Mugur Isărescu: Unconventional monetary policies and financial stability
- implications for banks and financial markets
Address by Mr Mugur Isărescu, Governor of the National Bank of Romania, at the joint CIGI
(Centre for International Governance Innovation) - Oliver Wyman conference, Rome,
15 December 2015.
* * *
The address was presented by Governor Mugur Isărescu during the panel session
"Unconventional monetary policies and their impact on financial markets", which also included
the following members:
• Domenico Lombardi, Director of the Global Economy Program, CIGI
• Malcolm Knight, Distinguished Fellow, CIGI (former General Manager of the BIS)
• Lorenzo Bini-Smaghi, Chairman, Société Générale (former Vice-President of the
ECB)
• Lorenzo Codogno - Professor in Practice European Institute, LES
• Pierpaolo Benigno, Professor of Economics, LUISS University
• Carlotta de Franceschi, Co-Founder and President, Action Institute
Participants included, among others:
• Robert Ophèle, Deputy Governor, Banque de France
• Dimitar Bogov, Governor, National Bank of the Republic of Macedonia
• Korbinian Ibel, Director General, Micro-Prudential Supervision IV, ECB
• Margarita Delgado, Deputy Director General, SSM, DG1, ECB
• Matthew Elderfield, Head of Compliance, Lloyds Bank
• Carlo Corradini, Member of the Supervisory Board, Intesa Sanpaolo
• Pierre Siklos, Senior Fellow, CIGI
Ladies and Gentlemen,
It is an honour for me to address the audience during this conference on unconventional
monetary policies.
In Romania, as in most other Central and Eastern European countries, monetary policy interest
rates are still above the zero bound and, as such, there has been no need to venture into the
uncharted waters of quantitative easing and negative nominal interest rates. Therefore, I will
not approach these two already classical unconventional instruments, since Romania's
experience is not illustrative from this perspective. Besides, I am sure that they will be
extensively dealt with by other panellists.
In this case, you are probably wondering why I am now in front of you. The answer is that,
10 years ago, the National Bank of Romania faced an economic and financial context which
could also be labelled as exceptional. It called for the use of unconventional instruments and
hence the departure from the prevailing economic precepts of the time and particularly from
the rules that defined the modus operandi of an inflation targeter. Some of these tools would
later be referred to as "macroprudential instruments", but back then we referred to them as
unorthodox monetary policy measures, the NBR responsibilities including not only monetary
policy, but also financial stability, the supervision of credit institutions and the issuance of
secondary legislation in the field of banking regulation.
Consequently, I have come in front of you today with the hope that at least some of the lessons
we learned at the time might prove relevant for this panel's discussions.
My intervention today is structured along 4 lines, namely:
1. What made the economic context in which the NBR was operating in the run-up to
the European Union exceptional?
2. How far has the NBR departed from the standard paradigm?
3. Did markets and banks react to the departure from the paradigm?
4. Was the unorthodox approach effective?
Allow me to sketch the answers to these questions:
1. What made the economic context in which the NBR was operating in the
runup to the European Union exceptional?
First of all, the banking system was dominated by foreign-owned banks. After a string of
domestic bank failures (particularly in the late nineties), the lack of domestic private capital,
combined with the fragile situation of the state budget, made it compulsory to privatize the
existing banks by selling them to foreign entities. As a matter of fact, the dominant view at the
time was that opening the banking system to foreign capital was essential for improving
efficiency and expertise, alleviating the shortage of domestic capital, and increasing
competition. Against this background, by facilitating a better resource allocation, the
penetration of foreign capital into the Romanian banking sector was seen as a means to
promote restructuring of the loss-incurring SOEs and to stimulate convergence to the EU.
Of course, such a development brought about positive effects in the economy, as it came with
stronger corporate governance and modern banking practices. However, it also had the
byproduct of rapidly growing forex credit, undermining the effectiveness of conventional monetary
policy and giving rise to risks from the financial stability perspective.
This occurred against the background of a significant interest rate differential, given the
comparatively high inflation and increasingly abundant capital flows, as the removal of capital
controls was proceeding rapidly due to the requirements of the forthcoming EU membership.
Such an environment naturally produced nominal appreciation of the domestic currency,
providing further incentive for foreign currency lending, booming domestic demand and an
unsustainable decrease in inflation, as revealed by an ever widening current account
imbalance (to the tune of two-digit numbers as a percentage of GDP). To further complicate
matters, the newly found prosperity lured fiscal policy into relaxing pro-cyclically.
Trying to cool down the economy through the standard recipe of policy rate hikes would have
been pointless, if not outright detrimental, by prompting even more capital inflows and nominal
appreciation, thus feeding the vicious circle described before.
2. How far has the NBR departed from the standard paradigm?
Quite far, I would say, if we use as a benchmark the clearly defined IT framework. Constrained
in the resort to the policy rate, the NBR had to depart, at times, from monetary policy orthodoxy.
Such departures from conventional practices involved full use of direct FX interventions,
allowing market interest rates to fall significantly below the policy rate through liquidity
management or deploying administrative measures to control credit growth. But probably the
most striking unconventional feature of our monetary policy back then was the active recourse
to reserve requirements, the rates of which were increased to levels exceeding by far those of
any other central bank in the EU: 20 and 40 percent for lei- and forex-denominated liabilities
respectively in 2006.
However, taking into account that studies published even before 2006 considered the pure IT
framework as not necessarily the most suitable for an emerging economy, one might think that
the NBR's departure from the mainstream was less significant. Specifically, the NBR opted for
a "light" version of inflation targeting, which meant retaining the managed float feature of the
exchange rate regime, which implied smoothing out excessive volatility, without defending a
certain level of the exchange rate or preannouncing interventions.
The actual form inflation targeting took in Romania thus matched the "managed-floating plus"
concept introduced by Goldstein in 2002, considered the most suitable choice for an
emergingmarket economy involved in the global capital market, as it combines the managed float part
with an inflation targeting monetary policy strategy and an active pursuit of measures to limit
the degree of currency mismatches in the economy.
Subsequently, this "managed-floating plus" approach gained acceptance, especially during the
global crisis, and now forex interventions are part of the arsenal of many central banks,
including some of those using a free floating regime before the crisis.
3. Did markets and banks react to the departure from the paradigm?
Yes, especially since we also used a number of administrative measures, controversial at the
time, but which now - after the crisis has warranted their use - are considered valid
macroprudential instruments. I will name some of them: enforcing maximum loan-to-value
ratio, introducing debt service ceilings relative to households' monthly disposable income (the
scope of which was subsequently expanded to include non-bank financial institutions engaged
in lending), setting limits to banks' forex exposure vis-à-vis unhedged borrowers, using
differentiated coefficients in stress tests (higher for exposures to EUR than lei, with even
stricter coefficients for CHF- and USD-denominated credit).
At the time, banks perceived such measure as excessive administrative interference and I
even remember a rather uncomfortable discussion with the president of a large foreign bank
operating in Romania, who reproved me for the fact that, only a few years after being invited
to invest in our country, banks were facing regulatory "innovations" that narrowed their scope
of business.
4. Was the unorthodox approach effective?
With the benefit of the hindsight, I would say it was, at least to some extent. I see now
3 limitations and 3 benefits of the approach we took 10 years ago.
Let me start with the limitations:
First, the measures were not entirely successful in cooling off foreign currency lending, as
banks found ways to circumvent the restrictions in place by externalising credit portfolios. Forex
credit continued to expand, its share in total credit approaching 60 percent by the end of 2008.
We are still dealing with this legacy: for instance, Swiss franc loans, even though accounting
for a much lower share of total credit than in neighbouring countries, proved troublesome in
the wake of the recent CHF appreciation.
Second, implementing the unorthodox measures has also proven very difficult from the
communication perspective. These measures proved difficult to explain to the public at large,
which saw them as preventing improvements in welfare, and also to the commercial banks
themselves, which - as I said earlier - were protesting against what they saw as an uncalled
for injunction into their activity. On top of that, we had a tough time explaining our policies even
to the ECB. Fortunately, President Trichet understood why we had to take the unusual
monetary policy approach, acknowledging that the standard policy consensus was not enough
to deal with the challenges a small open economy had to face amid a flood of capital.
Third, the exit from these measures has not been easy. While the post-crisis environment
provided an opportunity to gradually normalize the reserve requirements levels (thus supplying
an additional counter-cyclical tool), they remain high by European standards.
However, despite all these obstacles, I think the resort to unconventional policy instruments
had 3 major advantages.
I would name first the fact that they certainly managed to limit the size of the disequilibria. I
have no doubt that the outcome would have been a lot worse had we been complacent and
relied entirely on the self-corrective behaviour of markets. I will give here just one example:
forex interventions limited significantly exchange rate fluctuations, with the appreciation during
the massive capital inflows and the depreciation after the crisis outbreak not exceeding
25 percent. In the absence of such interventions, the magnitude of fluctuations could have
been as high as 40 to 60 percent.
The foreign exchange purchases made before the crisis not only limited the unsustainable leu
appreciation and the associated loss of export competitiveness, but supplied the ammunition
for subsequent interventions to cushion the currency depreciation once the outbreak of the
crisis changed the direction of the flows. And I believe this is the second benefit of the
approach.
Last, but not least, thinking outside the box allowed us to avoid incurring losses after 2006.
While profitability should not be a concern for a central bank, this development proved very
fortunate from the perspective of the political economy. On the one hand, it allowed the NBR
to preserve its independence in relation to the government by not generating quasi-fiscal
deficits in a period with an increasing fiscal imbalance. On the other hand, it helped preserve
institutional credibility in relation to the banks subject to NBR supervision, which were closely
monitored in terms of capital adequacy. Moreover, through our actions we wanted to avoid
rewarding the speculative behaviour several commercial banks were engaged in (i.e. carry
trade) and instead incentivize them to focus on their core activities.