he loga- * rihm of he effecive real exchange rae, z for he logarihm of he rend of he real exchange rae, and z _ gap for he real exchange rae gap. The average of he CPI inflaion raes for he previous, curren and he nex wo quarers was used as an approximaion of inflaion expecaions. π _ pm represens he inflaion rae of impor prices, compued using he HICP inflaion rae and he nominal effecive exchange rae. The error erms and are no cross-correlaed. π ε, ygap ε, rgap ε, zgap ε, yp ε, r* ε and znd ε are i.i.d. Equaion (5.20) describes he inflaion rae as a funcion of is persisence, inflaion expecaions, oupu gap and impor prices. In he aggregae demand equaion (5.21) he oupu gap is a funcion of is own persisence and lags of he real ineres rae and real effecive exchange rae gaps. (5.22) (5.24) are ideniies for he componens of GDP, he real ineres rae and he real effecive exchange rae. Equaions (5.25) (5.27) are laws of moion for poenial GDP growh, he real ineres rae rend and he growh rae of he real effecive exchange rae rend. Equaions (5.28) and (5.29) are second order auoregressive processes for he real ineres rae gap and he real effecive exchange rae gap, respecively. y = y + y _ gap, (5.22) P r = r r _ gap, (5.23) * + z = z z _ gap, (5.24) * + P P yp yp y = y 1 + ε, Var ( ε ) =0.10 (5.25) (0.04) r = ε, Var ( ε ) =0.04 (5.26) * * r* r* r 1 (0.0) (0.00) nd nd znd znd z = z 1 + ε, Var ( ε ) =0.10 (5.27) (0.02) r _ gap, Var ( ε ) =0.30 (5.28) rgap rgap = 0.80r _ gap r _ gap 2 + ε (0.00) (0.00) (0.00) z _ gap, Var ( ε ) =2.03 (5.29) zgap zgap = 0.76z _ gap z _ gap 2 + ε (0.06) (0.04) (0.19) Over 2003Q1-2006Q2, he average growh rae of poenial GDP was 5.78 percen per year. The esimaion resuls for he four models are presened in Table 1. Appendix 6. Srucural vecor auoregression (SVAR) The evoluion of poenial GDP can be deermined hrough srucural vecor auoregression (SVAR) models by imposing resricions in he long run on he effec of srucural shocks (resricions of he ype inroduced by Blanchard and Quah, 1989). The measuremen of he evoluion of poenial GDP by using he SVAR 1 mehod is done in hree seps: 1 Using srucural VAR models is par of he sandard economeric mehodology, so deailed explanaions can be found in mos ime series exbooks (e.g. Hamilon, 1994, or Lukepohl, 2005). Conference May 19-20, 2008, Minsk

144 Esimaion of a reduced VAR model A reduced VAR model A = ( L) x u is esimaed, where x is a vecor of macroeconomic variables and u is a vecor of i.i.d. residuals wih zero mean and covariance marix E ( u u ' ) = Ω. The x vecor includes real GDP growh along wih one or more oher economic variables. The VAR model is ofen used o capure empirically he dynamic inerdependency among macroeconomic variables wihou a priori imposing resricions based on economic heory. If x is saionary, he Wold heorem implies ha i can be represened as a moving average of pas residuals x = C( L) u. 2. Idenificaion of he srucural shocks The srucural shocks which have affeced he economy over he considered sample are idenified by decomposing he residuals of he esimaed VAR model. Thus, i is assumed ha he reduced form residuals are linear combinaions of he srucural shocks u = Sε, where he srucural shocks are conemporaneously uncorrelaed model is rewrien in he srucural VAR (SVAR) form as x he economic variables as driven by pas srucural shocks. n E ( ε ε ' ) = I. Wih he noaion D ( L) = C( L) S he = D( L) ε, explaining he dynamics of To decompose he residuals we need some resricions o allow he unique idenificaion of S, he marix which conrols he way srucural shocks combine o generae he esimaed residuals u. In order o measure he growh rae of poenial GDP, he resricions are of he Blanchard-Quah ype. These are expressed in he condiion ha D ( 1) = C(1) S is an inferior riangular marix, pracically requiring ha he cumulaed effecs of he ε i srucural shock (he i-h shock in he model) on each of he x j variables wih j<i be null (e.g., he cumulaed effecs of he hird srucural shock on he firs wo variables would be null). Consequenly, he ordering of he variables in he VAR model maers for he srucural decomposiion. The condiions underlying he Blanchard-Quah resricions are suggesed by he requiremen ha he variaion of he oupu gap becomes zero in he long run. The srucural decomposiion of he residuals was compued using he algorihm proposed by Hoffman (2001). 3. Deerminaion of he growh rae of poenial GDP In he analysis, he firs variable in he VAR is he quarerly growh rae of real GDP. As a resul of he resricions, he firs srucural shock has permanen effecs on economic growh, while he oher srucural shocks idenified have only ransiory effecs (he long-run cumulaed effec each of hese has on he growh rae of real GDP is zero). The growh rae of poenial GDP is idenified wih he componen of real GDP growh deermined by permanen shocks, while he oupu gap variaion is idenified wih he componen deermined by he ransiory shocks. As he mehodology achieves a decomposiion of economic growh in poenial GDP growh and he variaion of he oupu gap, o measure he level of poenial GDP and he oupu gap i is necessary o addiionally deermine/impose an iniial condiion regarding he value of excess demand a one momen in he sample. Considering ha such an iniial condiion would be arbirary, as well as ha he inenion of he paper is o measure he growh rae of poenial GDP, we do no use he esimaion resuls o measure he level of he oupu gap. Naional Bank of he Republic of Belarus To measure poenial GDP growh we esimaed SVAR models over he 1998Q1-2006Q2 sample. The small daa sample available pus resricions on he number of variables considered in he same model, as inroducing addiional variables leads o a rapid loss of degrees of freedom hrough he large number of parameers o be esimaed. The imporance of his resricion is increased by

145 145 he fac ha inroducing a large number of variables wih a small sample may force he selecion of insufficien lags, hus leading o sysemaic errors in he esimaion of he srucural componens (DeSerres and Guay, 1995). Consequenly, he esimaed SVARs include wo or hree variables he growh rae of real GDP and one or wo explanaory facors. The explanaory variables are chosen o reflec he effec of various ypes of ransiory shocks: emporary demand shocks (CPI inflaion, CORE2 inflaion), supply shocks (real gross wage, he number of employees, regisered unemploymen rae, he volume of indusrial producion) or shocks on he effecive real exchange rae (which could be he effecs of moneary policy shocks or exernal shocks). In he SVARs wih hree variables, one of he explanaory variables is always CPI or CORE2 inflaion in order o cach he effec of emporary demand shocks (considered relevan for moneary policy purposes). In hese cases, he inflaion rae appears las in he VAR o allow he demand shock o produce emporary effecs on all he oher variables. All he variables have been checked for uni roos using he Augmened Dickey-Fuller (ADF) and Phillips-Perron (PP) ess. For he nonsaionary variables (real GDP, he number of employees, he real effecive exchange rae, he real gross wage, and he indusrial producion index) we used he firs difference in esimaion so ha he VAR models would be sable. In some cases (CPI inflaion, he unemploymen rae), he wo ess have conflicing resuls; as he esimaed VARs have all he characerisic roos inside he uni circle, he variables were considered saionary. The opimal lag lengh was chosen based on he Akaike informaion crierion o insure a number of lags large enough o avoid sysemaic errors; he lag lengh hus chosen is in all cases greaer or equal o he one suggesed by he Wald and LR ess, which give good resuls regarding he minimum number of necessary lags according o DeSerres and Guay (1995). The signs of he impulse response funcions (compued based on he idenified srucural shocks) confirm he inerpreaion of shocks, generally being in line wih he inuiion suggesed by economic heory 1. Thus, a permanen shock on real GDP (considered a poenial GDP shock) leads in he esimaions o a decrease in he inflaion rae (boh CPI and CORE2), o a permanen decrease in he rae of unemploymen and o acceleraed growh in he number of employees, permanen increase in he indusrial producion, inensificaion of he real gross wage growh and of exchange rae appreciaion. A posiive demand shock is refleced in a emporary rise in excess demand, paired by emporary acceleraed growh in he number of employees/ emporary decrease in he unemploymen rae, as well as emporary inensificaion in he growh of indusrial producion and of he real wage. A posiive supply shock (permanenly higher growh of he indusrial producion or he number of employees/ permanen drop in he unemploymen rae) leads o a emporary decrease of he oupu gap and a decrease in inflaion. A cos-push shock, by permanenly raising he real gross wage, leads o higher inflaion and o ransiory oscillaions in economic growh, while a depreciaion shock feeds ino a emporary increase in excess demand and higher inflaion. The variance decomposiion shows ha he explanaory variables included in he esimaed VAR models explain in mos cases less han 30 percen of he variaion in real GDP growh (Table 2). As such, he reduced explanaory power may lead o underesimaion of he effec of he ransiory srucural shocks (mainly illusraed by hese explanaory variables) on economic growh. An underesimaion of he variaion of excess demand (defined as he cumulaed impac of ransiory shocks) implies, in counerpar, an overesimaion of he variaion in poenial GDP. Thus, he esimaed poenial GDP growh follows oo closely he evoluion of acual real GDP or, pu anoher 1 These are only general, qualiaive comparisons, as i is difficul o compare he resuls of esimaed VARs wih specific heoreical models as a resul of he resricions implici in he specificaion; hus, for insance, in he specificaions above i is impossible o idenify a supply shock producing emporary effecs on GDP as well as on he rae of unemploymen. Conference May 19-20, 2008, Minsk

146 146 way, he mehod produces growh raes of poenial GDP which are oo high in periods of rapid growh and oo low in periods of slow growh (effec visible in Figure 5). From his poin of view, we favor he hree-variable SVAR models which, due o he addiional variable, explain he evoluion of real GDP beer han he wo-variable ones. This effec is illusraed by he resuls for he average annual growh rae of poenial GDP over 2003Q1-2006Q2, which says in a igher range in he case of rivariae SVARs ( percen) han in he case of bivariae SVARs ( percen). On he oher hand, he rivariae SVAR models are generally based on a larger number of esimaed parameers using he same daa sample, so he degree of uncerainy in he esimaion is higher. Table 2. The explanaory power of he variables for he growh rae of real GDP SVAR model Lags R 2 in he real GDP growh equaion (%) The weigh of he effec of ransiory shocks in he variance decomposiion of he real GDP growh (%) 1 quarer 10 quarers Regisered unemploymen rae CORE2 inflaion CPI inflaion No. employees + CPI inflaion No. employees + CORE2 inflaion Real effecive exch. rae + CPI inflaion Real eff. exch. rae + CORE2 inflaion Real gross wage + CORE2 inflaion Indusrial prod. index + CPI inflaion Observaion: he variance decomposiion is based on he srucural decomposiion used for compuing he growh rae of poenial GDP. The esimaion resuls regarding he growh rae of poenial GDP are presened in Table 1. Each line in he able represens an esimaed model including quarerly real GDP growh and he explanaory variable or variables in he firs column. The resuls poin o he acceleraion of average annual poenial GDP growh from 3.3 percen over 2000Q1-2002Q4 o 6.1 percen over 2003Q1-2006Q2. The resuls of he SVAR models place he average annual growh rae of poenial GDP over 2003Q1-2006Q2 in he range of percen. Naional Bank of he Republic of Belarus

147 147 Aleksejs Meļihovs, Gundars Dāvidsons 1 The Role of Producion Progress and Human Capial in he Economic Growh of Lavia The paper ses a goal o assess he impac of producion progress and human capial o Lavia's economic developmen. The auhors made an aemp o consruc a producion funcion using non-linear modelling. An approach, slighly differing from ha used so far for he descripion of echnological process in he models for Lavia's producion funcion, has been applied because he auhors of his paper believe i reveals he evoluion of he echnological process more realisically. Inroducion When in he middle of he 20h cenury a number of new saes emerged, many prediced ha heir economic developmen would be fas. Though in many cases such predicions were underpinned by cerain heoreically consruced models (like he Solow Swan model), hey did no maerialise. The sudies laer in he 1980s proved ha he real siuaion since he 1960s was no consisen wih he producion funcion under he sandard Solow Swan model. R. J. Barro wries: "Therefore, in he absence of shocks, poor and rich counries would end o converge in erms of levels per capia income. However, his convergence seems o be inconsisen wih cross-counry evidence, which indicaes ha per capia growh raes are uncorrelaed wih he saring level of per capia produc." (Barro (1989). Observaions made in he 1990s renewed he discussion of wha he producion funcion should be. The main problem soluion, i was discovered, was he producion funcion augmened by human capial. The paper ses a goal o assess he impac of echnological progress and human capial and o esimae long-erm growh raes of Lavia's economic developmen. The auhors made an aemp o consruc a producion funcion using non-linear modelling. An approach, slighly differing from ha used so far for he descripion of echnological process in he models for Lavia's producion funcion, has been applied because he auhors of his paper believe i reveals he evoluion of he echnological process more realisically. In order o improve he producion funcion model for Lavia, he auhors augmened he model by human capial approximaion. Chaper 1 deals wih heoreical aspecs of human capial accumulaion and he problems arising when correlaions described in lieraure are esed empirically. Chaper 2 aims o apply he exising models o Lavia's economic growh and o es hem empirically; likewise, an aemp has been made o find ou wheher he GDP dynamics observed so far can be esimaed by means of a producion funcion augmened by human capial. Theoreical background When he analysis of cross-counry hisorical economic developmen was conduced in he 1980s, an absolue fac came o he foreground: no convergence in erms of real GDP had occurred since he 1960s. Consequenly, he correlaion beween he per capia GDP growh and iniial per capia GDP in a given period, which could be implicily derived from he Solow model, could no be esimaed empirically. Barro and Sala-i-Marin (1995), Barro (1989), Mankiw, Romer and Weil (1992) conclude ha he majoriy of GDP variances can be esimaed by a regression derived from he 1 The views expressed in his publicaion are hose of he auhors, employees of he Moneary Policy Deparmen of he Bank of Lavia. The auhors assume responsibiliy for any errors and omissions. Conference May 19-20, 2008, Minsk

148 148 sandard Cobb Douglas (hereinafer, C D) producion funcion ye i produces an unfoundedly high capial share in GDP. Hence he Solow Swan model reflecs he realiy incompleely. In all he models, he C D producion funcion is employed: where Y is real GDP, K is real accumulaed capial, L is employmen in he economy, α is capial share in GDP, and α 1 ( A L ) α Y = K (1) A is oal facor produciviy which is exogenous. When his model is employed (assuming ha he raio of A and saving rae o GDP are consan), all counries converge o one and he same developmen level (Romer (2001). Thus he model implies ha here is no need o inerfere in counry's growh because he convergence of per capia GDP akes place auomaically, provided ha A is consan and saving sufficienly high (he aim of higher saving and labour produciviy are boh aainable by way of, e.g. aracion of foreign invesmen as well as liberalisaion of foreign rade and capial movemens). Oher sudies (Mankiw, Romer and Weil (1992) show ha despie regressing equaion (1) displays a raher srong relaionship, i.e. he dynamics of Y is fairly well explained, o a grea exen, by he growh in variables on he righ-hand side of he equaion; however, he implied capial share α = 0.59 of his model canno be correlaed wih he empirically esimaed variable (approx. 0.30). Therefore, his regression is unlikely o be aken as a Solow model and, consequenly, he C D specificaion of equaion (1) does no hold eiher. The following equaion seems o be a beer approximaion: where an addiional variable α β 1 α β ( A L ) Y = K H (2) H denoing human capial is included. Mankiw, Romer and Weil (1992), inroducing a proxy obained from educaion indicaors as a facor for human capial and using a simple one-period cross-counry regression, produced a capial share of 0.31 and human capial of 0.28 (hence residual of 0.41 is he employmen share). Oher sudies employing hese and similar regressions also arrive a a significan correlaion beween GDP and human capial facors (Barro (1989), Barro and Lee (1993). The resul obained, however, is unlikely o be reaed as holding or being final. The problems relaed o mehodologies and daa are discussed in he nex chapers. Mehods The papers on he impac of human capial on he GDP growh use cross-counry regressions as a rule, hough regressions of a single counry are also common. Generally, he producion funcion can be expressed by Taking log of i, we obain: log α β φ ( A L ) H Y = K (3) ( Y ) β log( A ) + α log( K ) + β log( L ) + φ log( H ) =. (4) Naional Bank of he Republic of Belarus

149 149 Though a precise funcional form is no known, usually he model wih he consan reurns o scale 1 funcion is used (i.e. a version of equaion (4) where α + β + φ = 1 and 0 < α < 1, 0 < β < 1, 0 < φ < 1). Such assumpions are usually esed agains he so-called reasonable alernaives: a) a model of endogenous growh (in equaion (4), α = 1 and 0 < β < 1, 0 < φ < 1); b) a Solow model wih no human capial included (in equaion (4), α + β = 1, φ = 0 and 0 < α < 1, 0 < β < 1 ). Precauious aiude shall always prevail when correcness of such models is o be proved; likewise, he resuls obained coninue o be mixed. Barro and Lee (1993) conclude ha a human-capialaugmened model reflecs he realiy very well; Canning, Dunne and Moor (1995) oppose hem and prove ha neiher he augmened Solow model ((b) version) nor he endogenous growh model ((a) version) explains he daa. Barro and Sala-I-Marin (1995) conclude ha he daa can indeed be esimaed by a neoclassical producion funcion wih human capial and noe ha echnological diffusion models are also useful (as a rule, hey have decreasing reurns o scale on a facor-level and increasing reurns o scale on he whole). Romer (1990) demonsraes ha inernaional daa can be consisen wih endogenous growh models wih human capial, which is defined as he number of auhors producing research ideas. The examinaion of secor-level daa shows ha increasing reurns o scale are observed a he secor- or indusry-level (Oulon and O Mahony (1994): larger producion volumes are associaed wih higher produciviy of producion facors. Caballerro and Lyons (1990) find ha increasing reurns o scale are no observable a he indusry-level bu occur as a resul of muual ineracion of he producion secors. For insance, if he developmen of several secors or indusries is inerdependen, an addiional 5% of GDP is produced. Daa The absence of an unbiased and independen human capial variable reduces he significance of producion funcions augmened by human capial. Tha is why various approximaions are involved. However, he selecion of any such approximaion can be subjec o doub on wha grounds has his very approximaion been seleced? If a variable in a regression is endowed wih a higher explanaory capaciy, is i because of is srong link wih he explained variable and no because he variable causes i? Even if here is a relaionship, such equaions canno be easily inerpreed. Y = K 2 3 Assuming in equaion (3) (changing parameer designaion o ( ) β A L β 1 β H ) ha he echnical progress (produciviy) growh ( γ )is consan and, consequenly, ion ha can be regression-esed: A λ 0 = A e, we obain an equa- ( Y ) = β log( A0 ) + β 2λ + β1 log( K ) + β 2 log( L ) + β log( H ) + ε log 2 3. (5) If a funcion ignoring human capial ( β 3 = 0 ) is esimaed, we obain: ( Y ) = β log( A0 ) + β2λ + β1 log( K ) + β log( L ) + ε log 2 2. (6) where is he rend (in his case A0 is he echnological level a he beginning of he given period). 1 This sudy uses hree ypes of reurns o scale: increasing reurns o scale, decreasing reurns o scale and consan reurns o scale. Conference May 19-20, 2008, Minsk

150 150 Major sudies, in which he need o include he human capial variable in he producion funcion is emphasised (Barro (1989), Barro and Lee (1993), Barro and Sala-I-Marin (1995), suppor he condiional convergence relaion, meaning ha saes do converge o somehing bu his convergence is deermined by a human capial variable (i.e. he pace of growh for less developed saes is faser, and he income levels gradually converge, provided he counries have he same condiional facor human capial, in his case). Barro and Lee (1993) assume male secondary educaion as a condiional indicaor approximaing human capial. If he average lengh of male secondary schooling is increased by 0.68 year, he average annual GDP growh would pick up 1.1 percenage poins. Bu why should he male secondary educaion be he appropriae human capial indicaor? In a World Bank paper The Qualiy of Growh, Thomas, Dalaimi, Dhareshwar e al. (2000) poin o female educaion as a qualiaive indicaor of human capial. Some researchers, however, used aggregaed indicaors of schooling and have made a significan inference (Nehru and Dhareshwar (1994). The connecion beween schooling and economic growh indicaors has been verified by Levine and Renel (1992) who rank educaion level among he wo single significan and robus indicaors ha explain he level of economic growh (invesmen level being he oher indicaor). Oher scholars (Wolff (1994) mainain ha expendiure on educaion or he number of researchers rank among he basic indicaors (Eaon and Korum (1996). A he same ime, Oulon and Young (1996) who used he same daabase as Barro and Lee (1993) (freely available on Inerne and used in all sudies by R. J. Barro 1 ), failed o come up wih a significan relaion beween he level of schooling and economic growh. Priche (1995) even discovered a negaive relaion beween he wo. In boh papers, he Barro Lee daabase has been used bu male secondary educaion has no been disinguished as a separae facor. Summing up he findings of available papers, i may be assumed ha educaion indicaors do relae o he GDP growh, albei o some exen only. Any more daring opinions, e.g. on feasible causaliy, or how human capial eners, if a all, he producion funcion, are unlikely o be reasonably grounded. As o oher areas, producion funcions wih human capial variables are rarely used. Srucural models used by cenral banks, as a rule, are sandard C D funcions as in equaion (1) (Smes and Wouwers (2002). All in all, researchers have no ye formulaed heir opinion regarding he so-called rue model. Modelling Lavia s siuaion When aemping o obain reliable variables for he producion funcion, researchers face one cenral problem ha of daa. Equaion (6) shows ha daa would be necessary on he following ime series: real GDP Y, oal facor produciviy A, real capial K, human capial H and employmen L. Real capial is repored as accumulaed capial, aking ino accoun capial sock a he end of 1994, invesmen in gross capial formaion and he level of depreciaion, which is he average depreciaion of he period (10% per annum). Labour force surveys consiue he daa source for employmen. Unil 2002, such surveys were conduced on a semi-annual basis; hence for he period prior o 2002, no quarerly daa are available. The employmen ime series for his period has been inerpolaed on he basis of shor-erm employmen daa. Naional Bank of he Republic of Belarus The reporing of human capial presens problems and, as has been saed above, naional accouns do no presen such daa ses. I means ha any daa series employed is merely an approximaion. 1 hp://

151 151 Besides, he previous chaper emphasised ha he ype of approximaion is no specified. 1 The lack of quarerly daa prior o 2002 makes he problem more complicaed. Census-X12 algorihm has been used o seasonally adjus all ime series in economeric modelling. Consrucing of he C D producion funcion for Lavia has so far been aemped by several auhors. Sikus (2003) derives a relaion in which capial share is Beņkovskis and Sikus (2006) do no calculae β bu obain he value of hrough calibraion. (in he given sudy he annual growh in labour produciviy γ is 4.6%.) A similar funcion wih he variable for echnological progress obained wih he help of he Kalman filer has been esimaed in his sudy (refer o Hamilon (1994) for a more deailed informaion on mehodology used). The following producion funcion is assumed: α 1 α L Y = A K. (7) The TFP is modelled as a sochasic process wih an increase γ, which is random walk: A γ = A e (8) 1 and γ γ = γ 1 ε. (9) + Taking a log of equaions (7) and (8) and combining i wih he TFP growh facor, we obain he sae-space sysem ha can be echnically esimaed: log log( Y ) ( Y ) = log( A ) + α log( K ) + ( 1 α) log( L ) + ε log ( A ) = log( A 1 ) + γ γ γ = γ 1 ε. + (10) In fac, his sysem is similar o he one in equaion (6); i is only assumed here ha echnological progress is no linear. This consrucion builds on he assumpion ha hisorically he mos significan adjusmens were no cyclical bu have had a lasing impac on he supply side (producion funcion). I could be an adequae approach for he economy wih srucural changes sill in progress. I is assumed ha model errors ε γ log(y ) and ε are normally disribued and independen. The calculaions by auhors produced he following resuls. 2 Table 1. Sae-space sysem esimaions (for equaion sysem (10) Coefficiens Sandard error z-saisic Probabiliy α Final sae Roo MSE* z-saisic Probabiliy log( A ) γ This sudy uses daa on he raio of educaion secor expendiure o GDP and some schooling indicaors. 2 Here and hereinafer using he Kalman filer, he error is smoohed ou resricing is variances by var = exp( 14). The period used in calculaion is from he firs quarer 1995 o he fourh quarer Addiional ess are given in Appendix 1. Conference May 19-20, 2008, Minsk

152 152 In his case, TFP is obained as a sae variable (see Figure 1 for projeced TFP dynamics). Capial sock (0.303) slighly falls behind he one calibraed by Beņkovskis and Sikus (2006) (0.319), and differs from he oher esimaed by Sikus (2003) (0.225). The figure is consisen wih values observed in producion funcions of oher counries (which vary broadly; see Caballero and Lyons (1990), Dimiz (2001), or wih calibraed values, which usually exceed 0.3. For insance, he capial share is esimaed a 41% for he euro area (Fagan, Henry and Mesre (2001), a 36% for France, wih a TFP increase of 1.2% per annum (Bol and Van Els (2000), a 37% for Esonia (Kaai (2005), and a 36% for Lihuania (Velov (2004). The dynamics of observable γ (in his case approximaing TFP growh) is also ineresing and on he whole consisen wih expecaions (see Figure 1). Figure 1. TFP dynamics consisenly wih equaion sysem (10) TFP (lef-hand scale) TFP qrowh, y-o-y, % (righ-hand scale) I I I I V I I I I V I I I I V I I I I V I I I I V I I I I V I I I I V I I I I V I I I I V I I I I V Figure 1 shows ha he TFP growh varies in he reference period. During he Russian financial crisis, is growh subsided and was close o zero in he period beween he fourh quarer of 1998 and he fourh quarer of Economic recovery, on he oher hand, saw he TFP growh acceleraing buoyanly bu slowing down aferwards. Lavia's accession o he EU gave a fresh impeus o new acceleraion in he TFP growh. In order o separae shor-erm deviaions from he long-erm rend, an error correcion model has also been esimaed for he sysem: log log log( Y ) ( Y ) = log( A ) + α log( K ) + ( 1 α) log( L ) + ε log( Y ) LOG( Y ) ( Y ) = γ + φ log( K ) + ( 1 φ) log( L ) + λε ε log ( A ) = log( A 1 ) + γ 1 + T (11) γ γ = γ 1 ε. + Table 2 shows he esimaion of he given sysem. Naional Bank of he Republic of Belarus Table 2. Sae-space sysem wih error correcion (for equaion sysem (11)) α Coefficiens Sandard error z-saisic Probabiliy φ λ Probabiliy a end-period Roo MSE* z-saisic Probabiliy log ( ) A γ

153 153 Table 2 shows ha in his case he capial share is larger in he shor-erm han in he long-erm. The difference, however, is no significan. The TFP dynamics showed in Table 2 is quie similar o he model in equaion (10) (see Figure 2). Figure 2. TFP dynamics consisenly wih equaion sysem (11) 0.90 TFP (lef-hand scale) TFP qrowh, y-o-y, % (righ-hand scale) I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV The inclusion of he human capial variable in equaion is an alernaive approach. The following daa ses likely o figure as human capial approximaions are used for he purpose: c) share of real educaion expendiure in real GDP (Secion M of naional accouns; quarerly daa available; daa available since 1995); d) share of employed wih secondary and universiy educaion in he employmen group over 15 years of age (Eurosa daa; in line wih levels 3 6 of ISCED 1997); e) share of employed wih universiy educaion in he employmen group over 15 years of age (in line wih levels 5 6 of ISCED 1997); f) share of employed wih secondary and universiy educaion in employmen group over 25 years of age (Eurosa daa; in line wih levels 3 6 of ISCED 1997); g) share of employed wih universiy educaion in he employmen group over 25 years of age (in line wih levels 5 6 of ISCED 1997); h) share of male wih secondary and universiy educaion in employmen group over 15 years of age (in line wih levels 3 6 of ISCED 1997); i) share of male wih universiy educaion in employmen group over 15 years of age (in line wih levels 5 6 of ISCED 1997); j) share of male wih secondary and universiy educaion in employmen group over 25 years of age (in line wih levels 3 6 of ISCED 1997); k) share of male wih universiy educaion in employmen group over 25 years of age (in line wih levels 5 6 of ISCED 1997). Conference May 19-20, 2008, Minsk

154 154 All schooling level daa of he employed persons were available only as of 1998, wih daa for he firs four years being semi-annual. The observaions missing for he period beween 1998 and 2002 were obained via inerpolaion. 1 Approximaion-relaed problems are inheren in hese daa series. For insance, he share of educaion in GDP is consanly shrinking (see Appendix 3); however, if oher facors (e.g. he share of persons wih universiy educaion in he employmen group over 25 years of age; see Appendix 4) are considered, hey do no poin o a rend so unequivocally. Alhough all ime series are expeced o esimae he same human capial daa collecion process, hey presen differen dynamics. Tesing he given variables in a similar sae-space equaion sysem log log( Y ) ( Y ) = log( A ) + α log( K ) + β log( H ) + ( 1 α β ) log( L ) + ε log ( A ) = log( A 1 ) + γ (12) γ γ = γ 1 ε, + we come o he conclusion ha he relaion where boh α and β are significanly differen from zero and mee he erms of he producion funcion wih consan reurns o scale (i.e. 0 < α < 1, 0 < β < 1 and α + β < 1 ) is impossible o obain. None of he above esimaed variables displays a relaion ha could promp is inclusion in he producion funcion. Conclusions The employmen of various human capial approximaions in he producion funcion for Lavia convinced he auhors ha exending he producion funcion wih any such independen variable is no reasonable a his poin. The auhors mainain ha he dynamics of he Lavian curren economic growh is bes esimaed by he sandard C D producion funcion wih non-linearly modelled produciviy. Tesing wih he Kalman filer and assuming ha he TFP process changes in ime produced human capial share of around The TFP growh rae esimaed in he relevan period proved o be raher unsable. During he Russian financial crisis, TFP growh subsided and was close o zero in he period beween he fourh quarer of 1998 and he fourh quarer of The period of economic recovery saw he TFP growh acceleraing rapidly, albei moderaing laer. Lavia's accession o he EU, in urn, gave a new impeus o he TFP growh. In order o separae he shor-erm variance from he long-erm rend, he error correcion model was esimaed. I resuled in around 0.34 long-erm reurn on capial and a slighly higher 0.37 shor-erm reurn (however, he difference is saisically insignifican), wih he TFP dynamics remaining broadly unchanged from he previous model esimaion. The error correcion coefficien is 0.44, indicaing ha he deviaion from he long-erm growh rend will resul in a 44% adjusmen for each period and will disappear in he course of approximaely one year. Naional Bank of he Republic of Belarus 1 In his case, wo inerpolaion mehods are esed: he linear (a simple mean of wo closes values) and he cubic (inerpolaion mehod insignificanly smoohing ime series). The resuls did no change depending on he mehod applied. Resuls given in Appendix 5 were obained by he cubic inerpolaion mehod.

155 155 Appendixes Appendix 1 Model (10) normal error disribuion es Mehod Tes value Adjused es value p-value Lilliefors (D) No available (NA) >0.1 Cramer von Mises (W2) Wason (U2) Anderson Darling (A2) Mehod: maximum likelihood, degrees of freedom correced Parameer Value Sandard error z-saisic p-value Mean Variance Appendix 2 Model (11) error ess 0.03 log( Y ) Error ε I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV Error ε log ( Y ) uni roo es Null hypohesis: ε log ( Y ) is he uni roo. p-values Augmened Dickey Fuller es saisic Tes criical values 1% % % * MacKinnon (1996) one-sided p-values Error ε log ( Y ) normal disribuion es Mehod Tes value Adjused es value p-value Lilliefors (D) NA >0.1 Cramer von Mises (W2) Wason (U2) Anderson Darling (A2) Conference May 19-20, 2008, Minsk

156 156 Mehod: maximum likelihood, degrees of freedom correced Parameer Value Sandard error z-saisic p-value Mean Variance Error γ ε I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV Error γ ε uni roo es Null hypohesis: γ ε is he uni roo -saisic Augmened Dickey Fuller es saisic Criical es value 1% % % * MacKinnon (1996) one-sided p-values Error γ ε normal disribuion es Mehod Tes value Adjused es value p-value Lilliefors (D) NA >0.1 Cramer von Mises (W2) Wason (U2) Anderson Darling (A2) Mehod: maximum likelihood, degrees of freedom correced Parameer Value Sandard error z-saisic p-value Mean Variance Naional Bank of he Republic of Belarus

157 157 TPF, capial and employmen ime series coinegraion relaion in equaion sysem (11) Unresriced Coinegraion Rank Tes (Trace) Hypohesised Eigenvalue Trace saisic 0.05 criical value p-value* number of coinegraion vecors None A mos A mos * MacKinnon Haug Michelis (1999) p-values Hypohesised number of coinegraion vecors Eigenvalue Maximum eigenvalue saisic 0.05 criical value p-value* None A mos A mos * MacKinnon Haug Michelis (1999) p-values Appendix 3 Raio of real educaion expendiure o real GDP in Lavia, % Appendix 4 Proporion of persons wih universiy educaion in oal employmen of Lavia, %, over 25 years of age Conference May 19-20, 2008, Minsk

158 158 Appendix 5 Models wih human capial Sae-space sysem model wih human capial (equaion (13); 1996 Q Q4) Variables log(k ) log(h ) (consisenly wih he lis on p ) a) 0.91* (0.00) 0.55* (0.00) c) 0.44 (0.20) 0.07 (0.55) d) 0.30 (0.43) 0.30 (0.26) e) 0.47 (0.17) 0.04 (0.67) f) 0.32 (0.36) 0.23 (0.23) g) 0.50 (0.21) 0.01 (0.90) h) 0.32 (0.36) 0.22 (0.27) i) 0.60 (0.12) (0.98) * Saisical significance of coefficien a he 0.01 level ) Sae-space sysem model wih human capial (equaion (12); 1998 Q Q 4) Variables log(k ) log(h (consisenly wih he lis on p ) a) 1.43* (0.00) 0.67* (0.00) b) 0.83* (0.00) 0.04 (0.43) c) 0.69* (0.00) 0.05 (0.37) d) 0.81* (0.00) 0.03 (0.78) e) 0.73* (0.00) f) 0.78* (0.00) g) 0.78* (0.00) h) 0.77* (0.00) i) 0.78* (0.00) * Saisical significance of coefficien a he 0.01 level References 0.03 (0.53) 0.01 (0.87) 0.01 (0.87) 0.02 (0.78) 0.01 (0.87) Barro, Rober J. Economic Growh in a Cross Secion of Counries. NBER Working Paper, No. 3120, Sepember Barro, Rober J., Mankiw, Gregory N., SALA-I-MARTIN, Xavier. Capial Mobiliy in Neoclassical Models of Growh. NBER Working Paper, No. 4206, November Barro, Rober J., Lee, Jong-Wha. Inernaional Comparisons of Educaional Aainmen. Journal of Moneary Economics, Elsevier, vol. 32 (3), December 1993, pp Barro, Rober J., Sala-I-Marin, Xavier. Economic Growh. New York : McGraw-Hill, Naional Bank of he Republic of Belarus Beņkovskis, Konsanīns, Sikus, Dainis. Lavijas makroekonomiskais modelis. Rīga : Lavijas Banka, Pēījums. 2/2006. Boissay, Frédéric, Villeelle, Jean-Pierre. The French Block of he ESCB Muli-Counry Model. ECB Working Paper, No. 456, March Bol, Wilko, Van Els, Peer J. A. Oupu Gap and Inflaion in he EU. De Nederlandche Bank Saff Repor No. 44, 2000.

159 159 Caballero, R. J., Lyons, R. K. Inernal Versus Exernal Economies in European Indusry. European Economic Review, vol. 34, 1990, pp Canning, David, Dunne, Peer, Moore, Michael. Tesing he Augmened Solow and Endogenous Growh Models. Mimeo : Queen's Universiy of Belfas, Denis, Cécile, McMorrow, Kieran, Röger, Werner. Producion Funcion Approach o Calculaing Poenial Growh and Oupu Gaps Esimaes for he EU Member Saes and he US. European Commission Economic Papers, No. 176, Sepember Dimiz, Maria A. Oupu Gaps and Technological Progress in European Moneary Union. Bank of Finland Discussion Paper, No. 20, Eaon, Jonahan, Korum, Samuel S. Trade in Ideas: Paening and Produciviy in he OECD. Journal of Inernaional Economics, No. 40, May 1996, pp European Commission. Annual Innovaion Policy Repor for Lavia. Covering Period: Sepember 2003 Augus European Trend Char on Innovaion, Enerprise Direcorae-General [cied Augus 30, 2006]. Available: hp://rendchar.cordis.lu/counry_repors.cfm. Fagan, Gabriel, Henry, Jerome, Mesre, Ricardo. An Area-Wide Model (AWM) for he Euro Area. ECB Working Paper, No. 42, January Gundlach, Erich. Growh Effecs of EU Membership: The Case of Eas Germany. Inerim Repor , Inernaional Insiue for Applied Sysems Analysis, Sepember Hamilon, James D. Time Series Analysis. Princeon : Princeon Universiy Press, Jenkins, Helen. Educaion and Producion in he Unied Kingdom. Nuffield College, Oxford Universiy, Economics Discussion Paper, No. 101, Augus Jones, Charles I. Human Capial, Ideas, and Economic Growh. Paper presened o he VIII Villa Mondragone Inernaional Economic Seminar on Finance, Research, Educaion, and Growh. Rome, Ialy, June 25 27, Kaai, Rasmus. EMMA a Qarerly Model of he Esonian Economy. Eesi Pank Working Paper, No. 12, Ocober Levine, Ross, Renel, David. A Sensiiviy Analysis of Cross-Counry Growh Regressions. American Economic Review, vol. 82 (4), Sepember 1992, pp Mackinnon, James G. Numerical Disribuion Funcions for Uni Roo and Coinegraion Tess. Journal of Applied Economerics, vol. 11, No. 6, 1996, pp Mankiw, Gregory N., Romer, David, Weil, David N. A Conribuion o he Empirics of Economic Growh. The Quarerly Journal of Economics, vol. 107i2, May 1992, pp Nehru, Vikram, Dhareshwar, Ashok. New Esimaes of Toal Facor Produciviy Growh for Developing and Indusrial Counries. Washingon D. C. : The World Bank Policy Research Working Paper, No. 1313, June Oulon, Nicholas, O'Mahony, Mary. XLVI Produciviy and Growh. A Sudy of Briish Indusry Cambridge : Cambridge Universiy Press, Naional Insiue of Economic and Social Research, Oulon, Nicholas, Young, Garry. The Social Rae of Reurn o Invesmen. Naional Insiue of Economic and Social Research Discussion Paper, No. 93, April Priche, Lan. Where has All he Educaion Gone? Mimeo : Washingon D. C. : The World Bank, Quah, Danny T. Twin Peaks: Growh and Convergence in Models of Disribuion Dynamics. The Economic Journal, vol. 106, July 1996, pp Romer, David. Advanced Macroeconomics. New York : McGraw-Hill, Second Ediion, Romer, Paul M. Human Capial and Growh: Theory and Evidence. Carnegie Rocheser Conference Series on Public Policy, No. 32, Spring 1990, pp Smes, Frank, Wouers, Raf. An Esimaed Sochasic Dynamic General Equilibrium Model of he Euro Area. ECB Working Paper, No. 171, Augus Solow, Rober M. A Conribuion o he Theory of Economic Growh. Quarerly Journal of Economics, No. 70, 1956, pp Solow, Rober M. Perspecives on Growh Theory. Journal of Economic Perspecives, vol. 8, 1994, pp Sikus, Dainis. Lavijas fakiskā un poenciālā ražošanas apjoma sarpība: aprēķins un lieojums. Rīga : Lavijas Banka, Pēījums 2/2003. Thomas, Vinod, Dailami, Mansoor, Dhareshwar, Ashok, Kaufmann, Daniel, Kishor, Nalin, López, Ramon E., Wang, Yan. The Qualiy of Growh. The World Bank, Oxford Universiy Press, Sepember Velov, Igor. The Lihuanian Block of he ESBS Muli-Counry Model. Bank of Finland Insiue for Economies in Transiion, BOFIT. BOFIT Discussion Papers, No. 13, Wolff, Edward N. Human Capial Invesmen and Economic Growh: Macro-Economic Perspecives and Evidence from Indusrialized Counries. Inernaional Conference on Human Capial Invesmens and Economic Performance. Sana Barbara, California, Conference May 19-20, 2008, Minsk

160 160 Oxana Babeskaia-Kukharchuk 1 Transmission of Exchange Rae Shocks ino Domesic Inflaion: The Case of he Czech Republic This paper aims a esimaing he exchange rae pass-hrough (ERPT) for he Czech Republic. The exising empirical lieraure does no come o a consensus abou he degree of pass-hrough o Czech inflaion. Since here is no unique approach regarding how o measure ERPT, we use various specificaions found in he pass-hrough lieraure for he Czech Republic. In addiion, we esimae he passhrough along he disribuion chain in he spiri of McCarhy (2007). We ry o explore he properies of exchange rae shock ransmission ino Czech consumer prices by comparing impulse responses among 11 specificaions esimaed on daa ransformed in monhly differences and in annual raes. Equilibrium pass-hrough is esimaed wih he help of he VEC model. In addiion, we ry o accoun for possible variaion in ime. The simples approach is a re-esimaion of VAR models on wo subperiods. Our second sraegy is he esimaion of he error correcion equaion wih he Kalman filer. Finally, we explore how he pass-hrough differs beween radable (3 sub-groups) and non-radable goods. We find ha he speed of exchange rae shock ransmission o all prices is quie high. However, in absolue erms, ERPT does no exceed 25 30%. Nonechnical Summary The choice of he opimal moneary policy for he new EU members is no sraighforward. On he one hand, fuure paricipaion in he ERM-II and euro adopion require exchange rae sabiliy visà-vis euro. On he oher hand, he caching-up process induces real exchange rae appreciaion. Furhermore, he exchange rae in he new member saes sill represens an insrumen of adjusmen o various shocks. Togeher wih Hungary and Poland, he Czech Republic is in he las group for euro adopion among he new member saes of he 2004 wave of enlargemen, and assessmen of exchange rae pass-hrough is imporan on is road oward he euro. Undersanding he pass-hrough mechanism is also crucial for CPI inflaion argeing. As a small open economy, he Czech economy can be sensiive o exernal shocks. A he same ime, he empirical lieraure finds low pass-hrough in a low inflaion environmen or when a counry has inflaion argeing. In case of a significan exchange rae shock, i is imporan o know how srongly domesic prices will reac o his shock, in oher words, how far inflaion migh deviae from he arge and how quickly prices migh reurn o he equilibrium level. Under inflaion argeing, he moneary auhoriy ends o mainain price sabiliy, which should reduce he pass-hrough effec. Finally, undersanding exchange rae pass-hrough could be a useful elemen for inflaion predicion and, more generally, for predicion of real secor behavior. The paper aims o provide a beer undersanding of how domesic consumer prices respond o exchange rae shocks. The proposed empirical analysis ends o answer how srong and how fas is he exchange rae pass-hrough o domesic inflaion, wheher i changes over ime, wheher i has he 1 Czech Naional Bank; Cenre d Economie de la Sorbonne Universiy of Paris 1 ; Sae Universiy Higher School of Economics ( [email protected]). This work was suppored by Czech Naional Bank Research Projec No.E6/2005. Naional Bank of he Republic of Belarus The auhor is graeful o Luboš Komárek, Balázs Éger, and Iikka Korhonen for valuable commens. Special hanks go o Juraj Anal, Ian Babeskii, Ví Bára, Vladislav Flek, Marin Fukač, Kamil Galuščák, Tomáš Holub, Roman Horváh and Jiří Podpiera for heir consrucive suggesions. The auhor would also like o hank Hugh Mecalf and oher paricipans of he 7 INFER Workshop on Inernaional Economics held in Murcia on March 28-29, All errors remain hose of he auhor. The opinions expressed in his paper are hose of he auhor and do no necessary reflec he views of he Czech Naional Bank, he Universiy of Paris 1, or he Sae Universiy Higher School of Economics.

161 161 same magniude for radables and non-radables, how i is differen from he reacion of impor and producer prices, and how robus he resuls are when alernaive specificaions are used. Exising pass-hrough sudies for he Czech Republic repor shor-run exchange rae pass-hrough varying from 0 o almos 40 percen. Applying alernaive specificaions and economeric procedures o wo daases (m-o-m changes and y-o-y changes), we find ha he pass-hrough o he CPI is close o he upper bound of he exising resuls during , and is almos a he lower bound during The speed of exchange rae shock ransmission o all prices is quie high, which is usual for a small open economy. However, in absolue erms, he peak impulse response does no exceed 25%, and he oal reacion o he exchange rae shock is likely o be less han 30% for he esimaions performed on he whole sample. The esimaions obained from he whole sample are more significan han hose performed on wo sub-periods. Longer ime span and lower volailiy in he daa are possible explanaions of his resul. Noice ha i is difficul o find meaningful resuls when saic and ime varying vecor error correcion models (VECM) are used insead of VAR. Finally, in line wih he heory, we find ha radable goods reac more o an exchange rae shock han do non-radable goods. Furhermore, he magniude of he exchange rae pass-hrough decreases from he iniial sage of producion o final goods. We found ha he passhrough o producer prices is lower han ha o consumer prices. High compeiion on he domesic marke or high pass-hrough o impored goods in he consumpion baske could be a possible explanaion for his resul. 1. Inroducion By joining he European Union, he new EU members ake on an obligaion o adop he euro a some poin. This is preceded by a required minimum wo-year membership in he ERM-II, which imposes cerain exchange rae sabiliy crieria. A he same ime, he caching-up process in he new member saes is refleced in higher produciviy growh vis-à-vis he euro area, which, in urn, enails real exchange rae appreciaion. Also, he exchange rae sill represens a useful insrumen of adjusmen o various shocks. The new member counries ha join he ERM-II migh be viewed as balancing heir moneary policy beween low inflaion, as required by he Maasrich crieria, and a sable exchange rae vis-à-vis euro, as imposed by he ERM-II. In his conex, he link beween he exchange rae and inflaion, or, more precisely, he pass-hrough effec of a variaion in he nominal exchange rae on domesic inflaion, receives paricular aenion. In he conex of euro adopion, high sensiiviy o exchange rae shocks may increase he benefis of earlier euro adopion. As a small open economy, he Czech Republic can be sensiive o exernal shocks. A he same ime, he empirical lieraure finds low pass-hrough in a low inflaion environmen or when a counry has inflaion argeing. From a policy perspecive, undersanding he ransmission mechanism of exchange rae shocks ino domesic inflaion is vial for he implemenaion of a counry s moneary and exchange rae policies. In case of a significan exchange rae shock, i is imporan o know how srongly domesic prices will reac o his shock, in oher words, how far inflaion migh deviae from he arge and how quickly prices reurn o he equilibrium level. Under inflaion argeing (which is he case of he Czech Republic), he moneary auhoriy ends o mainain price sabiliy, which should reduce he pass-hrough effec. Finally, undersanding exchange rae pass-hrough could be a useful elemen for inflaion predicion and, more generally, for predicion of real secor behavior. The proposed empirical sudy conribues o he clarificaion of exchange rae shock ransmission ino domesic inflaion. The aim of he presen paper, herefore, is o assess he dynamics and magniude of exchange rae pass-hrough. Given he high inerdependence of economic facors, he Conference May 19-20, 2008, Minsk

162 162 ransmission mechanism of an exchange rae shock ino he domesic economy does no appear simple. I is no surprising ha here is no unique model o measure he pass-hrough effec, and he resuls vary significanly across sudies and across counries. The exising empirical lieraure on pass-hrough for he Czech Republic repors esimaes varying in he shor run beween 0% and almos 40%. The diversiy of he previous resuls gives addiional moivaion o his sudy. Furhermore, many of he papers are already ou of dae. The lieraure on exchange rae pass-hrough comes o a consensus ha he pass-hrough o domesic inflaion is incomplee. However, he reasons are quie diverse. The low reacion of domesic prices is explained by srong compeiion, pricing o marke, currency invoicing, degree of openness, and oher facors. Since i is no clear which facor dominaes, he presen paper esimaes ERPT using numerous specificaions; hen he resuls are discussed. The paper has he following srucure. The firs secion gives a definiion of pass-hrough and discusses is properies. In he second secion, we explain he differen approaches o modeling ERPT and ake corresponding examples from he lieraure on ERPT o consumer prices esimaed for he Czech Republic. The hird secion explains he esimaion mehods. The daa and preliminary ess are described in he fourh secion. Secion five shows he resuls. The main empirical findings are summarized in he conclusion. 2. Definiion and Properies of ERPT Tradiionally, exchange rae pass-hrough is defined as he percenage change in he local currency price of an impored good resuling from a 1 per cen change in he nominal exchange rae beween he exporing and imporing counries. 1 Menon (1995) makes a survey of empirical sudies on exchange rae pass-hrough conduced beween 1974 and Mos of hese sudies analyzed passhrough effecs o expor and impor prices, esimaed for large developed economies. Laer, he analysis of exchange rae pass-hrough was exended o consumer and producer prices. Saring from McCarhy (1999), he majoriy of he ERPT sudies focusing on domesic inflaion base heir analysis on he so-called disribuion chain: inpu prices, inermediae prices, and prices of final goods. The main advanage of his approach is is abiliy o compare he reacion of prices o an exchange rae shock a differen sages of he disribuion process. The sandard disribuion chain specificaion conains impor prices, producer prices, and consumer prices. Impor prices ransmi an exchange rae shock ino domesic inflaion indirecly, via inpus and inermediae goods for domesically produced producs, or direcly, via impored goods, which consiue a par of final consumpion. Consequenly, an exchange rae shock affecing one sage of producion is ransmied o consumer prices. Since he producion and disribuion process akes some ime, he ransmission mechanism is no likely o be immediae. Faruqee (2006) and Choudhri e al. (2005) esimae one of he longes disribuion chains. The auhors use he hree aforemenioned price indices, uni labor coss, and expor prices. By and large, ERPT is expeced o decline along he disribuion chain, i.e., consumer prices are expeced o reac much less han impor prices. When he reacion o a shock is less han he iniial shock, he pass-hrough is incomplee. Naional Bank of he Republic of Belarus Mos empirical sudies find incomplee pass-hrough. A class of he New Open Economics Models (NOEM) assumes ha exchange rae pass-hrough may be endogenous o he counry s moneary policy and he counry s inflaion performance. Saring from Taylor (2000) numerous empirical sudies find ha exchange rae pass-hrough declines if he inflaion environmen urns lowinflaionary, because his causes a decline in he expeced persisence of cos and price changes. 1 Bailliu and Fujii (2004)

163 163 Choudhri and Hakura (2006) es his relaion empirically in a sample of 71 counries over The auhors argue ha ERPT ends o be low in economies where inflaion is low and moneary policy is more credible. This finding is also proved by Bailliu and Fujii (2004) and Gagnon and Ihrig (2004) in he long run. The auhors use a macroeconomic model and Mone-Carlo simulaions for parameerizaion of heir model. Then, he model is fied for 20 indusrial counries using quarerly daa over Flamini (2004) proposes an analyical framework for incomplee or delayed pass-hrough o CPI inflaion in a small-open economy. His approach is based on a dynamic sochasic general equilibrium model. Coricelli e al. (2006) explain differences in he compleeness of pass-hrough also by differences in exchange rae regimes: counries wih inflaion argeing and flexible exchange rae arrangemens have much smaller pass-hrough ha hose wih less flexible exchange rae regimes. The auhors find complee pass-hrough in Slovenia and Hungary. The impac of an exchange rae shock is smaller in Poland and he Czech Republic. The oher possible explanaions of low pass-hrough include a low share of impored goods, price sickiness of nonradable goods in he consumpion baske, he subsiuion effec (Bursein e al., 2002), he presence of inermediaries beween exporers and consumers, currency invoicing and local disribuion coss (Bacchea and van Wincoop, 2003), 1 and slow adjusmen of consumer goods prices in a highly compeiive environmen. The signal from he exchange rae can also be disored by menu coss and conracing coss (Devereux and Yeman, 2002) or firms pricing-o-marke sraegy (Corsei and Dedola, 2005). Noice, however, ha changes in domesic prices are no necessarily caused by changes in he exchange rae. For his reason, Darvas (2001) proposes o decompose price changes ino pass-hrough and price convergence effecs. Pass-hrough esimaes on he aggregae consumer price index assume ha pass-hrough is he same for all goods in he consumpion baske. Parsley (1995), cied in Darvas (2001), criicizes he use of aggregaed price indices for he esimaion of exchange rae pass-hrough. Inference from he disaggregaed level has some advanages. For example, differen indusries may have differen sensiiviies o inflaion changes. One explanaion for his fac is a differen degree of compeiion among marke segmens. The use of disaggregaed price indices can, furhermore, le us ake ino accoun ha prices of non-radables grow faser han prices of radables. However, due o daa availabiliy, mos of he exising sudies use aggregaed price indices, and only a few sudies, mosly performed on US daa, analyze pass-hrough using disaggregaed daa. For developed counries his quesion was addressed, for example, in Pollard and Coughlin (2003). For ransiion economies, o our knowledge, here are only wo sudies on disaggregaed pass-hrough. Dabusinskas (2003) esimaes disaggregaed pass-hrough for Esonia, and Biāns (2004) shows impulse responses of various CPI sub-groups for Lavia. According o hese resuls, he level of price aggregaion affecs he esimaes of pass-hrough. Las bu no leas, ERPT is no necessarily symmeric and consan over ime. 2 Based on he general pass-hrough properies, we expec ha he ERPT o Czech inflaion is far from complee. This is due o boh a low-inflaion environmen and inflaion argeing. Impor prices consiue abou 25% of he CPI. Furhermore, according o he CNB Inflaion Repor (2004), in he second quarer of 2004 only 18% of impors were designaed for final consumpion, as agains 63% for inermediae consumpion. On he conrary, pass-hrough o impor prices is likely o be very high for a leas wo reasons. Firs, he Czech Republic is a small open economy wih a raio of expors/impors o GDP exceeding 60%. Second, according o Kamps (2006), during 1 If foreign exporing firms, e.g., euro area firms, esablish heir prices in euros, and domesic firms, e.g., non-euro area firms, assembling impored goods and selling final producs o consumers se heir prices in local currency, one can expec he pass-hrough o consumer prices o be lower han he pass-hrough o impor prices (see Bacchea and van Wincoop, 2003, and Bailliu and Fujii, 2004, for a discussion abou exchange rae pass-hrough o producer and consumer prices in indusrialized counries). 2 See, for example, Bussière (2006) for asymmeric pass-hrough and Darvas (2001), Rincon e al. (2005), and Sekine (2006) for ime-varying pass-hrough esimaes. Conference May 19-20, 2008, Minsk

164 around 90% of conracs for impored goods were denominaed in foreign currency (mosly in euro). In he empirical secions of he paper, we address mos of he properies of ERPT, namely, he speed and magniude of is ransmission ino domesic inflaion. In addiion, we ry o es wheher he pass-hrough varies over ime. We show how differen he reacion of price indices is along he disribuion chain, and how differen he resuls are when more disaggregaed daa are used insead of he aggregaed index. 3. Approaches o Modeling ERPT: The Case of he Czech Republic Pass-hrough o consumer prices is less ransparen han pass-hrough o impor prices. In is mos basic form, he pass-hrough is obained from ineracions among he exchange rae, domesic consumer prices, and he mos imporan ransmission channel impor prices. Due o daa problems, impor prices are someimes replaced by foreign consumer prices, reflecing he influence of he exernal economic environmen. The advanage of such a model is is simpliciy, which preserves he degree of freedom when he ime series is shor. However, i can suffer from misspecificaion due o neglec of he possible pass-hrough deerminans. This criicism, however, can also be addressed even a sophisicaed pass-hrough models. Despie he relaively simple definiion of exchange rae pass-hrough, in pracice i is approximaed and esimaed by various differen approaches. One possible mehod is a simple oneequaion regression. However, he mos commonly applied mehod is VAR or srucural VAR (SVAR). 1 VAR models accoun for endogeneiy and allow he magniude and dynamics of he passhrough o be measured. Here i is imporan o disinguish beween long- and shor-run passhrough. In a VAR framework, shor-run pass-hrough is measured as an impulse response o a given shock 2, which allows us o infer he magniude and dynamics of he pass-hrough. The accumulaed impulse responses can be inerpreed as long-run pass-hrough if he ime horizon is sufficienly long. In his paper, by shor-run pass-hrough we mean he insan impulse responses and he accumulaed impulse responses for he period up o one year. The coinegraed VAR or error correcion model allows us o measure equilibrium pass-hrough. Some ime equilibrium passhrough is also called long-run pass-hrough. According o he definiion of he error correcion erm, equilibrium pass-hrough represens he equilibrium o which he exchange rae coefficien ends o converge. The advanage of he VEC approach is ha i keeps he informaion in levels aking ino accoun causal relaionships and non-saionariy issues. 3 To sum up, he variey of applied procedures makes i difficul o find any encompassing approach. In addiion, here is no single model for measuring pass-hrough. The pass-hrough sudies for he Czech Republic cover a large specrum of economeric procedures, including simple univariae mehods and more complex sysems of equaions, such as auoregressive models or models wih preesimaed parameers (e.g., he Quarerly Predicion Model of Beneš e al., 2003). Table 1 shows he variables used in pass-hrough sudies for he Czech Republic. For comparison and furher analysis, we also include in Table 1 hree specificaions wih a disribuion chain, esimaed on a sample conaining he euro area counries. In he spiri of McCarhy (2007), we spli all he variables ino six groups: disribuion chain, exchange rae shock, supply, demand and exernal shocks, and moneary policy variables. Naional Bank of he Republic of Belarus 1 Pass-hrough esimaes can also be obained from a calibraed srucural model. On he one hand, he advanages of his model include is heoreical foundaions and he inclusion of moneary policy or cenral bank reacion funcions. On he oher hand, one criicism of he srucural models concerns he presence of pre-calculaed parameers, frequenly chosen on an ad-hoc basis. 2 Shocks are usually normalized o one percen or o one sandard deviaion. 3 Noice ha he VAR approach is criicized by Coricelli e al. (2006) for inconsisency wih he definiion of pass-hrough. In paricular, he auhors emphasize ha any ype of shock can cause co-movemens beween he exchange rae and prices.

165 Table 1: Pass-hrough Esimaes for he Czech Republic and he Euro Area 165 auhor esimaion mehod shor-run variables included in he model exern. moneary and supply demand disribuion [longrun] shock shock chain shock policy ERPT pm oil gap dgp s w pm px py pc pc f m i EURO AREA McCarhy (1999, 2007) VAR 0 d X X X X X X X a X a Faruqee (2006) VAR 0.02 X X X X X X Hahn (2003) VAR 0.08 X X X X X X X CZECH REPUB- LIC Biāns (2004) VAR 0.21;0.13 X X X X X X Ca'Zorzi (2007) VAR [0.61;0.55] X X X X X X Campa Goldberg (2006) OLS 0; [0.60] X X X X Campa Goldberg (2006) SVAR 0 X X X X Coricelli e al. (2006) b CVAR [0.46] X X X X Darvas (2001) c VAR,E ; C 0.15 X X X Darvas (2001) TVEC 0.10;0.15 X X X Korhonen Wachel (2006) VAR 0.03;0.09 X X X X Mihaljek Klau (2001) OLS 0.06 X X X X Beneš e al. (2003) S r u c u r a l m o d e l pm oil - oil prices w - uni labor coss m - broad money pm - impor prices i - ineres rae px - expor prices gap - oupu gap py - producer prices dgp - real GDP pc - consumer prices s - exchange rae pc f - foreign CPI Noe: a McCarhy (2007) only. b Coricelli e al. (2006) use inflaion and ineres rae differenials. Therefore, i is difficul o compare he model and he resuls wih oher esimaions. c Darvas (2001) also esimaes an equilibrium real exchange rae model wih ime-invarian parameers. d The original model was esimaed for indusrialized counries. The impulse response of he CPI o an exchange rae shock is insignifican for he majoriy of he euro area counries included in he sample. The differen economeric mehodologies and specificaions lead o a variey of pass-hrough esimaes. Shor-run pass-hrough varies from 0 o almos 40 percen (column 3 in Table 1). For comparison, he ERPT o he euro area HICP varies beween 2 percen (Faruqee, 2006) and 8 percen (Hahn, 2003). I is mosly insignifican in McCarhy (1999 and 2007). Long-run pass-hrough is found o be around , which is far from complee. Sudies wih cross-counries analysis find he lowes pass-hrough for he Czech Republic among he Cenral European counries (Coricelli e al., 2006, and Darvas, 2001) or he emerging economies (Mihaljek and Klau, 2001). In addiion, Mihaljek and Klau (2001) find high inflaion ineria for he Czech Republic (he highes in he sample). Mos sudies esimae pass-hrough using he effecive exchange rae, bu ohers, e.g., Mihaljek and Klau (2001), prefer he bilaeral exchange rae, which is more ransparen for firms in comparison wih he effecive exchange rae. Korhonen and Wachel (2005) esimae pass-hrough using he euro and dollar exchange raes. Pass-hrough is found o be higher when he euro is used. I worh menioning ha such variaion in he exchange rae pass-hrough resuls may be due o differen esimaion periods and differences in definiions of pass-hrough, as well as o differen frequency of he daa (monhly and quarerly). I may also be parially due o variaion in he underlying price indices. For example, Beneš e al. (2003) and Darvas (2001) exclude food, energy, Conference May 19-20, 2008, Minsk

166 166 and adminisered prices from he aggregaed price index. Coricelli e al. (2006) and Mihaljek and Klau (2001) use he aggregaed index of CPI inflaion. 4. General Esimaion Sraegy None of he aforemenioned approaches can be considered he bes. Therefore, he alernaive mehods should raher be viewed as complemenary o each oher. Wih a few excepions 1 we replicae he specificaions already applied o he Czech Republic daa. In addiion, we esimae McCarhyype specificaions wih a disribuion chain (see Table 1). If oil prices and he ineres rae are included in he model, we consider hem firs as exogenous and hen as endogenous. Therefore, we obain abou 20 specificaions, bu only 11 passed he sabiliy es. Only saionary specificaions are used for he pass-hrough analysis. These 11 specificaions are lised in Table 2. Table 2: Esimaed VAR Specificaions VAR endogenous exogenous No. variables variables 1 s pm px py pc w 2 pm oil gap s pm non oil py pc 3 gap s pm non oil py pc pm oil 4 gap s pm non oil py pc pm oil i 5 gap s pm non oil pc pm oil i 6 gap s pc pc EU 7 s pm pc pc EU 8 s pc pc EU 9 pm oil s pc pc EU 10 s pc pc EU pm oil 11 gap s pm pc pm oil - oil prices w - uni labor coss pm non oil - oil prices pm - impor prices i - ineres rae px - expor prices gap - oupu gap py - producer prices s - exchange rae (NEER) pc - consumer prices -CPI pc EU - euro area CPI All 11 specificaions are esimaed for five consumer price indices: pc aggregaed CPI, pc radables only, pc f food only, pc o oher radables (excluding food and beverages), and pc n nonradables excluding regulaed prices. The majoriy of pass-hrough sudies use he daa ransformed ino monh-on-monh changes. This daa, however, may conain addiional noise. For his reason, we complemen he esimaions on monh-on-monh changes wih esimaions done on he daa ransformed ino annual growh raes: (X -X -12 )/X -12 *100 (here and afer year-on-year changes). Esimaes are performed for hree periods: he whole period and wo sub-periods. In oal, his gives us 11*5*2*3=330 esimaed VAR models. Price indices and he exchange rae are ransformed ino log-differences for he monh-on-monh (m-o-m) esimaes and one-period dif- Naional Bank of he Republic of Belarus 1 We do no use, for example, broad money. Also, we do no replicae he model of Coricelli e al. (2006), esimaed wih inflaion and ineres rae differenials. Finally, Darvas (2001) esimaes he ime-invarian equilibrium real exchange rae, bu here is no unique approach o esimaing he equilibrium exchange rae (for differen sraegies of equilibrium exchange rae esimaion for ransiion economies, see Éger e al., 2006). In addiion, i is no necessarily he case ha he equilibrium exchange rae is sable over ime. Therefore, we do no follow his approach.

167 ferences for he year-on-year (y-o-y) esimaes. The ineres rae is ransformed ino one-period differences in he y-o-y VARs. 167 A VAR process is generally described as o ( ) y = C + C L y 1 + u, where y is a vecor of endogenous variables in firs log differences or in annual raes. Shor-run pass-hrough is compued as an impulse response from he VAR model. To compue he impulse responses, Cholesky ordering is seleced. Cholesky decomposiion implies a predeermined ordering of he impulse responses: in he firs period he firs variable is affeced only by is own shock, he second variable is affeced by he firs variable s shock and is own shock, ec., and he las variable is affeced by he shocks from all he variables. Le y be a vecor of n endogenous variables in log differences. The relaion beween he variables follows an auoregressive process of he form: By = ( ) y A + A L + ε, where B is an n n marix wih uniary elemens 0 1 along is diagonal, A(L) is a lag polynomial of order p (we selec p=2), A 0 is a vecor of consan erms, and ε denoes a marix of disurbance erms. The reduced-form VAR is obained by muliplying boh y C L y sides by B 1 : = C + ( ) + 0 u 1, where 1 C 0 B A0 =, 1 C 1 = B A, and = u B ε are reduced-form resi- duals, given by he shocks from all six variables. B is no observed direcly (wih unresriced VAR we can esimae only he C 0 and C coefficiens). If B is no diagonal, innovaions u will be correlaed wih each oher. This does no allow us o pick ou shocks from a paricular variable. To ensure orhogonaliy of he innovaions in he model wih n variables, a leas (n 2 n)/2 resricions should be imposed (for example, for Faruqee s 2006 specificaion wih six endogenous variables he number of resricions is equal o (6 2 6)/2=15). One possible way o do so is o ransform he symmerical residual covariance marix ino a Cholesky lower riangular marix. Thus, we obain he following recursive sysem: = ε ε c c u = 2 21ε 1+ c 22u 2 ε = 3 c31ε 1 c32ε 2+ c33u 3 ε = 4 c 41ε 1 c42ε 2 c43ε 3+ c 44u 4 ε = 5 c51ε 1 c52ε 2 c53ε 3 c54ε 4+ c55u... ε c n1ε 1 cn 2ε 2 c n3ε 3 c n4ε 4 c ε = n n c nn u n Noice ha he ordering of he endogenous variables maers. In pracice, i is difficul o es all he possible combinaions, e.g., a sysem of 6 variables gives 6!=720 possibiliies for ordering he variables. We seleced he ordering of variables which corresponds o he disribuion chain hypohesis. In he spiri of McCarhy (1999 or 2007) we place variables approximaing demand and supply shocks before he disribuion chain. The nex sep afer he shor-run pass-hrough esimaes is o esimae he equilibrium passhrough. The laer is based on VECM esimaes. The coinegraed equaion shows he equilibrium o which he inegraed variables will converge. Therefore, he equilibrium pass-hrough is compued as he inverse of he coefficiens from he coinegraed equaion. We also ry o assess he ime-varying pass-hrough. Firs, ime-varying resuls can be obained from a simple break-up of he sample ino wo sub-periods. The relaively shor sample size prevens us from experimening wih more han wo sub-periods. An alernaive sraegy is o esimae a ime-varian model. There are hree possibiliies for esimaing he ime-varying coefficiens: a Kalman filer, a Markov swiching process and smooh ransiion hreshold auoregression (STAR). Darvas (2006) argues ha he Kalman filer is he bes echnique, since i preserves flexibiliy. By conras, a smooh ransiion beween he beginning and end of he period and he paricular pah assumed by he STAR model or he several regimes wih he possibiliy of reurning o a previous Conference May 19-20, 2008, Minsk

168 168 regime (Markov swiching) seem o be unrealisic or oo resricive for counries like he Czech Republic. We herefore build a sae and space model where changes in he CPI index are explained by changes in he exchange rae and he error correcion erm. By applying he Kalman filer, we allow he exchange rae coefficien o vary over ime. 5. Daa Descripion and Preliminary Tess Aggregaed CPI, expor, and impor prices are obained from he Czech Saisical Office. The nominal effecive exchange rae 1 and he 3-monh ineres rae are aken from he ARAD daabase, while producer prices, labor coss, GDP, and he HICP for he euro area come from Eurosa. Sub-componens of he Czech CPI are esimaed by CNB saff. GDP, available on a quarerly basis, was convered o monhly frequency. The oupu gap is esimaed from GDP daa using he Hodrick-Presco filer. In order o keep as much informaion as possible, we sar wih he esimaions over he whole period. Then he daa are spli ino sub-periods: 1996:1 2001:12 and 2002:1 2006:12. The second inerval encompasses he period of CPI inflaion argeing. We do no divide he second sub-sample ino he pre- and pos-eu accession periods, in order o keep he ime series relaively long. The original series, apar from GDP and he ineres rae, are expressed in indices equal o 100 for he base year For he CPI, expor, and impor price indices, here was a mehodological change in 2001: he number of represenaive price caegories increased by approximaely 20%. Since here is no obvious way of combining he wo mehodologies, we merge he pre-2001 and pos-2001 series using 2000 as he base year. 2 Before saring he economeric esimaions, some commonly used procedures are applied o es he daa properies. Firs, he series are checked for saionariy. Generally, he number of lags for 1 he uni roo es is based on he following formula: T 4 k max = in A *, where T is he number of 100 observaions and A is equal o 12 for monhly daa. However, his gives us up o 13 lags. Tha is oo much for a small sample. The uni roo ess are esimaed wih he maximum number of lags se o 6. 3 Tables 3 and 4 summarize he es saisics for he ADF and KPSS ess. For addiional uni roo ess, see Annex 1 and 2. By and large, all he variables excep he oupu gap are non-saionary in levels and saionary in firs difference. The oupu gap is saionary by consrucion. For he ineres rae, he ADF and KPSS ess generae conroversial resuls. The uni roo es esimaed on he sub-sample is less conclusive. Noice ha in shor samples uni roo ess can lack power o rejec he null of nonsaionariy. Also, as noed by Enders (1995, Chaper 4), he Dickey-Fuller and Phillips Perron ess (see Annex 1 and 2) are unable o disinguish beween uni roos and non-linear rends. Since in he majoriy of pass-hrough sudies he ineres rae and he oupu gap are esimaed in levels, we also include hese variables in he VAR models in levels. The oher variables are esimaed in log differences (m-o-m daa) or firs difference (y-o-y daa). According o common pracice, i is also possible o have some non-saionary variables if he whole model passes he sabiliy es. Naional Bank of he Republic of Belarus 1 The weighs accoun for rade wih 23 principal rade parners. 2 The same approach was applied in he Emerging Marke Daabase (EMED) o consruc he series of Czech expor and impor prices. 3 Esimaion wih 2, 4, or 8 lags gives quie similar resuls.

169 169 Table 3: ADF and KPSS Tess on m-o-m Daa in Log-levels and Log-differences whole period ADF KPSS ADF KPSS ADF KPSS Esimaion in levels s *** ** ** px *** ** pm ** ** 0.09 pm non oil ** ** 0.08 pm oil ** ** ** py *** pc *** *** ** pc EU *** ** ** pc *** ** * 0.10 pc f *** * ** 0.09 pc o *** *** ** 0.08 pc n *** *** ** pc no *** *** * w ** * i * ** ** gap *** 0.18 ** ** Esimaion in firs difference s *** *** *** 0.08 px *** ** *** 0.12 * pm *** *** *** 0.11 pm non oil *** *** *** 0.11 pm oil *** *** *** 0.11 py *** *** * pc *** *** *** 0.09 pc EU *** *** 0.17 ** *** 0.09 pc *** *** *** 0.10 pc f *** *** *** 0.15 ** pc o *** *** *** 0.06 pc n *** 0.13 * *** *** 0.10 pc no *** *** *** 0.08 w *** 0.19 ** *** *** 0.10 i *** 0.15 ** *** 0.13 * *** 0.09 gap *** * Noe: a see Table 2 for he definiion of he variables. The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. b H0 in he ADF es assumes non-saionariy of he series. H0 in he KPSS es says he variables are saionary. Conference May 19-20, 2008, Minsk

170 170 Table 4: ADF and KPSS Tess on Daa Transformed ino Annual Changes whole period ADF KPSS ADF KPSS ADF KPSS Esimaion in levels s ** * px ** * pm * pm non oil ** pm oil * * py ** ** pc ** ** pc EU ** ** pc * ** * pc f ** ** pc o * * pc n * ** pc no ** w * ** *** 0.09 Esimaion in firs difference s *** ** *** 0.12 * px *** * *** 0.18 ** pm *** ** *** 0.06 pm non oil *** ** *** 0.10 pm oil * ** *** 0.16 ** py *** *** pc *** *** *** 0.06 pc EU *** *** 0.13 * *** 0.12 * pc *** *** 0.10 pc f *** *** 0.18 ** pc o *** *** 0.14 * *** 0.07 pc n *** *** 0.17 ** *** 0.09 pc no *** *** 0.14 * w *** 0.29 *** ** *** 0.05 Noe: a see Table 2 for he definiion of he variables. The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. b H0 in he ADF es assumes non-saionariy of he series. H0 in he KPSS es says he variables are saionary. Naional Bank of he Republic of Belarus

171 Table 5: Lag Lengh Selecion 171 VAR No.: m-o-m AIC SIC y-o-y AIC SIC Noe: AIC Akaike informaion crierion, SIC Schwarz informaion crierion. The numbers in he able show he number of lags in he VAR suggesed under he seleced informaion crieria. Table 5 shows he opimal number of lags for each VAR based on he Akaike and Schwarz informaion crieria. The Akaike informaion crierion suggess 6 8 lags. According o he Schwarz informaion crierion, he number of lags should no be greaer han 2. Since for shor samples he Schwarz crierion is preferred, we esimae all he VAR models wih 2 lags. All 11 VAR models passed he sabiliy es. 6. Resuls The measure of pass-hrough is based on he approach described in secion 3. Firs, we show he resuls from he VAR models. Then we presen calculaions based on VECM. Finally, we discuss possible ime variaion and asymmery in he pass-hrough. The impulse responses based on VAR models show incomplee and fas shor-run pass-hrough. The effec of he exchange rae shock o he CPI aains is maximum afer roughly 6 monhs, and a leas half of his effec occurs during he firs 3 monhs. In oher words, if we consider he accumulaed impulse response afer 12 monhs as a complee response, he ERPT afer 3 monhs accouns for a leas 50% depending on he specificaion chosen. In order o check how sensiive our resuls are o he seleced specificaion, we pu he resuls obained from differen specificaions in he same figure. Figures 1 and 2 plo he peak impulse response for each specificaion esimaed for 5 CPI indices 1 over 3 periods. The numbers from 1 o 11 on he horizonal axis correspond o he VAR numbering in Table 2. In oher words, each small graph in Figures 1 and 2 shows 11 peak impulse responses and heir confidence inervals esimaed from he 11 differen VAR models. According o our expecaions, he magniude of he pass-hrough is no he same for radables and nonradables. For non-radables i is he smalles and is almos insignifican, in line wih he heoreical lieraure. Among he hree groups of radable goods (oal index, food, and oher radables), he peak impulse response has more or less he same magniude. The year-on-year esimaes produce more significan resuls han he esimaes done on monh-on-monh changes. Esimaed on he whole sample, he peak impulse response of he y-o-y CPI is beween 7% and 12%. For some specificaions i is slighly higher during he firs period, bu i becomes insignifican in he second period. The m-o-m esimaes repor a peak response of around 10% for he esimaes done on he whole sample. In he firs period, only he aggregaed index and seleced specificaions for oher radables have a saisically significan impulse response (around 10% 15%). In he second period, he peak impulse is significan in half of he specificaions wih he oal radables index. 1 We assume ha he exchange rae shock may be ransmied hrough inermediae inpus ha do no necessarily belong o he same group as he final produc. Therefore, we keep all oher variables unchanged when he disaggregaed consumer price index is used insead of he aggregaed one. Conference May 19-20, 2008, Minsk

172 Figure 1: Peak Impulse Response o a 1% Exchange Rae Shock; m-o-m Daa whole period PC PC-NT PC-TT PC-TF PC-TO PC PC-NT PC-TT PC-TF PC-TO PC 0.20 PC-NT PC-TT PC-TF PC-TO Noe: The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. The numbers from 1 o 11 on he horizonal axis denoe he specificaion number as in Table 2. The solid line shows he peak impulse response from each specificaion. The dashed line is he 95% confidence inerval. The peak impulse response is observed in he 2nd monh for he sub-period for all prices excep oher radables. Oherwise, he peak impulse response occurs in he 3rd monh. Naional Bank of he Republic of Belarus

173 173 Figure 2: Peak Impulse Response o a 1% Exchange Rae Shock; y-o-y Daa whole period PC PC-NT PC-TT PC-TF PC-TO PC 0.30 PC-NT PC-TT PC-TF PC-TO PC PC-NT PC-TT 0.30 PC-TF 0.20 PC-TO Noe: The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. The numbers from 1 o 11 on he horizonal axis denoe he specificaion number as in Table 2. The solid line shows he peak impulse response from each specificaion. The dashed line is he 95% confidence inerval. The peak impulse response is observed in he 2nd monh for he sub-period for all prices excep oher radables. Oherwise, he peak impulse response occurs in he 3rd monh. Afer 6 monhs, he ERPT is mosly ransmied ino consumer prices. Figures 3 and 4 show he accumulaed impulse response in he 6h period. We display he resuls in he same manner as in figures 1 and 2. The ERPT o he aggregaed CPI does no exceed 25% for he m-o-m esimaes and flucuaes around 30% for he y-o-y resuls. I is found o be higher in he firs period (up o 40% 50%) and lower and insignifican in he second period. The lower pass-hrough in he second period is in line wih he gradual decrease of he arge level of inflaion during However, i is very unlikely ha here is no ERPT o domesic inflaion in he small open economy wih a significan share of impored goods in he consumpion baske. In case of he esimaions done on wo Conference May 19-20, 2008, Minsk

174 174 sub-periods, shorer daa se and possible volailiy in he daa may hide he rue magniude of he pass-hrough. For his reason, esimaions performed on he whole sample seem o provide more reliable resuls. Noice ha an insignifican accumulaed impulse response means ha he shock has already been ransmied and no longer affecs he variable of ineres. However, i can also be insignifican if all he insan impulse responses are insignifican. Figure 3: Accumulaed Impulse Response afer 6 Periods; m-o-m Daa whole period 0.60 PC 0.40 PC-NT PC-TT 0.60 PC-TF 0.60 PC-TO PC 0.80 PC-NT PC-TT 1.00 PC-TF 0.80 PC-TO PC 0.20 PC-NT PC-TT 1.00 PC-TF 1.00 PC-TO Naional Bank of he Republic of Belarus Noe: The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. The numbers from 1 o 11 on he horizonal axis denoe he specificaion number as in Table 2. The solid line shows he peak impulse response from each specificaion. The dashed line is he 95% confidence inerval.

175 175 Figure 4: Accumulaed Impulse Response afer 6 Periods; y-o-y Daa whole period PC PC-NT PC-TT PC-TF PC-TO PC PC-NT PC-TT PC-TF PC-TO PC 0.40 PC-NT PC-TT 1.00 PC-TF 0.40 PC-TO Noe: The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. The numbers from 1 o 11 on he horizonal axis denoe he specificaion number as in Table 2. The solid line shows he peak impulse response from each specificaion. The dashed line is he 95% confidence inerval. Finally, we show he pass-hrough evoluion along he disribuion chain. The verical axis on Table 5 shows he magniude of he pass-hrough (accumulaed impulse responses) o impor prices, producer prices, and consumer prices. The horizonal axis displays he periods of ime. We show he resuls from he wo VAR models where here is an aggregaed impor price index and he ERPT o consumer prices is significan. The esimaions are done on he whole sample. Conference May 19-20, 2008, Minsk

176 176 Figure 5: Pass-hrough Along he Disribuion Chain (accumulaed impulse response) m-o-m y-o-y pm1 py1 pc1 pc11 pm11 pm1 py1 pc1 pc11 pm Noe: pc is he aggregaed consumer price index, py is he producer price index, and pm is he impor price index. The numbers 1 and 11 in he legend denoe he specificaion number as in Table 2. The periods (monhs) are ploed on he horizonal axis. The resuls are in line wih he general findings of a fading pass-hrough effec along he disribuion chain: he highes close-o-complee pass-hrough is found for impor prices; he passhrough is much lower for he PPI and CPI. The pass-hrough o impor prices is around 85% on he m-o-m daa, which is close o Faruqee (2006) for he euro area. The pass-hrough is lower, and he disance beween he accumulaed impulse responses of impor and consumer prices is much narrower, when year-on-year changes are used insead. Ineresingly, he reacion of producer prices o he exchange rae shock is lower han he reacion of consumer prices o he same shock. Bacchea and van Wincoop (2003) explain he high pass-hrough o impor prices and he low passhrough o domesic prices by high compeiion in he domesic marke. In oher words, foreign exporing firms sell inermediae goods o domesic firms and se heir prices in he foreign currency. Domesic firms produce final goods, which include foreign componens. If he degree of compeiion among local producers in he local marke is high, he domesic firm prefers o se is prices in he local currency, which leads o a high pass-hrough o impor prices and low pass-hrough o consumer prices. Therefore, he main absorpion of he exchange rae shock occurs during he producion process. The higher pass-hrough o consumer prices relaive o producer prices in his case is a resul of he foreign componen in he consumpion baske. Table 6: Number of Coinegraed Equaions Based on Johansen Coinegraion Tes Naional Bank of he Republic of Belarus m-o-m y-o-y ECM No. PC PC TT PC TF PC TO PC NT PC PC TT PC TF PC TO PC NT , * 3 4* * 3 3* * - 3 2* 3* 3* * 2 3 2* 3* 3* 3* * 1* 2* , * Noe: The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. The numbers from 1 o 11 in he firs column denoe he specificaion number as in Table 2. Iniial es assumpions: a linear rend in he daa, bu only wih an inercep and no rend in he coinegraed equaions. * denoes he number of coinegraed equaions seleced under he differen es assumpions.

177 177 The majoriy of VAR-ype pass-hrough esimaes are aken in firs differences, due o nonsaionary of he variables in levels. However, as poined ou by Elbourne e al. (2001), if series are non-saionary in levels bu coinegraed, he vecor error correcion model may be more appropriae. Before proceeding o he VEC esimae, we es for a number of coinegraed equaions in each specificaion using he Johansen coinegraion es. The resuls are summarized in Table 6. Since he inerpreaion of equilibrium pass-hrough becomes very difficul when he number of coinegraed equaions is greaer han one, we compue he equilibrium pass-hrough from he specificaions where he Johansen coinegraion es deecs only one coinegraed equaion. Therefore, he equilibrium pass-hrough is esimaed for specificaions 2, 3, 8, and 11 on he m-o-m daa. The resuls are summarized in Table 7. Table 7: Equilibrium Pass-hrough No. PC PCTT PCTF PCTO PCNT whole period Noe: The upper scrips for he CPI denoe he following sub-groups: no upper scrip aggregaed CPI, radables only, f food only, o oher radables (excluding food and beverages), and n non-radables excluding regulaed prices. The numbers in he firs column denoe he specificaion number as in Table 2. In he sric sense, we canno inerpre he coefficiens from he coinegraion equaion as elasiciies, since he relaion of he causaliy is no explicily accouned for. However, he coinegraing relaionship represens some equilibrium sae o which he series end o converge. Hence, i may be inerpreed o some exen as he long-run pass-hrough. Long pass-hrough is compued as he inverse of he long-run coinegraing coefficiens. The esimaed equilibrium pass-hrough is found o be sensiive o he specificaion and ime period seleced. I is also no uniform across differen CPI groups. One possible explanaion of his resul could be insabiliy of equilibrium pass-hrough over ime. We do no es his due o he shor ime series. We apply he Kalman filer o he exchange rae coefficien in he equaion where changes in he CPI are explained by changes in he exchange rae and he error correcion equaion. The ime-varying coefficien is found o be insignifican in all specificaions. Noice ha he pass-hrough is also found o be low or insignifican when he ime-varying procedure is applied (see, for example, Darvas, 2001). I worh noing ha he assumpion of asymmery in price adjusmens could be imporan for he passhrough esimaes. In general, prices can be more rigid downward (see he menu-cos model of Ball and Mankiw, 1994, for possible heoreical explanaions of asymmeric price adjusmens in he presence of posiive rend inflaion, and Pollard and Coughlin, 2003, for esimaes of asymmeric pass-hrough o impor prices). This implies ha he reacion o exchange rae appreciaion is no he same as ha o Conference May 19-20, 2008, Minsk

178 178 exchange rae depreciaion. The sandard approach o he esimaion of impulse response funcions ignores his issue; for example, ERPT is calculaed from impulse responses o a negaive exchange rae shock, which corresponds o exchange rae depreciaion. However, in he case of impulses of he same magniude bu of he opposie sign (exchange rae appreciaion), he responses would also have he opposie sign and he same magniude. In fac, his VAR srucure implicily assumes ha prices reac o exchange rae appreciaion and depreciaion wih he same magniude. Some preliminary resuls obained from he 3-variable VAR (exchange rae, impor prices, and consumer prices) esimaed on he whole period wih wo coefficiens for he exchange rae for periods of appreciaion and depreciaion show very low pass-hrough (around zero) in he case of exchange rae appreciaion and around 9% 12% in he case of exchange rae depreciaion. I is no clear, however, how o define periods of appreciaion and depreciaion and how o disinguish emporary and permanen changes. We already have a broad range of pass-hrough esimaes, and we found a very low pass-hrough during Therefore, he resuls from he ime-varying model are in line wih he pass-hrough esimaes for he second period. A simple asymmeric model is no sufficien o draw a conclusion on he magniude of he asymmeric pass-hrough, and he resuls obained do no significanly conribue o he main conclusion. We expec o develop an asymmeric model in he fuure. 7. Conclusion In his paper, we measure he dynamics and compleeness of he pass-hrough for he Czech Republic by applying alernaive specificaions and economeric procedures o wo daases: m-o-m changes and y-o-y changes. The speed of he exchange rae shock ransmission o all prices is quie high (a leas 50% of he shock is ransmied during he firs 3 monhs and 100% afer 6 monhs), which is usual for a small open economy. However, in absolue erms, he peak impulse response does no exceed 25%, and he oal reacion o he exchange rae shock is likely o be less han 30% for he daa esimaed on he whole sample. The pass-hrough is found o be somewha higher han 30% during , bu i is mosly insignifican beween 2002 and Insignifican pass-hrough is also found when he ime-varying model is used insead of VAR. Shorer ime-series and possible volailiy in he daa may be responsible for insignifican pass-hrough esimaes. Since i is very implausible ha pass-hrough o domesic prices is zero for he Czech Republic, resuls based one he whole sample esimaes seem o provide more reliable resuls. We also find ha radable goods reac much more o an exchange rae shock han do non-radable goods, in line wih he heoreical foundaions. Furhermore, he magniude of he exchange rae pass-hrough decreases from he iniial sage of producion o final goods. However, we found lower pass-hrough o producer prices han o consumer prices. High compeiion on he domesic marke or he presence of impored goods in he consumpion baske could be a possible explanaion for his resul. References BACCHETTA, P. AND E. VAN WINCOOP (2003): Why Do Consumer Prices Reac Less Than Impor Prices o Exchange Raes? NBER Working Paper No Journal of he European Economic Associaion, Vol. 1(2 3), pp BAILLIU, J. AND E. FUJII (2004): Exchange Rae Pass-Through and he Inflaion Environmen in Indusrialized Counries: An Empirical Invesigaion. Bank of Canada Working Paper No BALL, L. AND N. G. MANKIW (1994): A Sicky-Price Manifeso. Carnegie-Rocheser Conference Series on Public Policy, Vol. 41, pp BENEŠ, J., T. HLÉDIK, D. VÁVRA, AND J. VLČEK (2003): The Quarerly Projecion Model and is Properies. in: Coas, W., D. Laxon, and D. Rose (eds.): The Czech Naional Bank s Forecasing and Policy Analysis Sysem. Czech Naional Bank, Prague. Naional Bank of he Republic of Belarus BITĀNS, M. (2004): Pass-Through of Exchange Raes o Domesic Prices in Eas European Counries and he Role of Economic Environmen. Bank of Lavia Working Paper, No. 4/2004. BURSTEIN, A. T., M. EICHENBAUM, AND S. REBELO (2002): Why Are Raes of Inflaion So Low Afer Large Devaluaions? CEPR Discussion Paper, 8748.

179 179 BUSSIÈRE, M. (2006): Exchange Rae Pass-Through in he G7 Economies: The Role of Nonlineariies and Asymmeries. ECB, mimeo. CA ZORZI,M., E. HAHN, AND M. SÁNCHEZ (2007): Exchange Rae Pass-Through in Emerging Markes. ECB Working Paper, No CAMPA, J. AND L. GOLDBERG (2006): Disribuion Margins, Impored Inpus, and he Sensiiviy of he CPI o Exchange Raes. NBER Working Paper, CAMPA, J. M. AND J. M. GONZALEZ MINGUEZ (2006): Differences in Exchange Rae Pass-Through in he Euro Area. European Economic Review, Vol. 50(1), pp CHOUDHRI, E. U. AND D. S. HAKURA (2006): Exchange Rae Pass-Through o Domesic Prices: Does he Inflaionary Environmen Maer? Journal of Inernaional Money and Finance, Vol. 25(4), pp CHOUDHRI, E. U., H. FARUQEE, AND D. S. HAKURA (2005): Explaining he Exchange Rae Pass-Through in Differen Prices. Journal of Inernaional Economics, Vol. 65(2), pp CNB (2004): Inflaion Repor. Ocober. CORICELLI, F., B. JAZBEC, AND I. MASTEN (2006): Exchange Rae Pass-Through in EMU Acceding Counries: Empirical Analysis and Policy Implicaions. Journal of Banking & Finance, Vol. 30(5), pp CORSETTI, G. AND L. DEDOLA (2005): A Macroeconomic Model of Inernaional Price Discriminaion. Journal of Inernaional Economics, Vol. 67(1), pp DABUSINSKAS, A. (2003): Exchange Rae Pass-Through o Esonian Prices. Eesi Pank Working Paper, No DARVAS, Z. (2001): Exchange Rae Pass-Through and Real Exchange Rae in EU Candidae Counries. Economic Research Cenre of he Deusche Bundesbank, Discussion Paper, 10/01. DARVAS, Z. (2006): Moneary Transmission in he New EU Member Saes: Evidence from Time-Varying Coefficien Vecor Auoregression. OENB Focus on European Economic Inegraion, No. 1/2006, pp DEV EREUX, M. B. AND J. YETMAN (2002): Price-Seing and Exchange Rae Pass-Through: Theory and Evidence. Proceedings of a conference held a he Bank of Canada, November Oawa: Bank of Canada. ÉGERT, B., L. HA LPERN, AND R. MACDONA LD (2006): Equilibrium Exchange Raes in Transiion Economies: Taking Sock of he Issues. Journal of Economic Surveys, Vol. 20(2), pp ÉGERT, B. AND R. MACDONA LD (2006): Moneary Transmission Mechanism in Transiion Economies: Surveying he Surveyable. Magyar Nemzei Bank Working Paper, No. 2006/5. ELBOURNE,A., J. DE HAAN,AND E. STERKEN (2001): Moneary Transmission in EMU: A Reassessmen of VAR sudies. mimeo. ENDERS, W. (1995): Applied Economeric Time Series. Wiley. FARUQEE, H. (2004): Exchange Rae Pass-Through in he Euro Area: The Role of Asymmeric Pricing Behavior. IMF Working Paper, No. 04/14. FLA MINI, A. (2004): Inflaion Targeing and Exchange Rae Pass-Through. HEI Working Paper, No. 04/2004. GAGNON, J. E. AND J. E. IHRIG (2004): Moneary Policy and Exchange Rae Pass-Through. Up-daed version of FRB Inernaional Finance Discussion Paper, No. 704, July Inernaional Journal of Finance & Economics, Vol. 9(4), pp HAHN, E. (2003): Pass-Through of Exernal Shocks o Euro Area Inflaion. ECB Working Paper, No KAMPS, A. (2006): The Euro as Invoicing Currency in Inernaional Trade. ECB Working Paper, No KORHONEN, I. AND P. WACHTEL (2006): A Noe on Exchange Rae Pass-Through in CIS Counries. Research in Inernaional Business and Finance, Vol. 20(2), pp MCCARTHY, J. (1999): Pass-Through of Exchange Raes and Impor Prices o Domesic Inflaion in Some Indusrialized Economies. BIS Working Paper, No. 79. MCCARTHY, J. (2007): Pass-Through of Exchange Raes and Impor Prices o Domesic Inflaion in Some Indusrialized Economies. Easern Economic Journal, Vol. 33(4), pp MENON, J. (1995): Exchange Rae Pass-Through. Journal of Economic Surveys, Vol. 9(2), pp MIHALJEK, D. AND M. KLAU (2001): A Noe on he Pass-Through from Exchange Rae and Foreign Price Changes o Inflaion in Seleced Emerging Marke Economies. in BIS Papers, No. 8 Modelling Aspecs of he Inflaion Process and he Moneary Transmission Mechanism in Emerging Marke Counries, pp POLLA RD, P. S. AND C. C. COUGHLIN (2003): Pass-Through Esimaes and he Choice of an Exchange Rae Index. Federal Reserve Bank of S. Louis Working Paper, No B. RINCON, H., E. CAICEDO, AND N. RODRÍGUEZ (2005): Exchange Rae Pass-Through Effecs: A Disaggregae Analysis of Colombian Impors of Manufacured Goods. Cenral Bank of Colombia Working Paper, No.330. SEKINE, T. (2006): Time-Varying Exchange Rae Pass-Through: Experiences of Some Indusrial Counries. BIS Working Paper, No TAYLOR, J. (2000): Low Inflaion, Pass-Through, and he Pricing Power of Firms. European Economic Review, Vol. 44(7), pp Conference May 19-20, 2008, Minsk

180 180 Appendix 1: Uni Roo Tess on m-o-m Daa whole period DFGLS PP ERS NP DFGLS PP ERS NP Esimaion in levels neer * * px ** ** pm *** *** pmnon oil ** pmoil py pc pceu pc pcf pco pcn pcno w *** *** i gap *** Esimaion in firs difference neer *** *** 0.45 *** *** *** *** 1.61 *** *** px *** *** 2.48 *** *** *** ** 5.02 ** ** pm *** *** 1.99 *** *** *** *** 3.70 *** *** pmnon oil ** *** 2.53 *** ** *** *** 3.68 *** *** pmoil *** *** 1.31 *** *** *** *** 2.63 *** *** py *** 6.47 * *** *** 3.08 *** * pc *** *** 1.30 *** *** *** *** 2.60 *** *** pceu *** *** 1.36 *** *** *** *** 2.71 *** *** pc *** *** 1.57 *** *** *** *** 2.66 *** *** pcf *** *** 1.83 *** *** *** *** 2.88 *** *** pco *** *** 2.21 *** *** *** *** 2.77 *** *** pcn *** *** 1.29 *** *** *** *** 2.67 *** *** pcno *** *** 1.33 *** *** *** *** 2.78 *** *** w *** 2.99 *** *** i *** *** 0.08 *** *** *** *** 0.31 *** *** gap ** *** DFGLS PP ERS NP Esimaion in levels neer px pm * pmnon * pmoil py pc pceu pc pcf pco *** *** *** pcn pcno w *** i gap Esimaion in firs difference neer *** *** 3.19 *** *** px *** *** 3.97 *** *** pm *** *** 3.81 *** *** pmnon *** *** 3.99 *** *** pmoil *** *** 3.35 *** *** py *** pc *** *** 3.10 *** *** pceu *** *** 3.29 *** *** pc *** *** 3.81 *** *** pcf *** *** 2.32 *** *** pco *** *** 0.95 *** *** pcn *** 3.69 *** pcno *** *** 3.06 *** *** w *** *** 1.81 *** i *** *** 3.93 *** ** gap * Naional Bank of he Republic of Belarus Noe: All ess are performed wih an assumpion of consan and rend in ime series.

181 181 Appendix 2: Uni Roo Tess on y-o-y Daa whole period DFGLS PP ERS NP DFGLS PP ERS NP Esimaion in levels neer ** *** *** * ** ** px *** *** *** *** *** pm ** *** *** *** *** pm non oil ** *** *** * *** *** pm oil * ** ** py *** *** *** *** *** pc * pc EU pc ** *** *** * * pc f * ** ** pc o pc n pc no ** *** *** w *** Esimaion in firs difference neer *** *** 2.16 *** *** *** *** 5.11 ** ** px *** *** 3.21 *** *** ** * 5.31 ** * pm *** *** 2.71 *** *** *** ** 4.65 ** ** pm non oil *** *** 3.17 *** *** *** ** 4.84 ** ** pm oil ** *** 5.28 ** * *** py *** *** 3.76 *** *** *** *** 4.32 ** ** pc *** *** 2.03 *** *** *** *** 3.49 *** *** pc EU *** *** 1.39 *** *** *** *** 3.23 *** *** pc *** *** 2.38 *** *** *** pc f *** *** 2.67 *** *** * ** pc o *** *** 1.40 *** *** *** *** 6.26 * *** pc n *** *** 1.39 *** *** *** *** 3.24 *** *** pc no *** *** 1.47 *** *** *** *** 3.31 *** *** w *** 4.07 *** *** DFGLS PP ERS NP Esimaion in levels neer px pm pm non oil pm oil py *** pc *** *** pc EU pc *** pc f pc o pc n *** *** pc no * *** *** w *** 4.65 ** Esimaion in firs difference neer *** *** 3.89 *** ** px *** *** 4.56 ** ** pm *** *** 4.23 ** ** pm non oil *** *** 4.28 ** ** pm oil *** *** 4.01 *** ** py * pc *** *** 4.05 *** ** pc EU *** *** 4.18 ** ** pc *** *** 3.89 *** ** pc f *** *** 4.20 ** ** pc o *** pc n *** 3.92 *** ** pc no *** *** 3.98 *** ** w *** *** *** 0.30 *** Noe: All ess are performed wih an assumpion of consan and rend in ime series. Conference May 19-20, 2008, Minsk

182 182 Michał Brzoza-Brzezina, 1 Tomasz Chmielewski, 2 Joanna Niedźwiedzińska 3 Subsiuion beween domesic and foreign currency loans in Cenral Europe. Do cenral banks maer? 4 Inroducion In his paper we ask a quesion abou he impac of moneary policy on oal bank lending in he presence of a developed marke for foreign currency denominaed loans and poenial subsiuabiliy beween domesic and foreign currency loans. Our resuls, based on a panel of hree bigges Cenral European counries (he Czech Republic, Hungary and Poland) confirm he exisence of he subsiuion effec beween hese loans. Resricive moneary policy leads o a decrease in domesic currency lending bu simulaneously acceleraes foreign currency denominaed loans. This makes he cenral bank's job harder wih respec o providing boh, moneary and financial sabiliy. Since he widespread inroducion of Inflaion Targeing sraegies in many developed and emerging marke counries, he role of moneary and credi aggregaes has subsanially decreased. Money and credi 5 are no reaed as inermediae arges anymore and cenral banks, as well as analyss, pay much less aenion o heir developmens han hey used o back in he 1980's. Sill, money and credi maer in moneary policy analysis of inflaion argeers for several reasons. Firs, credi creaion is considered an imporan driving vehicle ransmiing moneary policy decisions on ineres raes o he economy (e.g. Mishkin (1996), Bernanke and Blinder (1988)). Second, i has been shown in many counries ha developmens in moneary and credi aggregaes can yield useful informaion abou fuure real and nominal developmens (Borio and Filardo (2004), Fisher e al. (2006), Gerlach and Svensson (2003)). Third, i has been recenly argued ha credi creaion can be useful in assessing he overall creaed liquidiy, even if, in he shor and medium run, i does no affec consumer prices. This liquidiy, i is argued, flows o capial or real esae markes, where i can generae price bubbles. These bubbles can hreaen financial sysem and price sabiliy in he fuure. As a resul, inflaion argeing cenral banks pay aenion o money and credi developmens, reaing hem as one of he inpus o heir moneary policy decision making process. In his paper we do no aemp o prove he usefulness of credi aggregaes for moneary policy. Assuming ha he analysed cenral banks care abou credi creaion 6 and may wan o curb (or boos) lending, we ask he quesion wha impac cenral banks have on bank lending in he presence of a developed marke for foreign currency loans. In oher words, we hink of domesic and foreign currency loans as of close subsiues. Since he domesic cenral bank affecs only he price of one of hese goods (i.e. domesic credi) is impac on he oal amoun of loans graned can be small. 1 Naional Bank of Poland and Warsaw School of Economics, [email protected]. 2 Naional Bank of Poland and Warsaw School of Economics, [email protected]. 3 Naional Bank of Poland, [email protected]. Naional Bank of he Republic of Belarus 4 The views expressed in his paper are hose of he auhors and do no necessarily reflec he views of he Naional Bank of Poland. The auhors are graeful o Wojciech Charemza, Adam Ko, Tomasz Koźluk and paricipans of he NBP\ conference in Warsaw for insighful discussions and valuable commens. We would also like o hank Lea Zicchino and Inessa Love for providing us wih he codes for panel VAR esimaion. The projec has been sared when he second auhor was visiing he Financial Sabiliy Division of he European Cenral Bank. 5 Throughou he paper he erms loans and credi will be used inerchangeably. 6 This can be seen for insance from heir Inflaion Repors, Financial Sabiliy Repors and minues of MPC meeings, e.g. CNB (2006), MNB (2006), NBP(2007).

183 183 We analyse empirically domesic and foreign currency loan 1 developmens in a panel of hree bigges Cenral European counries: he Czech Republic, Hungary and Poland. All hese counries follow inflaion argeing sraegies and all have a subsanial share of foreign currency loans in oal loans o he privae secor. Our sudy is no he firs approach o credi expansion in Cenral and Easern Europe. The invesigaed opics included e.g. esimaing equilibrium level of credi-o-gdp for he new EU Member Saes and poenial speed of he caching-up process, he possible impac of fuure euro adopion on he credi marke developmens in accession counries and he risk of crises relaed o excessive credi expansion. We have, however, no come across a sudy reaing explicily he subsiuion beween domesic and foreign currency loans. Neverheless, he reviewed papers poin a problems relaed o rapid credi expansion and a risk associaed wih high share of foreign currency loans and hus will be briefly discussed below. Several sudies on rapid credi growh in Cenral and Easern Europe discussed he risk o sabiliy. The reason for his is ha credi expansion is ofen included in a se of early warning indicaors for banking disress. I should be, however, sressed ha he majoriy of lending booms has no led o banking secor/balance of paymens crises in he region 2. The paper by Boissay e al. (2005) reviews a broad se of counries of he region (Croaia ogeher wih en ransiion counries of Cenral and Souh-Easern Europe ha joined EU in 2004 and in 2007). The auhors assess credi growh especially in counries wih fixed exchange rae regimes as higher han jusified by he facors elaed o macroeconomic fundamenals and caching-up process 3. The sudy by Backé e al. (2006) concenraes on equilibrium levels of credi-o-gdp raios in he same sample of 11 ransiion economies. Taking ino accoun he esimaed corridor of deviaion from equilibrium, he auhors find ha mos of he reviewed counries 4 may have already come close o equilibrium by 2004 or even oversho i. In case of he bigges economies of he region (he Czech Republic, Poland and Hungary) hey were raher on he undershooing side alhough he upper edge of he esimaed band was close o he equilibrium level. Idenifying cases of credi boom in Cenral and Easern Europe moivaed also he sudy by Kiss e al. (2006). The auhors disinguish differen definiions of excessive credi expansion (based on levels and growh raes) leading o differen conclusions. On he one hand, considering credi-o-gdp raios for economies under review, currenly observed values seemed o be below levels jusified by macroeconomic facors. On he oher hand, assessmen of credi growh brings abou a mixed picure wih Lavia and Esonia considered as poenially he mos risky 5. Oher sudies assess he risk associaed wih curren credi expansions as no being a major cause for concern. Siraine and Skamnelos (2007) come o a conclusion ha sill, in he shor erm, he risk of an adjusmen coming form a macroeconomic shock in Cenral and Easern Europe is higher ha he risk of deerioraion originaing from he banking crisis relaed o rapid credi growh. Commening he resuls of heir sudies, several of he cied auhors (e.g. Kiss e al. (2006), Siraine and Skamnelos (2007)) marked ha he high share of foreign currency denominaed loans in privae secor borrowing may be an addiional concern for moneary policy in some counries, since moneary ighen- 1 The noion of foreign currency loans is undersood here broadly as including foreign currency denominaed loans (ha can be, echnically, paid and repaid in a local currency afer indexing any cash flows o changes in an exchange rae). 2 The link beween credi expansion and banking secor/balance of paymens crises has been broadly discussed in he lieraure, alhough wihou leading o a generally acceped conclusion. A shor overview on he empirical lieraure on ha issue can be found in Brzoza-Brzezina (2005). 3 According o Boissay e al. (2005) esimaes he mos excessive credi growh over he period was recorded in: Bulgaria, Lavia, Lihuania, Esonia followed by Croaia and Hungary. 4 Those include primarily: Croaia, Esonia, Lavia and Bulgaria. 5 According o Kiss e al. (2006), in Hungary he dynamics of credi expansion can be explained by he convergence process. The Czech Republic and Poland were described as economies wih no excessive credi growh. Conference May 19-20, 2008, Minsk

184 184 ing may raher lead o increased foreign currency indebedness han o credi growh slowdown. The issue of limied poenial efficiency of moneary ools as a response o a credi boom relaed o currency mismach was also noiced in oher sudies, e.g. in Hilbers e al. (2006) and Backé and Wójcik (2006), alhough i was never he main poin of ineres. A more explici discussion on domesic and foreign currency lending can be found in a paper on he bank lending channel in Hungary by Horváh e al. (2006). The findings presened here seem o suppor he exisence of a subsiuion effec beween he wo ypes of credi, hough i mus be sressed ha he analysis was concenraed on he supply side of he marke 1. A similar sudy was conduced on moneary ransmission in Poland by Wróbel and Pawłowska (2002). Analysing responses of privae secor credi o moneary policy shocks, he auhors formulaed a hypohesis ha heir resuls may also poin o a presence of he subsiuion effec. On he whole, he quesion of subsiuabiliy beween domesic and foreign currency denominaed loans and is consequences for moneary policy has been signalled in several sudies, however, as a main research opic i has no ye received subsanial aenion. We show ha indeed domesic and foreign currency loans are close subsiues in he analysed counries (i.e. in he Czech Republic, Hungary and Poland). Alhough domesic ineres raes affec negaively, as can be expeced, domesic currency loans, hey also affec posiively foreign currency loans. Hence, consumers, facing higher borrowing coss in domesic currency simply urn o foreign credi. Our esimaes show ha foreign currency loans subsiue a non-negligible par of he value of los domesic currency loans afer a moneary policy ighening. Alhough he resuls vary somewha beween models and counries, hey poin o he phenomenon ha migh pose a serious consrain on he abiliy of domesic moneary auhoriies o affec overall credi creaion. The general resul poining a he subsiuion beween domesic and foreign currency denominaed loans is robus wih respec o he model specificaion. Model and daa Loan developmens are difficul o model empirically. One reason is ha we do no have a consisen economic heory abou he deerminans of loans. Sandard microfounded models used for moneary policy analysis (e.g. Clarida e al. (1999), Roemberg and Woodford (1998), Woodford (2003)) do no show any explici role for loans. For his reason i is no fully obvious wha variables should ener a model explaining loan demand. Moreover, recen advances in he analysis of moneary ransmission (Bernanke and Blinder (1988), Kashyap and Sein (1995, 2000)) show ha he loan marke is relaively specific in he sense ha we can expec loan demand and loan supply diverging frequenly. In such a siuaion he observed quaniy of new loans is a nonlinear (min) funcion of demand and supply. Such problems are relaively difficul o model empirically, in paricular in he presence of shor ime series and uncerainy abou he rue daa generaing process 2. For he above menioned reasons we decided o follow he approach used relaively ofen in he empirical lieraure. As o he choice of he model, his approach ignores he possible supplydemand disequilibria, assuming ha in he long run he wo marke sides mus be equal. Since, on he aggregae level i is difficul o idenify supply side facors, his approach o modelling concenraes on he demand side of he marke. Regarding poenial deerminans of loan demand, he 1 The auhors invesigaed wheher here is an asymmeric adjusmen of bank loan supply o changes in ineres rae, condiioned on specific characerisic of individual banks. They used panel daa on Hungarian banks and followed Kashyap and Sein (1995, 2000). Naional Bank of he Republic of Belarus 2 One possible approach is based on he disequilibrium modelling echnique developed by Nelson and Maddala (1974). I has recenly been applied o modelling lending o enerprises in he UK (Aanasova and Wilson (2004)) and analysing he Polish loan marke (Hurlin and Kierzenkowski (2002)). However, our experience wih his esimaor based on simulaions, was raher negaive. The proper esimaion required no only much longer daa series ha were available o us, bu also a specificaion of he esimaed equaions perfecly maching he daa generaing processes.

185 185 sandard approach accenuaes primarily income (as measured by GDP) and he cos of borrowing (as measured by he real ineres rae). Despie is limied heoreical appeal his approach has been successfully used for modelling loan demand in developed and developing counries (Calza e al. (2001), Calza e al. (2003), Hoffman (2001), Brzoza-Brzezina (2005)). Our approach differs slighly from he one presened above because of he specific quesion we ask. Analysing subsiuabiliy beween domesic and foreign currency loans we recognise ha demand for any of hese producs can depend no only on is own price bu also on he price of he poenial subsiue. Hence, modelling (real) demand for boh, domesic and foreign currency loans we refer o he same se of explanaory variables: real income, he real cos of borrowing in domesic currency and he real cos of borrowing in foreign currency:,,, (1),,, (2) where L D i L F sand respecively for real domesic and foreign currency loans, Y denoes real GDP, r D denoes he real domesic ineres rae, r F denoes he real foreign ineres rae and e sands for he nominal exchange rae 1. I should be noiced ha he real cos of borrowing in foreign currency, from he poin of view of a residen, involves he nominal foreign ineres rae deflaed by (expeced) domesic inflaion and he expeced change in he nominal exchange rae. Since we do no have consisen daa on borrowers' expecaions regarding inflaion and he exchange rae, we deflae he ineres raes wih curren domesic inflaion and add he curren exchange rae (or is growh rae, depending on he economeric approach) as a proxy for fuure expecaions abou he exchange rae. As already saed, he analysis invesigaes credi developmens in he Czech Republic, Hungary and Poland. Since here was no unified daabase wih all necessary ime series, he daa has been colleced from differen sources (see Appendix 1). We use a panel of quarerly daa for he period 1997Q1 2007Q1. Endogenous variables have been defined as real loans o he privae secor 2 denominaed eiher in domesic or in foreign currency 3 (deflaed in each case wih he domesic GDP deflaor). The calculaions were based on average quarerly socks of credi, only in he case of Hungary end of period sock was used (due o lack of monhly daa). Explanaory variables included GDP a marke prices of he previous year, domesic and foreign real ineres raes (quarerly averages of 3 monh fixing inerbank raes deflaed wih domesic GDP deflaors) as well as Swiss Franc nominal exchange raes agains naional currencies (quarerly averages). As for he foreign ineres rae, we decided o use he Swiss Franc LIBOR 3M rae as a measure of nominal cos of foreign credi. The reason for ha is he dominan share of Swiss Franc loans in oal credi in Hungary and Poland. Alhough Euro is also an imporan currency in foreign indeb- 1 An increase in e means a depreciaion of he local currency. 2 Privae secor is defined as corporaions and households. Non-profi insiuions serving households are ofen reaed joinly wih households bu o ensure he comparabiliy of ime series across analysed counries (he daa for hose insiuions was no available for he whole sample period for all counries) we excluded hem from our definiion of he privae secor. However, aking ino accoun he minor share of loans o non-profi insiuions serving households, he resuls should no be affeced by ha decision. 3 Foreign currency credi included joinly all loans denominaed in foreign currency (i.e. Euro, Swiss Frank ec.) bu he ue was expressed in unis of domesic currencies. Conference May 19-20, 2008, Minsk

186 186 edness of he analysed counries, he Swiss ineres raes can be well viewed as a proxy for he overall cos of foreign credi, since he wo ineres raes and exchange raes 1 (Swiss Franc and Euro) move closely ogeher. The lack of daa on deailed srucure of foreign loans makes i impossible o use a weighed ineres rae. All variables were firs esed for he order of inegraion (see Appendix 2). The ess poined relaively unambiguously o a uni roo in he GDP series and saionariy of real ineres raes, which is consisen wih several exernal sudies (e.g. Shively (2001), Carpolare and Grier (2000)). The case wih nominal exchange raes was no clear-cu, however, since in he counries under review an appreciaion rend of real exchange rae can be observed (due o he caching-up process), we decided o rea he exchange rae as a variable inegraed of order one. Resuls Since he heory gives us only weak guidance, a number of alernaive empirical specificaions of equaions (1) and (2) have been ried in order o check he robusness of he resuls. Forunaely, he relevan conclusions are invarian o he specificaion chosen. In our daa se we have boh saionary and non-saionary variables. In paricular, our dependen variables LDT (oal loans denominaed in domesic currency) and LFT (oal foreign currency loans) are I(1). Therefore, in all he specificaions he dependen variable is a quarer-on-quarer growh rae (i.e. change in log-level) of eiher real domesic currency loans or real foreign currency loans. Since here is always a considerable ime lag beween a decision o apply for a loan and he momen of acual graning he loan by a bank, we decided ha all he variables ener he esimaed equaions wih he lag of a leas one quarer 2. In addiion, having in mind relaively shor ime dimension of our sample, we argeed a reasonably parsimonious specificaions. Some experimens wih daa proved ha i is enough o include a mos wo lags o achieve well-behaving residuals. The number of lags of he dependen variable was kep as low as necessary o jus eliminae he auocorrelaion in residuals. As o explanaory variables, we used lagged levels of domesic (rd) and foreign currency (rchf) ineres raes following he discussion presened in he previous secion. Furher, we included raes of changes (i.e. differences of log-levels) for hose variables ha, according o earlier ess, migh exhibi non-saionariy (i.e. exchange raes e and GDP). Such an approach allows us o inerpre he esimaed coefficiens as elasiciies or (in he case of ineres raes) semi-elasiciies. As already menioned, we used differen empirical specificaions o check he robusness of he resuls. We sared wih an error correcion specificaion wih he coinegraing vecor esimaed for our nonsaionary variables. Nex, we moved o a simple ADL model on saionary (differenced when necessary) variables and esimaed he wo equaions 3 joinly using he SUR esimaor. Finally, we ook he same approach (ADL), bu esimaed he equaions separaely using he Arellano- Bond esimaor. For he sake of compleeness, for each of hese empirical specificaions we presen he resuls based on hree approaches o he models' dynamic srucure. Firs, we repor he resuls of he esimaions where all he exogenous variables ener only as firs lags. Second, we use firs wo lags of all exogenous variables. Finally, we show he resuls of a general-o-specific approach we Naional Bank of he Republic of Belarus 1 The correlaion coefficien of Swiss Franc and Euro ineres raes is above 95% (for he period of 1998Q Q2) and he correlaion beween exchange raes of domesic currencies (Koruna, Forin and Zloy) agains Swiss Franc and Euro ranges beween 92% and 97% for he same period. The use of Euro exchange rae does no change significanly he resuls of he analysis. 2 In our sample i is confirmed by he daa once we ried o esimae specificaions wihou he lagged dependen variables on he righ hand side, he residuals exhibied srong auocorrelaion. 3 For domesic and foreign currency denominaed loans.

187 187 sar wih firs wo lags of all he variables and han successively drop he variables wih insignifican parameer esimaes unil all variables are significan a he 10% level. Given he main quesion asked in he paper, he parameers for boh domesic and foreign ineres raes are of he primary ineres. In wha follows our discussion concenraes on ineres rae semielasiciies. However, we consider our specificaion o be conrolling reasonably well for oher relevan effecs so no serious biases should be expeced in he esimaed coefficiens. In wha follows we presen he hree differen empirical specificaions. Since he conclusions are consisen across specificaions, we presen hem joinly aferwards. We sar wih he error correcion specificaion. The resuls of he panel order of inegraion ess (see Appendix 2) led us o he conclusion ha he real domesic and foreign currency lending, he real GDP and he exchange raes (all variables in log-levels, according o definiions presened in Appendix 1) are inegraed of order one. As a naural nex sep we esed for possibiliy of he coinegraion (again in a panel seing) beween hese variables 1. Alhough we deal wih relaively shor ime series, he resuls presened in Table 2 sugges a possibiliy of he exisence of a coinegraing vecor. In he mos general seing, he esimaed equaions of he error correcion model for he counry i and period is: LDT i = κ i D+ k = 2 + k = α i D LDT i-k + 2 λ kd rd i-k + k = 1 2 k = 1 β k D GDP i-k + γ k D e i-k + k = 1 θ kd rchf i-k + δ D ECT i-1d + ε i D 2 (3) LFT i = κ if + k = α if LFT i-k + 1 β kf GDP i-k + k = 1 k = γ kf e i-k + + λ kf rd i-k + k = 1 θ kf rchf i-k + δ F ECT i-1f + ε F i k = 1 The evidence for he saisical significance of he error correcion erm is somewha mixed (see Table 3). Moreover, due o he shor ime span of he daa available o he analysed counries i migh be claimed ha he resuls of coinegraion analysis could be misleading 2. Therefore, we decided o ry also specificaions assuming lack of he coinegraing relaionship, where he ECT was no included (i.e. he coefficiens δ D and δ F are consrained o 0). Accordingly, furher resuls are based on he assumpion ha here is no coinegraing relaionship beween poenially non-saionary variables. This means ha our specificaion reduces o a disribued lag model: (4) LDT i = κ id + k = α id LDT i-k + 1 β kd GDP i-k + k = 1 k = 2 + k = LFT i = κ if + k = λ kd rd i-k + k = 1 θ kd rchf i-k + ε i D α if LFT i-k + 1 β kf GDP i-k + k = 1 k = + = k 2 1 λ kf rd i-k + = k θ kf rchf i-k + ε i F 1 1 γ kd e i-k + γ kf e i-k + (5) (6) 1 We used FM OLS procedure proposed by Pedroni (2000) since i allows some cross-secional heerogeneiy. 2 Among oher problems, here is an issue of only parial coverage of he business cycle. Conference May 19-20, 2008, Minsk

188 188 Equaions 5 and 6 were subjec o wo esimaion procedures. Firs, hey were esimaed joinly using he seemingly unrelaed regression (SUR) approach (Table 4). Second, we esimae hem separaely, using he Arellano-Bond esimaor (Table 5). The former approach was moivaed by he fac ha, as we discussed in he previous secion, equaions (1) and (2) are dependen. Given no consrains on he supply side of he credi marke, a poenial borrower faces a join decision wheher o apply for a loan (given curren and expeced economic condiions) and if so in which currency he loan should be denominaed. Therefore, he shocks in equaions (1) and (2) could be dependen 1. In order o benefi from his poenial relaionship, we esimaed joinly equaions for domesic and foreign currency loans using he SUR approach. Second, as a robusness check, we also repor he resuls of he separae esimaions for he boh ypes of loans. In his case, given he dynamic naure of our panel models, we use he Arellano-Bond (1991) firs-sep esimaor. The mos imporan conclusions, robus across all specificaions and esimaion mehods, are as follows. Firs, he auoregressive feaure of credi ime series (for boh domesic and foreign currency lending) is confirmed by esimaion resuls, since he lagged dependen variable eners he equaions usually wih a saisically significan parameer. Second, esimaes of he parameers for he GDP and ineres raes have proper signs. An increase in economic aciviy resuls in more of boh domesic and foreign currency lending. A higher domesic or foreign ineres rae leads o a lower increase in lending in he respecive currency he effec of a higher borrowing cos. Third, changes in he foreign exchange rae seem o have no effec on domesic currency lending. Wha is ineresing, however, is is impac on foreign currency loans. The esimaion resuls consisenly show ha a depreciaion of he domesic currency leads o a slower increase in foreign currency lending (an appreciaion resuls in more foreign currency lending). If his las resul is driven mosly by he demand facors (and anecdoal evidence from Poland suppors his hypohesis) hen behaviour of poenial borrowers migh no be fully raional 2. Our main finding, however, is ha he domesic moneary policy migh be couner-producive in he case of a lending boom fuelled by foreign currency denominaed loans. We obained very srong (and consisen across differen specificaions and esimaion mehods) evidence ha an increase in he domesic ineres rae resuls is more foreign currency denominaed loans. Therefore, a moneary conracion, insead of curbing credi growh, leads raher o changes in currency composiion of new loans. The presened models convincingly show ha domesic moneary policy acs (o some exen) in a counerproducive way. However, given heir simple srucure hey are no capable in answering he quesion abou he magniude of he subsiuion effec. This is because any simulaion of domesic and foreign credi reacion o an ineres rae shock conduced on heir basis would be prone o he criicism ha i does no ake ino accoun he indirec effecs on loans via exchange rae or oupu reacion. For his reason we decided o run also a panel VAR 3 on our daa se and analyze he impulse responses of domesic and foreign currency loans o a domesic ineres rae shock. The esimaed VAR seems o reflec he basic feaures of he previously esimaed models, i.e. he negaive reacion of domesic loans and he posiive reacion of foreign loans o a domesic ineres rae shock. The subsiuion effec has been calculaed by dividing newly creaed foreign currency loans Naional Bank of he Republic of Belarus 1 For example, a deerioraion in he general economic oulook should have a negaive effec boh on new domesic and foreign currency denominaed lending. 2 This is rue if we assume ha he exchange rae is non-saionary due o he real appreciaion rend, as well as, if we assume ha he exchange rae is mean-revering. 3 We used he codes developped by Zicchino and Love (2006).

189 189 by desroyed domesic currency loans afer 16 quarers from he iniial domesic ineres rae shock 1. We repor he resuls for VARs wih 1 and 2 lags in Table 1 2. Table 1: Esimaes of he subsiuion effec he Czech Republic Hungary Poland VAR(1) 6% 39% 19% VAR(2) 5% 31% 15% The resuls are dispersed beween counries which resuls direcly from he differen share of foreign currency loans in oal loans, ranging from 11% in he Czech Republic o 45% in Hungary in 2007Q1. Consequenly, he subsiuion effec in he Czech Republic may be considered negligible. However is magniude in Poland and, in paricular, in Hungary canno be ignored by policymakers, in paricular aking ino accoun he coninuously growing share of foreign currency loans in hese counries. Given he simple approach hese resuls should be inerpreed wih cauion. Sill, we believe ha hey documen quie robusly no only he presence bu also he nonnegligible size of he subsiuion effec in he region. Conclusions In his paper we asked he quesion wha is he impac of moneary policy on oal bank lending in he presence of a developed marke for foreign currency denominaed loans. The relevance of his quesion is moivaed by he poenially high subsiuabiliy beween domesic and foreign currency loans. Since he cenral bank has only impac on he cos of borrowing in domesic currency i canno preven lending in foreign currency and hence, may have only limied impac on oal lending. We based our empirical analysis on a panel of hree bigges Cenral European counries: he Czech Republic, Hungary and Poland. The obained resuls confirm ha developmen of he marke for foreign currency loans makes he job of he cenral bank more difficul. Alhough, as can be expeced, a moneary ighening leads o a decrease in domesic currency lending, i has simulaneously an acceleraing effec on foreign currency denominaed loans. Therefore, insead of curbing credi growh, he cenral bank migh raher end up changing he currency composiion of new bank lending. Simulaing he magniude of he subsiuion effec shows a nonnegligible subsiuion beween domesic and foreign currency loans in Poland and Hungary. Given he increasing share of foreign currency loans in hese counries, his problem may worsen over ime. These resuls may be unpleasan for cenral banks for a number of reasons. Firs, significan subsiuabiliy beween domesic and foreign currency loans may negaively impac upon he effeciveness of moneary policy ransmission. Second, he populariy of foreign currency loans may make he one insrumen, wo goals problem relaed o providing price and financial sysem sabiliy even more difficul o ackle. Foreign currency loans end o be popular especially among households ha usually do no hedge agains exchange rae risk. If resricive moneary policy acceleraes foreign currency lending hen i leads o more risk presen in he households' balance shees. Finally, as suggesed in he lieraure, increased lending can resul in nonfundamenal increases in asse prices which, if suddenly revered, can negaively impac on moneary and financial sysem sabiliy. High subsiuion beween domesic and foreign currency denominaed loans makes cenral banks' aemps o preven such oucomes even less effecive. 1 This was based on he mos recen available observaion of loan amouns ousanding for each counry separaely. 2 Complee resuls from he VAR sudy can be obained from he auhors upon reques. Conference May 19-20, 2008, Minsk

190 190 References Arellano M., S. Bond (1991), Some Tess of Specificaion for Panel Daa: Mone Carlo Evidence and an Applicaion o Employmen Equaions, The Review of Economic Sudies, Vol. 58, Aanasova C.V., N. Wilson (2004), Disequilibrium in he UK Corporae Loan Marke, Journal of Banking and Finance, Vol. 28, No. 3, March, Backé P., C. Wójcik (2006), Caching-up and Credi Booms in Cenral and Easern European EU Member Saes and Acceding Counries: An Inerpreaion wihin he New Neoclassical Synhesis Framework, CESifo Working Paper No. 1836, Ocober. Backé, P., B. Éger, T. Zumer (2006), Credi Growh in Cenral and Easern Europe: New (Over)Shooing Sars?, ECB Working Papers, No. 687, Ocober. Bernanke, B.S., A.S. Blinder (1988), Credi, Money and Aggregae Demand, American Economic Review Papers and Proceedings, Vol. 78, Boissay, F., O. Calvo-Gonzalez, T. Koźluk (2005), Is Lending in Cenral and Easern Europe Developing oo Fas? Paper presened a he conference Finance and Consumpion Workshop: onsumpion and Credi in Counries wih Developing Credi Markes, Florence, June. Borio, C., A. Filardo (2004), Back o he fuure? Assessing he deflaion record, BIS Working Papers, no 152, March. Borio, C., A. Filardo (2004), Looking back a he inernaional deflaion record, Norh American Journal of Economics and Finance, December, Brzoza-Brzezina, M. (2005), Lending Booms in he New EU Member Saes -- Will Euro Adopion Maer? European Cenral Bank Working Paper No Brzoza-Brzezina, M., T. Chmielewski, J. Niedźwiedzińska (2007) Subsiuion beween domesic and foreign currency loans in Cenral Europe. Do cenral banks maer?, Paper presened a he conference Moneary Policy Challenges Resuling from he Rapid Credi Growh in Converging Economies, Warszawa, November. Calza, A., C. Garner, J. Sousa (2001), Modelling he demand for loans o he privae secor in he Euro area, European Cenral Bank Working Paper No. 55. Calza, A., M. Manrique, J. Sousa (2003), Aggregae loans o he Euro area privae secor, European Cenral Bank Working Paper No Carpolare, T., K. B. Grier (2000), Poliical Regime Change and he Real Ineres Rae, Journal of Money, credi and Banking, Vol. 32, No. 3 (Augus), Czech Naional Bank (2006), Financial Sabiliy Repor. Clarida, R., J. Gali., M. Gerler (1999), The Science of Moneary Policy: A New Keynesian Perspecive, Journal of Economic Lieraure, December. Duenwald, C., N. Gueorguiev, A. Schaecher (2005), Too much of a good hing? Credi booms in ransiion economies: The cases of Bulgaria, Romania and Ukraine, IMF Working Paper, No Fischer, B., M. Lenza, H. Pill, L. Reichlin (2006), Money and moneary policy: The ECB experience, Fourh ECB Cenral Ranking Conference, November. Gerlach, S., L. Svensson (2003), Money and inflaion in he euro area: a case for moneary indicaors?, Journal of Moneary Economics, Hilbers, P., I. Oker-Robe, C. Pazarbaşioğlu (2006), Going oo Fas? Managing rapid credi growh in Cenral and Easern Europe, IMF, Finance and Developmen, 43(1). Hofmann, B. (2001), The Deerminans of Privae Secor Credi in Indusrialised Counries: Do Propery Prices Maer? BIS Working Paper No Horváh C., J. Krekó, A. Naszódi (2006), Is here a bank lending channel in Hungary? Evidence form bank panel daa, MNB Working Paper No. 7, May. Hurlin, C., R. Kierzenkowski (2002), A heoreical and empirical assessmen of he bank lending channel and loan marke disequilibrium in Poland, Working Paper 22, May 2002, Naional Bank of Poland, Research Deparmen. Kashyap, A., J. Sein (1995), The impac of moneary policy on bank balance shees, Carnegie-Rocheser Conference Series on Public Policy, 42, Kashyap, A., J. Sein (2000), Wha Do a Million Observaions on Banks Say Abou he Transmission of Moneary Policy?, American Economic Review, 90(3), Kiss, G., M. Nagy, B. Vonnák (2006), Credi Growh in Cenral and Easern Europe: Trend, Cycle or Boom?, Paper presened a he conference Finance and Consumpion Workshop: Consumpion and Credi in Counries wih Developing Credi Markes, Florence, June. Maddala, G. S., F. D. Nelson (1974), Maximum Likelihood Mehods for Models of Markes in Disequilibrium, Economerica, Vol. 42, No. 6., November, Naional Bank of he Republic of Belarus Magyar Nemzei Bank (2006), Inflaion Repor (updae), Augus. Mishkin F. (1996), The Channels of Moneary Transmission: Lessons for Moneary Policy, NBER WP 5464, Cambridge. Naional Bank of Poland (2007), Minues of he MPC decision-making meeing held on 27 June 2007.

191 191 Pedroni P. (2000), Fully Modified OLS for Heerogeneous Coinegraed Panels, in: Nonsaionary Panels, Panel Coinegraion and Dynamic Panels, Elsevier, Roemberg, J., M. Woodford (1998), Ineres-Rae Rules in an Esimaed Sicky Price Model, NBER Working Papers Naional Bureau of Economic Research. Shively, P. A. (2001), Trend-Saionary GNP: Evidence from a New Exac Poinwise Mos Powerful Invarian Uni Roo Tes, Journal of Applied Economerics, Vol. 16, No. 4 (July/Augus), Siraine S., I. Skamnelos (2007), Credi Growh in Emerging Europe: A Cause for Sabiliy Concerns?, Policy Research Working Paper, No. 4281, The World Bank, July. Woodford, M. (2003), Ineres and Prices: Foundaions of atheory of Moneary Policy, Princeon Universiy Press. Wróbel, E., M. Pawłowska (2002), Moneary Transmission in Poland: Some Evidence on Ineres Rae and Credi Channels, Naional Bank of Poland, Maeriał y i Sudia, No. 24. Appendix 1: Daa sources The following sources of daa for he economeric model were used: 1. Loans o he privae secor: Loans denominaed in domesic currency (i.e. Czech Koruna) o he privae secor (households + non-financial corporaions) in he Czech Republic source: Czech Naional Bank (CZK millions) Loans denominaed in domesic currency (i.e. Hungarian Forin) o he privae secor (households + non-financial corporaions) in Hungary source: Naional Bank of Hungary (HUF billions) Loans denominaed in domesic currency (i.e. Polish Zloy) o he privae secor (households + non-financial corporaions) in Poland source: Naional Bank of Poland (PLN millions) Loans denominaed in foreign currency (all currencies oher han domesic currency) o he privae secor (households + non-financial corporaions) in he Czech Republic source: Czech Naional Bank (CZK millions) Loans denominaed in foreign currency (all currencies oher han domesic currency) o he privae secor (households + non-financial corporaions) in Hungary source: Naional Bank of Hungary (HUF billions) Loans denominaed in foreign currency (all currencies oher han domesic currency) o he privae secor (households + non-financial corporaions) in Poland source: Naional Bank of Poland (PLN millions) 2. GDP a marke prices of 2000 (Millions of naional currency i.e. Czech Koruna, Hungarian Forin and Polish Zloy respecively he Czech Republic, Hungary, Poland source: Eurosa 3. GDP deflaor (prices of he previous year = 100) he Czech Republic, Hungary, Poland own calculaions based on Eurosa daa 4. Nominal ineres rae Inerbank Raes (3 Monh, Fixing) he Czech Republic, Hungary, Poland, Swizerland source: EcoWin 5. Nominal exchange rae Swiss Franc exchange raes agains naional currency he Czech Republic, Hungary, Poland own calculaions based on EcoWin daa Conference May 19-20, 2008, Minsk

192 192 Appendix 2: Panel uni roo ess Real domesic currency loans log-levels Real domesic currency loans firs differences Exogenous variables: Individual effecs Exogenous variables: Individual effecs Auomaic selecion of lags based on SIC: 0 o 2 Auomaic selecion of lags based on SIC: 0 o 1 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) Im, Pesaran and Shin W-sa Im, Pesaran and Shin W-sa ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square Exogenous variables: None Exogenous variables: None Auomaic selecion of lags based on SIC: 0 o 2 Auomaic selecion of lags based on SIC: 0 o 2 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square Real foreign currency loans log-levels Real foreign currency loans firs differences Exogenous variables: Individual effecs Exogenous variables: Individual effecs Auomaic selecion of lags based on SIC: 0 o 1 Auomaic selecion of lags based on SIC: 0 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) Im, Pesaran and Shin W-sa Im, Pesaran and Shin W-sa ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square Exogenous variables: None Exogenous variables: None Auomaic selecion of lags based on SIC: 0 o 1 Auomaic selecion of lags based on SIC: 0 o 1 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Naional Bank of he Republic of Belarus Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square

193 193 Real GDP log-levels Real GDP firs differences Exogenous variables: Individual effecs Exogenous variables: Individual effecs Auomaic selecion of lags based on SIC: 0 o 5 Auomaic selecion of lags based on SIC: 0 o 2 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) Im, Pesaran and Shin W-sa Im, Pesaran and Shin W-sa ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square Exogenous variables: None Exogenous variables: None Auomaic selecion of lags based on SIC: 1 o 3 Auomaic selecion of lags based on SIC: 0 o 2 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square Exchange rae log-levels Exchange rae firs differences Exogenous variables: Individual effecs Exogenous variables: Individual effecs Auomaic selecion of lags based on SIC: 0 Auomaic selecion of lags based on SIC: 0 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) Im, Pesaran and Shin W-sa Im, Pesaran and Shin W-sa ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square Exogenous variables: None Exogenous variables: None Auomaic selecion of lags based on SIC: 0 Auomaic selecion of lags based on SIC: 0 Mehod Saisic Prob.# Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Null: Uni roo (assumes individual uni roo process) ADF - Fisher Chi-square ADF - Fisher Chi-square PP - Fisher Chi-square PP - Fisher Chi-square Conference May 19-20, 2008, Minsk

194 194 Real domesic ineres raes levels Exogenous variables: Individual effecs Auomaic selecion of lags based on SIC: 0 o 1 Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Im, Pesaran and Shin W-sa ADF - Fisher Chi-square PP - Fisher Chi-square Exogenous variables: None Auomaic selecion of lags based on SIC: 0 o 1 Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) ADF - Fisher Chi-square PP - Fisher Chi-square Real foreign ineres raes levels Exogenous variables: Individual effecs Auomaic selecion of lags based on SIC: 1 o 5 Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) Im, Pesaran and Shin W-sa ADF - Fisher Chi-square PP - Fisher Chi-square Exogenous variables: None Auomaic selecion of lags based on SIC: 1 o 5 Mehod Saisic Prob.# Null: Uni roo (assumes common uni roo process) Levin, Lin & Chu * Null: Uni roo (assumes individual uni roo process) ADF - Fisher Chi-square PP - Fisher Chi-square Naional Bank of he Republic of Belarus Newey-Wes bandwidh selecion using Barle kernel Auomaic selecion of maximum lags # Probabiliies for Fisher ess are compued using an asympoic Chi-square disribuion. All oher ess assume asympoic normaliy.

195 195 Appendix 3: Esimaion Resuls [sd. errors] (p-values) {-saisics} (1), (4) Firs lags of all exogenous variables (2), (5) Firs wo lags of all exogenous variables (3), (6) General-o-specific, saring wih specificaion wih firs wo lags of all exogenous variables Sargan - Sargan es of over-idenifying resricions Arellano-Bond (1) - Arellano-Bond es ha average auocovariance in residuals of order 1 is 0: H0: no auocorrelaion Arellano-Bond (2) - Arellano-Bond es ha average auocovariance in residuals of order 2 is 0: H0: no auocorrelaion Table 2: Panel group FMOLS resuls Coinegraing Eq: ECT D ECT F LDT LFT GDP {15.53} {10.44} e {-2.53} {0.15} _cons Coinegraion es##: Null: Uni roo group rho-sa 2.06** 1.78* group pp-sa 2.48** 2.02** group adf-sa 2.22** 1.40*** ##All repored values are disribued N(0,1) Panel sas are weighed by long run variances Table 3: Esimaion resuls using Arellano-Bond esimaor, specificaion wih ECT Firs lags of all exogenous variables Firs wo lags of all exogenous variables General-o-specific (1) (4) (2) (5) (3) (6) LDT LFT LDT LFT LDT LFT LDT *** 0.369*** 0.369*** [0.096] [0.099] [0.093] (0.000) (0.000) (0.000) LDT [0.104] [0.106] [0.098] (0.688) (0.535) (0.522) LDT ** 0.234** 0.238*** [0.092] [0.098] [0.090] (0.022) (0.017) (0.008) LFT *** 0.253** 0.468*** [0.093] [0.102] [0.091] (0.000) (0.013) (0.000) LFT *** [0.095] (0.001) Conference May 19-20, 2008, Minsk

196 196 GDP [0.667] [1.25] [0.908] [1.658] (0.443) (0.556) (0.537) (0.379) GDP [0.851] [1.552] (0.875) (0.146) e *** *** *** [0.078] [0.170] [0.080] [0.159] [0.160] (0.677) (0.000) (0.853) (0.000) (0.000) e ** [0.079] [0.165] (0.444) (0.022) rd *** 0.307* ** * *** [0.090] [0.181] [0.275] [0.502] [0.092] (0.001) (0.091) (0.022) (0.084) (0.000) rd ** 0.417** [0.278] [0.508] [0.178] (0.266) (0.024) (0.019) rchf ** ** [0.086] [0.172] [0.366] [0.681] [0.276] (0.314) (0.968) (0.029) (0.135) (0.034) rchf ** * [0.350] [0.649] [0.262] (0.049) (0.112) (0.068) ECT D -0.02* * [0.012] [0.13] [0.011] (0.097) (0.179) (0.066) ECT F ** ** ** [0.015] [0.014] [0.011] (0.025) (0.039) (0.002) Arellano-Bond (1) -7.09*** -6.11*** -7.34*** -8.18*** -7.56*** -6.16*** (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Arellano-Bond (2) -0.28*** (0.000) (0.303) (0.605) (0.601) (0.789) (0.247) Sargan (1.000) (1.000) (1.000) (1.000) (1.000) (1.000) Table 4: Esimaion resuls - seemingly unrelaed regression Firs lags of all exogenous variables Firs wo lags of all exogenous variables General-o-specific (1) (4) (2) (5) (3) (6) LDT LFT LDT LFT LDT LFT LDT *** 0.498*** 0.499*** [0.085] [0.086] [0.086] (0.000) (0.000) (0.000) LDT-2 Naional Bank of he Republic of Belarus LFT *** 0.270*** 0.307*** [0.087] [0.095] [0.091] (0.000) (0.004) (0.001) LFT ** 0.315*** 0.292*** [0.82] [0.089] [0.089] (0.013) (0.000) (0.001)

197 197 GDP *** *** [0.567] [0.885] [0.876] [1.552] [0.567] (0.007) (0.180) (0.139) (0.636) (0.007) GDP ** 2.520*** [0.800] [1.403] [0.859] (0.446) (0.011) (0.003) e *** *** *** [0.076] [0.156] [0.077] [0.152] [0.152] (0.711) (0.000) (0.736) (0.000) (0.000) e *** ** [0.076] [0.158] [0.158] (0.645) (0.009) (0.012) rd * 0.258* ** * * [0.072] [0.144] [0.257] [0.477] [0.072] (0.078) (0.073) (0.021) (0.096) (0.097) rd * *** [0.252] [0.482] [0.136] (0.073) (0.024) (0.007) rchf * 0.589* [0.065] [0.122] [0.347] [0.640] (0.485) (0.062) (0.089) (0.254) rchf * ** [0.333] [0.621] [0.114] (0.066) (0.103) (0.014) κ * *** *** [0.006] [0.012] [0.007] [0.013] [0.006] [0.011] (0.455) (0.063) (0.181) (0.001) (0.551) (0.001) Correlogram of residuals regressions of LDT (1) (2) (3) lag AC PAC Q-Sa Prob AC PAC Q-Sa Prob AC PAC Q-Sa Prob Correlogram of residuals regressions of LFT (4) (5) (6) lag AC PAC Q-Sa Prob AC PAC Q-Sa Prob AC PAC Q-Sa Prob Conference May 19-20, 2008, Minsk

198 198 Table 5: Esimaion resuls using Arellano-Bond esimaor, specificaion wihou ECT Firs lags of all exogenous variables Firs wo lags of all exogenous variables General-o-specific (1) (4) (2) (5) (3) (6) LDT LFT LDT LFT LDT LFT LDT *** 0.419*** 0.435*** [0.091] [0.095] [0.089] (0.000) (0.000) (0.000) LFT *** 0.221* 0.291*** [0.101] [0.114] [0.106] (0.000) (0.051) (0.006) GDP ** ** [0.588] [1.025] [0.927] [1.699] [0.584] (0.025) (0.730) (0.325) (0.705) (0.021) GDP * 1.956** [0.844] [1.536] [0.979] (0.458) (0.065) (0.046) e *** * ** [0.078] [0.181] [0.083] [0.182] [0.178] (0.687) (0.004) (0.544) (0.060) (0.019) e [0.081] [0.149] (0.442) (0.446) rd * 0.603*** ** *** [0.105] [0.228] [0.271] [0.524] [0.091] (0.060) (0.008) (0.031) (0.109) (0.008) rd *** 0.867*** [0.268] [0.567] [0.233] (0.141) (0.003) (0.000) rchf *** [0.127] [0.264] [0.366] [0.703] (0.358) (0.007) (0.112) (0.264) rchf ** ** *** [0.357] [0.728] [0.264] (0.033) (0.027) (0.003) Arellano-Bond (1) *** *** *** *** *** *** (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Arellano-Bond (2) (0.467) (0.414) (0.409) (0.104) (0.449) (0.238) Sargan (1.000) (1.000) (1.000) (1.000) (1.000) (1.000) Naional Bank of he Republic of Belarus

199 199 Omar A. Mendoza Lugo 1 The Differenial Impac of Real Ineres Raes and Credi Availabiliy on Privae Invesmen:Evidence from Venezuela The heory of financial repression or liberalizaion esablishes ha he relaionship beween privae invesmen and financial variables -real ineres raes and credi availabiliy- is nonlinear. We invesigae his issue applying a logisic smooh ransiion vecor error correcion (LSTVEC) model o Venezuelan daa during 1983:2 2000:4, a period ha corresponds o adminisraive conrols and deconrol of nominal ineres raes. We found evidence of asymmeries beween he growh rae of privae invesmen and financial variables; however, an increase of real ineres raes in periods of credi conracion does no simulae privae invesmen. In addiion, when he economy faces a credi consrain, a negaive shock o credi availabiliy causes a higher conracionary effec on he growh rae of privae invesmen. Thus, our findings are no oally in line wih he predicions of he financial liberalizaion heory. 1 Inroducion Privae spending on fixed capial goods has been an imporan opic of discussion among economiss and policy makers. The influence of invesmen on growh and is volailiy conribuing o business cycles jusify his focus. Recen empirical research has evaluaed he effecs of economic reforms, especially financial reforms, on capial formaion and growh in developing counries. This issue sheds ligh on he link beween financial and real variables. In radiional heory, his link is given by means of he real ineres rae. However, credi may also have a direc effec on real variables by affecing consumpion and invesmen when asymmeric informaion and/or excessive governmen inervenion characerize he financial marke. In he 1970 s, some economiss, led by McKinnon (1973) and Shaw (1973), began o argue in favor of financial liberalizaion as a medium of promoing saving, invesmen, and growh. This was based on he argumen ha real ineres raes are frequenly negaive in developing counries due o adminisraive conrols on he nominal ineres raes and heavy regulaion in he financial marke. This argumen implies ha real ineres raes have a ne posiive effec on privae invesmen, conradicing he radiional view of a negaive relaionship beween privae invesmen and real ineres raes. Neverheless, he financial liberalizaion lieraure argues in favor of higher ineres raes due o wha was observed in developing economies a he ime, and he possibiliy of a negaive relaionship beween invesmen and ineres raes was no ruled ou. McKinnon (1973) argued ha in hose counries where self-finance is very imporan and he ineres rae is negaive or very low, an upward increase in real deposi raes encourages saving (he subsiuion effec dominaes he income effec) and he subsiuion from goods o bank deposis. Boh have posiive effecs on privae invesmen because self-financed invesmen rises and because here is a rise in he availabiliy of funds o finance any profiable invesmen projec. However, a higher raes, economic agens would prefer o hold deposis ha yield a higher reurn han invesmen in physical capial. Therefore, a high raes, invesmen and real bank raes are expeced o be negaively relaed. Hence, McKinnon s argumens imply a nonlinear relaionship beween real ineres raes and privae invesmen. 1 Senior Economis, Cenral Bank of Venezuela, [email protected]. This paper is a summary version of my Ph.D disseraion, Texas A&M Universiy. The views expressed are hose of he auhor and do no necessarily reflec he views of he Cenral Bank of Venezuela. Conference May 19-20, 2008, Minsk

200 200 Furhermore, privae invesmen can be nonlinear in credi availabiliy (Günçavdı e al.(1998)). Tha is, if we expec ha credi consrains are presen a all levels of ineres raes, hen when he effec of an increase in he real ineres raes in he loan supply is higher han he coss brough abou by higher raes due o asymmeric informaion problems, a decrease in he sensiiviy of privae invesmen on credi availabiliy a higher raes should be expeced as well. Invesigaing he effecs of financial facors on privae invesmen, especially he role of ineres raes, consiues an imporan issue for developing counries where economic auhoriies in general believe ha real ineres raes play an imporan role in invesmen decisions and herefore on growh. In paricular, he curren Venezuelan governmen emphasizes he need o lower ineres raes o encourage privae invesmen. However, Venezuela is one of he counries ha has mainained, on average, low real ineres raes in recen years (see Mendoza Lugo, 2001, Appendix A, Tables A.1 and A.2), wih long periods of negaive real raes and wih periods of adminisraive conrol and deconrol on he nominal ineres raes. To invesigae he nonlinear relaionship and, herefore, he differenial impac of real ineres raes and credi availabiliy on privae invesmen, we use Venezuelan quarerly daa for he period 1983:1-2000:4. The variables used in his sudy, besides privae invesmen, are bank lending real ineres raes, bank loans o he privae secor as an indicaor of credi availabiliy, public invesmen and real gross domesic oupu generaed by he privae secor or privae GDP. All hese variables are, in principle, reaed as endogenous, bu he main focus is given o privae invesmen spending. In addiion o he menioned variables, some dummy variables are aken ino accoun o conrol for special evens, srucural economic reform and seasonaliy. Since we are ineresed in a model specificaion where he variable defining he saes of he economy is known, he proposed economeric model is a logisic smooh ransiion vecor error correcion (LSTVEC) model, which is a generalizaion of he smooh ransiion regressive (STR) models proposed by Granger and Teräsvira (1993). 1 We esimae a LSTVEC model for privae invesmen and is deerminans wih lagged values of DLCREDIT explaining he saes of he economy in four of he five equaions considered in his sudy. 2 To esimae he LSTVEC model, we use as a benchmark a linear specificaion, namely a subse or resriced in coefficiens VEC model, and follow, wih some modificaions, he procedure recommended by Granger and Teräsvira (1993) o esimae a STR model. From he LSTVEC model, generalized impulse response funcions are consruced (Koop e al (1996), Weise (1999)) o explore, especially, he effecs of posiive and negaive shocks o he real ineres rae and credi availabiliy on privae invesmen when facing credi conracions or expansions. The impulse responses show evidence for asymmeric effecs of shocks of he growh rae of hese financial variables o he growh rae of privae invesmen. However, hese asymmeries are no oally in line wih he predicions of he financial liberalizaion heory. Secion 2 summarizes some heoreical issues and empirical evidence repored in he lieraure wih special focus on developing counries. However, i is no our purpose o presen an exhausive survey of he lieraure, bu merely presen a review of resuls of previous research ha suppor and allow for comparison o he resuls of his research. Secion 3 presens he daa. Secion 4 inroduc- Naional Bank of he Republic of Belarus 1 The STR models belong o he caegory of regime-swiching models. Among he regime-swiching models, wo general caegories can be disinguished. They are: (1) he smooh ransiion regressive (STR) models (he hreshold models are a paricular case of his caegory), which assume ha he variable defining a regime or sae of he world process is observable; and (2) he swiching regression models, which assume ha he regime is no known wih cerainy bu some probabiliies of is occurrence can be assigned. Franses and van Dijk (2000) discuss he properies and applicaions of hese wo caegories in modeling financial variables. 2 Even hough he lineariy es indicaes ha he equaion for he growh rae of privae GDP is nonlinear when he ransiion variable is he growh rae of public invesmen lagged four periods, a saisfacory nonlinear equaion was no found. Therefore, he specificaion of his equaion is assumed linear.

201 201 es a smooh ransiion specificaion for a VEC model wih special emphasis on he modeling of a nonlinear privae invesmen funcion. Secion 5 is relaed o he esimaion procedure and presens he resuls. Secion 6 shows he impulse response funcions on he growh rae of privae invesmen (DLPRIVINV) o shocks on he five endogenous variables considered in he sudy. Finally, Secion 7 presens he conclusions. 2 On he deerminans of privae invesmen in developing counries Some economiss argue ha when sudying invesmen in developing counries, special feaures no accouned for in radiional heories of invesmen should be considered. Agénor and Moniel (1999, pp 97-99) lis six of hose facors. Firs, financial variables may influence privae invesmen because of underdeveloped financial sysems and financial repression. Second, foreign exchange raioning and he exchange rae in he free marke may influence invesmen decisions because of he imporance of impored capial goods. Third, due o heir imporance in he producion process in developing counries, impored inermediae goods should be aken ino accoun in he specificaion of relaive prices. Fourh, deb overhang inhibis invesmen because of he possibiliy of higher axes o finance fuure deb service. Fifh, public invesmen has played an imporan role in he process of capial formaion in developing counries. I may have a posiive or negaive effec on privae invesmen depending on wheher public invesmen is complemenary o or a subsiue for privae invesmen. And sixh, macroeconomic insabiliy and is resuling uncerainy, which have characerized developing counries, may have an imporan effec on privae invesmen. Despie he undersanding ha all hese elemens may be imporan deerminans of invesmen, he presen sudy focuses on he firs and fifh issues; ha is, his research is basically limied o he role of financial facors, credi availabiliy and ineres raes as deerminans of privae invesmen. Public invesmen is considered in he analysis because i may affec privae invesmen by means of is effecs on financial variables as well as is direc effec by means of posiive exernaliies enhancing he produciviy of he privae secor. In addiion, gross domesic produc and economic reform policies are aken ino accoun because hey have been found in previous research o be imporan deerminans of privae invesmen. Furher, hese wo variables migh play an imporan role in undersanding privae invesmen spending in he presence of asymmeric informaion and he ransiion from a heavily regulaed economy o a more marke-oriened economy. 2.1 Real ineres raes as a deerminan of privae invesmen The effec of real ineres raes on privae invesmen spending was firs formalized in an invesmen equaion by Jorgenson (1963), who derived he desired sock of capial as a funcion of real oupu and he opporuniy cos of capial. In his approach, known as he neoclassical approach, a represenaive firm maximizes he presen value of is fuure cash flows. The desired capial sock is direcly relaed o oupu and inversely relaed o he cos of capial. A decrease in he real ineres rae lowers he opporuniy cos of capial and, herefore, raises he desired capial sock and invesmen spending. Oher lieraure, emphasizing he role of financial markes on capial formaion (McKinnon (1973); Shaw (1973); Fry (1988)) includes suggesions ha an increase in real ineres raes has a posiive effec on he volume and qualiy of invesmen in financially repressed economies. 1 The former effec is seen because self-finance is imporan and invesmen is lumpy. Then, he economic agens mus accumulae resources before any invesmen projec is execued. An increase in real ineres raes hus simulaes boh oal and financial savings and, consequenly, invesmen. The laer ef- 1 Financial repression is defined as high inervenion by he governmen in he financial markes by seing ceilings on nominal ineres raes, imposing high legal reserve raios, and direc inervenion on credi allocaion. Conference May 19-20, 2008, Minsk

202 202 fec, improvemen in he qualiy of invesmen, occurs because a higher ineres rae will rule ou invesmen projecs wih low produciviy. A he same ime, higher raes move resources from less efficien (e.g. goods facing some depreciaion) o more efficien forms of accumulaion (e.g. bank deposis wih a more favorable reurn). 1 In paricular, McKinnon (1973), when explaining he link beween ineres raes, money and invesmen, suggess a nonlinear relaionship beween he real ineres raes on deposis and he rae of privae invesmen. When he real reurn o money is lower han he average real reurn o physical capial, a furher increase in money reurns induces he accumulaion of cash balances o finance a significan number of invesmen projecs. Bu a higher ineres raes, more economic agens may prefer o hold money raher han finance invesmen projecs because money offers a higher reurn han heir invesmen possibiliies in physical capial. Therefore, one expecs o find a posiive (negaive) relaionship beween hese wo variables a low (high) reurns holding he average reurn o physical capial consan. McKinnon s invesmen equaion is given by I = F( r, d), Y > < wih, F / r > 0 and F / d 0 if d r. Where, Ι denoes privae invesmen, Υ is oupu, r is he < > average reurn on physical capial, d is he real reurn on money, and he las derivaive expresses he nonlinear relaionship beween real ineres raes for money and he rae of invesmen. Warman and Thirlwall (1994) sudy he effecs of real ineres raes on saving, invesmen and growh. They use daa from Mexico for he period o quanify he level effecs of low and high ineres raes on privae invesmen. They use he following invesmen equaion. where b 1 >0, c 1 <0, d 1 >0, d 2 >0. e 1 + b1 r + c1[( r r ) D] + d1c + d 2 1 I = a GDP, They specify invesmen (I) as a funcion of he real ineres rae (r), credi o he privae secor (C), he firs difference of GDP ( GDP), and a erm, (r-r e )*D, o capure he no lineariy beween ineres raes and privae invesmen. r e is he hreshold rae or he border rae beween wo regimes in which he ineres rae affecs invesmen in differen (posiive and negaive) ways. D is a dummy variable aking values of one when r-r e is posiive and zero oherwise. Under he above specificaion, Warman and Thirlwall find ha he coefficiens for ineres raes and for he erm measuring no lineariy are very low and saisically insignifican. When a linear relaionship is assumed, he real ineres rae has an imporan negaive and saisically significan effec on privae invesmen. However, hey may have failed o find a nonlinear relaionship beween he real ineres rae and invesmen because of a misspecified nonlinear invesmen equaion. A furher sudy of he nonlineariy of invesmen in financial facors is provided by Günçavdı e al (1998). They argue ha afer financial liberalizaion, he invesmen equaion should become more sensiive o he cos of capial and less sensiive o he flow of credi o he privae secor because of he relaxaion of he credi consrains. Based on he fac ha afer financial liberalizaion he real ineres rae became posiive in Turkey, Günçavdı e al es for srucural changes in he coefficiens for cos of capial Naional Bank of he Republic of Belarus 1 Empirical research in general finds a posiive bu saisically insignifican effec of real ineres raes on savings. Bandeira e al. (2000) verify ha resul from previous research in a counry by counry sudy for eigh developing counries (Chile, Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey, and Zimbabwe).

203 203 and credi availabiliy in an esimaed privae invesmen equaion for Turkey. They find ha he sensiiviy of privae invesmen on credi availabiliy decreases afer financial liberalizaion bu hey do no find evidence for an increase in he sensiiviy of invesmen on he cos of capial. 1 Furhermore, some economiss argue ha when analyzing he effec of ineres rae policies in developing counries, he assumpion of perfec compeiion in he banking sysem is unrealisic because in hese counries he banking secor is characerized by a small number of banks. In addiion, credi markes face asymmeric informaion. For example, Demeriades and Luinel (2001) argue ha under imperfec compeiion, mild repression 2 in he lending raes has a posiive effec on bank loans. Tha is, under governmen inervenion wih an ineres rae fixed below he monopoly equilibrium level, i is opimal for bankers o increase he amoun of loans. However, repressing ineres rae levels below hose ha would prevail under perfec compeiion will likely reduce he amoun of loans and consequenly have a negaive effec in he economy. Daa on ineres raes is only available since he eighies or early nineies for mos of developing counries; herefore here is no an abundance of empirical work esing he effecs of ineres raes or he cos of capial on privae invesmen for developing counries. Previous work for developing counries is no only sparse bu also shows mixed resuls for he effec of ineres raes on invesmen spending. For insance, Warman and Thirlwall (1994) show a negaive and significan relaionship using daa for Mexico. De Melo and Tybou (1986) repor a negaive bu saisically insignifican effec using daa for Uruguay. Laumas (1990) and Ahukorala (1998) find a posiive relaionship beween real ineres on deposis and privae invesmen in India. Wih respec o he relaionship beween he cos of capial and invesmen, he relaion is found o be negaive in Ahukorala (1998) bu posiive in Günçavdı e al (1998) for Turkey. 2.2 Bank lending as a deerminan of privae invesmen When sudying developing counries, bank lending o he privae secor is an imporan deerminan of privae invesmen due o he banking sysem s imporance as a source of exernal finance in hose counries. Tha is, bank loans do no have close subsiues. Therefore, a conracion in he bank supply of credi may limi spending financed by credi. If he supply of bank credi is limied by he size of deposis, hen a conracion of deposis will conrac he supply of credi. The financial repression lieraure, or he lieraure in favor of financial liberalizaion, akes he special role of he banking sysem as a source of finance in developing counries ino accoun. When adminisraive conrols are imposed on ineres raes, credi is no allocaed according o he expeced reurn on he projecs, bu according o he qualiy of collaeral, loan size, poliical pressure, and cover benefis o loan officers. Wih ineres rae ceilings, financial insiuions do no ake risk because higher ineres raes canno be charged. Consequenly, many high-yielding projecs may face credi raioning (Fry, 1988, page 18). An increase in real ineres raes encourages deposis and, hence, increases he availabiliy of funds o he privae secor o finance invesmen projecs while deerring low-yield projecs. In conras, he heory emphasizing he role of asymmeric informaion in financial markes predics ha an increase in ineres raes causes credi raioning because he lenders expeced profiabiliy is no monoonically increasing in ineres raes. A higher raes, lenders may experience a decrease in profis due o adverse selecion, moral hazard, and monioring coss. Therefore, lenders are no willing o lend 1 In conras, Jaramillo e al (1996), using daa from Ecuador a he firm level, do no find suppor for a relaxing of he credi consrains for small firms afer financial reform. 2 Mild repression may be undersood as inervenions in he capial marke leading o fixing he ineres rae beween he equilibrium level of monopoly and ha which would exis under perfec compeiion. Conference May 19-20, 2008, Minsk

204 204 a a rae higher han ha which maximizes heir expeced profis, even hough here are agens willing o borrow a ha higher rae (see, for insance, Walsh, 1998, Chaper 7). 1 The opposie predicions of hese wo lieraures do no imply ha hey exclude each oher. If we inerpre he ype of consrain prediced by he financial liberalizaion heory as more closely relaed o price raioning han a credi consrain, hen boh effecs migh be presen in an economy. Tha is, higher ineres raes may lead o higher credi availabiliy bu, for a given amoun of credi, some firms may have access o bank loans and ohers may no. This would imply ha credi consrains migh be presen no only a low ineres raes, bu also a high ineres raes. If boh causes of credi consrains exis, hen i is expeced ha credi availabiliy will have a direc effec on privae invesmen a boh high and low ineres raes. A he empirical level, if he finding is ha credi availabiliy affecs invesmen only when ineres raes are low, his will be an indicaor of financial resrains and shed ligh in favor of higher ineres raes o encourage invesmen. If credi availabiliy also eners ino he invesmen equaion a high ineres raes, hen he sensiiviy of invesmen o credi availabiliy would depend on he ne effec of ineres raes on credi. Tha is, lenders may be willing o lend more if he effec of an increase of ineres raes on deposis is higher han he cos brough abou by he asymmeric informaion problem. If his were he case, we would expec a decrease in he sensiiviy of invesmen on credi availabiliy a higher ineres raes. This suggess a nonlinear relaionship beween credi allocaed o he privae secor and privae invesmen. Previous empirical sudies have generally found a posiive and saisically significan effec of credi availabiliy (ne flow of credi o he privae secor) on privae invesmen. Oshikoya (1994) finds ha credi o he privae secor has a significan posiive effec on privae invesmen in middle and low income African counries. 2 Shafik (1992) repors boh shor and long-erm posiive and significan relaionships beween privae invesmen and credi allocaed o he privae secor using daa for Egyp. Leff and Sao (1988), using daa for 21 Lain American counries, found, in general, a posiive relaionship beween privae invesmen and he change in oal real credi. Ramirez (2000) also found a posiive coefficien for he lagged raio of credi o he privae secor o gross domesic produc (GDP) in an equaion for he privae invesmen-gdp raio for eigh Lain American counries. 3 There is also evidence of financial developmen causing invesmen and growh. For insance, Bell and Rousseau (2001), using daa for India, find ha credi allocaed o he privae secor, and wo oher broader financial indicaors, 4 Granger cause aggregae invesmen and oupu wihou evidence of feedback. 2.3 Public invesmen as a deerminan of privae invesmen In developing counries, he governmen has played an imporan role in capial formaion. Tha is, public invesmen consiues an imporan porion of oal invesmen. Thus, evaluaing he effec of his expendiure on privae invesmen decisions may be worhwhile. According o heory, he effec of public invesmen on privae invesmen is indeerminae. Public invesmen can ac as a subsiue (negaive effec on privae invesmen) o or a complemen (posi- 1 A more recen developmen in his area emphasizes ha credi raioning could be a consequence of he weakness of he legal sysem o enforce conracs (see for insance, La Pora e al., 1998, and Levine e al., 2000). Thus, credi marke imperfecions may have large impacs on financial markes in developing counries due o he weakness of heir legal insiuions enforcing conracs. Naional Bank of he Republic of Belarus 2 In his sudy, he middle income counries considered for he esimaion of he privae invesmen equaion are Cameroon, Mauriius, Morocco, and Tunisia. The low income counries are Kenya, Malawi, and Tanzania. 3 See also, for insance, Warman and Thirlwall (1994), Günçavdı e al. (1998), and Ahukorala (1998). 4 These wo indicaors are domesic asses of deposi money banks and oal domesic credi excluding credi o money banks.

205 205 ive effec on) for privae invesmen. The sign of he effec depends on he area in which he governmen execues he invesmen projecs. Public invesmen may encourage privae invesmen when such expendiure conribues o increasing privae-owned firms produciviy. On he oher hand, i may crowd ou privae invesmen when: (i) he governmen invess in inefficien saeowned firms; (ii) privae invesors expec higher axes o finance such expendiures; and/or (iii) he public secor compees wih he privae secor for domesic loanable funds. 1 Empirical sudies on his issue repor conrasing resuls for boh developing and developed counries. 2 Oshikoya (1994) finds a posiive and saisically significan relaionship beween privae and public invesmen in middle income African counries. Paradoxically, his effec is weak or negaive in low income counries. Recenly, Apergis (2000) evaluaed he effec of public spending (consumpion and invesmen) on Greece for he period He found ha for early years boh variables are posiively coinegraed. However, for a more recen sub-period, , he coinegraion relaionship beween hose variables is negaive. Ramirez (2000) finds a posiive relaionship beween public and privae invesmen in eigh Lain American counries (Argenina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, and Uruguay) for he period Cardoso (1993) found a similar resul wih daa for six Lain American counries (Argenina, Brazil, Colombia, Chile, Mexico, and Venezuela) using a panel comprising informaion for hree sub-periods beween 1970 and Separaing public invesmen ino infrasrucure and non-infrasrucure invesmen, some empirical sudies have found evidence of a posiive relaionship beween public invesmen in infrasrucure and privae invesmen. By conras, he effec of governmen spending on non-infrasrucure has a negaive effec on privae invesmen (see, for insance, Blejer and Mohsin, 1984). Pereira (2000) repors ha five ypes of oal public invesmen have a posiive effec on privae invesmen and oupu in he US for he period , using a four variable VAR in firs difference. 4 Due o he ype of spending considered, 5 he resul is consisen wih he view ha public invesmen in infrasrucure ends o encourage privae aciviy by means of a rise in privae secor produciviy On he oher deerminans of privae invesmen 7 In addiion o he deerminans menioned above, privae invesmen spending depends on oupu, economic reform policy, and on is owned lagged values. Since he early sudy of Clark (1917), he change in oupu is considered as a deerminan of invesmen spending. This effec is he well known acceleraor effec. Oupu also plays an imporan role in he neoclassical approach of invesmen inroduced by Jorgenson (1963), alhough he cenral feaure of his heory is o evaluae he effecs of relaive prices on he demand for capial. Oupu affecs invesmen decisions due o 1 See Apergis (2000) for references on each of hese possibiliies. 2 For early references on his issue, see Agénor and Moniel (1999, page 101). 3 Anoher sudy reporing complemenariy beween public invesmen and privae invesmen is Ahukorala (1998) for India. 4 The VAR conains he firs difference of he logarihm of privae invesmen, privae employmen, privae GDP, and one of six indicaors of public invesmen. 5 Infrasrucure: classified in hree groups, including buildings for he provision of quasi-public goods (healh, educaion, ec) and conservaion srucures. 6 See also Rioja (1999) and Felensein and Ha (1999). Boh sudies, using a general equilibrium framework, conclude ha invesmen in infrasrucure is no always welfare improving. Rioja argues ha Lain American counries need an addiional 4% of GDP o dedicae o invesmen in infrasrucure o opimize heir welfare gains from his ype of invesmen. Felensein and Ha use daa for 16 secors of he Mexican economy and conclude ha only small increases in public infrasrucure have a posiive impac in he real economy. 7 Due o he large number of variables ha economiss consider when sudying developing counries, he erm oher deerminans of privae invesmen should be undersood as he oher variable considered in his research. Conference May 19-20, 2008, Minsk

206 206 is effec on firms profiabiliy and also by means of he oupu-saving-aggregae invesmen channel. 1 Empirical resuls usually confirm a srong and posiive effec of changes in GDP on privae invesmen or GDP growh on he invesmen-gdp raio. Moreover, recen empirical sudies for developing counries have found evidence for imporan changes in he invesmen equaion due o economic reform. For insance, Fielding (1997) evaluaes he impacs of policy reform in six African counries (Kenya, Nigeria, Zimbabwe, Côe d Ivoire, Cameroon, and Mauriius) and finds evidence for economic reform alering he invesmen equaion. Also, Ahukorala (1998) finds ha marke-oriened reforms posiively affeced he privae invesmen funcion in India. Oher empirical researchers have found evidence of he impac of financial reforms on privae invesmen. In general, his line of research ess for srucural changes in he parameers of he invesmen funcion. For example, Günςavdi e al (1998) and De Melo and Tybou (1986) es for srucural breaks in he invesmen equaion afer financial liberalizaion policies were implemened in Turkey and Uruguay. 3 Daa The daa cover he period 1983:1 1999:4. In Secion 2, we discussed he deerminans of privae invesmen considered in his research. For empirical implemenaion, hose variables, excep for he real ineres rae, are ransformed ino naural logarihms. These variables are denoed as follows: v = LPRIVINV or he logarihm of real privae invesmen spending; w = DLCREDIT or firs difference of logarihm of real sock of credi o he privae secor; x = RIQ or he real bank lending ineres rae; y = LPRIVGDP or logarihm of privae GDP; and z = LPUBINV or logarihm of public invesmen. Daa for GDP and invesmen have been provided by he economerics deparmen (Deparameno de Apoyo Cuaniaivo) of he Cenral Bank of Venezuela (BCV). Daa on he nominal sock of credi o he privae secor are obained from he IMF, Inernaional financial saisics, CD-R April The real sock of credi is he nominal sock of credi deflaed by he consumer price index (CPI). Invesmen (oal, public, and privae), GDP, and he real sock of credi are expressed in billions of bolivares and in 1984 prices. The naural logarihm ransformaion is applied o hose variables as well. Wha maers for invesmen spending in period is he amoun of funds available in ha period raher han he credi sock. Credi allocaed o he privae secor in real erms should be measured by means of he firs difference of he nominal sock of credi deflaed by he price index. This akes ino accoun no only he change in he real sock of credi bu also he replacemen of he sock due o inflaion. However, when he series are ransformed ino logarihms here is an imporan loss of informaion because he logarihm is no defined for negaive numbers. Neverheless, in his research, he indicaor for credi availabiliy is obained as he firs difference of he logarihm of real sock of credi. Naional Bank of he Republic of Belarus Furhermore, he real ineres rae in quarerly erms is consruced from monhly daa on nominal lending ineres raes from he six mos imporan banks, and he CPI is provided by he BCV. See Mendoza Lugo (2001, Appendix A) for deails on he procedure used in he calculaion of he real ineres rae series. In Venezuela, he public secor consiues an imporan proporion of oal GDP. I represens 37.5% of oal GDP hroughou he period under analysis. Therefore, i seems 1 In he Q-heory of invesmen, fuure oupu sream affecs he marke value of he firm and consequenly he firm s invesmen decisions.

207 207 beer o use GDP generaed by he privae secor raher han oal GDP as a deerminan of privae invesmen. Privae GDP for 1983:1 1990:3 is calculaed by inerpolaion based on proporions of privae GDP o oal GDP using annual daa obained from Anivero (1992), Tables II-8 and II-9, and he quarerly oal GDP for he same period obained from he BCV. Tha is, he proporion of privae GDP o oal GDP is obained from annual daa and he four observaions of quarerly oal GDP for each year are muliplied by his proporion. The compued new series is used as he indicaor of privae GDP. The series used in his research are inenionally lef seasonally unadjused. Even hough much empirical work uses seasonally adjused daa, some ime series analyss sugges working wih seasonally unadjused daa because: (i) seasonally adjused daa may lead o misleading inferences abou he relaionship among he variables; and (ii) seasonal adjusmens imply a loss of imporan informaion when seasonal flucuaions explain an imporan par of he behavior of he variables in analysis (see for insance, Lee (1992), Lee and Siklos (1997), and Bohl (2000)). Thus, he daa is esed for uni roos a all frequencies (seasonal and long-run) using he HEGY (Hylleberg, Engle, Granger, and Yoo) es for uni roos, which allows discriminaion of uni roos a long-run, semiannual and annual frequencies. Also, he augmened Dickey-Fuller (ADF) es and he Phillips and Perron (PP) es are performed for comparison purposes. The PP es is applied in his research only when he residuals from he ADF regression are hereroskedasic as repored by he Q saisic on he square of he residuals. The HEGY es indicaes ha he Venezuelan daa in his research does no have seasonal uni roos. While a he long-run frequency, uni roos are found for LPRIVGDP, LPRIVINV, and LPUBINV. Resuls and discussion abou uni roo ess are repored in Mendoza Lugo ((2001), Appendix B). 4 Modeling a nonlinear privae invesmen funcion The lieraure offers a wide variey of nonlinear models. Among he nonlinear parameric specificaions, he smooh ransiion regression (STR) models and he hreshold regression (TR) models have recenly been increasingly used in modeling economic relaionships. However, since he TR models are a paricular case of he STR models, i is convenien o sar invesigaing a nonlinear relaionship wih he STR models o avoid specificaion problems. The smooh ransiion models belong o he caegory of regime swiching models and are inroduced in he lieraure in heir auoregressive (STAR) version by Chan and Tong (1986); Luukkonen, Saikkonen, and Teräsvira (1988); Teräsvira and Anderson (1992); and Teräsvira (1994). Granger and Teräsvira (1993) exend he STAR models o a mulivariae conex resuling in he STR models A smooh ransiion specificaion for privae invesmen wihin a VEC model We model a nonlinear specificaion for privae invesmen wihin a smooh ransiion vecor error correcion (STVEC) model in which privae invesmen depends on is own lagged values and on he lags of oher variables deermining invesmen. In oher words, i is claimed ha if a linear specificaion for privae invesmen is rejeced, hen here exiss a nonlinear dynamic ha is appro- 1 The smooh ransiion models have been applied o explain he dynamic behavior of some macroeconomic variables. For insance, Weise (1999) ess for asymmeric effecs of moneary policy in he Unied Saes using a logisic smooh ransiion vecor auoregression (LSTVAR) model. Taylor and Peel (2000) find ha he exponenial smooh ransiion auoregressive (ESTAR) model explains he behavior of he deviaions of he dollar-mark and dollar-serling exchange raes from he longrun equilibrium rae. Saranis (1999) finds ha STAR models approximae he nonlineariy in he effecive real exchange rae for eigh of he G10 counries. Byers and Peel (2000) model he hyperinflaion in Germany, Brazil, and Argenina using he ESTAR model. Oher recen applicaions of smooh ransiion models are in Chen and Wu (2000), Öcal and Osborn (2000), van Dijk and Franses (1999), Lukepohl e al. (1999), Leybourne and Mizen (1999), Bradley and Jansen (1998), and Greenaway e al (1997). Conference May 19-20, 2008, Minsk

208 208 priaely described by an STR model. The STR models, in addiion o offering a less resricive framework, are recommended when analyzing aggregaes as in he case of privae invesmen spending (Granger and Teräsvira, (1993, page 40)). Tha is, a he micro level he decisions o inves may be consrained o inves given a sae of he economy, say sae or regime 1 or do no inves given sae or regime 2. However, a he macro level he lack of coordinaion among individual decisions may lead o a smooh ransiion from one regime o he oher. A general STVEC model can be expressed as follows: X =Π p 1 p 1 D +Π X + θ m X m + [ Π D +Π X + θ m X m] F( TV d ) + ε, 0,1 1 1,1 0,2 2 1,2 m= 1 m= 1 (4.1) where, D is a (n 0 x 1) marix of deerminisic erms, X is a (n x 1) vecor, n is he number of endogenous variables; Π 0, i, i=1,2, is a (n x n 0 ) vecor of coefficiens for he ih regime, and Π i andθ m, i are (n x n) marices of coefficiens. The rank of Π i, r, is he number of coinegraing vecors. The marix Π i can be ' expressed as Πi = γ iαi ; γ i and α i are (n x r) marices wih rank r. The former is he marix conaining he adjusmen coefficiens and he laer is he marix of coinegraing vecors. In he esimaion procedure, we assume α 1 = α 2 = α ; α X ' is he coinegraing vecor (CIV ) for boh regimes. Π 0, 2 is a marix of zeros excep he coefficien denoing he consan erm. Tha is, he model is lineal in deerminis ' variables excep he consan erm. In addiion, X = [ dv, dw, dx, dy, dz ] and F ( TV d ) is he indicaor or ransiion funcion aking values beween zero and one, boh exremes, inclusive. When aking inermediae values, i allows a smooh ransiion beween regimes. In general, F ( TV d ) is specified by one of he following wo forms: or 1 F ( TV d ) = {1 + Exp[ γ ( TV d c)]}, γ > 0, (4.2) F ( TV ) = 1 Exp{ [ γ ( TV 2 c)] }, γ > 0 d d. (4.3) These are he logisic and he exponenial ransiion or indicaor funcions. Noice ha he indicaor funcion has been resriced o conain only one ransiion variable. This is equivalen o assuming ha he ransiion variable,tv, and he delay parameer, d, are known. A model combining (4.1) and (4.2) is a logisic smooh ransiion vecor error correcion (LSTVEC) model. When using (4.1) and (4.3), he model is he exponenial smooh ransiion vecor error correcion (ESTVEC) model. The LSTVEC model allows he VEC o behave differenly when he ransiion variable akes low values. Tha is, wo regimes can be defined: he low regime and he high regime. The ESTVEC models, insead, assume ha he VEC behaves he same when he ransiion variable akes exreme values. This behavior differs from when he ransiion variable akes values locaed in he middle of is own range of values. In his case he wo regimes are called he ouer regime and he middle regime. Naional Bank of he Republic of Belarus In he logisic funcion, when ( TV d c) is large and posiive, Exp[ γ ( TV d c)] ends o zero and he ransiion funcion akes a value of one. In he opposie case, Exp[ γ ( TV c)] ends o infiniy and he ransiion funcion goes o zero. Therefore, in he low regime, he esimaed regression is d

209 209 given by he se of esimaed coefficiens in he firs and second erms of (4.1). While in he high regime, he whole se of esimaed coefficiens for all erms in (4.1) describe he dynamics of invesmen or he variable being analyzed. In he case of he exponenial funcion, when ( TV d c ) 2 akes eiher large posiive or negaive values, Exp{ [ γ ( TV d c)] } ends o zero and he ransiion funcion akes a value of one. Thus, his funcion resrics he dynamics of he equaion o be he same when he ransiion variable akes exreme values. When TV -d akes values close o c, 2 Exp{ [ γ ( TV c)] } ends o one and he ransiion funcion goes o zero. d Beween he logisic and he exponenial ransiion funcions, we have chosen he logisic funcion o invesigae nonlineariies in he VEC. This choice is based on he heory discussed previously. 4.2 The choice of ransiion variable The search for a ransiion variable will be done focused on possible nonlineariies in he VEC model due o nonlineariies in he privae invesmen equaion. 1 We suspec ha he invesmen equaion behaves differenly when he ineres rae akes high as opposed o low values. I could also be ha he invesmen equaion behaves differenly when here is a credi consrain and when consrains are relaxed. One addiional possibiliy is ha wheher he economy is expanding or conracing could define he sae of he world or regime. Tha is, he heory of financial consrains saes ha he severiy of agency coss should vary wih he general macroeconomic condiions. I is expeced ha during recessions a firm s inernal finance falls and he demand for exernal funds rises. Since he cos of exernal finance increases when he firm s balance shee deerioraes, invesmen falls and hus inensifies he magniude of he recession (Bernanke and Gerler (1989) and Walsh (1998), pp ). Consequenly, during recessions, he invesmen equaion may be more sensiive o credi han in periods of expansion. This implies a nonlinear relaionship beween invesmen and credi wih changes in oupu defining he sae of he economy. Finally, public invesmen can be he ransiion variable depending on is impac on he credi marke. We have no found a heoreical explanaion for using privae invesmen iself as he ransiion variable. However, we do no rule ou his possibiliy. Provided ha he invesmen funcion is nonlinear, differenial impacs of real ineres raes and credi availabiliy on invesmen can arise from he dynamic ineracions of he oher variables included in he model. Therefore, all lagged variables explaining invesmen oher han CIV are considered poenial ransiion variables. 5 Esimaion Teräsvira (1994) elaboraes on he procedure for esimaing a smooh ransiion model in he univariae case. Granger and Teräsvira (1993) discuss his procedure in he mulivariae conex. The echnique consiss of he following hree broad sages. Firs, specify he linear model. Second, apply he es for lineariy agains STR models following he hird order es procedure inroduced by Luukkonen e al (1988), bu using only one ransiion variable each ime for all possible values of d. And hird, if lineariy is rejeced, hen choose beween he logisic smooh ransiion regressive (LSTR) and he exponenial smooh ransiion regressive (ESTR) model by esing a sequence of hypoheses. 1 Weise (1999) shows ha in a srucural muliple-equaion model, a nonlinear equaion in a leas one of is coefficiens may lead o a nonlinear represenaion for all equaions in he reduced form of he sysem. Conference May 19-20, 2008, Minsk

210 The linear model Since no evidence for seasonal uni roos are found in he Venezuelan daa, coinegraion and he number of coinegraing vecors are esed wihin a linear VEC model from four o one lags. 1 Coinegraion is esed using he maximum likelihood procedure proposed by Johansen (1988, 1991) and well documened in Hamilon (1994). Evidence of coinegraion is found for one and hree lag specificaions wih LPRIVINV, LPUBINV, and LPRIVGDP as endogenous variables. The CIV for one lag is discarded because is coefficiens do no look reasonable. Therefore, he seleced CIV comes from a sysem specificaion wih hree lags and i is LPRIVINV = * LPUBINV * LPRIVGDP.The race saisic is , significan a 5%. 2 As a second sep, given he exisence of one coinegraing vecor, he erm LPRIVINV * LPUBINV * LPRIVGDP -1 is used o esimae a linear version of (4.1) where dummies for some special evens and srucural economic reforms are inroduced. 3 The VEC lag lengh is se arbirarily equal o 4. 4 Furhermore, insignifican coefficiens are eliminaed using he modified version of he likelihood raio es suggesed by Sims (1980). This second sep is performed using generalized leas squares or seemingly unrelaed regressions (SUR). As we can observe, he procedure applied differs from he wo-sep Engle and Granger (1987) mehod only in he mehod of esimaion applied in each sep. The resuling esimaed subse VEC model is shown in Table Lineariy es A lineariy es is performed using is one equaion and sysem version. For he mulivariable equaion seup, we use he augmened firs order es proposed by Luukkonen e al (1988), which is more suiable for small samples and has more power under he null hypohesis. The single equaion es, aking he equaion for dv as example, is given by he following auxiliary regression. dv 3 * = φ 0 + φ1h + φ2htv d + ψ dtv d + υ, (5.1) 1 In general, i is recommended ha he lag lengh of he VAR in levels should be chosen before esing for coinegraion (see, (see, for insance, Enders, 1995, page 396). However, when using he Akaike informaion crierion (AIC) and Schwarz informaion crierion (SIC) for lag lengh selecion, wih he same sample size and up o six lags in he VAR, boh crieria indicae one lag in he VAR in levels. This implies zero lags in he VEC model. Since a longer lag is preferable o one ha is oo shor (Banerjee e al., 1993, page 286), an alernaive procedure is followed o es and esimae he coinegraing vecor. Tha is, using he same effecive sample size (1984:2 2000:4), coinegraion is esed from one up o four lags in he VEC model and he coinegraing vecor wih more reasonable coefficiens is seleced. 2 The maximum eigenvalue does no indicae evidence for coinegraion. 3 The dummy variables are DC and DPC, which aemp o conrol for srucural economic reform as specified in secion 3. The dummies o conrol for special evens (See Mendoza Lugo, 2001, Secion 2.3) are inroduced only afer an iniial simaion evidences he need o conrol for some ouliers in hose periods. These dummies are D891 and D942 in he real ineres rae equaion, D944 and D962 in he credi equaion, and D861 in he public invesmen equaion. D891 is defined as +1 in 1989:1, -1 in 1989:2 and 0 oherwise. D944 akes he value of +1 in 1994:4, -1 in 1995:1 and 0 oherwise. D962 is specified as +1 in 1996:2, 1 in 1996:3 and 0 oherwise. And finally, D861 is defined as +1 in 1986:1, 1 in 1986:2 and 0 oherwise. D942 is specified as 1 in 1994:2 and 0 oherwise. Afer he inroducion of hese dummies, all equaions pass he diagnosic check in erms of normaliy, serial correlaion, and heeroskedasiciy. The subse VEC model is re-esimaed, saring from a full coefficien or unresriced VEC model accouning for hose especial evens ha he new dummies aemp o conrol for. Naional Bank of he Republic of Belarus 4 One problem encounered when specifying an unresriced VEC model using he Venezuelan daa is relaed o he lag lengh selecion. Boh SIC and AIC sugges a VAR in levels wih one lag or is corresponding VEC wih no lags. However, i is observed ha when esimaing he unresriced VEC wih a higher number of lags ha significan coefficiens are no uniform wih respec o he lag lengh for he lagged values of each variable in each regression in he VEC model. The main problem in coninuing wih an unresriced VEC wih lag lengh seleced arbirarily, say four lags, is he presence of oo many insignifican coefficiens. The price of oo many insignifican coefficiens is higher variance and consequenly imprecise impulse response funcions. Bu proceeding wih oo shor a lag specificaion may lead us o conclude ha a variable, or variables, does no affec he ohers because of a misspecificaion in he lag order for such a variable. Thus, i may be preferable o choose he lag lengh arbirarily, which we se equal o 4, and esimae wih a resriced-in-coefficiens version or subse VEC model. An early proponen of subse VAR is Hsiao (1981), who proposes a procedure for choosing a differen number of lags for each variable in he VAR based on he final predicion error (FPE) crierion. McMillin (1985) applies a subse VAR o invesmen in he Unied Saes. Lükepohl (1993, Chaper 5), discusses specificaion procedures, advanages, and disadvanages for resriced VAR, which are also applicable o a VEC. 5 E-views is used for all compuaional procedures bu he impulse response funcions. In his case, we use GAUSS.

211 211 Table 5.1: Venezuela: esimaed subse VEC model for privae invesmen and is deerminans. Period 1984:3 2000:4 DLPRIVINV DDLCREDIT DRIQ DLPRIVGDP DLPUBINV Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. C DS DS DS D D D D D DPC DLPRIVINV DLPRIVINV DLPRIVINV DLPRIVINV DDLCREDIT DDLCREDIT DDLCREDIT DDLCREDIT DRIQ DRIQ DRIQ DRIQ DLPRIVGDP DLPRIVGDP DLPRIVGDP DLPRIVGDP DLPUBINV DLPUBINV DLPUBINV DLPUBINV CIV R 2 adj Q(1) Q(4) Qsr(1) Qsr(4) Hausman JB Noes: The resriced VEC model is esimaed using seemingly unrelaed regression (SUR). R 2 adj. Is he adjused R 2. Q(i) (Qsr(i)) is he Ljung-Box Q-saisic for he ih lag of he residuals (squared of residuals). JB accouns for he Jarque-Bera saisic for normaliy. JB is disribued as a χ 2 wih wo degrees of freedom. The Q-saisics are disribued as χ 2 wih i degrees of freedom. The criical values for χ 2 I,0.05 (χ 2 i,0.1), for i =1 and 4 are 3.84 and 9.49 (2.71 and 7.78) respecively. CIV denoes he coinegraing vecor. Hausman corresponds o he -saisics for he Hausman es. The Hausman es is performed for he credi and public invesmen equaions. Due o he way ineres raes are calculaed in his research (see Mendoza Lugo (2001, Appendix A) RIQ-1 conains informaion for one monh of quarer, hen here exiss he possibiliy ha DRIQ-1, which eners in he credi and public invesmen equaions, is an endogenous variable. For he Hausman es: (i) DRIQ-1 is regressed on he righ hand side variables of each of he above-menioned equaions plus he variables on he righ hand side of he ineres rae equaion (all of hem lagged one period). Conemporaneous variables o DRIQ-1 are omied from he regression; (ii) he residuals from he esimaed ineres rae equaion are rerieved; and (iii) he credi or public invesmen equaion augmened for he residuals from he previous sep is esimaed. The Hausman saisic is he - saisic on he esimaed coefficien for he residuals obained from he ineres rae equaion. If he esimaed coefficien is no saisically differen from zero, we mus conclude ha DRIQ-1 is no an endogenous variable. The es saisics do no indicae evidence for endogeneiy in DRIQ-1. Conference May 19-20, 2008, Minsk

212 212 wih, H dv ' = [ 1,..., dv j, dw 1,..., dw q, dx 1,..., dx r, dy 1,..., dy s, dz 1,..., dz k, CIV 1] φ0 and ψ d are scalars and φ i, for i = 1 or 2, are 1 x k * vecor of coefficiens, k* = j+ q+ r + s + k, where j, q, r, s and k are resriced o be less or equal o p-1. The es consiss of a hypohesis conras, using he F saisic, in which he null for lineariy is se as he coefficiens of φ2 and ψ d are zeros. This es is performed for each possible TV d. Wih his es we canno perform nesed hypohesis ess for model selecion. However, boh models can be esimaed and he final model can be chosen based on a forecas evaluaion. In he paricular case of invesigaing nonlineariies of he invesmen equaion on financial facors, he heory suggess he use of a logisic model. Therefore, we resric esimaion o his kind of model and wihou any complicaion for model selecion when using he augmened firs order lineariy es. 1 Weise (1999) inroduces a lineariy es for a muliple-equaion framework. This is a likelihood raio es. Insead of a firs order es exended o a muliple-equaion framework proposed by Weise, we use a muli-equaion version of he augmened firs order es and correc for small sample bias. 2 Table 5.2 repors he resuls of he lineariy ess for each equaion, he F es, and for he whole sysem, he LR es. The firs 10 columns show he lineariy es saisics and heir respecive P- values for each dependen variable described a he op of he able. The las wo columns conain informaion abou he LR saisics for each ransiion variable and heir respecive P-values. The LR es suggess he use of DLCREDIT as he ransiion variable. I repors low P-values for delays of 1, 2, and 4 being he lowes one for DLCREDIT -1. The LR es also repors P-values lower han 5% when DRIQ and DLPRIVGDP are he ransiion variables wih delays of 4 and 1 respecively. On he oher hand, he F es does no always sugges using as he ransiion variable he same variable indicaed by he LR es. For insance, he LR es indicaes DLCREDIT -2 as a good choice when searching for a common ransiion variable and delay parameer. However, he F es in he equaion for DLPRIVGDP repors a P-value of 0.941, which suggess ha he use of DLCREDIT -2 as ransiion variable may no be a good choice o explain he poenial nonlineariy in he oupu equaion, even hough his equaion is esimaed in a muli-equaion conex. The F es repors evidence agains lineariy in all five equaions. In he privae invesmen equaion, lineariy is rejeced a he 5% significance level when DLCREDIT -1 and RIQ -4 are he ransiion variables. For he remaining four equaions, only in he oupu equaion does he es fail o rejec lineariy when financial variables are used as ransiion variables. However, he es rejecs lineariy in he oupu equaion when DLPUBINV -4 is he ransiion variable. In addiion, he lineariy es for each single equaion does no repor evidence for he use of a unique ransiion variable and delay parameer in all equaions. Teräsvira (1994), following Tsay (1989), recommends choosing he delay parameer, d, in he univariae model as he value wih he minimum P-value. Generalizing his decision rule o a muliva-. 1 In general, hird order lineariy es proposed by Luukkonen e al. (1988), which is based on he following mulivariae auxiliary regression. However, in a mulivariae conex he auxiliary regression conains 1 + 4k* parameer esimaes, which in small samples implies he use of oo many degrees of freedom. Naional Bank of he Republic of Belarus 2 Due o he cumbersome join ess for no coinegraion and lineariy agains coinegraion and nonlinear (hreshold) specificaion, where no only nosaionariy and nuisance parameers are presen under he null bu here is also a large class of nonlinear (hreshold) specificaions, Balke and Fomby (1997) sugges breaking up his analysis ino wo pars. These is: (i) a es for coinegraion; and (ii) a es for nonlinear behavior. An imporan argumen in favor of his separaion is ha sandard ime series analysis for linear coinegraion is asympoically valid for he hreshold coinegraion because he order of inegraion is no affeced by a hreshold specificaion. From a Mone Carlo experimen, hey find ha no serious problems arise when esing for coinegraion using a linear misspecified model. van Dijk and Franses (1995) use he same procedure o esimae a smooh ransiion vecor error correcion model. For oher references on hreshold and smooh ransiion EC models, see Franses and van Dijk (2000), page 133.

213 213 riae conex, i should be o choose he ransiion variable, TV, and he delay parameer d; ha is, TV -d, as he dh order lagged variable wih he minimum P-value. We could also selec, among he poenial TVs wih ess reporing P-values lower han 5 %, each variable wih he lowes P-value for each poenial TV and proceed o esimae he model for each of hese candidaes and hen make he final selecion based on specificaion ess. We explore his possibiliy by aemping o esimae he nonlinear model equaion by equaion using as TVs all possible candidaes wih F ess reporing a P-value lower or equal han 5%. We also aemp o esimae he nonlinear model, wihin a sysem procedure, using he same ransiion variable for all equaions as suggesed by Weise (1999) according o he LR es. The nex subsecion explains in deail he esimaion procedure for he nonlinear model. Table 5.2: Venezuela: lineariy es using he esimaed subse VEC model as benchmark Transiion variable DLPRIVINV DDLCREDIT DRIQ DLPRIVGDP DLPUBINV SYSTEM F-sa. P-val. F-sa. P-val. F-sa. P-val. F-sa. P-val. F-sa. P-val. LR-sa. P-val. DLPRIVINV DLPRIVINV DLPRIVINV DLPRIVINV DDLCREDIT DDLCREDIT DDLCREDIT DDLCREDIT DRIQ DRIQ DRIQ DRIQ DLPRIVGDP DLPRIVGDP DLPRIVGDP DLPRIVGDP DLPUBINV DLPUBINV DLPUBINV DLPUBINV DLCREDIT DLCREDIT DLCREDIT DLCREDIT RIQ RIQ RIQ RIQ Noes: P-values lower han 5% are repored in dark numbers. Conference May 19-20, 2008, Minsk

214 Esimaion procedure for he logisic STVEC model Due o he lack of evidence for esimaing he logisic STVEC (LSTVEC) model for a single TV -d, he nonlinear sysem is esimaed equaion by equaion and hen he five equaions are pu ogeher and is re-esimaed he logisic STVEC (LSTVEC) model using SUR.. We sar he esimaion procedure by performing a wo-dimensional grid search for he ransiion parameer, c, and he smooh parameer, γ, using as TV -d all possibiliies in Table 4.3 ha are associaed wih lineariy ess having P-values lower han 5%. Previously, he argumen of he ransiion funcion, F(TV -d ), is rescaled downward by dividing by he sandard deviaion of TV -d as recommended by he esimaion of he logisic model when he smooh parameer is large. This rescaling helps he compuing process in he model esimaion. See for insance, Granger and Teräsvira (1993), page We arrange he values of TV -d in ascending order and divide he range of values aken by ha variable ino 10 inervals, which gives 11 grid values. We assure all inervals conain informaion by discarding aypical observaions from he range of values for TV -d. The search for he ransiion parameer, c, is performed for he nine grids locaed beween boh exremes. The search for he smooh parameer, γ, consiss of 25 values from 1 o 49 augmening wo by wo. For hose cases where γ is locaed in he upper exreme, a new search is made for higher values of γ. Thus, here are a leas 225 combinaions for c and γ in each wo-dimensional grid search. We selec ha combinaion of c and γ reporing he maximum log-likelihood. 2 Those cases where he log-likelihood akes he maximum value for c locaed in any of he exremes of he range of values for he ransiion variable are ruled ou. 3 We proceed using only hose cases where he value of c maximizing he log-likelihood is locaed beween he hird and eighh grid values. The bes value of c should be a value of TV -d locaed in some par wihin he middle of is observed range of values such ha i guaranees boh regimes conain enough observaions for reliable esimaes of he coefficiens. Wih saring values from he wo-dimensional grid search, he parameer γ is allowed o vary while c is fixed o he value obained in he previous sep. Once γ is esimaed, a new grid search is performed; his ime only for he parameer c. Nex, wih saring values from he previous sep, γ is allowed o vary again. Finally, we allow all parameers o vary seing iniial values from he previous sep. In each sep involving he esimaion of γ or he join esimaion of γ and c, each equaion is esimaed using nonlinear leas squares (NLS). The esimaed coefficiens γˆ and ĉ for each equaion are repored in Table In previous work, we ried o esimae he nonlinear model performing a grid search for he ransiion parameer, c, fixing he sandardized smooh parameer, γ, equal o he sandard deviaion of TV-d. However, in mos of he cases he value of c maximizing he log-likelihood was locaed a he exremes of he range of values aken by he ransiion variable. Such a resul suggess ha he equaion is linear or he value given o γ is no he mos adequae. 2 Oher alernaive measures of fi are AIC, SIC and R 2, obaining similar resuls. Naional Bank of he Republic of Belarus 3 Wihin a wo-dimensional grid search, a ransiion parameer aking values in any of he exremes of he range of values of he ransiion variable, i is probably a consequence of he presence of ouliers. A problem facing he lineariy ess for smooh ransiion models is ha i may be biased oward rejecing he null hypohesis due o he presence of ouliers. See for insance, Franses and van Dijk (2000), page 105. In he presen sudy, some alernaives for TV-d are discarded when he ransiion parameer is found in he exreme values of he range of TV-d when performing he wo-dimensional grid search. The discarded choices for TV-d, in he credi equaion, are all lagged DLCREDIT, bu DLCREDIT-3. In addiion, RIQ-4, DRIQ-2 and DLPUBINV-4 are rejeced as TV-d in he equaions for DRIQ, DLPUBINV and DLPRIVGDP. Since he lineariy es does no indicae oher possible TV for he oupu growh equaion, hen his equaion is reaed as linear. Moreover, informaion for he esimaed equaion for DDLCREDIT under he assumpion ha RIQ-2 is TV-d are no repored in Table 4.3 since a unique soluion for his alernaive was no found. 4 Teräsvira (1998), page 527, recommends he use of a wo-dimensional grid search o ge reasonable saring values for he NLS esimaion and o reduce he size of he model by imposing exclusion resricions.

215 215 Fixing he parameers c and γ o hose values obained from he single equaion procedure, he LSTVEC model is esimaed, using SUR. To alleviae compuing problems, insignifican coefficiens on lagged variables are eliminaed. As a second sep, in heory, all coefficiens are allowed o vary using he esimaed coefficiens from he previous sep as iniial values. However, some compuing problems, which may be associaed wih he esimaion of logisic models in small samples and large adjusmen parameers, as is he case in general for he logisic smooh ransiion (LSTR) models, leads us o seek he maximum number of smooh and ransiion parameers ha can be joinly esimaed while fixing he remaining ones o hose values obained from he esimaion for each single nonlinear equaion. Table 5.3: Venezuela: summary of he esimaion of each single nonlinear equaion for each poenial TV γˆ T-sa. ĉ T-sa. P-value, F-es ( θ ' 0) 2 = Loglk TV for DLPRIVINV Equaion DLCREDIT RIQ TV for DDLCREDIT Equaion DLCREDIT TV for DRIQ Equaion DRIQ DLPRIVGDP DLPRIVGDP DLPUBINV DLPUBINV DLCREDIT DLCREDIT TV for DLPUBINV Equaion DLPUBINV DLCREDIT Noes: Loglk denoes log-likelihood. F-es ( θ ' = 2 0) is he es of wheher he esimaed coefficiens accompanying he ransiion funcion in each single equaion are joinly equal o zero. I ess for he specificaion of he LSTR models agains a linear specificaion. However, when he equaions are esimaed in a sysem, in paricular for DLPRIVINV and DLPUBINV equaions wih RIQ-4 and DLCREDIT-2 as TV-d, and insignifican coefficiens are dropped from he sysem applying a LR es, here is no evidence ha all hose coefficiens are equal o zero. Even hough he -saisics for he esimaed coefficiens c and γ are repored in his able, he lowes -saisics canno be inerpreed as evidence for lineariy. A precise esimaion of γ needs many observaions around c and becomes more difficul when his parameer is large. See for insance, Franses and van Dijk (2000), page 91 and Granger and Teräsvira (1993), page 123. Anoher elemen we should consider is ha hese parameers are no idenified under he null hypohesis of lineariy (Davies problem), so hey do no follow he sandard disribuion. We evaluae hree combinaions of ransiion variables and delay parameers in order o proceed o he esimaion of he LSTVEC model. These hree opions are illusraed in Table 5.4. In Opion 1 we allow for he same ransiion variable. In his case i is DLCREDIT bu allowing for differen delay parameers. Opion 2 is seleced according o he TV -d associaed wih he higher log-likelihood value for each nonlinear equaion. Finally, Opion 3 differs from Opion 2 only in he TV -d chosen for he privae invesmen equaion. In his case, RIQ -4 is used as TV -d. This opion is aken ino accoun because he log-likelihood values are only slighly differen from he case when DLCRE- Conference May 19-20, 2008, Minsk

216 216 DIT -1 is TV -d (see Table 5.3). The final specificaion(s) for he LSTVEC model will be chosen based on diagnosic ess on he residuals and long-run dynamic evaluaion. Table 5.4: Venezuela: esimaion opions for he nonlinear sysem according o he selecion of ransiion variables Transiion Variables Equaion for: Opion 1 Opion 2 Opion 3 DLPRIVINV DLCREDIT-1 DLCREDIT-1 RIQ-4 DDLCREDIT DLCREDIT-3 DLCREDIT-3 DLCREDIT-3 DRIQ DLCREDIT-3 DLPUBINV-4 DLPUBINV-4 DLPUBINV DLCREDIT-2 DLPUBINV-3 DLPUBINV-3 Afer esimaion, we evaluae each of he hree specificaions. For such purposes, we use diagnosic ess on he residuals and evaluae he long-run properies while compuing impulse response funcions. 1 Only in Opion 1 is convergence achieved. Opions 2 and 3 are discarded because hey are globally unsable. How he impulse response funcions are compued is he subjec of he nex secion. A diagnosic es is performed on he residuals of Opion 1. We apply he F es version of he LM serial correlaion es proposed by Eirheim and Teräsvira (1996) in he four nonlinear equaions. This es can be seen as a generalizaion of he Breusch and Pagan LM es for auocorrelaion for linear specificaions (Franses and van Dijk, 2000, page 110). In addiion, he Jarque-Bera normaliy es and he Engle s ARCH-LM es are applied o all five equaions. 2 All equaions passed diagnosic ess excep he credi equaion, which presened serial correlaion. Adding own lag values omied in he linear specificaion, DDLCREDIT -2 and DDLCREDIT -4, solves serial correlaion, in he credi equaion. The residuals of his equaion also presen an imporan oulier in 1989:1, he period of implemenaion of he srucural reform program. Thus, D891 was included o conrol for his effec. Under he new specificaion all equaions pass he diagnosic es. The saisics for hese ess are repored in he boom of Table 5.5. The esimaed ransiion funcions Figures 5.1 and 5.2 depic he four esimaed ransiion funcions for Opion 1. Transiion is very fas from one regime o he oher in all equaions bu public invesmen. In he credi and ineres rae equaions, wih oo few observaions around he esimaed ransiion parameers and a high speed of adjusmen given by he esimaed smooh parameers, he ransiion funcion akes mainly values of zero and one, indicaing hreshold specificaions. The ransiion funcion for he privae invesmen equaion depics a fas ransiion from he low o he high regime. 1 The evaluaion of he long-run dynamic of smooh ransiion models canno be done analyically. A numerical soluion is insead recommended. See Teräsvira e al. (1994), page 2945 and Granger and Teräsvira (1993), page 128. Also, we can evaluae he dynamic properies of he model when compuing he impulse responses. Tha is, if he effecs of a shock die ou, his implies he model is saionary. Naional Bank of he Republic of Belarus 2 Eirheim and Teräsvira (1996) do no recommend using he Ljung-Box Q-saisic o analyze he residuals of smooh ransiion models because is disribuion is unknown under he null. Eirheim and Teräsvira also propose a es for remaining nonlineariy and parameer consancy for smooh ransiion models. However, because of daa limiaions and he large number of addiional parameers o be esimaed in his research, heir applicaion is impracical.

217 217 Table 5.5: Venezuela: esimaed logisic smooh ransiion subse vecor error correcion (LSTVEC) model for privae invesmen and is deerminans wih lagged rae of growh of real sock of credi used as ransiion variable (Opion 1). Period 1984:3 2000:4 DLPRIVINV DDLCREDIT DRIQ DLPRIVGDP DLPUBINV Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. C DS DS DS D D D D D DLPRIVINV DLPRIVINV DLPRIVINV DLPRIVINV DDLCREDIT DDLCREDIT DDLCREDIT DDLCREDIT DRIQ DRIQ DRIQ DRIQ DLPRIVGDP DLPRIVGDP DLPRIVGDP DLPRIVGDP DLPUBINV DLPUBINV DLPUBINV DLPUBINV CIV Conference May 19-20, 2008, Minsk

218 218 Table 5.5 (con): Venezuela: esimaed logisic smooh ransiion subse vecor error correcion (LSTVEC) model for privae invesmen and is deerminans wih lagged rae of growh of real sock of credi used as ransiion variable (Opion 1). Period 1984:3 2000:4 DLPRIVINV DDLCREDIT DRIQ DLPRIVGDP DLPUBINV Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. Coeff. T-sa. C2 F(.) DLPRIVINV-1 F(.) DLPRIVINV-2 F(.) DLPRIVINV-3 F(.) DLPRIVINV-4 F(.) DDLCREDIT-1 F(.) DDLCREDIT-2 F(.) DDLCREDIT-3 F(.) DDLCREDIT-4 F(.) DRIQ-1 F(.) DRIQ-2 F(.) DRIQ-3 F(.) DRIQ -4 F(.) DLPRIVGDP-1 F(.) DLPRIVGDP-2 F(.) DLPRIVGDP-3 F(.) DLPRIVGDP-4 F(.) DLPUBINV-1 F(.) DLPUBINV-2 F(.) DLPUBINV-3 F(.) DLPUBINV-4 F(.) CIV F(.) γˆ (fixed) (fixed) ĉ (fixed) R 2 adj JB FAR(1) FAR(4) FARCH(1) FARCH(4) Noes: To calculae FAR(i), i = 1,4, missing observaions a he beginning of he series of lagged residuals are replaced by zeros as recommended by Teräsvira (1998), page 520. C1 and C2 denoe he consan erm in he linear and augmened par of each equaion, respecively. R 2 adj. is he adjused R 2. F(.) denoes he logisic smooh ransiion funcion. JB accouns for he Jarque-Bera saisic o es for normaliy. I is disribued as a 2 χ. CIV denoes 2 he coinegraing vecor. Naional Bank of he Republic of Belarus In he privae invesmen equaion, he esimaed value of c = which is close o zero- allows he associaion of hese wo regimes o credi conracion (F(.) = 0) and credi expansion (F(.) = 1). However, his canno be generalized o oher equaions in he sysem because esimaed ransiion parameers close o zero are no observed in hose equaions. For insance, he esimaed value of c has similar negaive values, and 0.049, in he public invesmen and ineres rae equaions respecively while i is posiive and equal o in he credi equaion.

219 219 Figure 5.1: Privae invesmen and credi equaions: esimaed logisic ransiion funcions versus ransiion variables F(DLCREDIT-1;33.295,0.008) F(DLCREDIT-3;84.711,-0.049) DLCREDIT(-1) (a) Transiion funcion for DLPRIVINV equaion DLCREDIT-3 (b) Transiion funcion for DDLCREDIT equaion Figure 5.2: Real ineres rae and public invesmen equaions: esimaed ransiion funcions versus ransiion variables 1.0 F(DLCREDIOT-3;84.711,-0.049) F(DLCREDIT-2;3.110,-0.047) DLCREDIT-3 (c) Transiion funcion for DRIQ equaion DLCREDIT-2 (d) Transiion funcion for DLPUBINV equaion 6 Tesing for differenial effecs of real ineres raes and credi availabiliy on privae invesmen To invesigae he differenial effecs of ineres raes and credi availabiliy on privae invesmen, we compue generalized impulse response funcions 1 using he Mone Carlo echnique described in Koop e al. (1996) and applied by Weise (1999) o sudy he asymmeric effecs of moneary policy using daa for he US. We explore how privae invesmen responds o shocks of differen sizes and signs and how differen his response is when here is a credi conracion or expansion. In addiion o shocks o financial variables, we also invesigae how he growh rae of privae invesmen responds o shocks o he growh rae of public invesmen, privae GDP, and o is own growh rae. 2 1 Generalized impulse response funcions can be used for linear and nonlinear models. However, hey are paricularly recommended for compuing he effec of shocks in one variable on he forecas of anoher variable when using a nonlinear model. Generalized impulse response funcions ake ino accoun ha in a nonlinear model impulse response funcions depend on he iniial condiions and on he sign and magniude of he shocks. 2 Srucural shocks are idenified using a Choleski decomposiion following he order DLPUBINV, DLPRIVGDP, DLPRIVINV, DRIQ, DDLCREDIT. Wih his ordering, i is assumed ha he governmen akes invesmen decisions based on he pas informaion of privae secor variables. Also, i is probable ha DLPRIVGDP affecs DLPRIVINV raher han in he oher way around in he shor run. Since he correlaion beween DLPRIVINV and DRIQ is conemporaneously posiive, hen DLPRIVINV should affec DRIQ. The converse does no make heoreical sense even hough we invesigae wheher he effecs of he real ineres rae on privae invesmen can be posiive given some economic condiions. A similar ordering is used for he ordering of DRIQ and DDLCREDIT. For more specific deails on how he generalized impulse response funcions are consruced in his sudy, see Mendoza Lugo (2001), Chaper IV. Conference May 19-20, 2008, Minsk

220 220 This secion presens he impulse response funcions for one-sandard-error posiive, negaive, and average shocks. 1 Negaive shocks are muliplied by minus one o make hem comparable o he responses o one-sandard-error shocks. We also compue impulse response funcions o wosandard-error shocks and normalize hem by dividing by wo o make hem comparable o he responses o one-sandard-error shocks. However, hese resuls are no shown because, in general, we found similar impulse response funcions o one-sandard-error shocks. 6.1 Response of DLPRIVINV o shocks of differen signs o DRIQ Shocks o DRIQ have he opposie sign on DLPRIVINV. Figure 6.1 repors he effec of shocks of differen signs o DRIQ on DLPRIVINV. This figure shows ha DLPRIVINV is more responsive o negaive shocks han o posiive shocks o DRIQ, and his effec is sronger for boh posiive and negaive shocks when he shock is caused in he low credi regime. A longer periods, a negaive shock has a cumulaive posiive effec on DLPRIVINV, and his effec seems o be sronger when he shock occurs in he low credi regime. Posiive shocks are also found o be sronger in he lower credi regime, bu his effec, in absolue erms, is smaller han he effec of negaive shocks o DRIQ. 6.2 Response of DLPRIVINV o shocks of differen signs o DDLCREDIT Figure 6.2 repors ha posiive shocks o DDLCREDIT have posiive impacs on DLPRIVINV and ha hese impacs are sronger and less volaile when he economy is iniially in he high credi regime. While negaive shocks cause a conracion in DLPRIVINV in earlier periods, he cumulaive response of DLPRIVINV o DDLCREDIT oscillaes beween posiive and negaive values in laer periods. We inerpre his las resul as having no effec on he rae of growh of privae invesmen. When he economy is iniially facing a credi conracion, in earlier periods, a negaive shock o DDLCREDIT has a sronger effec on DLPRIVINV han a posiive shock (see Figure 6.2.c). This resul is mild evidence for a more responsive privae invesmen o credi when credi resricions are more severe, as he heory of financial liberalizaion predics. 6.3 Response of DLPRIVINV o shocks of differen signs o DLPUBINV Shocks o DLPUBINV have opposie effecs on DLPRIVINV. A negaive shock o DLPUBINV has an imporan cumulaive posiive effec on DLPRIVINV up o period 12. Some asymmeries are observed afer he hird period beween posiive and negaive shocks. Tha is, DLPRIVINV is more volaile wih posiive shocks and more responsive o negaive shocks o DLPUBINV (Figure 6.3). 6.4 Responses of DLPRIVINV o shocks o DLPRIVGDP and DLPRIVINV Even when privae invesmen causes privae GDP in he long run wihou causaliy observed in he opposie direcion, impulse response funcions of DLPRIVINV o shocks o DLPRIVGDP reveal his variable o be he mos imporan deerminan of privae invesmen in he shor run. A sandard error shock o DLPRIVGDP causes a cumulaive response in DLPRIVINV of 16% by he hird period. Afer ha period, his effec sars o decrease, achieving values near zero by he 12h period (Figure 6.4). Furhermore, DLPRIVINV has an imporan immediae response of he same sign o is own shocks. This, however, vanishes as ime passes and reaches near zero by he 12h period (Figure 6.5). In boh cases, responses are symmeric and independen of he iniial sae of he economy. Naional Bank of he Republic of Belarus 1 One-sandard-error shock o hese five variables, in he same order as is lised, are of he following size: 1.044, 1.074, 0.996, 1.178, and

221 221 Figure 6.1: Venezuela: effecs of one-sandard-error posiive and negaive shocks o DRIQ on DLPRIVINV (Toal average and given he iniial sae of he economy) DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (a) Cumulaive response of DLPRIVINV o DRIQ: Toal average DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (b) Cumulaive response of DLPRIVINV o DRIQ: High credi regime DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (c) Cumulaive response of DLPRIVINV o DRIQ: Low credi regime Conference May 19-20, 2008, Minsk

222 222 Figure 6.2: Venezuela: effecs of one-sandard-error negaive and posiive shocks o DDLCREDIT on DLPRIVINV (Toal average and given he iniial sae of he economy) DDLPRIVINV Quarer (a) Cumulaive response of DLPRIVINV o DDLCREDIT: Toal average 1 s.e. neg. shock (imes -1) 1 s.e. pos. shock DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (b) Cumulaive response of DLPRIVINV o DDLCREDIT: High credi regime DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (c) Cumulaive response of DLPRIVINV o DDLCREDIT: Low credi regime Naional Bank of he Republic of Belarus

223 223 Figure 6.3: Venezuela: effecs of one-sandard-error posiive and negaive shocks o DLPUBINV on DLPRIVINV (Toal average and given he iniial sae of he economy) DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (a) Cumulaive response of DLPRIVINV o DLPUBINV: Toal average DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (b) Cumulaive response of DLPRIVINV o DLPUBINV: High credi regime DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (c) Cumulaive response of DLPRIVINV o DLPUBINV: Low credi regime Conference May 19-20, 2008, Minsk

224 224 Figure 6.4:Venezuela: effecs of one-sandard-error posiive and negaive shocks o DLPRIVGDP on DLPRIVINV (Toal average and given he iniial sae of he economy) DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (a) Cumulaive response of DLPRIVINV o DLPRIVGDP: Toal average DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (b) Cumulaive response of DLPRIVINV o DLPRIVGDP: High credi DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (c) Cumulaive response of DLPRIVINV o DLPRIVGDP: Low credi Naional Bank of he Republic of Belarus

225 225 Figure 6.5: Venezuela: effecs of one-sandard-error posiive and negaive shocks o DLPRIVINV on DLPRIVINV (Toal average and given he iniial sae of he economy) DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (a) Cumulaive response of DLPRIVINV o DLPRIVINV: Toal average DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (b) Cumulaive response of DLPRIVINV o DLPRIVINV: High credi regime DDLPRIVINV s.e. neg. shock (imes -1) 1 s.e. pos. shock Quarer (c) Cumulaive response of DLPRIVINV o DLPRIVINV: Low credi regime Conference May 19-20, 2008, Minsk

226 226 7 Conclusions Venezuela is a developing counry ha had very low average real ineres raes in he pas. Par of he period of sudy, 1983:1 1988:4, was characerized by adminisraive conrols on nominal ineres raes. Since 1989, more flexible ineres rae policies have been adoped. According o he financial liberalizaion heory, we should expec ha in hose economies wih very low or negaive real ineres raes, a posiive shock o ineres raes would cause a posiive effec on privae invesmen while he same effec is negaive, according o he radiional heory, a higher raes. This heory suggess a nonlinear relaionship beween privae invesmen and real ineres raes wih real ineres raes describing he saes of he economy. However, from he Venezuelan daa we did no find evidence for using he real ineres rae as a ransiion variable in a smooh ransiion logisic vecor error correcion (LSTVEC) model. Evidence was in favor of using lagged values of DLCREDIT as a ransiion variable. Under such a specificaion wih wo regimes - low credi and high credi - we have esimaed he effecs of shocks o changes in real ineres raes, DRIQ, on he growh rae of privae invesmen, DLPRIVINV. We should expec ha in periods of credi conracion, a posiive shock o real ineres raes will have a posiive effec on privae invesmen. However, we did no find evidence for such an effec using Venezuelan daa. In boh regimes posiive shocks o DRIQ have negaive effecs on DLPRIVINV, and his accumulaed effec is more negaive in he lower regime. Furhermore, he effec of posiive shocks o DRIQ on DLPRIVINV is lower in absolue values han he response o negaive shocks. Negaive shocks o DRIQ on DLPRIVINV have a sronger cumulaive effec when hey sar in he low regime. Despie he fac ha we have found evidence for asymmeric effecs beween posiive and negaive shocks o DRIQ on DLPRIVINV, hose resuls do no suppor McKinnon s argumen of posiive shocks on DRIQ causing a rise in DLPRIVINV, even in periods of credi conracion. In addiion, he Venezuelan daa provides evidence for an asymmeric response of DLPRIVINV o shocks in DDLCREDIT for immediae periods afer a negaive shock o credi when he economy is already facing credi conracions, as was expeced. On he oher hand, he cumulaive response of DLPRIVINV o posiive shocks o DDLCREDIT becomes bigger in laer periods when he high credi regime prevails. Why invesmen is more responsive o negaive shocks o he ineres raes when facing credi conracion and more responsive o posiive shocks o DDLCREDIT when facing credi expansion is difficul o explain. While he responses of he rae of growh of privae invesmen o shocks o he rae of growh of privae GDP and o is own shocks are symmeric, hey emerge as he mos imporan forces driving invesmen spending in he shor run. Furhermore, he fac ha he coinegraing vecor does no ener ino he privae invesmen equaion ells us ha he opposie effec on DLPRIVINV of shocks o DLPUBINV is emporal. This is evidence ha public invesmen acs as a subsiue for privae invesmen in he Venezuelan economy. Public invesmen has a negaive effec on privae invesmen when he governmen compees wih he privae secor o obain he resources o finance invesmen projecs or when i provides goods ha can be produced by he privae secor. Shocks o DLPUBINV of opposie effec on DLPRIVINV invie us o sudy he effecs of public invesmen policy in more deail using disaggregae daa on public invesmen spending. Naional Bank of he Republic of Belarus

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229 229 Azer Aleskerov, 1 Opimal Moneary Policy Sraegy During he Huge Foreign Exchange Inflows This aricle sudies he quesions of deermining moneary policy sraegy during foreign exchange inflows. Inernaional experience shows ha a huge surplus in a counry s balance of paymens pus he cenral bank in dillemma, wheher o arge inflaion or exchange rae. Targeing inflaion could cause sharp appreciaion of exchange rae and adversely affec he counry s economic compeiiveness. While argeing exchange rae could rigger inflaion and adversely affec he social life. This aricle paricularly sudies Azerbaijani experience in response o foreign exchange inflows. The aricle draws wih a conclusion ha combinaion of boh inflaion and foreign exchange argeing wih exchange rae prioriy is opimal moneary policy sraegy for a counry in ransiion wih huge foreign exchange inflows. Afer achieving financial markes developmen and solving oher insiuional problems, he main objecive of moneary policy could shif from exchange rae o inflaion argeing. Prioriizing exchange rae sabiliy o price sabiliy may have emporary significance. Foreign exchange inflow o a counry wih high degree of economic growh has been one of he imporan endencies in global economic processes during he las 5 years. If capial ouflow originaes hrea for currency depreciaion, he capial inflow enails diamerically adverse problems. The inflow of foreign exchange reserves causes naional currency o srenghen, increase in foreign reserves, hinders inflaion o be sable and increases risks for financial sysem sabiliy. Various cenral banks reac capial inflows differenly. Generally, in response o capial inflow cenral banks preven acceleraed currency appreciaion. For his purpose, cenral banks purchase excess foreign exchange from markes. This is he main reason why foreign reserves of developing counries have been doubled wihin he nex hree years. Some counries (such as Thailand, Columbia) apply resricions for capial inflows while oher counries (India, Souh Korea) liberalize capial ouflow. Counries in ransiion also faced wih he same problem. Deerminaion of opimal moneary policy sraegy under condiion of balance of paymens surplus is he main problem of cenral banks in ransiional economies where insiuional problems have no been compleely solved. During capial inflow, a cenral bank may choose one of he following moneary policy sraegies: Exchange rae argeing or nominal exchange rae sabilizing. Under his policy cenral bank should purchase excess supply in he foreign exchange markes. As a resul, moneary base will rapidly increase and push up inflaion which is undesirable from he social poin of view. Inflaion argeing or prices sabilizing. In his case, he cenral bank shouldn worry abou exchange rae appreciaion and purchase excess reserves from he foreign exchange markes. Sharp appreciaion of naional currency could have negaive affec on financial sysem sabiliy of a counry wih high degree of dollarizaion. In such a way, if he share of foreign currency in banking deposis and credis is high, sudden flucuaions in exchange rae will incur big losses for financial secor. Moreover, appreciaion of naional currency weakens he counry s compeiiveness. Simulaneous sabilizaion of nominal exchange rae and prices. In his case, he cenral bank should purchase excess supply of foreign currency and hen serilize excess moneary base in naional currency. As a resul, domesic ineres raes will increase and his will arac specula- 1 Depuy Direcor of Moneary Policy Deparmen, Naional Bank of Azerbaijan Republic. Maser in Economic Science. Conference May 19-20, 2008, Minsk

230 230 ive capial inflows which spill-overly lead o inflaion. Inflow of ho money will increase financial sysem sensiiviy o inernaional crisis. Selecing moneary policy sraegy depends on a counry s specific feaures. Azerbaijan has also experienced huge capial inflows during he las 5 years. Mainly, i is relaed o rapid exracion of oil producion and oil expor as well as increase of oil prices in he world markes. As a resul, curren accoun balance surplus amouned 30% of GDP in Presen and fuure oil inflows creae condiion for inernaional capial flows o he non-oil secor of he economy. Consequenly, inernaional capial inflow o non-oil secor of Azerbaijan is growing rapidly. Rapid increase in foreign liabiliies of domesic banks should be espesially noed. Only in 2007 foreign liabiliies of domesic banking sysem have grown up by 2,2 imes. Naional Bank of Azerbaijan (NBA) responds o foreign exchange inflows by pursuing combinaory policy, simulaneous argeing of inflaion and exchange rae. Considering high dollarizaion in he economy, NBA sees is main responsibiliy o keep sabiliy of he naional currency agains he USD. The naional currency appreciaed by 6,3%, 5,1%, 3% in 2005, 2006 and 2007 respecively. To keep exchange rae sabiliy, NBA purchases excess foreign exchange from he foreign exchange markes. Esimaions show ha wihou NBA inervenion in he foreign exchange marke he naional currency would be appreciaed a leas 20% in This would negaively affec he financial posiion of he banking sysem since, more han half of financial sysem asses are made up in foreign currency. Since 2002 NBA foreign reserves have grown up 4,8 imes. Moneary base also grows rapidly which is refleced in price movemen. Moneary base in naional currency increased 17%, 2,8 imes and 77% in 2005, 2006, and 2007 respecively. Annual inflaion (CPI) increased from 3 4% in o 16 17% in Why NBA prioriize exchange rae sabiliy o price sabiliy? As is well known, here are crieria s o deermine degree of flexibiliy of exchange rae regime for counries. These cirerias are deiermined base on he comprehensive analysis of inernaional experience. For deermining exchange rae regime we may analyze hese crierias from he case of Azerbaijan. 1. Size of economy. In general, counries wih large economies may selec more flexible exchange rae regime since, hese counries are less subjec o exernal facors. In his case, floaing exchange rae regime posiively affecs he exernal equilibrium. Azerbaijan is a small counry and he share of is economy is miserable in he global economy. Currenly, GDP of he counry amouns 0,02% of he world GDP. Therefore, we can predeermine ha for Azerbaijan fixed exchange regime is more appropriae. Naional Bank of he Republic of Belarus 2. Degree of economic openness. Counries wih high degree of economic openness should selec more fixed exchange rae regime because, in such economies he impac of exchange rae on he macroeconomic processes is higher. In counries wih high degree of economic openness flexible exchange rae regime is undesirable from he macroeconomic sabiliy poin of view. Economic openness of Azerbaijan increases each year. As a resul of 9 monhs of 2007 he share of impor amouned o 21,5% of GDP and share of expor reached o 73,9% of GDP. However, considering Azerbaijan specificaion, i is expedien o evaluae economic openness by using share of non-oil impor and expor in non-oil GDP, since impor and expor operaions in oil secor are no affeced by changes in exchange rae. In 2007 share of non-oil impor and expor in non-oil GDP amouned o 16,5% and 4,2%, respecively. Therefore, Azerbaijan is no a counry wih high degree of economic openness and his gives possibiliy o selec more flexible exchange rae regime. 3. Degree of economic diversificaion (paricularly expor). Counries wih high degree of economic diversificaion (paricularly expor) may selec more flexible exchange rae regime. Azerbaijan

231 231 economy is dominaed by oil secor. The share of oil and gas secor is 50% and 80% in GDP and expor, respecively. In he fuure, hese raios are expeced o be increased. Considering low level of economic diversificaion, selecing fixed exchange rae regimes is more appropriae for Azerbaijan. 4. Level of economic and financial marke developmen. Counries wih developed economy and financial marke may selec more flexible exchange rae regime. According o universal indicaors, Azerbaijan remains behind of indusrial counries for GDP per head. Financial markes are also no well developed. In financial markes i is passively used such insrumens as forward and fuures albei, high dynamism in foreign exchange marke. This crierion le us conclude ha, Azerbaijan should selec fixed exchange rae regime. 5. Capial mobiliy. The more capial mobiliy he more flexible exchange rae should be seleced. In Azerbaijan here is no any resricion on capial inflow. Capial ouflow was liberalized in June, Tha means Azerbaijan can be characerized as a counry wih high level of capial mobiliy. According o his crierion, Azerbaijan may selec free floaing exchange rae regime. 6. Degree of dollarizaion. The more degree of dollarizaion he more fixed exchange rae should be applied. Despie people s confidence in naional currency increases in Azerbaijan las years, degree of dollarizaion sill remains high. Thus, he share of foreign currency deposis in oal deposis is 50%, and he share of foreign currency deposis in M3 exceeds 29%. More han 45% bank credis are given in foreign currency. High degree of dollarizaion generaes prerequisie for selecing fixed exchange rae regime. 7. Difference beween domesic inflaion and inflaion in parner counries. The more he difference beween inflaion in domesic counry and in parner counries he more fixed exchange rae is appropriae. Recenly, i has been observed an increase difference beween inflaion in Azerbaijan and in parner counries ha suggess selecing fixed exchange rae regime. In 2007 inflaion in Azerbaijan conained 16%, where average weighed inflaion in parner counries conained 9%. So, 4 crieria from 7 sugges possibiliy of selecing more fixed exchange rae regime for Azerbaijan. Along wih he exchange rae argeing, NBA ries o inensify ani-inflaionary effeciveness of he moneary policy. For his reason, NBA realizes several measures in various direcions. Considering limied scope of he governmen securiy marke, since 2004 NBA has issued is own bills o limi moneary base growh. Through hese bills NBA conducs ourigh ransacion as well as REPO and reverse-repo operaions. Long-erm liquidiy shorage and surplus are regulaed hrough ourigh ransacions of NBA bills. Shor erm liquidiy is regulaed hrough REPO and reverse-repo. The volume of NBA shor-erm noe porfolios increased 58%, 3,6 imes and 2 imes in 2005, 2006 and 2007, respecively. However, he share of hese bills in moneary base is 7 8% in all. NBA considers irrelevan sharp increase of is bills since, such increase could cause ineres raes o be increased. In order o cu down demand for credis and decrease moneary base, NBA increased is discoun rae for 6 imes wihin he las 3 years. Presenly, ineres rae on overnigh credis of NBA is 19% ha exceeds annual inflaion. Because of disequilibrium in foreign exchange marke due o excess foreign exchange, a he beginning of June 2007 capial ouflow was liberalized. Saring ha ime Azerbaijani residen can have direc or porfolio invesmen in abroad, purchase real esae in abroad, and keep heir savings in foreign banks. Local banks were also given righs o lend o non-residens. To decrease residen s risks geographical limiaion is applied on capial accoun liberalizaion. Thus, residens could expor heir capials only o OECD counries and Russian Federaion. Unil June 2007 expor of capial was possible only due o NBA permission. Conference May 19-20, 2008, Minsk

232 232 Posiive oucome of seleced moneary policy sraegy in Azerbaijan is proecing of he counry s economic compeiiveness. Real effecive exchange rae has been appreciaed only 10% wihin he las wo years. If NBA don no preven naional currency o be appreciaed, real effecive exchange rae will be furher appreciaed. Ani-inflaionary effec of his policy could be small, since nominal exchange rae affecs inflaion indirecly while real effecive exchange rae affecs direcly. Due o curren exchange rae policy Azerbaijan was able o avoid so-called Duch Disease 1. In Azerbaijan non-oil growh is more han 10 %. Furhermore, such policy enables o keep financial and banking sysem sabiliy. Thus, simulaneous inflaion and exchange rae argeing wih exchange rae prioriy is opimal moneary policy for a counry in ransiion faced wih huge foreign exchange inflows. By achieving financial markes developmen and solving oher inuiional problems he main objecive of moneary policy can be shifed from exchange rae o inflaion argeing. Because effecive cenral bank i s a bank ha can provide low, sable and predicable rae of inflaion. Prioriy exchange rae sabiliy over price sabiliy can bear only for shor-erm. References Chrisiansen Anne Beri, Qvigsad Fredrik Choosing a Moneary Policy Targe, Scandinavian Universiy Press, 1997; Crisina Daseking, Aish Grosh, Timohy Lane, and Alun Thomas Lessons from he Crisis in Argenina, Occasional Paper, IMF, Washingon DC, 2004; DeLisle Worrell Moneary and Fiskal Coordinaion in Small Open Economies, IMF Working Paper, Inernaional Moneary Fund, 2000 Francesco Caramazza, Cahangir Aziz Fixed or Flexible? IMF, Washingon DC 2000, Economic issues N13; Kenneh S.Rogoff, Aasim M.Husain, Ashoka Mody, Robin Brooks, and Nienke Oomes Evoluion and Performance of Exchange Rae Regimes Occasional Paper, IMF, Washingon DC, 2004; Джеффри А. Френкель, «Ни один из валютных режимов не является правильным для всех стран или всех периодов времени», НБЭИ, Серия рабочих документов, Т 7338; Красавина Л.Н «Денежно-кредитная и валютная политика:научные основы и практика», «Деньги и кредит» 6/2002 Красавина Л.Н «Центральный банк в условиях рыночной экономики: мировой и российский опыт», «Деньги и кредит» 7/2002, Монтес.М.Ф, Попов.В.В «Азиатский вирус или голландская болезнь», Издательство «Дело», Москва Naional Bank of he Republic of Belarus 1 Deerioraion of compeiiveness in manufacuring indusry agains a background of sharp developmen of naural resource resource indusry.

233 233 Musafo Niyozov 1 Feaures of Moneary Programs in Small Economies The implemenaion of moneary policy in small economies can be accompanied by simpler moneary program. One on specifics of moneary policy in he Republic of Tajikisan is ha i is oriened on money supply aggregaes as he naional currency exchange rae shall be deermined on he marke in oher words while open regime of exchange rae. The basic calculaions on assessmen of usage of simplified model of moneary program by he example of moneary indicaors such as reserve money and broad money are used in he work. One of he reasons o use more simplified sysem is he specifics of naional economy where no all segmens of money marke have componens for complee applicaion of heory or generally acceped regulariies. For example, one of he widespread ools is he ineres rae which a selfinsufficien funcioning loses he classical sense. In urn, exernal cos of currency a a mode of freely floaing rae ges exogenous characer. Therefore he money supply aggregaes can be as he basic effecive endogenous parameer for influence on raes of a rise in prices which is an ulimae goal of moneary policy. Process of economic reforms and is efficiency in Tajikisan in many respecs is defined by sabiliy of he moneary and credi sysem conrollable by he Naional Bank of he counry. Condiions for moneary policy implemened by he Naional Bank developed in 1991 o 1997 during circulaion of he currency of Russia in he erriory of he Republic of Tajikisan. The independence of he Naional Bank was enough condiional and was srongly limied o consanly varying poliical siuaion. Financial-budgeary crisis, consequences of civil war, and non-paymens, a hyperinflaion, almos impossible o implemen some he well effecive considered moneary policy direced on he decision of long-erm problems of macroeconomic sabilizaion Neverheless, he basic laws regulaing he moneary sysem have been acceped, precondiions for formaion and developmen of moneary sysem in a ransiion period are creaed. These laws and sauory acs were: The Law of he Republic of Tajikisan On Banks and Bank aciviy in Republic Tajikisan (1991.), he Law of he Republic of Tajikisan On Naional Bank of Tajikisan (1991), he Law of he Republic of Tajikisan On securiies and sock exchanges (1992), Insrucion 28 On he selemen, curren and budgeary accouns opened in esablishmens of banks of he Republic of Tajikisan (1993), General rules of regulaion of aciviy of banks in he Republic of Tajikisan (1995), Regulaions On order of esablishmen of commercial banks and sopping heir aciviy in he Republic of Tajikisan (1995) and ec. These and oher documens had been incorporaed a basis for creaion and funcioning of he wolevel bank sysem meeing new requiremens of a ransiion period. Thus, banking and moneary sysem were considerably ransformed and i was generaed new principles of funcioning of financial markes (currency, securiies marke, iner banking credis marke). The funcions of he Naional Bank, is place and a role in moneary sysem have essenially changed. I was effeced he 1 Chief of Moneary Policy Implemenaion Division of Moneary Policy and Saisics Deparmen of he Naional Bank of Tajikisan. Candidae of Economics Science, Associae professor. Conference May 19-20, 2008, Minsk

234 234 ransiion from sysem of uniform sae bank o wo-level sysem. The role of Naional Bank of Tajikisan in moneary advancing of expanded producion on he basis of providing he branches of a naional economy wih money resources has amplified. So, influence on volume of issued loans is made, he accoun policy is usually combined wih sae regulaion of ineres raes of deposis and loans. Though banks basically independenly define ineress on deposis and loans, neverheless, hey are guided by a rae of he Naional Bank of Tajikisan. Oher insrumen of regulaion of he Naional Bank of Tajikisan is definiion of amoun of required reserves for commercial banks ha means commercial banks shall be obliged o hold a par of credi resources on he ineres-free base wih he Naional Bank. The sandard amoun of required reserves can be decreased or increased depending on a conjuncure in capial marke. The policy of regulaion of amoun of required reserves exends on all ypes of credi insiuions (and in some counries on some special credi and financial insiuions), however is basic objec are commercial banks which define ineres raes on loans. The majoriy of oher credi and financial insiuions (non-banking credi insiuions) in he ineres policy follows commercial banks. Through definiion of sandard of required reserves he Naional Bank influences as a whole he ineres rae of loan, which, in is urn, influences he profiableness of hose or oher securiies. One more form of regulaion of he Naional Bank is operaions in he open marke wih he sae bonds and cerificaes of deposi of he Naional Bank of Tajikisan, by heir sale and purchase Selling he sae bonds and cerificaes of deposis he Naional Bank in ha way reduces moneary resources of banks and oher credi and financial insiuions and promoes an increase of he ineres rae in he loanable funds marke. The form of regulaion is also direc sae influence of he Naional Bank of Tajikisan on credi sysem by direc rules of conrolling bodies in form of insrucions, insrucions of applicaion of sancions for violaion. Naional Bank of Tajikisan carries ou he conrol over large credis, limiaion of bank credis, seleced inspecions of credi insiuions. However he mehods of direc influence basically exend on commercial and savings banks and o a lesser degree on oher credi and financial insiuions. One of mehods of regulaion is a ax policy. I reflecs in change of ax raes of profis received by various credi and financial insiuions. As a rule, he laer are subjeced o profis ax, as well as all oher legal eniies operaing in cerain economic condiions. The increase in axes can promoe reducion of credi-loan operaions and increase of ineres raes. On he conrary, reducion of income ax of hese insiuions leads o expansion of such operaions and can promoe decrease of ineres raes. Therefore ax influence represens a sufficienly effecive sae regulaion Naional Bank of he Republic of Belarus Oher regulaion mehod of credi sysem is paricipaion of he sae in aciviy of credi and financial insiuions. I is expressed in hree basic direcions: purchase of a par of credi insiuions by he sae by naionalizaion; he organizaion of new esablishmens as addiion o pars; individual share of he sae by purchase of socks of credi and financial esablishmens and as a resul creaion of he mixed insiuions. Through given mehod he sae renders effecive influence on func-

235 235 ioning of all crediing sysem. The mehod of regulaion by creaion of a sae ownership is widely enough widespread in he counries of coninenal Europe and developing counries. I is necessary o noe, ha in he majoriy of indusrially developed counries o solve a problem of a public deb by sale of he governmenal securiies o he credi insiues is quicker and more effecive and due o he laer i is financed large invesmen projecs of naional scale. Besides a presence of he sae influence on a supply and demand of loan capial, dynamics of is marke, ineres raes, he big influence on regulaion of credi sysem is rendered by legislaive measures underaken by he cenral governmen, local governmen auhoriies and also legislaure. They develop projecs of laws and he insrucions regulaing various fields of aciviy of credi and financial insiuions. Thus he basic regulaing funcion is carried ou by cenral execuive and legislaive auhoriies, which develop he main laws defining aciviy of credi and financial insiues. Wihin he framework of execuive auhoriy he basic regulaing bodies are in he sphere of moneary and finance policy he Naional Bank of Tajikisan and he Minisry of Finance of he Republic Tajikisan. Usually hey operae in he counries wih raher high level crediing of credi sysem by he sae. Legislaive bodies ake acive par in regulaion, along wih execuive auhoriies. Special commiees, commissions, subcommiees, coordinaing he governmenal policy, as well as credi sysem aciviy operae in heir srucure. Insurance companies as long-erm credis suppliers in he loan capials marke of loan capials occupy special place in sae regulaion. As he basic objecs of heir regulaion, as a rule, is Minisry of Finance (an excepion of his rule is he USA, where insurance ariffs are regulaed by execuive auhoriies of he saes). Feaure of credi sysem regulaion by means of insurance ariffs is ha insurance companies aspire o raise raes. Especially, in he field of propery insurance as i is unprofiable. As a resul, level of limis of insurance ariffs on propery insurance is regulaed enough rigidly as from Minisry of Finance, and from local auhoriies. In he Republic of Tajikisan moneary policy is developed according o he Law of he Republic Tajikisan On he Naional Bank of Tajikisan and i defines he major aspecs of he Republic of Tajikisan moneary policy realizaion. For achievemen he purposes of moneary policy is supposed realizaion he following problems: perfecion of open marke operaions mechanism, including inerbank currency marke and inerbank credi marke, where he Naional Bank of Tajikisan role is a basic regulaion body of he financial insiuions operaions in his marke; expansion of banking services specrum, in paricular, morgage crediing and crediing in he counryside, in paricular, mounain areas, for business developmen, increasing he erms of microcredis, reducion of heir percen and srenghening of he banking sysem financial condiion; coninuaion he works on populaion rus increasing and managing subjecs o banking sysem. In his case, aracion of populaion deposis o banking sysem and subsequen crediing of he naional economy of he republic; increasing he auhorized capial of he banks a he expense of inernal and foreign invesmen aracion; Conference May 19-20, 2008, Minsk

236 236 improvemen of normaive legal documens in banking sysem and reducion of heir provisions in accordance wih marke economy requiremens; The Naional Bank of Tajikisan considers an issue of he ools formaion on decreasing he liquidiy changes and money resources providing in he form of he daily credis, assured by he Sae Securiies. Wih a view of liquidiy managemen is foreseen providing he money resources o he credi organizaions, by carrying ou he pawn aucions. Obligaory reserves using mechanism will be coninued as addiional and long-erm ool of moneary policy realizaion, direced o deducion of he necessary level of moneary circulaion. I is aken ino consideraion, ha a an opimum macroeconomic condiion, his rae will be gradually decreased furher, as ha norm was lowered by 12 percen in 2007 in comparison o 20 percen in Aciviy of inerbank credi marke, relaed o graning o he banks possibiliy of acquisiion and realizaion of free credi resources and definiions of a marke ineres rae of a credi, is improved. Necessary condiions for acivizaion of banking operaions in inerbank credi marke are creaed. In currency policy he mode «regulaed, freely floaing wihou definiion and announcemen of rae change borders» will be kep, official exchange rae of Somoni agains US dollar will be defined and appear daily on he basis of an average rae under ransacions in inerbank and inrabank markes. In his connecion, he Naional Bank of Tajikisan will perform operaions on foreign currency purchase and sale on inernal currency marke exclusively in cases of he excessive rae flucuaion and for implemenaion of he conrol indicaors of moneary program reserve money. Now here is a number of problems and risks, inerfering developmen of banking sysem and moneary policy realizaion. In is urn, he arrangemens direced o he banking sysem srenghening, foreseen he following problems decision: credi risks, unimely credis repaymen and percen by borrowers; high level of problem credis in he liquidiy limiaion condiions reduces credi aciviy of banks; level of credi organizaion capializaion (oal capial of he credi organizaions makes 7,7 percen from GDP, auhorized capial 4,8 percen, when hese indicaors in European counries make 40 percen, in he USA 288 percen, in Kazakhsan 12,5 percen, and in Kyrgyzsan 4,9 percen. This low level will lead o deerren facor of banking operaions developmen and covering possibiliy of he arisen banking risks; corporae managemen does no make essenial impac on effecive aciviy of he banks, and available banking echnologies do no answer properly o expansion and improvemen of banking operaions qualiy; hough some improvemens in srucure of acives and obligaions of banks are observed, bu, in some cases heir erms mismach each oher; small volume of long-erm money resources involved by he banks limis possibiliies of long-erm invesmen; Naional Bank of he Republic of Belarus parial conducing of he accoun, according o inernaional sandards of financial reporing, a he enerprises (cliens of he banks) limis ransparency of a borrower and consrains inegraion process of he banks wih regional and world financial markes; low compeiion level on banking services marke, conneced wih insufficien quaniy of foreign banks, having high echnologies and modern service.

237 237 I is necessary o ake following measures for coninuaion of domesic banks and non-banking financial organizaions sabiliy policy: srenghening of banking supervision on aciviy of he banks and non-banking financial organizaions; furher perfecion of he normaive legal papers under he conrol of risks on credis, given ou o persons, conneced wih he banks (in paricular, afer recepion of he obligaory consen of Board of Direcors of a credi organizaion on credi operaions, resricion of sof loans o responsible persons, ec.); perfecion of credi organizaions aciviy esimaion, according o Basel Commiee recommendaions on banking supervision and inernaional experience of banks aciviy esimaion; mainenance of prompness and efficiency of he decisions, acceped wihin he frames of banking supervision; srenghening of inernal conrol in he banks; mainenance of he banks aciviy ransparency, which promoes populaion s rus increasing o he banks; full auomaion of informaion collecing and Financial Repors making in he credi organizaions; coninuaion of he banks improvemen and rehabiliaion policy, having financial problems by heir re-srucuring; increasing of he banking resources by aracion populaion means, as well as aracion he means of esablishmens and enerprises in he form of securiies; srenghening of he conrol over sric banking legislaion observance in he field of he cliens righs proecion, preservaions of bank secrecy and observance of corporae managemen principles in he banks; assisance in he creaion of The Banking Associaion and formaion he condiions for sandard-legal basis creaion for Credi Bureaus organizaion; srenghening of Warraning Fund of Physical Persons Deposis aciviy; srenghening he requiremens o he banks, concerning regular audi conducion and publicaion of heir financial reporing in mass media; The Naional Bank of Tajikisan wih a view of inersae selemens implemenaion perfecion and mainenance he qualiaive and reliable selemen-paymen process, gives favorable condiions for he banks, which are users of Poin of Collecive Access o Nework SWIFT, allowing banks o have modern mechanisms of ineracion wih world banking communiy wih smaller expenses and o represen a se of new services o he cliens. For he decision of forhcoming problems in sphere of financial sysem developmen, work on banking aciviy s legal base perfecion will be coninued. Wih a view of he judicial permission of bank secrecy disclosure, legislaion of laws on amends and aleraions in he Republic Tajikisan s Law On Banks and Banking Aciviy will be prepared, he Conference May 19-20, 2008, Minsk

238 238 Civil Code of he Republic of Tajikisan, Criminally-Remedial Code of he Republic of Tajikisan are submied o consideraion o Governmen of he Republic of Tajikisan. Moneary and currency policies of he Republic of Tajikisan are developed in coordinaion wih axaion-budgeary policy and will be direced o creaion he condiions for naional economy s growh. In his connecion, Minisry of Finance of he Republic of Tajikisan will sudy an issue of prescheduled repaymen of he long-erm securiies possibiliy, sored in he Naional Bank of Tajikisan. Service of republican and local budges will be carried ou on a paid basis. An emission issue of he sae exchequer bills will be considered by Minisry of Finance of he Republic of Tajikisan. The Naional Bank of Tajikisan, as an auhorized bank of he Governmen of he Republic of Tajikisan, became he full member of he Inerbank Union and has fruifully begun is aciviy wihin he frames of he Inerbank Union of he Shanghai Organizaion for Cooperaion and is inended o coninue i. Close cooperaion of he Naional Bank of Tajikisan wihin he frames of he Inerbank Union promoed developmen of our counry s economy, decreasing he level of povery and creaion of he new workplaces. Wih a view of foreign invesmen aracion and privae secor developmen he Naional Bank of Tajikisan will coninue is policy, direced o aracion he foreign invesmens ino privae secor, including following direcions, which will be considered: improvemen and furher developmen of normaive legal bases for improvemen of foreign invesors aciviy, aking ino accoun ineress of Tajikisan; favorable invesmen climae creaion, firs of all inroducion of incenive axaioncusoms sysem for foreign invesors, conformiy o modern requiremens of he marke, effecive proecion mechanisms of he invesors ineress and righs implemenaion a invesmen projecs realizaion, creaion of foreign invesmens insurance sysem; mainenance of foreign and domesic invesors wih modern informaion abou new acceped normaive legal acs in sphere of banking aciviy. Naional Bank of he Republic of Belarus

239 Vladimir Tarasov 1, 239 Theoreical Aspecs of Currency Regulaion, Balance of Paymens and Ani-Inflaion Policy Saus Theoreical problems of currency regulaion, ineracion beween he balance of paymens and exchange rae, as well as characerisic feaures of modern ani-inflaion policy are discussed. I is demonsraed ha arificial mainenance of a sable naional currency exchange rae may sraegically lead o mos negaive consequences for a susainable developmen of he naional economy. Specific feaures of modern inflaion and he applicabiliy of various ani-inflaion policy mehods are discussed. Modern indusrialized saes gran heir cenral banks a discreion o independenly selec he main lines and insrumens of he moneary policy. Such independence of he cenral banks is a prerequisie for moneary policy implemenaion and aaining is main objecive, i.e. ensuring he sabiliy of he naional currency and he consumer prices, and reducing inflaion. A he same ime, he general moneary policy goals may be defined by he cenral bank wih regard o specific feaures of he curren circulaion of money and he banking sysem as a whole. Specifically, moneary policy of he cenral bank may be aimed a reaching he goals conneced, firs of all, wih confidence-building o he naional currency and reducing he inflaion rae and, secondly, wih mainaining he naional economy sabiliy and simulaing is economic growh, primarily in he mos progressive naional economy spheres, such as expor oriened or currency earning spheres, or, in recen years, he Belarusian agriculural producion. Unless he above objecives are me, i may no be possible o avoid excessive money in he money circulaion channels and, as a consequence, increased inflaion rae. However, he impac of he moneary policy on economy mus bear a long-erm sraegic characer o which he cenral bank mus pay special aenion. If he moneary auhoriies pay oo much aenion o individual and no crucial aspecs of he moneary policy his may run conrary o he sraegic goals of he general economic policy, for insance, o a susainable growh of he naional economy. In paricular, an aemp o mainain unrealisic currency exchange raes may lead o disorions wih regard o expor and impor, desabilizaion in aracing foreign capial (direc foreign invesmens, inernaional credis, grans, ec.). In order o aain sraegic goals of he general economic policy, moneary auhoriies can jusifiably use he socalled inermediae moneary policy arges which include change in he oal money, money and credi emission, money marke price level, including ineres raes and exchange rae. The dynamics and relaion beween such inermediae arges show, o wha degree, how acively and using wha insrumens of moneary and credi regulaion he cenral bank is going o use for reaching is sraegic objecives. The insrumens of moneary regulaion hemselves are common for all counries. Only he specific form of heir implemenaion may differ, depending on he radiions, he level he banking sysem developmen, he role of he sae and he cenral bank in he economy, he exising legislaive and normaive framework, and he specific poliical and economic siuaion. In his connecion, he problem of an efficien applicaion of currency regulaion deserves special aenion. The currency regulaion in each counry primarily depends on he currency exchange rae sysem used, wheher i is a fixed or a floaing raes sysem. Therefore, he currency (exchange) rae is one of he mos imporan aspecs in conducing economic reforms based on exchange rae 1 Belarusian Sae Universiy. Docor of Economics, professor. Conference May 19-20, 2008, Minsk

240 240 mechanism. However, his is also rue wih regard o oher insrumens of he sae s general economic policy, for insance, o prices, axes, ineres raes, ec. The fixed exchange rae sysem used in he pas is a sysem based on sricly fixed currency pariy and a full currency converibiliy. I is a currency sysem in which relaive currency prices are esablished bu here is no absolue price level. A problem of n-h currency may arise in such a sysem because he exchange rae is a relaive price of wo currencies, while in a sysem where he number of currencies equals n here may n-1 exchange raes. I follows from his ha he counry of one of n currencies may no wish o fix a cerain exchange rae for is own currency bu will choose o mainain a cerain level of prices. In he Breon Wood sysem, he role of he key currency serving as a reference value for he price level was played by he US dollar, he currency of he mos economically powerful player wihin he sysem. The USA herefore had a privilege o deermine he inflaion level wihin he enire sysem. I is, however, difficul o resolve he problem of he n-h currency if he players wihin he sysem are more or less equal in power. A possible opion would be monioring he moneary policy of he counry which has agreed ha her currency play he role of he leader. However, i is unlikely for any counry o agree ha is price levels should be deermined by oher paricipans in he currency carel since his would influence he counry s balance of paymens, ec. Therefore, he fixed exchange rae sysem is characerized by permanen conflics beween he inernal and exernal policy objecives. Wihin he floaing currency exchange rae sysem, he balance of paymens is equalized using foreign exchange markes. Therefore, he cenral banks are exemp from he duy o make inervenions on currency markes and are able o pursue an auonomous moneary policy. If he currency exchange raes correspond o price differences on he inernal and he exernal markes, exchange rae flucuaions will no damage exernal rade relaions. However, experience shows ha, even afer he inroducion of floaing exchange raes, he currency exchange raes may for a long ime deviae from he purchasing power pariies. This undermines he naional moneary policy and, herefore, requires appropriae regulaing measures. Floaing exchange raes have been exering a very negaive impac on he price seing mechanisms and credi ransacions of exernal rade companies in he European Communiies (ЕEС). The experience of using a floaing exchange rae shows ha i does no resul in a durable sabiliy of he balance of paymens, i srenghens he insabiliy of currency markes and is an imporan inflaion facor. Therefore, many saes use fixed (hard) bu regulaed currency exchange raes and pracice a hard floaing rae regulaion. In his case, hey proceed from he fac ha a relaive sabiliy of exchange raes exers a favorable impac on he inernal and exernal economic balance. A relaively sable exchange rae faciliaes (oher condiions being equal) beer condiions for exchange because i allows he impor price o be suppressed and srenghens figh wih inflaion. As for considerable deviaions of exchange raes from he purchasing power pariies, is reasons are aribued by many economiss, firsly, o a slow reacion of he rade balances due o he lack of flexibiliy in commodiy prices and, secondly, o he exisence of conracual commimens, and oher reasons. Naional Bank of he Republic of Belarus I is no by chance ha he US dollar exchange rae flucuaions clearly demonsrae he limiaions of he freely floaing exchange rae model normally used in heoreical discussions. The efficiency of using eiher a fixed or a floaing currency exchange rae is confirmed by he foreign experience. For insance, hanks o he European Currency Sysem (ЕCS) a zone has appeared where he sabiliy of currency exchange raes and prices is relaively high. During he ECS hisory (saring from 1979) he flucuaions of he currencies of he paricipaing saes wih regard o each oher has considerably decreased. On he conrary, he exchange rae flucuaions of he oher imporan floaing currencies, such as he dollar and he pound of serling, have been very high. Meanwhile, he con-

241 241 cep of fixed bu periodically adaped (periodically adjused) exchange raes, on which he ECS is based, has jusified iself and is going o be preserved in fuure since here are no prerequisies for forming a sysem of hard (fixed) exchange raes. This fully applies o he modern European currency sysem (Euro zone). Noably, a currency regime exised in he Sovie Union which had he following characerisic feaures: he Sovie ruble exchange rae wih regard o foreign currencies was hardly fixed; here exised a planned conversion sysem whereby all enerprises were able o exchange Sovie rubles for a foreign currency wihin an adoped fixed plan; he ruble was a locked currency in ha he prices in he conracs were no specified in Sovie rubles; no Sovie ruble or currency values were allowed o be expored in large quaniies from he counry by Sovie or foreign ciizens or by legal eniies; foreigners were forbidden o purchase enerprises, land and oher real esae in he USSR; he basis of exernal economic relaions of he USSR on he world Socialis marke was formed by he ransferable ruble which, unlike he naional currencies of indusrial counries, carried he main load in servicing he USSR rade urnover. A he same ime, he sysem of fixed exchange raes (wih narrow bounds of exchange rae flucuaions, as exised in he ECS) gives birh o wo convergence effecs for he economies of differen counries. The firs one is in ha fixed exchange raes faciliae close inernaional relaion in prices and economic siuaion, bringing abou convergence of he inflaion raes and harmonizaion of he economic siuaion. The mechanism of he balance of paymens equilibraion also leads o he convergence of he change raes of money per uni of goods, bringing abou a furher change in inflaion. This effec may be called an economic convergence effec which, however, is no able o cause convergence of real economic variables (GDP, ec.) since i is mainly limied o moneary values. The second, indirec convergence effec, caused by fixed exchange raes is refleced in he convergence of he economic policy since his sysem necessiaes a long-erm mainenance of exchange raes. To a cerain degree, he above wo convergence effecs are characerisic for Belarus and Russia. Currency exchange rae sabilizaion leads o more convergence of prices in differen counries. I may be concluded herefore ha ECS has caused a considerable sabilizaion of exchange raes, made a posiive conribuion o he convergence of price dynamics in he region, alhough i is impossible o prove i saisically. A he same ime, he inroducion in 1973 of he floaing exchange raes in indusrial counries (IC) mean he delegaion of funcions of deermining equilibrium exchange raes o he marke. However, he increased exchange rae flucuaion which i brough abou disurbed he sabiliy of inernaional rade, and caused disequilibrium of rade and paymen balance. All his required an acive and flexible currency policy on he par of he cenral banks. In oher words, he currency exchange rae regulaion acquired a special imporance, which is, in effec, wha is happening a presen. However, here exis a marke and a sae regulaion of exchange rae value. The marke regulaion based on compeiion and acion of he laws of value, as well as on he supply and demand, is sponaneous. The sae regulaion is aimed a overcoming he negaive consequences of he marke regulaion of he currency relaions and a aaining a sable economic growh and balance of paymens equilibrium; a reducing he unemploymen and inflaion in he counry. I is effeced using he currency policy, i.e. a complex of measures in he sphere of inernaional currency relaions implemened in line wih he counry s curren and sraegic objecives. The currency policy is legally shaped by he legislaion on currency and he currency agreemens beween saes. Currency inervenions, proecionis measures and ohers, such as he discoun policy, belong o he mos imporan sae impac on exchange rae. Conference May 19-20, 2008, Minsk

242 242 The mos imporan insrumen of he sae currency policy includes currency inervenions, ransacions of he cenral banks on currency markes, rading in he naional currency agains leading foreign currencies. The aim of inervenions is o change he level of he respecive exchange rae, he balance of asses and liabiliies wih regard o various currencies or expecaions of he currency marke players. The effec of he currency inervenion mechanism is similar o ha of he goods inervenions. In order o increase he naional currency exchange rae, he cenral bank mus sell foreign currencies and buy he naional one. This reduces he demand for he foreign currencies and, consequenly, increases he naional currency exchange rae. In order o reduce he naional currency exchange rae, he cenral bank mus sell he naional currency and buy he foreign one. This increases he foreign currency exchange rae and reduces he naional currency exchange rae. As a rule, official foreign exchange reserves are used for inervenions, and heir changed levels may serve as an indicaor of he scale of he sae inervenion ino he process of exchange rae formaion. Official inervenions may be carried ou using differen mehods, such as a sock exchanges (publicly) or a he iner-bank marke (confidenially), via brokers or direcly hrough ransacions wih banks, for a erm or wih immediae effec. Addiionally, official currency inervenions are subdivided ino serilized and non-serilized inervenions. Serilized are he inervenions in he course of which any change in he official foreign ne asses is compensaed by respecive changes in he inernal asses, so ha is here is virually no impac on he volume of he official money base. If, however, he change in he official currency reserves in he course of he inervenion resuls in he change of he money base, he inervenion is non-serilized. In order for he currency inervenions o aain he desired resuls in erms of changing he naional currency exchange rae in he long-erm perspecive, i is necessary o have sufficien reserves a he cenral bank for conducing currency inervenions, confidence of he marke players in he long-erm policy of he cenral bank, changes in such fundamenal economic variables as he rae of economic growh, inflaion, change (increase or decrease) in money, ec. In connecion wih he cenral bank currency inervenions on he foreign exchange marke wihin he so-called regulaed floaing, he quesion arises, wheher i is possible o make an impac on exchange rae by serilized inervenions, or inervenions which do no change he scope of money a he cenral bank. Theoreically here is no ready answer o he quesion. However, he resuls of empirical sudies show ha, using serilized inervenions, i is no possible o influence exchange raes. This means ha, in order o pursue a exchange rae policy, he sae only avails of he classical insrumens of is moneary and fiscal policy. In conducing currency inervenions, here is a concern ha he main reasons for long-erm rends in exchange raes may come unnoiced. This is conneced wih he fac ha impor limiaions and financial suppor provided o individual secors in order o proec hem enhance he currency risks for he unproeced secors and for he goods and services inegraed in he inernaional urnover. Such secors will require proecion by moneary policy measures and wage resrain. Sill, currency inervenion currenly remains he main insrumen of he sae impac on exchange rae. I is a direc inerference of he cenral bank ino he currency marke aciviy, aimed a changing he naional currency exchange rae by rading in foreign currency. However, currency inervenions can only be efficienly applied by sufficienly economically developed counries. Naional Bank of he Republic of Belarus The so-called proecionis measures may be used for currency regulaion. These are he measures aimed a proecing cerain segmens of he naional economy and regulaing cerain bank operaions, in his case, currency ransacions. Proecionis measures primarily include foreign exchange resricions, which represen legislaive or adminisraive prohibiion, as well as regulaion of ransacions wih currency or oher values by residens and non-residens. Among he ypes of foreign exchange resricions are he currency blockade; prohibiion on free rade in a foreign currency; regulaion of inernaional paymens, capial movemen, profi repariaion, circulaion of gold and securiies; concenraion by he

243 243 sae of he foreign currency and oher values. The sae sufficienly frequenly manipulaes wih exchange rae in order o change he counry s exernal rade condiions, using such mehods of currency regulaion as a double currency marke, devaluaion and revaluaion. The developing counries, due o heir chronic unfavorable balance of paymens, are no aracive for shor-erm capial and have o resor o various foreign exchange resricions (concenraing he naional currency circulaion in he hands of he sae, inroducing muliple currency exchange raes, prohibiing impor and expor of currency values wihou a special permi, limiing he righs of naural persons for possessing foreign currency and ransferring i abroad, limiing he exchange of he naional currency for foreign currency for going abroad, imposing currency clearings, ec.). An imporan facor in forming a demand for foreign currency in he counries wih foreign exchange resricions is a wish o inves ino i he naional currency which is devalued as a resul of inflaion. In his case, mos currency ransacions are made by he banks a he exchange raes esablished by hem on he basis of supply and demand on he currency marke. In implemening measures of currency regulaion, he following mus also be aken ino accoun: The rade balance condiion he defici of which, while forcing he sae o buy foreign currency o pay for he impor, resuls in exchange rae reducion. On he conrary, a posiive balance leads o is increase; The capial urnover balance conneced wih he fac ha an inflow of foreign capial ino he counry increases is currency exchange rae. However, in he long-erm perspecive, his facor may bring abou a reverse endency in connecion wih a ouflow of ineres paymens; The inflaion rae and inflaion expecaions, due o he fac ha a higher inflaion rae in he counry compared wih oher counries will reduce is exchange rae and vice versa. Since he rade balance occupies a major place in he balance of paymens, he laer s accouns which reflec he curren ransacions exer a mos significan impac on he naional currency exchange rae. A defici of he curren balance of paymens demonsraes low compeiiveness of he naional goods and services on he world marke and a higher araciveness of foreign goods for he counry s ciizens. This resuls in a growing exernal deb of he counry and a endency of reducing he naional currency exchange rae. However, an imporan role here is played by flexible prices for he expored and impored goods. This means ha, if demand for impored goods is no flexible, a drop in he naional currency exchange rae may deeriorae he counry s rade balance. If demand for impored goods grows faser han is supply, he naional currency devaluaion may emporarily deeriorae he rade balance. Such disurbed rade balance demonsraes ha, despie he decrease of exchange rae, he consumers sill buy impored goods bu, since he naional producers have failed o expand heir expor, he rade balance deerioraes. Wih a growh of he naional currency exchange rae and coninued non-flexible demand for impored goods, impor expenses are reduced. If he expor does no drop as fas as impor, he counry s rade balance will improve. However, he currency marke may remain sable even in he condiions of non-flexible expor and impor, because here are numerous oher facors which form he demand and supply of he naional currency. A favorable rade balance of he counry means a higher demand of foreign debors for he naional currency and, respecively, a growh of is exchange rae. A firs glance, such a siuaion demonsraes a consan inflow of foreign currency which may be used for impor purchases. Bu in pracice a favorable balance is no always a doubless benefi for he counry. For example, due o he growh of he currency exchange rae in counry А, is goods are becoming more expensive for imporers and heir compeiiveness as compared wih similar goods from oher counries deerioraes. Since he rade parners of counry А find i more and more difficul o earn is money hey ry o limi he impor of goods from Conference May 19-20, 2008, Minsk

244 244 his counry. If counry А is srongly oriened owards expor his siuaion may become painful for is economy as a whole, and will force i o look for ways o reduce is currency exchange rae. 1 The impac of he balance of paymens on exchange rae depends on he degree of openness of he naional economy. For insance, he higher he share of expor in he gross domesic produc (higher he openness of economy), he higher elasiciy of exchange rae o change in he balance of paymens. The currency exchange rae is also dependen on he sae s economic policy in he area of regulaing such elemens of he balance of paymens as curren and capial accoun. The sae of he curren accoun, for example, is influenced by changes in he duies rae, limiaion of impor, rade quoas, expor subsidies, ec. The urnover of he long-erm and shor-erm capials depends on he level of he naional ineres raes, on limiaion or encouragemen of capial inflow and ouflow. A he same ime, an excessive inflow of shor-erm capial ino he counry may foser an increase in money, hereby simulaing a growh in consumer prices and devaluaion of he naional currency. I should be born in mind ha he balance of paymens characerizes he quaniaive aspec of he sae s exernal economic aciviy and gives an idea of he srucure of he naional economy exernal rade secor. One of he main purposes of he balance of paymens is reflecing and presening informaion on all concluded exernal economic ransacions by residens of one counry wih nonresidens or residens of oher counries. On he basis of such informaion, decisions are made on adjusing he exernal economic aciviy boh on he naional level and on he level of individual economic eniies. Equilibrium of he balance of paymens is one of he crieria of efficien naional economic policy, jus like absence of a high inflaion, minimum unemploymen and exernal deb levels, mainenance of high GDP growh raes, ec. As for he Republic of Belarus, in order o acivae is balance of paymens i is necessary o channel he effors of economic eniies owards improving he qualiy of manufacured producs, heir closer inclusion ino he inernaional division of labor (for insance, acive creaion of join venures), exensive incorporaion of foreign echnologies in he producion and managemen areas, implemenaion of modern markeing sraegies, ec. In his connecion, one should noe he problems of Belarusian ranspor organizaions in he area of inernaional ransporaion, low expor level of high-ech services, insignifican volumes of foreign capial araced o he Republic of Belarus (direc foreign invesmens, inernaional credis, ec.), growh of shor-erm exernal deb of he naional economic eniies. The oday s cenral banks ry o pursue heir currency policy aimed a mainaining he marke (equilibrium) naional currency exchange rae. Their role on he currency marke is mainly limied o avoiding sharp flucuaions of heir naional exchange rae and keeping i wihin a cerain range. The cenral banks regulae he commercial banks aciviy in currency ransacions, underake measures agains excessive speculaion on he currency markes. In many counries, he scope of commercial banks currency ransacions is limied o 20% of heir asses. Currency ransacions of privae persons and nonbanking companies are subjeced o a sricer regulaion. Through he cenral bank, he sae esablishes he norms of currency sale and purchase, regulaes loans in foreign currencies and makes oher inerferences ino he banks currency ransacions. Currency regulaion is also based on coninuously improved currency legislaion which is undersood o mean no only main laws bu also by-laws, insrucions, various guidelines, rules and orders. In he long run, he currency legislaion is aimed a resolving he problem of seing exchange raes and jusifying heir regulaion principles. Naional Bank of he Republic of Belarus Meanwhile, during he firs half of he 80 s of he 20h cenury he dollar exchange rae was influenced by a number of conradicory facors. In paricular, he effec of he rade balance defici proved o be weaker han he effec of high ineres raes and he inflow of foreign capial o he USA. Therefore a presen, he moneary policy of indusrialized counries (in paricular, ineres rae regulaion) is subordinaed o he currency regulaion asks. For insance, due o a decrease in he dollar exchange rae a 1 Tarasov V.I. Money, Credi, Banks: Texbook. Mn.: Micana p.

245 245 he and of 1985, a considerable par of capial was convered from dollars o Wes Germany marks resuling in an increase of he mark exchange rae. In order o decrease he mark exchange rae, he Bundesbank was forced o accep lower ineres raes, despie he fac ha i was conrary o radiional 10 goals of ani-inflaion regulaion. Similar siuaion developed in he UK a he ime, where hey had o decrease he ineres rae (which was considerably higher han he raes in oher European counries and caused conversion of capials ino pounds of serling), despie heir prioriy ask o figh inflaion and carry ou measures o sabilize money circulaion. A presen, he main measures of sabilizing money circulaion include he ani-inflaion policy and moneary reform. Ani-inflaion policy is a complex of measures on sae economy regulaion aimed a reducing inflaion. Such measures may be subdivided ino sraegic, including he long-erm goals and mehods, and acical, oriened owards aaining shor-erm resuls. The ani-inflaion sraegy includes a reducion of inflaion expecaions by srenghening marke mechanisms (a complex of insiuional reforms) and eliminaion of unconrollable inflaion by expanding he compeence of managemen auhoriies; long-erm moneary policy which envisages regulaion of money demand (regulaion of money growh) by imposing sringen limis on he annual money growh; budgeary policy aimed a reducing he budge defici; naional economy proecion from exernal inflaion impac (he policy of limiing he inflaion impor) which includes regulaion of he balance of paymen and exchange rae. Ani-inflaion policy, raher han aiming a eliminaion of he inflaion causes, is oriened owards he use of shor-erm bu srong measures aimed a reducing he curren inflaionary pressure and preparing he ground for long-erm sraegic measures. The mehods of ani-inflaion acics allow he supply o be drasically increased wihou a respecive increase in demand or faciliae a sharp decrease in he curren demand wihou a respecive decrease in he supply (indirec impac on money by increasing saving raio and decreasing heir liquidiy, ec.). The basis of ani-inflaion measures is in eliminaion of he long-erm disequilibrium of he money marke and, in he long run, in reaching a relaive long-erm equilibrium on all markes. The ani-inflaion impac mehods include he aciviy of he sae which is aimed a eliminaing he inflaion causes (in he macro-economic aspec a eliminaing disequilibrium of he supply and demand markes) and desroying he mechanism of is acion. Here, he mos efficien is he figh wih inflaion which bears an open characer. A he same ime, one should differeniae he ani-inflaion measures proper from he mehods o alleviae he inflaion consequences (social proecion of he populaion, compensaion, income indexing, ec.) and pseudo-ani-inflaion measures (sae inerference measures, such as a oal sae conrol over he prices, direc adminisraive regulaion of demand and supply, ec.), which do no eliminae he inflaion causes bu only shif i from he open form ino he hidden one. The world pracice has accumulaed an exensive experience in forms and mehods of ani-inflaion policy. I includes a wide range of moneary, budgeary, axaion measures, he policy of income and sabilizaion programs up o imposing radical moneary reforms. The figh wih inflaion herea is carried ou wih he use of measures which exer a negaive impac on he economic growh and have a poenial of producion drop and unemploymen growh. A he same ime, any aemps o simulae he producion developmen resul in he growh of inflaion. The regulaion mehods in boh cases are he same bu hey ough o ac in he reverse direcions. Fighing monopoly should also be considered as an imporan line of he ani-inflaion policy. The conrol over changes in money by he cenral bank is a key elemen in he money circulaion sabilizaion. The cenral bank, by influencing he money base, ges an opporuniy o influence is quaniy. The direc conrol by he cenral bank is only possible by monioring he issue of cash agains public securiies. A he same ime, heir issue agains privae commercial bills of credi or foreign currency, as well as check deposi issues of commercial banks may only be indirecly influenced. Conference May 19-20, 2008, Minsk

246 246 Disurbed money circulaion, inflaionary processes lead o very serious consequences for he economy. There is virually no counry which, o his or ha degree, during his or ha period of is hisory, has no faced such problems. However, inflaion level and is manageabiliy considerably differ in differen counries. As a rule, slow raes are he effec of mainaining a balanced and susainable economic growh and, a he same ime, a successful regulaion of money circulaion by he sae. Therefore, money circulaion sabilizaion in effec means a sable economic developmen. This is recognized by represenaives of differen scienific schools and rends. For insance, he use of moneary measures in neo-classic and New Keynesian heories is aimed a economic sabilizaion, alhough by he applicaion of differen mehods. As for he Republic of Belarus, a presen many negaive phenomena in is economy which were ypical for i a he beginning, in mid and even lae 90 s of he las cenury have been eliminaed. Specifically, he super-high inflaion raes have been eliminaed, he sharp drop of he naional currency exchange rae has been sopped, here is no obvious producion sagnaion, he overall social sabiliy of he Belarusian sociey has been improved. However, along wih a number of above posiive endencies in he Belarusian economy here is sill considerable sae inerference ino is funcioning. There is no doub ha, because he marke relaions sysem has no ye fully developed where marke mechanisms could hemselves regulae and eliminae negaive aspecs, here appears and persiss a necessiy of sae inerference ino he counry s economy. However, he degree of such inerference mus be scienifically grounded and sricly measured. In he conex of he above, he efficiency of economic policy in he Republic of Belarus acquires special aenion. As is known, all acions by he Belarusian auhoriies for a raher long ime have been direced owards a mos close inegraion wih he Russian Federaion. The Belarusian economic policy has been shaped on his fac. The evens of lae 2006 and early 2007 demonsraed ha such acions had been erroneous. Incidenally, many economiss a he ime warned abou negaive consequences of such biased orienaion. This was confirmed by he oil and gas war sared early in 2007, herefore he economic policy of he Republic of Belarus, raher han being oriened owards geing some unilaeral advanages from any conracing paries in he economic relaions (such as Russia, Kazakhsan, Ukraine, ec.), should ry and build a sysem of civilized economic relaions and economic ies envisaging an equivalen and muually advanageous exchange wih is rade parners. Only in his case a long-erm economic ineres, raher han shor-erm poliical ambiions, will prevail in he iner-sae relaions. In his connecion, all illusions o he effec ha such amorphous srucure as he CIS will coninue o exis for any durable ime mus be dumped. The Republic of Belarus mus build is economic policy based primarily on equal economic relaions wih all rade parners boh in he Eas and in he Wes, in he Souh and in he Norh. I should also be based on inernal economic developmen sources aracing foreign capial wihin reasonable (economically based) limis. This means ha, during he ransiional period of swiching over o such marke relaions, he Belarusian economic policy mus be oriened no owards resolving myhical CIS problems bu owards solving is inernal problems while primarily relying on is own producion, economic and scienific and echnological poenial. In his case i needs o beer uilize he Republic s producion poenial, o develop hose secors and producions which are needed currenly and will be needed in fuure by he Republic s leading rade parners, raher han o adap o he economy of he Russian Federaion. Naional Bank of he Republic of Belarus In he economic condiions which developed early in 2007, all effors o pursue he sraegic componens of he economic policy of he Republic of Belarus mus be aimed, firs of all, a he creaion and mainenance of a healhy economic environmen a he macro-economic level by relaxing he economy as a whole, secondly, a he provision a he micro-economic level of economic freedom for manufacurers in order o sar he marke mechanisms, hirdly, a he developmen and mainenance of a reliable legal framework for a normal funcioning of all economic srucures, irrespec-

247 247 ive of heir form of propery. The acical componens of he economic policy a presen mus be aimed a price and finance sabilizaion, conrol of inflaion, limiaion of he sae inerference ino he economy, sopping he arising economic sagnaion process, and prevenion of a poenial social explosion in he Republic. An imbalance of he naional economy may in very near fuure become a realiy. This is confirmed by he fac ha, under he condiions currenly arising in he Republic, here is no inerrelaed funcion of prices, finances and money circulaion, aimed a ensuring a balanced naional economy developmen. For insance, lack of efficien compeiion has failed o overcome he cos mechanism of price formaion while he prices have no become an impeus for building up he producion of really high-qualiy goods. The price seing again sars o reveal paernalism on he par of he sae. The formaion of he sae financial resources is more and more loosing is ies wih he maerial producion (real secor of he economy) and is efficiency. For insance, he revenues from he cusoms aciviy form a considerable par of he sae budge. The inflaion of he coss becomes clearly noiced, when manufacurers produce heir goods a whaever cos and make such coss o be born by he consumers. Due o a big difference in he growh raes of wholesale (ex-facory) and reail prices, a considerable inflaion poenial has accumulaed and coninues o accumulae in he economy. A durable mainenance of a sable naional currency exchange rae wih an increasing rade balance defici may become an Archilles heel for he naional economy in he form of a sharp rise of unconrollable inflaion. In order o work ou an ani-inflaion policy, he saring poin is he furher developmen of he inflaion heory as a muli-facor socio-economic process he roos of which lie in he reproducion mechanism. This means ha one should no only orien owards he moneary characer of he modern inflaion or owards he pricing facors conneced, for insance, wih increasing prices for impored goods (spare pars for he Belarusian real economy secor) or owards inernal low-profi or unprofiable goods (services). Therefore, a long-erm ani-inflaion sraegy mus be elaboraed and measures o resrain he inflaion facors defined. Along wih he general economic long-erm sraegy, urgen measures are needed o conrol of inflaion and urn i ino a manageable one, since i is impossible o overcome inflaion overnigh, is requires years. In his connecion, he recen experience promps wo opions of inflaion regulaion, depending on he economic siuaion: deflaionary policy conneced wih limiing he growh of money, credis, wages and, in he long run, of he effecive demand. However, deflaionary policy is only applicable in he condiions of an economic growh and should be aimed a reducing he so-called overheaing of he economy, which does no happen ofen. As a resul, deflaionary measures cause a jusifiable negaive reacion on he par of workers, bankers and businessmen; income policy applied during sagflaion (a combinaion of inflaion wih producion drop) and represening a coordinaion and inerconnecion beween he wage growh raes and price growh raes under he surveillance and mediaion of he sae. The second opion is a more accepable and reliable way o gradually come ou of inflaion and economic decline. Moneary reforms are also aimed a sabilizing he money circulaion and conrol of inflaion. Economic heory and he world experience demonsrae ha a moneary reform conneced wih he inroducion of a new currency is a measure o ake he economy ou of he crisis wih subsequen sabilizaion. The principles and specific measures of he moneary reform mus herefore be closely ied wih he sae economic policy implemenaion. Noe, ha he moneary reform should be carried ou no for he reform s sake bu wih he aim o aain macro-economic sabilizaion and ge an addiional impeus for subsequen inroducion of an efficien moneary, pricing, fiscal and invesmen policy, removal of limiaions on aracing foreign sae and privae invesmens ino Conference May 19-20, 2008, Minsk

248 248 he producion and circulaion sphere. The required complex of measures mus be adoped gradually, in a sequenial and coordinaed way. Moneary reforms may be carried ou in differen forms. A shock herapy moneary reform has recenly become o be applied. Typically, such moneary reform may be, depending on he specific ani-inflaion sraegy and acics, an iniial or he final sage of sabilizing money circulaion. However, he moneary reform does no provide a sraegic soluion of conrol of inflaion wihou inerconnecion wih oher ani-inflaion measures. Hisorical experience confirms his. For insance, he moneary reform in he Russian Empire, conduced in , placed Russia on a par wih oher grea European naions in erms of finances. One of he main measures by he zar s governmen in preparing he moneary reform was accumulaion of gold reserves. To his end, measures were underaken o expand he expor of agriculural producs, he inernal axaion was increased. Simulaneously, he governmen encouraged he gold mining expansion by graning a number of privileges o gold miners. Such measures resuled in an increase in he gold reserves. While he Russian gold reserves as of January 1, 1886, only amouned o million rubles, on January 1, 1896, hey already reached million rubles. As a resul of he moneary reform, a sysem of gold monomeallism was esablished and gold was pu a he basis of he enire moneary sysem. Having devalued he gold conen in he ruble by one-hird, he governmen se is new gold conen a share of pure gold. Simulaneously, a free exchange of banknoes for gold was announced. The banknoes issued by he bank for he amoun of up o 600 million rubles were backed in gold a leas by half, while he banknoes issued in excess of his amoun were 100 % backed by gold. Silver coins became an auxiliary insrumen of paymens, in paricular, he paymens in high-sandard gold were limied o he amoun of 25 rubles, hose in subsidiary insrumens o 3 rubles. Issue of silver coins was no o exceed 3 rubles per capia. This moneary reform ensured a sable currency in Russia. The moneary reform in he Sovie Russia ( ) was conneced wih he use of a parallel currency, i.e. he old Sovie currency was used along wih he new money, he chervones. The chervones was inroduced ino circulaion in he following way. The wholesale buyer of goods, upon heir receip, issued a promissory noe o repay he deb wihin sricly fixed ime limis. Due o a high insabiliy of he Sovie currency, all ransacions were concluded wih regard o is devaluaion in relaion o gold by he day of he promissory noe repaymen. The seller produced he promissory noe issued by he buyer o he bank which acceped i and issued a loan in chervones agains he promissory noe, deducing is own respecive ineres. On he day of he promissory noe mauriy, he bank produced i o he buyer wih a reques o repay i in chervones. If he buyer had no hard currency he had o buy he necessary amoun of banknoes for he Sovie currency a he marke exchange rae and repay he promissory noe. If he failed o repay he promissory noe in chervones in due ime, he deb was recovered by he Sae Bank by aking possession of he debor propery who was declared bankrup. The issue by he Sae Bank of loans in chervones on he goods wih guaraneed sale was also widely praciced. The graned credis were also subjec o repaymen in banknoes. The sric economic and legal responsibiliy of he eniies involved ino he economic urnover ensured close ies of he chervones wih he commodiy flows, mainained a high purchasing power of he new currency and proeced i from devaluaion. Thanks o a consisen observance of he issue legislaion, he amoun of he issued chervones was lower han he oal cos of he goods in circulaion. Hunger for chervones was he bes argumen in favor of he sabiliy of he banknoes. Naional Bank of he Republic of Belarus The experience in he pos-war Germany shows ha is revival was linked wih a sringen currency and financial policy, reliance on he force of a free marke and enrepreneurship. Sill, he major facor of improving he German economy was resoraion of he moneary sysem viabiliy which was impossible wihou a moneary reform. As a basis, he assumpion was made ha he dispro-

249 249 porion beween he money and he goods circulaion can be bes eliminaed by limiing money and adaping he commodiy volume o he exising legal prices. The alernaive opion conneced wih an increase in prices in order o adap hem o he exising money had very lile suppor. The money reform was carried ou in he following way. All naural persons and economic eniies were obliged o declare heir cash and bank deposis in Reichsmarks a heir disposal. The money was o be exchanged for new German marks in he 100:10 raio, which only lef 10% of he previous amoun. Addiionally, afer a check by he ax service, half of his 10% came a he owner s disposal, while he oher half was divided once more, specifically, 1/5 remained a he owner s disposal, 1/10 wen o he blocked accoun for invesmens and he res 7/10 was cancelled. As a resul, he real exchange raio was 100:6.5 (alhough cerain concessions were made wih regard o small amouns). These condiions were also applied o all ypes of deposis. As can be seen, he exchange was carried ou very sringenly and raher painfully for he populaion, in a confiscaory way. In order o provide he populaion wih minimum money resources, 60 German marks was allocaed per capia, ou of which 40 marks could be received by each person on he day of he reform and 20 marks more in wo monhs. New money was also paid in exchange of old Reichsmarks in 1:1 raio. In order o avoid a complee failure o pay wages and make oher paymens, each enerprise was allocaed an amoun of new money equal o 60 marks per one employee. The local auhoriies, including land auhoriies, received an iniial sum in he amoun of heir acual monhly income, while heir previous savings were wrien off. Since a sharp reducion of money paymens under previous shor-erm obligaions impossible, such debs were devalued in he 10:1 proporion. Special rules were applied o he long-erm obligaions, especially morgage debs, which precluded illegal enrichmen. Conribuions from he morgage profis were ransferred o he special fund from which financing under he program of leveling he burden was subsequenly made. The world experience demonsraes ha he money reform mus be aimed a reaching he following main objecives: To mach he commodiy and money (wih or wihou differenial confiscaion measures) or, in some cases, inroduce a new naional currency; To sop he developmen of inflaionary endencies in he economy and, consequenly, devaluaion of he naional currency; To limi for a cerain ime period he wage growh, resoring o freezing wages and, respecively, consumer prices; To se sric limis o issuing new banknoes, and exercise a sringen conrol over he circulaion of he cash and no-cash money aggregaes; To economically sabilize he new currency exchange rae, provided ha, a he iniial sage of he reform, is exchange rae will be relaively fixed wih regard o srong currencies. The saring poin for developing an ani-inflaion program, which includes improvemen of money circulaion, is he use of wo regulaors, i.e. he marke and he sae ones. The economic heory and he world experience demonsrae herea ha he ani-inflaion policy and he moneary reform are only one measure o ake economy ou of a crisis wih is subsequen sabilizaion. Therefore, he principles and specific measures of he ani-inflaion policy mus be closely linked wih he implemenaion of he sae s general economic policy. This means ha he ani-inflaion policy mus be pursued no for he sake of he policy bu wih he aim o ensure macro-economic sabilizaion and ge an addiional impeus for subsequenly pursuing an efficien moneary, pricing, axaion and innovaion-invesmen policy, lifing limiaions on he aracion of foreign capial ino he real secor of economy and he circulaion sphere. Conference May 19-20, 2008, Minsk

250 250 Vladimir Usosky 1 Resricions o Moneary Policy Choice in Belarusian Economy In he aricle he naure of moneary policy in he advanced marke economy and in he ransiion economy is analyzed. The following definiions are highlighed: a arge economic parameer used by he cenral bank for implemenaion is moneary policy; a nominal sabilizaion anchor; a ransmission mechanism; moneary insrumens of he cenral bank. Various regimes of moneary policy differ from each oher in he maer wheher his moneary policy of he cenral bank is aimed a he ulimae objec of regulaion ( he regime of inflaion argeing) or is moneary policy is aimed a inerim objecs (exchange rae argeing, moneary aggregae argeing). Conenbased characerisics of he esablished economic relaionship and he degree of is marke mauriy lay a foundaion of choosing a cerain regime of moneary policy. For he cenral bank o successfully carry ou is regulaory funcions, i is imporan o consider he exen of sabiliy and predicabiliy of he formed funcional ies among moneary insrumens, inerim objecs and he ulimae objec of he moneary policy. In he aricle he preliminary condiions ha should be realized before inroducing of he inflaion argeing regime in Belarusian economy are considered. The auhor focuses upon he sraegy aimed a gradual liberalizaion of he currency marke and ransiion from usage of he BYR exchange rae as an anchor o direcion hrough he ineres rae channel of is ransmission mechanism. Changes in argeing sraegies of he Naional Bank and hose of he Governmen from achieving inerim objecs o reaching he ulimae aim of heir economic policy (he argeed level of open inflaion) are also considered in he paper. 1. The essence of a moneary policy regime in he advanced marke economy and in he economy in ransiion. A moneary policy regime is an organizaional-adminisraive mehod underaken by he cenral bank o achieve is moneary arges hrough using differen channels and insrumens of is ransmission mechanism. The cenral bank by using he regime of moneary policy coordinaes he chosen arge parameers of economy or arge insrumens wih he means of achieving he arge and wih he mechanism of realizaion his moneary policy. For effecive economic regulaion, he cenral bank should creae a specific fixaing economic base, which is known as a nominal anchor. Due o i he cenral bank cenralizes and forms moneary policy. While shaping is moneary policy he cenral bank may no be necessarily and explicily based on he nominal anchor. In his case, however, he chances o suppress inflaion effecively will be limied. Experience in moneary regulaion of he marke economy gained by he cenral bank and heoreical summarizaion of hese processes make i possible o caegorize moneary policies as follows: exchange rae argeing, moneary aggregae argeing, inflaion argeing, and moneary policy wihou inroducing a nominal anchor. A ransmission mechanism implies mehods of channelling naional currency emissions (reserved money) o he economy, which is implemened due o specific marke insrumens. Qualiaive and quaniaive parameers of he ransmission mechanism embrace he following: firs, a oaliy of inerconneced arges of he cenral bank and naional currency issue lines for he circulaion, and quaniaive characerisics of naional currency emissions; second, erms of he cenral bank s graning loans o business eniies and he Governmen and heir repaying he borrowed money; hird, a sysem of moneary insrumens pracised by he cenral bank; fourh, a mechanism of quoing ineres raes in he na- Naional Bank of he Republic of Belarus 1 Docor of Economics. The Belarusian Sae Economic Universiy.

251 251 ional currency and on sae securiies, heir levels; fifh, a mechanism of quoing exchange currency raes and heir levels, fixed on he financial marke. The cenral bank employs hree ransmission channels: 1) graning refinancing credis o commercial banks; 2) purchasing foreign currency alongside wih emission BYR ino circulaion; 3) purchasing sae securiies on a secondary marke. Refinancing credis and sae securiies purchased by he cenral bank on a secondary marke consiue he ineres rae channel of a ransmission mechanism, while foreign currency purchases accompanied by BYR brough ino circulaion refer o he mechanism of currency ransmission channel. The order of naional currency emission ino he circulaion by using he ineres rae channel is closely conneced wih he exchange currency channel of a ransmission mechanism. By employing he ineres rae channel of a ransmission mechanism, he cenral bank influences upon he level of ineres raes in foreign currency, affecs he dynamics of demand for and supply of foreign currency and he level of exchange raes. Tha is why he regime of exchange rae argeing, consruced by he cenral bank, is closely conneced wih he realizaion of a ransmission mechanism of BYR emission. Specifically, credi money can be considered as marke obligaions and orders. They are issued by he cenral bank only a supporing shor-erm liquidiy of commercial banks on he principles of obligaory loan repaymen, prioriy-based loan making, and paid loan servicing. The cenral bank s observance of he menioned rules allows i o properly carry ou is funcions wih a paricular concern abou he creaion of credi-deposi money by commercial banks in accordance wih he order shor-erm loans are graned by hese commercial banks o business eniies in he real secor of he naional economy. I becomes virually imporan ha he inerbank channel of refinancing shor-erm liquidiy of commercial banks should no be subsiued for a ruly bad pracice of graning credis for special purposes ( invesmen credis) o commercial banks for furher ransferring hese credis o heir cliens (business eniies in he real secor of he naional economy), financing heir aciviy. A shor-erm inerbank credi is no a credi for special purposes, or an invesmen credi. In fac, hese are absoluely differen hings. Following by he wrong pracice of graning credis for special purposes ( invesmen credis ), he cenral bank wihin he wo-ier banking sysem execues he funcions of he main credior of prioriies of he so-called planned naional economy, meaning i imiaes he execuion of funcions of he sae bank during he epoch of he so-called planned naionalized (quasi-money) economy. The cenral bank can no adequaely perform hese funcions wihin he wo-ier banking, as i is no saffed wih a number of people necessary o implemen credi ransacions. Furher explanaion relaes o he fac ha he cenral bank canno race he way he given credis are used. Under such circumsances he cenral bank performs, raher ineffecively, he funcions of commercial banks. In a marke economy he cenral bank s firm credi money ses an exremely srenuous deb relaionship beween commercial banks while hey gran loans o cliens of he real secor of economy. The high exen of deb relaionship in he banking sysem enails he esablishmen of very rigid sandardized obligaions and requiremens owards he business eniies of he real secor of economy. Very rigid condiions of graning loans and repaying he borrowed money in he banking sysem form he sandard of he ineviabiliy of he repaymen by enerprises o heir conracors. The sricer he erms of loan repaymen are, he more likely he borrowed money will perform is funcions, he lower he rae of inflaion will be. The major facors influencing he choice of moneary policies by organs of he sae adminisraion are as follows: a naional economy ype (marke, non-marke, or ransiion economy), is quaniaive parameers, he degree of rigidness of budgeary resricions o banks and enerprises, he volume of a social componen in he naional economy s srucure, availabiliy or lack of social consensus, allowing o Conference May 19-20, 2008, Minsk

252 252 achieve a low rae of inflaion. The choice of a moneary policy is also influenced by he configuraion of a financial marke and a commodiy marke and pariculariies of heir funcioning, he volume and he characer of ies esablished beween he domesic marke and he world marke (he level of he naional economy s openness). Depending on he maer, wha economic parameer is chosen by he cenral bank as he arge parameer, and wha kinds of moneary mechanisms are used o achieve he appoined goal, he essence of a moneary policy regime is defined. The main purpose of he moneary policy pursued by he cenral bank is he aainmen of price sabiliy. The core of one moneary policy which makes i radically differen from anoher consiss in a parameer chosen by he cenral bank as he arge parameer. Oher differences may include moneary ools used o pracically implemen he chosen policy. A nominal anchor may be idenified as a nominal macroeconomic variable, argeed by he cenral bank. The nominal anchor allows o creae a valid mechanism o suppress inflaion hrough a sysem of moneary insrumens specifically ailored o i. Moneary policies may also differ from each oher depending on wheher hey are aimed a achieving he final regulaion goal (inflaion argeing), or a reaching some inermediae goals (exchange rae argeing, moneary aggregae argeing). The conen-based characerisics of he exising economic relaionship and he degree of heir marke mauriy lay a sound foundaion of choosing a moneary policy. For he cenral bank o be able o carry ou is regulaory funcion i is imporan ha sabiliy and predicabiliy of he exising economic links among he menioned final goal, inermediae objecives and moneary insrumens be well esablished. The level of digi open inflaion suppressed o he indicaor of 1 3% per year wihin a long-erm period of ime inexorably leads o a drasic decrease of inflaionary expecaions in he naional economy and serves as a crierion o evaluae he effeciveness of he moneary police held by he cenral bank. The lower is he menioned level, he higher is he level of sabiliy and predicabiliy of economic links among moneary and macroeconomic parameers, and moneary ools regulaed by he cenral bank. Aaining, in he long run, sable and susainable pricing condiions will enable he cenral bank o make use of more advanced and hence economically more effecive moneary policies. 2. Exchange rae argeing in a marke economy Exchange rae argeing implies he cenral bank s pegging he naional currency exchange rae o hard currency (a currency baske) of a counry (counries) in which he indicaor of digi inflaion is very low. This mode of pegging is oped for due o he fac ha he currency of a counry-anchor is characerized as being inernaionally sound and is widely used in global producion and rade. Exchange rae argeing appears o be paricularly ofen used o comba high inflaion in small open economies. Wha makes he above argeing excepionally aracive is ha in a small open economy he exchange rae is a key facor affecing considerably he process of price formaion. Simulaneously, i serves as an effecive ool o conrol capial and commodiy flows. Globally accumulaed pracice shows ha exchange rae argeing comes handy when a counry s cenral bank looks for he ways o consrain poenial speculaive aacks upon is naional currency. Naional Bank of he Republic of Belarus The menioned argeing is ofen pracised a a poin in ime when a ransiion economy ransforms ino a marke economy. The inflaion rae in a ransiion economy is very high while he economy iself is exremely vulnerable o ouside shocks. Exchange rae argeing makes i possible o considerably reduce he level of impored inflaion. When he raes of price growh are high, i may lead o disinflaion, which is decreasing prices wihin a given period of ime. The described arge-

253 253 ing approach causes business eniies o rely upon heir naional currency and he implemened moneary policy. I proves o be an effecive means of curbing inflaionary expecaions. Alongside wih posiive feaures ypical of he regime of exchange rae argeing, i may be disadvanageous in he way ha he exchange rae policy of he cenral bank domineers over is moneary policy, resricing is flexibiliy and changeabiliy. This regime simplifies funcional inerconnecions of moneary and macroeconomic parameers, making hem, on he oher hand, all oo more rigid. Provided he condiions under which he naional economy is funcioning, drasically change, he cenral bank s aciviies ge confined o a limied number of hem, hus making he cenral bank a hosage of he policy i has been carrying ou. The regime of exchange rae argeing may be presened in several models. One of hem may be described as a regime of he sricly fixed naional currency exchange rae under which he naional currency is paricularly ighly pegged o he currency (currencies) of he counries considered o be a sabilizaion anchor. The cenral bank may also adhere o anoher model when he nominal exchange rae afer having he volume of is flucuaions fixed, will be freely flucuaing wihin he fixed boundaries. The meri of his model direcly arises from a very high degree of he exchange rae s volailiy and he same high degree of he cenral bank s independen behaviour on he marke, and expresses iself in a decrease of he degree of inensiy wih which shor-erm speculaive capial flows. An exreme oughness of he said regime dicaing is erms o he moneary and macroeconomic policies led by he cenral bank may be somewha lessened. As a resul, he cenral bank operaionally becomes more independen while using moneary insrumens and he economy appears o have acquired more flexibiliy. The hird model of exchange rae argeing is repored o have been widely used by cenral banks. I is based on he sliding fixaion of he exchange rae. This model makes i possible o gradually carry ou a fully conrolled devaluaion of he currency exchange rae a a pace somewha slower han he one expressed as he difference among he raes of inflaion in differen counries. The sliding fixaion resrics excessive re-evaluaion of he real exchange rae, prevening he price compeiiveness of he naional economy from going down. All ha will finally resul in a greaer degree of responsiveness of he moneary and economic policies of he naional economy o possible ouside shocks. If he level of he naional economy insabiliy is exceedingly high, he governmen may decide o inroduce he regime of a currency commiee, which is he oughes of all he models of exchange rae argeing. Under his regime he cenral bank emis he naional currency only hrough a currency ransmission channel, i.e., following he purchase of foreign currency on he marke alongside wih replenishing is foreign currency reserves. In his case, he process of credi money muliplying occurs a he level of commercial banks cliens and is highly resricive by naure. I happens because reserve money emied by he cenral bank is no used in he capaciy of credi money in circulaion. Credi money emission becomes a prerogaive of commercial banks, and he ineres ransmission channel is idle, for he cenral bank s insrumens are fully involved in securiies ransacions held on he open marke, or heir use may be very heavily resriced. The regime of a currency commiee inroduces simplified and a he same ime exremely rigid funcional inerconnecions among macroeconomic parameers, hus resricing very noiceably he cenral bank s auonomy and he naure of is funcions. Major insrumens wih he help of which he cenral bank carries ou he above menioned models (excluding he regime of a currency commiee ) are as follows: posiive ineres raes on refinancing credis graned o banks and on sae securiies purchased on he open marke; currency inervenions, when adminisraive inerference wih he funcioning of marke mechanisms is inadmis- Conference May 19-20, 2008, Minsk

254 254 sible. If he cenral bank s marke insrumens are no adminisraively resriced, i will allow he cenral bank o send accurae signals o business eniies of he real secor of he naional economy hrough ransmission mechanism channels, evoking adequae reacions from hem. Consequenly, he cenral bank manages o esablish a sable exchange rae, simulaneously reducing inflaionary expecaions and he rae of inflaion, hus simulaing he GDP growh. An effecively devised regime of exchange rae argeing allows for a small difference beween raes of inflaion recorded in he naional economy and hose of a counry (counries) o which currency (a baske of currencies) he naional currency exchange rae is pegged. I also becomes possible o suppress inflaion and o simulaneously ake measures o suppor he counry s compeiiveness. However, if he counry s raes of inflaion wih regard o commodiy prices end o be higher han he raes of is naional currency devaluaion, hindrances o he counry s compeiiveness may be many. This discrepancy beween inflaion and devaluaion raes may predicably lead o a gradual appreciaion of he naional currency and a reducion of he counry s expor poenial. As ofen as no such siuaions occur when he cenral bank ogeher wih he counry s governmen canno effecively preven cheap money from peneraing ino he counry s economy via ransmission and budgeary channels, respecively. The hen possible breakage of he recorded foreign economic disbalance of commodiy and services flows may gradually creae condiions endanging he naional currency of speculaive aacks. Wha makes he regime of exchange rae argeing paricularly challenging is ha i is necessary o consanly keep he counry s ineres raes and inflaion raes of he counry-anchor a approximaely he same level. If one of hese he cenral bank or he counry s governmen happens o break he rules of properly mainaining he regime, he sable developmen of he naional economy may be rialled. Key problems relaed o he regime arise when he naional economy is affeced by inner or ouside shocks. Drasically increased disproporions beween commodiy and capial flows may break is earlier achieved sabiliy level hus puing he regime of exchange rae argeing hrough rigorous validiy ess. Again, lessened volailiy of he exchange rae may reduce he effeciveness of moneary insrumens responsiveness o challenge. Moneary insrumens are very closely linked o he currency ransmission channel and he exchange rae which fac will in paricular manifes iself in case of ouer shocks. As ineres insrumens of he given moneary policy are underdeveloped, and he policy iself comes o he prevalence of he cenral bank s currency policy, he rigid naure of he governmen s fiscal policy insures he smooh funcioning of he regime of exchange rae argeing. 3. Moneary aggregae argeing Under his regime, marke conrol over commodiy prices is exercised by he cenral bank s emiing money hrough he chosen arge money aggregaes. Unlike he regime of exchange rae argeing, he regime of moneary aggregae argeing allows he cenral bank o creae a naurally operaing moneary sysem embracing hree ransmission mechanism channels and allowing for free peneraion of moneary signals ino he counry s economy. Under he regime described here is no need using he exchange rae as a disciplinary measure aimed a exering a sricer conrol over oher moneary insrumens and very considerably reducing he cenral bank s independence in carrying ou is aciviies. As he cenral bank manages o creae condiions characerized by a low level of inflaion and ha of he naional currency devaluaion, i sars o conrol he currency marke hrough currency inervenions accompanied by free flucuaions of he exchange rae. Naional Bank of he Republic of Belarus The regime of moneary aggregae argeing is based on he quaniaive heory of money in accordance wih which he growh of commodiy prices, in he long run, is deermined by supply of

255 255 money. The heory assers ha here exiss a one-way causal relaionship linking money, commodiy prices and income (he GDP), while a backward causal relaionship, making commodiy prices and income (he GDP) dependen on money is non-exisen. The heory mainains ha he volume of supply of money is proporional o he growh of he nominal volume of producion (he GDP). The regime of moneary aggregae argeing enables he cenral bank o ensure he well-conrolled growh dynamics of he chosen money aggregae, and ha, in is urn, leads o he GDP growh. The choice of concree measures o realize ha regime relies on wha exacly money aggregae is conrolled by he cenral bank, wha exacly arge channel may be applicable for money aggregae growh, and wha exacly insrumens will be used o regulae he arge money aggregae. To effecively regulae moneary relaionship he cenral bank needs o form a well funcioning ineres channel wih he help of which commercial banks, by changing ineres raes, ransform reserve money ino credi money. An obvious advanage of he said regime is ha for he cenral bank o esablish i he cenral bank should be ruly independen of he governmen s conrol. I will enable he cenral bank o pursue an independen moneary policy and o adequaely respond o various economic challenges hrough exercising conrol over supply of credi money. The major difficuly in realizing he regime in quesion is in creaing valid condiions for he regime o funcion properly. I implies, firs and foremos, he availabiliy of a srong and sable link beween he arge money aggregae regulaed by he cenral bank and inflaion raes. In a wo-ier banking sysem he cenral bank very rigidly conrols he moneary base and he narrow aggregae (M0), while changes in he broad aggregaes (M1, M2 and M3) fully depend on banks aciviies and hose of heir cliens. Their join effor is aimed a ransforming cenral bank s reserve money ino deposi-credi money wihin he process of reserve money muliplying. Formaion of he broad aggregaes of he overall money supply involves wo paries banks and heir cliens, and in a marke-driven economy may urn ou o be hardly predicable. The cenral bank may only influence he process of deposi-credi money muliplying by employing marke leverages, which will resul in provoking he naional economy s added value growh. Money is no jus a medium of exchange, mediaing in he process of exchanging goods for money and vice versa, i is an acive credi insrumen, which creaes a compeiive capial marke, on which he ineres rae (he cos of credi money) operaes in he capaciy of a marke regulaory device. I explains why he characer of economic funcional links under he regime of moneary aggregae argeing is far more complex han ha under he regime of exchange rae argeing. Besides, ideas of moneariss claiming ha he regulaion of increases of money supply is a key variable allowing for he conrol of commodiy prices growh do no correspond o real life siuaions. I should be sressed ha an increase of money supply o a larger exen depends on demand for credi money announced by business eniies operaing in he real secor of he naional economy, on he one hand, and he cenral bank s credi money supply, on he oher hand, and is refleced in he balanced level of he ineres rae he role of which moneariss generally end o underesimae. Pracice shows ha he cenral bank canno a one and he same ime regulae boh credi price and supply of money, demand for money being a key variable. As a rule, an effecive moneary policy of he cenral bank presupposes he fixed characer of one variable, while demand for and supply of money on he money marke deermines he oher, indirecly influencing i hrough he cenral bank s ransmission mechanism. I is necessary o menion ha beween he effec produced by he cenral bank s moneary policy upon he chosen money aggregae and inflaion here, exiss a big and an unsable ime lag, dependen on many facors difficul o predic. In fac, a consan spread of financial innovaions simulaing he appearance of diversified financial insrumens on he marke, new compuer ech- Conference May 19-20, 2008, Minsk

256 256 nologies, allowing for banks cliens o be quickly provided wih new financial services, he impac of global marke endencies upon an economy (paricularly, a small open economy), ineviably cause he links among economic variables o become highly volaile and difficul o forecas. Taking he oaliy of all he reasons menioned above ino consideraion, he cenral bank urns ou o be unable o conrol he chosen money aggregae wih a required degree of predicabiliy. I has already been proved more han once ha a relaively rigid conrol exered by he cenral bank over he moneary base will enail a high volailiy of shor-erm ineres raes and may influence very considerably he dynamics of price changes and hose of he GDP. Moreover, i becomes nex o impossible o simulaneously conrol he overall money supply, commodiy prices and ineres raes. A he ouse of he 1980ies he USA, Grea Briain and Canada made heir decision no o ever pracise he regime of money aggregae argeing, as he insabiliy of funcional links among indices idenifying he dynamics of money aggregaes and he levels of arge variables did no allow o reach he se goals. 4. A moneary policy wihou inroducing an anchor A moneary policy, no oriened owards a cerain nominal anchor, means a cerain nominal variable argeed by he cenral bank unofficially, i.e., i is no announced by he cenral bank as chosen as an official macroeconomic parameer. Under his regime he cenral bank enjoys a far greaer degree of auonomy, as i does no ake upon iself rigid and clear obligaions o achieve cerain nominal indices (i concerns he exchange rae, he rae of inflaion, he rae of growh of money aggregaes). I announces is long-erm objecives (a susainable economic growh, a high level of employmen, and a low rae of inflaion) alongside wih esablishing is inermediae aims. A high level of rus in he cenral bank originaed from is successful effor o preserve a long price sabiliy siuaion in he naional economy is a sound prerequisie for he cenral bank s effecive implemenaion of he named regime. Normally, his regime is pracised in an advanced marke economy. I is based on smooh and well-organized funcioning of he cenral bank s ransmission channels and is highly auonomous aciviies. This auonomy is refleced in he cenral bank s independence of he governmen s budgeary and financial policies. Demeris of he non-nominalanchor-based policing may be many, as he characer of i implies lack of ransparency in he cenral bank s choosing is hierarchy of objecives and insrumens o reach hem. 5. The regime of inflaion argeing in a marke economy In order for he regime of inflaion argeing o be execued effecively he cenral bank mus be highly auonomous in is aciviies which are solely aimed a reaching he only arge index, i.e., he arge inflaion index. The cenral bank is free o choose a sysem of insrumens wih he help of which he arge index is inended o be reached. Under he said regime he governmen canno simulaneously se oher arge indices, such as he GDP level, wage (salary) levels, he level of employmen and he exchange rae. This requiremen adds addiional responsibiliy o governmenal regulaory bodies aciviies. Naional Bank of he Republic of Belarus The governmen exercises conrol over marke processes by forming a compeiive marke environmen and producing a regulaed impac upon his environmen. I is necessary o emphasize ha he regime canno be inroduced wihou esablishing effecively performing ineres and currency channels of he cenral bank. These channels serve he cenral bank o send is signals o business eniies in he real secor of he naional economy via commercial banks. To ensure a smooh operaion of hese ransmission channels i is expedien ha a compeiive marke environmen be creaed. I should be characerized by relaively sable funcional ies beween macroeconomic variables and he level of inflaion. These conribuions are very responsive o effecive

257 257 conrolling measures carried ou by he cenral bank. The ulimae goal of he described regime in a liberalized economy consiss in achieving a sable level of marke prices on condiion ha he prices in quesion are deermined by business eniies following in heir price quoing effor he demandand-supply paern promped by commodiy markes. This, in fac, is he cenral bank s major sraegic goal. As an independen moneary insiuion, he cenral bank is eniled o se he arge inflaion index which is achieved by is using available marke insrumens. The cenral bank and he governmen are doomed o coordinae heir economic effor rying o achieve he common goals refleced in he arge inflaion index, which, as a maer of fac, is seen as he only anchor of a sabilized economy. The regime described is exremely difficul o execue as i necessarily requires he inroducion of cerain erms and prerequisies prior o he inroducion of he regime iself. Boh he cenral bank and he governmen bear responsibiliy for he oucomes of he said regime. The regime of inflaion argeing is successfully realized subjec o he naional economy s adequae response o he oucomes arisen from he cenral bank s and he governmen s regulaory aciviies on commodiy and money markes. Wha is also imporan is ha he cenral bank s ineres channel used for puing credi money ino circulaion should operae effecively (or, as hey say, i should be cleared up in accordance wih marke requiremens). Now, he exchange rae is viewed as a marke regulaed parameer influenced by he currency marke; in oher words, he cenral bank is o sop using i as a kind of anchor in case i has been used in he said capaciy previously. To his effec, he cenral bank no longer adheres o currency inervenions, exercising conrol over he naion s markes hrough ineres raes. The greaer he degree of a small open economy s exposure o he exernal environmen is, he more difficul i becomes for he cenral bank o conrol he exchange rae which earlier fulfilled he funcion of an anchor in sabilizaion processes, wihou pracising currency inervenions. While carrying ou curren ransacions he naional currency mus by all means undergo he process of conversion. Capial ransacions in he inernaional economic arena should be very sricly observed in order o resric he negaive influence produced by speculaive capial on he naional economy. The ransiion period wihin which condiions for inroducing he regime of inflaion argeing are creaed should ake a longer ime, while preliminary arrangemens relaed o furher marke reforming and carried ou by he cenral bank and he governmen mus be more sizable and more inensive by naure. Under he regime of inflaion argeing he governmen is expeced o expedie he formaion of a marke mechanism valid for adequae evaluaion of inflaionary expecaions of business eniies in he real secor of he naional economy and for effecive regulaion of heir level and developmen dynamics. The basis of he regime is consiued by a sable linkage of inflaionary expecaions of business eniies in he real secor of he naional economy o he phenomenon of open inflaion, which level and dynamics are conrolled by organs of sae adminisraion, mainly hrough heir using marke insrumens (regulaing commodiy and money markes). Differen budgeary, financial and quasi-money insrumens used o achieve specific budgeary and financial suppor arges wih regard o some secors of he naional economy, and ypical of he previous sage of he moneary policy should be enirely abandoned while passing on o he regime of inflaion argeing. Inroducion of moneary policy marke insrumens mus be accompanied by a gradual, successive and deermined riddance of non-marke regulaory mechanisms used earlier for resources redisribuion. Moneary insrumens known o have become deformed and considered o have los heir primary predesinaion mus never be used by he cenral bank again as no corresponding o he very essence of moneary relaionship. Conference May 19-20, 2008, Minsk

258 Major preliminary condiions necessary o inroduce prior o esablishing he regime of inflaion argeing in he economy of he Republic of Belarus 6.1 Transiion o he regime of open inflaion and formaion of sable and predicable relaionship among macroeconomic parameers The economy of he Republic of Belarus is characerized by he phenomenon of suppressed inflaion due o a very sric conrol exered by he governmen over a considerable number of prices. This prevens business eniies and he governmen iself from having adequae informaion relaed o inflaion. Hence he relaionship among macroeconomic parameers is unsable and unpredicable and canno be fully regulaed by moneary insrumens due o he fac ha channels ransmiing he overall money supply influence on prices and he GDP are deformed. A considerable excess of price growh raes over incremen in he overall money supply and he GDP esifies well o he previous saemen. For example, in 2005 incremen in he real money supply amouned o 59.5%, while he level of inflaion achieved 8%; in 2006 incremen in he real money supply was equivalen o 44.5%, while he level of inflaion equalled 6.6%. In connecion wih he above i should be menioned ha he governmen conrols no only commodiy prices (on commodiy markes), bu also money prices (ineres raes and exchange raes on financial markes). The prioriy ask of he governmen, herefore, is a gradual ransformaion of inflaion from is suppressed form ino is open form. For his o become possible i is necessary o elaborae a sae programme, o deermine he ime for is execuion (no more han 2 or 3 years), and o release prices on commodiy and money markes. While execuing he programme, he governmen will aim a reaching wo ends. One consiss in business eniies adjusing heir aciviies o he liberalized srucure of commodiy and money prices. The oher implies he creaion of a governmenal sysem he purpose of which will be o regulae marke demand-and-supply prices. Meanwhile direc (much he same as command) regulaion of non-liberalized srucure of prices is sill operaive. Under he regime of inflaion argeing he esablishmen of a sable price level is assumed as a basis of a long-erm cooperaion beween he Naional Bank and he Governmen. Open inflaion forecasing should be carried ou by sae bodies and independen research cenres specifically creaed o objecively measure i. An imporan precondiion for such measuremens is ha i needs o be execued in he condiions of free pricing. A he curren momen he experience accumulaed wih regard o open inflaion evaluaion, is dynamics and forecasing is, indeed, very limied. 6.2 Join effors underaken by he Naional Bank and he Governmen o creae condiions for regulaing is economy on a marke basis Naional Bank of he Republic of Belarus A he curren sage of cooperaion beween he Naional Bank and he Governmen in he sphere of economic regulaion and responsibiliy division aimed a achieving he projeced suppressed level of inflaion wha has already been achieved in his direcion proves ha he aciviies of sae regulaory organs are far from being coordinaed and effecive. The Naional Bank bears responsibiliy for moneary base and money supply incremen, which being a moneary facor, influences he level of inflaion. The Governmen has he righ o manage commodiy prices using adminisraive measures, which being a non-moneary facor, influence very considerably he suppressed level of inflaion. The siuaion described leads, objecively, o he appearance of inflaionary shed hidden behind he suppressed inflaion, which does no reflec a rue picure of how he demandand-supply paern funcions on he commodiy marke. The Naional Bank and he Governmen, boh wihin he scope of heir responsibiliies, answer for arge financial suppor of economic growh making use of moneary and budgeary-financial insrumens passing hem hrough heir

259 259 own moneary and budgeary-financial channels. Recenly accumulaed pracice of esablishing goals and working ou mechanisms impacing inflaion causes moneary insrumens o be replaced by financial-budgeary insrumens used o regulae economic processes and appearing o be deformed. The said deformaion primarily embraces ineres mechanisms, which do no funcion o he fulles exen possible. Esablishmen of he regime of inflaion argeing is only possible on condiion boh he Naional Bank and he Governmen are held responsible for effecive regulaion of he level of open inflaion. Only if his is he case, hey will be able o effecively affec he level of open inflaion urning o adequae means of governmen regulaion. A he momen, he Governmen is focused on he achievemen of curren aims, pursued by he Minisry of Finance of he Republic of Belarus whose responsibiliy is o provide for budgeary financing of he naional economy. In case of ax arrears he Governmen exercises pressure upon he Naional Bank making he laer adjus is moneary policy o he aims of he Minisry of Finance. This resuls in he Naional Bank s policy being simplified and deformed, acquiring he feaures of quasi-money policy which enails lessened validiy and reduced efficacy of moneary insrumens of boh he Naional Bank and commercial banks of he counry. Summing i all up i is again necessary o underline ha in order o inroduce he regime of inflaion argeing he Naional Bank and he Governmen should unie heir effor o perform in harness. Join effor is called for by he necessiy o reach heir common marke-oriened arge, ha of a direc projeced conrol over he level of inflaion. On heir way o achieving he oulined goal he Naional Bank and he Governmen will aemp a he reasonable and effecive disribuion of heir roles and obligaions so ha o effecively regulae he naional economy being ransformed ino a marke-driven economy. Only in his case he formaion of adequae insrumens o suppress open inflaion on he liberalized commodiy and money markes will come rue. In such circumsances he role and he saus of he Governmen is of primary imporance as abou 50% of he GDP is refleced in he counry s consolidaed budge, and his canno bu ell upon he moneary policy of he Naional Bank. The goals of he Minisry of Finance and he Naional Bank, boh allocaing funds o he naional economy, hough hrough differen channels, should coincide. A presen, however, he Minisry of Finance does no always involve he Naional Bank in he process of decision making when deciding o wha budge users o direc is money. This may produce a derimenal effec on he level of regulaory processes wih regard o he money marke. 6.3 Creaing condiions under which he rae of refinancing becomes a sole and a universal insrumen of he money marke The key insrumens of he counry s banking sysem have acquired feaures incompaible wih heir naure, and ha prevens hem from adequaely performing heir funcions which consis in measuring how effecively funds are used. For example, he Naional Bank s rae of refinancing does no reflec he money demand-o money supply raio, due o which he said insrumen fails o fully execue is funcion. The Naional Bank carries ou non-sandard arge financing of he prioriy economic secors and is exclusive cliens a he rae of refinancing and below i, hus undermining he appropriae funcioning of he moneary marke. There has long been exising a hree-ier refinancing mechanism (he level below he rae of refinancing, he rae of refinancing, and he level above he rae of refinancing). Ineres raes on he so-called permanenly accessible and aucion liquidiy regulaion insrumens (earlier called he second level of refinancing) are overly higher han he iniial rae of refinancing. The rae of refinancing has disanced iself from he exising realia of he money marke, i does no longer reflec demand for and supply of money, and acually has become a formal marke indicaor. Conference May 19-20, 2008, Minsk

260 260 Ineres raes of he second level of refinancing carry ou a penaly funcion wih regard o banks lacking liquid means. Oversaemen of he second level of refinancing made i possible for he Naional Bank o force oher banks o sell heir currency funds o i, hus enlarging is gold and foreign currency reserves. This, in is urn, resuled in he decrease of ne foreign holdings of commercial banks from a posiive meaning in 2000 o a negaive meaning equalling minus 1,2 milliard USD (as of March 1 s, 2008). The policy in quesion enailed a huge disproporion beween he banks asses and liabiliies and he siuaion sill deerioraes due o a rapidly growing credi balance of he paymen balance s curren accoun ( ). So, he counry s banks have o conribue heavily o is financing. In case he demand for foreign currency goes up, he Naional Bank may be faced up wih a risky possibiliy of widening he already exising gap beween he banks asses and liabiliies, on he one hand, and he recorded disbalance on he money markes, on he oher. Consequenly, he sysem of commercial banks may become even more fragile. The policy of goal esablishmen and he choice of means o execue he se goals by sae organs is based upon he prioriy ask of exercising budgeary and quasi-budgeary suppor of he producion sphere, which mainains ha he Naional Bank and he counry s oher banks carry ou quasifuncions wih regard o arge financing of he counry s naional economic prioriies. Following he oulined policy, he funcional meaning of credi refinancing ges deformed, as parially i sars o be used no only o supply he banks wih shor-erm liquid funds which is exacly wha i should do as a marke mechanism. A specific feaure of non-sandard credi ransacions held by he Naional Bank is ha he subsance of hem is he same as ha of arge quasi-budgeary ransacions. Wha comes ou of he above is ha credi refinancing graned by he Naional Bank is used as an insrumen of quasi-financing of enerprises via commercial banks. Credi refinancing is o serve he purpose of shor-erm suppor provided o commercial banks if, emporarily, liquid funds in heir possession are insufficien. Credi refinancing should no carry ou he funcion of quasiinvesmen refinancing in case sysem-forming banks and heir cliens are consanly experiencing shorages of money on heir accouns. A muli-vecor sysem of refinancing raes creaed by he Naional Bank ogeher wih an inadequae hree-ier spread of hese raes used for diamerically differen purposes, have creaed an unprecedened siuaion when, quaniaively and qualiaively, hey have disanced hemselves from he money marke realia. Wha happens hen is ha he wo-ier bank sysem menioned above begins o also funcion inadequaely, and is merely ransformed ino a replica of a sae bank sysem. The Naional Bank s ineres rae channel as well as ha of oher banks in he counry has been deformed; is original subsanive funcions need o be resored. The Naional Bank mus ge down o creaing condiions under which commercial banks will have equal chances o perform heir aciviies on he money marke. The ask may be implemened hrough he rae of refinancing being aached o he saus of a sole and a universal insrumen of he money marke. This done, he formaion of a uniary compeiive marke of inerbank credis and a compeiive credi capial marke will follow. 6.4 Esablishmen of sable and predicable inerlinks beween macroeconomic parameers and formaion of adequae insrumens of he Naional Bank, aimed a regulaing he credi marke, he deposi marke and he sae securiies marke Naional Bank of he Republic of Belarus The iniial refinancing rae of he Naional Bank serves as a kind of an adminisraive saring poin, i.e., i is he rae a which banks sar o gran credis o heir cliens. In is refinancing policy he Naional Bank sricly follows a from-op-o-boom insrucion according o which a bank credi rae should be equivalen o he iniial refinancing rae + 3% (he so-called margin). Due o

261 261 he above pracice, oher banks credi raes a presen do no reflec he real demand for and supply of money on he credi marke, in connecion wih which i is possible o speak abou a gap beween he deermined credi rae and he degree of risk borne by boh a credior-bank and is clienborrower. The rue level of credi raes appears o be hidden and ends o be posed up o differen paymens affeced by a clien-borrower o a commercial bank for he allowed credi and oher services. The Naional Bank does no pracise sysemaically processing informaion colleced from he counry s banks concerning he real credi raes on he credi marke. The said pracice has resuled in sysemic funcioning breakages on he commodiy and money markes. They hinder he iniial refinancing rae of he Naional Bank from being used effecively; hey do no allow for a valid use of he bank margin when exending credis o cliens, hus, prevening a clear and exac moneary signal from being delivered o business eniies. The esablished informaion asymmery makes i impossible o influence he level of firm commodiy prices. Vicious circle has been closed, and i means ha he Governmen is incapable of effecively impacing he said prices using quasi-marke insrumens. In such condiions wha is necessary o be done is as follows: o abolish adminisraive resricions on he use of he Naional Bank s ineres rae channel o influence he counry s economic developmen hrough marke insrumens; o clear up he channel from malfuncioning which leads o deforming sable and predicable links beween macroeconomic parameers and hinders he process of formaion of adequaely operaing insrumens aimed a regulaing he credi and he deposi markes, as well as he sae securiies marke. 6.5 Eliminaion of he esablished pracice of non-marke financing of he sae budge s defici hrough sysem-forming banks and formaion of an open compeiive marke Since abolishmen, on January 1 s, 2004, he pracice of direc credis he Naional Bank used o gran o he Governmen a an annual rae of 6.5% as non-marke financing of he sae budge s defici, he majoriy of he Governmen s ransacions wih securiies has been carried ou on a marke basis. Some blocks of he Governmen s securiies, however, disribued hrough sysemformaion banks, are used for subsidizing. These securiies are characerized by non-marke feaures, are issued on a non-marke basis, and are used as insrumens of quasi-budgeary financing. The pracice of non-marke financing of he sae budge s defici hrough sysem-forming banks mus be abolished. Is aboliion will benefi he given segmen of he financial marke making i srucurally more effecive. I will also allow for clearing up of he Naional Bank s ineres rae channel, used o influence he naional economy, of adminisraive layers. Moreover, an overall process of inroducing blocks of securiies of join sock enerprises ino he marke should be urged in order o expedie he formaion of a channel influencing he marke of financial asses being creaed a he momen. Tha s where a vas poenial for furher and more effecive economic growh is hidden, and in order o make i work he Governmen should display a sronger will owards implemening reforms of all kinds. 6.6 Suggesions peraining o he ways of reforming he banking sysem Accumulaion of capial in he larges commercial banks, auhorized o carry ou governmenal programmes, obsacles he developmen of compeiion on he money marke. A peculiar feaure abou he banking sysem of he Republic of Belarus is ha he capializaion scheme of sysem-forming banks proves o be ineffecive. I means ha whenever deposis and credis are graned by he Governmen and he Naional Bank o heir exclusive cliens o suppor financially heir economic aciviies, hey, pracically yearly, end o be ransferred o an ever growing Governmen s share in he banks capial. This pracice deforming he financial resul of he larges banks and heir marke value, breaks he rules of open compeiion on he banks marke. I is clear ha i should be gradually eliminaed. As far as he Conference May 19-20, 2008, Minsk

262 262 low level of banks capializaion is concerned, i needs o be sruggled hrough by aracing capial, including foreign capial, o he banking sysem on a marke basis. The siuaion when huge financial resources are accumulaed in several larges banks should be sep by sep changed using measures which will encourage a compeiive sruggle among banks o win heir cliens benevolence and arac heir resources. Condiions for banks recapializaion should be creaed which is based on heir resrucuring and de-saisaion, supplemened by aracing he needed amoun of capial. Search for new sraegic invesors o inves in he banking sysem, aracion of foreign capial o increase compeiiveness is viewed nowadays as ask Number 1. The larges banks (he open join-sock company Agroprombank and he open join-sock company JSSB Belarusbank ) adheres o such measures as allocaion of fixed deposis of he Governmen o cover he defici of liquid funds, hus increasing risks arisen from he Governmen s money being placed on banks accouns. This unfavourable pracice when he Governmen s money placed on sysem-forming banks accouns is used o cover heir shorages of liquid funds should be abolished. All governmenal funds should be placed on he Naional Bank s accouns, aking ino consideraion ha his ype of funds is very special and canno be used by banks for heir non-arge purposes. Then he srucural liquidiy disorion in he banking sysem is expeced o be eliminaed, and governmenal ineress are sure o be fully me. The pracice when sae securiies on a non-marke basis are ransferred by he Governmen o he larges banks hrough some formal procedures, hus breaking he rules of heir marke-oriened allocaion, alongside wih which he Naional Bank carries ou quasi-budgeary financing, should be sopped. I is expedien ha he formaion of a liquid sae securiies marke be sared. Wih he help of he above marke non-marke financing of he sae budge s defici will be execued, while he Naional Bank will be using he open marke for regulaing shor-erm liquidiy of banks on a marke basis. Alongside, banks asses should be invenoried so ha o sor ou bad asses. Such asses should be hen direced o he deb marke currenly being formed and hrough selling-purchasing of asses paricipaing in he procedure of marke discouning heir book value should be ransformed ino heir commercial value. This is necessary for idenifying he banks commercial value and esimaing heir rue financial oucome. By selling-purchasing asses of banks and enerprises he banking segmen eners ino sable links wih he real secor of he naional economy. These links will lay a foundaion of resrucuring debs of enerprises belonging o he real secor of he naional economy, hus simulaing he process of he banking sysem recovery. The developmen of he deb marke of banks and of he real secor enerprises will allow for he esablishmen of price equilibrium on he commodiy and money markes as well as o deepen he process of forming he marke of financial asses. Naional Bank of he Republic of Belarus Exising adminisraive consrains wih regard o he currency channel of he Naional Bank s ransmission mechanism are considerable. The currency marke is under conrol of he Naional Bank, his conrol being exercised wih he help of wo caegories of regulaory measures. On he one hand, depending on he currency and rouble marke siuaions, he Naional Bank exers is conrol over he markes using moneary insrumens. Bu he Naional Bank s awareness of he way currency inervenions should be used is no ye complee, and his makes he funcional links among macroeconomic parameers unsable. On he oher hand, following increasing disproporions on he rouble and currency markes he Naional Bank, he Minisry of Finance and he Governmen widely use mehods of manual conrol over demand for and supply of currency experienced and held by banks and enerprises. Adminisering he foreign currency marke, he Naional Bank aims a dosing access o he currency in possession of he counry s larges imporers (for example, Belransgas and ohers), which have accumulaed huge rouble resources. This approach makes i possible for he Naional Bank o rigidly conrol he exchange rae by parallelly using ad-

263 263 minisraive and economic measures. Owing o he exising pracice, he exchange rae has been fixed for already more han hree years and is devoid of marke flexibiliy. The Naional Bank s regulaion insrumens relaive o he foreign currency marke are weak and his makes he regime of exchange rae argeing funcionally limied. Gradual inroducion of he regime of inflaion argeing requires consan liberalizaion of he foreign currency marke, complee refusal o use mehods of manual conrol over demand for and supply of foreign currency. Anoher imporan requiremen is ha he Naional Bank should sar using only currency inervenions o conrol he exchange rae. A prerequisie for ransiion o a free rae fixing reamen is he Naional Bank s economic conrol over he exchange rae volailiy and he laer s greaer degree of flexibiliy wihin he se range of flucuaions. While carrying ou he said measures he Naional Bank is recommended o simulaneously execue measures aimed a increasing he impac of he universal ineres rae on he inerbank marke. Upon he formaion of he ineres rae channel, he Naional Bank is supposed o proceed wih he creaion of a sysem of measures purposed o regulae he currency marke on a marke basis wihou urning o currency inervenions. Under he condiions of a small open economy his ask is even more han jus being complicaed, so is realizaion should be posponed ill 2011, when world prices for mineral resources used as sources of power will sar funcioning in he economy of he Republic of Belarus. 6.7 Developmen of a sysem of non-bank financial inermediaries and non-bank insrumens of he financial marke Furher developmen of he financial marke and is insrumens is viewed as urgen as a presen bank credi ransacions prevail over any oher aciviy carried ou on he financial marke. Enerprises are no willing o borrow funds from a poorly developed financial marke using oher (noncredi) insrumens. The banking sysem appears o be overloaded wih credi ransacions, par of which by is naure is quasi-budgeary. Commercial banks are engaged in carrying ou a redisribuion funcion aimed a channelling arge resources o ineffecively performing business eniies. This funcion is oally irrelevan o he naure of banks. A naural conclusion ha follows is ha par of he borrowing ransacions should be ransferred o non-commercial financial inermediaries and o he non-banking secor of he naional economy, presenly being in need of a dynamic developmen. The new Governmen s policy should be direced owards he developmen of a sysem comprising differen non-bank financial inermediaries as well as eniies belonging o he nonbanking secor of he economy. Following he new policy requiremens he Governmen will have o ake pains o creae new non-bank financial inermediaries and esablish condiions under which diversified financial insrumens are sure o be emerging. They will enlarge he range of marke regulaion, widen he financial marke segmenaion and increase he level of is deph. As a resul, he excessive loan overload experienced a he momen by he banking secor will sar reducing, gradually approaching is opimal indicaor. 6.8 Increase in he lengh of he saved money (2 o 5 years), invesed in he naional economy To ensure a successful funcioning of he regime of inflaion argeing a more diversified srucure of financial inermediaries and a wider variey of financial insrumens should be creaed, which will enail lenghening of saved money (2 o 5 years), invesed in he naional economy. This will allow for widening of he financial marke segmenaion, will lead o he creaion of a larger variey of asses and liabiliies (compared o he variey ha is available now) of differen financial inermediaries. Thus, he ever growing savings of business eniies of he real secor of he naional Conference May 19-20, 2008, Minsk

264 264 economy will urn o be fasened hrough he aciviies of he newly-esablished financial inermediaries and banks will undergo he off-loading process. A presen he lengh of money araced o he banking secor is no really big, and his does no allow banks o creae greaer amorizaion chances o diminish he damaging effec produced on he naional economy and is banking secor by exernal shocks. The process of money lengh increase, furher diversificaion of financial inermediary ypes, and creaion of new financial insrumens is hindered by a huge secor of he naional economy whose aciviies aimed a redisribuing free and cheap money are execued under he condiions of very mild budgeary resricions. Moreover, he said secor ses sandards of financial discipline seen as poor, unreasonably grasps he credi money, emied by he banking secor, as well as he money graned by he Governmen s budgeary-financial sysem. A regular characer of he menioned facors resrics he srucural effeciveness of he financial marke and prevens money lengh from increasing. 6.9 Seing sraegic goals o gradually liberalize he currency marke and refusing o use he BYR exchange rae as an anchor Transiion from he BYR exchange rae pegged o foreign currencies (USD, EURO, and RUB) as an anchor o he regime of he currency marke liberalizaion and he BYR exchange rae, alongside wih is releasing o freely flucuae is exremely complicaed from he organizaional-echnological view poin and may be economically dangerous. Liberalizaion of he currency marke urges o sop using he exchange rae as an anchor wih he help of which he Naional Bank s currency channel may be employed o influence he economy. The consrains which considerably complicae he process of ransiion o he regime of inflaion argeing under he exising economic policy are as follows. Firs, i is he naure of he naional economy iself being a small open economy, srongly subjecive o he impac produced by impored inflaion and severe exernal shocks. Second, i is he exising sysem of well-ried conrol mechanisms which allow for regulaing inflaion hrough he BYR exchange rae. The use of he said mechanisms is accompanied by a srong influence of he governmenal non-marke regulaion on he process of purchasing currency. Third, huge accumulaions of currency and BYR resources of physical persons and legal eniies wih commercial banks, wih he said deposiors having go accusomed o he fixed currency rae. Transiion o a free esablishmen of he BYR exchange rae in a small open economy is an excepionally dangerous underaking as i requires a radical reconsideraion of he curren economic policy of he Governmen. The problem is ha wihin he framework of his policy he role and he funcions of he Naional Bank are resriced o hose of a modes moneary body, engaged in arge financing of he secors of he naional economy hrough puing reserve money ino circulaion following he esablished naional economic prioriies Ranging he Naional bank s pricing sraegy and ha of he Governmen from achieving inermediary objecives o reaching direc goals of he economic policy (he projeced level of open inflaion) Naional Bank of he Republic of Belarus Transiion from he regime of exchange rae argeing o he regime of inflaion argeing suggess ha he pricing policy of boh he Naional Bank and he Governmen should be urned all he way round from achieving inermediary objecives o reaching direc economic goals (he projeced level of open inflaion). If now he Governmen achieves is pricing goals hrough adminisraive measures, he pricing aimed a he esablishmen of long-erm, low, and digi inflaion canno be reached wihou enforcing marke regulaion insrumens, he mere characer of which fis he defined goal. Needless o say ha he ransiion in quesion means a radical change in he characer and srucure of economic relaionships, ypical of he presen sae of he naional economy. In

265 265 order o carry i ou he presen subsance of verical regulaion relaionship beween organs of sae adminisraion and business eniies should be alered drasically; he curren horizonal ineracion paern embracing business eniies should be compleely ruined, oo. Such changes in case hey occur will lead o he creaion of a sable and predicable relaionship among macroeconomic parameers regulaed by he Naional Bank and he Governmen on a marke basis. Conference May 19-20, 2008, Minsk

266 266 Sergey Kalechis, Naalya Koloonchik 1 Improving Moneary Policy in he Economies in Transiion: Making Choices abou Effecive Regime or Enhancing he Efficiency of he Chosen Regime? Issues peraining o moneary policy improvemen in he economies in ransiion are linked, as a rule, wih he need o employ more effecive moneary policy regimes exising in he world. From he auhors poin of view, changes in he moneary policy regime should no be viewed as an end in iself. In counries where gradual ransformaions are carried ou agains a background of cerain macroeconomic sabiliy, while he moneary regime corresponds, on he whole, o he curren economic condiions and ensures he aainmen of is objecives, enhancing he efficiency of he channels of he moneary policy mechanism which is already in use migh be more appropriae and of op prioriy. The issue of making choices abou he mos effecive moneary policy regime, for he economies in ransiion in paricular, is radiionally one of he mos debaed problems among boh scieniss and expers who work in he sphere of moneary regulaion. In ackling his problem, he advanages and disadvanages of each of he esablished regimes are usually subsaniaed, while measures aken in differen spheres of he economy whose implemenaion is desirable or necessary for evolving ino a more perfec moneary mechanism are viewed, more ofen han no, as acionoriened recommendaions. A he same ime, he economic measures proper may be quie radical, including even subsanial changes in he elemens of he social and economic developmen model which is in place in a given counry. As a resul, burning quesions arise: Is i worhwhile alking abou he choice of a more effecive moneary policy regime for he economy in ransiion if he implemenaion hereof requires subsanial changes in he elemens of moneary policy; Isn i, o a cerain exen, he issue of changing he objecive for he sake of he improvemen o he means? Nowadays here are four basic moneary regimes in heory and in pracice: foreign exchange rae argeing, moneary aggregaes argeing, inflaion argeing, and an implici regime. Their meris and demeris have been researched fairly well in he scienific lieraure. Also, he long-erm advanages of he inflaion argeing regime, including in comparison wih he foreign exchange rae argeing, have been described quie a long ime ago. However, he IMF s daa on moneary regimes adoped in differen counries all over he world in sugges ha only abou 13% of 192 surveyed economies employ he inflaion argeing regime and around 47% he foreign exchange rae argeing. Hence, furher quesions arise: Why do nearly half of he counries around he world employ he regime which has, as heory and pracice show, major shorcomings in he long erm in comparison wih inflaion argeing? In paricular, under cerain circumsances, say, in case of free movemen of foreign capial, i is fraugh wih a subsanial loss of he sae gold and foreign exchange reserves. Is such pracice linked wih he problem of choosing he moneary policy regime ou of, basically, four well-esablished regimes? Naional Bank of he Republic of Belarus This paper deals wih he above-menioned problems. 1 Naional Bank of he Republic of Belarus

267 267 Le us differeniae beween concree siuaions agains he background of which he issue of improving moneary policy is decided. I is well-known ha here are wo/ There are wo well-known ways o carry ou ransformaions in he economies in ransiion: shock herapy ; and gradual ransformaions mehod (or he gradualis approach ). For an economy which employs he shock herapy mehod o effec ransformaions he issue of choosing a more perfec moneary policy regime as par of a search for a more effecive mechanism of enire economic policy is jusifiable indeed. The siuaion which requires radical changes in he mehods of economic regulaion is generally characerized by financial and social desabilizaion as well as by subsanial unpredicabiliy of is developmen. In general erms, op prioriy asks ackled by he sae in such siuaion are as follows: he sabilizaion of inflaion, reducion in he foreign exchange rae volailiy, eliminaion of exernal and inernal causes underlying financial and social insabiliy, and ohers. In such case, he sae and, in paricular, moneary auhoriies in paricular face he problem of making choices abou he forms of and mehods for pursuing furher economic policy. And a radical change in he moneary policy regime may emporarily become an effecive insrumen for dealing wih he assigned asks because in hese condiions i looks as if he economic sysem is formed anew. A fairly rapid change in he moneary regime is also advisable in cases where here are subsanial conradicions beween he economic sysem and mechanisms of he curren moneary policy regime, wih he resul ha such regime fails o effecively ensure he aainmen of is objecives. The experience of he Czech Republic is a shining example of his. Failure o effecively employ he foreign exchange rae argeing regime agains he background of subsanial flows of exernal capial brough abou, a one poin, srong anagonisms and he hrea of financial desabilizaion, as well as he foreign exchange crisis. In his siuaion, he Czech Republic abandoned in 1997 foreign exchange rae managemen and made a rapid ransiion o he inflaion argeing regime which was mos suiable for he economic condiions exising in he counry. So, he problem of choosing an effecive moneary policy regime is given he highes prioriy in cases where i is vially necessary for he counry o adap o he inernal and exernal fundamenal changes and herefore effecive soluions are urgenly required o clear he backlog of problems. A he same ime, he answer o he quesion as o wheher i is advisable o choose a new effecive regime is equivocal for an economy in ransiion which ransforms by gradual implemenaion of consisen reforms and employs he moneary regime ha allows for fairly effecive accomplishmen of is objecives and asks, and, herefore, maches he macroeconomic condiions, especially if required condiions have no ye been creaed for such a regime. Here is some heory o prove his asserion. The foreign exchange rae argeing regime is based on exchange rae fixing and implies, above all, a close inerrelaionship beween he naional currency exchange rae and inflaion. Accordingly, rigid fixing, flucuaions wihin he band, differen forms of foreign exchange rae pegging o oher currencies, and some ohers can be designaed as foreign exchange rae regimes which can be employed in his case. Underlying he moneary argeing regime is he quaniy heory of money which implies ha over ime he money supply grows in line wih economic growh raes. I is no recommended ha he fixed exchange rae regime be used in moneary argeing because is mainenance requires subsanial expendiures relaing o inervenions. Sofer regimes, such as he crawling peg and dif- Conference May 19-20, 2008, Minsk

268 268 feren forms of exchange rae bands are employed in case of foreign exchange curren converibiliy whils managed floaing regimes are more appropriae for capial converibiliy. The inflaion argeing regime implies ha inermediae arges for he exchange rae or moneary aggregaes are replaced by a number of macroeconomic indicaors which are indicaive in characer and are used o forecas he inflaion rae. The employmen of foreign exchange rae regimes which are close o free floaing is mos appropriae for he inflaion argeing regime. The above argumens regarding compaibiliy of moneary policy regimes wih exchange rae seing is also suppored by pracice. For example, according o he IMF s daa, all inflaion argeing counries employed in 2006 eiher he freely floaing exchange rae or he managed exchange rae regime wih an unpredicable rend, all of hem enjoying curren and capial converibiliy. A he same ime, counries which are caegorized as exchange rae argeing economies employed he following regimes: currency board, crawling peg, pegged exchange rae wihin he band, fixing o anchor currency, and ec. And only a few counries enjoyed capial converibiliy. All his poins o he conclusion ha in such counries a issue is, as regards moneary policy, he improvemen of he efficiency of he moneary policy insrumens influence on he processes aking place in he economy or, in oher words, he enhancemen of is efficiency raher han he selecion of he moneary policy regime. A he same ime, since cerain financial and social sabiliy as well as predicabiliy of economic eniies performance have been achieved in he counry, i is vial, while improving moneary policy, o mainain curren sabiliy. Moneary policy has an impac on he economy by means of he ransmission mechanism consising of a cerain se of channels. I means ha, in fac, he cenral bank exers an impac on some parameers of he moneary sphere hereby influencing redisribuion of financial flows herein. Such changes in he moneary sphere are ransmied, in urn, o oher secors of he economy sill by redisribuing heir financial flows. Sricly peaking, i means ha he srucure of financial flows in he exising economic sysem undergoes changes wih he economic relaions sysem, infrasrucure developmen level, he exen of he economy s inegraion ino he global economy, ec. remaining unchanged. Also, he characerisic feaure of he economies in ransiion is ha by no means all financial mechanisms, e.g. he financial markes sysem, operae effecively and a full capaciy. And, if he cenral bank employs insrumens designed o bring he idle financial mechanisms back ino operaion, he economy s response may go beyond he scope of expeced resuls, being boh posiive and negaive,. Thus, moneary policy efficiency depends no only on wha insrumens help o exer influence on he moneary sysem, bu also on he sae of he economy as a whole and he environmen in which i funcions. In urn, he very moneary regime does no, in fac, subsanially change he economic sysem and relaions herein. I impars ransparency o he cenral bank s decision-making process, i.e. he model of is behavior in cerain siuaions. A he same ime, he exising economic sysem predeermines o a large exen he ype of he moneary regime which can be used as a key regime in pursuing moneary policy. Here are some examples in suppor of he above-menioned saemen. Naional Bank of he Republic of Belarus Firs, as saed above, boh heory and pracice sugges ha raher rigid regimes of exchange rae seing as well as he lack of capial converibiliy require, as a rule, he exchange rae argeing regime. Given his, i would no be reasonable o adop he managed or floaing exchange rae seing regime for he sake of carrying ou he efficien inflaion argeing regime. For example, in he Republic of Belarus, agains he background of vigorous srucural reforms and modernizaion of he

269 269 non-financial secor, as well as he negaive foreign rade balance and inadequae gold and foreign exchange reserves, he issue of exchange rae sabiliy is sraegic. All his is agains he relaively independen exchange rae seing and, as a consequence, agains inflaion argeing. Second, in our counry, for example, individual indusries, such as house building, are funded, o a grea exen, a he expense of he banks sof credis. Therefore, he level of ineres raes does no direcly affec credi aciviy of such economic eniies which is required for he efficien use of he ineres rae channel of he ransmission mechanism. As a resul, his channel may no be used as he key one. Hence, such sysem of financing also influences he ype of moneary policy. Third, a number of inernaional organizaions noe ha he financial markes of ransiion economies are underdeveloped and, herefore, funds cross-flows relaed o he changes in muual profiableness do no always occur and do no involve all financial marke paricipans. This hinders and, in a sense, disors he signal formed by he cenral bank wihin a cerain moneary regime ha may weaken moneary policy efficiency, for example, under inflaion argeing. More examples could be cied here. Said argumens confirm, o a grea exen, he assumpion ha in he ransiion economy ha implemens is reforms sep-by-sep he moneary regime opions are subsanially limied and predeermined by he model of he economic sysem. Besides, he problem of moneary regime selecion is beyond he scope of a simple undersanding of he mechanism of is operaion wihin he moneary sphere as well as creaion of cerain empirical assessmens. In our opinion, i is ransformed ino he problem of seing crieria for assessing he performance of he moneary sphere proper and he ransmission mechanism wih respec o is channels. The resuls of such assessmen, in urn, may form he basis for deciding which channel is mos efficien under he exising economic condiions. Besides, in he course of he gradual ransformaion he efficiency of he ransmission mechanism channels may vary erraically, and i is no cerain ha he ineres rae channel will be he mos efficien one. In his case, if several efficien channels are available, he implici moneary policy regime may be seleced, which happened, in our opinion, in he Russian Federaion. As a resul, he majoriy of he ransiion economies ha have been successful in implemening gradual reforms should op o improve he already successfully funcioning moneary regime and all channels of he ransmission mechanism raher han swiching o a more advanced one. The issue of he moneary policy improvemen wih a view o increasing is efficiency in aaining macroeconomic arges wihin he seleced model of social and economic developmen is of curren imporance for he Republic of Belarus as well. A presen, he moneary policy regime which is used in he Republic of Belarus is based, virually, on argeing he exchange rae of he Belarusian ruble versus he US dollar. Taking ino accoun he imporan role of he exchange rae in he open economy in regulaing impored inflaion, foreign rade price compeiiveness, and economic eniies expecaions, is use as a moneary arge proved efficien in he Belarusian economy and was one of he key facors ha led o he financial sabilizaion. For insance, in he Republic of Belarus he exchange rae of he Belarusian ruble is used agains he US dollar as a moneary arge due o he laer s dominaing share in he foreign economic selemens, domesic foreign exchange marke, and households foreign exchange savings. Therefore, mainaining a sable Belarusian ruble US dollar exchange rae conribues o boh curbing he growh of impor prices in he ruble equivalen and lowering inflaionary and devaluaionary expecaions of he economic eniies, while he long-erm rend of he US dollar depreciaion versus he Conference May 19-20, 2008, Minsk

270 270 currencies of he main rade parners of he Republic of Belarus makes is possible o improve, o a cerain exen, he price compeiiveness of he domesic goods and services. A he same ime, in ligh of he changing role of he US dollar in he world markes an increase in he share of oher foreign currencies, above all, he euro and he Russian ruble in he servicing of he foreign economic and foreign exchange spheres of he republic becomes indispensable. Therefore, choosing anoher, probably, more complicaed exchange rae arge, such as he baske of currencies, is no a long-erm issue any longer. Besides, as he period of mainenance of exchange rae sabiliy lenghens, is imporance as one of he facors influencing inflaion is declining and, consequenly, he resraining effec of he sable exchange rae on inflaion is gradually losing i efficiency as well. A he same ime, he possibiliy of significan exernal srenghening of he Belarusian ruble is objecively consrained by he sae of he curren accoun of he balance of paymens of he counry. Finally, he level of he sae s gold and foreign exchange reserves makes i possible o ensure quie confidenly a sable exchange rae under curren resricions relaed o capial movemen. In case of liberalizaion of he above-menioned operaions a fixed exchange rae may, in cerain condiions, cause a reducion in he level of he gold and foreign exchange reserves. Is i appropriae, aking ino accoun he above-menioned problems, o alk oday abou he need for he Republic of Belarus o move o anoher, more advanced, moneary policy regime, or is he approach based on he improvemen of he ransmission mechanism of he exising regime more weighed? On he whole, inflaion argeing seems more effecive. A he same ime, for he purpose of an efficien ransiion o his regime in he Republic of Belarus, a variey of significan ransformaions affecing essenial elemens of economic policy is needed. This involves he curren sysem of sof credis in some indusries, financial marke developmen, including on he basis of privaizaion, and a number of oher areas affecing he exising sysem of social and economic prioriies. I is clear ha hese spheres ough o undergo evoluionary change wihin he general sraegy of he naional social and economic developmen. Therefore, i is no unil he enire se of required condiions is creaed in he economy ha he ransiion o a more advanced moneary policy regime could be considered. Given curren condiions, including, iner alia, he lenghy effec of rising exernal energy prices, he regime which is being used in he Republic of Belarus is oally adequae and is improvemen in he near fuure may include an increase in he performance of he individual channels of he ransmission mechanism. The following key conclusions may be drawn from he above-menioned argumens: firs, he prevailing behavior of he economic agens in he corresponding counry, as well as a number of economic and insiuional facors predeermine he selecion of an efficien moneary policy regime; Naional Bank of he Republic of Belarus second, he problem of moneary regime selecion goes beyond he scope of undersanding he mechanism of is operaion wihin he moneary sphere as well as creaion of cerain empirical assessmens. In his conex i may also be added ha he selecion of a moneary policy regime and swiching o a new one may no be viewed as an objecive of economic ransformaion. I is a means of increasing moneary policy efficiency. A he same ime, i mus borne in mind ha he moneary regime is a sor of he means of imparing ransparency hereo and a form of bringing he informaion on he principle ha will underlie he cenral banks fuure acions o he noice of he economic eniies; and

271 271 hird, in he conex of moneary policy improvemen in he counries ha are implemening heir reforms sep-by-sep he issue of moneary regime selecion is ransformed ino he problem of developing crieria for assessing moneary sysem efficiency and is ineracion wih oher secors of he economy. Such crieria mus be developed on he basis of a comprehensive analysis of he role of he moneary mechanism in he sysem of aaining all of he arges of he counry s economic policy. In urn, he resuls of such assessmen may serve as he basis for aking a decision as o he mos advisable channel of he ransmission mechanism in he curren economic environmen. References Moiseev S.P. Moneary Policy: Theory and Pracice. Texbook. Moscow: Economis, pages. Lobanov A.V., Kalechis S.V. Naional Currency Sabiliy Assurance Mechanism / Bankovski Vesnik No pages. Kalechis S.V., Koloonchik N.N. Role and Naure of he Exchange Rae Seing Policy Under Various Moneary Policy Regimes. / Sable Developmen of he Economy: Presen Sae, Problems, and Prospecs: Theses of he repors a he Inernaional scienific and pracical conference, Pinsk, May 10-11, 2007: In 4 volumes Pinsk: Polessky Sae Universiy, Volume pages. Conference May 19-20, 2008, Minsk

272 272 Ryzhkovskaya Oksana 1, Approaches o he Regime Choice and Crieria of he Opimal Moneary Policy of he Transiion Period Choosing opimal moneary policy opion has is own hisory and his problem will be a subjec of heoreical sudies for a long ime. One may speak abou he grea scienific and pracical imporance of he problem of choosing he arges and opimal moneary policy regime for every counry, especially, for ransiion economy. A presen, he world experience is represened by wo basic full-fledged moneary policy regimes hough he curren classificaion is relaively coningen and he pracice of moneary managemen iself is represened by he muliple mixed forms of and approaches o he moneary sphere regulaion, ha evidences he ongoing process of moneary managemen improvemen and revision of he pre-exised heoreical and pracical approaches. The evoluion of asks and objecives faced by he cenral banks is caused, o a grea exen, by he developmen and qualiaive changes in he financial secor iself, as well as moneary and economic relaions and inerrelaions. Every ype of aciviy as well as any policy, wheher i be moneary, economic or fiscal, is relaed o he arge-seing process, i.e. availabiliy of a arge wih a view o aaining which i is designed, as well as deerminaion (developmen) of he mehods and mechanisms for is implemenaion by means of he specific insrumens ha each of hem has a is disposal. Whereas an economic growh is mos ofen he economic policy arge, and ha is already axiomaic, as a basis for increasing sociey s well-being (someimes, along wih oher parameers, for example, lowering of unemploymen, reducion of inflaion, assuring sable balance of paymens and ec.) he oher componens of he macroeconomic policy mus have heir specific arges ha are inseparably linked and aimed a aaining of he sraegic arges of economic developmen (general economic arge). The availabiliy of specific arges derives from and is deermined by he specific feaures of he objec of impac iself as well as by he insrumens being a he regulaory body s disposal ha make i possible o make an impac on he objec. As a resul, owing o he aainmen of specific objecives he synergeic impac of all he moneary policy componens on he general arge of he economic sysem is being srenghened. For example, moneary sysem is he objec of he moneary policy impac. To his effec i has specific insrumens (an ineres rae, an exchange rae, ec.) and is own channels (a ransmission mechanism) of economic impac. The noion moneary policy arge was inroduced for he firs ime by Jan Tinbergen. Under i he undersood a fixed quaniaive parameer which he moneary policy mus seek o aain by selecing he values of he policy insrumens or insrumenal variables (a moneary policy insrumen). According o he Tinbergen s concep, moneary policy is characerized by he hierarchy of he arge variables: a final arge an inermediae arge he acical arges he insrumens of he cenral bank s policy. Bu, a moneary policy arge iself as well as he principles of he srucure of he sysem (hierarchy) of indicaors for is aainmen may change ha is raced in he hisorical conex. Naional Bank of he Republic of Belarus For example, during he gold sandard he final moneary policy objecive consised in he mainenance of he fixed price for gold, or, in oher words, keeping he fixed exchange rae. During he 1 Naional Bank of he Republic of Belarus, Ph.D. in Economics.

273 273 Breon-Woods Agreemen he exernal and inernal sabiliy of he naional moneary uni (he fixed exchange rae and low level of inflaion) was sipulaed as he final arge in he laws on cenral banks. During he period of high inflaion, moneary argeing, i.e. he creaion of money supply in accordance wih he prescribed arges of he money supply growh, proved o be efficien as well. Bu, when he demand for money became more and more unsable and he relaions beween he moneary supply and inflaion raes less and less predicable he cenral banks gave preference o he conrol of he ineres rae again. Afer swiching o he floaing exchange raes he obligaion of he grea number of cenral banks o mainain he fixed pariy was annulled and price sabiliy became he final arge. Based on he available approaches o he modificaion of arges and objecives, he level of aainmen of he sipulaed arge is he mos imporan crierion of efficiency of every policy. The exen of aainmen of he sipulaed arges may be considered as a crierion of he regime selecion and, consequenly, he subsequen assessmen of is efficiency wih reference o he moneary policy. During he las years a grea number of cenral banks seleced reducion and keeping of inflaion a a low level as he key moneary policy arge. Is price sabiliy guaraneeing consan economic growh and serves as he basic indicaor of he economy developmen? Mus he inflaion be a prioriy of he economic or moneary policy? If he above-menioned quesions will be answered unambiguously, hen such a arge of he cenral bank as ensuring of he low inflaion raes may be considered as he main conribuion o he implemenaion of he economic policy designed o ensure a sable and long-erm economic growh. Unforunaely, a presen here is no common undersanding of his inerrelaion. The resuls of he empirical analysis of he raio of he inflaion dynamics and he raes of he economic growh for he hisorical period covering which was carried ou by he IMF specialiss for 140 seleced counries confirm he imporance of he inflaion for he economic growh, bu his inerrelaion is nonlinear, i.e. he volailiy of he economic growh increases as he inflaion is growing. Oher invesigaions which were carried ou in differen counries of he world show ha he high inflaion raes (ha are expressed in wo-digi numbers) are accompanied by he low raes of economic growh or economic recession. For example, in he Eas European counries he economic growh has been resumed afer successful lowering of he high raes of he prices growh a he iniial sage of ransiion o he marke economy. S.Moiseev, Direcor of he Cener of Economic Sudies of Moscow Financial and Indusrial Academy, gives he following comparaive macroeconomic characerisic of he counries ha are argeing inflaion and money supply under independen floaing of he exchange rae (he median for , in %) 1. Groups of counries Economic growh Inflaion Developing counries ha are argeing money supply Developing counries ha are argeing inflaion Indusrial counries ha are argeing inflaion The given daa show ha he higher raes of he economic growh are accompanied by he higher level of he consumer prices growh hough a lo of economiss disinguish several cycles in his in- 1 S.Moiseev. Formalizaion of he Economy and is Consequences for he Moneary Policy // Issues Relaed o he Economy No.2, Conference May 19-20, 2008, Minsk

274 274 errelaion. A a definie sage economic growh invokes he cyclical increase in prices which is followed by he increase in he maximum inflaion level and a he final sage he inflaion gives rise o he negaive economic growh (sagflaion). Wih respec o he shor-erm inerrelaions, some economiss believe ha he excessive increase in he money supply under he shor-erm saics (consancy) of prices leads o he economic growh. Laer on hese processes are counerbalanced by he increase in prices and decrease (suspension of growh) in he real producion volumes, i.e. here is a cerain level a which he inerrelaion of he inflaion and economic growh becomes inverse, he level for developing counries ha are characerized by he srucural disproporions and insiuional ransformaions in progress being higher han ha for he developed sysems. I should be noed ha he resuls of any comparaive analysis of wo variables, in our example of inflaion and raes of economic growh, may be hardly considered as absoluely unambiguous because i is difficul o disinguish per se he impac of he inflaion on he economic growh and he reversed impac, as he laer is he resul no only of one or anoher moneary policy bu of he whole sysem of oher macroeconomic facors. In he auhor s opinion, when selecing one or anoher moneary policy regime i is necessary, in he firs place, o ake ino accoun macroeconomic deerminans, such as, he srucure of he economy and is monopolizaion level, availabiliy of srucural disproporions, price flexibiliy and pricing mechanism, he exen of he adminisraive impac on he economy and he share of marke insrumens, he exen of he ransparency of he economy, mauriy of he moneary markes and financial sysem as a whole, ransmission channels and mechanisms of affecing he economy, he characer of fiscal policy, coss relaed o he marke ransformaion and esablishmen of he new marke insiuions, ec. The unsable characer of he ransiion economy as a whole and lack of he unambiguous undersanding of he ransmission mechanism funcioning beween he money supply and macroeconomic variables complicae he problem of he choosing corresponding moneary policy opion and he use of a number of radiional models of moneary regulaion. A he same ime, when he moneary policy arge is being defined i is reasonable o ake ino accoun o a maximum degree he impac of he seleced arge on he economy as a whole. In oher words, when a moneary regime is being seleced he following should be aken ino accoun: Naional Bank of he Republic of Belarus an exen of he seleced prioriy impac on he economic parameers, namely, he dynamics of producion and economic aciviy, as well as on he consumpion, savings and invesmens, i.e., on wha do he real economic variables reac srongly exchange rae volailiy or flucuaion of prices in he form of inflaion growh; he available insrumenal opporuniies of moneary auhoriies o influence economic variables, for example, wha is he reacion of invesmens and demand for money on he changes in he ineres rae; he explici coss of one or anoher moneary managemen mehod and is advanages; he poenial efficiency limis and produciviy loss risks; he ani-inflaionary capaciy of he regime and limied naure of he moneary aniinflaionary regulaion in he ransiion sysems as a whole; an availabiliy of price-seing processes in he economy of he non-moneary naure and naural limied naure of he moneary policy impac on he economic growh; a capabiliy of he moneary regime o proec he economy from he exernal and inernal negaive impacs, ec.; and

275 275 a ime horizon owards which he policy is direced and ohers. The saisical invesigaions of he Russian economiss ha were focused on he impac of he US dollar exchange rae, inflaion and shor-erm moneary flucuaions on he volumes of producion in differen branches of indusry revealed ha none of he branches suffer from he increase in he US dollar nominal exchange rae. Bu he producion is reduced in all he branches of indusry (excep for he building maerials producion indusry) following an increase in he inflaion raes. Among hem are: non-ferrous meallurgy, chemical indusry, and machinery manufacuring. When he inflaion level is being increased he volumes of ransporaion experience he mos significan decrease and he gross profi in he indusry reduces sharply as well 1. Thus, macroeconomic variables such as he exchange rae and inflaion make diverse impac on he producion volumes in differen branches of indusry. Increasing inflaion raes make a greaer adverse impac on he producion han moderae flucuaions of he exchange rae. The invesigaion ha focused on he valuaion of he relaions beween he real exchange rae flucuaions and economic growh in Russia gave rise o he conclusion on he ambiguous characer of such impac because i is deermined by he reasons ha underlie changes in he real exchange rae. If he srenghening of he currency is he resul of capial inflows or an increase in he income from expors, he general implicaions for he economy would be posiive. If he real exchange rae is changed due o he increase in he real coss, economic growh would slow down, in he firs place, in he impor-subsiuing branches, bu he exchange rae reflecs only he increase in he coss ha cause he slowing down of economic growh. Therefore, he general impac on he economy would, virually, be equal o zero 2. The auhor did no reveal any assessmen of such comparaive impac wih respec o he economy of he Republic of Belarus. A he same ime, in a more general sense, he impac of he exchange rae on he economy is expressed hrough he simulaion of rade a he expense of foreign exchange risk reducion; impac on he producs price compeiiveness; simulaion of invesmens, because he exchange premium of ineres raes is being decreased; formaion of he inernal price dynamics by changing he prices for impors (especially, for he counries wih open economies) hus reducing impored inflaion, he impac on he exchange rae and inflaionary expecaions, ec. A presen, a lo of counries enjoy progress in he implemenaion of moneary policy which is based on he use of he exchange rae as a nominal anchor wih a view o ensuring macroeconomic and financial sabiliy. Bu in he process of seing he exchange rae arges he economy may face some problems. For example, when he financial accoun is being liberalized and he capial is acively moving he possibiliies of a speculaive aack on he naional currency and pracical impossibiliy o assure, in hese condiions, he ackling of he wofold ask, namely, o mainain a sable exchange rae and he desirable dynamics of prices, would be srenghened as he cenral banks inervenions make a diverse impac on he changes in he real exchange rae and inflaion growh. The exchange rae policy is unable o efficienly comba foreign exchange speculaions based on he objecive weakness of he naional currency. Besides, for he purpose of meeing he chosen quaniaive exchange rae arge significan gold and foreign exchange reserves are required ha may be afforded by he counry ha has he srong foreign economic secor and posiive rade balance. A ha, he effeciveness of he ineres rae 1 I.S.Ivanchenko. Inflaion Channel of he Moneary Policy Transmission. // Finance and Credi No.17, A.Ulukaev, O.Zamulin, M.Kulikov. Precondiions and Consequences of he Inflaion Targeing Implemenaion in Russia. Conference May 19-20, 2008, Minsk

276 276 channel would be weakened and he mechanism of banks refinancing would be funcioning inadequaely. Under relaively low levels of inflaion he resriced ani-inflaionary capaciies of he exchange rae argeing regime would become apparen (he effors aimed a reducing he inflaion below 10-12% failed in he counries using such a regime). Besides, he cenral banks poenial o adjus he exchange rae o is long-erm equilibrium parameer would be limied. If he cenral bank arges he exchange rae he disadvanages of such policy would be also he loss of he abiliy o carry ou an independen moneary policy since he changes in he moneary base (reserve money) occur hrough he foreign exchange purchase and sale operaions, in oher words, he bank would loss is abiliy o manage he liabiliies side of is balance shee. Under such regime he inernal conrol of inflaion (a leas, is moneary componen) would be los. May hese wo asks be complemenary and consisen wihin moneary policy and a wha sage does he necessiy o abandon he dilemma of arge-seing and o focus on one arge which becomes single and prioriized arise? Shall he reliance in he naional currency be assured under he fixed exchange rae bu relaively high level of is domesic depreciaion, i.e. inflaion? As i is apparen from he hisorical experience, he effor aimed a he simulaneous aainmen of wo arges - he seing of he nominal exchange rae arges and inflaion raes was realized in many counries of Cenral and Easern Europe a a definie sage of heir economical and financial developmen, bu laer on ook he form of currency crises. Nowihsanding he imporance of he exchange rae channel for he reducion of inflaion in many of he aforesaid counries hey failed o aain he sable exchange rae and decrease he level of inflaion in he changed economy developmen condiions (in paricular, when financial accoun is liberalized and he real exchange rae is increased). Under a more flexible exchange rae seing regime he possibiliy o implemen independen moneary policy would arise and in such condiions a cenral bank may perform a funcion of he credior of las resor and provide commercial banks wih he required liquidiy. The efficiency of one or anoher liquidiy regulaion mehod, including he ineres rae policy, depends upon he mehod of money supply creaion which is used in he concree period of ime. A he same ime, he exchange rae may play he role of sabilizer in case of he impac made by he adverse foreign rade facors. The main advanage of he moneary policy implemened under he floaing exchange rae lies in he removal of he hrea of imbalance relaed o he inconsisency beween he exchange rae and changing macroeconomic condiions and making a serious adverse impac on he economic developmen. The adverse impac of he high inflaions raes on he economy is well-known as well. In he firs place, money savings are depreciaed, primarily, he enerprises fixed incomes, curren asses and profis; he developmen of he securiies marke is slowed down due o he ineviable parial loss of value of conribuion o his asse; dollarizaion of he economy increases; he high-echnology and invesmen developmen of he economy is hindered because any innovaional decision in he business and in he economy as a whole is fraugh wih risks, including he inflaion risk. If one canno forecas precisely he dynamics of prices one canno assess he profis and losses associaed wih he invesmen projecs. Naional Bank of he Republic of Belarus Bu, inflaionary process in he ransiion economies is relaed o he inernal insabiliy of such sysems, accumulaed srucural deformaions of he reproducion and echnological characer and inflaionary poenial. Inflaion in such counries is caused no only by he moneary facors, bu, o a greaer exen, by he disproporions ha generae and srenghen he srucural and insiuional facors of inflaion. Therefore, he possibiliies of he moneary policy impac on he inflaionary processes in hese condiions are limied and as macrovariables reach equilibrium sae, including srucural and insiuional characerisics, he moneary sysem aains greaer inflaion immuniy.

277 277 In hese condiions i is difficul o influence he price level hrough he changes in he ineres rae because he inernal price srucures, including prices for goods and services, as well as he wages are no sufficienly flexible and are adjused in an adminisraive way. The influence of he change in he ineres rae on he price level would be diverse depending on he iniial parameers of he economy. A full-fledged marke financial sysem would be needed o assure normal funcioning of he ransmission channel of he moneary sysem. If a counry lacks a developed banking sysem or financial marke hen a cenral bank s capabiliies o influence wih he help of he ineres rae he crediing of he non-financial secor hrough he banking sysem liquidiy would be limied. Therefore, when a cenral bank deermines for iself he main arge i should, cerainly, ake ino accoun all he above-menioned approaches and he assessmens of he influence of he chosen arge on he producion volumes and economic developmen raes. Bu, producion was influenced in differen counries by differen facors whose impac mus be aken ino accoun. These facors were exernal as well as domesic. Namely hey may be of a primary imporance because he ransformaions ha ake place in he ransiion economy affec he pre-exised inerrelaions beween he macroparameers and moneary indicaors and lead o he changes in he radiional impac. I is worh menioning ha insiuional changes ha are required for he inflaion argeing regime faciliae an improvemen of he macroenvironmen and increase efficiency of whaever moneary policy as hey make i possible o use anoher, mainly, marke channels of influencing economy by increasing efficiency of marke raher han adminisraive moneary insrumens. Moneary policy acivizaion wih a view o simulaing economic growh requires deerminaion of limis and consequences of he impac of such acivizaion on he economy, mainly, on he dynamics of producion and prices growh raes. The capabiliies of he moneary policy in he creaion of favourable condiions for he economic growh would be efficienly implemened only in he sysem of measures ha presumes coordinaion of he moneary policy soluions wih he acions in he oher areas of he economic policy. Theoreically i is sufficienly grounded ha under differen regimes he efficiency and imporance of moneary and fiscal policy in ackling macroeconomic sabiliy issues would be changed. A necessiy o revise he moneary policy impac on he macroeconomic parameers is caused by he fac ha every economy is developing, is coninually in he non-equilibrium sae and he models and regimes of he economic growh are changed. Bu, moneary mehods of macroeconomic regulaion should be considered only as a facor, moreover, no as a single one bu having an effec along wih he oher more or less significan facors promoing economic growh, since he basis of high economic developmen raes is, mainly, formed by a new echnological mehod of producion which is no a long-erm facor of economic growh. Even he availabiliy of a single arge such as reducion of inflaion does no mean for he cenral bank ha he seleced mehod of is aainmen would be opimal forever. The worldwide economic condiions are being changed ha during he period of economies globalizaion and muual financial capial flows bring in new facors ha would mean a permanen search for new approaches o he undersanding of he reasons of inflaion and, consequenly, new forms of combaing i. The new facors requiring he developmen of a new paradigm of moneary managemen and revision of he insrumen ha have been used may be added o is well-known classical forms: cospush inflaion, demand-pull inflaion, impored inflaion, inflaionary expecaions, and accumulaed inflaionary poenial. The rapidly growing economies sared o make a greaer impac on he world inflaion a he expense of he addiional demand for resources for he invesmen developmen, as well as for foodsuffs ha was refleced in he world dynamics of prices. Thus, he long-erm inflaion rend in he naional economy may be synchronized wih he global inflaion o Conference May 19-20, 2008, Minsk

278 278 an increasing degree. Alhough i makes a nonequivalen impac on differen counries, such impac is more likely o be sronger on he counries having he highes share of consumpion producs in he baske and relaively shor hisory of price sabilizaion. The foregoing indicaes he consanly changing condiions in he counries and increased impac of world processes on he ransiion economies making he search for opimal moneary policy more complicaed. This means ha he rends in he world economy make a direc impac on he naional economies and vice versa. The Belarusian economy is no an excepion and, herefore, i is necessary o ake ino accoun in wha way he exernal economic facors influence he raes of is growh. In he condiions of he available access o he inernaional capial markes and he possibiliies of he free capial movemen cerain abiliies of moneary regimes are being los. Inflaion depends, o a grea degree, no only on he policy of he exchange rae, foreign exchange reserves movemen, he sae of balance of paymens and rade balance, bu also on he changes in he world prices and capial movemen beween he counries. A presen, economiss noe he change in he shor-erm saisical dependency in he ransiion economies beween he moneary aggregaes and inflaion. This may confirm ha srucural reasons, exising imbalances, poor marke infrasrucure and insrumens developmen, and accumulaed inflaionary poenial have he greaes imporance for he inflaion in ransiion economies ha limis he efficien impac of moneary insrumens on he inflaion. The inerrelaion is decreased, more likely, on he background of he changes in he srucure of economy and is insiuional characerisics. As he financial marke of hese counries enjoys developmen, he influence of he money supply volumes on he inflaion and economic growh raes changes because in his environmen money supply makes an impac on he dynamics of producion no only by way of he direc servicing of he maerial producion sphere, bu also hrough he financial marke. Besides, he regisered change in he inerrelaion beween money supply and inflaion is explained as well hrough he anoher vision of impac on he gap beween he poenial GDP and acual level of producion, ha is maximum real producion coss, which creaes inflaionary poenial raher han inflaion iself. All he above-menioned facs evidence he necessiy of he furher deep analysis of he inflaion reasons, undersanding of he role and significance of marke insiuions for he economic developmen of he counry, and ongoing analysis of qualiaive changes in he inerrelaion beween he moneary sphere and macroeconomic variables. Hisorical experience shows ha he movemens in he moneary policy arge-seing happen in case of he efficiency loss or impossibiliy o aain he saed arges by means of previously used approaches. To some exen i could be explained by he disrupion or change in he previous inerrelaions beween a big number of indicaors. The criical poin of every regime is he issue of sabiliy and soundness of such mechanism, confidence of he economic eniies, availabiliy of limis (borders) of is efficien use owing o qualiaive changes in he moneary sphere, he economy as a whole, and deerminaion of he momen of swiching o a new arge. References Kudrin A. Inflaion: Russian and World Tendencies // Issues of he Economy No.10, Naional Bank of he Republic of Belarus Ulyukaev A., Zamulin O., Kulikov M. Prerequisies and Consequences of Inflaion Targeing Implemenaion in Russia. Moneary Policy Insrumens and Mechanisms of Their Use. Inflaion Targeing. Aricles o he Inernaional Seminar, Tula, November 27-30, 2007.

279 279 Moneary Policy of he Bank of Russia: Topical Aspecs. Inerview of he Firs Depuy Chairman of he Board of he Bank of Russia. Money and Credi No.5, Ivanchenko I.S. Inflaion Channel of he Moneary Policy Transmission. Finances and Credi No.17, Macroeconomic Managemen and Issues Relaed o he Financial Secor. Maerials of he Join Vienna Insiue. January 29 February 9, Conference May 19-20, 2008, Minsk

280 280 Lepushynskyy Volodymyr 1, Lines of Moneary Transmission Opimizaion under Condiions of Transiion Economy An essenial condiion of he effeciveness of price-sabiliy-based moneary regime is availabiliy of an efficien mechanism for ransmission of moneary policy impulses o he real secor of economy. Characerisic of he economy of Ukraine, he same as many oher ransiion economies is he exisence of insiuional and srucural facors ha reduce he effeciveness of moneary ransmission mechanism. This paper discusses he above menioned facors and measures aimed o srenghen he efficiency of ransmission mechanism of moneary policy. An essenial condiion of he effeciveness of price-sabiliy-based moneary regime is availabiliy of an efficien mechanism for ransmission of moneary policy impulses o he real secor of economy. I should be noed ha neiher academic communiies nor pracical economiss have common oulook on he naure of ransmission and lags of moneary policy makers influence on he economy. The naure and effeciveness of ransmission mechanism vary depending on he size, srucure and openness of he economy. I is bu naural ha for developing counries he naure of moneary policy influence on he economy is characerized by greaer degree of uncerainy as opposed o he developed counries due o insiuional and srucural changes in he economic sysems and oher limiing facors. Characerisic of he economy of Ukraine, he same as many oher ransiion economies is he exisence of insiuional and srucural facors ha reduce he effeciveness of moneary ransmission mechanism due o imperfecions of financial marke, fiscal policy of he governmen and oher srucural facors. This paper discusses he above menioned facors and measures aimed o opimizaion of he ransmission mechanism of moneary policy ha shall be reaed as reducion of is uncerainy and improvemen of he effec of is channels. Many eminen researchers such as F.Mishkin, B. Bernanke, L. Svensson, R. Clarida, M.Gerler, and A.Blinder repor on heir inquiries ino boh heoreic and pracical aspecs of he ransmission mechanism of moneary policy. A survey prepared by expers of he Bank for Inernaional Selemens S. Kamin, F. Turner and J.Van dack is he mos comprehensive paper on he naure of ransmission mechanism of developing counries. The work by K.Smidkova presening he key feaures of moneary ransmission in he developed and developing economies is also worhy of noe. The sudy conduced by Ganev e al. (2002) highlighs ha under he condiions of ransiional economy cerain limiing facors make he radiional insrumens of moneary policy less effecive han under neoclassical condiions. In he period of ransiion, insiuional srucures of imporance for conducing efficien moneary policy have no ye been properly formed whereas he processes ha inhibi moneary ransmission (disbalanced budgeary policy, negaive inflaion expecaions, ec.) may be fairly srong and dominan a cerain sages. Under such condiions he moneary auhoriies may be forced o conduc inconsisen policy ha would have reduced is effeciveness sill furher. Naional Bank of he Republic of Belarus Despie he variey of moneary regimes and mehods of conducing moneary policy in ransiion economies, here are cerain common characerisics ha may reduce he effeciveness of moneary 1 Senior Economis, Naional Bank of Ukraine

281 281 ransmission. In he following we discuss he mos imporan facors for he majoriy of ransiion economies ha exer primary influence on he effeciveness of moneary ransmission. Sae of Financial Markes The availabiliy of well-developed financial marke is crucial for effeciveness of he ransmission mechanism of moneary policy. The level of developmen and liquidiy of he marke deermine he exen of cenral bank policy influence on marke ineres raes and prices on financial asses. Thus he level of financial marke developmen deermines he role and significance of boh he ineres rae and asses price channels of ransmission mechanism. Generally, developing economies are characerized by inferior financial markes as compared o hose of developed economies in such aspecs as compeiion, liquidiy, capializaion, and involvemen of a wide range of economic agens. Accordingly, he efficiency of moneary policy is reduced. I is refleced on uncerain influence of policy measures on he financial marke indicaors. Le us consider he impac of financial marke developmen level on he effeciveness of moneary ransmission in erms of is key componens such as bank credi marke and sock marke. Bank lending For many ransiion economies, including ha of Ukraine, he role of banking sysem in he ransmission mechanism is decisive. This is largely associaed wih he lack of oher sources of borrowing han banking credi for financing invesmen and consumer spendings such as capial marke resources. The efficiency of moneary policy is mosly deermined by he size of banking secor relaive o he real secor of economy. The role of bank lending in he economy of Ukraine like in many ransiion economies has been dynamically growing in imporance a a seady pace. Thus, for example, he raio of bank credi o GDP in Ukraine increased from 6.7% in 1996 o 45.8% in The majoriy of sudies evidence ha key srucural characerisics sipulaing he efficien role of bank lending in he ransmission mechanism is compeiion on he marke and sound banking sysem. In a highly concenraed banking secor, oligopolisic pricing may be possible, hereby prevening he ranslaion of changes in prices on he inerbank marke resources (which he cenral bank has he mos influence) o bank credi and deposi raes for he real secor of economy. Eger and MacDonald (2006) in heir paper on ransmission in he counries of Cenral and Eas Europe, noed ha high concenraion of capial is acually associaed wih lower efficiency of ineres rae channel. Neverheless, an enry of foreign capial ino he bank marke (hereby increasing concenraion of capial) cause he ineres rae channel o work faser and in a more efficien way. This may be explained by he fac ha he enry of foreign capial involves new sandards of business hereby sepping up compeiion in he marke. For Ukraine, he same as for many developing economies, his issue is opical because of he growing share of foreign capial in he banking secor. In recen years he share of foreign capial in he auhorized capial of he Ukrainian banks increased from 9.6% as of early 2005 o 33% as of November 1, Even he availabiliy of compeiion in he banking secor canno be a sufficien condiion of ineres raes flexibiliy relaive o policy measures. An imporan consrain on he effeciveness of moneary ransmission is a large risk premium included ino he bank ineres rae under condiions of ransiion economy. This is semming from Conference May 19-20, 2008, Minsk

282 282 boh macroeconomic insabiliy (inflaion unpredicabiliy) and poliical ension as well as from he problem of collecion and evaluaion of economic informaion a a micro level (in connecion wih evaluaion of collaeral or financial posiion of borrower). These combined complicae he aciviy of banks as financial inermediaries, which is refleced in an increase of risk premium and adverse selecion by banks. Therefore, he linkage beween variables conrolled by cenral bank and ineres raes may be weakened under insabiliy. Moreover, he effec of credi channel is mos conspicuous wih informaion asymmery. In his case banks are no inclined o raise he ineres rae in response o ighened policy since he raised ineres rae would have involved a decline in demand for credi on he par of he mos crediworhy borrowers, whose business is less risky. A he same ime, demand on he par of borrowers wih high credi risk will remain unchanged. Therefore, banks are forced o selecively approach o he maer of borrower eligibiliy by applying he so called credi raioning, ha is eiher sricly limi or compleely suspend crediing. Despie he fac ha his leads o decline in consumer demand, he policy effec, however, will be asymmeric since credi raioning is likely o hi households and small businesses ha have no alernaive financing sources. This, in urn, increases he uncerainy of moneary policy ransmission as is scope narrow considerably. In Ukraine like many ransiion economies, he effec of credi channel is significan, especially in respec of consumer credis. Banks are inclined o respond by a cuback in lending o a ighening of moneary policy raher han an increase in ineres raes. Sock Marke Anoher facor ha leads o reducion in he effeciveness of moneary ransmission in developing counries is he lack of esablished and well-funcioning sock marke. In developing counries where capializaion of companies relaive o GDP exceeds 100%, he effeciveness of moneary policy is grealy magnified under he influence of he developed capial marke due o srong effec of he asses price channel (Tobin s Q, wealh channel, household liquidiy channel). In he developing economies, capial markes are resriced, shallow and low liquid as compared o hose in he developed economies. Scaniness of financial markes leads o high ransacion expendiures and significan difference beween ask and bid prices hereby considerably increasing he coss of financing by issuing securiies and bonds. Moreover, even small groups of players may exer a pronounced effec on he marke. Under condiions of underdeveloped sock marke, financing of invesmen expendiures of mos companies is no dependen on he capial marke siuaion. Moreover, paricipaion of households in his marke is resriced, i.e. lack of securiies in heir porfolio prevens he moneary auhoriies from influencing he aggregae consumpion by changing prices of heir asses. Naional Bank of he Republic of Belarus I should be noed ha he absence of efficien securiies marke complicaes boh he aciviy of cenral banks in conducing moneary policy (efficien open marke operaions are impossible) and he aciviy of commercial banks as financial inermediaries (collaeral esimaion problems). As a resul, as repored in BIS (1998), ransmission of moneary policy measures may be especially uncerain a he early sages of capial marke developmen.

283 283 Figure 1: Difference in capial marke size Unied Kingdom USA Souh Asia Europe and Middle Asia Czech Rep. Poland Ukraine Capializaion of lising companies /GDP *Daa of World Bank 2005 The above-lised problems are o a cerain exen pressing for Ukraine. In spie of fairly dynamic growh of capial marke (capializaion of GDP lised enerprises increased from 6% in 2000 o 40.4% in 2006), is figures look moderae enough as compared o hose of developed counries (Fig. 1). The process of pricing in his marke is sluggish due o low liquidiy. Invesors can respond o a moneary policy acion wih a significan lag ha is aribued o high ransacion coss and impossibiliy o rapidly leave he marke wihou high financial loss. Lines of moneary ransmission opimizaion The effeciveness of moneary ransmission may be grealy improved by he developmen of financial marke. Among he measures on he financial marke developmen are he following: suppor of compeiive environmen in he marke of banking services and financial marke as a whole, he developmen of sock marke by proecion of invesor righs, creaion of an adequae infrasrucure, ec. The policy of governmen securiies issue may simulae he developmen of sock marke. By issuing securiies of differen mauriies and aracive yield, he governmen can provide he marke wih he required yield arges and mainain is liquidiy o a large exen. Inflaion Expecaions The majoriy of ransiion economies experienced he periods of high and insable inflaion a he early sage of ransformaion, and many of hem chose exchange rae peg as a nominal anchor o sabilize inflaion expecaions. In he process of macroeconomic sabilizaion, inflaion raes remain fairly volaile despie heir decline hereby prevening he cenral bank from sabilizing inflaion expecaions a a proper level and efficienly influencing he aggregae demand. Sofening of moneary policy under hese condiions may lead o decline raher han rise in business aciviy. Sofer moneary policy may engender negaive inflaion expecaions wih economic agens. A he same ime, disinflaion measures may foser an increase in business aciviy in he hope ha macroeconomic sabiliy will be resored. Therefore, in he shor run he Phillips curve may be eiher verical or wrongly inclined higher inflaion levels lead o decline in economic aciviy (BIS, 1998). The Phillips curve vericaliy may be due o hypersensiiviy of inflaion expecaions o changes in moneary condiions caused by recen episodes of hyperinflaion and insabiliy. The effeciveness of moneary ransmission can be considerably decreased due o inflaion volailiy. Firsly, i is difficul o discriminae which par of nominal ineres rae is associaed wih real ineres rae and inflaion risk premium. Secondly, inflaion unpredicabiliy leads o reducion in mauriy erms of financial insrumens hereby reducing he efficiency of he asse price channel. Conference May 19-20, 2008, Minsk

284 284 Cenral banks in he developed and developing counries ha are seing inflaion arges and have succeeded in sabilizaion of inflaion expecaions by conducing ransparen policy, have an addiional signal insrumen a heir disposal as an inflaion arge iself. Then by seing he value of argeed inflaion level, he cenral bank can use he inflaion expecaions channel hereby srenghening he effeciveness of moneary policy. Lines of moneary ransmission opimizaion A cenral bank can significanly conribue o opimizaion of he effec of moneary ransmission primarily by couneracing negaive inflaion expecaions, which is relaed wih he problem of confidence in he cenral bank acions. As noed by K.Smidkova (Smidkova, 2001), if inflaion expecaions are unsable here may be wo possible reacions of cenral bank: eiher impor credibiliy by seing a rigid currency peg or esablish credibiliy from inernal sources by announcing an explici arge of moneary policy (mosly inflaion arge) by gradually increasing he ransparency of heir decision-making. Though he firs ype of decision brings faser resuls, i canno las long. The second way of resoluion works slower bu i helps o fix inflaion expecaions more efficienly han by using various ypes of exchange rae fixing. Therefore muually reinforcing effec is manifesed. Announcemen and achievemen of price sabiliy by cenral bank exers a sabilizing effec on inflaion expecaions. A he same ime, wih inflaion expecaions sabilized a a requisie level, he moneary policy can more efficienly aain is objecives due o improvemen of ransmission mechanism efficiency. Exchange rae, dollarizaion and capial mobiliy We can idenify hree dimensions of an exchange rae channel. Firsly, a change in exchange rae affecs impor prices and, hence, consumer prices. Secondly, compeiiveness of he economy will change in he world markes. A change in he exchange rae leads o a change in prices of domesic goods as compared o foreign ones hereby influencing he volume of ne expor. And hirdly, he said acions will affec he balance posiions of all economic players ha have asses or liabiliies denominaed in foreign currency and are exposed o currency risk. The effec of moneary policy hrough he exchange rae channel may be versaile. Where he counry is ne debor o he res of world (as in many developing economies), a ighening of moneary policy followed by an appreciaion of he naional currency may lead o improved balance-shee posiions of definie secors hereby nullifying or oubalancing he effec of reducion in demand for domesic goods, which become relaively expensive. Thus he effec of exchange rae o economy will be condiioned by openness of he economy, dollarizaion of asses and liabiliies of is secors, currency marke developmen, and exernal deb level. Openness of he economy Naional Bank of he Republic of Belarus The difference in he exen of openness beween developing and developed economies is eviden (Fig.2). This should be considered when analyzing he effec of ransmission mechanism since wih he openness being high, mos of he economic variables are under grea influence of he exchange rae, and he pace of influence is faser han he effec of radiional exchange rae channel in developed economy.

285 285 Dollarizaion I is radiionally considered ha o a large exen dollarizaion is a response o economic insabiliy, sharp devaluaion of he naional currency and high raes of inflaion ha arise a he early sages of ransformaion of ransiional economies. However, as noed by A. Berg and E.Borenszein (2000) he increase in dollarizaion in many developing counries has coninued and even acceleraed following successful resrained hyperinflaion and relaive macroeconomic sabilizaion (Fig. 3). Figure 2: Difference in he openness of economy Czech Rep. Belarus Ukraine Poland Romania Europe and Middle Asia Counries wih high Unied Kingdom USA Foreign rade urnover/gdp (World Bank Repor of 2006) I is useful o define he erm of «dollarizaion» in more deail. While in he period of hyperinflaion foreign currency is used as means of paymen (he so called currency subsiuion ), wih he macroeconomic sabiliy achieved i would be more reasonable o rea dollarizaion as asse subsiuion, ha is economic agens prefer o hold a cerain porion of heir savings in foreign currency. Naurally, high degree of dollarizaion inroduces uncerainy ino he acion of ransmission mechanism of policy due o he effec of exchange rae channel. Wih a high level of dollarizaion of boh deposis and credis, he effec of moneary ransmission Figure 3: Dollarizaion of deposis in several counries Russia Poland Ukraine Turkey Kazakhsan Belarus Georgia Foreign currency deposis /broad money supply will be followed by greaer uncerainy and asymmery because exchange rae flucuaions exer differen effec on he financial posiions of differen groups of economic agens depending on wheher hey are ne crediors or ne debors in foreign currency. A he same ime he marke of currency risk hedging insrumens is in inchoae sae in many developing counries aking ino accoun he lack of moivaion for is developmen under long-ime experience of using he exchange rae peg. Lines of opimizaion of moneary ransmission R.Pionkovsky (2003) has derived a conclusion from his inquiries ino he causes of dollarizaion in he counries of Cenral and Easern Europe (inclusive Ukraine) ha he rise of relaive reurns on domesic asses does no lead o a reducion in dollarizaion if i is accompanied wih an increase in inflaion volailiy. Hence volaile (no necessarily high) inflaion may be he major reason of sable dollarizaion. Conference May 19-20, 2008, Minsk

286 286 I is worhy o noice ha many of counries have recenly succeeded in dedollarizaion by shifing o direc inflaion argeing (Turkey, Peru). These resuls have favored he view ha by shifing o more flexible exchange rae regime and lower inflaion volailiy i is possible o promoe dedollarizaion and hereby improve he effeciveness of moneary ransmission. Oher Srucural Facors Deerminaion o implemen srucural reforms, heir qualiy and speed are decisive facors ha characerize he economic environmen and o a greaer exen he relaions beween he effecs of moneary policy and macroeconomic variables. From he poin of view of moneary policy and is ransmission mechanism, srucural facors governing mos of he resricions ha economic agens have o face in heir aciviy and hence heir behavior in differen circumsances, including heir response o moneary policy acions. Among he srucural facors ha affec he effeciveness of moneary ransmission is he degree of governmen involvemen in he conrol of individual commodiy markes and marke prices, share of public ownership in corporae secor, proecion of proprieary righs, ec. Thus, for example, in Ukraine 48 per cen of capial asses is in he ownership of he governmen or erriorial communiies, anoher 10-11% is in mixed privae and public ownership. The Governmen has an opporuniy o back is firms by subsidizing hem and hereby exending heir inefficien business and prevening more efficien new firms from enry ino he marke. This significanly disors marke rivalry and herefore affecs he produciviy of oupu facors and invesmen decisions a macro level. I is bu naural ha under he above condiions he effecs of moneary policy will be characerized by higher uncerainy and irregulariy in impac on he real secor of economy han under normal marke condiions. Similarly, in he conex of srucural reforms, we can consider proecion of proprieary righs. Inadequae proecion of proprieary righs significanly narrows he ime horizons of planning due o high uncerainy in he resuls of is aciviy and lowers he opporuniies of financial sysem o cope wih is key funcions. Decisions made by economic agens in choosing of heir line of aciviy and ime horizons of planning generally deermine invesmen aciviies, GDP dynamics, performance and effeciveness of financial sysem. Lines of moneary ransmission opimizaion Acions ha would have favored he effeciveness of moneary ransmission (in he conex of srucural reforms) coincide wih he objecives of economic policy of he governmen and o a large exen lie ouside he conrol of cenral bank. Among he srucural policy measures aimed o improvemen of he effeciveness of he economic sysem as a whole, we can mark ou he following: proecion of proprieary righs, suppor of fair compeiion environmen, reducion in he share of inefficien public secor, reducion in he share of conrolled prices and ariffs, ec. Once hese measures have been implemened, i would be possible o creae more ransparen condiions for economic agens and lower uncerainy level in he economy hereby allowing adoping long-erm invesmen decisions and reducing he share of shadow economy. Naional Bank of he Republic of Belarus A he same ime, reorienaion of he economy o domesic marke needs will make i possible o significanly reduce is vulnerabiliy o exernal economic shocks and lower he dominan role of he exchange rae ransmission channel.

287 287 Conclusion The process of moneary ransmission in ransiional economy is characerized by significan uncerainy semming from such facors as low level of financial marke developmen, fairly high degree of dollarizaion and openness of he economy, insabiliy of inflaion expecaions as well as oher insiuional and srucural facors ha end o reduce he effeciveness of economic sysem as a whole. Due o dynamic changes in ransiional economy parameers, he influence of moneary policy channels also changes, he same as heir weigh and imporance ha should be considered in conducing moneary policy. Hence moneary ransmission and facors affecing is effeciveness shall be consanly explored. As he ransiional economy evolves and he above-menioned srucural and insiuional reforms have been successfully implemened, he degree of uncerainy in he effec of moneary ransmission will reduce and is effeciveness increase. Acions ha would have favored he effeciveness of moneary ransmission for he mos par coincide wih economic policy objecives of he governmen and lie ou of conrol of he cenral bank. Cenral bank acions owards opimizaion of moneary ransmission mosly consis in sabilizaion of inflaion expecaions, and lessening uncerainy in he funcioning of exchange rae channel. These objecives may be achieved by esablishing a regime based on price sabiliy and increasing credibiliy o he policy of cenral bank. References Berg A., Borenszein E. "The Choice of Exchange Rae Regime and Moneary Targe in Highly Dollarized Economies", IMF Working Paper 00/29. BIS Policy Papers No.3 (1998): "The Transmission of Moneary Policyin Emerging Marke Economies", January. Eger В., MacDonald R. Moneary Transmission Mechanism in Transiion Economies: Surveying he Surveyable, MNB Working Papers 2006/5. Ganev, Georgy; Kriszina Molnar, Krzyszof Rybinski and Przemyslav Wozniak (2002): "Transmission Mechanism of Moneary Policy in Cenral and Easern Europe", CASE Repor Case No. 52. Pionkovsky, Ruslan (2003): "Dollarisaion, Inflaion Volailiy and Underdeveloped Financial Markes in Transiion Economies", Economics Educaion and Research Consorium, Working paper 03/02. Smidkova, Kaerina (2001): "The Transmission Mechanism of Moneary Policy a he Beginning of he Third Millenium", WUSTL Working Paper Conference May 19-20, 2008, Minsk

288 288 Anaoly Belzesky 1 Shaping and Funcioning of he Corporae Bonds Marke in Condiions of Transiion Economy The corporae bonds marke is a ool o finance he real secor of economy. Now here are no uniform recipes which would promoe promp developmen of he effecive corporae bonds marke in ransiion economy. However, sufficien number of empirical facs conneced wih shaping and developmen of he naional corporae bonds markes in counries of Europe, Asia and Lain America have been colleced. Based on heoreical generalizaion of empirical facs and aking ino accoun he need o respec economic ineress of key players of he marke he presen paper formulaes he law of conservaion of economic gain on he primary corporae bonds marke. The paper suggess a model of funcioning of he corporae bonds marke and analyses he major facors influencing on is formaion in condiions of ransiion economy. Recommendaions on formaion and developmen of he marke of corporae bonds in he Republic of Belarus are developed. Developed naional corporae bonds marke promoes increase in sabiliy of financial sysem of he counry, reduces he counry s dependence on exernal sources of financing and on flucuaions of he inernaional capial flows, reduces dependence of enerprises and he whole economy on bank crises. Las decades in he world saw he endency of growh of imporance of securiies markes in general and he corporae bonds marke in paricular. This endency has exended o he Wesern Europe, Japan, he Souheas Asia counries and Lain America. In condiions of growing global imporance of he corporae bonds markes hey are acively shaped in counries wih ransiion economy, including he Republic of Belarus. Successful shaping of he corporae bonds marke in condiions of ransiion economy requires sudying endencies and laws of is developmen, analyzing facors ha promoe and inerfere wih is formaion. Marke Developmen Facors Organizaions like he Inernaional Moneary Fund IMF (Corporae Finance, 2005), he Inernaional Organizaion of Securiies Commissions IOSCO (The Developmen of Corporae Bond Marke, 2002) and he Bank for Inernaional Selemens BIS (The Developmen of Bond Markes, 2002) have conduced he mos comprehensive research of he fundamenal facors deermining he corporae bonds markes developmen dynamics in he developed and developing counries. These researches resuled in findings ha a counry wih well funcioning corporae bonds marke shall have: 1) a reliable regulaory srucure; 2) a developed marke infrasrucure; 3) an adequae corporae managemen and he sandard reporing sandards; 4) a well funcioning sae bonds marke; 5) a developed credi culure; 6) a well-regulaed bank sysem; 7) wide invesors basis; 8) well funcioning derivaive ools marke. Numerous examples show ha a subse of hese condiions probably, 1 5 is required o shape he corporae bonds marke. Naional Bank of he Republic of Belarus Despie of wide use of he facorial approach o drafing sraegy of he corporae bonds markes developmen in differen counries i seems ha many researchers exaggerae is imporance oo much, which frequenly does no give a desirable resul. The realiy is such ha in many cases he corporae bonds markes in condiions of ransiion economy develop under own scrips no always fiing ino he facorial approach sraegy. I is explained by an alernaive characer of ransiion 1 Open Join Sock Company BelMezhComInves. Direcor, Ph.D. of Techical Sciences.

289 289 economy developmen, which follows from is mos naure where elemens of old and new condiions are mixed, as well as from variey of he facors influencing developmen during his period. We shall consider some examples. Disincive feaure of he corporae bonds marke in Russia is ha is shaping has sared during he second half of 1999 when he sae bonds marke did no funcion and here was no reference ineres raes srucure. I is explained by he 1998 defaul, resuling in undermining rus o he sae bonds. There were no srong insiuional invesors and he credi culure in he counry (a he same ime i is necessary o noe ha in many developing counries he corporae bonds markes are shaped a absence or weak developmen of insiuional invesors, i.e. a absence of he major facor of demand for corporae bonds). The Russian corporae bonds marke is one of he few developing naional markes, which has been significanly influenced by foreign invesors hough radiionally i is considered ha foreign invesors, as a rule, do no show ineres in he naional corporae bonds marke, especially a iniial sages of is formaion. Finally, banking sysem played an essenial role in shaping he Russian corporae bonds marke hough i is considered ha banks are no key invesors in corporae bonds. Invesmens of he Billion Rubles Figure 1: Dynamics of invesmens ino corporae bonds, made by Russian banks (by end of he year) Russian commercial banks in corporae bonds show exponenial growh (See Fig. 1). Presence of banks a he Russian corporae bonds marke is explained by excess liquidiy ha oil prices jump caused in 2000 and significan corporae secor financing needs. For he period from 2000 o 2004 he Russian corporae bonds marke has grown from 1 o 2.8% of gross naional produc. These facs evidence ha Russia follows is own way o he developed corporae bonds marke, which does no fi o he concep of developmen based on he fundamenal facors. Le s consider anoher example. Tradiionally i is considered ha cerain macroeconomic sabiliy should be achieved in he counry for shaping he corporae bonds marke, i.e. budge defici should be under conrol wih low inflaion. Daa on 35 counries (BIS, 1999; IMF, 1997) esify o negaive correlaion beween developmen of he bond markes (marke volume in percenage o gross naional produc) and raes of inflaion, however absolue value of he correlaion facor equal o -0,45, is far from being high and does no allow o refer o seady negaive inerrelaion beween hese facors. A he same ime, experience of cerain counries, in paricular, Brazil, Iceland, Israel, indicaes ha he corporae bonds marke can be developed even in condiions of very high economic insabiliy. In his case various forms of bonded debs can be used, in paricular, bonds wih variable ineres rae, inflaion or currencyindexed bonds and he bonds nominaed in foreign currency. The considered examples prove ha each counry follows is own way o developed corporae bonds marke. Probably, fundamenal facors deermining developmen of markes represen arge reference poins for hese counries, however, changes and rajecory of ransiion o he developed corporae bonds marke for each of hese counries differ and are deermined by iniial counry condi- Conference May 19-20, 2008, Minsk

290 290 ions, naional specific feaures and exernal economic facors. Besides, he facorial approach is oo he general and no always answers curren quesions of he ransiion period, for example, wha facors are deermining and wha problems need o be solved firs of all. There is also a problem of compleeness of fundamenal facors and is heoreical decision is no found ye. In his respec generalizaion of empirical facs and disclosure of laws of funcioning of corporae bonds marke in condiions of ransiion economy represens is an imporan problem. Marke Funcioning Formalized Model The corporae bonds marke (hereinafer he primary corporae bonds marke is mean), as well as any oher marke, has a complex srucure. Basic elemens of his srucure are paricipans of he marke (subjecs), corporae bonds (objec), he informaion and legal environmen and marke funcioning organizaional and economic mechanism. Paricipans of corporae bonds marke are naural and legal persons enering cerain economic relaions on he occasion of issue, placemen, circulaion and reiremen of bonds, and also serving heir circulaion and seling accouns on hem. The following paricipans of securiies marke are disinguished: issuers; invesors; professional inermediaries and he sae (See Fig. 2). Key funcion of he corporae bonds marke is mobilizaion and redisribuion of emporarily free moneary resources o develop real secor of economy. The corporae bonds marke carries ou is funcions only when is paricipans receive economic gains from he paricipaion herea. Paricipans of he marke pursue heir economic ineress and economic relaions are manifesed hrough hese ineress, forming moive force, prioriies and reference poins, highways and mechanisms of marke funcioning. Thus, he main condiion of funcioning of he corporae bonds marke is in combinaion of economic ineress of is paricipans which forms necessary insiuional precondiion of growh of is efficiency. Fundamenal facors significanly influence economic ineress of key marke paricipans, changing heir economic behavior in he scales leading o radical changes in he marke as a sysem. Tools necessary o coordinae economic ineress of paricipans of corporae bonds marke are locaed in sphere of acive use of socially focused marke relaions in combinaion wih sae regulaion and self-regulaion. Economic relaions beween paricipans of corporae bonds marke deermine is developmen owing o wha precondiions of building a model of is funcioning are creaed. Such model should be buil from he poin of view marke performing is basic funcions and analysis of behavior of is basic paricipans, ensuring performance of hese funcions, pursuing heir economic ineress and being influenced by fundamenal facors. The model as well, should consider combinaion and exen of coordinaion of economic ineress of paricipans of he marke. Economic Ineress of Key Paricipans of he Marke The major condiion of funcioning of corporae bonds marke is respec of economic ineress of all is key paricipans - issuers, invesors, inermediaries and he sae - professional paricipans of marke of securiies. Naional Bank of he Republic of Belarus Economic ineress of bonds issuer is in his aspiraion o receive a long erm loan possibly wih lower ineres rae. For he issuer aracing invesmens by issuing corporae bonds has he following advanages: provides publiciy o he company; forms is credi hisory; promoes depreciaion

291 291 of deb servicing and increases loan volumes wih subsequen references o he financial marke; improves image of he company for an invesor. Figure 2: Corporae bond marke funcioning model formalizing diagram FACTORS OF DEVELOPMENT OF CORPORATE BONDS MARKET Adequae corporae managemen Macroeconomic environmen Liquid moneary marke Sae securiies marke Supply Demand Marke infrasrucure Regulaory sysem PARTICIPANTS OF CORPORATE BONDS MARKET Issuers Invesors Inermediaries Sae ECONOMIC INTERESTS OF PARTICIPANTS OF CORPORATE BONDS MARKET Low cos of bond loan High yield, low risk, liquidiy Commission fee, fee for service Financing of real secor of economy, axes Combinaion of ineress of marke paricipans CORPORATE BOND MARKET FUNCTION- ING MODEL Bond is quie rigid promissory noe: issuing bonds, he issuer bears cerain risks and here is always a probabiliy ha he bonded deb will no be successful, ha is he fac of bonds issue ye does no guaranee heir placemen on condiions developed by he issuer. Therefore he issuer aspires o receive a loan under lower ineres rae and o compensae risks relaed o placemen of bonds. The invesor is ineresed in invesing under probably higher ineres wih he minimal risk. From he invesor s poin of view appeal of corporae bonds is explained ha hey allow he invesor o form and operaively manage bonds porfolio, diversifying invesmen risks; o resore curren liquidiy, carrying ou REPO operaions and sale ransacions wih bonds buy back obligaion; o paricipae in financing borrowers irrespecive of he size of invesor s own capial. Bonds are aracive o he invesor wih he righ of premaure reiremen, high level collaeral and liquid secondary marke. Economic ineress of he sae on corporae bonds marke are in, on he one hand, maximizing ax revenues during issue, circulaion and reiremen of corporae bonds, and from anoher hand, in Conference May 19-20, 2008, Minsk

292 292 providing an opporuniy for normal invesmen process in real secor of economy ha will promoe o increase in ax revenues as well. Professional paricipans of securiies marke render services during issue, placemen, circulaion and reiremen of bonds and are ineresed in corporae bonds marke developmen and also in receiving of incomes of heir aciviy. Measuremen of Economic Gain of Paricipans of he Marke To measure economic gain of key paricipans of he corporae bonds marke we shall ake advanage of concep yield. Yield of invesor Y Inv is a rae of corporae bond ineres yield, which he invesor shall receive as a resul of possessing his bond. Yield of issuer Y Is represens profiabiliy in he form of risk premium, which he issuer should receive, placing issue of corporae bonds raher han aracing a bank credi. Yield of axaion Y T is a par of corporae bond yield, which he sae will wihdraw in he form of ax on he yield income. Here he yield income is undersood as any ineres declared (esablished) in advance on he corporae bond, including in he form of discoun or coupon paymens. The concep yield of axaion is inroduced in order o compare ineress of he sae and oher paricipans of he marke on a uniform basis as comparing yield income ax rae wih yield of, for example, he issuer or he invesor is incorrec. Inermediaries yield Y In corresponds o a par of corporae bond yield ha he issuer spends for issuing, placing, circulaion and reiremen of bonds in he form of paymen of commissions o professional inermediaries. The inroduced noions abou he yield, measuring economic gain of key paricipans of he marke have inerrelaions, which can be presened in he form of ineres raes srucure. Ineres Raes Srucure The long-erm analysis of ineres raes in he developed and developing markes of promissory noes has shown ha corporae bonds in hese markes occupy he niche, and heir yield is wihin he limis of, he alernaive ools limied by profiabiliy (See Fig. 3). Figure 3: Srucure of ineres raes on he primary corporae bonds marke Y S Y SSec Y R Y T Y In Y Iss Y Inv Y CB Y L I BC Naional Bank of he Republic of Belarus Y S yield spread; Y SSec sae securiies yield; Y R premium risk; Y T yield corresponding o income ax; Y In inermediaries yield; Y Iss yield of issuer; Y Inv invesor yield (he bond hold-

293 293 er); Y CB corporae bonds marke yield; Y L credi ineres rae. bonded deb cos reduced o bond yield; I BC bank The lower bound of corporae bonds yield is limied o sae securiies yield Y SSec, which by heir emporary srucure (erms of paymen of ineres and erm of circulaion) are he closes o he emporary srucure of paymens of he bonded deb. For he invesor yield of corporae bonds should be above yield of he sae securiies by he size of risk premium Y R o make sure ha he/she finds i favorable o buy corporae raher han he sae bonds. The upper bound of corporae bonds yield is deermined by he bank credi ineres rae I BC. In he course of placemen of bonds he issuer incurs risk non-placemen of bonds on he offered condiions, measured by yield Y Inv. For he issuer he cos of bonded deb Y L should be more aracive in comparison wih he bank credi ineres rae o make sure ha he/she finds i favorable o place bonded deb raher han o ake bank credis. Paricipans of he marke find he corporae bond yield level accepable when he issuer, in order o ineres invesors, offers premium Y R o he sae securiies yield. A he same ime he borrows a lower raes compared wih available sources of bank crediing for value Y Iss. Therefore in he funcioning marke corporae bonds yield should be inside of hese bounds and his can be expressed by he following inequaliy: Y SSec Y Iss Y CB < Y L I BC. (1) The inequaliy (1) says ha in order o respec economic ineress of all paricipans of he corporae bonds marke yield Y CB canno be below sae securiies yield Y SSec, and cos of bonded deb Y L canno be above he bank credi ineres rae I BC. In addiion, he bonded deb cos Y L always will be above corporae bond yield Y CB as he bonded deb is conneced wih addiional charges on issue, placemen, circulaion and reiremen of corporae bonds. Finally, invesor yield Y Inv will be below he corporae bond yield by he value, relaed o ax paymens. In case he corporae bonds income ax is no levied by he sae, hen Y inv = Y CB. In inequaliy (1) economic ineress of all key paricipans of bond marke are aken ino accoun: invesor s (Y SSec Y inv ), inermediaries (Y CB < Y L ), issuer s (Y L I BC ) and he sae (Y Iss Y CB ). In case he corporae bonds yield will be ouside of he designaed bounds he marke will no funcion. If lower bound of inequaliy (1) is disruped ha is when Y SSec > Y Inv, he invesors will find i more favorable o buy more profiable, reliable and liquid sae securiies. If upper bound of inequaliy (1) is disruped ha is when Y L > I BC, hen he issuer will find more favorable o ake he bank credi raher han place he bonded deb. Thus, he bank credi is considered an alernaive o he bonded deb, and he sae securiies an alernaive o corporae bonds. Therefore corporae bonds yield is limied from above by he bank credi ineres rae, and from below by he sae securiies yield wih corresponding parameers and erms of circulaion. The inequaliy (1) is no sric as here may be an opion when he invesor finds i so imporan o diversify a porfolio ha he can refuse he risk premium, ha is he invesor will be happy wih his opion, when Y SSec = Y CB. On he oher hand, here is a chance when he issuer is ready o place bonds wih he cos of he bonded debloan equal o he bank credi ineres rae, ha is Y L = I BC. Such cases ake place quie ofen a he very firs placemen of bonds when he issuer eners on he corporae bonds marke for he firs ime in order o make a public credi hisory. Conference May 19-20, 2008, Minsk

294 294 Thus, for normal (from economic poin of view) funcioning of he corporae bonds marke i is necessary ha corporae bonds yield is more profiable han he sae securiies wih corresponding parameers and erms of circulaion by he value corresponding o he corporae bonds risk premium, and he bonded deb cos is less han bank credi ineres rae. Therefore ineress of he sae and he invesor shif corporae bonds yield o an increase whereas ineress of he issuer shif his yield o he opposie side and diminish i. The Law of Conservaion of Economic Gain I follows from he corporae bonds marke funcioning model ha he maximum probable bonds yield is equal o he bank credi ineres rae, whereas he minimum - o he sae securiies yield. A difference beween hese yields shall be referred o as corporae bonds yield spread Y S. Y S = I BC - Y SSec. (2) The corporae bonds yield spread is a measure of general economic gain from issuing corporae bonds, which he key paricipans of he marke should divide among hemselves: he issuer in he form of he placed bonds yield Y Iss discoun compared o he bank credi ineres; he invesor in he form of risk premium Y R compared o he sae securiies yield; he sae in he form of ax receips Y T ; inermediaries in he form of commission Y In. Therefore, i is fair o use he following equaion for corporae bonds yield spread (See Fig. 3): Subsiuing (2) in (3) shall resul in Y S = Y SSec + Y T + Y In + Y Iss. (3) I BC - Y SSec = Y R + Y T + Y In + Y Iss. (4) The equaion (4) shows ha in he funcioning corporae bonds marke here shall be a balance beween he general marke economic gain, measured by corporae bonds yield spread, on he one hand, and he sum of economic gains of he key paricipans of he marke, wih anoher. None of he corporae bonds marke paricipans including he sae, in he case mos favorable for i canno receive economic gain ha exceeds corporae bonds yield spread. An increase in economic gain of one of he marke paricipans can happen only when economic gain of oher marke paricipans is reduced. In addiion, a he funcioning corporae bonds marke he economic gain canno disappear a all, i.e. if any paricipan of he marke for whaever reasons receives less economic gain, his par of he half-received benefi goes o oher marke paricipans. As he corporae bonds marke occupies he niche in he marke of promissory noes, and corporae bonds yield should be wihin he limis of he alernaive ools limied by yield in he funcioning corporae bonds marke here mus be a balance of economic ineress when he oal economic gain of key paricipans of he marke equals o is general economic gain. Such balance of economic ineress can be referred o as he law of conservaion of economic gain as i represens a seady and naurally repeaing inerrelaion. Naional Bank of he Republic of Belarus In general, he law of conservaion of economic gain is formulaed as follows: a he funcioning primary corporae bonds marke general economic gain is deermined by he alernaive ools limiing marke niche of he primary corporae bonds marke and is always allocaed beween key paricipans of he marke (he issuers, he invesors, he inermediaries and he sae). The law of conservaion of economic gain says ha he oal economic gain does no appear a he funcioning corporae bonds marke from anywhere and from anyhing, and is deermined by he alernaive ools limiing is marke niche, and does no disap-

295 295 pear o anywhere, does no generae unused surpluses, and is always shared beween key paricipans of he marke. The equaion (4) is he mahemaical descripion of he law of conservaion of economic gain. The lef par of his equaion describes general economic gain of he funcioning corporae bonds marke, measured by yield spread and he righ par reflecs he oal economic gain of main paricipans of he marke. I is imporan o emphasize ha he law of conservaion of economic gain akes place only a he funcioning corporae bonds marke. If he law of conservaion of economic gain is no observed, he marke will no funcion. The las is possible in case when he overesimaed economic gain of one or several main paricipans of he marke exceeds he oal economic gain of he corporae bonds marke. The bes proof of violaion of he law of conservaion of economic gain is he exising siuaion a he sock marke in Belarus when he sae, having esablished unreasonably high ax rae on corporae bonds income, ries, by means of ax wihdrawals, o ake away all yield spread a he corporae bonds marke, leaving nohing o paricipans of he marke. Finally i has led o absence of he corporae bonds marke as in his case here is no economic gain for oher marke paricipans - issuers, invesors and inermediaries. Exempion from income ax on bank bonds, according o he Decree No 537, issued by he Presiden on Augus 28, 2006 made an impeus o shaping of he marke of hese bonds. Developing markes of Brazil, Chile and Mexico could give anoher example proving he law of conservaion of economic gain (See Tab. 1). In Brazil and Mexico corporae bonds income is no axed, whereas here are such axes in Chile. Comparing he srucure of coss of bonded debs in hese counries i is possible o noice ha wih absence of axaion of bond income oher iems of expendiures, firs of all, organizaional coss increase according o he law of conservaion of economic gain. I is especially clear on an example of comparing of organizaional coss for bonded debs in Brazil and Chile for small corporaions wih volumes of issue of bonds no exceeding US$ 17 M and 15 M respecively. For he same oal cos of he bonded deb equal o 4.6% of he nominal price, absence of income ax on corporae bonds in Brazil has led o increase in organizaional coss, fee relaed o assigning credi raing and marke expenses. For Brazil hese componens are equal 65%; 14.3% and 11.8% respecively and for Chile 45.6%; 4.3% and 2.6%. In oher words, ha par of spread of corporae bonds yield ha in Brazil he sae does no wihdraw in he form of axes passed o inermediaries responsible for organizing and servicing he bonded deb and for assigning credi raing. Table 1: Srucure of Coss of Corporae Bonded Debs (Zervos, 2004), % o he oal cos Volume of issue, US$ mln. Iem of expendiures Brazil Chile Mexico Organizaional coss Regisraion fees Fee for assigning credi raing Marke coss Taxes Toal cos, % o nominal price Therefore, he law of conservaion of economic gain in he corporae bonds marke esablishes inerrelaion beween key parameers of funcioning of he marke, which are yield of invesor, of axaion, of inermediaries, of issuer and exernal parameers yield of he sae securiies and iner- Conference May 19-20, 2008, Minsk

296 296 es rae on bank credis. However, implemenaion of he law of conservaion of economic gain ye is no a guaranee funcioning of he marke, as in he funcioning marke should be respec o boh balance of economic ineress of is key paricipans and economic ineress of each key paricipan of he marke separaely. Using he language of mahemaics, he law of conservaion of economic gain is a necessary raher ha sufficien condiion of funcioning of he corporae bonds marke. I is his fac ha leads o necessiy of sudying economic gain for each key paricipan of he corporae bonds marke separaely. The Risk Premium The risk premium is he main componen of economic gain of he invesor inended o buy corporae bonds. Compared o he sae securiies corporae bonds should be more aracive in erms of profiabiliy being a higher risk level ool. Therefore ne yield ha he bond holder should receive afer paying income ax, should differ from sae securiies yield by size of risk premium and he general yield ha he bond holder receives, shall be equal: Y Inv = Y SSec + Y R. (5) The risk premium size is deermined by issuer s solvency in relaion o specific issue of bonds, i.e. abiliy of he issuer o pay in ime he principal sum of deb and ineres on i and o execue oher obligaions arising from condiions of bond issue. The easies mehod of assessing risk premium is o deermine is size depending on respecive bond issue raing. Corporae bonds raing is a comprehensive assessmen of he issuer s abiliy o fulfill obligaions in relaion o a specific bond issue enirely and promply during he period of heir circulaion, aking ino accoun he forecas of possible economic environmen changes. Table 2: Naional Raing Scale (Бельзецкий, 2005) Raing Raing level Risk of full or parial defaul of issuer o fulfill obligaions Risk premium, % per annum Invesmen level ААА Very high Minimal 0.75 АА High Insignifican 1.00 А Upper medium Low 1.80 ВВВ Medium Relaively low 2.25 Speculaive level ВВ Saisfacory Moderae 3.50 В Below average Accepable in general 6.50 ССС Low wih poenial o increase Quie high СС Low High С Very low Excepionally high D Unsaisfacory Defaul refusal o fulfill obligaions Naional Bank of he Republic of Belarus The corporae bonds raing should be assessed using he naional raher han he inernaional raing scale (See Tab. 2). The main advanage of he naional raing scale is in greaer differeniaion and more exac correlaion beween risk levels of issuers of corporae bonds in a specific counry compared wih he inernaional raing scale. Unlike inernaional raing scales he naional scales reflec risks of companies-issuers in one counry. Wihin he framework of he naional raing scale many counry risk aspecs are no considered as i is assumed ha all counry risks equally influ-

297 297 ence naional issuers and hey all are in idenical condiions. As a resul, he seadies companies of he counry, as a rule, receive he highes possible raing on he naional scale. Oher companies receive naional scale raing how heir parameers relae wih parameers of he counry s seadies company. Thus, he naional raing is a curren conclusion on he issuer s abiliy o fulfill obligaions, in comparison wih similar parameers of oher issuers and heir obligaions in a specific counry. The knowledge of corporae bonds raing allows deermining he risk premium ha was based on saisical sampling of bonds wihin he range of a specific raing caegory ha were lised a he sock marke (See Fig. 4). Figure 4: Impac of corporae bond raing on risk premium Risk premium, % per annum Defaul probabiliy, % AAA AA A+ A A- BBB BB B+ B B- CCC Defaul. probabiliy Bond Raing Risk premium Taxaion Yield Taxaion yield is a par of corporae bond yield, conneced wih ax paymens. This definiion shows ha connecion beween axaion yield and he ax rae on corporae bond ineres income T is described by he following expression: Y T = T Y CB. (6) In pracice, a a sage of bonded deb developmen i is no always convenien o use he formula (6), as he corporae bond yield, as a rule, is unknown. To exclude an unknown value Y CB i is possible o use anoher formula, following from he ineres raes srucure (See Fig. 3): Y CB = Y SSec + Y R + Y T. (7) Subsiuion of (7) in (6) and resolving he received equaion in relaion o Y T resuls: Y T T = ( YSSec + YR ). 1 T (8) Conference May 19-20, 2008, Minsk

298 298 In he las expression he ineres income ax rae T should be expressed as decimal fracion. If he ax rae is expressed more naurally, in percenage, hen expression (8) will look as follows Y T ( Y + Y ) T SSec = 100% T R. (9) Example: To assess he corporae bond yield ha he issuer should offer he invesor a Y SSec = 10, Y R = 2% per annum and T = 40 %. Subsiuion of hese daa in (9) resuls: Y T ( ) 40 = = 8% per annum So ha o ineres he invesor, expecing o obain yield on a specific bond equal o = 12% per annum, he issuer should increase his yield by 8% per annum, i.e. according o (7) o offer he yield equal o: = 20% per annum. The considered example evidenly shows ha he ax rae is a key parameer, which influences disribuion of general economic gain beween he sae, on he one hand, and oher paricipans of he marke (he issuer, he invesor and he inermediaries), wih anoher. Bonded Debs Cos The bonded deb cos is deermined by corporae bonds yield and coss, relaed o organizaion and servicing of he loan Y In (See fig. 3) (Бельзецкий, 2005). Y L = Y CB + Y In. (10) Coss of organizaion and servicing of he loan are conneced wih services ha professional paricipans of securiies marke render o issuer of bonds. I is worh considering he conen and cos of hese services. Bond issue organizer services are of organizaional, consuling, informaion naure and include developmen of he bonded deb concep, financial engineering of bonds, preparing and submiing documens o he sae regisraion auhoriy, drafing of he invesmen memorandum. Financial adviser services include analysis of financial saus of issuer, preparing prospecus and cerificae of conformiy of informaion, disclosed by he issuer in he course of issuing bonds o requiremens of he legislaion. The paymen for services a primary placemen of corporae bonds depends on he way hey are placed: 1) aucion; 2) direc placemen by he issuer; 3) underwriing. In case corporae bonds are placed by carrying ou aucions a he Open Join Sock Company Belarusian Currency Sock Exchange i is necessary o noe ha he sock exchange charges quie insignifican fee from ransacion s paricipans, which is only 0.01% from value of corporae bonds ransacion (aking ino he VAT). Besides, he sock exchange does no charge for procedure of corporae bonds admission o lising a sock exchange, and also for corporae bonds primary placemen. Naional Bank of he Republic of Belarus In case bonds are placed direcly i is necessary o ake ino accoun ha according o he legislaion bonds are sold wih mediaion of professional paricipan of securiies marke, which charge, on average % of he volume of issue. On average, he ransacion regisraion fee is one base uni minimum salary.

299 299 In case bonds are placed by underwriing, he underwrier assumes liabiliy o place eiher all volume of issued bonds or is par. Advanage of such placemen is he opporuniy o place significan volumes of issue, whereas he disadvanage is in necessiy o pay commission, ranging from 0.5 o 1.0% of he volume of issue par value. The paymen for securing service depends on he form, used o execue bond obligaions: morgage, guaranee or bank guaranee. If securiies or real esae of he issuer are chosen o be he subjec of bond morgage he paymen for guaranee will be minimal or none. In case of guaranee or bank guaranee paymen size for guaranee will be he maximal. The bank guaranee paymen can reach 3 5% of he volume of issue. Paymen for deposiary services depends on he bonds issue form. Bonds can be issued in he documenary form o he bearer or regisered, in he form of records on accouns. In he firs case here would be charges conneced wih producing he cerificae of bonds, in he second insance here would be fees, paid o he auhorized deposiary. The commission charged by deposiaries is linked, as a rule, wih base uni. So, for sorage of issue of bonds he commission is approximaely one base uni; sorage of he regiser of bond holders ranges from wo o six base unis a monh; for regisraion of one ransacion one base uni; opening of he depo accoun o he clien (excep for opening in he uncondiional order) wo base unis. Services of he paying agen include paymen of ineress on bonds and he principal loan amoun a heir reiremen and oher selemens, conneced wih loan arrangemen. Besides, he paying agen duy includes informing bond holders and marke paricipans abou he erms and condiions of paymens, providing repors on paymens made o issuers and he persons auhorized o receive ineres paymens and he sums from reiremen of par value of bonds. Marke-making is a service o mainain he secondary corporae bonds marke, based on he conrac concluded beween marke-maker and he issuer. Such bonds liquidiy suppor promoes increase of invesmen appeal of bonds and improves heir assessmen as objec of invesmen. As marke-making is conneced wih risks he marke-maker assumes in case of adverse marke condiions, he markemaker demands compensaion for i. Is size may reach % of he issue volume par value. Oher coss include publicaions in press, noary official regisraion of papers, loan presenaion and promoion campaign. Here i is possible o include a 30 base uni fee raised by he Minisry of Finance Securiies Deparmen. Miscellaneous coss, on average, amoun o % of he issue volume par value. Table 3: Average Service Fee for Issue, Placemen, Circulaion and Reiremen in he Shaped Corporae Bonds Marke No Descripion of he service Fee, % o issue par value volume 1. Issue Organizer Financial Adviser Primary Placemen (underwriing) Securing (guaranee) Deposiary Paying Agen Marke-Making Oher (miscellaneous) Coss Conference May 19-20, 2008, Minsk

300 300 Average commission for he same services rendered in he Russian and Ukrainian corporae bonds markes are provided in Table 3. Generally he bonded deb cos is deermined by degree of he corporae bonds marke developmen and spread of inermediaries Y In can be roughly presened by following values: emerging marke 3 5; developing marke 1 3; developed marke 0.5 1% of he issue volume par value. Marke Funcioning Scenarios Scenarios of he corporae bonds marke funcioning are based on he law of conservaion of economic gain a a level of ineres raes exising in Belarus by lae 2007 (Y SSec = 10; Y BC = 13 17% per annum). Marke funcioning scenarios were based on probable corporae bonds yield spread ineger values (Tab. 4). Thus for each scenario he prese value yield spread was disribued beween he basic paricipans of he marke depending on posiion wih which hey occupy in he marke and degrees hey influence on is funcioning. Firs of all (a Y S = 3% per annum) yield spread was disribued beween invesors and inermediaries, secondly (a Y S = 4% per annum) beween invesors, inermediaries and issuers and hirdly (a Y S > 4% per annum) beween all key paricipans of he marke. Table 4: Corporae Bonds Marke Key Characerisics for Differen Scenario, % per annum Yield spread Economic gain indicaors Yield indicaors Y R Y In Y Iss Y T T, % Y Inv Y CB Y L For all scenarios he risk premium Y R was se a 2% per annum. Such premium provides economic gain when invesors buy bonds ha can have any invesmen raing level (ВВВ and higher, see Tab. 2). The remained par of yield spread (Y S - Y R ) was disribued evenly beween oher marke paricipans, however, a a level, no smaller han heir accepable economic gain ha amouned o 1% per annum. I is necessary o emphasize ha he acceped yield spread disribuion beween paricipans of he marke is no absoluely exac. Such disribuion does no consider marke mechanisms of disribuion of economic gain beween key paricipans of he marke and was used o simplify scenarios analysis. Thus absolue values of economic gain parameers (Y R, Y In, Y Iss, Y T ) were acceped no smaller han heir maximum accepable values corresponding o economic ineress of key paricipans of he marke and ensure is normal funcioning. For example, for Y S = 5% per annum were acceped following values of parameers of an economic gain: Y Р = 2.0; Y In = 1.0; Y Iss = 1.0; Y T = 1.0% per annum (Tab. 4). Based on hese parameers in formulas (5), (7) and (10) yield parameers Y Inv, Y CB and Y L, which values are refleced in he las hree columns (Tab. 4) were deermined accordingly. The sixh column shows ax rae calculaed on he basis of axaion yield: Naional Bank of he Republic of Belarus T = Y SSec YT + Y R + Y T 100%. (11)

301 301 For scenarios of marke funcioning wih narrow yield spread here is no axaion on corporae bonds ineres income (Fig. 5). I is explained by he fac ha all corporae bonds yield spread is disribued beween key paricipans of he marke, which ensure is funcioning. For hose cases when yield spread is equal o five and more percen per annum, an opporuniy arises o wihdraw a par of yield spread in he form of axing of corporae bonds incomes, causing no disrupion o normal funcioning of he marke. And, accordingly, he more yield spread, he higher ax rae may be. Thus, he ax rae is a he level of 10%. The ax rae is no deermined absoluely precisely because cerain arbirariness ook place in he course of disribuion corporae bonds yield spread beween key paricipans of he marke, including he sae. This arbirariness was jusified while analyzing main scenarios of funcioning of he marke, bu o define ax rae on corporae bonds ineres income more precisely sricer approaches are necessary. 8 Figure 5: Srucure of ineres raes on corporae bonds primary marke depending on yield spread Y S 7 6 Yield, per annum, in % Yield of axaion YT Risk premium for issuer YIss; Yield of inermediaries YIn; Premium for risk of invesor YR; Yield spread, % per annum The Opimum Tax on Corporae Bonds Opimum means such corporae bonds axaion when he sae receives maximal economic gain in he funcioning marke (Бельзецкий,2004). In oher words, wih opimum axaion of bonds he sae wihdraws maximum of wha i can hough axes, however, here is sill accepable level of benefi for oher paricipans of he marke and he laer coninues o funcion. To deermine he opimum corporae bonds ineres income ax rae i is worh using he law of conservaion of economic gain in he corporae bonds marke. Thus, i is expedien o assume ha disribuion of economic gain beween non-sae paricipans of he corporae bonds marke does no influence he opimum ax rae. Such assumpion allows o absrac from marke mechanisms of disribuion of he oal economic gain beween non-sae marke paricipans and o reduce number of independen parameers of funcioning of he marke down o wo. I resuls, on he one hand, in consideraion of economic gain of he sae, and on he oher hand of he oal economic gain of oher paricipans of he marke: Conference May 19-20, 2008, Minsk

302 302 Yield spread Taxaion yield Figure 6: Impac of corporae bond income ax rae on oal yield on non-sae paricipans of he marke Where Y is he oal yield of non-sae paricipans of he marke Y = Y R + Y In + Y Iss, (12) Subsiuing (8) and (12) in (4), afer simple mahemaical ransformaions we shall receive YS T Y BC (13) Y =. 2 1 T 3 In he course of making conclusion (13) i was assumed ha he economic gain of non-sae paricipans of he marke is disribued evenly, i.e. Y R = Y In = Y S = Y Σ/L. The laer follows from a previous assumpion ha disribuion of economic gain beween non-sae paricipans of he corporae bonds marke does no influence he opimum ax rae. Fig. 6 shows he inerrelaion beween economic gain of he sae and he oal economic gain of non-sae paricipans of bond marke. Non-sae paricipans of he marke will receive he maximal benefi, when he ax rae on corporae bond ineres income is zero. In his case all corporae bonds yield spread is disribued beween he invesor, he emier and inermediaries. Wih increase in he ax rae he oal gain of invesors, issuers and inermediaries goes down and he sae gain increases. And, a las, wih ax rae equal o is limiing value, he sae ges all gain from corporae bonds placemen (Y T =Y S ), whereas he issuer, he invesor and he inermediaries have no gain from placemen of bonds (Y Iss= Y In= Y Inv= 0). Naional Bank of he Republic of Belarus The described inerrelaion allows solving a problem of finding he opimum corporae bonds income ax rae T T when oal yield [Y Σ ] of non-sae paricipans of he marke a which is funcioning is possible is known. Transforming he equaion (13) concerning he ax rae and subsiuing [Y Σ ] wih Y Σ we shall receive

303 T T YS = 2 YBC 3 [ Y ] [ ]. Д (14) 303 For earlier analyzed daa and acceping [Y Σ ] = 3%, we shall receive T T 6 3 = = 21.4%. 16 (2 /3) 3 (15) Thus, for Y BC = 16 %, Y S = 6% per annum and [Y Σ ] = 3% per annum he opimum corporae bonds income ax rae will be a a level of 20%. Conclusion Shaping he corporae bonds marke in condiions of ransiion economy is a naural resul of developmen of financial sysem of he counry. By virue of his, here are grounds o assume ha he corporae bonds marke in Belarus has good prospecs for developmen, and is value as a source of financing mid- and long-erm invesmen projecs will increase. In he counry here are favorable precondiions, as never before, which consis in he following: Increase in demand of enerprises for invesmens, caused by improvemen of financial resuls of heir aciviy; Significan invesmen poenial of he populaion, which prefers keeping heir saving in hard currency or on deposis in banks; Sabilizaion of exchange rae; Decrease and sabilizaion of ineres raes in he deb marke; Moderae loan policy of he Minisry of Finance in he inernal financial marke; The effecive infrasrucure of he sock marke is creaed consising of he Belarusian Sock Exchange; wo-level deposiary sysem; professional paricipans of securiies marke; sae regulaing and managing bodies. The law of conservaion of economic gain is he heoreical basis of shaping and developing he corporae bonds marke. Key parameers deermining funcioning of he corporae bonds marke are he sae securiies yield, he bank credis ineres rae, he corporae bonds risk premium, he corporae bonds ineres income ax rae, he yield describing coss of organizing and servicing of he bonded deb and he issuer risk premium. The lised parameers should become he basis for acions o ensure funcioning of he corporae bonds marke. A he iniial sage of he corporae bonds marke shaping i is necessary o exemp bonds ineres income from axaion and hen, in he process of shaping and developmen of he marke depending on he ineres raes ha exis in he deb marke, he ax rae may be esablished a a level of 10 20%. Developing and perfecing he sae bonds secondary marke, he main supplier of ineres raes reference srucure is imporan. Yield of he sae securiies should be esablished on he basis of demand-supply raher han by is rigid pegging o he refinancing rae. Besides, i is necessary o creae equal condiions of funcioning for he sae and corporae bonds markes. The axaion of income on he sae securiies posiively influences srenghening and developmen of he corporae bonds marke (Бельзецкий, 2005). Conference May 19-20, 2008, Minsk

304 304 I is necessary o minimize adminisraive influence on seing bank credis ineres raes as heir underesimaed value narrows corporae bonds yield spread, reduces he general economic gain in he corporae bonds marke and deers is developmen. To reduce coss of organizing he bonded deb i is necessary o include he corporae bonds ineres and oher coss conneced wih issue, placemen and circulaion of corporae bonds ino he srucure of coss excluded from axable profi ino he documens regulaing axaion. To reduce risk componen of corporae bonds i is recommended o inroduce he following changes ino he curren legislaion (Бельзецкий, 2008, 2004): 1) o provide an opporuniy of issuing bonds wih variable erm of reiremen; 2) o allow issuing bonds wih he righ of premaure sale by heir owners o issuer (bonds wih he irrevocable offer); 3) ex face o provide an opporuniy of adjusmen of he bond par value; 4) o inroduce and deermine concep bond defaul ; 5) o include in he decision on issue (he prospecus of issue) bonds he descripion of guaranees of securing and for revocable bonds - he descripion of he rules of premaure reiremen. Besides, creaion of naional raing agency and assignmen of raings o corporae bonds is an imporan direcion of reducing risks in he corporae bonds marke. Thus, he problem of shaping and developmen of he corporae bonds marke in condiions of ransiion economy is raher many-faceed and ouches upon economic ineress of all key paricipans of he marke. To ensure ha he corporae bonds marke jusifies he hopes, based on he law of conservaion of economic gain i is necessary o implemen complex measures aimed a perfecion of he curren legislaion, shaping he mechanism of he organized corporae bonds marke, he organizaions of aciviies wih issuers and oher paricipans of he corporae bonds marke. References Corporae Finance in Emerging Marke // Global Financial Sabiliy Repor: Marke Developmens and Issues. Inernaional Moneary Fund. 2005, April. P The Developmen of Corporae Bond Marke in Emerging Marke Counries. Inernaional Organizaion of Securiies Commissions May. P The Developmen of Bond Markes in Emerging Economies. Basel: Bank for Inernaional Selemens, BIS Papers No. 11, 2002, June. P Zervos S. The Transacions Coss of Primary Marke Issuance: he Case of Brazil, Chile, and Mexico. Washingon: World Bank, Working Paper No P. 19. Бельзецкий А. Рейтинги корпоративных облигаций // Банковский вестник С Бельзецкий А. Стоимость корпоративных облигационных заимствований // Банковский вестник С Бельзецкий А., Котова В. Оптимальное налогообложение корпоративных облигаций // Белорусский фондовый рынок С Бельзецкий А. Налогообложение корпоративных игосударственных облигаций // Банковский вестник С Бельзецкий А. Риски корпоративных облигаций // Банковский вестник С Бельзецкий А. Рынок корпоративных облигаций: от существующего к возникающему // Фондовый вестник С Naional Bank of he Republic of Belarus

305 305 Dmiry Kruk 1 Opimal Insrumens of Moneary Policy Under he Regime of Inflaion Targeing In Belarus The choice of moneary policy insrumens under inflaion argeing as a rule bases on he moneary ransmission mechanism channels. In his paper we esimae a number of ransmission channels in Belarus and hus sress he challenges for shifing o he inflaion argeing regime in Belarus. Assessmen of he exising channels of moneary ransmission shows a subsanial role of he exchange rae channel for Belarus. In his conex we sress he following obsacles for adopion inflaion argeing in Belarus: dollarizaion, openness of he economy and ransiion conex. We analyze he experience of swiching o he new regime by oher ransiional and emerging counries, which shows ha evoluionary approach hrough he forms of inflaion argeing lie may be reasonable in Belarus. Taking all hese in mind we sugges our vision of IT regime parameers for Belarus. Furhermore in his paper we deal wih he impac of new moneary policy regime for he long-erm agenda. In his paper we propose a number of heoreical argumens in favour of his vision. We show ha besides providing low and sable inflaion successful inflaion argeing regime migh favourably influence he financial sysem, which in urn spurs economic growh. We propose a mehodology of esing his hypohesis, which is he goal for he furher research. 1. Inroducion During he las decade an increasing amoun of counries acceped inflaion argeing (IT) as he regime of heir moneary policy. In recen years he endency ouched a number of ransiion and emerging counries, including Belarus, which announced possible shif o he IT regime closer o Inflaion argeing regime of moneary policy is based on he unique heoreical concep ha deermines is advanages. Bu in pracice he IT regime can be inerpreed in differen manner and he moneary policy sraegy under he IT can differ among counries (e.g. see Daianu, Lungu (2005) and Mishkin, Schmid-Hebbel (2001)). The core in his regime is he balance beween commimen and discreion in a cenral bank s policy, basing on which classificaions of moneary policy regimes are made (Sone, Bhundia (2004)). Because of he number of specific obsacles a counry faces wih, a subsanial amoun of he ransiion and emerging counries acually end o so called IT Lie (Sone (2002)). Deviaions from he heoreical concep of he IT may limi possibiliies of exploiing is heoreical advanages. Bu neverheless i migh be he opimal pracical choice due o counry specific economic condiion ha supposes acceping big risks due o srong commimen under he IT. The analysis of he expediency of he IT regime for he individual counry should sar wih possible challenges o he heoreical concep of IT. In some cases hese specific feaures may deermine ineffeciveness of he IT, hus making quesionable an overall expediency of implemening o his regime. For insance a range of peculiariies is sressed for he IT regime in small open economy (e.g. see Gali, Manacelli (2002) and Svensson (1998)), in dollarized economies (e.g. see (Leiderman e al (2006)), in ransiion agenda (e.g. see Jonas, Mishkin (2003)). All hese feaures are peculiar o Belarus and one canno sae per se ha he classic IT regime is he bes choice for Belarus. Hence poenial challenges for he Belarusian IT should be horoughly analyzed. This analysis should also emphasize he srucure of he moneary ransmission mechanism in an individual counry, which is crucial for he moneary policy under he IT regime. 1 IPM Research Cener Conference May 19-20, 2008, Minsk

306 306 IT concep requires a range of rules o be followed a he operaional level as well. So he second sep of he analysis for Belarus is he one ha considers he srucure of moneary policy insrumens. Verifying eiher exising pracice of using moneary policy insrumens coincides wih IT concep is vial, while wrong moneary policy mix may undermine he success of IT. Furhermore we suppose ha while IT heoreical concep supposes creaing precondiions for opimal long-erm growh, he long-erm agenda should be also reaed. In his conex possible channels of moneary policy impac on he long-erm growh are of ineres. In Kruk (2006) he relaionship of financial sysem and growh is considered. Moreover i is shown ha a range of specific issues in ransiion counries may lead o very weak impac of finance on growh, which migh be he case of Belarus. So here we deal wih impac of changing moneary policy regime of he financial sysem and is furher impac of long-erm growh. We sress he possible channels of hese relaionships and hus make background for furher empirical research. The paper is srucured as follows. In Par 2 we deal wih challenges for he Belarusian IT regime. In Par 3 we assess he channels of moneary ransmission ha are of ineres in he conex of IT. In Par 4 operaional level of he Belarusian moneary policy is analyzed. In Par 5 we consider linkages beween shifing o IT regime and possible change in he relaionship beween finance and growh. Furher conclusions and direcions of furher research are provided. 2. Challenges for Implemenaion of Inflaion Targeing in Belarus 2.1. Dollarizaion and Inflaion Targeing The firs poenial hrea o he IT regime in Belarus o be menioned is he high level of dollarizaion peculiar o Belarusian economy. One can argue ha IT regime is generally no appropriae for he dollarized economy. Firs, he difference in moneary ransmission mechanism should be aken in mind. IT regime by definiion supposes an informaion inclusive sraegy in which many variables, no jus moneary aggregaes or exchange raes are used for deciding he seing policy insrumens 1. On pracice i means ha cenral bank as a rule uses ineres rae as a dominan insrumen of moneary policy, while oher moneary indicaors (including exchange rae) are mainained as indicaive ones, which may be shock absorbers. A he same ime pass-hrough effec from he exchange rae o prices is much higher in dollarized economies raher han in nondollarized ones. Thus i migh be argued ha he classic design of IT does no work properly in condiion of high dollarizaion, leading o high vulnerabiliy of inflaion rend. Second, he balance shee effec should be aken in mind in regard o dollarized economies 2. I assumes ha while subsanial par of banks and firms liabiliies are nominaed in foreign currency and asses are nominaed in naional currency allowing exchange rae o be he shock absorber may lead o significan negaive oucomes. For insance, subsanial depreciaion of he exchange rae may cause he banks run because of currency mismaching. Moreover i may lead o subsanial decline in money demand ha may cause reflaion nowihsanding he policy insrumens used for meeing he arge rend. These oucomes are oally opposie o he expeced resuls of depreciaion in non-dollarized economy. However, IT under he condiion of dollarizaion has chances o be successful. For insance, Leiderman e al (2006) argue ha despie differen pass-hrough effecs in dollarized economy, implemening IT regime informs posiive signals o he economic agens. More ransparen and predicable moneary policy provides lower inflaionary expecaions and faciliaes o inflaion Naional Bank of he Republic of Belarus 1 Mishkin (2000). 2 Leiderman e al (2006)

307 307 decline. Moreover hey argue ha IT regime iself causes he reducion of dollarizaion hus converging he MTM o he benchmark one and miigaing possible negaive balance shee effecs. In Belarus in he level of dollarizaion 1 had subsanial decreasing rend and decreased from abou 65% in 2001 down o abou 35% in In early 2007 a small jump ook place and sill han he level of dollarizaion is flucuaing a he level of 32%. Bu neverheless he level of dollarizaion in Belarus is definiely very high according o inernaional norms. So boh he obsacles for IT implemening conneced wih dollarizaion is likely o be valid for Belarus. However despie hese obsacles we may argue ha implemening IT is possible in Belarus and jus hrough i an addiional incenive for decline of dollarizaion may be creaed. I should be emphasized ha a disinflaion and a real exchange rae appreciaion migh have been subsanial facors of dollarizaion decline in despie lack of saisical suppor of his fac 2. Thus aking in mind all he issues ha dollarizaion implies on he IT moneary policy regime we suppose ha high dollarizaion does no mean ha IT implemening is inexpedien in Belarus in overall, bu he exchange rae should no be reaed as he only absorber of shocks during IT a leas a he beginning of he shif owards he new regime. Therefore, he firs seps of he ransiion process o an IT regime should be done in such a manner ha sharp and large flucuaions of he exchange rae are limied as well. The concree framework of gradually allowing more flexibiliy may be a (widening) exchange rae band, a crawling band or a managed floa, depending on he facors menioned above Open Economy and Inflaion Targeing The second poenial hrea for he IT regime in Belarus is high exen of he economy dependence on he exernal secor (exernal rade is abou 113% from Belarusian GDP). Thus Belarus can be recognized as 100% small open economy. In his case exernal compeiiveness plays a severe role for he naional economy. From he poin of view of MTM i deermines a relaively high effeciveness of exchange rae channel and as well as in case of dollarizaion he pass-hrough from he exchange rae o prices is he dominan one in he economy. Hence raher ofen counries ha may be classified as small open economy exploi exchange rae argeing as a regime of moneary policy or a leas exchange rae (i.e. exernal compeiiveness) is considered as he secondary final arge. The classic design of IT regime for small open economy wih inflaion as he goal and exchange rae as shock absorber acually provides goals ambiguiy and may lead o unfavorable oucomes. In regard o Belarus he following scenario migh be a hrea. Rigid policy under he IT regime may cause an appreciaion of real exchange rae and correspondenly o decline of exernal compeiiveness. In longer-erm perspecive i may cause pressure on he exchange rae and furher depreciaion (in case if he exchange rae reaed as shock absorber). While he pass-hrough effec from exchange rae o prices is likely o be mos powerful, i may lead o subsanial deviaion from he arge inflaion rend. Moreover in Belarusian condiions here is a high probabiliy of growing rade defici due o energy rade. In his environmen allowed and non-resriced flucuaions of exchange rae are likely o affec he price level significanly. Moreover in las years jus due o exchange rae peg ha a he same ime ook in mind exernal compeiiveness 3, here has been a success in inflaion decline. 1 We calculae dollarisaion level as he share of deposis nominaed in foreign currency in he oal volume of all deposis. 2 See Horvah, Maino (2006). 3 Esimaion of he NBB reacion funcion by Horvah, Maino (2006) shows ha 1% innovaion of he real effecive exchange rae lead o inverse 0.73% change in nominal exchange rae. Conference May 19-20, 2008, Minsk

308 308 Thus, under he condiion of Belarus being a small open economy here is an idenical o dollarizaion facor requiremen, i.e. he goal wihin he IT regime and is pursuing should coincide wih prevening high vulnerabiliy of exchange rae Transiion Agenda and Inflaion Targeing The hird poenial hrea for IT in is he fac ha Belarus is he ransiion economy. Major concern in regard o ransiion economies is unsable relaionships among economic indicaors represening he behavior of economic agens. One can argue ha in ransiion economies reacion funcions of economic agens are sensiive o economic condiions and policies being carried ou. Through his he commonly recognized problem of idenifying hese relaionships is emphasized. I means ha as a rule quaniaive idenificaion of MTM channels in ransiion economies is problemaic 2. This problem is srenghened due o he lack of saisics available, low range of saisical samples and a las someimes non-reliable daa in ransiion counries. All hese problems are more or less valid for Belarus 3. A he same ime inflaion forecas is he core of inflaion argeing, in oher words inflaion argeing may be inerpreed as argeing he forecas of inflaion 4. So if he cenral bank is inefficien in forecasing inflaion, i.e. i canno provide consisen and reliable forecas for a medium-erm perspecive, i can hardly carry ou he IT regime. Firs, i will no have enough grounds for using his or ha moneary policy ools or managing his ool migh be conradicory o he declared arge. Hence i will mean ha a cenral bank is unable o fulfill he own forecas, i.e. o carry ou IT regime effecively. Second, impossibiliy and/or inabiliy of cenral bank o provide reliable forecas will undermine public rus, which is he severe facor of successful IT regime mainaining. Thus i may lead o changing behavior of economic agens nowihsanding wih hose considered by he cenral bank. I will lead o he necessiy of he escape from IT regime as well. Neverheless hese hreas are no rigid obsacles for implemening he IT regime, while he hesis of forming more sable and eviden behavior of economic agens under he IT may be argues in analogy wih dollarizaion case. Thus, he main requiremen o he sraegic issues of IT from his poin of view is ha he goal of moneary policy should be formulaed in a way o be obviously achieved during medium-erm perspecive. 3. Assessmen of Moneary Transmission Channels in Belarus 3.1. Exising Empirical Evidence of he MTM Channels in Belarus Alongside wih a range of problems for esimaing MTM channels in Belarus due o insable relaionships of economic agens behavior and someimes missing and/or low reliabiliy of he saisical daa here are few papers rying o idenify MTM in Belarus. In his subsecion we provide a brief analysis of exisiing findings. One of he firs papers devoed o his subjec was by Kallaur, Komkov and Chernookiy (2005). In his paper he approach of unresriced VARs is used for esing he MTM channels. They analyze impulse responses from he VARs ha include money aggregaes, he oupu gap and indusrial producion gap (derived hrough Hodrick-Presco filer) and overnigh inerbank and refinancing ineres raes. They argue ha he oupu gap and indusrial producion gap have a negaive re- 1 However i should be menioned here ha he conex of small open economy should analyzed in one row wih capial flows. I means ha in case of predicable capial inflows he focus of moneary auhoriies on he exernal compeiiveness may be weakened. Naional Bank of he Republic of Belarus 2 See Ganev e all (2003). 3 See Horvah, Maino (2006); Kruk (2005); Kallaur, Komkov, Chernookiy (2005). 4 See Svensson (1997).

309 309 sponse on boh he innovaion in he refinancing rae and inerbank rae. Furhermore, hey show he negaive significan response of he real refinancing rae on he change in he money supply (M1). According o hem, hese findings suppor he validiy of he ineres rae channel in Belarus. Bu neverheless hey sress he weakness of his channel. Moreover, hey argue abou idenificaion of credi channel in Belarusian economy. Such a conclusion is empowered by he posiive impulse of indusrial producion gap on he innovaion in he raio beween ruble loans o ruble money (M2). A las, a posiive and significan response of inflaion on he innovaion in he nominal exchange rae proves a srong exising exchange-rae pass-hrough. In addiion here is a srong relaionship beween changes in he nominal exchange rae and real exchange rae. The laer reurns o is equilibrium level when he effec of he nominal exchange rae on prices is over. The nex conribuion was made by Horvah and Maino (2006). They exploi he mehodology of unresriced VAR as well and also sae he srong pass-hrough effec from he exchange rae o prices. The posiive significan impulse response of prices o he innovaion in he exchange rae coninues during five periods (monhs) afer he shock. Besides hey argue ha his effec implies a subsanial cumulaive impac on prices. Furher hey find raher weak relaionships beween money and inflaion (posiive significan bu weak) and beween money and oupu (insignifican), which sipulaes obsacles of he second ransmission sep. The mos valuable findings in our conex are hose conneced wih Granger causaliy beween he inerbank rae and he NBB refinancing rae and esimaion of he NBB reacion funcion. Firs, he formal es shows ha NBB adjus is policy rae (refinancing rae) o he inerbank rae, which runs srange o wha one would expec in sandard moneary policy frameworks. However, his conclusion coincides wih heoreical expecaions on he operaional framework, where he exchange rae is reaed as he dominan arge, while he ineres rae is acceped from is marke value. Second, heir esimaion of a linear NBB reacion funcion shows ha NBB depreciaes he nominal exchange rae reacing o he deviaion from he inflaion arge (hrough lagged values of inflaion level), appreciaion of he real exchange rae and increase in he US Federal Funds rae ha is aken as a proxy for ineres rae pariy. I suppors he vision ha he acual regime of he moneary policy carried ou currenly is raher close o FFCT regime where exernal compeiiveness plays a crucial role. The resuls of he recen sudy by Bogeic and Mladenovic (2006) mosly conras o he previous findings. They exploi he VAR mehodology as well bu a he same ime esing i for coinegraion, developing a Vecor Error Correcion Model. On he one hand hey also suppor he srong pass-hrough from he exchange rae o prices. They find coinegraion beween prices and exchange rae, saing ha prices are deermined by a long-run relaionship wih he exchange rae. There he same relaionship wih Granger-causaliy from exchange rae o prices is valid in he shor-run as well. Furhermore he exchange rae generaes he sronges response of prices during he shor-erm. On he oher hand, hey sae he Belarusian moneary policy has go a srong accommodaing effec, i.e. changes in wages are crucial for generaing changes in prices. Thus hey conclude ha he Belarusian moneary auhoriy reacs on he shocks in he real secor, hus weakening heir own impulses sending o he economy. The pracical use of hese resuls is less valuable, since he sample size was limied o he period of and since hen moneary policy framework has subsanially changed New Evidence abou he Belarusian MTM VAR Mehodology In our opinion he use of VAR mehodology for esimaing moneary ransmission channels exhibis some limiaions in general and in applicaion o Belarus as a ransiion counry specifically. Firs, when analyzing he MTM channels using VARs he division for wo ransmission seps is Conference May 19-20, 2008, Minsk

310 310 worhwhile. As here migh be obsacles for ransmiing cenral bank impulses (e.g. hrough he ineres rae) o he inermediae variables (e.g. o he marke ineres rae), hen esing direc response of eiher inflaion or oupu (oupu gap) migh include relaionships from oher channels raher hen esed ineres rae channel. In he same manner, he economic meaning of impulse response from moneary base (aggregae M1) o inflaion and oupu may be ambiguous 1. A he same ime, he menioned feaures of dollarizaion and he small open economy saus give enough heoreical grounds for inerpreing responses from innovaions in he exchange rae o prices as a proof of he exchange rae channel. In he conex of our discussion we emphasize he following issues regarding he archiecure of he MTM in Belarus: (i) he srong pass-hrough beween exchange rae and prices and he role of money wihin his channel, (ii) relaionships and causaliy among nominal exchange rae, real exchange rae 2 and inflaion rae, which boh characerize he exchange rae channel, (iii) he possibiliy of NBB o ransmi he desired impulses o he inerbank, deposi and loan raes, which will characerize he firs sep of ransmission wihin he ineres rae channel. For he firs issue we analyze impulse responses in unresriced VAR of firs differences of logged values of nominal exchange rae 3, cumulaive CPI and M1 sock based on quarerly daa 1995q1-2007q2 (four lags). The resuls show ha (1) here is a srong direc pass-hrough from he exchange rae o prices (response of dlcpi o dlner), (2) besides he innovaion in exchange rae influences M1 (dlm1 o dlner), which may demonsrae specific effec for a dollarized economy and has a furher pass-hrough (weaker) o prices (dlcpi o dlm1) (see Figure 1). Figure 1: Responses of prices, M1 and nominal exchange rae o corresponden shocks. Response o Cholesky One S.D. Innovaions ± 2 S.E Response of DLM1 o DLNER Response of DLM1 o DLCPI Response of DLNER o DLM Response of DLNER o DLCPI Response of DLCPI o DLM Response of DLCPI o DLNER Furhermore, VAR Granger causaliy ess show ha he nominal exchange rae is he key cause variable for inflaion and M1, while he exchange rae iself may be caused only by inflaion. These resuls coincide wih hose in Horvah and Maino (2006) and sress he supreme role of he exchange rae channel in he Belarusian economy. Naional Bank of he Republic of Belarus 1 As shown in Kruk (2005) here is no empirical suppor of he firs sep of ransmission in ineres rae channel, i.e. NBB raes canno send saisically significan impulses o he deposi and credi marke raes. Some relaionships beween declared level of he refinancing rae (no acual level) and marke raes (on deposis and loans) are significan and NBB declared rae is a Granger cause for he marke raes. Bu neverheless hese relaionships are very weak and in our opinion are winessing he direc measures ha are connecing declared refinancing rae wih deposi and loan raes. 2 In regard o boh he nominal exchange rae and real exchange rae we consider he bilaeral rae vs. US dollar. 3 Cumulaive index.

311 311 Analyzing he relaionship and causaliy among nominal exchange rae, real exchange rae and inflaion we again consider an unresriced VAR of he firs differences of he corresponden logged variables (see Figure 2). This analysis shows significan responses of nominal exchange rae (real appreciaion causes nominal appreciaion) and inflaion (real appreciaion causes disinflaion) o he shock in real exchange rae. Thus he adjusing mechanism runs as follows: real appreciaion causes nominal appreciaion, which in urn causes more subsanial disinflaion and hus enforcing he real exchange rae o he equilibrium level. Granger es in VAR shows ha he real exchange rae is he Granger cause for changes in boh nominal exchange rae and inflaion. Analysis of his VAR does no say so much abou he wihin economy impac of he exchange rae channel, bu shows he causaliy of relaionship where he real exchange rae is he leading one. Figure 2. Responses of nominal exchange rae, real exchange rae and prices o corresponden shocks. Response o Cholesky One S.D. Innovaions ± 2 S.E..15 Response of DLNER o DRER.15 Response of DLNER o DLCPI.10 Response of DRER o DLNER Response of DRER o DLCPI.08 Response of DLCPI o DLNER.08 Response of DLCPI o DRER Thus, we can sae ha he exernal compeiiveness migh be of vial imporance when governing he curren level of nominal exchange rae. In he conex of discussion of NBB s abiliy o ransmi is policy raes o he marke level we consider in a hird sep an unresriced VAR of following logged real quarerly ineres raes: refinancing, inerbank, on new loans and on new ime deposis. Granger causaliy es does no give suppor o rejecion of any hypohesis ha any of hese ineres raes does no cause anoher one 1. Thus, we may sae here is no clear proof of NBB abiliies o ransmi ineres raes o he marke. Furhermore if using his VAR for an analysis of impulse responses, i demonsraes responses of oher ineres raes o he innovaion in he inerbank rae, while all he responses on he change in he real refinancing rae are insignifican Srucural Model Mehodology A he IPM Research Cenre s quarerly model of he Belarusian economy, here are fewer srucural relaionships ha are of ineres in he conex of MTM discussion. These relaionships demonsrae he validiy of he range of he MTM channels no only a a purely saisical level (as in he VAR approach), bu a he heoreical level as well, i.e. hey give us heoreical grounds for discuss- 1 The resul migh have been worsened due o analyzing quarerly daa which may be no an opimal frequency for he ineres raes ha are raher volaile wihin he quarer. Conference May 19-20, 2008, Minsk

312 312 ing an individual MTM channel. Here we can change he causaliy a bi and say ha while srucural model suppors he exisence of one or he oher channel, here are grounds for more horough economeric research of his individual channel apar from he srucural model. The srucural model includes wo channels of moneary ransmission: he exchange rae channel and he ineres rae channel (see Figure 3). Figure 3. MTM channels in he srucural macromodel in he Belarusian economy. Nominal exchange rae NBB real refinancing rae Inflaion Real exchange rae TFP Real ineres rae a he deposi marke Real expors Real impors Real wages Real GDP Nominal ineres rae a he deposi marke RGDP Real invesmens M1 (Money demand) Real households consumpion Inflaion Exchange Rae Channel Ineres Rae Channel The specifics of he Belarusian economy and some specific feaures of he modeling deermine no fully a benchmark srucure of he exchange rae channel. For insance, he relaively small scope of he model excludes a range of inermediary variables from i, and due o his we have go a very srong direc relaionship beween exchange rae and inflaion. Neverheless, oher relaionships of his channel mirror he causaliy in is influence on he real indicaors (componens of he aggregae demand and GDP). Furhermore his specificaion of he model allows including he ineres rae channel in i. Bu neverheless he pass-hrough effec from ineres raes o prices is raher weak 1, allowing he ineres rae o be a weak predicor of he money demand only in he shor-run relaionship. Two slighly differen available specificaions of he model demonsrae a changing naure of he MTM channels included. For insance, here is no evidence of he ineres channel in he second specificaion of he model, while he role of he exchange rae channel is emphasized. Through his srucural modeling gives enough grounds for exploring and esimaing exchange rae channel, while he exisence of he ineres channel is sill no eviden. Hence, boh he VAR approach and he srucural modeling approach emphasize he prominen role of he exchange rae channel for Belarus. Under his condiion he shif o he new moneary policy regime should be very cauious and he high degree of he pass-hrough from he exchange rae o prices should be kep in mind. Naional Bank of he Republic of Belarus 1 Moreover some assumpions in he model migh lead o minor misspecificaion in he ineres rae channel. For insance, he causaliy beween NBB rae and marke deposi rae was aken wihou preliminary esing.

313 313 Bu however here are heoreical and empirical grounds o suppose ha he channels of moneary ransmission will be changing due o he decision o change he moneary policy regime. In his sense, a NBB shif o IT iself may lead o more favorable moneary environmen for his regime. 4. Moneary Policy Operaions under Inflaion Targeing Regime 4.1. Goals of Cenral Bank when Shaping he Operaional Framework under IT Previous analysis shows ha shif o he IT regime is raher ambiguous sep, as i migh emphasize he problem of moneary policy goals mismaching. This problem migh be more eviden in applicaion o he operaional framework of he moneary policy. Implemening he IT regime means ha cenral bank adops i operaional framework (chooses he prior moneary policy insrumen) in a way ha i has go a conrol under he key ransmission channel. As a rule he IT regime is carried ou under he condiion ha here is a pass-hrough effec from he ineres rae o he oupu and prices, i.e. ha he ineres rae channel (shaped in any form) may be reaed as mos powerful one 1. For he firs sep of ransmission i means ha here is a powerful pass-hrough from he cenral bank s ineres rae o he marke ineres rae. For he second sep of ransmission i means ha economic agens rapidly and srongly reac o he change jus in he marke ineres rae. Hence he cenral bank should shape he operaional framework in such a way ha he base official rae (mos ofen open marke operaions rae, OMO) should be ransmied o he economy as he average shor-erm marke ineres rae. Marke rae is derived from he marke ineracions of commercial banks. Governing heir liquidiy level hey plan a definie volume of heir operaions during he shor-erm. While he cenral bank is he legal lender of las resor, hese plans of he commercial banks are based as well on heir expecaions on he dynamics of he OMO and volumes of needed ransacions wih he cenral bank. The laer defines he expeced probabiliy of using he main refinancing operaions and sanding faciliies. Boh expeced probabiliy of using sanding faciliies and main operaions and expeced ineres raes (OMO and sanding faciliies rae (SF)) by commercial banks influence marke rae. Thus he ask of he cenral bank may be presened as minimizing of gap beween expeced ineres rae by banks and acual rae. The simples measure o achieve his is predicable change of official ineres rae for marke agens ha may ake place only according o he schedule. From his poin of view cenral bank should follow an implici policy rule when defining is policy rae. A he same ime cenral bank faces much more crucial problem of predicing shor-erm liquidiy flucuaions. In oher words i s he same o predic liquidiy flows governed by commercial banks and hus decreasing heir expeced probabiliy of using sanding faciliies. If i is he case commercial banks will use jus main operaions a OMO rae for saisfying heir liquidiy needs and jus his rae will be ransmied o he money marke. Thus hey key problem in making OMO liquidiy smoohing rae and providing ransmission of his policy rae o he money marke is he abiliy of cenral bank o predic shorerm liquidiy vulnerabiliy and minimize using of sanding faciliies Transmiing he Policy Rae o he Money Marke Predicing he Shor-Term Liquidiy Level The shor-erm money demand may be reaed as almos absoluely inelasic. Through his unexpeced increase in he shor-erm money demand by banks will push money marke rae up o he 1 I does no mean ha oher channels ha are conneced wih change in official ineres rae are invalid for a counry, bu means hey are weaker han he ineres rae channel. Furhermore, he IT regime can funcion alongside wih he dominaion of asses price channels. Conference May 19-20, 2008, Minsk

314 314 SF rae and vice versa. For he purpose of predicing liquidiy cenral bank should horoughly analyze oher possible source of liquidiy inflow or ouflow. Based on he srucure of he cenral bank balance shee we can derive he following ideniy: excess (lack) of liquidiy= ne foreign asses + ne claims on governmen + claims on banks + oher iems(ne) cash (ouside banks) required or conracual reserves desired (by commercial banks) level of free reserves (1) 1 If cenral bank has enough informaion o anicipae flows in hese balance iems during he shorerm hen i can provide a consisen liquidiy forecas and hus se he level of OMO ha will smooh liquidiy vulnerabiliy and provide needed impac on money marke rae and furher on inflaion. A par of hese iems are under he full conrol of he cenral bank per se, namely claims on banks (excluding sanding faciliies), oher iems (ne) and required reserves. The problems in adequae forecas may be caused from unexpeced change in: (i) demand for cash, (ii) demand for desired level of free reserves, (iii) ne foreign asses, (iv) ne claims on he governmen. Taking in mind very shor-erm of predicing liquidiy and inelasic demand for money in i, he demand boh for cash and non-cash money is usually deermined by auonomous raher predicable facors. I may be, say, he days of ax paymens or anoher seasonal facor. Much more of cenral bank concern are indicaors conneced wih asses side of he balance ha are no conrolled direcly by he cenral bank. Firs, under differen from he floaing exchange rae regime cenral bank s foreign asses are reaed as he shock absorber in order o mainain he exchange rae arge. Hence ne foreign asses are vulnerable in his case, which deermine corresponden liquidiy in naional currency flows. This or ha exen of foreign reserves vulnerabiliy are peculiar o all counries, while here almos no examples of pure floaing exchange. Bu generally vulnerabiliy of reserves is decreasing under he differen exchange rae regimes, being he highes under he pegged rae and he lowes under he floaing rae. Moreover he share of foreign reserves in cenral bank s asses also maers. If he counry bases is currency issue much on foreign reserves hen even imaging floaing rae and relaively small inflow/ouflow of reserves may injec/wihdraw subsanial in comparison o he moneary base excess liquidiy. Similar problems for liquidiy projecions may be caused by he unexpeced changes in ne claims on governmen. These ne claims mirror boh governmen bonds in he cenral bank s porfolio and deposis of he cenral governmen. As a rule governmens place heir deposis ha are formed from he consolidaed revenues in he cenral bank. A mismach beween consolidaed income and expendiure caused by any reason hen will influence acual money supply. In counries where governmens have some seasonal facors in eiher incomes or expendiures or he governmen aimed a gaining some profis due o marinaing emporary profici he money marke will face some seasonal inflow/ouflow of liquidiy. Thus, we may argue ha moneary environmen should allow predicing shor-erm liquidiy vulnerabiliy in policy-making decisions, which will faciliae OMO (policy rae) o be he effecive insrumen under IT. A he same ime vulnerabiliies of foreign reserves and ne claims on governmen may undermine his cenral bank s abiliy. Naional Bank of he Republic of Belarus One more moneary policy insrumen should be considered in he conex of liquidiy forecas, i.e. reserve requiremens. Conemporary cenral banking pracice assumes he mechanism of averaging he volume of required reserved during definie mainenance period. In he view of our discussion his possibiliy of averaging reserve does no suppose addiional unpredicable liquidiy flows, bu jus on he conrary means adopion of addiional liquidiy smoohing insrumen. As a rule com- 1 See Gray, Talbo (2006).

315 315 mercial banks use his insrumen prior o he sanding faciliies for regulaion relaively small liquidiy deviaions. In case of liquidiy defici a commercial bank can wihdraw an available under he regulaion par of required reserves for recovering he desirable level and vice versa. Hence his mechanism of forming required reserves reduce a bi he demand on sanding faciliies ha enhancing he possibiliy of ransmiing he OMO rae o he marke. Neverheless if he cenral bank s rae(s) are going o change during he reserves mainenance period hen commercial banks will adjus heir liquidiy behavior in he direcion opposie o he direcion of expeced change in he ineres rae(s). If i is he case insead of enhancing of ransmission he policy rae o he marke rae, commercial banks will preven such a ransmission. The simples soluion is prevening his mismach beween he mainenance of reserve requiremens period and he period of he change in he policy rae. Thus he siings of he body ha is empowered o change he cenral bank s policy rae should be scheduled a he days of he end of one mainenance period and beginning of he nex one Seing he Policy Raes Corridor Sysem Anoher possible opion for ransmiing policy rae owards he money marke is narrowing he corridor beween raes on sanding faciliies. As a rule SF raes (on overnigh loans and deposi faciliies) form he corridor in boundaries of which marke raes are flucuaing. Mos ofen i has he same spread beween he OMO rae and upper and lower SF raes, which mirrors cenral bank s inenion o proper regulaion of liquidiy wih equal probabiliy of using sanding faciliies in boh direcions. This corridor should creae incenives for commercial bank o use OMO rae as heir core rae, while he SF raes have go a penaly characer. Bu a he same ime a wide corridor will cause deviaions of marke raes from he OMO rae if unexpeced liquidiy movemen shave occurred. Moreover in case of absence of averaging mechanism of reserves narrower corridor may faciliae o offse liquidiy flucuaions. Through his some cenral banks pursue a acic of exremely narrow corridor. For insance cenral banks of Ausralia, Canada and New Zeland (Gray, Talbo (2006)) all ake his approach. Furhermore he Bank of England adoped since 2006 reserve averaging sysem ogeher wih a narrow ineres rae corridor on he las day of mainenance period 1. In general case here canno be a common soluion in regards o he variance of he corridor. I depends on he shape of oher moneary policy insrumens and moneary environmen. However, under he IT or ransiion o IT i is desirable ha for any variance of he corridor i should reflec he neural liquidiy orienaions by he cenral bank hrough reaing OMO as he middle of he corridor wih equal spreads o sanding faciliies in boh direcions Improving he Moneary Policy Operaional Framework in Belarus under he Transiion o IT The archiecure of liquidiy regulaion and moneary operaional framework in Belarus may be reaed as raher developed according o he inernaional sandards. I reflecs he sandard conemporary division of liquidiy regulaion insrumens on sanding faciliies (overnigh loans (for one day and wihin he day) and shor-erm deposi faciliies and open marke operaions. The laer may be implemened hrough aucion REPO operaions (in pracice mainly lombard aucions (eiher rae or volume aucions)) ha may be reaed as main refinancing operaions, longer-erm operaions and fine-uning operaions on bilaeral basis. Furhermore, he NBB has already implemened he mechanism of reserves averaging and here is conformiy beween he mainenance of 1 See Gray, Talbo (2006). Conference May 19-20, 2008, Minsk

316 316 reserve requiremens period and he period of he change in he policy rae. However, despie almos perfec legal archiecure i does no work in a perfec way. The firs drawback o be emphasized in using he liquidiy regulaion mechanism is he inensive using of sanding faciliies in absolue and in comparison wih main refinancing operaions as well. A number of reasons for his may be sressed. A he beginning i mus be admied ha high liquidiy vulnerabiliy is conneced wih hesiaions in he level of NBB ne foreign asses. The inverse connecion beween he dynamics of ne foreign asses and using sanding faciliies is more eviden since 2006, when foreign asses became he key facor in base money growh. In overall i mus mean ha while significan par of base money is based on hard currency he adequae liquidiy forecas and hence regulaion is unlikely o be mainained. The possibiliies of liquidiy forecas in Belarus are worsened by anoher source of base money, ne claims on governmen, due o he volailiy of governmen deposis wih he NBB. These wo insrumens formed he major par of base money dynamics during las years (see Table 1). Table 1. Conribuion of Balance Facors in Growh of Base Money (in percenage poins) Ne foreign asses Ne claims on governmen Claims on commercial banks Oher ne asses Base money Source: Own calculaions basing on he NBB daa. This relaionship is raher objecive and demonsraes on he operaional level he challenges for implemening Belarusian IT in Secion 2, i.e. dollarizaion, openness of economy and ransiion agenda. The composiion of base money reflecs he exernal environmen of he moneary policy. So his problem ha causes inabiliy o provide a shor-erm forecas of liquidiy and hus o ransmi policy rae o he marke canno be reaed on he level of operaional framework. If he moneary policy environmen will change, e.g. jus due o he decision o shif o IT as described in Secion 2, i will influence corresponden changes in base money and he problem will be miigaed. Naional Bank of he Republic of Belarus However wo more issues should be menioned in he conex of he Belarusian operaional framework. Firs, i is prevailing volume of providing liquidiy operaions in comparison o absorbing ones. As shown above effecive offseing policy assumes he equal probabiliy of using boh direcions of insrumens of sanding faciliies. Hence a proporion wih loans dominaing over he deposis demonsraes liquidiy limiaion policy of he NBB. I means ha for he NBB he siuaion of liquidiy defici is more favorable raher han is excess, because in he las case i will have o incur losses and provide real financing for he excessive liquidiy. Besides he srucure of he ineres rae corridor mainained is no opimal in our opinion. There is no acual gap beween he OMO rae and rae on overnigh loans ha belongs o he sanding faciliies. A he same ime here is significan corridor beween OMO and deposi rae, bu which is unsable boh in nominal and real erms. Parially such a srucure may be useful for forming desired fla yield curve and/or ransmiing he desired rae o he money marke by narrowing he ineres rae corridor from he upper side. Bu as described in 4.2.2, such approach is only possible under already predicable liquidiy flows; oherwise OMO ineres rae is under he risk of loosing is anchor meaning for marke agens a all.

317 317 Thus, when he decision for shifing o IT has been made, we propose a shif o he corridor where he OMO rae will be he average one wih equal spreads beween boh SF raes. The variance of his corridor should depend on he abiliy of he NBB o predic liquidiy level during he curren ime period. Second, he low economic meaning of he official refinancing rae for he Belarusian marke should be emphasized. Today here is no clear economic meaning of he official refinancing rae and no NBB operaion is direcly conneced wih rae. Furhermore spreads beween raes on NBB operaions and refinancing rae are also vulnerable boh in nominal and real erms. Today, he refinancing rae is mainly an indicaive parameer of he ineres rae ha has been conneced hrough direcive measures wih deposi and credi marke raes. We suppose ha while shifing o IT here should be a clear informaive indicaor of ineres rae (eiher i will be reaed as an operaional ool or he shock absorber during inermediary period) ha should be he average of he corridor. Thus, we suppose ha he refinancing rae should reflec he acual main OMO rae of he NBB and is change should be made on he scheduled basis on he end day of he reserve mainenance period. 5. Approaches o Implemening Inflaion Targeing in Belarus Taken in mind menioned above we mus sae ha classic IT regime is no worhwhile for Belarus a leas a he iniial sages 1, while a he same ime he high vulnerabiliy of exchange rae should be prevened and he reliable forecas should be provided. Through his for shaping he sraegic issues we iniially will choose he possible and mos proper for Belarus design (he relaionships of arges and operaional ools) of moneary policy during firs seps owards he IT regime. Referring o he inernaional experience regarding counries wih dollarized and/or open economy in addiion o classic design of IT regime some researchers poin ou few more sraegies of moneary policy ha in higher or less exen deal wih IT (see Table 2). Table 2. Alernaive Moneary Policy Designs Full-Fledged Inflaion Targeing (FFIT) Inermediae Inflaion Targeing (IIT) Fear of Floaing Compeiiveness Targeing (FFCT) Primary final arge Inflaion Inflaion Compeiiveness Secondary final arge Compeiiveness Compeiiveness Inflaion Operaional arge Ineres rae Moneary aggregae Rae of crawl Primary shock absorber Secondary shock absorber Exchange rae Ineres rae Foreign asses Foreign asses Exchange rae/foreign asses Ineres rae Source: Leiderman e al (2006) In he FFCT case and parially in he IIT case here is a possibiliy of prevening high vulnerabiliy of exernal compeiiveness ha is severe under he condiion of open economy. Moreover focus on hese regimes coincides wih poenially high pass-hrough effec of exchange rae (FFCT in a grea- 1 This conclusion is much in depending on he ime of shifing o he IT regime. The program Banking Secor Developmen in foresees his shif during he las years of his period wihou fixing more narrow ime inerval. Bu neverheless is doubful ha all he facors menioned dollarisaion, openness of economy and ransiional conex may aler is impac in predicable fuure before implemening he IT regime. Conference May 19-20, 2008, Minsk

318 318 er exen, IIT in lower exen). Argues agains hese designs may be as follows. Firs, i does no fully coincide wih IT definiion when inflaion is reaed as he only and dominan ulimae goal. Second, i may weaken he auomaic characer of he moneary policy and hus is ransparency and public suppor. Bu he impac of dollarizaion and high imporance of exernal compeiiveness are much more crucial for Belarus. Furhermore, absoluely auomaic moneary policy looses a par of is poenial of absorbing and prevening shocks. Thus, in our opinion, a he firs sages of IT regime he choice should be made beween FFCT and IIT (i.e. IT lie). The experience of majoriy counries shows ha he direc shif o IT is raher risky and hey used iniial sep o IT lie and acceping FFIT only afer ha (Sone (2002), Sone, Bhundia (2004)). Iniial choice should be done in favor of FFCT, while i includes he imporance of exchange rae in more suiable for Belarus manner. If his policy becomes a facor of more sable economic agens behavior and he rae of dollarizaion as well he exchange rae pass-hrough effec decline, a furher shif o IIT is possible. However, his shif has o be made in a gradual manner because of he facors menioned, which also govern is speed. In case adverse shocks do no allow a quick ransiion owards full IT, he ime period for reaching i needs o be exended and used for he esablishmen of he necessary requiremens. 6. Impac of Swiching o IT in a Long-Term There is a wide heoreical consensus ha providing low and sable inflaion is he bes conribuion by he cenral bank o he long-erm growh. While economic agens have go expecaions of low and sable inflaion, heir behavior is no disored and he economy is reaching is growh poenial ceeris paribus. Emperically i has been shown by Fischer (1996) ha he inflaion of 1% o 3% is ideal for a long-run growh. Moreover, Sarel (1996) has shown ha he relaionship beween inflaion and growh urns from negaive o posiive below around 8% of inflaion. Iniial idea of IT is aking commimen by cenral bank of mainaining inflaion under he explici level. Recognizing ha moneary policy has go a forward-looking characer, i commis o reac on deviaion of he eiher curren acual inflaion rae or forecased inflaion rae wiing he imehorizon from he arge level by means of is main insrumen. Policy ineres rae as rule is viewed as such an insrumen. Because of his commimen (iа he IT is acceped as credible by he economic agens) cenral bank enhance more cerainiy o he economic agens. Hence heir expecaions and consequenly heir behaviour is concordan wih he policy of he cenral bank. Bu in our opinion providing a low and sable inflaion migh no be he only channel of faciliaing o growh by means of IT adopion. There is a pleny of sudies dealing wih relaionship of finance and growh (lieraure review of hese sudies can be seen for insance in Kruk (2006), Eschenbach (2004), Thiel (2001)). Despie differen approaches o he heoreical relaionship beween finance and growh (bank-based view, marke-based view, financial services view, law-based view) a parial consensus may be formulaed as follows: deeper, healhier and more efficien financial sysem is more beneficial for long-erm growh. Relaionship beween srucural policies, financial sysem and is impac on he real dynamics of he economy may be presened as follows (see Figure 4). Naional Bank of he Republic of Belarus

319 319 Figure 4: Relaionships beween financial sysem and economic developmen. Srucural policies (legal, axaion, ec) Financial sysem Srucure Dephs Sage of developmen Efficiency MTM Long-erm growh Shor-erm pah Range of accessible policy insrumens and is qualiy Adoping new regime of moneary policy may be considered as a measure of a srucural policy, while i assumes o implemen a range of new incenives for economic agens, including financial inermediaries. Hence, besides providing low and sable inflaion in case of successful IT, he regime iself may influence financial sysem creaing precondiions for widening of is deph and increasing efficiency. Levine (2002) has sressed he following mos basic channels of how he financial sysem can promoe economic growh. 1. Assessing poenial invesmen opporuniies and hus exering corporae conrol. 2. Enhancing liquidiy and easing savings mobilizaion 3. Faciliaing risk managemen and hus reducing risks in he economy. In projecion o he bank-based view his general classificaion may be broadened a bi as follows: (i) acquiring informaion abou firms and managers and hereby improving capial allocaion and corporae governance; (ii) mobilizing capial and hereby exploiing economies of scale; (iii) managing crosssecional, ineremporal and liquidiy risks and hereby enhancing invesmen efficiency economic growh. In applicaion o growh heory hese channels of growh are usually associaed wih capial produciviy (in AK-models) or wih oal facor produciviy in models wih few producion facors. In Kruk (2006) i shown ha for ransiional economies hese channels may be encompassed by wo more channels: (i) implemening new managemen and pracices o he financial inermediaion and hus raising compeiiveness and reducing losses of financial sysem; (ii) implemening cos-reducing echnologies o he financial sysem and hus reducing losses of financial sysem. These wo laer channels are usually conneced wih he loss raio in a growh heory. In Kruk (2006) i is shown ha he role of he Belarusian financial sysem as a growh propagaor is exremely low. A range of disorions in he work he menioned channels is he key reason for his underperforming of he Belarusian financial sysem. Wihin he heory of finance and growh (us- Conference May 19-20, 2008, Minsk

320 320 ing he caegories by King and Levine (1993 b)) hese disorions for he financial sysem of he ransiion economy may be revealed as follows (Kruk (2006)). 1. Low qualiy of he enrepreneurs pool and low probabiliy of innovaions. Enrepreneurs compee o each oher by means of price, qualiy and volume of labour and capial, which form compeiive advanages herewih. Hence heir ineres in he innovaions and exering corporae conrol migh be raher low. Furhermore on his sage a siuaion of sof budge consrains ofen ake place, which also undermines he qualiy of he enrepreneurs pool and he inenion o innovaions. 2. Disorions in banks screening and selecing proper projecs behavior. In case of low qualiy of enrepreneurs pool banks may be relucan o screening procedures, while i requires excessive resources. Furhermore on his sage influence of governmen may be raher subsanial and hrough his a significan par of he resources may be allocaed under he governmen s prioriies, which undermines selecion incenives for banks and hus leads o inefficien allocaion of resources. Furhermore his siuaion may be srenghened if he governmen has a significan share in he banking sysem, which is a case in a range of ransiions on his sage, and influence he allocaion of resources (creaing sof budge consrains regime) direcly. 3. Differen access o capial by differen enrepreneurs. This fac is consequen o he previous one and sof budge consrains. Furhermore even if he laer problem is miigaed, hen banking sysem being he only subsanial financial inermediary has incenives o exploi he economy on scale hrough focusing on he relaively big enerprises, being relucan o crediing SME due o larger overhead coss per uni of credi. 4. Low level of compeiion in he financial secor. While he banking sysem in ransiion counries iniially derives from he sae banks in direcive economy, he banking sysem migh be monopolized by hese banks especially on early sages. Furhermore if keeping his environmen and mainaining sae monopoly in he banking sysem, oher sources (for insance foreign capial) of capial are limied, as poenial invesors canno inves in sae banks, while foundaion of new inermediaries may be oo cosly in his environmen wihou possibiliies for compeiion wih large sae banks, due o he sae policy. 5. Limied possibiliies of aracing liabiliies and in provision liquidiy. On he one hand here is almos no alernaives for savings raher han bank deposis, bu neverheless some difficulies migh ake place, for insance due o he generally low demand for naional currency and hus preference of holding savings in foreign currency ouside banking sysem. Moreover as discussed above here may be obsacles for increasing he capializaion of he banking sysem on he firs sage. This sylized fac is no consan during he period. Iniially he defici in liquidiy required may be no so meaningful, bu when being closer o he second sage of he developmen pah his problem migh srenghen. Naional Bank of he Republic of Belarus 6. Low level of ineremporal risk managemen. While he enrepreneurs are in major compeing o each oher due o he producion facors, he incenives for innovaions and longer erm projecs is relaively low. Hence he banking sysem execues he funcion of provision liquidiy, bu mainly making he loans shor-ermed. Thus financial sysem avoid ineremporal risk managemen, which undermines he channel of growh conneced wih risk sharing in he economy. As shown in Kirchner, Kruk (2007) successful and credible IT assumes esablishmen of a number of macroeconomic and financial precondiions, exernal and financial secor sabiliy. These include

321 321 five pillars: absence of oher nominal anchors, an insiuional commimen o price sabiliy, absence of fiscal dominance, policy insrumen idependence, policy ransparency and accounabiliy (Mishkin, Schmid-Hebbel (2001)). These insiuional precondiions cover he disorions conneced wih differen access o capial by differen financial inermediaries; enhance proper screening procedures, risk-managemen and compeiion in he financial secor. So if hese requiremens are me 1 we may argue ha adopion of IT will have a favourable effec on he deph and efficiency of he Belarusian sysem and hence will conribue o he perspecives of he long-erm growh. This hypohesis migh be one of he major argumens in favour of inflaion argeing Tesing his hypohesis is he direcion for furher research. I could be done in wo ways. Firs, hrough reaing he moneary policy regime as a special insiuional dummy variable rough he mehodology of poliical economy of growh (Chubrik (2002)). Moreover, while major channels of moneary policy regime impac on growh are conneced wih echnological progress, i.e. oal facor produciviy, his componen could be poined ou hrough esimaion of he producion funcion. The nex sep is he esimaion of oal facor produciviy using moneary policy regime as an explanaory variable. This approach is likely o be used wih panel daa on a range of counries wih differen moneary policy regime. Second approach assumes esimaing he significance of he financial sysem o growh before adoping IT regime and afer i. Separaing oal facor produciviy and esing impac on i by he financial sysem before and afer he adopion of IT regime is also viable here. Such an approach will give grounds in favour or agains he hypohesis ha IT regime makes financial sysem deeper and more efficien. Alongside a number of mehodological requiremens should also be considered Conclusions and Direcions for Furher Research In his paper we have sressed a number of challenges for he adopion of IT in Belarus. Main obsacles are dollarizaion, openness of he economy and ransiion conex. Assessmen of he exising channels of moneary policy ransmission also shows a subsanial role of he exchange rae channel for Belarus. Hence revoluionary adopion of IT regime may undermine financial sabiliy due o balance shee effec and banks run. Thus in our opinion he opimal way for Belarus is gradual shif o IT, using inermediary forms of IT Lie (FFCT and IIT). Furhermore we sress a number of requiremens a he operaional level of moneary policy for successful exploi of IT regime. Taking all hese in mind we sugges our vision of IT regime parameers for Belarus. However, we suppose ha oday s knowledge abou IT regime may no include is possible favourable impac of he long-erm growh, which is he core of he economic developmen. In his paper we propose a number of heoreical argumens in favour of his vision. We argue ha besides providing a low and sable level of inflaion IT regime could also enhance posiive incenives for he financial sysem and i, in urn, may play a role of he growh propagaor. We propose a mehodology of esing his hypohesis, which is he goal for he furher research. 1 I migh be a case in Belarus, while a number of similar measures has been foreseen by Program of Banking Secor Developmen in he Belarusian Economy for Taking ino accoun mehodological discussion on making such research (Pelipas, Chubrik (2007), De Haan, Lundsrom and Surm (2005)) he mehodology of modelling his relaionship should include analysis of he order of inegraion of he daa and he model should exploi daa wih he same order of inegraion. Furhermore, for avoiding using boh levels and differences in one equaion, i migh be more reasonable o use he real GDP per capia in a lef side raher han GDP growh rae (Pelipas, Chubrik (2007)). Conference May 19-20, 2008, Minsk

322 322 References Bernanke, Mishkin (1997) Inflaion Targeing: a New Framework for Moneary Policy? NBER WP No Bogeic, Mladenovic (2006) Inflaion and he Moneary Transmission Mechanism in Belarus, , Inernaional Research Journal of Finance and Economics, Issue 1 (2006). Chubrik A (2002), Reurn o scale of he producion funcion and oal facor produciviy: example of Poland and Belarus, Ecowes, 2, (in Russian). Daianu, Lungu (2005), Inflaion Targeing, Beween Rheoric and Realiy. The Case of Transiion Economies, William Davidson Insiue WP No.743. Eschenbach F. (2004), Finance and Growh: A Survey of he Theoreical and Empirical Lieraure, Tinbergen Insiue Discussion Paper No. 039/2. European Cenral Bank (2004) The Moneary Policy of he ECB Fischer (1996) Why Are Cenral Banks Pursuing Long-Run Price Sabiliy? paper presened a he Federal Reserve Bank of Kansas Ciy Symposium Achieving Price Sabiliy. Gali, Manacelli (2002), Moneary Policy and Exchange Rae Volailiy in a Small Open Economy, NBER WP No Ganev G., Molnar K., Rybinski K., Wozniak P. (2002), Transmission mechnisms of moneary policy in Cenral and Easern Europe, CASE repor No. 52. Gray, Talbo (2006) Moneary Operaions, Bank of England, Handbook in Cenral Banking No.24. Horvah, Maino (2006) Moneary Transmission Mechanisms in Belarus, IMF WP/06/246. Jonas, Mishkin (2003), Inflaion Targeing in Transiion Counries: Experience and Prospecs, NBER WP No Kalaur P., Komkov V., Chernookiy V. (2005), The mechanism of ransmission of moneary policy in he economy of Belarus, Belarusain Economic Journal, 3 (in Russian). King R., Levine R. (1993 a), Finance and growh: Schumpeer migh be righ, The Quarerly Journal of Economics, 108, King R., Levine R., (1993 b), Finance, enrepreneurship, and growh: heory and evidence. Journal of Moneary Economics, 32, Kirchner, Kruk (2007) Adoping Inflaion Targeing: Overview of Precondiions and Insiuional Requiremen, IPM Research Cenre PP/07/06. Kruk (2005) The Channels of Moneary Transmission in Belarus, mimeo. Kruk (2006) How Can Financial Sysem Spur Growh in Transiion Counries? ICEGEC Working paper 32 Leiderman, Maino, Parrado (2006). Inflaion Targeing in Dollarized Economies, IMF WP 06/157. Levine R. (2002), Bank-based or marke-based financial sysems: which is beer, Journal of Financial Inermediaion 11, Libich (2008), An Explici Inflaion Targe as a Commimen Device, Journal of Macroeconomic, V-30, Mishkin (2000) Inflaion Targeing in Emerging Marke Counries, NBER WP No.7618 Mishkin, Schmid-Hebbel (2001), One Decade of Inflaion Targeing in he World: Wha Do We Know and Wha Do We Need o Know? NBER WP No Pelipas, Chubrik (2007) Marke Reforms and Economic Growh in Possocialis Counries: Resuls of he Empirical Analysis, IPM Research Cenre WP/07/01 (In Russian). Sarel (1996) Nonlinear Effecs of Inflaion on Economic Growh, IMF Saff Papers, V-43, Sone (2002), Inflaion Targeing Lie, IMF WP/03/12. Sone, Bhundia (2004), A New Taxonomy of Moneary Regimes, IMF WP/04/191. Svensson (1997) Inflaion Forecas Targeing: Implemening and Monioring Inflaion Targes, European Economic Review, V-41, Svensson (1998), Open Economy Inflaion Targeing, NBER WP No Thiel M. (2001), Finance and economic growh a review of heory and available evidence, Commission of he EC, European Economy Economic Papers, No Trew (2004), Endogenous growh and welfare wih asymmeric informaion in financial inermediaion, Universiy of Warwick, MSc Disseraion in Economics. Naional Bank of he Republic of Belarus

323 323 Naalia Lazareva 1 The Developmen of Morgage Lending Marke in a Transiion Economy: Problems and Perspecives One of he significan issues of he loan marke developmen in he counries wih a ransiion economy is design and implemenaion of financial insrumens and echnologies for refinancing of a morgage lending mechanism. The above issue is relevan for Belarus as well. Morgage aims o solving residenial house building problems as well as developing a financial marke as such. A weighed approach o he implemenaion of morgage lending will allow increasing he volume of house building in Belarus a he micro level and will add o he growh of effeciveness of he moneary policy a he macro level. Morgage lending marke developmen has been one of he key issues in he economy lieraure for many years. Economiss, scieniss, bankers and lawyers have been discussing he following issues: he exen of influence of morgage lending as a financial insrumen on economy; he funcion of he banking sysem in his issue; he resraining and simulaing facors in erms of morgage marke developmen. In Belarus morgage lending was a he cenre of he acive discussion in 2003, on he hreshold of cancellaion of cenral financing of residenial house building by he Naional Bank of he Republic of Belarus. There were plans o increase he number of banks paricipaing in house-building wih suppor of new insiuions: morgage lending, building up a sysem of long erm savings of individuals in he form of housing savings, as well as reiremen and insurance saving funds. The banking sysem of he counry is acively involved in he implemenaion of sae-run housebuilding programs. The acualizaion of he role of he banks in he implemenaion of he approved Concep of consrucion (reconsrucion) of affordable and comforable accommodaion for he residens of he Republic of Belarus (hereinafer referred o as Concep ) 2 is indispuable. The saed documen subdivides he endency of he house-building developmen ino 3 periods: Shor-erm (unil 2010 ); Medium-erm (unil 2015); Long-erm (afer 2015). The Minisries of Archiecure and Consrucion, Economy, Finance, Municipal Affairs and Housing, joinly wih he Naional bank of he Republic of Belarus, have been auhorized o program he aciviies aimed a implemenaion of he Concep before July 1 s of he curren year. Wih a view o sele relaionships in he morgage secor and form he legal plaform for long-erm morgage lending, along wih he Concep, he law On morgage is being prepared in he republic. This projec has been passed in he firs reading and is planned o be considered in he second reading during spring session by he depuies of he House of Represenaives of he Naional Assembly of he Republic of Belarus. The pracice of marke economy, as well as in CIS counries, shows ha he legal basis alone is no enough for he funcioning of morgage lending in he republic. Ten years ago (in 1998) in Russia 1 Head of Yzhnoye Branch of Belagroprombank OJSC in Minsk. 2 The Concep of consrucion (reconsrucion) of he affordable and comforable accommodaion for he residens of he Republic of Belarus, approved by he Resoluion of he Council of Minisers of he Republic of Belarus as of March 3 rd, Conference May 19-20, 2008, Minsk

324 324 he Federal Law On morgage (propery morgage) was adoped, in 2003 he Federal Law On morgage securiies, however, he legal basis failed o live up o expecaions. Moreover, considering he significan volume of arrears on morgage loans, in Russia he creaion of he regulaory and legal framework wih regard o bankrupcy of individuals is a issue. I is obvious ha in he course of he Concep implemenaion in a ransiion economy he banking sysem in Belarus will face a series of currenly unseled issues of loan marke developmen, such as: imperfecion of he legal basis in he field of morgage lending;; availabiliy of house-building loans for individuals; commensuraion of he cos of he square meer of propery wih he income level of individuals; choice of he opimal erm of morgage lending; commensuraion of ineres rae on loan for residenial house-building wih he income level of individuals ec. Besides, i is necessary o define he rends o increase efficiency of he ineres channel of he ransmission mechanism of he moneary policy in Belarus. I is necessary o choose he opimal pace of developmen by loan marke banks, weigh he influence of he morgage lending growh on flucuaion in propery prices by way of sudying, in he firs place, he pracice in he counries of near and far abroad. To have a clear vision of he essence of he maer under sudy and analysis, i is necessary o differeniae he noions morgage and morgage loan. Therefore, he press ofen uses he formulaion: Morgage is a long-erm loan issued agains securiy of propery o purchase a house. (Volianiuk, Nezvanov, 2007) Morgage is a Greek word for hypoheke pledge, encumbrance on propery for he purpose of geing a loan, a morgage loan. A morgage loan (morgage credi, real esae loan), in is urn, is a way of raising funds agains propery. Morgage daes back o he beginning of he 7 h cenury B.C., Greece. On issuing morgage as a loan liabiliy, a he boundary of he land lo, owned by he borrower, a pos was pu wih a sign on i under pledge morgage, where all debs of he land owner were regisered. Some ime laer morgage (land) regisers were inroduced for his purpose. On signing he morgage agreemen in he noary office, he morgage was made up, which represened a securiy on pledge of propery. Morgage gives he righ o he pledge holder of preferenial saisfacion of claims o he pledger wihin he regisered loan amoun. The main characerisic feaure of morgage is ha i gives opporuniy of geing a series of morgage loans agains he pledge of one and he same propery under 2nd, 3 rd ec encumbrances. Morgage is widely praciced in developed counries. Thus, in he USA 63 million families live in houses purchased wih a morgage loan. Over 3 rillion USD circulaes annually in he morgage marke and ha is more han in he marke of US governmen securiies. Morgage loans are issued by savings and loan associaions (40 50% of he oal number of morgage loans), morgage banks (18 30%), commercial banks (19 20%), muual savings (cooperaive) banks (8 10%), credi unions (1 2%) 1. Naional Bank of he Republic of Belarus Influence of he pace of morgage developmen on financial sabiliy of he counry and real sae price variaion, and significance of he opimum pah for ineres rae is demonsraed by he example of he morgage crisis in he USA. As a resul of he crisis in in he USA, he par of speculaive money poured ino he morgage secor ha led o a drop in he value of long-erm 1 Finance and credi encyclopedia, edied by A.G.Griaznova. Moscow, P

325 325 loans. Individuals were offered loans wih a variable rae and a low down paymen. However, in he conex of increasing ineres raes, he service cos of he specified loan servicing wen up sharply, causing an increase in lae morgage paymens, and as a resul morgage companies wen bankrup, closed or were sold. Among he fighing-crisis measures aken by he US governmen, were he lenghening of he loan erm o 40 years, rae reducion and graning ax concession o individuals and companies. The amoun of ax concession is expeced o be equal o 600 USD per head. The US Senae is working ou is own program, valued a 156 billion USD, wihin he framework of which analogous paymens will amoun o abou 500 USD per head (Tarasov 2007). As a resul of he morgage marke crisis, he US economy may suffer loss o he amoun of 2 rillion USD, as each dollar los on morgage loans can lead o loan reducion by more han 10 dollars, as repored by Bloomberg wih reference o predicions of he analyss from Goldman Sachs Group Inc. Problems in he morgage lending secor have a negaive impac on economic growh in he USA ha increases he probabiliy of a recession. In he opinion of he FRS ex-chairman Alan Greenspan, he chances of a recession depend on wheher problems of morgage lending will spread ino consumer lending business in he USA. Taking ino accoun he laws of hisory, we draw a conclusion ha he siuaion in he sock marke has a direc influence on real esae marke. Thus, he US sock marke crash of Ocober 21, 1929, oherwise known as Black Tuesday, resuled in a real esae price collapse. Again, he nex financial crisis happened in he USA: he sock marke crash of Ocober 19, 1987 Black Monday led o real esae marke collapse. Hong Kong marke was hi hard in Ocober The crisis affeced he weakening of he US dollar. Since he dollar is a reserve currency for he majoriy of he counries, economiss say i can be he icking bomb for he world economy. The US Federal Reserve Sysem and cenral banks of he developed counries ake measures o reduce liquidiy deficiency in he global financial sysem, graning considerable volume of funds o commercial banks. The miigaion of financial policy resuled in FRS raes reducion by 0.75 per cen. Invesigaion ino financial crisis shows ha many of he crises were provoked by a general pricelevel change. In he conex of he maer under review, he influence of he growh rae of morgage lending on he financial sabiliy of he counry depends on he curren level of price consisency and soundness of he banking sysem, characerisics of exchange rae channel in he ransmission mechanism, flexibiliy of he moneary and financial policy regimes (Kallaur, 2007). The US morgage marke crisis had an impac on he moneary policy in Russia. Thus, in 2006 he average morgage loan rae in Russia amouned o 11 % per annum. The naional projec Affordable housing provides for morgage loans cos reducion in 2008 o 10%, in 2010 o 8%, by 2015 o 2 4%. However, as a resul of he US morgage crisis, he banking sysem in Russia was subjec o he following changes: wih a view o minimizing loan risks, a range of banks pu on hold he loan issue ha slowed he pace of morgage lending; he flow ou of foreign invesmens changed ino heir flow ino acive aracion of individual s funds in domesic marke; wih a view o aracing more deposis, he banks increased he ineres rae on morgage loans by per cen per annum; Conference May 19-20, 2008, Minsk

326 326 he loan graning procedure was reconsidered, and requiremens in erms of loan issue and loan schemes for propery purchase ou of own were oughened; loans wihou down paymen were pu on hold; he saring poin for down paymen wen up o 10 per cen; approach owards research ino he borrowers credi hisory was changed; morgage loans issue wihou relevan income confirmaion was pracically abolished. The above processes emphasize ha he money and credi sphere are in coninuous ineracion wih exernal macroeconomic environmen. The deerioraion of he foreign rade business leads o decrease in expor and an increase in he credi balance of he curren accoun of he balance of paymens, conribues o he growh of ension in domesic currency marke, herefore hreaening he moneary and financial sabiliy. To avoid a sharp fall in he exchange rae and no o endanger he price sabiliy, he cenral bank needs o oughen he moneary policy and increase ineres raes in domesic money marke (Kallaur, 2007). Influence of he US morgage crisis on moneary policy of a range of counries once again sresses he need for he weighed approach in deermining he following facors for he Belarusian ransiion economy: inegral regulaory and legal framework wih regard o morgage lending in accordance wih he inernaional requiremens and sandards; weighed risk assessmen and is insurance; he opimum growh raes for he loan marke as a whole and morgage lending in paricular; weighed commensuraion of he influence of morgage lending growh on financial sabiliy and real esae price variaion; value of raised funds and heir ineracion wih he planned value in he form of he loan; loan ineres rae pah; opimizaion of loan erms; mechanism of loan graning procedure; issues of design and implemenaion of new reliable financial insrumens and echnologies for refinancing of long-erm morgage loans. The lending pracice in Belarus is based on propery securiy. The savings bank Belarusbank OJSC and Belagroprombank OJSC were one of he firs o implemen his pracice. A presen 16 banks of he counry can ac as pledgees of land los, owned by legal eniies and individuals, during loan issuing. One of he paramoun asks in developing he morgage lending sysem is he formaion of marke land relaionships. Besides, Belarus qualifies for access o inernaional capial markes; herefore, legislaion should correspond o he common inernaional requiremens and sandards applied o morgage lending. Thus, here is need for legislaive acs, which could conribue o he inegraion of domesic sock marke ino he inernaional securiies marke for use of world reserve funds (Ovchinnikov, 1995). Naional Bank of he Republic of Belarus The curren Belarusian legislaion is inadequae o implemen he sysem of long-erm morgage lending. Le s assume he bank secures fulfillmen of obligaions on loan agains he aparmen (we will no deep ino legal deails regarding land lease of a mulisoried house). Under he conrac of propery morgage, he bank has o oblige he pledger no o regiser anybody in he encumbered propery before he specified conrac is signed. As soon as he saed conrac is regisered, he borrower s family (wih minor children) regisers and moves ino he aparmen, which is he only accommodaion for he specified family. Due o inconsisency of a series of legislaive acs, he bank will no be able o levy execuion on morgaged propery if such necessiy arises.

327 327 Banks need o have a guaranee for weighed risk assessmen. I is worh bearing in mind he fac ha we consider he significan loan amoun for a long period of ime ha increases he risk of non repaymen. In he auhor s opinion, morgage loan risk insurance is designed o provide financial securiy of he operaions hereby. The following ypes of obligaory and volunary insurance should be inroduced ino he banking sysem: insurance of subjec of he pledge (morgage) (analogous o hull insurance). This ype of insurance needs o be obligaory; non-repaymen risk insurance. In he auhor s opinion, if a loan amoun exceeds 150 million BYR, his insurance ype mus be obligaory. Under he presen circumsances, non repaymen risk insurance can serve as loan enhancemen; however, under he curren legislaion, he bank mus ac as an insurer and bear all relevan expenses. The legislaor should foresee he possibiliy of ransfer of expenses o he borrower; he borrower s life and working capaciy insurance. In case of absence of a loan enhancemen, which could be, for example, a hird-pary guaranee, his insurance ype mus be obligaory; consrucion risks insurance. This insurance ype can be volunary; and oher insurance ypes. I is an obligaory requiremen ha an insurance conrac should sae ha he bank is a beneficiary pary under insurance conrac, hough a he bank s discreion he borrower has he righ for insurance claim in case of loss occurrence. When choosing he mos effecive moneary policy, i is essenial o define he opimal growh raes of he loan marke as a whole and morgage lending in paricular. According o he Principal rends of he moneary policy of he Republic of Belarus, he amoun of loans, supplied by he banks for propery morgage invesmen in 2008, is expeced o be equal o rillion BYR, including residenial building loans rillion BYR. Taking ino accoun he upper bound, Belarusian banks invesmens will increase by 25.8%, or 1.2 rillion BYR, as compared o Growh raes of invesmen loans supplied by Belarusian banks in comparable prices surpassed he growh of he real GDP by 11.7 percenage poin. In his connecion he value of loans issued by domesic banks las year amouned o 4.5 rillion BYR, he amoun of loans issued by foreign banks made up 0.4 rillion BYR. The volume of residenial houses buil a he expense of bank loans, increased from 17% o 40 % as compared o 2006, ha demonsraes he growing role of he banks in solving his imporan social ask. According o he banking saisics, he raio of preferenial morgage loans graned for residenial housing in 2007 amouned o abou 2 rillion BYR. In he course of he year he banks issued preferenial morgage loans o individuals o he amoun of 1.1 rillion BYR, o economic eniies o he amoun of over 0.8 rillion BYR. The arrears of loans aken by individuals o purchase or build accommodaion, issued on a common basis, increased by almos 1.5 imes during he year and came up o 1.3 rillion BYR. In accordance wih he governmen programs, morgage is o play a crucial par in consrucion of commercial real esae and in solving a residenial-housing problem. I does no mean hough ha accommodaion will become affordable. While aracing addiional funds ino he morgage secor, i is necessary a he same ime o increase consrucion volumes, as a rising demand and a slow consrucion pace will ineviably cause he increase in already high real esae prices, i.e. inflaion in real esae marke. The nex criical issue when choosing he effecive moneary policy is a weighed commensuraion of he influence of morgage lending growh on financial sabiliy of he counry and real esae price variaion. Conference May 19-20, 2008, Minsk

328 328 The analysis of he indexes of consrucion cos (Illusraion1) demonsraes ha in residenial building for all caegories of individuals (a he expense of all sources of financing and wih sae suppor) an increase in he cos per square mere of he floor space anicipaed he increase in cos of consrucion works. Figure1: Variaion in average consrucion cos per square mere (growh rae in he relevan period of he previous year) % I qu I II qu I III qu I-IV qu I qu I II qu I III qu I-IV qu Growh rae of he average cos of residenial floor area per square mere Growh rae of he consrucion work cos Source: prepared by he auhor on he basis of (Main rends, 2007). Price index for consrucion assembly works (able 1), having increased from % in he 1 s quarer of 2007 o 110.8% per annum in oal, exceeded he upper bound of he average annual value of he prediced parameers ( per cen). Table 1: Variaion in average consrucion cos per square mere of residenial floor area (growh rae in he relevan period of he previous year), % Indicaors I qu. I II qu. I III qu. I-IV qu. I qu. I II qu. I III qu. I-IV qu. Average consrucion cos per square mere of residenial floor area, buil a he expense of all sources of financing (housand rubles) Growh rae (%) Including sae budge financing (housand rubles) Growh rae (%) Average consrucion cos per square mere of residenial floor area, buil a he expense of all sources of financing, for individuals in need for housing improvemens (housand rubles). Including sae budge financing (housand rubles) Growh raes of consrucion work cos (%) Source: (Main rends, 2007). Naional Bank of he Republic of Belarus Le s no go deep ino he analysis of he facors ha influence he price variaion in he sphere of invesmens, as hey go far beyond he maer under consideraion.

329 329 As of oday, according o research ino he offers of real esae agencies, he average cos of accommodaion in Minsk amouns o: in he primary marke USD per 1 m 2 ; in he secondary marke (aparmens less han 15 years old) USD per 1 m 2. The average price of a wo-room aparmen is: Floor space of a wo-room aparmen 68 sq.m. х 1700 USD per 1m 2 = USD. Le s consider he fac ha he average salary of he residen of Belarus is equivalen o 327 USD. Assuming ha all income is saved o purchase an aparmen and real esae prices are fixed, he will be able o purchase his aparmen 29.5 years laer. Taking ino accoun he cos of repair he aparmen will need, which will amoun o 1000 USD a he minimum, he worker will sele in 32 years laer, jus by he ime his children need he accommodaion. There is an obvious long-fel need for new financial insrumens as means of accommodaion purchase, which will no have a bearing on he increase in he propery price for he square mere. One of he insrumens is an increase in volume of residenial house building by way of puing ino exploiaion by organizaions of he oal residenial floor area for heir employees who are in need for housing improvemens, pursuan o he Resoluion of he Governmen 1. In % of residenial housing was financed ou of enerprises funds. In 2008 a he organizaions expense, wih accoun of heir share in consrucion, i is planned o issue morgage loans o employees of organizaions for 72.4 housand sq.meres of residenial area. Among he menioned organizaions are ASB Belarusbank OJSC 2.0 housand sq. meres, Belagroprombank OJSC 0.24 sq. meres, Belinvesbank OJSC 0.45 housand sq. meres. Therefore, one of he forms of non-budgeary financing of residenial house building is financing ou of enerprises and organizaions own funds. The laer, in heir urn, will be subjec o ax concessions. In 2006 he shared consrucion was pracically curailed, pursuan o he Decree of he Presiden of he Republic of Belarus as of June 15, On shared consrucion of aparmen houses, due o resrain of accommodaion prices. Wih a view o fosering shared consrucion, he Governmen 2 inroduced amendmens ino he legislaive basis, herefore faciliaing shared consrucion erms for real esae developers. These amendmens also reduced he profi-earning capaciy o 5% from hose who need housing improvemens, lifing resricions on profi-making from hose in no need. The value of raised funds has a considerable impac on he loan value. In his respec i is crucial o creae a favourable invesmen climae. The counries ha managed o offer a favourable invesmen environmen are ahead in erms of economic growh rae and living sandards. Ineres policy is boh one of he mos imporan and raher complex insrumen of banking regulaion as well as he key facor in he mechanism of funcioning of he economy secor. (Tarasov, 2003). In he curren siuaion he banks make an exensive use of invesmens from inernaional financial insiuions (World Bank, European Bank for Reconsrucion and Developmen). Successful cooperaion wih hese financial insiuions will enable hem o bring in more capial by aracing privae invesmens from inernaional financial markes. 1 The Resoluion of he Council of Minisers and he Naional Bank of he Republic of Belarus as of December 27, /18 «On measures o implemen residenial housing building in 2008» 2 The Decree of he Presiden of he Republic of Belarus as of On issue of shared consrucion". Conference May 19-20, 2008, Minsk

330 330 Along wih aracing foreign invesmens, i is criical o creae an advanageous invesmen environmen o accumulae domesic savings, by heir effecive invesmen ino economy. One of he sources of financing of he banking sysem, hough expensive, is deposis of legal eniies and individuals. Therefore, on July 1, 2006 ASB Belarusbank sared o accep money deposis wihin he Consrucion savings sysem. Wih a view o increasing he number of mehods of fund raising, banks offered a new produc longerm securiies wih morgage collaeral. I is assumed ha morgage securiies marke will play an imporan social role in he capial flow ino he residenial house building secor (Taur, 2007). The moneary policy has deermined ha by he end of 2008 ineres raes on loans for nonfinancing secor are planned o be reduced o % per annum. In he 2nd quarer of he curren year he banks of he republic offer an ineres rae on real esae loans o individuals in he naional currency amouning o % per annum (excluding paymen for mainenance and repaymen of loans). The rae on newly-issued loans o individuals in he naional currency (including preferenial loans) for longer han a year amouned o 10.9 % for he year I is obvious ha he aracion of morgage lending depends on is cos. The mos aracive loans are hose in Japan (Fig 2). Figure 2: Ineres raes on morgage loans, % By inroducing morgage lending, he sae as a whole and he banking sysem in paricular need o solve wo issues reducing loan ineres raes and inflaion reenion. Opimizaion of loan erms is also a crucial issue in morgage lending. A presen he Belarusian banks supply 2 real esae loans wih duraion of up o 15 years. Pursuan o he Decree of he Presiden 0.5 of he Republic of Belarus as of April Japan England USA China Russia 14, ,he maximum preferenial loans duraion shall no exceed 20 years (for he residens permanenly living and working in he inhabied localiy wih a populaion of up o 20 housand; for families having many children 40 years). As a comparison: In China he duraion of a morgage loan is years, in he USA 40 years. I is obvious ha o implemen morgage lending i is necessary o solve he following problem: o replace cosly and shor erm loans by cheap and long-erm ones. Naional Bank of he Republic of Belarus The design and implemenaion of new reliable financial insrumens and echnologies for refinancing of long-erm morgage loans are of paricular imporance. One of such insrumens is fiduciary managemen of funds and oher propery owned by legal eniies and individuals. The implemenaion of he fiduciary managemen scheme is imporan for he bank as means of aracing resources and for he populaion as a mehod of deposi of emporary free funds. This is proved by rising frequency of ciizens recourse o he Naional Bank wih regard o operaional procedure of funds ransfer ino he uni invesmens funds of he Russian Federaion (On deposis of funds, 2008).

331 331 The invesor wih an acive living posiion does no always have ime o make decisions regarding he placemen of his free funds. Fiduciary managemen is he pracice of capial saving and incremen commonly used in he whole world. Therefore, he invesor russ his funds ino fiduciary managemen for deposi in real esae consrucion (commercial or residenial). The bank, in is urn, issues loans o he real esae developer. The efficiency of funds deposi by he invesor ino fiduciary managemen o he bank is made up of many elemens. Firs banks-professionals in he loan secor wih many years experience. Second he suppor of bank s infrasrucure and he professional eam. Bank has he following deparmens dealing wih loans: loan deparmen: deals wih he credi hisory of he borrower, analyses he curren and prospecive credi worhiness of he borrower in accordance wih accouning sandards, gives ou he ranking score and comparaive assessmen of financial and economic sanding, analyses he feasibiliy of fulfillmen of obligaions, esimae sufficiency and liquidiy of he offered guaranee of he fulfillmen of obligaions under he loan conrac; securiy deparmen: checks business repuaion, legal saus, credi hisory and oher maers concerning clarificaion of he borrower s liabiliy ; legal deparmen: deals wih he legal capaciy of he borrower, juridical aspecs of he deal. Third he bank requires from he borrower he guaranee of he fulfillmen of obligaions under he loan conrac and conrols he loan securiy during he loan life. Fourh he bank conrols he purpose of a loan. Fifh in case of delay in paymens he bank forms a reserve and akes relevan measures. Sixh he invesor makes more profi han from deposi placemen. Fiduciary managemen of invesors funds will allow he bank: o implemen new insrumens of aracing resources; o involve ino he sysem legal eniies and all levels of populaion wih an average income; o offer he invesors more profi han from deposi of emporary free funds, a he expense of he absence of necessiy of formaion of a reserve; o place a direc proporion beween he erm of deposis of emporary free funds ino fiduciary managemen and he profi made, so he longer he erm he higher he profi; o arac long-erm resources ha will have a posiive impac on liquidiy; o improve he level of loan ineres raes; in order o avoid cash ouflow from he republic we need o adjus o a maximum he inernaional bes pracice aking accoun of he peculiariies of our domesic economy; Wih a view o implemening he sysem of fiduciary managemen of he funds for furher onlending aciviies in consrucion, i is necessary o make he following amendmens in he regulaory and legal framework: 1. To widen he use of funds given for fiduciary managemen. Conference May 19-20, 2008, Minsk

332 To free he income, obained by he invesors from fiduciary managemen, from he income ax. The advanage of he fiduciary managemen sysem implemened by he banks is he implemenaion of new reliable financial insrumens and echnologies for refinancing of long-erm morgage loans, heir capaciy o choose he opimal loan ineres rae pah by way of regulaing he value of araced resources. The research ha was carried ou allows formulaing a series of summarizing conclusions, regarding he subjec of research. One of he significan issues in choosing he effeciveness of he moneary policy is design and implemenaion of new reliable financial insrumens and echnologies for refinancing of a morgage lending mechanism in Belarus. Morgage should solve residenial building problems as well as develop a financial marke as such. The main objecive of he loan marke developmen in Belarus in he environmen of a ransiion economy is o launch in full he mechanism of morgage lending by creaing he civilized marke based on healhy compeiion and araciveness for invesors. Wih a view o aaining he objecives se ou, he following facors need o be defined for he ransiion economy of Belarus: 1. Inegral regulaory and legal framework wih regard o invesmen lending in accordance wih he common inernaional requiremens and sandards. 2. The opimal developmen raes of he loan marke as a whole and morgage lending in paricular. 3. Weighed risk assessmen, including risk insurance. The facor ha lowers he loan risk is inroducion of he following erms for he borrowers: a. The lower he loan amoun of he oal propery value, he lower he ineres rae; b. From he momen of regisering he morgage loan agreemen, i is necessary o consider a lower loan ineres rae, which will encourage he borrower o accelerae he morgage regisraion, and he bank o provide guaranee. 4. Weighed commensuraion of he influence of morgage lending growh on financial sabiliy and real esae price variaion. 5. Creaion of he favourable invesmen environmen. 6. Implemenaion of new reliable financial insrumens and echnologies for refinancing of long-erm morgage loans, heir capaciy, by way of regulaing he value of araced resources, o choose he opimal loan ineres rae pah. One of hese insrumens is fiduciary managemen of funds and oher propery of individuals and legal eniies 7. The value of araced resources and heir ineracion wih he planned deposi cos in he form of a loan. 8. Opimizaion of he loan duraion. Wih his regard i is raional: a. To expand loan erms up o 30 years; Naional Bank of he Republic of Belarus b. To abandon fixed loan erms; c. To consider he possibiliy of prior loan repaymen;

333 333 d. In case of prior loan repaymen of he oal loan value o consider a sligh reducion of loan charge. This is a moivaion for he borrower, and he reducion of loan risks, he reducion of cash cycle duraion and, consequenly, saisfacion of he loan needs of he larger number of borrowers for he bank. 9. Mechanism of a loan graning procedure. Therefore, a weighed approach owards implemenaion of morgage lending will help solve he problem of residenial housing developmen in Belarus a he micro level and will have a favourable influence on he enhancemen of efficiency of he moneary policy a he macro level. References Volianiuk V., Nezvanov A. Geomery of a corner// Belarus oday (22707). Tarasov V.I. Marke Forex in January: recession danger suppored he dollar // Currency regulaion and foreign rade aciviy P.68. Kallaur V.P. The guaranee of he moneary and financial sabiliy: a conflic or he harmony of objecives? // Banking bullein (384). P.4 7. Ovchinnikov V.V. The pracice of commercial banks in residenial housing consrucion // Fianaces P. 28 Main rends in he economy and he moneary secor in he Republic of Belarus// he Naional Bank of he Republic of Belarus //Analyical review. Minsk [Elecronic reference resource] Access regime: hp: // Access dae Tarasov V.I. Influence of an ineres policy on he real secor of economy// Banking bullein (249). P.23. I.Taur. Firs morgage securiies in he Republic of Belarus // Banking bullein (384). P.35. On deposis of funds ino uni invesmen funds of Russia // he Naional Bank of he Republic of Belarus/ Press-releases. Minsk [Elecronic reference resource] Access regime: hp: // / Press/Prin. Access dae Conference May 19-20, 2008, Minsk