Monetary and Financial Issues in German Unification

Garry J. Schinasi, Leslie Lipschitz, and Donogh McDonald

This chapter examines some of the issues that arise in At a microeconomic level, it is important that the the process of integrating the monetary and financial restructuring of the east German financial system trans system of the former German Democratic Republic form it quickly into an efficientchannel of intermediation. (GDR) into that of the Federal Republic of Germany Given that the financial market is open to the participation (FRG). The topic is divided into three broad areas: an of banks from west Germany and other countries and is analysis of the currency conversion. an examination of subject to the same laws and regulations that govern the difficulties that will be faced in conducting monetary financial markets in west Germany. the efficiency of the policies in the new environment, and issues related to financial system is unlikely to be limited by its structure. the restructuring of the financial system and its prospec The principal concern is to ensure that bank lending and tive performance at a microeconomic level. deposit policies are responsive to market signals, eco The conversion of GDR marks into deutsche mark nomic incentives. and a proper evaluation of risks and was a monetary event and thus, in principle, should not returns. In particular, it is important thatlending decisions have a long-lasting effect on the real economy. However, are consistent with an efficient distribution of resources the conversion process will influence inflation. current and are not determined by a perception that the Trust payments (such as wages) in the very short run, and the Fund (Treuhandansta/t) or the Government will stand distribution of wealth between debtors and creditors . For behind certain preferred cred its. east Germany, the conversion rate has important impli cations for the distribution of wealth: between the State Mechanics of the Conversion and households on one level, and within the old state sector (comprising the Government, the banking system, Following the announcement of currency union, there and the state enterprises) on another. Under the old was widespread debate on the conversion rate. Some system. households were financial creditors (through considered a rate of M I = OM I to be appropriate, as their savings deposits). while the State was a net financial it was judged to be the rate that would set starting wages debtor; obviously the redenomination of the creditor and in the GDR relative to those in the FRG in line with debtor positions affects both. Within the old state sector. relative prod uctivity levels.1 Others suggested conversion the distribution of financial positions is important because rates ranging as high as the prevailing free-market rate. 2 the economic reform enrails a breaking up of this sector There was also some discussion of a schedule of con into a banking system and an enterprise system that are version ra tes varying by type of asset and liability, as independent of government. The financial solidity of the was done in the conversion of reichsmark to dcutsche banking system and the burden of debt on the enterprise mark in 1948.3 sector are the key considerations in this context. The broad outlines of two official proposals were made Monetary control will be more difficult. The Deutsche public before agreement was reached by the two Gov-

Bundesbank is detern1ined to maintain a low-inflation ' Sec the discussion of wage and productivity leveb in the GDR in stable financial environment. A combination of higher Chapter lfl. section on "Economic Background ·· fiscal deficits, rapidly ri sing demand, and an anti-infla �In December 1988. the market rate in We�t Berlin averaged M 7.75 = OM I. In January 1990. it was about M 7 = OM I. The tionary monetary policy would create tensions in most mark appreciated following the announcement of currency umon to circumstances: given the limited guidance as to how the M 5.75 = OM I in February und to M 2.75 = OM I in June 1990. demand for money and credit will evolve in east Gem1any. ' For a discu�sion of the 1948 currency conver>ion �ec Thoma$ Mayer and Gunthcr Thumann. "Radical Currency Rctom1: Gcrm;my. the conduct of monetary policy will be even more 1948. ·' Finance & Del'e/opmem (Washington). March 1990. pp. challenging in the present circumstances. 6-8.

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©International Monetary Fund. Not for Redistribution Mechanics of the Conversion ernments: the Bundesbank's proposal and a proposal that The consolidated balance sheet for the banking system emerged from the Government in Bonn.�The Bundesbank of the GDR as of June 30. 1990 was not available at the proposal. published on April 2. 1990. called for a time of writing. However. the balance sheet implications conversion rate of M 2 = OM I for all assets and of the conversion agreement can be approximated from liabilities denominated in marks, except for bank accounts the position at the end of May (Table I). As of that date, up to M 2,000 per person, which would be converted at financial assets with a book value of M 447 billion were the rate of M I = OM I. Other important features of on the books of the various financial institutions in the the proposal were as follows: participation in GDR state GDR. Credit to enterprises amounted to OM 232 billion properties would compensate holders of bank accounts (52 percent of assets), balanced in part by enterprise in excess of M 2.000 for the less favorable conversion deposits of DM 57 billion. Credit to the housing sector rate: the Bundesbank would have full control over totaled DM 103 billion. On the liability side of the monetary policy in the GDR; the GDR would adopt FRG balance sheet, the largest single item was deposits of banking law. with banks from the FRG and abroad households totaling M 182 billion (40 percent of total allowed to set up establishments in the GDR: and interest liabilities). The other key liability for the conversion rates and fore ign currency transactions would be fully process was the liability position of the State Bank to liberalized. Current payments would also be converted future exporters-the Richrungskoeffi:ielllen (RIKOs). at the rate of M 2 = OM I. but wages and pensions see below- reflecting the difference between the official would be adjusted to compensate for subsidies removed exchange rate and the exchange rate used in fore ign before currency union and for the introduction of social trade. security contributions. Table I shows the results of applying the conversion The Bonn proposal, announced on April 23, 1990. rates to the balance sheet at the end of May. On this differed somewhat concerning the treatment of savings basis, the banking system would have had assets with a deposits and current payments. It called for a rate of M book value of OM 246 billion and a net worth of OM I = OM I for currency and deposits up to M 4.000 for 23 billion (91f2 percent of total assets). It is u eful to each individual and a rate of M 2 = OM I for the describe the key elements of the conversion of assets and remaining balances: a rate of M 2 = OM I for all other liabilities. assets and liabilities denominated in marks: and a rate of M I = OM I for wages and pensions, with no Liabilities compensation for the removal of subsidies. On May 2. 1990 the Governments of the GDR and Taking into account the favorable conversion rate For the FRG announced a jointly agreed plan for currency a portion of household deposits. the average conversion conversion that would take effect on July I , 1990. rate for GDR mark deposits was about M 1.6 = OM I. Financial t:laims and liabilities of permanent residents For fore ign currency liabilities. market rates were applied and enterprises would be converted at M 2 = OM I. as far as possible. while equity capital was converted at

However. as an exception to this general fo rmula. M I = OM I. However. the average ovenrll conversion individuals would be allowed to convert limited sums at rate was M 1 .8 = OM I. This relkcted the nonconver a more favorable rate of M I = OM I, according to the sion-that is, a writing down to zero-of the RIKO fol lowing schedule: M 2.000 for persons under 14 years: fund. M 4.000 for persons of 14 to 58 years: and M 6.000 for The RIKO fund can be interpreted as a reserve to help persons 59 years and older. Wages. salaries, stipends, linance future export activities of GDR enterprise�. The rents. leases, and other maintenance payments would be valuation of the fund resulted from an internal accounting conv�rtcd at M I = OM I. with wages and salaries set system involving an official exchange rate and a more initially at their gros� lcveb as of May I. GDR pensioners depreciated commercial rate. The difference between the would be provided the same benefits in relation to earnings two exchange rates was in essence a tax on importers as in the FRG.' Deposits in marks held by persons with and a subsidy to exporters 6 The surplus in the fund residence outside of the GDR would be converted at M '' There arc lW!\ w�y� of viewing rhc opcrarion' ol rhc RI KO lund. 2 = OM l if acquired up to December 31. 1989. and Thar prcsenred here �larb \\'ilhrhc "''umprion thal rhe aclllal cxchang.: at M 3 = DM I if acquired between January I. 1990 rate bcrwccn rhc deurschc mark. rhc valura mark. anu rhc GDR mark and June 30. 1 ()90. The official exchange rate between wa� DM I = VM I = M I. bur rhal hard-currency rrad� w:L' 'ubjec t in cffccr e o t 'ub�idic, irnpon 1:1.xc' rhat wen: n1id uul the mark and the deutsche mark. which was used chiefly m xp r and 1 nr received by rhe RIKO fund. Alrcrnarivdy. one mighr 'cc rhe aclllal 3 = 2 for tourism. was changed from M OM I to M exchange rare al DM I = VM I = M 4A wirh expuncr' receiving I = DM I on May 2. 1990. M I direcrlv and M 3.4 rhroul!h rhc RI KO fund for .:ach l)f\•1 of exports. In �irher case rhe ch:u;gc in lhe exchange 'Y'Icm meant rhal ' S�c 13o� I in Chapter Ill rhc RIKO fund became ob,olcrc. and. ,jnee rhcrc were no acru;tl

· In I in.: "irh lmvcr ''ag� le\'<.:I' in rhc GDR. pem.iun p;�ym�nl> claimant� on il. il �ould be u,ed In help bridge lhl' a') nHnclr) hcrw..:..:n would h.: Ill\\er in I he CJ IJR. rhe conversion of as::.cls Hnd liabiliric>.

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Table I. German Democratic Republic: Consolidated Balance Sheet of the Credit System Before and After Currency Conversion

I Based on figures for May 31. 1990: in billions of marks and deutschc mark)

In In In Conversion Delllsche In Conversion Deutschc A'sel\ Marks Rate Mark Liabilities Marh Rate Mark

Domestic credit 397.4 180.7 Domestic deposits 249.0 M 1.6 = DM I' 156.6 Enterprise; 231.7 M2 = DM 115.8 Enterpri!>es 57.0� M 2.05 = DM I 27.8 1-1\>u,ing 102.6 M2 = DM 51.3 Con,um.:r' 2.5 M2 = DM 1.3 Hou;,ehold' 182.1 M 1.48 = DM I' 123.4' Government 60.6. M2 = DM 12.3 Government 10.8 M 2 = DM I 5.4

Fore ign a�!)I.!(:O. 45.0 36.3 Foreign liabilities 56. 1 55.6 State-twding State-trading countrie, 17.-l M2 = DM I 8.7 countries 1.1 M 2 = DM 0.6 Other 17.6 M I DM I 27.6 Other 55.0 M I = DM 55.0

Currency in Participatilln> 1.1 M DM 1.1 circulation 13.6 M 2 = DM 6.K

Other a�'et' 3. 1 M2 = DM 1.5 Other liabilities I 27.0 27.0 Equity 23.4 MI = DM I 23.4 Subtotal 446.6 M 2.03 = DM I' 219.6 RIKOs 96.4 Other 7.2 M 2 = DM I 36 Equalization claitm, 26.4

Total -146.6 M l.l>l = DM I' 246.0 Total

Sources: Deutsche Bundc�bank: and author�· calculations. ' Average conversion rate. � A small part was deposited after December 3 I. 1989 by nonresidems and was therefore converted at M 3 = DM I. l M 2.000 million for each of 3.2 million re,idems under age 14, plus M 4.000 million for each of 10.1 million resident:. between ages 14 and 58. plus M 6.000 for each of 3 milli

M I = OM I) at the preconversion level. The banking Assets system was technically insolvent, however. as. without equalization claims, the gap between the liability and asset The average conversion rate on domestic credit of the sides would have been larger than the converted value of banking system was about M 2.2 = OM I. This was equity. 9 The process of conversion will not be completed above the conversion rate of M 2 = OM I because of the special treatment of the above-mentioned credit outstanding to the Government. Of the total claims on ehan2es in the commercial exchange rate. The Government absorbed the v';.luation losses. sometimes th';-ough budgetary contributions but Government of OM 60Y billion, only M 24Yz million 2 more recently through borrowing from the State Bank. was actually converted. Most of the balance reflected credit • The mechanics of the equalization claims and the establishment extended to the Government associated with revaluations of the Equalization Fund are described below. • Interpretation in a normative sense is. however. haz.ard. First. of the RIKO fund7-consistent with the treatment of this the insolvency renectcd the arbitrary asymmetric conversion rate. Second. the distribution of assets ;tncl liabilities within the �talc sectt>r 7 From time to time, the RIKO fund was revalued in line with had had little economic meaning under the former �ystem.

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©International Monetary Fund. Not for Redistribution The Implications of the Conversion Rate

Table 2. Estimates of the Money Supply in Germany Under Various Conversion Proposals

(In billions of marks and deutsche mark)

In Oeutsche Mark In At Bundesbank Bonn Agreed Marks MI =OM I proposal proposal plan

(;DR Currency 13.6 13.6 6.81 6.8' 6.81 Towl deposits� 235.7 235.7 134.2 150.5 150.3 One-to-one (M I =OM I) 32.63 65.2. 64.!!' Two-to-one (M 2 = OM I) 101.6 85.3 85.5

Estimate of M3 249.3 249.3 141.0 157.3 157.1

FRG MJ (May 3 I. 1990) l ,221.9 1,221.9 1,221.9 1.221.9

E�timah.: of t·ombincd M3 I ,471.2 1,362.9 1,379.2 1.379.0

Perecnt increase in dcubche mark M3

owing to conversion 20.4 11.5 12.9 12.9

Sources: Consolidated Balance Sheet of the GDR Banking System, May 31. 1990 provided by the Oeutsche Bundesbank; Oeutsche Bundcsbank. i\1/onthfv Report; and authors· calcuiHtions. 1 Converted at M 2 = OM I . � Excludes insurance company deposit� of M 14.2 billion.

1 Assumes that the population of 16.3 million residents each had a M 2,000 deposit which was converted at M I = OM I. All other deposits arc assumed to have been convened at M 2 = DM I.

1 Assumes that each resident had a deposit of M 4.000 which was converted at M I = OM I. All other deposits are assumed to have been convened at M 2 = OM I. ' Assumes that each resident between the ages of 14 and 58 ( 10.1 million) had a deposit of M 4,000, that each resident under 14 years of age (.1.2 million) had a deposit of M 2.000. and that each esir dent age 59 or older (3 million) had a deposit of M 6,000, and that these deposits were convened at M I = OM I. All other deposits arc assumed to have been converted at M 2 = OM I.

unlil the initial balance sheets ofthe banks and the enterprises roughly 20 percent above the level of M3 in the FRG. can be closely evaluated; what is described above represents Under the Bundesbank proposal. M3 after unification only the first stage. The status of enterprise debt, in would have been 111! 2 percent higher than M3 in the FRG particular, is still uncertain, both as to its value and the before unification, while under the Bono proposal it would extent to which it will be borne by the enterprises themselves. have been 13 percent higher. the same increase as under The size of the equalization fund and the starting equity the plan actually implemented. position of the banking system will thus not be determined Assuming underlying productivity at about one third of until the end of 1990 or early 1991. the level in the FRG. output in the GDR was about one tenth of the level in the FRG. Thus, if one assumed velocity of M3 in the GDR similar to that in the FRG, the actual The Implications of the Conversion Rate terms of the currency conversion seemed unlikely to produce a dangerous increase in liquidity. It was thought that even if velocity in east Germany turned out to be higher than in Effects on Liquidity west Germany, there was not much basis for concern. Bank deposits in the GDR represented the entire financial holdings The money supply in the GDR was determined initially of households at the time of conversion; it was reasonable by the rate at which marks were converted into deutsche to expect, therefore, that a significant part of the deposits mark. Table 2 examines how the conversion rate would of households would be shifted into higher-yielding non have influenced M3 in the GDR and in the unified monetary assets that would become available after July I. German economy on the basis of the balance sheet In this context, it is interesting to note that the ratio or position of the banking system at the end of May.1o At households' financial assets to income in the FRG in the late 1950s and early 1960s was similar to that in the GDR a conversion rate of M I = DM I for currency in circulation and all domestic deposit liabilities of the in recent years. Moreover. in view of the uncertainties banking system, M3 in Germany would have been about short-term employment and income prospects. it seemed likely that households would be quite cautious in their expenditure behavior in the immediate aftermath of '" M3 in the GDR was approximated by the sum of currency in <:irculation held by individuals and total domestic deposits. currency union.

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Implications for the Labor Market involved. In fact there was no such exchange. The Bundesbank did not take mark notes on its books in While the actual rate of conversion is unlikely to have return for the supply of deutsche mark-denominated base had much influence on the equilibrium real wage in the money to the GDR. Rather the banks in the GDR. having GDR, it did set the initial wage rate. Actual GDR wage called in all the cash in the economy , simply redenom rates at the end of May 1990 were converted at a rate inated assets and liabilities in dcutsche mark. To the of M I = OM I on July I. As such, the conversion extent that deutsche mark cash was then needed for cash rate influenced starting demand and supply conditions, withdrawals. deutsche mark were borrowed from the migration decisions, and the initial cost of the social Bundesbank at the discount or the Lombard rate. Thus. safety net. the currency conversion. in it elf. did not represent a One might have expected the extent and duration of subsidy to the GDR. Indeed. the Bundesbank gained this influence to depend on a number of economic factors: seignorage through the supply of reserve money to banks for instance, the degree of flexibility in wage formation. in the GDR. the initial level of wages relative to the equilibrium level. Second. the currency conversion did influence the and the rate of change of productivity. To the extent that distribution of wealth between households and the State. nominal wages were inflexible downward over an ex The mechanics of this process arc clearest if, as a tended period, setting initial wages too high could have simplification, one thinks of the GDR as being made up had adverse supply effects in the economy. with rami of two sets of agents: households, whose wealth consists fications for unemployment and government finances. entirely of financial assets, and the State which is a net I lowcver, on the basis of the evidence available prior to debtor in financial terms (largely the counterpart to GEMSU. it did not appear that the average level of household net financial assets) but which own all of the wages was initially pitched too high. First. wage levels real assets in the economy . The difference between the relative to the FRG seemed to be roughly proportionaJ value of real assets and the net financial liabilities of the to relative prod uctivity levels.1 1 Moreover. it was thought State reflects the equity position of the State. At this likely that productivity would rise fast in the early stages level, the conversion rate can be seen as determining the of GEMSU as tabor dishoarding occurred. The level of distribution of the net worth of the GDR between the wages would not greatly affect the dishoarding of surplus financial wealth of households and the net wotth of the tabor. although it would, perhaps, influence the absorp State. 11 But, as there is no objective way of deciding tion of dishoarded tabor into other activities.11 upon the correct distribution of wealth. these distribu Developments in the opening months of GEMSU have tional considerations do not provide any useful criteria called into question earlier judgment.!. on relative pro for dctcm1ining the appropriate exchange rate . 1� ductivity levels and the pace of dishoarding. However. A number of other considerations may have entered the clearest indication that the conversion rate wa not, into the determination of the appropriate conversion rate. in the event. of great consequence in the tabor market First, caution was needed to ensure that the overall level was the pronounced upward pressure on wages imme of liquidity provided was appropriate. This liquidity diately after the currency union. Wage demands seem to constraint could have been circumvented by effecting have been determined more by aspirations for parity with the conversion partially in the form of nonmonetary west Germany (and poss ibly by a belief that the Gov assets (as was, for example. suggested in the Bundesbank ernment would protect employment) than by any realistic proposal), but nonmonetary wealth might also have economic assessment. influenced spending decisions. To the extent that the conversion rate was determined mainly by liquidity considerations. any unwanted distributional effects could Di tributional Effects easily have been altered by fiscal mechanisms. Second. the architects of GEMSU may have believed that the Central to the currency conversion were its distribu private rate of time discount was high relative to the tional effects. Two aspects of this arc interesting to social one, 15 and that it was therefore desirable for the explore. First. did the CliiTcncy conversion in itself represent a direct subsidy to the GDR? lt is popularly 11 1t is. of course. impo>sible to e�timatc the net wonh l)fthe State supposed that the Bundcsbank simply swapped deutschc with any confidence at the pre,ent juncture becau\e of unccrtaintie� mark for marks so that. to the extent that the rate of about the value of its holding� of land and mduMrial capital. 14 Indeed. if one saw the net wonh of the State being ultim:ucl) exchange was not an equilibrium one. there was a subsidy as attributable to households. one could argue that the distribution of \\ealth between the two is un.mponant: thl\. however. would be an 11 SecChapter Ill. section on "Economic Bacl.ground." extreme view.

1: G1ven the <.honage of cap1tal and the mev11able mismatch of " Panicularly given concern� about an impat1encc for ri�ing t.:on >k1lb m the labor market. the extent to wh1ch lower wages would �umption levels in the GDR after many ye�•" of living ,tandard'> far have ca,ed the unemployment sltuauon m the \hon run is not clear. below tho�e in the FRG.

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©International Monetary Fund. Not for Redistribution Monetary Control During the Early Stages of GEMSU

State itself to marshal resources to restructure the econ inliation under control. With higher fiscal deficits and omy. Third. the national wealth would depend. inter strong demand pressures, however, one can imagine alia, upon how efficiently assets were managed; it is circumstances under which monetary policy would come possible that views on the conversion rate were influenced under pressure in the period ahead. Moreover, in guiding by an assessment of how efficiently the State would monetary policy, the Bundesbank will face technical manage the assets entrusted to it. In the final analysis it challenges related to uncertainties about how to imple is likely that the choice of the conversion rate was ment monetary policy in east Germany. determined chieliy by a desire to maintain a reasonable Thus far. the Bundesbank has monitored monetary amount of wealth and liquidity at the level of households developments separately in west and east Germany. In on the one hand. without stimulating excessive con the west, it has not departed from its traditional methods sumption or crippling the finances of the State on the of operating (see Box I), with its primary rocus on other. keeping monetary growth in line with potential output The conversion process. aside from its effect on and an acceptable inflation rate. Initially. statistics in the household wealth and the overall financial position of west may not be greatly distorted by money held in the the State. redistributed the net financial debtor position east. although it will be difficult ro identify the geographic of the State between its various components-banks. the distribution of cutTency holdings. As the two economies Government. and the producing enterprises. For example. become more integrated, however, segregated monetary changing the conversion rate from M 2 = DM I to M statistics and monetary management will become less

3 = DM I (while still retaining a rate of M I = DM I reliable. for a ponion of household savings) would have increased In the early stages ofGEMSU. with monetary targeting the value of producing enterprises (by reducing their only in the west and a single currency with free capital debt) and hence the value of the State's equity position flows between east and west. the money supply in the in these enterprises. orrsetting this. however, there would east will be determined by demand. In normal circum have been a drop in the net worth of state-owned banks stances this should not pose an inflation risk-after all. or an increase in the capital infusion needed to maintain for the smaller countries participating in the exchange the equity position of the banking system. ln principle. rate mechanism of the European Monetary System. whose therefore. there would not have been any net effect on currencies are effectively pegged to the deutsche mark. the Government's financial position. the situation is not very different. One should not interpret the foregoing analysis as In the case of east Germany, however, there arc two implying that the actual distribution of the State's net impot1ant differences. First, a substantial increase in financial position is irrelevant. In particular. to the extent certain prices--chiefiy for services-may be warranted that the separation of institutional responsibility. espe as part of the unwinding of distorted relative prices in cially the enterprise sector from the Government, is the GDR. Monetary conditions will accommodate this strictly maintained. the level of debt left on the books and it may be difficult to distinguish these relative price of enterprises is likely to be an important practical changes from general inflation pressures. Second. normal determinant (next to their underlying competitiveness) credit extension by ba11ks, in line with the production of whether they are able to survive the transition and decisions of enterprises and reasonable expectations about how easily they can be privatized. In particular.enterprise inflation, would not constitute a problem; but credit debt levels that are too high would prejudice the ability extended under government guarantees 10 fund unrealistic of enterprises to raise financing and would divert earnings wage increases by enterprises with very short life ex from investment to debt service.16 pectancies could result in a monetary expansion that is out of line with real developments. This second mech anism is largely a "fiscal" as opposed to a "monetary·· problem-the government guarantees are the essence of Monetary Control During the the problem. Early Stages of GEMSU It is difficult to see any alternative to the approach followed by the Bundesbank in the first stage of unifi The track record and recent statements of the Bundes cation. There is no reasonable basis for determining how bank leave little doubt about its determination to keep much liquidity to supply to the east German market. Traditional indicators are of little use: there is no sound statistical base, and no basis for extrapolating the demand

'" 1t is worth noting that the distribution of debt between various for money or the behavior of velocity from historical components of the Stntc had li11le to do with economic fundamentals. relationships. The relative scale of the two economies. 11 rcncctctl the arbitrary nature of the pricing system under central however, is sucb that errors in the provision of liquidity pl;mning and the role of enterprises as the major source of government revenue.

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Box 1. Monetary Policy Instruments and Procedures in the FRG'

Overall Strategy term interest rates over a time horizon measured in months. 2 Over a shorter time horizon, measured in weeks, the interest After the final breakdown of the Bretton Woods system rate on repurchase transactions influences the rates in the of fixed exchange rates in early 1973, domestic anchors short-term interbank money market more directly. The had to be found to limit monetary expansion in individual interest rate corridor established by the discount and Lom countries. In late 1974, the Bundesbank introduced a target bard rates is used by the Bundesbank to signal its intentions for monetary growth through 1975. The Bundesbank chose regarding the general stance of monetary policy; within this central bank money (CBM), comprising currency in cir corridor, the repurchase rate is used to determine the center culation and banks' required reserves on domestic deposits of gravity of money market rates. (measured at constant 1974 reserve ratios), as its target Within the established interest rate band, the Bundesbank aggregate. CBM served as the target aggregate through employs its liquidity instruments to vary the ease. predict 1987. but in 1988 the Bundesbank shifted to announcing ability. and timing with which reserves are made available targets for broad money (M3). The Bundesbank's experience to the banking system. Because the FRG does not have a of using monetary targets to anchor inflation and inflation well-developed short-term market for securities, the Bun expectations has been successful; while targets (or target desbank has relied on supplementary instruments known as ranges) were exceeded in some years (owing. inter alia, to "reversible assistance measures ." These measures take the turbulence in foreign exchange markets), the targets them fonn of short-term bilateral transactions between the Bun selves provided a clear and transparent point of reference desbank and the commercial banks in the money, foreign for an anti-inflationary monetary policy that was widely exchange, and long-term securities markets. The Bundes accepted. bank also injects reserves into the system by shifting federal In setting its monetary targets, the Bundesbank seeks to government deposits into the money market for short accommodate not current re al growth but the rate of growth periods. of productive potential and a minimal (and acceptable) rate Since 1985, open market transactions under repurchase of inflation. This means that monetary developments provide agreements in fixed-interest securities (repurchase agree stabilizing feedback to the real economy: if actual growth ments) have been the Bundesbank's main instrument for exceeds potential, monetary conditions tighten, while if influencing bank liquidity. as well as short-term money growth falls below potential, monetary conditions ease. market rates, on a week-to-week basis. Such transactions This method of setting monetary targets requires the Bun are short-term agreements. which usually run for one or desbank to estimate potential growth and to detem1ine an two months. "acceptable" and achievable rate of price inflation. Con For day-to-day fine-tuning of bank liquidity and short sumer price inflation has averaged less than 3!12 percent in term interest rates, the Bundesbank uses its other reversible the period since monetary targeting began. despite some major assistance measures. From an operational point of view, global bouts of inflation. In the cyclical upswing from 1983-- the day-to-day management of money market conditions is 89, consumer price inflation has averaged only l:Y.perc ent. guided by operating constraints on the level and structure of key interest rates and the development of the banking The Buodesbank's Instruments system's liquidity position. The monetary authorities mon The Bundesbank uses both interest rate and liquidity itor key balance sheet indicators of the banks' liquidity policy instruments to influence money and credit market position-including unutilized rediscount quotas. indebt conditions and the reserve position of the banking system. edness to the Lombard facility, and net liability positions These mechanisms accommodate two key features of finan resulting from "fine-tuning'' operations. cial markets in the FRG: the dominant role of the universal commercial banking system, which represents the main

channel of transmission of monetary policy. and the almost 1 The Lombard facility is a borrowing fa cility for exceptional exclusive reliance of banks on the interbank money market financing with an administered interest rate (the Lombard rate). for short-tenn money management. While there arc no explicit ceilings on Lombard credit. the Bundesbank discourages the use of Lombard credit by an individual The Bundesbank uses its interest rate instruments, chiefly bank continuously. in large amounts. or over long periods. The the Lombard rate and the discount rate , to establish upper Lombard facility is designed to offer liquidity at a penalty rate; and lower bounds. respectively, for the movement of short- the rate on overnight money in the interbank market. the call money rate, is usually below the Lombard rate. The discount ' For further discussion, see Deutsche Bundesbank, The Deut.tche window offers a rate below both the Lombard rate and market Bundesbank: Its Monetary Policy Instruments and Functions rates. The quantity of borrowing at the discount window is limited (Frankfurt, 1989): Deutschc Bundesbank. ''The Longer-Term by quotas that are generally fully utilized. The Bundesbank also Trend and Control of the Money Stock,'' in Momhly Report has established an intervention rate at which it offers short-term (Frankfurt), January 1985, pp. 13-26: and Hermann-Josef Dudler. treasury bills. usually with a maturity of three days. This rate "The Jmplementation of Monetary Objectives in Germany-Open places a lower bound on the call-money rate, above the discount Market Operations and Credit Facilities." in Central Bank Views rate. Thus. the call-money rate is bounded from above by the on Monetary Targeting, ed. by Paul Meek (New York: Federal Lombard rate and from below by the interest rate offered by the Reserve Bank of New York. 19S3). Bundesbank on short-t.erm treasury bill transactions.

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©International Monetary Fund. Not for Redistribution Structural Reform of the East German Banking System to the east are unlikely to have any major effect on the the State Bank consisted of serving the state-owned German economy as a whole. 17 enterprises and the Kombinate in industry, construction, At a technical level, even access by banks to Bundes transportation, and domestic trade. in order to execute bank resources initially presented problems insofar as this function, the State Bank majntained 41 branches. banks did not have financial instruments eligible for The commercial banking activities of the State Bank refinancing. To solve this problem, the Bundesbank Act were supplemented by a number of state-owned and was amended to allow east German banks temporary cooperative banks. Among the former were the Deutsche access to the discount window and to the Lombard Aussenhandelsbank AG (DABA), the Deutsche Han facility against equalization claims and single signature delsbank AG (DHB),2t and the Bank fiir Landwirtschaft paper (i.e., banks' own IOUs).H; Pending the issuance und Nahrungsguterwirtschaft (BLN). DABA and DHB of equalization claims, liquidity operations by the Bun were the designated special institutions for all interna desbank have been exclusively against single signature tional trade and financial transactions of the GDR; BLN paper. was the state-owned bank for the agricultural sector. The cooperative banks comprised the Genossenschaftsbanken fur Handwerk und Gewerbe (GHG) and the Bauerliche Structural Reform of the Handelsgenossenschaften (BHG). The former served the East German Banking System crafts and trade sector, while the latter provided banking services to farmers. The municipal and county savings banks (Stadt- und The Banking System in the Kreissparkassen) together with railways and postal banks (Reichsbahn- und Postsparkassen) Centrally Planned Economy had the function of collecting the monetary savings of the population and passing them on to the commercial banks and the As in the other socialist countries, the banking system commercial of the State Bank as a source of funding of the GDR had to contribute to the execution of the arm for their lending business. About 80 percent of private central plan. Accordingly, it was organized as a one-tier sight and savings deposits were held at the savings banks. system with the State Bank (Staatsbank) at the head and a few commercial and a larger number of savings banks The remainder was distributed over the BLN, GHG, BHG, as well as the railways and postal banks. at the lower levels. The State Bank was the "central organ of the Council of Ministers for the implementation of the monetary and credit policy issued by the party and the government." 19 in this regard, it served as both The Banking Reform of March 1990 a central bank and a commercial bank. As a central On March 6, 1990, the GDR parliament, in preparation bank, it had the exclusive right to issue bank notes and for GEMSU, passed a Jaw (Geset: iiber die Anderung coins and, with the agreement of the Council of Ministers, des Gesetzes iiber die Staatsbank der DDR) that replaced to set the official exchange rate between fore ign CUITen the one-tier, socialist banking system by a two-tier system cies and the mark, the rate between foreign currencies compatible with that of the FRG. The State Bank gave and the valuta mark (the unit of account for foreign up its commercial banking activities but remained the trade), and the domestic rate between the valuta mark central bank of the GDR. The larger pa11 of the com and the mark.2o The commercial banking activities of mercial branch of the State Bank was used to create the Deutsche Kreditbank AG, and the smaller East Berlin 11 Moreover. !here is nothing 10 prevent the Bundesbank reacting 10 any dislurbing inOalionary lendencies in !he cast by lightening operation (Stadtkontor Ost) was transformed into the mone1ary condilions in !he wcs1-1hcre is room wilhin !he larger range Berliner Stadtbank AG. The central operation of the for discretionary action and !he Bundesbank's concern. after all, is BLN was used to create the Genossenschaftsbank Berlin with in nation in all ofGcnnany. The Bundesbank has no! ye! announced ils mone1ary policy intentions for 1991. der DDR, while the branches of the BLN together with '" As in the west. each bank has been assigned a rediscount quota. the BHG were merged into rural cooperative banks In total, these amounl 10 DM 25 billion. The banks have access to (Genossenschafts- und Rai.ffeisenbanken); the GHG forn1ed additional funds from the Lombard facility. '" See Geserz iiber die Sraarsbank der DDR, December 19. 1974. the nucleus of the Volksbanken, the cooperative banks 20 The system seems to have been logically inconsistent in 1ha1 for the crafts and trade sector.22 The municipal and cross-restrielions between these exchange rates did not always hold. For example, 1he official exchange rale between the deutsche mark 21 In order to facilitate business with Western countries, !he GDR and the mark, as well as the rate between !he deutsche mark and the Governmenl had given DHB and DABA !he s1a1us of Aktiengesell valuta mark, were both 1:1. In 1989. however, the internal ra1e sclwjlen, that is, joint-stock companies. already at the lime they were between the valuta mark and lhc mark for hard-currency trade was founded in 1956 and 1966. respectively.

VM I = M 4.4. A fund was created at the State Bank (RlKO fund) 22 The Genossenschaflsbank Berlin was created as the head orga to finance differences between the official and the internal exchange nization for the local Genossensclwjls- und Ra!ffeisenbtmken. as well rates (see above and Chapter Ill). as the Volksbanken.

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©International Monetary Fund. Not for Redistribution X • MONETARY AND FINANCIAL ISSUES I UNIFICATION county savings banks remained. The organization of the the State Bank registered a gain from currency conversion GDR commercial banking system and the constitution (after converting its equity position at the rate of M J of its components as universal banks set up a structure = OM I) and was allocated a con·esponding liability to similar to that of the banking system in the FRG. the Equalization Fund (Chart I). At the time of the reorganization, however. ownership All other major banks suffered conversion losses and of the GDR commercial banking system remained with had to be given claims on the Equalization Fund. Since the State or the cooperatives. The State Bank was given the savings and cooperative banks held the lion's share more than 80 percent of the shares in both the Deutsche of the population's sight and savings deposits. part or Kreditbank AG and the Berliner Stadtbank AG, which which was converted at parity, their conversion losses. were both constituted as joint-stock companies.2 -' The and hence equalization claims, were the largest. Banks State Bank was also the main shareholder in DABA and holding foreign liabilities (DABA and OH B) also incurred Dl-IB (also both organized as joint-stock companies). substantial conversion losses as their liabilities to Western which. in addition to their commercial activities. contin countries had to be valued at market rates while their ued to perform the functions of a house bank for the assets had to be converted at a rate of M 2 = OM I . :�> external trade companies engaged in trade with member Based on calculations using data from end May 1990, countries of the Council for Mutual Economic Assistance the Bundesbank estimated that the GDR banking system

(CMEA). 2'1 In contrast to the above-mentioned banks, would have gross claims of about OM 57 billion on the the Genossenschaftsbank Berlin and the savings banks Equalization Fund. These would be offset in part by (Swdr- wtd Kreissparkassen) were organized as public liabilities of the State Bank to the Equalization Fund so corporations. 25 The Genossenschajis- und Ra(ffeisenban that the net claim on the Government by the Fund was ken and the Vu/ksbanken continued to be organizated as estimated at about OM 26Y2 billion. A preliminary cal cooperatives. culation. as well as an allocation, of equalization claims. would be made as soon as the end-June balance sheets became available. A final calculation would be made only The Equalization Fund and Equalization Claims after cast German companies had published their opening balance sheets in deutsche mark. the distribution of enter The establishment of a two-tier banking system com prise debt was decided, and banks had evaluated their patible with that of the FRG was an important prerequisite portfolios incorporating this information. for the currency conversion that took place on July I. Since the assets of most banks were converted into deutsche mark at a lower rate than the liabilities. in order Developments in East German Banking to maintain the equity of the banks, the assets of the After GEMSU banking system had to be topped up with claims issued by the Equalization Fund. that is. the equalization claims As mentioned above, the commercial operations of discussed above. The Equalization Fund, in turn,covered the GDR banking system were placed with the newly its liabilities by claims against the State Bank and the created Deutsche Kreditbank (DKB) in March 1990. GDR Government. Reflecting the structure of their ao:;sets Subsequently, the DKB entered into joint ventures with and liabilities on the day of conversion, however, indi the two largest west German commercial banks. Deutsche vidual banks were affected differently by the currency Bank invested OM I billion in a joint venture with DKB con version. that encompasses 122 of the DKB's branches and 8,500 On July I, 1990. the State Bank ceased to exist as a of its employees. Dresdner Bank also entered into a joint central bank. lt nevertheless continued to perform an venture wirh DKB covering 72 branches of DKB with important role as a "money market bank'· I inking the an original investment of OM 150 million effective savings deposits of lhe population held at the savings, July I. 1990. An additional investment of OM 350 postal, and cooperative banks to the business and housing million was made in September 1990. which increased credits extended by the Kreditbank. Since an important the Dresdner Bank's stake in the joint venture from 49 liability. the RlKO fund, was eliminated in conversion, percent to 85 percent. At that time, Dresdner Bank also and since it had no deposits that were converted at parity. had 35 branches in the GDR which it had established de novo, including its original headquarters in Dresden. �' The remainder of the equity interest was acquired by state-owned cntcrprbc� and Kombin(llc>. ,. DABA. in panicular, remained the designmed bank for transac �" Rellecting the

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Chart 1. German Democratic Republic: Simplified Outline of the Banking System and Interbank Relations at the Time of the Currency Conversion'

(;trrnon Lredir 8ank German Foreign Trade Bank (OKBJ (OABA)

0epos11S rrom Liabilities to. .. cnu:rpri�

Other dcposil:s Balances with from nonbatlks Stale Bankl - Sra

Liabthtics ao ... ltl3ns to Cl aims on..• c:ntcrpnses Bal ance� abroad

... Savi11gs h::mh .. Slate Boml - Loans 10 enterprises a i9 ...D Hll Lr bihtit to ,.--- :, � ... OKB St:ale Bank EqualiUIIOOz ... Ente:rpn�-. , - dainh . .. Coopcrtt uve banks io- Other t iabilitie!t ba nk s ... oPsra. l

Lo:tn\ 10 housmg sccaor ... OABA/DHB 

Govcm tnent Olhe t a:-sell I Depo>i!S rrum 1 1 cooper.uiYc I Equalizalion fund �,I\ banl> I ( I I ilitie Loan � to Liabilltie� Linh s 10.•• 1 1 hou-.mg I 10 1 SCC IOI Suttl! Bank I 1 Other .ts.set� I 1 1 u l l l t 1 ..- - Eq a claim.\ Other iabi i ies I 1 s�wines banks I ( 1 1 I I_,Chtinbon ... Savings b�nki> 1 1 ;- I Sla!e Bank '-t1 I I 1 I 1 1 I 1 ... DABA -1 I I '-- Balance..�"i1h I I � Stale Bllnk ti _J t:oopcra vt bank� ••.D I I B Savang' dcposu s - a ... DKB tro CJ tmson.. Equ i i m . al za1 on gencruJ pub1 ic tlaimson ...B � N - Saving-. Govemmcnl I ...Sutte lhnJ.. .. . C ooperative dc�ils bank � �I Lo a n .; ror from 1 priv :ue generol 0 1her liabilities 1 housebuilding and other ufJ'O'CS ... BLN public 1 1 p 1 1 1 Other �� ' " 1 unli ation DepositS 1 Et� 7 frorr 1 ----- claims _ Equtdi1;�tion C Jllcrpn� lj clauns liabilil� lj 1 Other Other liabilities I lj ======::1 1

Source: Deutsche Bundesbank. Monthly Reporr, July 1990. p. 17. ' Excluding the Bundesbank. The joint venture banks established since 1he currency conversion. and the restructuring of the GDR banking system effected since then, are not included.

1 Now known as Stale Bank Berlin. 3 Now known as Cooperative Bank Berlin. ] 53

The Westdeutsche Lanclesbank, another FRG bank, competition both in terms of cross-border business and has entered into a joint vemure with the Deutsche the participation of external banks (i.e., from the FRG Ausscnhandelsbank (DABA), taking over 200 branches and other countries) in the domestic market. Furthermore. and approximately 1.200 employees. The joint venture laws regulating financialmarkets in the FRG were adopted is called the Deutsche lndustrie- und Handelsbank (DII-IB). by the GDR although, in certain circumstances, they Likewise, the Berliner Handels- und Frankfurter Bank could be applied more flexibly than in the FRGY (BHF) has taken a 64 percent stake in the Deutsche Jt will no doubt take some time before banks in east Hanclelsbank (DHB). Germany operate as efficiently as those in the west. The ln contrast to the other large FRG banks operating in principal concern about the operations of the banking east Germany, the Commerzbank decided not to engage system, however. would seem to be that the incentives in joint ventures with former GDR banks; instead it facing banks in their lending decisions are appropriate. adopted the strategy of opening new branches in the east. Credits to enterprises extended before July I, 1990 appear Commerzbank expects to have 50 branches operating in to have an implicit guarantee from the Trust Fund or the east Germany by the end of 1990; as of the end of Government. But for new credits, and given the desire September. its east German operations had total assets not to distort the allocation of credit by government of about OM 6 billion, with about 80,000 customers and intervention, the situation is more difficult. Uncertainties OM 2 billion in deposits. about the underlying competitive position of enterprises There are also a number of non-German banks oper are likely to persist for some time. Banks will therefore ating in east Germany: Citicorp has established repre be extremely cautious in extending new credits without sentative oftlces in East Berlin, Dresden, and Leipzig; government guarantees, at least until decisions are made Salomon Brothers and Barclays Bank have offices in on the allocation of existing enterprise debt and on East Berlin; and the Bank of Tokyo has received per enterprise balance sheets. Jn the period July-September, mission to establish a branch in East Berlin. the Trust Fund was authorized to guarantee working Savings institutions. which are generally owned by capital loans to enterprises up to a total of DM 30 billion. municipalities in west Germany. will be similarly struc A significant portion of these guarantees, at least in the tured in the east. As of mid-October. there were 4,000 first tTanche of DM 10 billion in July, was allocated to branches of savings banks (Spaarkassen), with 20,000 enterprises that are unlikely to survive the transition to employees. which accounted for about 80 percent of a market economy. lt now appears likely that the system total deposits in east Germany. Like in west Germany, of guaranteeing working capital credits will be continued there were also a number of cooperative banks (Genos through the first quarter of 1991. senschqftsbanken): 95 in urban areas and 272 in rural A second consideration relates to the next step of areas catering to the agricultural community. balance sheet reorganization that will occur with the valuation of enterprise debts and perhaps also the redis tribution of these debts. The redistribution of assets and Role of Banks in Economic Reconstruction liabilities within the state sector may have important consequences for the success of the restructuring effort The central position of the banking system in the as it will influence assessments of the creditworthiness allocation of resources gives it a key role in the trans of individual enterprises. lt is important that as a result formation or the cast German economy. The March of this process, viable economic entities not be exces banking system reform initiated the refashioning of the sively burdened with debt related to decisions under the GDR's banking system to this end. The establishment previous system. of the necessary institutional structure has been embodied 17 For example. the Banking Supervisory Ofllce in the FRG could. in the State Treaty on GEMSU. ln particular. after July under certain circumstances, grant exemption from the banking law I. financial markets in the GDR were opened to external to east German banks.

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