Júlia Király: A policy recipe for successful convergence of CESEE
countries1 in the post crisis world
Speech by Ms Júlia Király, Deputy Governor of Magyar Nemzeti Bank (the central bank of
Hungary), at the Conference on European Economic Integration (CEEI) 2010, Vienna,
15 November 2010.
* * *
I would like to thank the contribution of my colleagues Csajbók, Attila and Kovács, András Mihály.
Dear Ladies and Gentlemen,
First of all, I would like to thank for the opportunity of being invited to this very interesting
conference. The topic "Catching-up strategies after the crisis" could not be more relevant. As
I will argue in the next few minutes, we should not consider the financial crisis as something
fading quickly away, its aftermath will most probably stay with us for several years. Let me
put it another way, my impression is that the crisis clearly changed the rules of the game for
countries with the intention to converge to Western-European income levels. This road will
be much bumpier compared to what it seemed from the past, therefore it requires a very
conscious strategy in policy making.
In the next few minutes I would speak about four interrelated topics. First, I sketch the new
rules of the game in the post crisis world. Second, monetary policy options and
macroprudential challenges in the years ahead will be outlined. Finally, I would make a few
remarks regarding my opinion on euro-area accession. Most remarks of mine, I believe will
be general, valid for all CESEE countries. Others will be more valid for countries with high FX
debt burden.
Taking stock of the starting position: the financial crisis forces changes in the
convergence model of CESEE countries
The financial crisis brought a reassessment of risk attitude toward debt financing. Those
countries, where real convergence was accompanied by current account deficits and
excessive debt flows did face deeper recession.
The reliance of CESEE countries on foreign funding depended on two key elements of
macroeconomic framework: fiscal and exchange rate policies. Countries with tight fiscal
policies
and low government debt ratios ceteris paribus had lower external imbalances (for
example Czech Republic and Poland versus Hungary). Second, flexible exchange rate
system ceteris paribus helped avoiding large credit booms (flexible inflation targeting versus
currency board regimes). Naturally, these two parameters do not capture all the relevant
information on whether a country became fragile in macroeconomic terms prior to the crisis.
However, research has shown,2 that they were instrumental in the resilience of countries with
respect excessive capital inflows and sudden stops. In addition, differences in macro
prudential policies in controlling capital flows helped somewhat mitigating excessive capital
flows, but their effectiveness were very far from perfect.
Though the situation on financial markets consolidated somewhat in the last year or year and
a half, I believe, that lower risk tolerance compared to pre-crisis levels will prevail in the next
few years. This is a natural consequence of global deleveraging, which takes several years
after a financial crisis.3 As is shown in several papers,4 deleveraging means, that CESEE
rely on external financing to a lesser
countries in the post crisis world might extent, than
previously. Unless these countries find more domestic savings to finance the catch-up
process, real convergence will slow down.
Lower risk tolerance at the end of the day might lead to higher uncertainty, and higher
volatility. Lower risk tolerance means, that economic sustainability had become a key issue,
and there are very few if any countries among CESEE who are surely on a sustainable path.
The closer is a country to a point where the sustainability of a country's economic policy is
questioned, the more sensitive it becomes to both global and country specific economic
news. As a Hungarian central banker, I had to learn this lesson already several years ago.
We need economic policies that push countries towards sustainability.
As already mentioned, on the fiscal side, sustainability requires tight policies, we have to
decrease indebtness to levels, where countries do not become excessively reliant on
external financing sources. As CESEE countries are less developed than core Europe
- contrary to the traditional macroeconomics - the same level of government debt can not be
afforded. As lower GDP/capita implies lower household wealth, the same level of
government debt as e.g., in Germany, would require much more external financing, hence
external debt. This is also a lesson, you must learn from the Hungarian case. Tight fiscal
policy also helps private savings to finance private investments, and hence we can avoid a
slowdown in real convergence in a period of scarce external financing.
However, it is clear that - apart from Hungary - most problems among CESEE countries
were rather caused by excesses in the private sector, than by excessive government
spending. Though, as is shown in case of "peripheral Europe", this picture can change
quickly, systemic risk in the private sector can easily turn to government debt.
Regarding private sector imbalances, the issue is even more complex, as we cannot identify
one actor, responsible for the behavior of a whole sector. Here we have two policy optimon:
monetary and macro-prudential, and one should not forget about their interaction. Let me
look at them in turn.
Monetary policy in a post-crisis world: living together with permanent level of high
uncertainty
As I argued, the crisis brought a reassessment of risk, resulting in the reassessment of
sustainable external balances. Foreign investors are not the only actors to change their
opinion regarding the most likely path of future variables. Households, corporates and all
economic actors should reassess, what they thought sustainable previously about the future.
With forward looking agents, this means that they react now stronger in output, expenditures
and prices compared to how they did in the past. All this means an extreme level of
uncertainty.
We need a robust monetary strategy that helps to live together, with high level of uncertainty.
We need a transparent framework, flexible enough to absorb risk premium shocks, but such,
that ensures price and financial stability in the long run. Flexible inflation targeting might be
considered as such a system. Inflation target as a final nominal anchor is transparent but
flexible enough to (1) avoid reacting to excessive risk premium volatility with interest rate
policy (2) incorporate other type of policy considerations, like macro-prudential ones.
It is also obvious however, that one instrument, namely interest rate policy, cannot be
enough to achieve both price, and financial stability. One of the most important lessons from
the financial crisis is that there can be conflicts. The empirical evidence shows, that
increasing price and macroeconomic stability gives extreme incentives to financial risk
taking, as risk aversion declines due to observed stability.5
As almost every problem, the conflict of price stability and financial stability among small
open emerging economies is mostly linked to the volatility of capital flows.6 During "good
times", excessive capital inflow appreciates the exchange rate, and, as a consequence,
overheating does not necessary appear in inflationary pressure, but in rising external
imbalances, credit booms. During "bad times", on the contrary, capital outflows cause
depreciation and inflationary pressure, when financial sector imbalances are closing. From
financial stability point of view traditional inflation targeting seems to be too loose when
imbalances are building up, and too tight, when financial imbalances are closing.
Macroprudential policies can help to tackle this problem, though their effectiveness largely depends
on the fact whether they are implemented internationally or only nationally. National policy
can easily be circumvented in a world of globalized capital markets and multinational banking
sector.
We also know however, that CESEE countries are not uniform regarding their fragility of their
financial systems. In fact there are more countries in the region that relied on excessive
foreign funding prior to the crisis, than those who did not. Hungary is one of the countries
where external deficit was relatively large prior to the crisis, though we did not achieve the
level of fixed exchange rate countries. These countries could only run these sizeable deficits
absorbing FX based capital flows, as in line with international observations, foreign investors
were reluctant to take the FX risk associated with quick debt accumulation.7 In other worlds,
the "original sin" syndrome created sizeable currency mismatches in them.
There is an increasing complexity of the monetary transmission mechanism (MTM) in
countries, moving from sizeable external deficit to more sustainable path. The first point is a
likely strengthening of the interest rate channel on new flows. Prior to the crisis, the interest
rate channel was circumvented by FX borrowing, which meant that only the exchange rate
channel of the monetary transmission mechanism did really work. As a result, after the crisis,
macro-prudential regulation has been implemented in several countries to constrain FX
lending (in Hungary FX base mortgage lending is already legally prohibited), and it is also
true that observed exchange rate volatility also induced a reassessment of risk associated
with FX lending. These factors in the future should mean that on new credit flows, the
domestic interest rate will be the dominant price, contributing to a strengthening of the
traditional interest rate channel. However we cannot estimate the exact magnitude of these
new parameters, as there is not available data for the new regime.
A second point regards the inheritance of the past: we have to live together with the
unhedged FX loan stock for several years, as there is no possibility of quick
redenomination.8 This would require transferring FX risk to the foreign sector, which by
definition is hardly feasible due to the problem of original sin.
Due to these factors, the stock and flow channels of monetary policy might counteract each
other. While the effect of monetary loosening/tightening on output and hence inflation might
increase if we only consider new flows, the unhedged FX debt stock effect works in the
opposite direction. A given change in the exchange rate has a smaller effect on output and
hence on inflation as in the past. A weakening of the HUF increases household indebtness,
which causes a drop in the domestic demand, weakening the effect of stronger net exports.
The exact magnitude of different channels, and most notably the FX stock channel can vary
from time to time, depending on the level of the exchange rate.
Furthermore, there can be serious nonlinearities in the MTM mechanism depending on the
levels of the risk premium, exchange rate, and hence banking sector resilience: the higher
the risk premium, the weaker the exchange rate and the banking sector's capital base, the
more likely, we will enter in a situation, where monetary loosening has recessionary effects,
when the banking sector cuts back lending seriously, this situation might hinder financial
stability.
The crisis has highlighted the importance of macroprudential policies and their
cross-border coordination
I already mentioned macroprudential policies here and there, let me now turn to them in
more detail. The crisis had made it clear that in order to achieve long-lasting macroeconomic
stability, striving for price stability is not enough: it has to augmented by stability in the
financial system. These two goals often conflict, therefore monetary policy alone is not
capable of continuously facilitating both of them. Additional policy tools are needed. As I said
earlier, in small open economies the conflict often manifests in volatile capital flows. A first
policy reaction to such a situation often is the introduction of capital controls, just like the
ones we currently observe in Latin American and Asian emerging countries. Now, the
CESEE region may not currently be a target of hot money inflows, but this may change in the
future. The use of capital controls is a controversial issue, and excessive reliance on them in
the CESEE region (at least in the countries that are already EU members) is off the cards
anyway, as it is against the fundamental EU principle of free capital movement. This leaves
macroprudential regulation as a potential policy tool in these countries to mitigate systemic
risk, either inherent or stemming from volatile capital flows.
Macroprudential tools are generally categorized into two types according to their primary
aims, which can be (a) enhancing systemic resilience or (b) leaning against the financial
cycle (reducing procyclicality). Systemic resilience tools are typically microprudential
instruments recalibrated for macroprudential purposes. These may include the regulation of
various ratios, such as loan-to-value (LTV) or payment-to-income (PTI), or forbidding "toxic"
products. Hungary recently has deployed such tools in order to discourage unhedged FX
lending, which proved to be a major source of systemic risk. Regulation may be stricter in the
case of systemically important (e.g. too-big-to-fail) financial institutions. Typical examples of
countercyclical tools are dynamic provisioning (e.g. the one in place in Spain even before the
crisis) or a countercyclical capital buffer (e.g. the one proposed in the new Basel III
regulatory standards).
Similarly to monetary policy, macroprudential policy can be tight or loose. In other words
macroprudential policy may be characterised by its stance, just like monetary policy.
As I mentioned earlier, an important factor in the effectiveness of macroprudential policies is
cross-border consistency.9 Cross-border coordination in the end should boil down to
coordination of macroprudential stances. The key motives for cross-border coordination are
to avoid regulatory arbitrage on the one hand and to provide a level playing field for financial
institutions on the other. I believe that this is especially true in the case of the CESEE region
as these countries are deeply integrated in the European banking system, with the branches
and subsidiaries of Western European banks being dominant players in the CESEE domestic
financial systems. Home-host coordination is therefore of primary importance.
If macroprudential policy stances substantially differ in home and host countries, this may
encourage regulatory arbitrage. Regulatory arbitrage stems from the feature of the globalised
financial system that many financial transactions between two parties in the same country
can in fact be executed in another country (through e.g. subsidiaries/branches of
internationally active financial institutions). In a home-host setting for example, tightening the
macroprudential stance in the host could be circumvented if the home stance is loose and
allows for a re-direction of intermediation through e.g. branches.
The flipside of this story, which gets less attention, is that a cross-border rechanelling of
financial activity from a country with a tougher regulatory regime to a more lightly regulated
one increases the potential for contagion to the more disciplined country (think of the decline
in share prices of the large internationally active Austrian banks when the markets started to
focus on their Eastern European exposures).
While regulatory arbitrage seems to be a home-host issue, the "level playing field" argument
for macroprudential coordination is probably more relevant in host-host relations. This stems
from the fact that the financial systems in CESEE countries often share the same parent
banks. As a result they are to some extent competitors in the cross-border allocation of funds
from parent banks. In such a situation, loosening the macroprudential stance in one host
country might channel intermediation activity from another host. In addition to violating
fairness, such beggar-thy-neighbour regulatory policies can lead to a mutually detrimental
'race to the bottom' regarding regulatory standards,10 leading to the increase of region-wide
systemic risk.
In a nutshell, the case is strong in the CESEE region for a cross-border coordination of
macroprudential policies both in the home-host and in host-host directions in order to avoid
regulatory arbitrage and to create a level playing field. While bilateral coordination may be
sufficient in certain home-host issues, multilateral coordination seems to be superior in most
of the cases and certainly in host-host coordination. As of today, however, the institutions for
such coordination are not in place. Supervisory colleges may come close, but they don't
have a macroprudential angle. The planned cross-border stability groups seem to be better
suited for this purpose, but if they are organised according to banking groups instead of
geographical areas with significant exposures to each other, they will probably not turn out to
be efficient macroprudential coordination fora. It remains to be seen whether the
soon-toturn-operational European Systemic Risk Board (ESRB) can serve as an effective
coordination vehicle for CESEE macroprudential policies.
Finally, allow me to make a precautionary warning against too much reliance on
macroprudential policies in facilitating financial stability. In my opinion, although they are
necessary, they certainly are not sufficient in themselves for this purpose. First, without
sustainable macro policies (fiscal in particular) and price stability the financial system may
easily find itself in trouble or may intermediate insufficiently. Secondly, although its aim is to
reduce system-wide risk, macroprudential policy in the end is a set of particular tools
targeting particular problems in particular parts of the financial system. In other words it is not
as general as monetary policy, which affects virtually all economic agents. If, for example,
there is a long-lasting general tendency of increased (and excessive) risk-taking in the
economy, macroprudential policy in itself can at best slow it down but cannot offset it
permanently. In such situations support from monetary policy, e.g. in the form of
leaningagainst-the-wind behavior, is necessary.
Euro entry: our ultimate safe harbor or compulsory task
Prior to the crisis, it seemed a safe bet to assume, that euro entry brings stability and
prosperity in the region, especially in Central Europe. Arguments in this respect were based
on three main results. First, there is a deep economic integration with core European
countries, like Germany: high trade share, with high intra-industry component, high level of
FDI in the traded sector. Second, deep financial integration, mainly due to high level of
foreign ownership in the financial sector, with core European countries. Finally institutional
similarity and convergence also made it probable, that most of the region forms an optimal
currency area, with the eurozone.11
In Hungary, with probably the largest swings in fiscal policy in the last decade, we soon
realized that we should - at least in fiscal terms - "put our house in order", before entry. We
also carefully watched the performance and sustainability of Mediterranean countries.
However, relatively small care was taken when analyzing the institutional weakness of
euroarea set-up. The unexpectedly large shock of the crisis brought up these institutional
weaknesses of the euro: the enforceability of the Stability and Growth pact, and imbalances
with fixed exchange rate in the private sector. With the hope, that recent reform efforts tackle
area-wide problems, we still cannot sit back and relax. We have to draw conclusions from
small, acceding country point of view, which are necessary for successful membership. It is
especially important, given that (1) weak economic performance of some countries became
obvious only after several years of entry, (2) prevention seems much cheaper, than crisis
resolution.
The first lesson is, that formal convergence criteria are necessary, but more care should be
taken with respect to sustainability of fulfilling them, and a careful monitoring of general
economic
sustainability. Unsustainable fiscal policies, and private sector imbalances are hard
to correct inside the euro-area, as countries has less policy tools to adjust by giving up
exchange rate flexibility. Though it is also true, that in the short term with high FX debt
burden, the room for exchange rate adjustment is also limited.
Second, it turned out that deep economic and financial integration without monetary
integration raises coordination issues: the exchange rate is not just a handy tool, but a
source of shocks as well. Thus, from this point of view, new member states should enter
EMU as soon as possible, because outside countries are more vulnerable. However, this is
only an option if policies are proved to be sustainable.
Finally, we have to admit that being a sustainably successful country in the euro-area is
going to be an extremely challenging task. It's like a labyrinth, and it is easy to loose the way
at every step. First we need a disciplined government, to keep fiscal reserves for bad times.
Second, we need anchored inflation expectations, to avoid artificially low interest rates
fuelling a credit boom in the private sector, and to minimize the possibility of wage
competitiveness problems. Finally we need flexible prices and wages, so that they can adjust
relatively easily inside, given that corrections in the real exchange rate are necessary. If we
have all of these, we can probably exploit all of the benefits of a single market. In my view
however, we should not pretend, that staying outside in the long term is a feasible solution.
It's not just a compulsory task, in a highly globalized world domestic policies can have
smaller and smaller role in controlling the economy, so the overall trend should be obvious
for us.