Ardian Fullani: The convergence of economic systems and institutions
of South East Europe towards the EU - a view from Albania
Lecture by Mr Ardian Fullani, Governor of the Bank of Albania, at Bocconi University, Milan,
10 October 2007.
* * *
Good Afternoon Ladies and Gentlemen,
Dear Students, I am pleased to appear before you tonight. This is a fantastic occasion and I
am delighted to share with you some of my thoughts and findings over my country and the
Balkan region.
1. Few words on Albania
I would like to start my presentation by saying few words on my country, on its roots, on its
past and its present.
Albania is a small country placed in the Southeastern Europe, bordering the Adriatic Sea and
Ionian Sea, between Greece, Macedonia, Kosovo and Montenegro.
It is generally recognized today that the Albanians are one of the most ancient people in
southeastern Europe. All indications point to the fact that they are descendants of the
Illyrians. Authors of antiquity relate that the Illyrians were a sociable and hospitable people,
renowned for their daring and bravery at war. Illyrian women were fairly equal in status to the
men, even to the point of becoming heads of tribal federations. The land of Illyria was rich in
minerals - iron, copper, gold, silver - and Illyrians became skillful in the mining and
processing of metals. They were highly skilled boat builders and sailors as well; indeed, their
light, swift galleys known as liburnae were of such superior design that the Romans
incorporated them into their own fleet as a type of warship called the Liburnian.
The famous Roman orator Cicero, astonished by the beauty of Apollonia named it in his
Philippics, magna urbs et gravis - a great and important city. In the first century B.C.,
Octavian Augustus studied philosophy there until he heard news of Caesar's murder in the
Senate and went on to become the next Roman emperor.
More than thousand years after, Skanderbeg's stronghold in the mountain town of Kruja,
became highly significant to the Albanian people, as it strengthened their solidarity, made
them more conscious of their national identity, and served later as a great source of
inspiration in their struggle for national unity, freedom, and independence. Skanderbeg's
military successes evoked a good deal of interest and admiration of the Papal state, Venice
and Naples, themselves threatened by the growing Ottoman power across the Adriatic.
Whoever discovered Albania (decided to visit Albania was marveled by its beauty and the
spirit of its inhabitants. World figures were usually so moved that the name of Albania
became eternal in their masterpieces of art.
Albania has a reputation as a land of great natural beauty and romantic remoteness. These
two characteristics have made it all the more attractive, mysterious, forbidding, challenging,
or exasperating to outsiders, be they travelers, scholars, diplomats, or merchants. Many of
them have referred to it as the "Switzerland of the Balkans" or as the "rock garden of
southeastern Europe." On the other hand, the country's uncommon isolation from the world,
arising generally from its rugged, mountainous terrain, has led foreigners to speak of it as
"the Tibet of Europe" or as a country more mysterious than central Africa.
The great eighteenth-century British historian, Edward Gibbon, speaking of Albania, said that
it is "a country within sight of Italy, which is less known than the interior of America."
The remoteness and isolation of the country became practically legendary and all too
frequently gave rise to reports and descriptions of the land and of the people - even in books
and encyclopedias - that were closer to legends than to reality. Perhaps because of its
romantic remoteness and other reasons, Albania has exerted a continuous fascination on
artists, including poets, playwrights, composers, and more recently film makers and
producers of television programs.
Shakespeare set his comedy Twelfth Night in Illyria - the name by which Albania was known
in ancient times. Lord Byron, who visited southern Albania in 1810, wrote some stirring lines
about her landscape in his poem "Childe Harold".
Morn dawns: and with it stern Albania's hills...
Robed half in mist, bedewed with snowy rills.
In Mozart's comic opera "Cosi fan tutte" the principal male characters, Ferrando and
Guglielmo, appear for the most part as two "Albanian noblemen" in clever scheme to test the
love of their fiancés.
I was trying to bring a bit flavor of my country across centuries. Being a crossroad, the main
gate from east to west, today Albania represents an important actor whose solely role is to
provide peace and stability in the region.
2. Albania through transition
For many decades Albania was cut off from other European countries, including the Central
and Eastern European ones because of its extreme economic centralization and adherence
with the principle of self-support. Transition brought about a structural change in the
principles of economic philosophy. The market forces took over the distribution of economic
resources and the reduction of existing economic imbalances. This process resulted in
increased unemployment, reduced output and consumption, while prices of consumption
goods increased over 100 percent. Foreign reserves disappeared almost instantly under the
pressure of reduced output and drastic devaluation of domestic currency. Meanwhile a
relatively large and growing stock of foreign did not stop the declining trends. Public
confidence dived and many Albanians emigrated mostly in neighboring countries. Financial
situation deteriorated at a fast pace as well. Monetary policy as we know it was inexistent for
Albania did not have a modern central bank.
Early structural reforms focused on cutting the subsidies for insolvent state owned
enterprises; massive price liberalization; privatization process; land reform; and provided the
necessary incentives for the rapid macroeconomic consolidation of 1993-1995. During '90s
Albania's path has been quite disordered scoring one of the most unique transitory
experiences. It was an experiment a trail and error by everybody. It was a quest to
understand and the role and position in this new market economy; to rediscover the
incentives of the private initiative and the risk that embodied in economic decision making.
Along this process Albanian society established the foundations of the macroeconomic
consolidations that started with the new millennium and accession to EU has scored
significant progress. For a long period of time the economy has grown around 6 % percent
annually, contributing to an upward trend of GDP per capita reaching around 2.500 euro.
Inflation has been quite stable within our target band 2-4 % supported by responsible
Monetary and Fiscal policies.
Further structural reforms improved the functioning of the market economy. Privatization of
big and medium enterprises, the privatization of former public banks, the modernization of
legal framework and many other important reforms contributed to such impressive
performance of Albanian economy.
In the last years I believe the country has made a substantial progress in its way towards
European Union. After wasting our chances during '90s I believe we are in the right track and
personally I'm confident that the distance to our final destination, Brussels is getting shorter
day after day. The coming years are of a vital importance in adhering to EU as far as Albania
is preparing itself to move with its own feet. The current agreement with IMF will finish at the
end of 2008. I hope that Acquis Communautaire will become external driving forces guiding
our country toward the European Family.
3. Bank of Albania
Albania had its first central bank institution in 1913. It was founded as an outcome of the
agreement of the Ismail Qemali government with some representatives of an
AustrianHungarian bank group and of the Banca Commerciale Italiana. The Institution did not live
long due to the outbreak of the First World War and it was not before the year 1925 that the
bank's activity started under the name of the National Bank of Albania. During the years
1944-1992, it was named State Bank of Albania, which at that time exercised both the
functions of a central bank and those of a commercial one and only after 1992 the two-tier
system is established and Bank of Albania starts performing the functions of a modern
central bank. Based on a parliamentary law it has the attribute of the monetary and
supervisory authority of the country.
The primary objective of the Bank of Albania is to achieve and maintain price stability. It
seems that this way Bank of Albania has solved the dilemma of choosing the key objective of
monetary policy in favor of price stability will contribute to sustainable growth and to generate
equilibrium in the labor market over long term period.
From the historic prospective, since the early stages of transition we adopted a monetary
targeting regime. The choice was made believing in the Friedman's postulate that Inflation is
wherever and always a monetary phenomenon. Direct control on money growth, credit
growth and interest rates were the operational tools of monetary policy aiming at the control
of money supply, which served as the intermediate objective.
A free floating regime of exchange rate was chosen to match the monetary targets. Other
forms of exchange rate regimes were never discussed due to lack of adequate foreign
exchange reserves and therefore the incapability to support a fixed rate of domestic
currency. In addition the floating regime was chosen as an automatic stabilizer of the fast
growing current deficits. Therefore the choice between different alternatives of stabilization
program was conditioned (and easy).
In general this regime has resulted successful and still continues to be the operating
framework of the monetary policy. I believe that its success was conditioned by low financial
intermediation and under developed financial markets . The presumed stable relationship
between money and transactions and permitted for confident monetary programming based
on the Fisher's equation of exchange. However, as the efficiency and speed of financial
intermediation increased and financial innovation set in motion, this policy setup become
obsolete. Bank of Albania moved away from direct control on money in favor of indirect
control of money supply in the economy.
In the context of reviewing our approach to monetary policy during the recent years we have
dedicated the bulk of our research and analytical resources to better understand the
relationship and causality between inflation and economic factors that influence it in the
context of Albanian economy. For most of this period, we have integrated in our policy
important monetary policy elements that define essential characteristics of the inflation
targeting regime. Various internationally recognized experts of monetary policy have
compared the current setup of monetary policy to a fully fledged inflation targeting
framework.
During these recent years Bank of Albania has publicly announced a numeric objective of 3
percent with a tolerance zone of plus minus 1 percent for inflation in the 12 coming months.
In addition, weekly repurchase argument rate, the key policy rate, has become the most
important instrument of monetary policy and signaling tool. Yet, we are still in the process of
empirical investigation and quantification of the monetary transition channels, with particular
focus on the efficiency of the inter-bank markets.
Modestly but surely I have to admit that the efficiency of our monetary policy has increased.
In general we are satisfied with the reaction of the interest rate behavior, which model the
developments of the bank of Albania key rate with the appropriate lag structure. Moreover
increased and more efficient communication with the public are reflected in contained
inflation expectations which are anchored to Bank of Albania announced numeric objective.
We are happy to observe that results of consumer and business confidence as well as
financial market expectations surveys indicate these trends.
It is widely accepted that such results are outcome of our continuous attention toward ever
lasting improvement of institutional and regulatory framework on which Bank of Albania
operates. Particularly, this stand for: independence, transparency and accountability.
It is well recognized by foreign and domestic institutions that legal and real independence
status of Bank of Albania enjoys satisfactory standards. On the other hand we believe that
independence represents a dynamic rather than a static process, therefore we have adopted
contemporaneous practices of communication explaining our decisions to Albanian public.
This process is embodied in the continuous improvement of the monetary policy report,
standard communication of the supervisory board monetary policy decisions, improved
analyses and research efforts, and last but not the least, intensive public activity of the Bank
of Albania Governor, with various groups of interest across the country. Taken together these
have improved public understanding and expectation building for current and future
developments in inflation and economic activity.
Our approach to communication has further improved our accountability and has resulted in
increased credibility and authority within Albanian public.
During the past 2-3 years we have increased our ownership in the short and medium run
economic and financial development programs. Since the beginning of transition the
economic program has been designed and implemented under the setup of IMF support
programs. The current program will end in 2008. Starting from 2009, the Bank of Albania and
other Albanian authorities will have full ownership in the design and implementation of
financial and monetary policies. In the meantime our relationship with IMF will continue under
Article IV, moreover the IMF assistance will be considered a welcomed secondary factor.
In such contest bank of Albania has been working together with important Albanian
institutions, first and foremost with fiscal authorities, different European Central Banks,
international financial advisories and academia to identify the new regime of monetary policy.
The new regime must be efficient in the light of recent changes in financial markets and most
importantly must provide good anchors for monetary policy and its sovereignty.
Please allow me to briefly describe the major characteristics of what we think will become the
new regime.
A. Monetary policy regime
As I already mentioned we have been working on the new regime for more than two years.
During this period we have been tossing ideas and scrupulously studying the details of a fully
fledged inflation targeting regime. As you might well understand, we are getting ready to
launch the new regime at the beginning of 2009. Our analyses show that, considering the
current features and expected developments of the financial markets, inflation targeting
provides the best policy choice for the future. A relatively long history of low and stable
inflation, efficient monetary policy, sound banking system, free floating exchange rate, fiscal
consolidation and last but not the least a suitable and reliable institutional framework, are
important factors that have convinced us on the potential success of inflation targeting
regime.
B. Institutional framework
The harmonization of monetary and fiscal policy will continue to be a challenge. I believe that
long run success and real independence of monetary policy is gained in the well functioning
of this simultaneous relationship. Albanian Constitution and the current Bank of Albania Law
grants the responsibility of monetary policy design and implementation exclusively and
without equivoque to the Bank of Albania. We believe that such legal framework and
Albanian society aspirations and commitment toward Maastricht criteria's of convergence
provide essential assurance for future compliance of monetary and fiscal policy.
C. Financial market efficiency
Albania is a small open economy and relatively highly euroized. In general the financial
markets are characterized by low trade volumes and interest rate volatility. This situation
represents a high concentration in assets and liabilities in the banking system as well as a
very limited supply of financial instruments in domestic currency. In this respect, we have
been very aggressive to prepare and introduce a new set of rules for operational framework.
The new regulation aims to increase the efficiency of the inter-bank borrowing market, it
targets thinking on the margin behavior of the banks by reducing the frequency of treasury
bills auctions, rearranging required reserves regulation and introducing a prime rate. Our
objective is to have this package operative by the beginning of 2008.
D. Financial stability
This process has progressed with the increase of the banking activity. However I have to
admit that increase and consolidation of the banking activity is accompanied by a rapid
growth of credit to economy. This rapid credit growth has become the challenge of the
moment. However I believe that efficiency and soundness of financial system is a dynamic
process and a continuous challenge. Frequently this challenge might generate from
international financial markets too. Globalization of financial markets has increased the risk
of contagion. The recent developments in the sub-prime mortgage loans, must serve as a
excellent reminder of the never ending surprises, which make the trade off between
monetary policy and financial stability a difficult balance.
I want to make it clear that by financial stability I do not assume only the absence of a
financial crisis, but a well functioning financial system that performs well its functions. I think
too tight regulations that definitely minimize all the risks are not conducive to sustained
growth. Therefore the real challenge for which we are working hard is to find an optimal
balance between deregulation which promotes market forces and financial innovations and
negative consequences of possible market failures and financial crisis.
4. Balkan region: trends and major characteristics
Dear students,
The rest of my discussion will provide few remarks on the developments of the South East
European region. I will briefly comment on the common problems and characteristics of the
region and voice my opinion upon possible direction of progress and convergence in policies.
Recently the Governors of the Region have been increasingly concerned regarding the
issues related with banking system activity, market efficiency, financial stability, risk exposure
and of course the role of central bank.
All this discussion is structured by the context of regional aspirations for EU integration.
Not only because I'm a Governor but also due to my own philosophy I have come to believe
that there could not be real political cultural and social integration without a reasonable
financial integration. I share the same opinion with other European sensibilities on the values
and importance of consolidation of democratic society and embrace of new social and
cultural mentalities. Regardless I sincerely think that the process of transformation that has
changed our societies since the fall of the Berlin wall is irreversible. The real question is how
long this process will take to be complete. I believe that laying down solid foundations for
efficient allocation of financial support and financial intermediation will significantly shorten
this process. This will also provide the necessary infrastructure framework for the integration
objectives and will supplement this process with the support of private initiative.
On the other hand, a developed and financially integrated region will be more attractive for
foreign strategic investors, opening up the path toward regional development projects,
particularly infrastructure, labour market, real estate ones where region's banks might be the
financing and co-financing ones.
If I would have been asked to say with simple word how I understand the convergence
process my answer would be very simple: The convergence means a set of performance
criterion and structural reforms benchmarks. This means that each country should adopt the
standards stemming from the Acquis Communautaire and different international codes
(Basle's II) combined with energetic steps in improving economy, society, culture and
environment as well. I think this is a MUST for promoting financial market efficiency in the
entire Region."
Allow me to summarize financial system in the region along the following characteristics:
- The system is dominated by commercial banks. Financial intermediation role of
the other financial institutions is weak. The insurance industry in most countries of
the region is quite small and underdeveloped. Traditionally poor governance,
inadequate risk management practices and lack of consumer confidence have
limited total assets held by these institutions, in the same time limiting to some
extent the possibility to present a source of systemic risk to the financial sector.
However this sector's rapid expansion in some countries including Albania calls for
the development of an adequate legal framework for conducting insurance business
and the strengthening of the supervisory framework. Other financial intermediation
such as leasing activities have grown sharply in the last years (Serbia, Bosnia and
Herzegovina) representing an important source of funding source for fixed
investment and for small and medium-size enterprises. Micro credit institutions have
a significant presence in Bosnia and Herzegovina, being mostly established with
donor funds but over the last years having shifted their funding source toward bank
loans. Consolidation into larger credit unions would be a viable method to be able to
offer larger loans and provide more banking-like services. Financial Sector
Assessment Program (FSAP) calls for further strengthening of the underlining of the
supervisory framework, even though unified supervision under a single supervisory
agency was considered premature. Capital and money markets are small or
nonexistent. At this stage of development it is necessary that the policy of regulatory
institutions should focus on enhancing infrastructure and governance.
- Banking system in the region is close 100 percent privately owned, with clear
dominance of foreign capital. The banking system in the region amounts from 40
percent of total assets to GDP in Macedonia to 119 percent of total assets to GDP in
Croatia and is dominated by private foreign owned/joint ventures banks. The
privatization of large state owned banks has been completed in all countries, except
Serbia and representing approximately only 38 percent of total capital in the banking
system respectively. The system is dominated by a restricted number of big
European banks that have set presence across all countries in the region. Lately
there is evidence of increasing interest of other banking groups as well.
- Increased financial intermediation of the recent years has lead to a rapid credit
expansion. This trend reflects increasingly deep financial integration with EU
Member States and supports rising trade, investment flows, and institutional
strengthening. The expansion of the financial sector and inflows of foreign savings
can strongly support real convergence. However, increasing credit to GDP ratio in
all countries, ranging from 23 percent in Macedonia to 76 percent in Croatia also
raises the concerns for a possible credit boom. There are some important trends
worth being noted: Credit composition is dominated by consumer credit and less
oriented to enterprises; Credit/deposit ratio has steadily increased indicating banks
willingness to extend their lending activity at a faster pace than the growth of
savings. However, the average of credit/deposit ratio of the region is still below the
level of the new EU member; Lending is mostly in foreign currency as a result of
high euroization of the economies and lower interest rates in foreign currency;
Another structural change in credit portfolio relates to the upward trend towards
longer-term lending, which at least in three countries of the region (Albania,
Macedonia and Bosnia & Herzegovina) consisted of 50 percent or more than total
lending; The spread between interest rates of deposits and credits remains high.
There are several explanations to this such as lack of efficiency and
competitiveness among banks, high premium risks of the economies in the transition
period, collateral problems, legal system obstacles etc. However, it's worth
mentioning that the spread between deposit interests and credits has declined in the
recent years, as a result of increased competition in the banking system.
Despite these characteristics must be admitted that the share of the banking system in the
economy is relatively small by European standards. The total of banking assets measured as
percentage of GDP shows that our region lags behind when compared to developed
economies. Meanwhile prudential measures indicate problems with the credit portfolio
quality, and the speed of growth could be beyond what is generally accepted sound. The
risks that usually accompany fast credit growth could soon exerting pressures on monetary
policy and financial stability.
In my opinion the low financial and real economic integration among countries in the region
constitutes as well as international financial markets constitutes another major problem in the
region. The problem could become more severe if you were to keep in mind the very
integrated ownership structure of banking system in the region.
Cross-border lending and borrowing, or other forms of international financial flows are still
relatively insignificant. With the stabilization of the economy and the rescheduling of debts,
the countries together with their financial sectors have started to be gradually integrated in
the international markets. Sovereign ratings given for these countries have accompanied and
accelerated in some cases these developments. While the financial sectors, and particularly
commercial banks, have strengthened their international ties and have been gradually
integrated in the international financial markets, the competitiveness from cross-border
banking activities remains still restricted. Cross-border lending activity increased slowly in the
countries of the region. However, even in this field there is room to move more quickly. The
foreign capital penetration in the countries I refer to is still low and mainly reflects the inability
of our financial systems to facilitate the absorbing of foreign investments in our economies.
Finally, considering the above mentioned trends of financial intermediation the following
region specific sources of risk need caution scrutiny, namely credit risk, indirect foreign
exchange risk, and vulnerabilities associated with foreign branches entry.
- Credit risk
The acceleration of credit growth rates in some countries of the region is warning when
associated with an increase in the NPL ratio. Unfortunately there are chances that the
buildup in credit risk may be underestimated The deterioration in quality of disbursed credit is not
immediately apparent as the increase in the share of new loans can temporarily depress the
reported nonperforming loans (NPLs) and credit quality problems typically emerge with a
delay. In the aftermath of deterioration in loan portfolio an increased risk of a credit crunch
emerges; when banks recognize the extent of the build up they may sharply cut or reverse
lending growth.
Specifically the domination of foreign banks in the region may possess additional risks
associated with a possible credit crunch. As long as subsidiaries of foreign banks earn high
profits, they have easy access to new capital from their headquarters given that they account
for a small share of the loan book of their international banking group. If the build up in credit
risk is underestimated, foreign banks will tend to set overambitious ROE targets. When the
extent of underestimation is recognized, banks have to increase their provisioning rate in line
with their upward reassessment of credit risk, reducing ROE projections. This could lead
management of large foreign bank groups to conclude that their ambitious ROE targets
cannot be met and curtail lending growth in response.
The entrance of big international foreign groups puts upward pressure on the entire banking
system attempt to compete for borrowers. However, there is a risk that credit growth is
associated with lower lending standards, enhanced by the lack of financial information
available on potential borrowers that continues to be a problem in the region. As the FSAP
for Albania indicates, in the area of corporate lending, firms balance sheets and income
statements may be altered to avoid taxes, while information about remittance income for
individuals is imprecise and unverifiable.
The rising real estate prices in the region have also encouraged lending, using the real
estate as collateral to a great extent. As real estate prices continue to rise, this could lead to
an over-extension of credit, and if the real estate market becomes more speculative and
more leveraged through bank loans, a decline in demand can cause a fall in real estate
prices, causing both collateral to fall in value, and the ability of borrowers to pay to decline.
Thus, there is a greater need for authorities to monitor development in real estate prices and
warn against possible asset bubbles, while the collateral needs to be less homogenous.
- Risks associated with the foreign exchange
As a result of large financial assets euroization in all countries of the region, the foreign
exchange rate fluctuations are an important source of vulnerability. Stress tests in almost all
countries suggests that there is limited exposure of banks balance sheets to the direct
exchange rate risk as banks are able to hedge foreign currency loans wit FC deposits and
sources from their parent banks. However, the dominance of loans either denominated in or
linked to the euro to borrowers with income in national currency means that sudden
exchange rate depreciation could threaten their capacity to repay.
- Vulnerabilities associated with foreign branches entry and domination
Turning to the issue of opening of the banking sector to foreign investors, specific issues
need considerable attention by supervising authorities. The recently conducted Financial
Sector Assessment Program in Serbia listed several benefits. Attracting funds from
households that may be reluctant to deposit with domestic banks, providing new sources of
funding for domestic credit, introducing new financial products and credit instruments,
reducing the influence of vested interests, and enhancing competition by buying state banks
and increasing the number of players.
However, in presence of externally generated and domestically generated shocks the
banking system in the countries of the region can be vulnerable to lower profitability, less
willingness on the part of the banking group to provide capital, and, ultimately, generate a
credit crunch. Among the external shocks were listed rises in euro zone interest rates,
adverse shocks to one or more of the countries of origin of the foreign banks, and contagion
from an adverse shock elsewhere in the CEE region altering investor perceptions regarding
the domestic economy. On the other hand domestic shocks such as declining margins from
foreign banks fighting to gain market share, and lowering of credit portfolio induced by a
weakening economy or an unexpected domestic political event could have large effects in
the presence of less adequate risk management in the context of foreign owned banks rapid
expansion and increasing euroization of financial assets.
5. Policies to mitigate financial vulnerabilities: constraints and challenges
In some cases supervisory authorities (Serbia, Croatia) have recurred to less market oriented
macro prudential measures to contain credit growth. While credit controls create the
incentive to route lending through less regulated non-bank intermediaries, the imposition of
such credit controls in Bulgaria and Croatia was accompanied by a jump in cross-border
loans.
Watson (2007) argues that prudential policy needs to allow for the fact that foreign-owned
financial institutions, with a majority of assets in most cases, have deep pockets in terms of
capital and liquidity. Thus, prudential tigh