Supporting central banks and local currencies in the Western Balkans

Central Bank of Bosnia and Herzegovania celebrated its 20th anniversary recently.

ECB Member Benoît Cœuré gave a speech on the occasion and touched on an issue we hardly think much about. It has been seen that in small countries the balance sheets are not in the local currencies but in currencies of a dominant currency.

Any shock hits these small countries which run on unofficial currency as we saw in South East Asian crisis. The loans were in US Dollars and as crisis hit and the local currency depreciated, the value of  these liabilities increased manifold.

Even  in Balkan countries most of the balance sheets are in Euro. It is called as unofficial Euroisation. Euro is not an official currency but what happens in Euroarea plays a major role in these economies.

How does one work around this issue?

Let me therefore spend a few minutes on the one recommendation that is specific to candidate and potential candidate countries, albeit not uniformly to all, namely that the use of local currencies be strengthened.

As you know, the high degree of unofficial euroisation is a striking feature of the banking systems in the Western Balkans. In the region as a whole, on average 56% of total loans and 52% of total deposits are denominated in, or indexed to, foreign currencies, in most cases the euro.[3] This phenomenon, also known as currency substitution, is driven by many factors, such as low confidence in the domestic currency, which is often the result of not-so-distant memories of monetary instability.

Another factor relates to the fact that the risk premium on loans in the domestic currency is higher, thereby providing an incentive to take out foreign currency loans. Lower funding costs, in turn, are often supported through strong integration with the euro area via trade and financial channels, but also via migration and remittances, which contribute to the holding of bank deposits in euro. All this is conducive to widespread unofficial “euroisation”.

But a high degree of foreign currency use also has serious drawbacks. For example, unofficial euroisation, while being a sign of trust in the euro as a stable store of value, constitutes a financial stability risk in the event of sudden and substantial exchange rate fluctuations. Households and firms may suddenly no longer be able to service their foreign currency-denominated debt, creating credit risk for banks. The same holds true for dollarisation in other parts of the world, as the Asian financial crisis vividly demonstrated.

Unofficial euroisation also impedes monetary policy transmission and may limit the overall room for manoeuvre of monetary policy. In Albania and Serbia, for instance, where central banks have adopted inflation-targeting frameworks, exchange rate flexibility remains relatively limited as policymakers are mindful of adverse balance sheet effects resulting from sudden and substantial exchange rate fluctuations. In countries that have opted to stabilise the exchange rate in the first place, such as Bosnia and Herzegovina, maintaining the credibility of the framework remains central to keeping financial stability risks contained.

Prospective EU countries that have their own legal tender and monetary policy have recognised these risks and constraints, and are thus making efforts to promote the use of the local currency, in line with the ECB’s recommendations. This is certainly not an easy task. Success crucially hinges upon the track record of the domestic monetary authority in maintaining monetary stability. To this end, central banks in the region have made laudable progress in recent years. Efforts need to be channelled towards extending this track record.

History teaches us that central banks’ success in sustainably maintaining confidence in the currency critically hinges on two elements: political independence and a clear mandate. The ECB was successfully built on these principles. Independence and a clear stability-oriented mandate ensure that central banks are not overburdened with pursuing other, potentially conflicting objectives, and that monetary policy makes the best possible contribution to growth and employment. They are therefore also a necessary condition for strengthening the use of local currencies.

Experience in other regions of the world – in Latin America, for example – suggests that targeted prudential measures as well as deeper local capital markets in domestic currency can reinforce the use of local currencies.[4] Such advances should ideally be embedded in a carefully designed comprehensive strategy involving all relevant stakeholders. Serbia adopted such strategies in 2012, and Albania has done so more recently, while other countries have started to put in place measures of this nature or are considering designing similar strategies.

So progress is clearly visible, in particular on the lending side, but more remains to be done. There are certainly no quick fixes, as currency substitution tends to be a sticky phenomenon. But the drawbacks of unofficial euroisation deserve policymakers’ attention. The expectation that countries will at some point join the EU, and eventually also the euro area, should not divert attention from such policy efforts.

Hmm..

 

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