Small Economies in the Euro Area

CONTENTS

EDITORIAL

Mitja Gaspari: Jumping the Last Hurdle Towards the Final Stage of Convergence 1

MACROECONOMIC FRAMEWORK OF SMALL OPEN ECONOMY

Willem H. Buiter and Anne C. Sibert: When Should the New Central European Members Join the Eurozone? 5

George Kopits: Policy Scenarios for Adopting the Euro 12

Dejan Krušec: Common Monetary Policy and Small Open Economies 17

Lars Calmfors: The Revised Stability and Growth Pact – A Critical Assessment 22

Fabio Mucci and Debora Revoltella: Banking Systems in the New EU Members and Acceding Countries 27

Mathilde Maurel: The Political Business Cycles in the EU Enlarged 38

FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS IN EMU

Kevin R. James: Small Countries, Big Markets: Achieving Financial Stability in Small Sophisticated Economies 43

Garry J. Schinasi and Pedro Gustavo Teixeira: Financial Crisis Management in the European Single Financial Market 47

Franjo Štiblar: Consolidations and Diversifications in Financial Sector 56

Fabrizio Coricelli: Financial Deepening and Financial Integration of New EU Countries 70

THE CASE OF SLOVENIA

Ivan Ribnikar: Slovenian »Transition« and Monetary Policy 75

Igor Masten: Expected Stabilization Effects of Euro Adoption on Slovenian Economy 83

Velimir Bole: Fiscal Policy in Slovenia after Entering Euro – New Goals and Soundness? 87

Božo Jašovič and Borut Repanšek: Application of the Balance Sheet Approach to Slovenia 95

STATISTICAL APPENDIX

Matjaž Noč: Selected Macroeconomic and Financial Indicators 105 EDITORIAL

Jumping the Last Hurdle Towards the Final Stage of Convergence Mitja Gaspari *

n 1 January 2007, Slovenia will join the 12 current members of the euro area and adopt the single European currency. This is a historic moment for Slovenia and for euro area enlargement. It shows that the Treaty criteria are objective and allow new entrants to adopt the euro in due course once they fulfil the requirements. Slovenia’s fulfilment of the Maastricht criteria and its adoption O of the euro are part of a well-prepared project that saw all of the relevant policymakers fulfilling their task to ensure a positive outcome. The government kept fiscal deficit and public debt within the Maastricht levels with sufficient safe margin and contained the impact of administered prices on inflation by encouraging monopolistic structures to care about costs while preparing further steps to increase competition in such sector. Furthermore, it led a careful public wage policy that, among others, spurred employers and employees to settle for wage increases that lag productivity growth and hence reduce cost-push as well as demand pressures on inflation. By lowering inflation in a sustainable manner to enable smooth entering in ERM II, the Bank of Slovenia succeeded in keeping key interest rates high, while reinforcing anti-inflationary policy by stabilising tolar exchange rate to euro after ERM II entry. Resulting convergence of inflation to the Maastricht levels allowed also convergence of nominal interest rates towards the level of euro area interest rates without affecting the achieved macroeconomic balance. Minor current account deficit and a growth rate very much in line with Slovenia’s economic fundamentals are indicators of the fact that fulfilling the inflation and exchange

* Mitja Gaspari, rate criteria for euro adoption has not triggered other disequilibria, Governor of the Bank of Slovenia supporting the long-term sustainability of this achievement.

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Once Slovenia formally adopts the euro it will be able to fully reap the benefits of membership that it partially enjoys already. On the macroeconomic level this in particular involves the elimination of currency risk, generating potentially significant effects on investment. By microeconomic standards, the benefits of euro adoption are arguably even more pronounced, albeit more difficult to measure and to be observed in a longer-term horizon. A larger market enables to benefit from economies of scale and leads to further trade intensifi- cation, especially where small companies are concerned, since in general they cannot afford to hedge against currency risks. Moreover, price transparency brought about by the euro is likely to give another boost to competition and decrease the clout of certain rigid market structures. In the financial sphere, the switch to the euro helps to make capital markets more liquid and transparent by increasing the circle of potential market agents to all those who are reluctant to invest in a foreign currency. Finally, adopting the euro as the first of the new EU member states may highlight Slovenia’s sound economic performance in the eyes of foreign businesspersons and certainly enhances the perception of Slovenia also by a wider foreign public. Yet, the adoption of the euro also poses some short– to medium– term risks that must be addressed with caution to avoid an early disappointment. The most important is to maintain the tight fiscal stance in line with the recommendations issued within the framework of the assessment of the convergence programme under the Stability and Growth Pact and to deal properly with the risks identified in the May Convergence Report on Slovenia. In the longer term, Slovenia’s benefits of euro adoption will depend on the economy’s structural adjustment to the new environment. Especially product market reforms to step up competition and bring further improvements to the functioning of the labour market are necessary elements to smooth asymmetric shocks which national monetary policy can no longer prevent. Some factors such as Slovenia’s trade openness, its geographical and cultural proximity to the euro area’s core countries, and an economic cycle that is well tuned to the euro zone, already point to Slovenia’s fundamental readiness for the currency union. I am confident that Slovenia will overcome these new challenges skilfully and be well positioned for the future.

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UDC 339.923:061.1 EMU When Should the New Central European Members Join the Eurozone? Willem H. Buiter and Anne C. Sibert *

The eight new EU n 1 May 2004, eight Central European former members from Central and Eastern Europe (the CEE8) should all aim communist states, together with Cyprus and Malta, to join the Eurozone as soon as possible. Even joined the 15-member European Union. Estonia, the largest among them, Poland, is too small, to Lithuania and Slovenia joined the Exchange Rate open and too vulnerable to destabilising capital OMechanism (ERM) of the Economic and Monetary Union (EMU) flows to be an optimal currency area. With in June 2004 and hoped to become members of the Euro area by unrestricted labour 1 mobility with the EU15 no 1 January 2007. Latvia joined the ERM in May 2005 and targets later than 2011, the CEE meet all the conventional full membership of the EMU in 2008. Slovakia also joined ERM Optimal Currency Area criteria for membership in 2005 and hopes to join the Eurozone in 2009. The Czech in the Eurozone. In some of the larger Republic, Hungary and Poland have not yet joined the ERM. In CEE8 countries, especially Hungary, Poland, the May 2006, only Slovenia was recommended, by the ECB and the Czech Republic and Slovakia, fiscal sustain- European Commission, for Eurozone membership on 1 January ability is not yet soundly established. It is in the self-interest of countries 2007. Estonia had been bullied into dropping its request for with question marks behind their fiscal-finan- membership on 1 January 2007 and Lithuania was judged not cial sustainability to defer Eurozone membership to be ready. In this article we consider whether or not the new until that issue has been resolved. member states would benefit from joining the Eurozone and any The inflation criterion for EMU membership – is (a) potential economic grounds for excluding them. stupid because it is based on the inflation perform- SHOULD THE NEW MEMBERS JOIN THE EUROZONE? ance of the 25 EU members rather than on that of the 12 member Euro- The benefits to the new members from Central Europe zone; (b) stupid because of membership it ignores Balassa-Samuel- son equilibrium inflation differentials, and (c) in From the point of view of the economic fundamentals violation of both the spirit and the letter of the emphasized by optimal currency area theory, it is in the interest Treaty because of the definition of ‘best of all eight new Central European members (the CE8) to join the performing in terms of price stability’ for Eurozone as soon as possible. They are all too small, too open candidate EMU members that amounts to ‘the three and too vulnerable to speculative attacks against their national member states with the lowest inflation rates * Willem H. Buiter, Professor of European Political Economy, European Institute, London School of Economics and (barring anomalies)’ that Political Science, Universiteit van Amsterdam, CEPR and NBER. is different from and tougher than the Anne C. Sibert, Professor of Economics, Birkbeck College, University of London and CEPR. definition used for the 1 The European Monetary Union has 12 members. The UK, Sweden and Denmark, as well as the 10 new EU Eurozone itself. members that joined the EU on 1 May 2004, are not members of the Eurozone.

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currencies to be optimal currency the new member states and should foreign savings to augment their areas. For the smallest ones among become significantly higher. These domestic capital stocks. It permits them, it is indeed doubtful whether a countries still trade significantly less foreign direct investment, which national currency is a viable option in than would be expected, given their brings financial resources and trans- the medium to long run. size, per capita income, distance fers skills, knowledge and technology. In terms of economic size, as from trading partners and man-made It increases the efficiency of financial measured by their percentage share barriers to trade.4 The latter impedi- intermediation and permits cross-bor- of world GDP, the new member states ment is primarily the legacy of misdi- der risk sharing. However, it exposes are tiny, as seen in Figure 1.2 Several rected central planning which has still countries to whims of international of the countries are about the size of not been completely overcome. financial markets. Average daily Luxembourg (0.05 percent) and While openness to trade is high, global turnover in the global foreign collectively at 1.93 percent the eight financial openness is nearly com- exchange market is roughly $2 trillion countries are about the same size as plete. As part of body of EU laws, and a single large hedge fund may Mexico (1.76 percent) or Canada regulations and directives that the have more financial resources at its (1.84 percent). new EU members have to adopt to disposal than the monetary authorities As shown in Figure 2, the CE8 are qualify for EU membership – virtually of most of the new member states. relatively dependent on trade.3 all fiscal, administrative and other in- Their size and openness imply Their share of trade in GDP, calcu- stitutional barriers to financial capital that for the CE8, a national currency lated as the percentage of the sum of mobility have been lifted. The only is a liability. If they attempt to peg imports and exports to GDP ranges exceptions are some remaining their exchange rate, then sooner or from about 70 percent for Poland to restrictions on foreign ownership of later they will almost certainly under- nearly 140 percent for the Slovak Re- land and real estate that are not of go a sudden and costly disruption to public. This contrasts with the United macroeconomic significance. their financial sectors. The disastrous States, where the share of trade in An open financial account has experiences of East Asia, Russia and GDP is about 24 percent and with many advantages: it permits nations, Latin America in the late 1990s and France, where it is about 56 percent. such as the new member states, with 2002 serve as a warning that, for Moreover, openness is increasing in high economic potential to draw on small open economies with mobile financial capital, pegged exchange Fig 1: Percentage Share of World GDP rates lead to turmoil and output loss. The current situation of Iceland and New Zealand illustrates the problem with the alternative floating exchange rate regime. Swings in capital flows brought about by external events can force central banks to have to choose between cutting off growth with high interest rates or allowing precipitous declines in the value of their currency. Writing in the Financial Times, Wolfgang Munchau argues that Estonia and Lithuania are too poor to join the eurozone.5 Indeed, as shown in Figure 3, Estonia and Lithuania are poor relative to most of the new members states and the new member states are poor relative to the Euro- Fig. 2: Share of Trade in GDP zone.6 But, the gap is narrowing and two new member states (the Czech Republic and Slovenia) are wealthier than the Eurozone member Portugal.

2 GDP based on PPP share of world total, source: IMF World Economic Outlook and EconStats 2006. 3 Source: World Bank Development Indicators, 2004. 4 This can be demonstrated empirically using “Agravity models”, which relate trade intensity to such variables as real GDP per capita and distance from trading partners, see e.g. Transition Report 2003, European Bank for Reconstruction and Development, London 2003. 5 “Monetary union is not for the poor”, 30 Jan 2006. 6 Source: Eurostat.

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Fig. 3: Per Capita GDP in Thousands of Euros World Bank publishes an index measuring the ease of doing business in different countries. The index depends on such factors as business regulations, property rights and labour market rigidities. On this index, Lithuania and Estonia rank 15th and 16th in the world, respectively, not far behind the best EU25 performer (Denmark in 9th place) and ahead of Germany (19th place) and France (44th place).8 Another potential cost to losing an independent monetary policy arises from public finance considerations. Due to different abilities to collect taxes and differences in the size of the informal sector, different countries may have different optimal inflation rates. If a government is relatively However, if poverty implies sharing poor at collecting taxes and if its (fre- a common currency with wealthier quently cash-intensive) informal sector neighbours is undesirable, perhaps The obvious is relatively large – so that non-infla- Tower Hamlets should leave the ster- tion taxes are distortionary – then a ling area.7 The smallness and open- country may find it optimal to collect ness of the member states implies that cost to a significant inflation tax, either the exchange rate is not an effective through seigniorage (revenues from instrument or buffer that would allow the member base money issued by the central them to achieve the necessary chang- bank) or an erosion of the real value es in international relative costs and countries of domestic-currency fixed interest prices with small transitional costs debt at a rate of inflation higher than of excessive inflation and unemploy- was anticipated when the debt was issued. Thus, the inflation rate which ment. Instead, the foreign exchange of joining the is optimal for one Eurozone member market itself is a source of excess may not be optimal for another. volatility, instability and, at times, euro area Furthermore, as different member persistent misalignment. countries have different consumption The obvious cost to the member baskets, there can be significant countries of joining the euro area is is the loss of differences in inflation rates across the loss of an independent monetary countries even with a common mone- policy. One consequence of this is an independent tary policy. Thus, even if all member that monetary policy cannot be used countries had the same optimal to stabilise country-specific shocks. monetary rate of inflation and this rate were However, there is debate about achieved on average across coun- whether monetary policy makers tries, inflation could still be too high are good at stabilising the economy, policy. or too low in individual member coun- beyond what would be achieved as a tries. For the CE8 however, this cost by-product of inflation targeting. It can is likely to be small compared to the be argued that monetary policy countries that did not invoke the benefits of Eurozone membership. should attach only limited weight to option to restrict (for a transitional the stabilisation of the real economy. period of up to 7 years) labour immi- The Cost to the Eurozone of the One reason is that an inflation bias gration from the new member states new members from Central may result when the monetary policy after 1 May 2004. Labour mobility Europe becoming members maker actively pursues the stabilisa- can serve as a substitute for conven- tion of output or employment. Another tional stabilisation policy in coping An inability or unwillingness of reason is that stabilization is difficult: with country-specific shocks. new member states to commit them- shocks are hard to identify and quanti- It should also be noted that the selves to a sustainable fiscal policy fy and monetary policy is subject to cost of a common monetary policy to is viewed as a potential cost of their lags which are long, variable and countries such as Estonia and Lithua- highly random. nia would not necessarily be greater 7 Tower Hamlets is a London (UK) borough, just than the cost to the existing Eurozone east of the City of London. It contains the heart A factor which might mitigate any of the old London docklands and is among the cost associated with losing a stabili- members. In the fourteen years since poorest boroughs of London, although it con- sation role for the central bank is the their independence Estonia and Latvia tains Canary Wharf, London’s new ﬁnancial centre. surprisingly high degree of cross- have been remarkably successful in 8 World Bank, Doing Business in 2006, over- country labour mobility between the transforming themselves into flexible view. The ﬁrst three countries are New Zealand, CE8 and the few earlier EU member and resilient market economies. The Singapore and the United States, respectively.

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membership in the Eurozone to the They certainly show no evidence As regards fiscal sustainability, the existing member states. It is frequent- of being capable and willing to three Baltic countries and Slovenia, ly believed that a country’s actual generate primary surpluses. For this and possibly even Slovakia, are or threatened insolvency might reason it may be justifiable to claim ready for Eurozone membership now jeopardise the entire Eurozone finan- that at present Poland, Hungary and (see Figure 6). Indeed, they were cial system or destabilise the common the Czech Republic are not ready for ready on 1 May 2004 and are currency by forcing the European Eurozone membership. clearly far more »ready« than Italy, Central Bank into a bail out. While it is not entirely clear that this fear Fig. 5: Government Deficit as a Percent of GDP is reasonable, this is one reason why the current Eurozone members might have grounds for objecting to the entry of some new member states. Establishing whether or not a country is following a sustainable fiscal policy is not a straightforward matter. The economic concept of sustainability should not be confused with whatever numerical benchmarks or criteria may feature in a set of legal documents or administrative procedures, be it the two fiscal Maastricht criteria for EMU membership or the fiscal criteria of the Excessive Deficits Procedure for existing EMU members. Unsustainable public debt, implying the prospect of government insolvency and debt default, is a threat whenever the outstanding Fig. 6: Government Surplus as a Percent of GDP stock of debt is high relative to the ability and willingness of present and future governments to generate primary budget surpluses, that is surpluses before interest payments. It is clear from Figure 4 that the existing debt-to-GDP ratios of all of the new member countries from Central Europe are well below the average of the Eurozone and much lower than the stratospheric levels of Greece and Italy.9 Poland, Hungary and the Czech Republic are, however, as shown in Figure 5, running large and persistent conventional budget deficits.10

Fig. 4: Government Debt as a Percent of GDP Greece, and quite possibly also France and Germany, none of which can be confidently stated to have sustainable fiscal programmes.

WHAT ARE THE PROSPECTS FOR ESTONIA, LITHUANIA, LATVIA, SLOVAKIA AND SLOVENIA TO SATISFY THE MAATSTRICHT CONVERGENCE CRITERIA?

There are four Maastricht criteria for full membership in EMU. The first is a pair of fiscal conditions that constrain gross general government debt

9 Source: Eurostat, OECD. 10 Source: Eurostat.

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to be less than sixty percent of (annu- deficits will continue to decline and to change rate and the tolar has traded al) GDP. The second is an interest rate reach one percent in 2008. The same close to its fixed central euro parity criterion: long-term (ten-year) nominal fiscal austerity has not characterised rate since entry. Latvia joined the interest rates on central government Euro-member countries; in 2004 the ERM on 2 May 2005 and the lats debt are to be within two percent of Euro area as a whole had a 2.7 has remained well within Latvia’s the average in the three EU member percent deficit-to-GDP ratio and the target zone of plus or minus one countries with the best (lowest) infla- three-percent limit was exceeded by percent around the central parity. tion record. The third is an inflation Germany, Greece, France and Italy. Since Slovakia entered the ERM on criterion that specifies that the annual The five candidate countries 28 Nov 2005, the Slovak Koruna inflation rate cannot exceed the aver- should easily meet the long-term inter- initially appreciated, but has since age of the three best performing EU est rate criterion; bond yields within stabilised between one and two member countries by more than 1.5 the Eurozone have converged and percent above the central rate. percentage points during the year the average of the three lowest infla- Inflation, measured as the change prior to the formal assessment of tion countries’ interest rates is close to from the same month of the previous whether a candidate has met the EMU the Eurozone average. In December year, for the twelve months of 2005 membership criteria. Finally, there 2005, the ten-year interest rates on and January 2006 for the five is an exchange rate criterion: the ex- public debt in Latvia, Lithuania, candidate countries is shown in Fig. 7 12 change rate has to remain within the Slovakia and Slovenia were 3.59, below. Average inflation in the three normal fluctuation margins provided lowest-inflation countries of the EU for by the ERM of the European Mone- was a little over one percent in Janu- tary System without severe tensions for ary 2006. The Benchmark or target at least the last two years before the Poland, inflation rate, calculated as the aver- formal assessment. In particular, the age of the three lowest inflation rates candidate must not devalue its curren- in the EU plus 1.5 percentage points, cy on its own initiative during the peri- Hungary is shown in Chart 1. The benchmark in od. The »normal fluctuation margins« May 2006 was therefore 2.6% infla- have been interpreted by the ECB and and the Czech tion. This Chart also shows the behav- the European Commission to be plus iour of an alternative benchmark (not, or minus 15 percent around a fixed Republic unfortunately, part of the Treaty-based central parity against euro. In addi- Maastricht criteria), labelled “Euro- tion, there is a requirement that central zone” and given by the average bank of the candidate country must be are, however, Eurozone inflation rate plus 1.5 per- independent. Only the fiscal criteria cent. With the benchmark rate at 2.6 have any hope of being rationalisable running large percent early in 2006, only Slovenia in terms of optimal currency area con- met the inflation criterion. It is clear siderations, and even there the con- that Latvia is far from being able to nection is weak: the two Maastricht and persistent satisfy the inflation target, that Lithua- fiscal criteria are neither necessary nor nia misses it by a whisker and that sufficient for fiscal sustainability. conventional Estonia, Slovakia miss it by a wider By being fiscally profligate and by margin. With the more sensible not joining the ERM, Poland, Hungary Eurozone inflation-based benchmark and the Czech Republic are out of the budget deficits. now running above 3.5 percent per running for Eurozone membership this annum, Lithuania would pass the test decade. However, Estonia, Lithuania and Estonia would come quite close. and Slovenia aspire to adopt the euro 3.79, 3.62 and 3.69 percent, Finally, with a criterion based on the on 1 January 2007, Latvia sometime respectively. The Euro area average inflation rates of the three countries in 2008 and Slovakia during 2009. was 3.41 percent, making the target whose inflation rate is closest to but Slovenia is likely to be successful rate well over five percent. Estonia below 2.0% (the ECB’s own price in meeting the Maastricht criteria; has lacked an instrument for compari- stability criterion!) Lithuania would Estonia is unlikely to be and it is un- son (that is, at least a five-year easily pass the test. certain whether or not Lithuania will bond), but based on its low public- Given their success in maintaining comply. sector kroon interest rates and sound their exchange rates against the euro, As was seen in Figure 4, no CE8 budgetary position, it should not face the inflation rates in Figure 7 are country is in danger of exceeding the difficulties meeting this criterion. no surprise. In the face of external upward bound on government debt. Estonia, Lithuania and Slovenia shocks, either a small open econo- The general government surplus (defi- joined ERM on 28 June 2004. Esto- my’s exchange rate fluctuates or its cit, if negative) is depicted in Figure 6 nia and Lithuania maintain currency inflation rate varies. It is not possible and it can be seen that the of the five board arrangements and assumed achieve both an inflation target and candidate countries, only Slovakia is a unilateral commitment to peg their an exchange rate targ et simultane- in danger of exceeding the three per- currencies to the euro; the kroon and ously, except by chance. The legislat- cent limit.11 Estonia has been running litas have traded at their central pari- 11 ty rate since Estonia and Lithuania Monthly Bulletin Feb. 2006. The 2005 esti- surpluses and Slovenia and Lithuania mates are from the EBRD Transition Report 2005 are running small deficits. The Slove- joined the ERM. Slovenia’s monetary and the European Commission. nian central bank projects that its policy is aimed at stabilising its ex- 12 Source: Eurostat

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Fig. 7: Inflation be met. Neither choice seems particularly appealing. Slovenia’s better inflation performance may reflect Slovenia’s greater convergence towards Euro area levels, seen in Fig. 3. Per capita income in Slovenia is already about three quarters of the average of current area members and, thus, Slove- nia is likely to be experiencing less of a Balassa-Samuelson catch-up effect. In addition, it is possible that Slovenia is more able than are Estonia and Lithuania to influence inflation through its control of administered and regulated prices and more willing to put up with the resulting distortions.14 The most unusual and unfortunate feature of the Maastricht inflation Chart 1: Benchmark Inflation Rates criterion is that its benchmark is based on the 3 lowest inflation rates among the 25 EU members, and not just on the inflation performance of the 12 member Eurozone. Indeed, in recent months, two of the three lowest inflation rates were for countries that are in the EU but not in EMU – Poland and Sweden. It would make as much economic sense to base the decision on admitting the candidate Eurozone members on the inflation performance of Sub-Saharan Africa as on that of EU members that are not in the Eurozone. Indeed even the inflation performance of the 12 individual Eurozone members is irrelevant for prior nominal convergence by the candidate members. This prior nominal convergence requirement (which ed goal of the Estonian central bank size of the inflation increase due to is not implied by optimal currency is to achieve price stability and to that the Balassa-Samuelson effect on the area considerations) would require end Estonia has operated a remarka- accession countries, but current esti- convergence on the Eurozone aver- bly successful currency board since mates are in the range of 1.5 percent age rate of inflation (shown as Euro- 1992. Since June 2004 Estonia has to 2.5 percent per year.13 As the zone in Chart 1) or on the target rate maintained an unchanged exchange Maastricht Treaty only allows for of inflation of the Eurozone – close to rate in the ERM. However, mainly as inflation to be 1.5 percent above the but below 2 percent per year. For a a result of oil price rises, its inflation best-performing members of the EU, small country joining a large common rose to 4.1 percent in 2004. As a this creates a serious problem for currency area, prior inflation conver- consequence, Estonia will not meet Estonia and Lithuania. gence (up to the differential warrant- the Maastricht inflation criterion in Estonia and Lithuania may simulta- ed by the Balassa-Samuelson effect) 2006; it is unlikely to meet it in 2007. neously satisfy the inflation and the is helpful but not essential. Member- Even without an energy price exchange rate criteria by luck. Eco- ship in the common currency is a shock, the Balassa-Samuelson effect nomic theory suggests that the only implies that as the accession coun- other macroeconomic policy options 13 A discussion of this is found in Willem Buiter, tries’ productivity levels catch up are either to abandon their highly »To Purgatory and Beyond: When and How should the Accession Countries from Central with Euro area countries their real ex- successful currency boards and adopt Europe Become Full Members of the EMU,« change rates will appreciate. For cur- a more flexible exchange rate system: 2004. rency-board countries such as Estonia the fifteen percent exchange rate 14 The European Bank for Reconstruction and and Lithuania with a fixed nominal Development ranks countries on their degree of bands may permit more leeway than price liberalisation from 1 (a rigid centrally exchange rate this implies that their the 1.5 percent band in the inflation planned economy) to 4+ (an industrialised inflation will be higher than in the Eu- target. Or, they can use fiscal policy market economy). Estonia and Lithuania scored 4+; Slovenia scored a 4. Some other countries rozone. Short data sets and cyclical to drive down their domestic demand scoring a 4 were Azerbaijan, Kazakhstan and factors make it hard to estimate the to the point where both criteria can Ukraine.

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swift and efficient way of achieving immediate Eurozone membership. All Lithuania over the reference period, the right degree of inflation conver- that stands between the four countries which resulted in a 12-month average gence. and a Eurozone membership that rate of -0.2% due to the accumulation A good case can be made that would benefit both them and the exist- of specific factors, have been judged the inflation criterion used by the ing EU members is the likelihood of to be an outlier and were consequent- European Commission and the ECB the rigid application of an arbitrary ly excluded from the calculation of the for Eurozone membership – the three inflation criterion, and one which reference value.«17. The ECB then fur- lowest inflation rates among the 25 probably violates even the letter of ther underlines the scope for flexibility EU members, except for anomalies, the Treaty, because it is based on the and discretion by making the follow- is inconsistent with both the letter three lowest inflation rates rather ing point: »It should be noted that the 15 and the spirit of the Treaty. The than on the inflation rates of the three concept of 'outlier' was already re- Treaty refers to the three best per- countries that are best performing in ferred to in earlier convergence reforming countries in terms of price terms of price stability. ports. It does not imply any mechani- stability. The ECB has, as part of the It is clear that Lithuania has good cal approach to the exclusion of cer- operationalisation of its price stability grounds for contesting in the Europe- tain inflation rates but was introduced target, defined price stability as close an Court of Justice the decision to in the 1998 EMI Convergence Report to but below 2 percent. This means exclude it from Eurozone membership. to appropriately deal with potential that the tree best performing coun- Estonia and Latvia are unlikely to have significant distortions in individual tries in terms of price stability are any legal recourse at this stage: the countries’ inflation developments.«18 not the three countries with the lowest decision to exclude them makes no Finally, there is some further hope rate of inflation but the three coun- sense, but is ‘legal’. This raises the that Estonia and Lithuania will join tries whose inflations rates are closest problem of what to do when “the law Slovenia on January 1, 2007 as Euro- two but below 2 percent. The aver- is a ass”.16 Failure to enforce a law, or age of the three countries whose in- zone members, because that decision a Treaty-based rule like the applica- flations rates are closest to and will be taken by the European Council tion of the Maastricht criterion, weak- below 2.0 percent was 1.9 percent in – the ministers of finance. The ECB ens the rule of a law and the May 2006. Adding 1.5% gives a and the European Commission have respect for rule-bound behaviour. benchmark of 3.4%, something easily a merely advisory role in this matter. Enforcing a law or a rule that makes met by Lithuania. The very creation of EMU has been no sense and inflicts unnecessary a triumph of political will over techno- Conclusion: what to do when harm also weakens respect for the cratic timidity. It could happen again “the law is a ass”? rule of law and for rule-bound behav- here. iour and thus undermines them. In the Of the five candidate Eurozone case of the Maastricht criteria, this di- REFERENCES: members, Estonia, Latvia, Lithuania, lemma has already be resolved by the Slovakia and Slovenia, only Slovakia 1. World Bank Development Indicators, fact that, for better or worse, the crite- 2004. is not yet a convincing candidate for ria have been violated both in spirit 2. Transition Report, 2003, European Bank and in the letter so frequently, that lit- for Reconstruction and Development, London 15 The ECB does not give a definition of what an anomaly is. In the 2004 Convergence Report, tle or no further damage will be done 2003. Lithuania was left out of the calculation of the by a flexible interpretation of the infla- 3. World Bank, Doing Business in 2006, benchmark with an inflation rate of -0.2 per- tion criterion. Italy, Greece and Ger- overview. cent. This could indicate that negative inflation rates are anomalous. many joined EMU despite not meeting 4., Eurostat, OECD. 16 »If the law supposes that,« said Mr. Bumble, the debt criterion at the time of entry. 5. European Central Bank, Monthly Bulletin, »the law is a ass - a idiot. If that’s the eye of the Finland, Italy and Greece also did not Feb. 2006 law, the law is a bachelor; and the worst I wish the law is that his eye may be opened by expe- satisfy the exchange rate criterion. 6. EBRD Transition Report 2005 rience - by experience.« From Charles Dickens, Furthermore, the ECB has, in its 7. Willem Buiter, To Purgatory and Beyond: Oliver Twist, chapter 51, p. 489 (1970). First Convergence Report 2004, explicitly published serially 1837B1839. When and How Should the Accession opened the door to a flexible inter- Countries from Central Europe Become Full 17 European Central Bank, Convergence Report 2004, Frankfurt am Main, p.16. pretation and calculation of the refer- Members of the EMU, 2004. 18 European Central Bank, Convergence Report ence value for inflation. It contains the 8. European Central Bank, Convergence 2004, Frankfurt am Main, Box 1, p. 8. statement: »The price developments in Report 2004, Frankfurt am Main.

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UDC 336.7:339.923:061.1 EMU Policy Scenarios for Adopting the Euro George Kopits *

The new EU Member he purpose of this paper is to examine recent States face an extraordinary challenge developments in the conduct of macroeconomic policies in macroeconomic management as they in the new EU members, with a view to outlining various navigate toward the euro. At the outset of scenarios for euro adoption in the period ahead. The their journey to the euro, the eight post-socialist Tscenarios are formulated on the basis of the policy approach new members accelerated the being followed by each member. To conclude, the paper explores completion of the transition to a market options for enhancing the prospects for adoption of the euro. The economy, in order to adopt the acquis paper does not question the design of the Maastricht criteria or communautaires and to qualify for membership, their actual enforcement by EU institutions. Instead, the criteria which became effective May 2004. The initial are assumed as given, especially in light of the prevailing aspiration of the accession countries to narrow interpretation in assessing certain members’ recent adopt the euro soon after membership, and in any application to join the euro area. case, before the end of this decade, seemed perfectly feasible to Maastricht criteria and the new members materialize. Since then, however, differences have emerged among The origin of the criteria for adopting the euro can be found the new members and currently only Slovenia in the Maastricht Treaty of 1993. The criteria establish the has been approved for euro participation as of requirements for the third stage of economic and monetary January 2007. For the rest of them, adoption of union that culminated in the creation of the euro. They were the euro is likely to slip to a more distant future meant to ensure that the initial participants of the euro area date. exhibited sound macroeconomic fundamentals. The criteria for entering the euro area are well known. The candidate member state, with the consent of the European Central Bank, must formally operate within the ERM II exchange rate mechanism, for at least two years.1 This regime prescribes a stable central exchange rate parity vis-á-vis the euro, within a

* George Kopits is a member of Monetary Council, National Bank of Hungary. Comments by Agnes Csermely and Eduard Hochreiter are gratefully acknowledged. The views expressed are those of the author and do not necessarily reﬂect the position of the National Bank of Hungary. 1 Buiter and Grafe (2002) provide a criticism of the rationale for ERM II and for the two-year waiting period requirement for small EU members which already meet the ﬁscal criteria.

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wide +/– 15% band. In principle, on this requirement until after mem- curred sizable budget deficits. Ulti- exchange rate stability is understood bership. But, by the early 2000s, mately, these differences have be- to obtain with variations within a most new members seem to have come the key determinant of each narrow +/– 2¼% band around the formulated a discernible strategy for country’s pace toward euro adoption. central parity.2 In addition, in the year joining the euro area. Recent trends preceding adoption of the euro, On the monetary front, as a first the candidate cannot exceed the step and precondition for member- As they approached membership, reference values for the inflation rate ship, all accession countries had vest- two very distinct policy approaches and long-term government bond rate, ed their central banks with independ- had emerged in the accession coun- set respectively at 1½ and 2 percent- ence—which since then has been test- tries. One group of countries pegged age points above the average rates ed and challenged on a number of their exchange rate. Consistent with of the three best performing EU mem- occasions in several countries. By the this approach, these countries have bers. Also, the candidate must keep second half of the nineties, they had been characterized by strict fiscal disci- the general government deficit below adopted a broad range of policy pline. The other group followed a rath- the reference value of 3% of GDP and frameworks, including currency board er indulgent fiscal policy stance and gross public debt must be on a declin- arrangement, preannounced ex- exercised monetary control in the con- ing trend to below 60% of GDP.3 change rate crawl, and various forms text of an inflation targeting regime.7 In their original design the criteria of targeting monetary aggregates or Under the first approach, the Bal- were internally consistent under cer- tic countries and Slovenia anchored tain reasonable, albeit arbitrary, macroeconomic policies to a fixed set of assumptions. However, when and a managed exchange rate re- applied to new entrants in the euro One group gime, respectively. Among the Baltic area, the criteria seem to exhibit States, Estonia has adhered to the some logical flaws. In particular, the currency board arrangement intro- reference value for the inflation rate of countries duced in the early years of transition, has been questioned, especially in whereas the others maintained vari- view of the pending transfer of mone- pegged ous forms of fixed exchange rate. In tary control to the ECB, upon adop- a more pragmatic manner, Slovenia tion of the euro. 4 Furthermore, the their exchange held on to a mix of a soft peg and exchange rate and inflation rate crite- of targeting the M3 aggregate. ria may pose a potential inconsisten- Over time, all these countries cy for the new members, owing to the rate. maintained approximate balance in appreciation of the real equilibrium their public accounts. Notably, the exchange rate associated with signifi- Baltic countries followed a textbook- cant productivity gains in the tradable inflation. In principle, each of these like countercyclical fiscal stance. In sector, as discussed below. regimes was compatible with the ERM response to the Russian crisis of 1998, By contrast, the fiscal criteria are II, as long as fiscal behaviour was they ran significant budget deficits critical to avoid free-rider behaviour kept under control and wage determi- that turned into surpluses during the within the Union and should be nation remained flexible.5 In practice, 2 strictly enforced not only for euro it was clear from the very beginning In practice, exchange rate stability is usually defined for each member under multilateral or candidates—as it had not been done that the accession countries would unilateral commitments. Further, there may be in the case of Greece and Italy which have to cope with upward pressures allowance for temporary deviations beyond the narrow band and for some appreciation in had met the criteria mainly through on the exchange rate and/or on the excess of the narrow band. For a discussion of creative accounting or temporary price level that stemmed from strong the ERM II regime and its background, see measures—but equally for all EU productivity growth in the tradable Deroose and Baras (2004). 3 Member States. This, of course, is the sector (the so-called Balassa-Samuel- Compliance with the fiscal criteria is determined in accordance with ESA95 reason why the fiscal criteria are en- son effect) and with capital inflows accounting conventions. shrined in the Stability and Growth attracted by the advent of euro. These 4 Buiter (2004) is not only critical of the inflation Pact and applied, admittedly in a forces, however, can be stymied by criterion, but for the same reason also questions the rationale for inflation targeting in these somewhat diluted form, to the entire weak fundamentals, particularly in countries. Whereas the criticism of the inflation membership. connection with a poor fiscal outlook. criterion may be valid, his argument for Against this backdrop, already On the fiscal front, in the run-up abandonment of inflation targeting is weak, unless the date of euro entry is imminent. prior EU accession, the new members to EU membership, most of the acces- 5 For an early discussion of the conditions had to make key strategic choices sion countries still experienced con- underlying this compatibility, see Kopits (2004), (at least by default) on the conduct of siderable stress reflecting transition-re- initially presented at the Conference on Shaping the New Europe, Vienna, November 1998. monetary and fiscal policies, with a lated expenditures along with weak- Technically, however, countries with a freely view to eventually to meeting the nesses in the tax system. In addition, floating exchange rate, or with the exchange Maastricht criteria. Although the EU since accession, they have been fac- rate pegged to the SDR, were not strictly speaking ready to join the ERM II regime. Thus, authorities failed to encourage the ing a significant net negative budget- Latvia had to shift its peg to the euro, and the accession countries to address macr- ary effect of membership.6 However, Czech Republic and Poland will need to establish appropriate bands around a declared oeconomic fundamentals at an early fiscal policy orientation became in- parity prior to entering the ERM II stage, some of these countries did creasingly differentiated among the 6 See Kopits and Székely (2003) for estimates prepare for compliance with the crite- new members. While some sought of this effect. ria while others did not really focus to maintain fiscal discipline, others in- 7 For a broad overview, see Kopits (2005).

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upswing that followed. In Estonia, monetary control to contain inflation time of membership, they followed an fiscal policy is subject to a self-im- below the reference value (Table 1). inflation targeting system, which, after posed balanced-budget rule. The Under the alternative approach, some initial teething problems, led latter is accompanied by a stabiliza- the larger Central European members to a deceleration in inflation to low tion fund. Surpluses generated during (the Czech Republic, Hungary, Po- single digit rates. Earlier, inflation expansionary periods are deposited land, Slovakia) had a markedly differ- targeting was handicapped in several in the fund and deficits incurred ent experience in recent years. These respects: unclear target, attempt to during recessions are financed with countries have incurred wide fiscal simultaneously targeting inflation and withdrawals from the fund. Overall, imbalances and mounting public debt exchange rate, slow response to the Baltic States have become the as a ratio to GDP, reflecting in part a changes in risk premium, changes in start performers, in terms of stability generous system of social entitlements indirect tax rates, and insufficient and growth, in the Union. and, in some cases, a significant inter- transparency. However, these prob- Not surprisingly, in 2004, immedi- est bill (as a result of high interest lems have been largely overcome ately after membership, three of these rates and large debt). Moreover, and inflation targeting is now being countries joined the ERM II regime endogenous increases in tax revenue pursued with state-of-the-art technolo- and windfall gains from privatisations and planned to adopt the euro by gy. As a result (and assisted by glo- were channelled to finance increased 2007. Latvia joined the following, bal disinflation), these members have government outlays, resulting in a thus paving the way to eligibility for come close to the reference values for procyclical fiscal stance. By and the euro by 2008. Notwithstanding inflation and interest rate, though large, these countries have been lag- their ease in complying with the refer- experiencing considerable volatility in gards in undertaking much-needed ence values for the budget deficit, the exchange rates. In particular, structural reform in public pensions, debt and the interest rate, as well Poland ranks among the three best in- health care, and other areas of public flation performers in the EU (Table 1). as with the exchange rate obligation, 8 finance. With budget deficits above In some respects, the case of Slo- these members are confronted with the reference value, all four members the difficulty in fulfilling the inflation vakia may be regarded as an outlier. have been subject to the excess deficit It was the last country that introduced rate criterion. As a result of a recent procedure under the Pact. Hungary deterioration in the terms of trade and inflation targeting, shortly after acces- (with general government deficit at sion. However, more important, rapid credit expansion—besides the 10% of GDP in 2006, while debt has also after accession, the preceding anticipated productivity growth and risen above 60% of GDP) stands out government embarked on a major capital inflows—the inflation rate in as the worst performer.9 structural reform and adjustment in the Baltics exceeds the reference These countries retained control public finances. Central features of value. Meanwhile, Slovenia, with a over monetary policy, rather than the reform program included trimming soft peg, has had sufficient scope for pegging the exchange rate. By the of household transfers and switching to a moderate uniform-rate tax sys- Table 1. Selected New EU Member States: Indicators for Euro Adoption, 2005 tem. In all, Slovakia’s reform-based adjustment proved to have a salutary General Government Inflation Interest Rate expansionary impact. Rate Balance Debt (annual %) Largely because of failure to rein (annual %) ( % of GDP) ( % of GDP) in public sector imbalances, the Cen- Catch 22 scenario tral European members were unable Estonia (2004) 1.6 4.8 4.2 3.8 to step into the ERM II regime and they shelved earlier attempts at set- Latvia (2005) 0.2 11.9 6.8 3.6 ting a date for euro adoption. As an Lithuania (2004) -0.5 18.7 2.7 3.8 exception, Slovakia entered the ERM II regime as of 2006, with the objec- Cautious pragmatism scenario tive of joining the euro area by 2009. Slovenia (2004) -1.8 29.1 2.7 3.7 Reform-cum-adjustment scenario Policy scenarios in the Baltic Slovakia (2006) -3.5 34.5 3.4 3.6 States and Slovenia Muddling-through scenario The governments of the Baltic member states and Slovenia have been sin- Czech Republic -2.6 30.5 1.7 3.6 gle-minded in treating the euro adop- Hungary -7.5 62.4 4.1 6.9 Poland -4.4 47.9 3.0 5.2 8 For a game-theoretic explanation of fiscal indulgent behavior in Central Europe prior to Euro reference value -3.0 60.0 2.5 5.3 EU accession, see Berger, Kopits and Szekely (2006). Source: Eurostat. 9 Interestingly, the Czech Republic has a Notes: Years in parentheses indicate beginning of ERM II; general government data classified relatively low public debt ratio, but projected to according to ESA95; government balance excludes government-mandated private pension rise well over 100% of GDP—the highest ratio among new members—over the next couple operations (following derogation ending in 2007); government debt as of end-2005; inflation decades, as illustrated by the baseline rate refers to change in harmonized index of consumer prices; and interest rate refers to mar- projections in Deroose, Montalcino, and ket yield on 10-government bonds denominated in domestic currency at end-2005. Stromsheim-Wold (2005).

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tion as the priority objective of macr- must be congratulated for qualifying specific concerns about fiscal devel- oeconomic policies. In particular, the to enter the euro area effective opments or about the outlook for euro pursuit and maintenance of sound fun- 1 January 2007. Slovenia’s policy adoption. damentals have not been questioned approach can be summarized as a In brief, future prospects for the by any major political movement or scenario of cautious pragmatism. This four larger Central European mem- party in these countries. Both the EU scenario combines discretionary bers hinge primarily on their ability to accession and the target date for euro monetary and fiscal policies, aimed implement a successful convergence adoption have enjoyed unwavering primarily at converging to within the to the budget deficit reference value. and broad-based public support. reference values with comfortable As discussed, unlike the Baltic coun- Broadly speaking, as the Baltics and margins. The monetary authorities tries and Slovenia, these members Slovenia have so far met, in substance, were successful in restraining both have been experiencing considerable all the criteria, their entry in the euro inflation and exchange rate volatility, fiscal stress in recent years. At best, area should be no more than a mere though in a less than transparent man- current attempts to relieve this stress formality. Yet there are some differenc- ner.11 Similarly, despite some slippag- through policy action have been es within this group and two distinct es on the reform front, the government barely sufficient. scenarios can be identified. has maintained a budget position Among the larger Central Europe- The Baltics’ policy framework can close to balance. Unlike the rest of the an members, Slovakia has made a be regarded as the most transparent new members, Apparently, Slovenia conscious shift from years of fiscal in- and disciplined among all new mem- did not need to resort to »training dulgence to a path of fiscal probity. If ber countries. Anchored by a fixed ex- wheels.« In other words, this scenario this is sustained, then Slovakia can be change rate and, in comparison with illustrates a rather exceptional case of said to be facing a reform-cum-adjust- other EU Member States, with minimal a successful application of discretion- ment scenario that, apart from some government intervention, a slim public ary policies, as distinct from a rules- challenges on the exchange rate sector, efficient budget procedures, based framework (i.e., involving front, should lead to adoption of the a nondistotionary tax system, strict a hard peg, inflation targeting, euro as scheduled. Specifically, bar- balanced budget rules, and a small balanced budget obligation, etc.). ring a unanticipated reversal by the public debt ratio, the Baltic members Policy scenarios recently elected government, Slovakia should fully qualify for the euro. Argu- in Central Europe is well placed not only to adopt the ably, their policy record and growth euro, but also to continue benefiting performance surpass the performance As compared with the Baltic coun- from narrowing interest spreads and of the rest of the EU. However, the tries and Slovenia, the larger Central higher growth than the rest of Central inflation rate in these countries, stuck European members should find it Europe. Slovakia’s ability to observe above the current reference value, is relatively easy to meet the inflation the timetable will depend on the dura- beyond the control of the monetary reference value with continued adher- bility of recent fiscal adjustment. authorities under the hard peg. ence to the inflation-targeting frame- At this time, the new government ap- The recent rejection of the applica- work. In the event, exchange rate appears hesitant about staying the ad- tion of Estonia and Lithuania for euro preciation, due to the Balassa-Samu- justment course, with repercussions on adoption, on grounds that their infla- elson effect, might be possible to ac- the risk premium and the exchange tion rate exceeds marginally the commodate over a two-year period rate. Subsequent attempts at manag- current reference value, can be char- within the narrow band of the ERM II ing the exchange rate through a tight- 12 acterized as a Catch 22 scenario. mechanism. However, considerable er monetary stance and intervention Such a strict interpretation of the infla- exchange rate volatility − as ex- have not been entirely effective. tion criterion can be questioned on change rate targeting is incompatible The more perilous approach, economic grounds and in terms of the with inflation targeting − stemming currently followed in the other central spirit of Maastricht, insofar as their from surges of speculative capital European members, particularly Hun- inflation outcome reflects exogenous movements, may well constitute an gary and Poland, involves a series of developments. In any event, inflation impediment to staying comfortably one-off measures, including creative in the new entrants is likely to acceler- within the narrow band. Meanwhile, accounting practices, just barely ate further after euro entry, as sug- any downward pressure on the enough to meet the yearly budget def- gested by above-average inflation exchange rate, for instance due to icit targets in convergence programs rates in several lesser developed uncertainties regarding the govern- formulated under the excess deficit high-growth members already in the ment’s ability to comply with the defi- procedure. Under this muddling- euro area. A possible solution to this cit criterion, may be difficult to offset anomaly would be simply a step nom- through intervention alone. 10 See for example Kopits (2004). inal appreciation immediately prior In principle, observance of the 11 Exchange rate stability has been attributed in to adopting the euro—a precedent set long-term interest rate criterion should part to the strong inﬂuence or moral suasion exerted by the central bank over the banking by a couple of existing euro mem- follow from successful inflation target- system. 10 bers, notably, Greece and Ireland. ing and containment of inflation 12 This view is supported by estimates of the Thus far Slovenia is the only post- expectations. But, in addition, occa- effect across countries reviewed in Kovács sionally in tandem with exchange rate (2004), which, over time, have been declining socialist EU member that has success- in size. On the other hand, model-based fully operated within ERM II over the movements, long-term interest rates simulations suggest that, under current policies, prescribed two-year period and has reflect the risk premium driven by real appreciation of the Czech, Hungarian and Polish currencies would prevent compliance met all Maastricht reference values. investor sentiment in emerging mar- even within the wide ERM II band. See the Accordingly, the Slovenian authorities kets overall or regionally, or country- calculations in Bulir and Smidkova (2005).

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through scenario, the budget targets euro area, they have pursued different The other countries of the region have tend to be missed, often by a wide paths toward that common goal. On proceeded along a more uncertain margin, while the monetary authori- the basis of the strategy followed so far path as regards public finances, giving ties seek to compensate with a by each member, four stylised scenari- rise to a muddling-through scenario cautious monetary policy. At best, this os have been identified. Depending on with likely slippages in adoption of the approach will result in relatively high the selected fiscal and monetary policy euro. It is conceivable that under pres- and volatile interest rates and lacklus- framework, they face differing pros- sure from EU institutions and financial tre growth, along with likely overruns pects for fulfilling the Maastricht crite- markets, Hungary as well as the other of budget projections stipulated in ria. Of the eight candidates only five Central European members may yet convergence programs, resulting in are presently operating in the ERM II, take seriously the commitment to the further slippages in the adoption of the anteroom for adopting the euro. convergence program and switch to euro well into the next decade. The Baltic members and Slovenia, the reform-cum-adjustment scenario. Lastly, a worst-case outcome under all ERM II participants, have good this scenario cannot be ruled out. prospects for joining the euro by the REFERENCES: Large public sector imbalances, as end of the decade. Their common 1. Berger, H., G. Kopits, and I. Székely, well as questionable sustainability of a strategy is a consistent combination of 2006, “Fiscal Indulgence in Central Europe: rising public debt ratio, can contribute fiscal discipline and an exchange rate Loss of the External Anchor?” Scottish Journal of Political Economy (forthcoming). to a high external financing require- peg. A key difference is that whereas 2. Buiter, W.H., 2004, “En Attendant for ment and render the country vulnera- Slovenia has pursued a discretionary Godot? Financial Instability Risks for ble to a shift in investor sentiment. and flexible strategy (including a soft Countries Targeting Eurozone Membership,” Thus, deterioration in market percep- peg), the Baltic countries operate paper presented at the CEPR/ESI Annual tion about the government’s willing- within a rules-based framework (con- Conference: EMU Enlargement to East and West, Budapest (September 24-25) ness to take corrective action can sisting of a hard peg in combination precipitate a financial crisis.13 In other of a balanced-budget rule). The 3. Buiter, W.H., and C. Grafe, 2002, “Anchor, Float or Abandon Ship: Exchange words, conceivably, these countries former approach has facilitated fulfil- Rate Regimes for the Accession Countries,” remain exposed to a sudden stop of ment of all criteria on schedule, while Banca Nazionale di Lavoro Quarterly financing triggered by a sharp tighten- the latter has failed to do so. The Review, No. 221 (June), pp. 1-32. ing in world liquidity (due for example upshot is that Slovenia has already 4. Bulir, A., and K. Smidkova, 2005, to a rapid correction in global imbal- gained formal entry effective January “Exchange Rates in the New Accession ances) or by some other unexpected 2007 in a scenario of cautious prag- Countries: What Have We Learned from the Forerunners?” IMF Working Paper developments (including some random matism. By contrast, the Baltic coun- WP/05/27 (February). noneconomic event) that lowers the tries for all intent and purpose are 5. Deroose, S., and J. Baras, 2004, “The risk appetite of a critical mass of inves- being denied entry under a Catch 22 Maastricht Criteria on Price and Exchange tors in the region. scenario for missing the reference val- Rate Stability and ERM II” European Convergence to the fiscal refer- ue for inflation. Short of some positive Commission, DG Economic and Financial ence values for deficit and debt boils exogenous developments (e.g., an Affairs, Brussels. down, in essence, to a political econ- improvement in the terms of trade) or 6. Deroose, S., A. Montanino, and I. Stromsheim Wold, 2005, “The EU Approach omy problem. Apparent weakness or adoption of a restrictive fiscal policy to Fiscal Sustainability,” paper presented at indecision by present coalition gov- stance, the solution to this impasse the Conference on Fiscal Policy and the Road ernments in all four countries, as well seems to lie in restrained price setting to the Euro, Warsaw (June 30-July 1) as their unwillingness to anchor poli- through some combination of moral 7. Goldstein, M., 2005, “What Might the cies to a target date for entry in the suasion, real wage cuts, and appreci- Next Emerging-Market Financial Crisis Look ERM II and for adopting the euro feed ation of the nominal exchange rate. Like?” Working Paper Series WP 05-7 (Institute for International Economics, July) adverse expectations. On the other Overall, the outlook for the larger hand, every Central European govern- Central European members seems far 8. Kopits, G., 2004, “Exchange Rate Policy in Central and Eastern Europe in the Context ment does have a fresh opportunity to less favourable. Monetary policy is of EU Accession,” in M.A. Landesmann and shift from one approach to the other. conducted prudently in the context of D.K. Rosati, eds., Shaping the New Europe: In this vein, the revised convergence an inflation-targeting framework. To Economic Policy Challenges of EU program just submitted by the govern- the extent that this is associated with Enlargement (London: Palgrave Macmillan), pp.49-83. ment of Hungary to the European exchange rate volatility, these candi- Commission may signal a break with dates may find it difficult to stay within 9. Kopits, G., 2005, “No Smooth Sailing: Budapest, Warsaw and Prague Struggle to past trends and a shift to the reform- the narrow ERM II band. However, the Steer into the Euro Zone,” Wall Street Journal cum-adjustment scenario. principal impediment to euro adoption Europe (September 23), p. 6. for these countries is the inability or 10. Kopits, G., and I. Székely, 2003, “Fiscal Conclusion unwillingness of bringing the public Policy Challenges of EU Accession for the finances under control. As an excep- Baltics and Central Europe,” in G. Tumpel- A review of macroeconomic poli- Gugerell and P. Mooslechner, eds., Structural cies in the eight post-socialist new EU tion, Slovakia has launched a number Challenges for Europe (Cheltentham: Edward member countries indicates that, while of reform measures in the context of a Elgar), pp. 277-297. sharing the aspiration of joining the fiscal adjustment. This reform-cum-ad- 11. Kovács, M., 2004, “Disentangling the justment scenario, however, is currently Balassa-Samuelson Effect inb CEC5 13 See Goldstein and Wong (2005) for an under reconsideration by the newly Countries in the Prospect of EMU application of a wide range of indicators for elected government, thereby creating Enlargement,” in G. Szapáry and J. von assessing the likelihood of a forthcoming Hagen, eds, Monetary Strategies for Joining currency crisis in the Czech Republic, Hungary, some unease in financial markets and the Euro (Cheltentham: Edward Elgar), and Poland. straining its participation in the ERM II. pp. 79-105.

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UDC 336.1/.7:061.1 EU Common Monetary Policy and Small Open Economies Dejan Krušec *

This paper analyses two issues that characterise he European Union acted as an “external anchor” for new Member States and are of importance for the most of the new Member States and it has provided the common monetary policy. First is the interplay of oil incentives to meet the entry conditions set by the EU prices, exchange rate regime and the (Trichet, 2006). The new Member States’ performances Maastricht criterion on T inflation, which caused have been good since price and trade liberalization have been a freeze on the euro adoption route for fully adopted and competition policy has been successful. In Estonia and Lithuania. He second is the credit addition, considerable macroeconomic stabilization has been and real estate boom, which is directly and achieved. This paper stresses that more work still needs to be indirectly linked to inflation. As for the first, done, since the new Member States have some distinctive char- we find that completion of the disinflation process acteristics with respect to the current members of the Eurosys- is needed to allow for increases in inflation tem. In particular, we will deal with two of them: first, with the rates in a controlled fashion, without oil prices and its linkage with the challenge to complete the substantial adverse effects on inflation disinflation process and to allow for increases in inflation rates expectations and wage developments. As for in a controlled fashion, without substantial adverse effects on in- the second, reforms and progress in the banking flation expectations and wage developments. Second, we discuss and other financial sectors are needed to the credit and real estate boom, which is linked with the reforms create a solid and sustainable base for and progress especially in the banking and other financial joining the Eurosystem. sectors. Both have direct or indirect effects on inflation: reforms and progress in the banking and other financial sectors can create a solid and sustainable base for joining the Eurosystem, while fulfilling the Maastricht criteria is a sign that sustainable convergence has been reached and that countries are on the right path. This is why policy-makers have to design and implement a credible consolidation path based on durable and growth- enhancing structural reforms. Monetary authorities play an important role by conducting a credible policy, which leads to

* Dr Dejan Krušec, Economist, Euro area Macroeconomic Developments Division, European Central Bank. Views expressed here do not necessarily represent the view of the European Central Bank.

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price stability, and thus creating an (2.4%) would have made it, at least a very small economy, its inflation environment where entering into EMU on this criterion, by a small margin. rate can hardly be disruptive for the will be smooth and credible. So, is the way the Maastricht criterion monetary policy of EMU, and thus is calculated, too harsh? To answer banning its entry on this ground is Oil, inﬂation and Maastricht this, one has to look at its purpose, hard to justify, especially when a which is to limit the inflation differen- country as large as Spain, with a Now it is already clear that Lithua- tials within the union aside from moni- similar inflation rate, already partici- nia and Estonia will not join EMU toring the stability of a country’s pates in the euro. on 1 January 2007, since they both economy. Since the criterion has to What about the costs of the rejec- overshot the Maastricht’ inflation be fulfilled at a certain point in time, tion for these two countries? Bundes- criterion of the latest European Com- this goes against the longer-term bank report (2006) sees the biggest mission (EC) Convergence report – stability evaluation. The criterion risk in the choice of a potentially delayed from July. This is highly unfor- methodology uses inflation rate for wrong currency conversion rate when tunate for their fragile economies, the three lowest inflation countries in entering the euro. This risk has to be which are finally growing fast. the EU to calculate this cut-off value. viewed with reservation, since the two The debate at the moment in In December 2005 these countries Baltic states have relatively long expe- these two countries is about what the were Poland, Finland and Sweden – rience with currency boards (Estonia reasons for the high inflation rate are two of which are not in EMU, and do since 1992, first to DEM then EUR; and whether central banks are able Lithuania since 1994, first to USD then to fight against it. The reasons are EUR) and have actually gained quite ranging form the booming credit substantial experience in managing market to high oil prices and mone- Recent a fixed exchange rate. Having fixed tary policy strategy. While we deal exchange rates in the past couple of with the first cause later, let us turn to years, despite rapid growth, the coun- the second and third reason for the oil price tries did not see much of the problem growing inflation. of misalignment and the currency Recent oil price increases have increases have overvaluation has not been an obsta- already shown their adverse effects cle until now (Bundesbank, 2006). on inflation in the two (Lithuania and On the other hand, Ahearne and Estonia) out of three countries who already shown Pisani-Ferry (2006) claim that the applied for EMU accession. In these undervaluation of “premature” EMU two countries, compared to the euro their adverse entry had adverse effects on Italy and area, oil prices have a greater weight Portugal, and the loss of the possibili- in the national Index of Consumer effects ty to devalue currency as a response Prices (CPI), the national gasoline to shocks may be problematic also excise is lower and the economy’s for rapidly growing Baltic countries. dependence on energy resources on inflation Although the currency board experi- is heavier. Therefore, the recent rise ence of Lithuania shows that its cur- in oil prices has a significantly great- in the Lithuania rency is undervalued at the moment, er impact on Lithuanian and Estonian the likely increases in exports in future inflation than on the inflation of the should align it (Ahearne and Pisani- euro area. In addition, the indirect and Estonia. Ferry (2006). effect of higher oil prices, which The other major potential determi- occurs when producers build-in nant of a relatively high impact of oil higher production costs into their final not seem to be determined to enter. on these economies could be the prices, could exert upward pressure If we recalculate the benchmark using monetary regime. Estonia and Latvia on inflation in these countries in the only EMU members data (which are both currently operating under months to come. would arguably serve better to look the currency board regimes. This At the moment, EMU is experienc- at differentials in the Union) we ob- regime has its advantages over the ing quite low levels of inflation, which tain the benchmark value of 3.1%, alternatives in other EU countries, causes the benchmark to be relatively which is already more favourable for especially over the inflation targeting low compared to previous years. In the candidate countries we examine. (adopted by Hungary, Czech Repub- our calculations, the Maastricht entry In addition, the past experiences lic, Slovakia and Poland), however, value for December 2005 data for of Greece, Italy and others, which it also has its downsides. Among the annualized rate of inflation of the had substantially higher rates than advantages is the central bankers’ HCPI was 2.6% (the Maastricht entry the criterion after they fulfilled it, credibility, as well as the fact that the requirement). Despite the fact that the shows that criterion alone does not inflation financing of high fiscal defi- most recent evaluation values may guarantee low inflation rates in future. cits channel is shut. And indeed, both differ slightly, we used these ones to Even up to date, the inflation rates countries have maintained currency explain some points. First, if the evalu- are 3.5% in Greece, 3.7% in Spain boards for over a decade, surviving ations had taken place on the 1 Janu- and 3.4% in Luxembourg, which crises, and for the last years they ary 2006, Estonia (3.6%) and Lithua- shows that differentials of similar pursued fixing to the euro itself and nia (3%) would not have been eligi- magnitude already exist within the have by default performed well on ble for the euro entry, while Slovenia common currency. Since Estonia has the exchange rate criterion.

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Currency board regime also criteria. Of course, one could say on year basis has caused preoccupa- requires a sound fiscal policy and that this does not, at the moment, tion of authorities and a discussion local shocks can be taken care of only seem to be a priority to policymakers whether measures to curb lending through fiscal policy. This requires in those countries. This is communi- should be introduced. a prudent stance during upturns in cated through distant or even unde- The booming credit market is a order to be able to accommodate clared (Poland) target EMU-entry phenomenon present in Estonia and the shocks in recessions. While the dates, but it may be a sheer result Lithuania, most likely connected to Baltic maintained sound fiscal policy, of pragmatism, i.e. learning not to the increased competition in financial avoiding a similar crisis to Argentina (officially) desire what one can not sector, and as a result, the interest even during the Russian Crisis, all the achieve, or perhaps the fear of rates are at record low level and floating regime countries had relative- committing and not being able to credit growth is fast. Most of the tightly profligate fiscal stances and, as a live up to it. ening in competition occurred in the consequence, the board regime could Since inflation targeting regime housing loan market and can be at- not have been as dangerous to stabili- enables the country to focus on tributed to the EU accession in 2004, ty as the flexible exchange rate domestic shocks, it therefore enables while the price competition in con- regime. And this is important, since the central bank to focus on domestic sumer loans has not grown significant- persisting fiscal deficits are the main supply and demand disequilibrium, ly in recent years. The annual in- obstacle to Euro adoption in the new which could be harmful to the econo- crease of property loans was 43% Member States with a floating regime. between 2000 and 2004 in the new At the same time, the currency board EU states versus 8% in countries in the arrangement overcomes problems Eurozone. The increase in lending related to the operational procedures Estonia volume is expected to continue, of inflation targeting. Czech Republic especially in the light of the low levels and Poland had problems of over- of indebtedness of households. In ad- shooting and undershooting the tar- and Latvia dition, higher disposable incomes in gets by wide margins at the onset “New Europe” in recent years also of the regime. are both help to fuel the credit boom. On the other hand, inflation tar- The most striking issue about the geting allows the central bank to currently composition of household credit in insulate domestic shocks in addition new Member States is that while to the foreign ones, which is particu- current consumer credit is at a compa- larly important in the current time of operating rable level to the Eurozone (5% of high credit growth. It also allows the GDP on average in “New Europe” central bank to become accountable under compared to 7% of GDP on average and transparent in pursuing its infla- in EMU in 2004 from Coricelli et al. tion goal. Not the last, inflation (2005)), mortgage lending, despite targeting would be more compatible the currency quadrupling in the last 5 years, is far to the strategy currently pursued by lower (4% of GDP compared to 34% the European Central Bank. Although board regimes. of GDP). It is remarkable that in coun- inflation targeting has proven rela- tries with relatively high home owner- tively successful alternative monetary ship and substantial financial deepen- regime in the new Member States ing (and thus credit to GDP growth) my. However true this may be, the due to its transparency, the success this gap remains so wide. The imme- argument has another side to it – has been more in bringing down diate conclusion is that in the future, exchange rates can be a source of inflation, than in allowing the coun- it is reasonable to expect a surge in shocks themselves. Artis and Ehrmann tries to adopt the euro. If we assume mortgage lending. The situation (2004) show that this is possible even that the main goal is to enter EMU seems to be in line with anecdotal in very well established market econo- as soon as possible after entering the evidence, which suggests that the mies, which suggests that it can be of EU, the currency board, as it seems, effect of transition and financial even higher importance in volatile failed to guarantee them entry in deepening causes the consumer to transition countries. 2007. But entering EMU is not just first take out consumer loans to buy about fulfilling the inflation criteria Credit boom cars and household appliances. After by a few decimal points. It is not a hike, new car sales in new Member obvious that the Baltic would have Credit growth in the new EU mem- States such as Poland is now down to made it, had they let their exchange bers is another important issue. In this early 1990s levels, while in Bulgaria, rates float and adopted an inflation respect, we are interested especially whose transition is arguably at an targeting regime. First of all, Slove- in whether the credit level is catching earlier stage, there is a large increase nia, probably the only CEEC that will up or speeding up in the new Mem- in new car sales (Samar, 2005). It is adopt the euro next year is not, and ber States? Although the issue is very only in the next step that a household in fact never was an explicit inflation interesting, the scope for substantial can think of buying property – and as targeting country. Moreover, none research is limited both by the quality it seems, most new Member States of the current inflation targeting coun- of data and also by the high degree are still to undergo this phase, also tries (especially Poland and Hungary) of uncertainty of the tools used. Real called the property credit boom. The are close to fulfilling the Maastricht credit growth of even 40-50% year lag between these steps may depend

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on many factors such as household Thus, there is no doubt, we can respect to other macroeconomic indebtedness (previous consumer expect a strong catch up effect and developments, putting strain on the credit burdens). Although household financial deepening should cause current account, despite already debt to GDP ratio is still on average rapid growth. The question is wheth- prudent fiscal stance (fiscal surplus 4-5 times lower than in EMU, credit er the change we observe can be in 2004 and government’s focus on to financial assets ratio is in some regarded as too fast? The problems further tightening). cases already higher (Coricelli et al., with assessing whether lending is Moreover, there is some consen- 2006). Therefore, as the countries get growing too fast are substantial and sus on possibility of credit boom richer, there seems to be a lot of room not much different from the typical developments in the Baltic countries, for mortgage credit to expand. One problems of boom/bubble literature. so it seems that countries with a rigid of the indicators to track will possibly First, it is difficult to say a priori that exchange rate (currency board) are be housing prices, which are still a rapid development is dangerous – more likely to have rapid credit lower than in old Europe, but if they most measures are criticized of being growth. Perhaps this sounds plausi- were to exhibit a bubble at some arbitrary (growth above a certain ble, as these economies seem rather point, this could trigger some credit threshold, deviations from the trend stable and the currency board brings market troubles, mainly through the component, additional “non-funda- along lower interest rates. The revaluation of collaterals if such mental” growth, out of sample authors argue that in their analyses bubble were to burst. projections etc.) or of being useful they take care of developments in Why is the credit boom of such fundamentals such as changes in the importance? First of all, Borio and interest rate and rapid GDP growth. Lowe (2002) claim that “one of the But this potentially implies important relatively few robust findings to Credit consequences – if this credit boom emerge from the literature on leading feeds into inflation by increasing indicators of banking crisis is that internal demand, it could harm EMU rapid domestic credit growth increas- growth entry prospects. Although no studies es the likelihood of a problem”. More- of this issue seem to exist, it might be over, a series of papers cited by in the new EU that even a small inflationary effect Duenwald et al. (2004) estimate the of the rapid credit growth in Lithua- probability of a lending boom ending member states nia could have made a difference in a bust to be as high as 20%. on the decision whether the country The macroeconomic risks of the fulfilled the Maastricht inflation credit boom are primarily due to the is another criterion or not. rapid increase in demand, and consti- Among other risks there is the tute the deterioration of the current important large share of foreign currency account and inflationary pressures. denominated loans, which can prove Banking system risks are more an troublesome especially for household effect of insufficient supervision and issue. loans, since households seem to be improper accounting for risk, espe- attracted by lower real interest rates cially when competitive pressures of foreign exchange loans. Banks push towards rapid increase of loans. only once it’s too late (non perform- seem to enjoy this type of lending, The pressure for better performance ing loans). In the context of the recent as it provides the notion of shifting in a boom may foster piling-up of discussion of potential housing the exchange rate risk to the custom- non-performing loans, overvalued col- booms in many developed markets, er. Related to this, the argument that laterals and even connected lending. we see that even with longer series very high levels of foreign ownership Previous crises (Bulgaria and Croatia and relatively stable economies it is of banks in New Member States in the 1990s) have proven to have a hard to agree whether there is a drastically reduce the probability of a high output cost, especially since the boom or not. Transition economies banking crisis is not entirely correct. new Member States are predominant- have an additional nuisance such Although foreign entry helped the ly bank financed. Bond and equity as short series, which make the modernization the banking system, markets are still very small. discussion of trends, cycles and it does not, by any means, fully At the same time, credit markets equilibrium levels even more problem- protect from a credit bust. Instead of in the new Member States practically atic. Moreover, even this short period bailing out a foreign subsidiary, the did not exist 15 years ago. In some is highly transitory, abundant with main branch of the bank may just de- segments they hardly existed about changes (monetary regimes, structur- cide to pack up and leave if troubles a decade ago, so we can say that the al reforms, EU entry etc.), which appear, especially if the market is starting points were approximately may potentially impose breaks. tiny relative to overall group revenue. zero. Even today, despite substantial Finally, credit in both the old EU Such cases have been recorded in financial deepening, the levels of and the growing countries is at very Argentina, but may be even more credit to GDP remain well below diverse levels, so it is difficult to significant in the case of a relatively (average and individual) old EU assess what to expect of the credit small market such as, for instance, levels, and in most new Member in new Member States. Estonia. States they are below levels expected The results of several papers seem Another issue that seems impor- for countries with similar GDP per to point to Bulgaria as a country tant is contagion, which denotes the capita. where credit growth is excessive with idea that a banking crisis in one of

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the new Member States would trigger EU economy after enlargement 5. Bundesbank Report. 2006. Comments on similar reactions in others. While if monetary, fiscal and economic the enlargement of the EU and EMU. Speech by Professor Hermann Remsperger, Member previous crises in the 1990s (Bulgar- policies fulfil their respective tasks. of the Executive Board. Available on-line: ia, Croatia) seemed to be rather However, the performance of EMU www.bundesbank.de/download/presse/. bounded within these countries, this economies has to be improved: 6. Coricelli F., Mucci F., and Revoltella, time, with a set of countries labelled non-inflationary growth must be D.,(2006) Household credit in the new as having ‘excessive’ credit growth, enhanced and inflation persistence Europe: lending, boom or sustainable a bust in one of them could initiate should be tackled by structural growth? problems of the others. reforms in order to foster price and 7. Duenwald C., Gueorguiev N., Schaechter To summarize, the research done wage flexibility. Some reforms (were A., (2005) Too much of a good thing? Credit booms in transition economies: the cases of on this issue does not give a definite made in these direction, but further Bulgaria, Romania, and Ukraine. answer as it could have been ex- improvement is to be expected, 8. Europen Commission. 2006. Report on pected, but it contributes to creating especially in controlling the booming the Functioning of the Transitional “early warning” indicators, as well credit markets. Arrangements set out in the 2003. Available as to increasing awareness of the on the internet ec.europa.eu/employment_ potential problems, justifying more LITERATURE: social/news/2006/feb. scrutiny, better risk assessment and 1. Ahearne, Alan and Jean Pisani-Ferry. 9. Kiss G., Nagy M., Vonnak B., (2006) supervision. Authors are not fast to (2006). The Euro: only for the agile. Bruegel Credit growth in Central and Eastern Europe: trend, cycle or boom? advocate measures to curb lending Report. (which have been introduced for in- 2. Artis, Michael J & Ehrmann, Michael, 10. Munchau. Walter. (2006). Monetary union is not for the poor. Financial Times stance in Bulgaria) but warn on both 2000. »The Exchange Rate – A Shock- Absorber or Source of Shocks? 30/01/06, p.15. the macroeconomic and financial A Study of Four Open Economies,« CEPR 11. Parker, R. and R. Atkins. (2006). risks associated with the rapid credit Discussion Papers 2550, C.E.P.R. Discussion Lithuania set to become victim of tough EU expansion. Papers. single currency stance. Financial Times 13. 3. Boissay F., Calvo-Gonzalez O., Kozluk T. 6. 2006. (2005), Is Lending in Central and Eastern Conclusions 12. Trichet, Jean Claude. 2004. Third ECB Europe developing too fast? Central Bank conference on ‘The new EU This paper shows that we have 4. Borio, Claudio and Phillip Lowe. 2002. Member States: convergence and stability’ in Asset prices, ﬁnancial and monetary Frankfurt, 21 and 22 October Concluding good prospects of dealing successful- stability: exploring the nexus. BIS Working remarks. President of the ECB. 22 October ly with the growing diversity of the Paper No. 114. 2004.

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UDC 339.92:336.76:336.2:061.1 EU The Revised Stability and Growth Pact – A Critical Assessment Lars Calmfors *

The 2005 reform of the he Stability and Growth Pact – the stability pact for stability pact implies a radical watering-down of short – has been seen by many as a cornerstone of the the EU fiscal rules as the scope for discretionary EMU. The stability pact complements and gives opera- decision-making has been widened substantially. A tional contents to the provisions regarding the excessive cyclical improvement of public finances may only Tdeficit procedure in the Maastricht Treaty. Together, the pact conceal the need to strengthen the incentives and the procedure regulate how the EU system should deal with for fiscal discipline at the EU level. It is easy to outline how this could be countries having fiscal deficits above three per cent of GDP or done but the political prospects remain dim. not fulfilling the treaty obligations on government debt (a debt- One possibility might be to link changes in the to-GDP ratio of less than 60 per cent or if the ratio is higher that monetary and fiscal policy frameworks in the it should be declining). The rules stipulate gradually escalating EU to each other. Another is to strengthen incentives measures to induce a country with an excessive deficit to take for fiscal discipline at the national level, for corrective action: the scale starts with a recommendation from example through the establishment of the Ecofin Council and ends with the possible imposition of fines independent fiscal policy councils. for those countries that have adopted the euro. The aim of the EU fiscal rules is to counterbalance the deficit bias that is a feature of fiscal policy making in many modern democracies. This bias was very evident in most EU countries in the 1975-95 period, which was characterised by large budget deficits and increasing government debt. It has been a common worry that the deficit bias could be exacerbated in the monetary union, where part of the costs of fiscal profligacy in one member state may have to be borne by the other states. The excessive deficit procedure was invoked for the first time in the monetary union in 2002, when it was applied for Portugal. But already in 2003 the pact was thrown into a crisis when the Ecofin Council did not follow the stipulated procedures

* Lars Calmfors, Institute for International Economic Studies, Stockholm University. The author is grateful for comments from Emma Bäcke.

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for Germany and France, which both Germany has embarked on a path of “public investment” and “the overall had begun to run deficits above three budgetary consolidation, which will quality of public finances” as well as per cent of GDP in the preceding again make Germany interested in “any other factors that in the opinion year. This led to a situation where upholding the fiscal rules (“restoring of the Member State concerned are it was very unclear what rules did German ownership of the stability relevant”. The latter factors have been in effect apply. The stalemate was pact” in the EU jargon used). exemplified with “budgetary efforts “resolved” through a reform of the sta- It is true that some of the changes towards increasing or maintaining at bility pact in 2005, which introduced in the stability pact – for example, for- a high level financial contributions to a number of changes. Today, the mulations on an increased emphasis fostering international solidarity and deficits in six of the old EU members on the debt criterion and on a to achieving European policy goals, (in addition to Germany and France, “commitment” to enhanced budgetary notably the unification of Europe”.3 also Greece, Italy, Portugal and the discipline in good times as well Table 1 shows that, compared to UK) and in six of the new ones as provisions on “minimum fiscal the original stability pact, there could (Cyprus, the Czech Republic, Hunga- efforts”– may help strengthen fiscal be a maximum extension of the ry, Malta, Poland and the Slovak discipline. But these changes apply deadline by three years (the fourth Republic) have been classified as mainly to the soft parts of the pact, column) or even by four years (the excessive by the Ecofin Council. that is those that concern mechanisms fifth column) if one were also to use This short article assesses the con- for avoiding that excessive deficits the new possibility not to classify a sequences of the stability pact reform deficit above three per cent of GDP and discusses various possibilities as excessive when it first arises. of restoring stronger incentives for The implication is that a deficit above fiscal discipline. The analysis builds The excessive three per cent of GDP in year t need on a more extensive assessment in not be corrected in year t+2, as was Calmfors (2005).1 originally envisaged, but first in year deficit t+5 or possibly in year t+6. This post- An assessment of the revised pones also the dates when the coun- stability pact procedure was try in question can be required to pay a deposit and when the deposit There exists a positive interpreta- invoked for the can be converted into a fine. The tion of the revisions of the stability dates for fines are moved from year pact.2 According to this view, the t+5 to year t+8 or year t+9. reform of the stability pact has first time in the This represents a very significant introduced more room for sensible watering-down of the pact. The judgement, at the same time as the monetary union problem is the widening of the scope fundamental rules, in particular the for discretionary decision-making in three-per-cent deficit ceiling, have the enforcement process. This goes been saved. Although some changes in 2002, when very much against the original work in the direction of loosening the German proposals on the pact in pact, they may be counterbalanced it was applied the mid 1990s, which advocated that by others. It is also maintained that in- sanctions should be more or less auto- creased flexibility may increase the for Portugal. matic in order to circumvent the politi- legitimacy of the pact and therefore cal process. The idea was that sanc- make it easier to enforce. This optimis- tions would be imposed unless there tic view takes comfort from the fact arise in the first place (the “preventive was a majority in the Ecofin Council 4 that the revisions of the stability pact arm” of the pact). The most important against doing so. have not yet triggered any adverse changes are those that apply to the The motive behind the establish- reactions in financial markets. hard parts, that is to the excessive ment of the EU fiscal rules in the Also, according to this line of deficit procedure and the ultimate use first place was to institute rules to con- reasoning, the short-term prospects of sanctions when large deficits have strain discretionary decision-making appear rather bright. The budgetary already arisen (the “corrective arm”). at the national level. Widening the situation is likely to improve in the The crucial changes are the new scope for discretionary decisions in current cyclical upswing in most possibilities for the Ecofin Council to the enforcement procedure means eurozone countries, including those extend the deadlines for correcting that the rules become less binding for with excessive deficits. And most excessive deficits if this is judged as national budgetary decision-making. importantly, the new government in motivated after consideration of a The implication is a large step back number of “other relevant factors”. in the direction of discretionary fiscal 1 See also Buiter (2005) and Wyplosz (2006) These include a very mixed bag policy making at the national level, for other recent assessments of the stability pact reforms. consisting of “potential growth”, which was the problem that the rules 2 See, for example, Public Finances in EMU “prevailing cyclical conditions”, were designed to address. (2005), Buti and Franco (2005) or Buti, Eijfﬁn- “the implementation of policies in The root of the enforcement ger and Franco (2005). the context of the Lisbon agenda problem with the EU fiscal rules is the 3 The quotations are from Ecoﬁn Council Regula- tion 1056/2005. and policies to foster R&D and inno- strong incentives of finance ministers 4 See Stark (2001) for an insider account of the vation”, “fiscal consolidation efforts in the Ecofin Council to act strategi- “birth” of the stability pact in 1995-97. in good times”, “debt sustainability”, cally and collude to avoid sanctions

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Table1: Theoretically possible scenarios for the excessive deficit procedure in case of non-compliance (time until first fine)

Old pact as originally Lax application Very lax application Super-lax application Maximum laxity Year envisaged and strict ap- of new pact of new pact of new pact according to new pact plication of new pact Budget deficit above Budget deficit above Budget deficit above Budget deficit above Budget deficit above t 3% of GDP 3% of GDP 3% of GDP 3% of GDP 3% of GDP Council decision Council decision Council decision on Council decision Excessive deficit t +1 on excessive deficit on excessive deficit excessive deficit on excessive deficit exception and recommendation and recommendation and recommendation and recommendation Council decision t +2 Deadline for correction on excessive deficit and recommendation Extended initial Extended initial Extended initial t +3 First deposit deadline deadline deadline Repeated Repeated recommendation recommendation Extended initial t +4 Second deposit First deposit and new extension and new extension deadline of deadline of deadline Repeated Repeated notice First deposit recommendation t +5 Second deposit First deposit and further extension converted into fine and new extension of deadline of deadline Repeated notice First deposit t +6 Second deposit First deposit and further extension is converted into fine of deadline First deposit converted t +7 Second deposit First deposit into fine First deposit converted t +8 Second deposit into fine First deposit converted t +9 into fine

Note: The table has been constructed under the assumption that a deficit above three per cent of GDP is identified the year after its occurrence. Later identification would lengthen the period before fines should be imposed according to the new rules. for violators of the fiscal rules. This The situation has been set for the future. In fact, has partly been the result of several in the coming years one has probably gone even beyond countries running large deficits at the the new rules, as the requirement for same time. But also finance ministers A counter argument to my reason- such a long extension should be the in countries without deficit problems ing is that budget deficits are likely occurrence of “unexpected adverse have a strong incentive of treating to be reduced in the coming years. events”, which is hard to argue in colleagues in countries with such This is true. But deficits are not likely the German case. In a strictly formal problems in a lenient way: this can to be reduced enough. We will prob- sense, it is not a violation of the be regarded as an investment, raising ably see a repetition of earlier experi- revised pact since this requirement the probability that they themselves ences, where fiscal policy is not tight- refers to repetitions of a recommenda- will be treated in a similar lenient ened sufficiently in a cyclical up- tion or a notice from the Ecofin way were they, too, to run large swing. It is commonly acknowledged Council, which have not taken place deficits in the future. It cannot then that most of the deficit problems in the for Germany. Instead, the extension be the solution to increase the scope EU countries have their origins not in derives from the phasing-in of for discretionary decisions even the policies pursued during downturns Germany into the revised pact. But further; this can only aggravate the but in the policies pursued in the pre- still there is a de facto violation of the enforcement problem. ceding upswing.5 new rules. It would not help much But the worst problem is not the What about the current deficit even if Germany were to reduce its actual changes made in the stability reductions in Germany? Does not deficit below three per cent of GDP pact. It is the demonstration that the that mean that adherence to fiscal already this year since the damage rules are endogenous: they are likely discipline will be restored? has already been done. It is extreme- to be changed in response to viola- Unfortunately, much of the credibility ly unlikely that it will in the future be tions that have occurred, at least if loss has already been suffered. possible to treat other countries more the violations have been made by In sum, Germany has obtained a strictly than Germany was ex ante. large countries. This represents a very three-year extension (till 2007) of the There is also another serious prob- major credibility loss. Why should original deadline (2004) for correct- lem with the German case. For an one not expect the same thing to hap- ing its excessive deficit. This is the 5 maximum according to the new rules, See, for example, Buti and Franco (2005), pen again if the new looser rules are Buti, Eijffinger and Franco (2005) or Wyplosz also violated? so it means that a very lax precedent (2006).

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outside observer it looks very much tion of the enforcement procedure: The front-loading of the sanctions as if a precondition for the last step politicians are clearly unwilling to probably deters politicians from using taken in the excessive deficit proce- give up their current control of it. The them. The chances would be larger dure against the country – the notice alternative would then be to strength- if the sanctions were initially smaller given by the Ecofin Council in March en the incentives for enforcement in and then gradually increased over 2006 – was that the German govern- the political process among finance time instead. ment agreed to it beforehand. This is ministers. A rather obvious improve- One could even question the wis- close to establishing a principle ment – again from a purely technical dom of applying pecuniary sanctions where a perpetrator – at least if it is point of view – would be to deny at all. A common “folklore” objection a large country – is given a de facto member states with excessive deficits against them is that fines will exacer- right to veto later steps in the exces- the right to vote in the excessive defi- bate the deficit problems they are sup- sive deficit procedure, so that it is cit procedures against other countries, posed to counteract. This is likely to not allowed to pass a certain point as this would make it harder for the weaken the legitimacy of the sanc- without consent from the country “sinners” to collude. tions. It is an argument for contemplat- concerned. Another issue concerns the severi- ing non-pecuniary sanctions instead, The lax treatment of Germany ty of sanctions. One reason why poli- for example a gradual loss of voting comes on top of a lenient treatment of ticians have shun them is that they power in general in the Ecofin Council. Portugal and Italy, which have both, may be perceived as too harsh. It is after the adoption of the new rules, The balance between ﬁscal been given extended deadlines (three and monetary policy years instead of two) to correct their excessive deficits. It has proved It is very difficult to see how re- My discussion leads me to the forms of the type discussed above conclusion that improving budget could be politically feasible within the positions in the short term in the EU possible foreseeable future. After the “traumat- countries may not be much of a cause ic” conflicts regarding the treatment of for optimism. A limited improvement to eliminate the Germany and France under the old fis- in a cyclical upswing could even have cal rules and the difficulties of agree- the adverse effect of deceiving many ing on a revised stability pact, politi- people into believing that the re- inflation bias cians do not want the issue on the formed rules are effective. This might table again. Another obstacle is the serve as an excuse for complacency, of monetary stalemate regarding the EU Consti- which is likely to exacerbate the tution. In addition, the cyclical im- problems later on instead. provement in fiscal balances that can policy by be expected over the coming years Possible improvements will in all probability reduce the per- of the stability pact delegating it ceived need to strengthen incentives for fiscal restraint, as argued above. From a technical point of view, to independent The long-run consequence of the it is easy to point out how the enforce- weakening of the stability pact is ment of the fiscal rules could be im- likely to be an unfortunate balance proved. If the problem is the political »technocrats«. between monetary and fiscal policy. decision-making among EU finance Lax fiscal policy will induce a more ministers, the obvious solution would contractive monetary policy on the be to depoliticise the enforcement de- also a peculiarity that the deposit part of the ECB than would otherwise cisions. One proposal is that deci- (fine) associated with a given exces- be the case. And such a monetary sions in the excessive deficit proce- sive deficit is higher in the first than in policy will weaken the incentives of dure would at some stage be trans- subsequent years (unless the deficit is governments to make fiscal policy less ferred from the political level of the very large: above seven per cent of expansionary. The eurozone risks be- Ecofin council to the judicial level GDP). This can be seen from Table 2, coming trapped in a bad equilibrium of the European Court of Justice.6 which shows how large the deposits with high interest rates and large However, it is politically very unre- (fines) will be in different years budget deficits, which will be very alistic to expect such a depoliticisa- depending on the size of deficits.7 unfriendly to growth.8

6 See Calmfors and Corsetti (2003) and EEAG Table 2: The size of deposits/fines (2003). 7 In the first year that a deposit (fine) has to be paid it consists of a fixed component of 0.2 per Deposit/fine (per cent of GDP) cent of GDP and a variable component that Deficit (per cent of GDP) increases with the size of the deficit (0.1 per Year 1 Subsequent years cent of GDP for each whole percentage point 3-4 0.3 0.1 excess of the deficit-to-GDP ratio over three per cent). In subsequent years, there is only the 4-5 0.4 0.2 variable component. In each year, the deposit (fine) is maximised to 0.5 per cent of GDP. 5-6 0.5 0.3 8 This risk has been analysed in a large number 6-7 0.5 0.4 of contributions. See Buiter (2005) and EEAG (2006) for two recent examples. 7- 0.5 0.5

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As is well known, also the mone- establishing incentives for fiscal re- come, as there is likely to be a cycli- tary policy framework of the ECB has straint at the national level instead. cal improvement in public finances in been subjected to a large amount of Governments usually formulate many EU countries. But this may only criticism. The price stability goal of sound principles for budget policy. conceal the underlying long-run prob- inflation “below but close to two The problem is that their incentives lems. If this is so, there is a need to percent” has been criticised for being to follow these principles often are find other ways of strengthening fiscal too low: it makes real exchange rate weak. One idea for strengthening discipline. It will just not do to dismiss adjustments inside the euro area these incentives is to establish nation- all ideas of how this could be done. difficult and implies large risks of al fiscal policy councils, consisting In the end, European politicians will ending up in a liquidity trap in a of independent experts, which could have to address these issues again. severe downturn. The monetary policy be given the task of monitoring that But we may have to wait for quite framework has also been criticised ex post government budget policy is some time before the need for this for being non-transparent, especially consistent with ex ante formulated will be clearly perceived. regarding the importance attached to objectives.9 Such a council could be monetary developments. One could given a formal role in the annual REFERENCES: therefore argue that it would be desir- budget process: it could give recom- 1. Buiter, W (2005), “The Sense and able to reform both the fiscal and the mendations on the appropriate fiscal Nonsense of Maastricht Revisited”: What monetary policy frameworks in the policy stance to which the govern- Have We Learnt About Stabilization in EMU?, CEPR Discussion Paper 5405. EU and to link these reforms to each ment could be obliged to respond other. In a long-run perspective, this formally in the parliament, it could 2. Buti, M and D Franco (2005), Fiscal Policy in Economic and Monetary Union. Theory might be one of the few politically supply the forecast forming the basis Evidence and Institutions. Edward Elgar, feasible ways of restoring a more for the government budget proposal Cheltenham. stringent fiscal policy framework at (so as to avoid an “optimism bias”) 3. Buti, M, S. Eijffinger and D Franco the EU level. The desirable timing – and it could make an evaluation of (2005), The Stability Pact Pains: A Forward- in order to reduce the risk that the the final budget proposal that could Looking Assessment of the Reform Debate, reforms would only result in a more serve as the basis for the parliamen- CEPR Discussion Paper 5216, London. permissive attitude to inflation – tary discussion of it. The idea would 4. Calmfors, L (2003), “Fiscal Policy to would then be for governments to be to increase the transparency Stabilise the Domestic Economy in the EMU: What Can We Learn from Monetary take the first step by restoring stronger of the budget process, so that the Policy?”, CESifo Economic Studies 49(3), incentives for fiscal discipline. In a reputation costs of bad fiscal policy 319-353. second step, the ECB could then “re- would rise and voters could more 5. Calmfors, L (2005), What Remains of the ward” governments through reforms easily hold the government accounta- Stability Pact and What Next? SIEPS Report of the monetary policy framework ble. 2005:8, Stockholm. implying more transparency and a It has proved possible to eliminate 6. Calmfors, L and G Corsetti (2003), “How symmetric inflation target of say 2.5 the inflation bias of monetary policy to Reform Europe’s Fiscal Policy Framework”, or 3 per cent. But if the proper reform by delegating it to independent World Economics Journal 4, 109-116. incentives for governments are to be “technocrats”. It would be much more 7. EEAG (2003), Report on the European created, such co-ordinated reforms problematic to delegate fiscal policy Economy 2003 by the European Economic Advisory Group, CESifo, Munich. would require an ex ante understand- in a similar way to counteract the ing that the ECB would reciprocate in deficit bias, as fiscal policy is inter- 8. EEAG (2006), Report on the European Economy 2006 by the European Economic this way. twined with income distribution Advisory Group, CESifo, Munich. concerns where value judgements are National fiscal policy 9. Ecofin Council Regulation 1056/2005, crucial. In contrast, the monetary Brussels. committees policy objectives of low inflation and 10. Jonung, L and M Larch (2004), output stabilisation are more univer- However, if one makes a realistic “Improving Fiscal Policy in the EU. The Case sally accepted. However, there is a for Independent Forecasts”, European appraisal, one has to be sceptical much stronger case for establishing Economy – Economic Papers 210, European about the possibilities of restoring countervailing powers in fiscal policy Commision, Brussels. well-functioning fiscal rules at the making by giving an independent 11. Stark, J (2001), “Genesis of a Pact”, in European level. The basic reason is council a role to speak up on deficit A. Brunila, M. Buti and D. Franco (eds), The that the European Union may not in and debt developments. Stability and Growth Pact, Palgrave, London, 77-105. the end have the legitimacy required Proposals of this kind are, of to uphold supranational fiscal rules. 12. Public Finances in EMU (2006), course, also politically very unrealistic European Commission, Brussels. The conclusion is then that it might at least in a short-term perspective. be better to focus the attempts at 13. Wyplosz, C (2005), “Fiscal Policy: Rules They usually meet with strong resist- or Institutions?”, National Institute Economic ance from politicians. However, one Review 91, 70-84. 9 Such proposals have been formulated by, for has to acknowledge that the EU fiscal example, Calmfors (2003, 2005), EEAG 14. Wyplosz, C (2006), “European (2003), Jonung and Larch (2004) and Wyplosz rules have lost their bite. Things could Monetary Union – The Dark Sides of a Major (2005). look a little bit better for some time to Success”, Economic Policy, April, 209-261.

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UDC 336.7:061.1 EMU Banking Systems in the New EU Members and Acceding Countries Fabio Mucci and Debora Revoltella *

Over the last decade, ver the last decade, banking systems in the new EU banking systems in the new EU members and member and acceding countries (NM&AC) underwent a acceding countries (NM&AC) underwent a profound transformation in a very short period of time. profound transformation in a very short period of Quite successfully, they have been able to transform time. Quite successfully, they have been able to Othemselves from unstable, undercapitalised and risky systems transform themselves from unstable, under- into modern and effective ones, able to play a significant role in capitalized and risky systems into modern supporting macroeconomic growth in their respective countries and effective ones, able to play a signiﬁcant role and the catching up process to the EU living standards. At the in supporting macroeconomic growth same time, legal and regulatory changes, induced by the EU con- in their respective countries and the real vergence process, have fully realigned the operating environment economy convergence towards the EU to the best international standards. While the effective EU entry standards. At the same time, legal and had an only limited impact on the NM&AC banking sector, as the regulatory changes, induced by the EU market was already widely open to cross-border competition, due convergence process, have fully realigned the to the widespread presence of international players, the next op- operating environment to the best international portunity/challenge for the local financial industry is related to standards. While the effective EU entry had the EMU accession. an only limited impact on the NM&AC banking The present analysis focuses on the recent evolution of banking sector, as the market was already widely open to system in the NM&ACs, to highlight the main prospects and chal- cross-border competition, due to the widespread lenges on the road towards the euro. Following this introduction, presence of international players, the next par. 2 concentrates on the structural features of banking system in important target for the local ﬁnancial industry the NM&ACs. Par. 3 focus on the recent evolution of financial inter- is related to the EMU accession. mediation, distinguishing among the retail and the corporate sector potential. Par. 4 investigates the determinants of the net interest margin differential between the NM&ACs and the Eurozone, to gain some insight on possible future developments. Par 5 concludes, highlighting the main trends in view of the euro convergence.

* Fabio Mucci, Economist c/o UniCredit New Europe Research Network. Debora Revoltella, CEE Chief Economist UniCredit. The views expressed are those of the authors and not necessarily correspond to those of UniCredit Group.

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Structural features Chart 1: Share of foreign presence in total banking system assets (2005) of CEE banking systems

All the banking systems in the NM&ACs are today characterised by sound, modern and dynamic players, in a context of lively competitive pressures. Since the late 1990s, restructuring and recapitalisation, together with the ambitious privatisations programmes and the elimination of restrictions to foreign competition, profoundly changed structural features and competitive conditions in local banking. The opening up of the domestic banking system to foreign players, in particular, has been definitely the key feature of the NM&AC transformation Note: (*) As of 2004. (**) Dotted line refers to the share of foreign ownership including process. non-residents with less than 50% management rights. Foreign banks have achieved a Source: local CBs and ECB for Eurozone dominant position in the region, with the share of foreign ownership in Chart 2: Value and number of cross-border M&A activity undertaken by terms of total banking assets equal to European banks in NM&ACs 77% at the aggregate level. Among the NM&ACs, the share of foreign banks in terms of assets appears to be the lowest in Slovenia, where the state still controls roughly 19% of the domestic banking assets. This is fully connected to the late removal of entry barriers (at the end of the 1990s) and one of the two biggest banks not being privatised yet. By contrast, the dominance of foreign banks is highest in the case of Estonia and Slovakia, where more than 90% of banking market assets is in the hands of large international players. Those shares are in any case well above the average euro area level, where, excluding two regional integrated markets, like Benelux and the Nordic countries, Source: authors’ calculations based on Thomson Financial Securities database foreign ownership ranges between 5% and 20% of the total banking Today the NM&AC banking sector capital, best practices and competen- assets and cross border M&A opera- is characterised by the widespread cies in fields like the risk manage- tions still represent only one third of presence of a few international play- ment, credit allocation, etc. the total value of the deals recorded ers, which consider the region as a (Claessens et al (2001)). Interesting in the 1985-2005 period1. second home market for growth. to note, on top of those, and despite While a few of the international Examples of regional expansion strate- relatively high level of concentration players entered those markets via gies include Austrian, German and in the NM&AC banking sector, they green-field operations, the privatisa- Italian banks. It is interesting to note brought international competitive tion programme implemented since that only eight players control roughly pressures, even before the enlarge- the late 1990s was the main driver of 48% of the NM&AC banking market. ment of the EU and the effective M&A activity, enabling western Such international players are among integration in the EU banking market. European banks to enter through the the top players in several countries The widespread presence of such an acquisition of the large state-owned of the region and profit from a wide- indirect international competition in banks. European banks have spent spread cross-regional network the domestic market explains why more than € 13 billion on approxi- (Table 1). the effective EU entry had only a very mately 190 direct M&A transactions, It is widely recognised that foreign limited effect on the local banking acquiring stakes in banks in the re- players positively influenced the trans- system. Moreover, quite significant, gion, and more has been spent for formation process of the NM&AC greenfields or direct further recapitali- banking sectors (or at least the speed 1 Figures refer to overall M&A activity underta- sations. of such process), as they brought ken by EU-15 banks

28 BV 11/2006 MACROECONOMIC FRAMEWORK OF SMALL OPEN ECONOMY

Table 1: Top players by country, respective ownership and market concentration (as of end of 2005)*

Top 5 EST LT CZ LV SK Sl RO BG HU PL Players Slovenská Hansa Vilniaus Hansa NLB PKO BP CSOB (3) Sporitelna BCR (2) DSK (7) OTP (16) pank (8) Bankas (9) banka (8) (3)** (12) (2) Eesti AB Bankas Česká Bank Uhispank Hansaban- Sporitelna SEB (9) VUB (6) NKBM (12) BRD (5) Bulbank (1) K&H (3) Pekao (1) (9) kas (8) (2) HVB- Nordea Komercni Parex Bank Tatra Banka Abanka NordLB RZB (4) Hebros MKB (14) BPH (1) Bank (10) Banka (5) (12) (4) Vipa (12) Bank (1) HVB Bank Sampo Bankas Sno- SKB Banka HVB Tiriac ING Bank Czech R. NordLB CSOB (3) UBB (13) CIB (6) Pank (11) ras (16) (5) (1) Slaski SA (1) Eesti Kredii- Sampo Commerz Rietumu Bank ING Raiffeisen BRE Bank ING Bank Erste (2) di pank(12) bankas (11) Bank (15) Banka (12) Austria (1) Barings Bulgaria (4) (15) CR5 98% 90% 74% 68% 67% 64% 62% 53% 53% 49%

Note: (*) Based on consolidated results except for Sl, RO, HU and EST; (**) Minority stake; (1) UniCredit, (2) Erste, (3) KBC, (4) RZB, (5) Société Générale, (6) Intesa, (7) OTP, (8) Swedbank, (9) SEB, (10) Nordea, (11) Sampo Group, (12) Other local investors/state, (13) NBG, (14) Bayerische Landesbank, (15) Commerzbank, (16) Majority foreign capital. Source: UniCredit New Europe Research based on local banks’ financial statements while foreign ownership quickly Germany). Both those indicators penetration gap for all the NM&ACs influenced the behaviour of the reveal a growth potential, assuming under review. Still, with financial foreign owned institutions, also the convergence of living standards of the deepening proceeding extremely domestic or state owned players have population towards the Western ones. fast throughout the region, particularly largely benefited, thanks to beneficial The limited level of banking intermedi- in countries like the Baltic States or spill-over effects, arising from the ation is also reflected in the share of Bulgaria, the pure financial gap is change in the competitive environ- domestic credit and deposits to GDP: rapidly shrinking4. This means that, ment. The emergence of OTP as a in the NM&ACs, on average it while in the past financial sector strong regional player is an interest- amounts to around one-third of that growth was fuelled by both the need ing example in this sense. in the Euro area. Still high degree of to close the financial penetration gap, heterogeneity characterizes different given the current level of development Size and Depth of the countries in the region. of the country, and the catching up NM&AC Banking Sector The theoretical and empirical liter- process in economic terms of the ature on economic development has NM&ACs towards the EU, in the next Despite the recent accelerated highlighted a positive and significant years the second aspect will take a growth, banking sectors in the relationship between banking sector stronger role, while the first gradually NM&ACs remain quite modest com- penetration and the degree of eco- fades up. pared to that of Eurozone countries. nomic development of a country As Chart 3 shows, by distinguish- The entire regional banking sector (Beck and Levine, 2002). Assuming ing among components, financial comprises 300 banks, with total as- this, we can estimate a rough meas- penetration so far has been particu- sets of approximately € 500 billion. ure of market potential in different larly fast on the lending side. In most This corresponds to roughly 2.7% countries of the region. Using the of the NM&ACs, credit to the private of the consolidated balance sheet Eurozone countries as a benchmark, sector registered a significant expan- of all banks in the Euro area. This is with a 7 years sample, we estimate a sion in the last couple of years, well even lower than the total weight of target relationship between economic above the pace seen in the Euro NM&AC GDP over the Eurozone growth and banking sector depth. area. Growth have been particularly ones (8%). Applying this to the current level of fast in the Baltic states, Bulgaria and The level of under penetration of per capita GDP in PPP in the NM&AC the NM&AC banking sector appears countries, we get the theoretical po- 2 To note that this is a static measure of the current financial penetration gap. evident when looking at the number tential size of the market, given the 3 We performed a pooled regression based on of branches per million inhabitants current level of economic develop- a panel of eurozone countries (excluding Luxem- (which in 2005 stood at 195 com- ment and thus we can measure the bourg) for the period 1998-2005. In the analy- 2 sis, we assume the existence of a linear rela- pared to 545 in the Eurozone) or current financial penetration gap . tionship between the level of banking develop- at the percentage of the bankable Chart 3 presents the theoretical ment and per capita GDP measured in PPP population having a business relation potential size of the banking system parity. with a bank (in 2005 such a percent- in each country and the actual size, 4 In our very simple calculations, the gap is fading up in just one year in Estonia and Latvia age stood on average at 59% in the considering as a measure of financial and in a couple of years in Bulgaria. While CEE countries compared to approxi- penetration the ratio between loans more accurate estimations with a wider sample 3 could give slightly different results, the fading of mately 100% in more developed and deposits and GDP . The data the financial penetration gap is a clear feature Western countries like Austria and indicate the persistence of a financial of those markets developments.

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Table 2: Structural indicators of banking sector in the NM&ACs:

Banking Branches Total Assets Gross Loans + Deposits No. of CIs penetration* per mn inhabitants € bn % GDP € bn % GDP NM 227 78%(1) 197 435 80% 473 88% Poland 61(3) 62% 220 152 60% 176 69% Hungary 34 65% 122 75 87% 83 96% Czech Rep. 36 81% 179 102 99% 105 102% Slovakia 23 81% 212 37 96% 35 91% Slovenia 25 99% 321 29 107% 31 114% Estonia 13 n.a. n.a. 12 112% 14 134% Latvia 23 n.a. 93 16 123% 14 107% Lithuania 12 n.a. n.a. 13 63% 16 77% AC 73 44%(1) 182 52 52% 59 58% Bulgaria 34 37% 236 17 78% 20 92% Romania 39 50% 162 35 45% 39 50% NM&AC 300 59%(1) 195 487 76% 532 83% EMU** 6,403 98%(2) 545 17,895 224% 16,535 207%

Note: (*) Percentage of the population aged 15+ having a business relation with a bank; (**) Number of CIs and branches for the Euro- zone are as of 2004; (1) Unweighted average; (2) Unweighted average of Austria and Germany; (3) As of Q3 2005. Source: UniCredit New Europe Research Network based on local CBs and ECB

Romania where loans to the private with the boost in economic growth it side, credit expansion throughout sector as a percentage of GDP in- associated to the effective entry into the region is increasingly being creased between 3 p.p. and 14 p.p. the EU in 2004 for the NMCS and in financed by alternative forms of fund- on yearly basis (with nominal growth 2007 for the AC is providing a posi- ing, with foreign resources having rates ranging from 40% to 50%) tive stimulus. On top of that, macr- a significant role. In countries like in the 2003-2005 period. In the oeconomic stabilisation and interest Hungary and the Baltic States, total other countries (i.e. Czech Republic, rates declines, in view of the EMU banking loans are already lower, in Slovakia, Hungary and Slovenia), nominal convergence, reflect in a absolute levels than total deposits, the rate of growth has been more higher demand (and supply, when with the banking system relying on in- moderate, but has picked up recently, risk factors are considered) of credit. ternational capital markets or interna- while in Poland it has slowed down The dynamic on the deposit side tional debt for its funding. Not yet at considerably, following the peaks has been less impressive. The ratio of this point, but also in Bulgaria and reached around the turn of the bank deposit over GDP remained sub- Romania banks start increasingly to decade. stantially stable in the last few years feel the funding pressure. While on Credit expansion throughout the in the NMCS, while some growth has a microeconomic perspective, such region has been influenced by both been recorded in the ACs, mainly due funding gap is not a problem, if one structural and cyclical factors. On the to the increasing confidence in the considers that the banks are actually one side the financial penetration gap banking system and thus the conse- being financed by their parents com- and the long term economic catching quent re-emergence of hidden saving. panies, still concerns arise at the mac- up process played a role. On the With a divergent pattern of roeconomic level, mainly reflecting in other, the positive phase of the cycle, growth on the lending and the depos- widening international debt positions and/or current account deficit Chart 3: Banking intermediation gap (gross loans and deposits throughout the region. However, what as a percentage of GDP) emerges clearly is that the lack of domestic savings could put a cap to the catching up process in terms of financial penetration and thus to the economic catching up, in case of reducing international funding. Finding the right balance is thus an important matter of discussion.

Developments of credit and saving in the household sector

The retail segment has been the main driver of growth for the NM&AC banking sector, mainly on the lending side. Market growth has been fuelled by both supply and demand factors. On the one hand, the economic cycle, falling interest rates Source: authors’ elaborations and increased households consump-

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tion and debt propensity have trig- creasing fast, as testified by the mortgage market was observed in the gered higher demand. On the other, strong growth rates averaging 117% last few years triggered by a lowering banks increasingly targeted the retail and 80% for Romania and Bulgaria, of interest rates and high non-satura- segment, by recognising the unex- respectively in the 2000-2005 peri- tion of residential market. ploited potential of this market, inter- od. Poland and Slovenia, with a 15% Hungary and the Baltic states nalising the expected increase in households debt over GDP ratio show show a relatively high level of finan- income of households and the low a gradually developing household cial deepening and a strict preva- associated risk (on top of low capital lending market, with some phases of lence of the mortgage component in absorption). bust in the case of Poland, as the one households debt portfolios, which is Between 2000 and 2005, loans generated by FX exposure in 2000. confirmed by the rapid growth in to households have more than dou- The consumer credit market has been mortgages during the period 2000- bled from 6% in 2000 to 15% in growing fast in the last years and still 2005. In Hungary the development of 2005 as a percentage of GDP. accounts for roughly 70% of total the mortgage market has been affect- Mortgage has been the main driver households debt portfolio. In ed by government subsidies for house behind the significant expansion in Slovenia, where the expansion of purchase, which as well prevented households’ indebtedness, increasing credit to households has not been contraction in market rates (as the ac- on average by 48% per year, while based on housing loans, such loans tual price paid by the client was consumer credit has been less dynam- have also begun to pick up consider- equal to the face interest rate minus ic. This has led to a radical shift in the composition of debt, with mortgages Chart 4: Household indebtedness in NM&ACs now representing 46% of total lend- (as a percentage of GDP) ing market compared to only 24% at the end of the ‘90s. Interesting to note, by comparing consumption credit to GDP ratios in the NM&AC with those of the Eurozone, we do not see any penetration gap. On the contrary, the gap is still widely present in the mortgage segment, where a 6.9% ratio in the NM&AC compares with a 36.5% at the Eurozone level. Aggregate data for the whole region do of course conceal regional variations, given the different levels of market maturity and the country specific supply conditions. Credit to the household sector has been particularly fast in those countries, which have had to build financial markets Source: UniCredit New Europe Research Network based on local CBs statistics from scratch. This is the case of Bulgaria and Romania where the ably more recently. Slovakia and the the subsidy). Between 2000 and strong dynamic of income, falling Czech Republic feature a relatively 2003 there was a significant housing interest rates and increased access to developed household lending market, boom in the country, stimulated by credit has fuelled household demand with almost equal weight of the mort- housing shortages, economic growth for consumption resulting in a signifi- gage and the consumer component. and the above-mentioned subsidy cant expansion of household indebt- Mortgage finance and housing subsi- program. Borrowing boomed, and by edness. In both countries, consumer dy scheme have been introduced in the end of 2003 outstanding mort- credit still represents the most signifi- the first half of the 1990s, relative gage loans had risen sharply to 8% cant share of household debt, al- early compared to the rest of region. of GDP from 1% in 2000. Curtailment though the mortgage market is in- Tremendous increase in volume in the of the subsidy scheme discouraged further borrowings and the loans mar- Table 3: Household lending market in NM&ACs ket rapidly fell in 2004, partially de- pressing the housing market, with the NM&AC NM AC EMU pick up in FX mortgage products late- Household debt growth (nominal) CAGR ‘00-’05 30.9 28.7 82.3 7.1 ly representing the source of a new Mortgage loans growth (nominal) CAGR ‘00-’05 47.7 46.5 90.0 9.2 boom. Lending growth in Estonia, 2000 6.2 6.8 1.0 45.2 Latvia and Lithuania has instead been Debt-to-GDP ratio associated with low interest rates. In 2005 15.3 16.3 10.0 52.4 Estonia, mortgage interest rates de- 2000 1.5 1.7 0.2 28.5 Mortgage-to-GDP ratio ductibility was also allowed. As a re- 2005 6.9 7.7 2.5 36.5 sult of lowering rates and increased 2000 4.4 4.8 0.8 7.2 Consumer loans-to-GDP ratio access to credit, household incurred 2005 7.3 7.3 7.1 6.9 to finance both consumption (particu- Source: UniCredit New Europe Research Network based on local CBs larly of durable goods) and invest-

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ment (mainly in real estate) increased rate markets, and despite the struc- 2000 roughly 77% of household sharply in the three countries exceed- tural trend in terms of real apprecia- financial assets was in cash and ing (or being close) the level of 30% tion of the NM&AC currencies, this deposits, 12% was in securities other in the case of Estonia and Latvia. represents a possible source of risk. than shares and mutual funds and When looking at the recent expan- The share of foreign denominated the remaining 11% in long-term sion of household indebtedness, there loans has been expanding very fast vehicles like insurance and pension are good reasons to interpret such de- also in the case of Bulgaria and the funds. Today, while the role of cash velopments in the region to date as a Baltic states. In those countries, how- has remained substantially un- manifestation of both economic con- ever, despite a huge share of FX in- changed, bank deposits reduced vergence and increasing financial dexed loans, risks appear to be tem- their relevance to 48% of total deepening (Kiss et al. (2006), pered as long as current exchange wealth (from 65% in 2000). Coricelli et al (2006)). At the same rate regimes hold and FX loans are Structural reforms (i.e. the introduc- time, credit expansion in some coun- denominated in euro. tion of fully funded pension system) tries under review has been rapid The accelerated growth observed and increasing appetite for diversifi- and persistent, raising concerns on the credit side is not reflecting on cation, in search for higher yields, whether the adjustment to the expect- the deposit side. Households through- supported accelerated growth of ed longer-term levels of financial out the region are internalising the fu- alternative products. A combination depth takes place at an appropriate ture growth in income, anticipating of lower financial wealth accumula- or possibly at an overly fast pace. consumption in durable goods or in tion (due to increasing relevance of The accelerated credit growth the house. Saving ratios tend to re- housing investment) and increasing and exposure to the exchange rate main stable/low, with most of saving switch towards alternative forms of risk may represent a source of vulner- being directed toward the real estate saving thus explains why the retail ability. In most countries, the rise in market. Still, accumulation of finan- deposits over GDP ratio throughout household debt has been accompa- cial wealth continued to step up the region remained substantially nied by a strong growth in loans de- throughout the region, grounded by stable (with the exception of Poland nominated in foreign currency (most- strong economic growth and further and Slovakia), with significant ly long-term loans for house pur- improvements in household financial increases being recorded only in chase). Such a phenomenon has conditions. As a result, net financial the AC countries driven by re-emer- been particularly fast in countries wealth of households, as a percent- gence of hidden savings. like Hungary, Poland and Romania age of GDP, slightly increased on av- fostered by still high differential in in- erage from 36% in 2000 to 37% at terest rate level compared to those the end of 20055. Developments of credit and deposits prevailing for the most popular for- Although households’ portfolios in the corporate sector eign currencies, low awareness of continue to show a prevalence of households’ and the supply pressures traditional products like banks’ de- The evolution of banking activity exercised by banks. In view of the in- posits, significant changes occurred on the corporate sector has been creasing volatility in the exchange in the last five years. At the end of strongly affected by bank restructuring programs, which occurred in the mid-nineties. Before the period of Chart 5: Dynamic and structure of household financial assets banking crisis and distress, which (as a percentage of GDP) involved most of the countries under review, loans to non-financial corporations had dominated the assets side of banks’ balance sheets. The practice of governmentally-directed lending to large loss-making state-owned enterprises inherited from the Communist era and careless lending practises accommodated by a loose legal framework and inefficient supervisory system resulted in large volumes of bad loans. Following several episodes of banking failure and crisis, which materialise throughout the region during the 1990s, most countries embarked on a significant process of bank restructuring and consolidation taking corrective actions for the resolution of bad-debt problems. The cleaning-up of banks’ balance sheets extended over most Note: (*) Figures for the NM&AC aggregate excludes the Baltic states; (**) Assets held in the form of securities, shares and mutual funds; (***) Assets held in the form of insurance 5 Figures refer to aggregate CEE-7 which exclu- and pension funds de the Baltics states due to unavailable informa- Source: UniCredit New Europe Research Network tion on ﬁnancial assets back to the year 2000

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of the nineties resulting in constant tation and strong acceleration in the growth are instead related to the decline in the ratio of corporate cred- economic activity. Credit growth has small business segment, under the it to GDP particularly in the case of been particularly dynamic in the case expectation that economic growth of the Czech Republic and Slovakia. In of candidate countries and Baltic the region supports an expansion of the Czech Republic, the extraordinar- States while steadier growth rates the production base. ily high level of credit to the corpo- have been registered in the case of The inflows of foreign capital and rate sector fell significantly both in Hungary and Estonia. direct investment in the corporate sec- absolute terms and relative to GDP Several factors contributed to the tor have largely contributed to the im- from 1997 (50.8%) to 2000 (33.2%). observed dynamic in corporate credit provement in the underlying business The structural bad-loan problem and throughout the region. Among them, environment, strongly conditioning the the even more restrictive turn in mon- the increase in investment ratio and dynamic of deposits of non-financial etary policy in 1997-1998 were be- output growth, improving financial corporations in the region. hind such decline. Lower bank lend- position of enterprises, corporate and Performance indicators and growth ing contributed to the recession in banking sector privatisation and sub- in deposits suggest a substantial in- 1998-1999, which in turn reinforced the decline in lending. Finally, a sub- Table 4: Lending to non-financial corporations in NM&ACs stantial part of these non-performing loans were transferred to the state- % of GDP 1997 2000 2005 CAGR ’97-‘00 CAGR ’00-‘05 owned consolidation bank in 1998 Poland 14.0 16.2 12.5 18.6% 0.4% and above all, in 1999 and 2000. Hungary 20.3 24.0 26.3 22.5% 12.4% Similar pattern were observed in Czech Republic 50.8 33.2 17.7 -7.6% -6.2% Slovakia where the restructuring of Slovakia 50.6 37.9 18.4 -0.4% -5.4% banks in the pre-privatisation process in 2000 with the subsequent transfers Slovenia 16.9 21.6 36.0 20.4% 20.5% of classified loans in portfolio to the Estonia 19.8 17.1 32.1 5.5% 27.1% consolidation agency caused a mas- Latvia n.a. n.a 33.7 n.a. n.a. sive decline in the volume of credits Lithuania 8.4 8.7 22.5 6.7% 31.9% to enterprises from 50.6% in 1997 Romania 13.4 8.5 12.4 26.4% 39.1% to 37.9% in 2000. Comprehensive Bulgaria 8.2 9.9 26.4 22.9% 33.2% action for the resolution of bad debt NM&AC1 22.0 20.4 17.5 6.1% 5.4% problems were also taken in Slovenia EMU 37.0 40.8 42.6 8.0% 4.9% in mid-1990s but with much lower impact on the total stock of credit to Note: (1) Excluding the Baltic states the corporate sector which perhaps Source: UniCredit New Europe Research Network based on local CBs statistics increased from around 17% in 1997 up to around 22% in 2000. In Poland sequent inflow of foreign direct invest- crease in the profitability and finan- and Hungary, credit development in ments played a significant role. cial standing of firms in the last few the corporate sector has been strong- Moreover, the empirical evidence years. Overall, the penetration of ly influenced by the strong cutback of suggests that on top of structural de- corporate deposits in the region has bank lending to the government regis- velopments, growth in the corporate steadily increased approaching the tered starting from 1996 and 1997, lending market appears increasingly level observed in the euro area to respectively. This development helped tied to economic factors as testified reach 13.2% in 2005 from 8.6% in to boost the stock of bank lending to by the quite clear relation observed 2000. Growth has been particularly the corporate sector relative to GDP between the expansions in loans and strong in the Baltic States and acced- in both countries to a level of 16.2% the industrial production in most ing countries fuelled by the significant 6 and 24.0% in 2000, respectively countries of the region. Still, only in expansion in the economic activity after it had fallen from the beginning a few cases credit expansion is found observed since 2000. Estonia emerg- of the 1990s up to 1995 in Poland to provide a stabilising effect at the es with the highest ratio of corporate and 1996 in Hungary. economic level, supporting the econo- deposits over GDP also compared to The year 2002 represents an im- my also during the set back periods average level observed in more devel- portant turning point in the evolution of the cycle. oped neighbouring countries reflect- of corporate credit all over the region Overall, bank credit growth to the ing the large size of foreign deposi- with steadily increasing ratios com- corporate sector has lagged largely tors in the system. In the remaining pared to GDP with the only exception behind the growth observed in the new member states, growth in corpo- of Poland where the economic slow- households’ segment. This can be rate deposits has been also sustained down during the earlier years of this partly explained by the fact that an throughout the observed period with decade and the ample profit situation important share of investment by the some phases of deceleration as those of the enterprise sector following the non-financial corporate sector, partic- more recent upswing contributed to ularly when the large corporate are 6 a significant deceleration in lending A simple correlation analysis between the considered, has been financed by cyclical component of corporate loans and activity. In the Czech Republic and retained earnings and foreign capital, industrial production reveals the existence of a Slovakia, growth in credit to corpo- including credit from banks in other quite clear relationship between economic activity and corporate credit growth as proved rate sector has recently picked up countries and foreign direct invest- by the high contemporaneous correlation ran- sustained by banking sector rehabili- ment. Opportunities for market ging from 0.4 to 0.6 for NM&AC countries.

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Table 5: Deposits of non-financial corporations in NM&ACs regressions: (1) country specific macroeconomic conditions, such as the % of GDP 2000 2005 CAGR economic growth, the level of short Poland 6.3 10.2 16.5% term interest rate and country risk rating, (2) bank specific characteris- Hungary 11.7 12.9 12.6% tics, such as the degree of operational Czech Republic 11.0 17.7 17.1% efficiency and the ownership structure Slovakia 13.5 17.5 15.2% and (3) regulatory features, such as Slovenia 10.3 11.4 11.0% the cost of reserve requirements, the Estonia 15.7 29.1 26.8% level of taxation and degree of free- Latvia n.a. 14.0 n.a. dom of credit market regulation. Our Lithuania 5.3 11.0 26.3% sample is made of individual banks Romania 8.9 13.3 39.8% data for the top 10 players in each of Bulgaria 8.7 15.9 23.4% the Eurozone and of the NM&ACs. All NM&AC1 8.6 13.2 18.4% estimations have been performed using a Random-Effects (RE) panel EMU 13.2 15.2 6.9% data estimation approach9. Note: (1) Excluding the Baltic states. Variables capturing the impact of Source: Unicredit New Europe Research Network based on local CBs statistics macroeconomic conditions appear to observed in Poland in 2002 and Table 6: Determinants of net interest margins: Slovakia in 2004. With total deposits panel regression for 2001-2005 ranging from 13% (in Poland) to 27% (in Lithuania) of total enterprises finan- Coeff. Std. Error t-statistic Prob cial assets in the NM&AC, versus Cons 1.511564 0.9173419 1.65 0.099 7 11.3% at the Eurozone level , non-fi- GDP 0.0155273 0.0244844 0.63 0.526 nancial corporations in the region RATE 0.0247608 0.0127425 1.94 0.052 show a relative preference for liquidity, which might be the consequence RISK 0.2809612 0.0294955 9.53 0.000 of still stronger preference for internal EFF -0.0285291 0.0129212 -2.21 0.027 sources of funding and relatively PROP -0.3470001 0.1737951 -2.00 0.046 underdevelopment of equity and debt markets. RRR 0.1118965 0.0271553 4.12 0.000 TAX 0.003298 0.0019216 1.72 0.086 Investigating the determinants REG -0.0512859 0.1075323 -0.48 0.633 of bank interest margins Sigma_u 1.0780381 in NM&ACs Sigma_e 0.65141972 Changes in the operating environ- Rho 0.73252822 (fraction of variance due to u_i) ment have exerted a substantial impact on the structure of banking mar- including economies of the new mem- confirm our a priori, with both the kets and the degree of competition. ber states, acceding countries and level of interest rates and country risk With the dominance of foreign owner- the euro area. Taking an internation- being positively related to interest ship and stable financial systems in al perspective allows us to delineate margins. Results also reveal that the place, banks’ performance and pric- the key dimensions in which NM&ACs coefficient on economic growth is in- ing behaviour have become increas- differ from western European econo- significant. This seems to be consistent ingly market-based. Still, banks in the mies and the possible implications of with the literature. Moreover, al- region show a relatively higher profit- structural changes which are going to though the positive association be- ability than in the Eurozone. occur as convergence with the EU fi- tween business cycle and bank mar- We try to have a more in-depth nancial markets progresses and inter- gins is a well-known characteristic of look to the determinants of bank est rates drop further in view of a fu- Western European bank markets margins in NM&ACs using bank and ture Euro-participation. The main ob- (Claeys and Vander Vennet, 2003), country-level data from 22 countries, jective is to investigate whether the the relative economic uncertainty ob- 7 Eurostat ﬁgures relatively high margins of banks in served in the euro area in our sample 8 Gelos (2006) examines the determinants of NM&ACs are primarily driven by period may have influenced the level banking margins in Latin America, using a market structure and bank-specific of significance of such a relationship panel dataset from Bankscope comprising balance sheet and income statement data factors, such as an often concentrat- in recent years. (2001-2005) on more than 200 banks. ed market structure and a lack of Bank-specific variables appear to 9 We assume that some unobserved heteroge- bank efficiency, or rather by regula- be significant and negatively correlat- neity between banks exists. Since economy- tory factors and underdeveloped ed with bank margins. In particular, re- wide statistics are repeated in the sample for all banks from the same country, we also include banking conditions (business cycle sults on the efficiency ratio are in line country random effects. More details regarding and institutional factors). with Vander Vennet (2002) who finds data description, estimation techniques and 8 results, and robustness checks are provided in By following Gelos (2006), we that higher efficiency reduces interest the appendix. include three types of variables in our margins significantly in a sample of

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Western European countries. In the Chart 6: Contribution of different factors in explaining difference NM&AC, as already highlighted, for- between NM&ACs average bank margins and average for the euro area (percentage points) eign ownership has played an important role in increasing the level of efficiency. Interesting to note, in 2005, the average cost to income ratio for NM&AC banks (a standard measure for cost efficiency) equalled 57% (55.9% for NM banks and 63.2% for AC banks), versus a 63.7% for banks in the Eurozone. The foreign ownership dummy enters significantly with a negative sign, meaning that foreign owned banks – ceteris paribus – are able to charge lower spreads, as also reported by Martinez Peria and Mody (2004). As previously mentioned, foreign ownership in the banking system might have a positive impact also at the system level, as it stimulates competition, while generating positive spill- Source: authors’ elaborations based on estimation results reported in Table 6 over effects. When turning to the role played by regulatory issues on mar- to explain part of the observed differ- ally the second determinant, with gins, the estimation results confirm that ence in the level of spreads between a significant role particularly in higher reserve requirement ratios and NM&ACs and Eurozone countries. Romania, Estonia and Bulgaria. taxes on profits are associated with On the one side, this might reflect We consider the MRR as an indicator higher margins. Instead, no evidence levels of profit taxation quite in line for the costs of regulation at the is found for the relevance of the de- with the European standards as well system level. The relevance of this gree of freedom of credit market regu- as the ability of foreign banks to shift variable suggests that in view of lation on interest margins. profits internationally to minimize Euro introduction and in view of fur- Based on such estimation results, their tax bill. On the other, the fact ther harmonisation of regulatory re- we can evaluate up to what an extent that the top banks in the different quirements at the EU and Eurozone the identified determinants contribute NM&ACs nowadays belong to large level, the effectiveness of the local to the observed difference in the level European banking groups which rank financial systems might easily be of spreads between the banks in among the top players in their home further improved. NM&ACs and in the euro area. We markets as well. Such trends are particularly impor- find out that most of the difference is By distinguishing among coun- tant to understand, if one considers explained by the level of country risk tries, differences emerge. Country that the net interest margins explains which accounts for 1.7 percentage risk is confirmed as the main driver a large share of the difference in total points of the total difference of 2.5 of net interest margins in all the coun- profitability of banks in the NM&ACs percentage points. Differences in the tries of the region. The MRR is gener- and in the Eurozone. reserve requirements ratio contribute to another 0.5 percentage points, Chart 7: Contribution of different factors in explaining bank margins while higher interest rates explain 0.1 difference with euro area in NM&ACs (percentage points) percentage points of the remaining gap. It is interesting to note that differences in the level of bank efficiency explain only a minor share of the overall gap (around 0.06 percentage points). This is quite consistent with the evidence that consolidation and restructuring in the NM&AC banking systems have already spurred significant improvements in the efficiency of banking operations, substantially reducing already the east-west efficiency gap. Finally, differences in the speed of economic growth and degree of freedom of credit regulation are found to explain only a minor share of the difference (around 0.05 and 0.02, respectively). Other factors such as the profit tax rate and ownership structure fail Source: authors’ elaborations based on estimation results reported in Table 6

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Next steps – towards the euro M&As at the Western European level. effectiveness and the efficiency of the Still, we believe competitiveness in the EU financial system are likely to have The next challenges for the market will remain high, with a combi- a positive influence on the NM&AC NM&AC banking sector mostly rely nation of aggressive international and financial market. Finally, and different- on the EMU convergence and acces- domestic players targeting for increas- ly from what happened for the banks sion process. So far, only Slovenia ing market shares and best standards. of the current Eurozone members at qualified for accession, with entry due Despite a gradual fading of the the time of accession, the room of fur- in January 2007. The other countries financial penetration gap, we expect ther cost cutting for enhancing profita- still lag behind, with inflation delaying a continuation of the pattern of bility is very limited. entry for the Baltic countries and risks growth of banking volumes, particu- arising for the remaining new member larly on the lending side. Such growth REFERENCES: states, due to the inflation criteria will be mostly driven by the catching 1. Beck T. and Levine R. (2002), Stock (Slovakia) or the fiscal one (Czech up process in economic terms, en- Market, banks and growth: correlation Republic, Hungary and Poland). Still, hancing the standard of living of the and causality, World Bank Working Paper we expect the overall pattern of EMU population, as well as by favourable n.2670 convergence, together with the ongo- cyclical features. Still, as domestic 2. Brock P. and Suarez L.R. (2000), ing process of further integration of fund raising is increasingly insufficient Understanding the behaviour of bank to finance the lending market growth, spreads in Latin America. Journal of the EU banking and financial sector to Development Economics 47, 221-248 play a role in reshaping the future the issue of how much rapid growth is 3. Claessens, S., Demirguc-Kunt, A. and prospects of the local markets. sustainable remains an important one. Huizinga, H. (2001), How does foreign entry Although banking systems of the The next challenge for banks in the affect domestic banking markets?«, Journal region today are strongly intertwined NM&AC is to keep a good pattern of of Banking and Finance, Vol. 25, pp. 891- 911.

Table 7: NM&AC banking sector profitability and efficiency indicators 4. Claeys S. and Vander Vennet R. (2003), Determinants of bank interest margins in Central and Eastern Europe. Convergence to Net interest mar- Net non-interest Return on assets Cost-to-income the West, Ghent University Working Paper, gins/ income/ (ROA)* ratio No. 203 Tot. Assets Tot. Assets 5. Coricelli F., Mucci F. and Revoltella D. 2003 1.4 2.9 1.8 63.5 (2006), Household credit in the New NMS 2005 1.7 2.6 1.8 55.9 Europe: lending boom or sustainable growth?, CEPR Discussion Paper n. 5520 2003 2.9 5.2 3.8 64.2 AC 6. Csaba M.. and Márton N. (2003), 2005 2.0 3.9 2.9 63.2 Relationship between market structure and 2003 1.5 3.1 1.9 63.6 bank performance: empirical evidence for NM&AC 2005 1.7 2.7 1.9 57.0 Central and Eastern Europe, MNB working paper, December 2003 2003 0.5 1.3 1.1 64.5 EMU 7. Demigüç-Kunt A. and Huizinga H. (1999), 2004 0.6 1.2 1.1 63.7 Determinants of commercial bank interest Note: (*) Based on profits before taxes and extraordinary income margins and profitability: some international evidence. World Bank Economic Review 13(2), Source: UniCredit New Europe Research Network based on local CBs statistics and ECB 379-408 8. Demigüç-Kunt A., Laeven L. and Levine R. with the EU through the prominent role profitability in a changing environ- (2004), Regulation, market structure, played by international banks, the ment. To note that today banks in institutions, and the cost of financial remaining adjustments to reach euro NM&AC show a higher profitability intermediation. Journal of Money, Credit and area standards remain significant. In than banks in the Eurozone, with an Banking, 36 (3 Part 2), 593-622 this context, the changes occurring average ROA at 1.7% in 2005, versus 9. Gaston Gelos R. (2006), Banking in the euro area’s financial sector a 0.6% at the Eurozone level. Much of Spreads in Latin America, IMF working paper, 2/06 imply that NM&AC countries need the gap in terms of profitability is ex- to catch up with a moving target. plained by the net interest component. 10. Kiss G., Nagy M. and Vonnák B. (2006), Credit Growth in Central and From a structural point of view, In the NM&AC the net interest margin Eastern Europe: Trend, Cycle or Boom?, international players in the market will over total assets of the banking system MNB Working Paper continue to play a significant role, is equal to 2.7%, versus a 1.2% for the 11. Martinez Peria S. and Ashoka Mody targeting the region as a market for banks in the Eurozone. With country (2004), How foreign participation and market growth and possibly gradually risk and higher interest rates explain- concentration impact banking spreads: expanding towards new developing ing a significant share of the net inter- evidence from Latin America, Journal of regions. We expect some possible est margin differentials between the Money, Credit and Banking, vol. 36, no. 2, transformation in the landscape to be NM&AC and the Eurozone countries, pp. 511-537 related to ongoing concentration at we see the need to rebalance the prof- 12. Uiboupin J. (2005), Short-term effects of the domestic level. More importantly, itability mix for NM&AC banks, with foreign bank entry on bank performance in as only five among the eight leading increasing focus towards higher value selected CEE countries, Eesti Pank Working Papers No 4, 2005 international groups in the market are added activities and products. Further significant players in the European harmonization of regulatory require- 13. Vander Vennet R. (2002), Cost and profit efficiency of financial conglomerates arena, concentration in the market ments at the EU level and convergence and universal banks in Europe, Journal could also be imported, as a conse- in the cost of regulation, as part of the of Money, Credit and Banking 34(1), quence of wider scope cross-border ongoing process for enhancing the 254-282.

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Appendix: Data Sources and Estimation Results

In the econometric analysis, we follow the approach We finally include a vector, which contains regula- used by Gelos (2006) applied to our panel of bank and tory variables that varies across countries and over time. country level data for Eurozone and NM&AC countries. A first variable is the cost of reserve requirements RRRj,t, The dataset on balance sheet and income statement measured as the rate of required reserves on demand de- which covers around 200 banks for the 2001-2005 pe- posits. The empirical evidence support the hypothesis riod was built based on the information available in the that reserve requirements tend to be strongly correlated Bankscope database. In general, we selected the top 10 with intermediation spreads. Compulsory reserve require- commercial, savings and cooperative banks in each parti- ment ratios tend to be relatively high in CEECs – as they cularly country using unconsolidated statements whene- represent one of the tools used by monetary authorities ver possible, although in some cases we had to rely on in recent years to limit credit growth – and are likely to consolidated statements due to data unavailability. be among the main factors behind high intermediation We carry out estimations of the following functional spreads. The second indicator is the percentage of taxes form: paid by the bank on total gross profit (TAXi,j,t). This variable has a significantly positive impact on interest margins and profitability as financial transaction taxes are usually pass through to bank customers to some degree. Third, we include a variable related to the level of freedom of the local credit market regulation. Countries with (1) interest rates determined by the market, stable monetary policy, higher presence of foreign-owned banks and posi- where NIMi,j,t stands for the net interest margin of bank i tive real deposit and lending rates received higher ra- in country j at time t calculated as the difference between tings. This variable comes from the Economic Freedom In- interest income and interest expenses as a proportion of dex of the Heritage Foundation and is designed to provi- total bearing assets. The first two explanatory variables de an overall measure of the openness of the banking in- are included to control for country specific macroecono- dustry and the extent to which banks are free to operate mics conditions. GDPj,t represents the real GDP growth in their businesses. country j at time t used as a proxy for business cycle fluc- All estimations have been performed using a Ran- tuations, RATEj,t is the nominal short term interest rates in dom-Effects (RE) panel data estimation approach, where country j at time t while RISKj,t is an indicator of risk, ba- we assume that some unobserved heterogeneity bet- sed on S&P’s ratings that ranges from 1 to 17 (larger va- ween banks and countries exists. lues are associated to higher risk). A positive sign would To test whether our results are robust to the estimation support the general findings in the literature that higher technique employed, we performed some robustness macroeconomic volatility and country risk are associated checks. The first set of checks relates to the exclusion of with higher interest margins. country dummies. When estimating the equations assu- Equation (1) further contains a vector of bank-specific ming observed heterogeneity on the country level, we characteristics. As in Claeys and Vander Vennet (2003) find that all results are confirmed with the most significant we include a measure of the degree of operational effi- change in size registered for the coefficient of RISK, GDP ciency (EFFi,j,t) calculated as the inverse of total overhead and REG. This means that those variables partially captu- costs to total assets. The efficient structure hypothesis pre- res some of the country-specific unobserved effects con- dicts a negative relationship between interest margins and nected to differences in the macroeconomic environment efficiency. We also include a dummy variable capturing and regulation. A second check is related to the exclu- the ownership structure of all banks. Such a variable sion of time dummies. Cross-country regressions for each equals one whenever the level of foreign ownership is lar- individual year shows that changes in coefficient size ger than 50% of bank’s equity and zero otherwise. Alt- and sign involves only the two variables which proved to hough a more accurate approach would require exami- be insignificant in the panel estimation, i.e. GDP growth ning the ownership structure for each individual year, we and the degree of freedom of credit market regulation. opted for disregarding shareholders’ changes in our sam- Furthermore, when testing for the presence of time hetero- ple period thus building the variable based on the latest geneity we are unable to reject the nil hypothesis for the available information in the Bankscope database. Uibou- absence of time heterogeneity. This seems to be consi- pin (2005) finds evidence that foreign bank entry tend to stent with the evidence that we consider a period where be associated with decreasing interest incomes for a sam- no major financial distress occurred and CEE banking ple of 319 banks located in 10 CEE countries. systems underwent a significant stabilisation.

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UDC 339.9:061.1 EU The Political Business Cycles in the EU Enlarged Mathilde Maurel *

The paper looks into the he rationale behind the EU enlargement has been exten- EMU expansion to include Eastern European sively debated1. Several authors have emphasised the countries and assesses the pros and cons of the lack of convergence between old and new members, and EMU enlargement using the Optimal Currency the risk of jeopardizing economic growth by limiting the Area theory. The OCA teaches us that in the Troom for political adjustment, others considered that the process absence of economic symmetry, two countries of enlargement was a way of anchoring the transition towards are less likely to benefit from a common currency the market, of stabilising the economies, and of accelerating the and that, if they do, the task will be easier with speed of convergence and catching-up. The most popular analyti- flexible markets. More recent studies go further cal framework used for assessing the pros and cons of the by demonstrating that the process of monetary enlargement of EMU is the OCA (Optimal Currency Area) theory. unification is an endogenous process. Basically, the theory tells that in the absence of economic sym- Once the political decision of entering a common metry, two countries are less likely to benefit from a common market and sharing the same currency has been currency, and that if they do, the task will be easier with flexible taken, business cycles become more markets. More recent studies go further by demonstrating that synchronized – thanks to the increase in intra- the process of monetary unification is an endogenous process. industry trade amongst others – internal openness Once the political decision of entering a common market and increases, capital market imperfection vanishes, sharing the same currency has been taken, business cycles be- contributing to ease the financing of backward come more synchronized – thanks to the increase in intra-indus- regions. try trade amongst others – internal openness increases, capital market imperfection vanishes, contributing to ease the financing of backward regions. Politics matters therefore, through the decision of making a currency union, which is rendered rational ex post without being it necessarily ex ante. It matters also through political business cycles, which are key in the OCA literature, and which can

* Mathilde Maurel CES, Université Paris I Panthéon-Sorbonne, 106-112 Bd de l’Hôpital 75647 Paris CEDEX 13, France. Email: [email protected]. I wish to thank Thomas Barré and Amélie Guillin for their excellent research assistance. 1 See Fidrmuc and Maurel (2004), and Duchêne, Maurel and Najman (2004).

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be generated in Philips curves models voters do not reward fiscal manipula- deficit increases”. For Hallerberg and under limited or perfect rationality. tion, and they do so only for the first de Souza (2000), the ten Eastern A good macro-economic situation is three four years elections up to which European accession countries6 have appreciated by the voters and helps the very mechanism of manipulation – followed political business cycles dur- incumbents to be re-elected. Hence its consequences on the increase in the ing the period of their accession, but politicians try to create political busi- level of prices and on the output – is the pattern is no more pronounced ness cycles by tightening economic known5. In other words if the informa- than in the core EU-15 countries. policy at the beginning of the political tion is perfect, voters are more likely to Those above contradictory find- mandate and by relaxing it just be “fiscal conservative”, and only if the ings are likely to be partially at least before the elections. If they succeed, information is not perfect, a myopic the product of different methodolo- then business cycles are political in vote can reward opportunistic increas- gies and specifications. In order to the sense that they are induced by es in deficits. Improving information by be able to compare our results with political activism; they can be made fighting against the lack of transparen- similar findings in the literature, we more symmetric through electoral cy, against corruption and any institu- follow the specification of Brender synchronisation, through convergence tional mechanism lowering the well and Drazen (2005): of political preferences, or through functioning of the democracy will re- adherence to the same political agen- duce therefore the scope for a political da like the Stability Pact. All those business cycle. factors should increase the symmetry (Eq.1) of shocks that is the desirability of the common currency. where ƒi, t is a fiscal indicator in What is the state of arts of the Politicians country i in year t, χ is a vector of empirical literature? First a strong eco- i, t control variables, ELEC is an elector- nomic situation favours the incumbents t are likely al dummy set equal to one for the four and their re-elections; this has been quarter before and during the elec- shown for several European coun- tion, and µ is a country fixed effect. tries2. Given that, politicians are likely to manipulate i In addition to fixed country effects, to manipulate economic policy for try- our control variables are those used ing to create (the illusion of) an eco- economic policy by Brender and Drazen (2005)7, that nomic expansion. If the public holds is quarterly GDP per capita, the trade rational expectations, this is doomed for trying share, two demographic variables to fail. If not, or if part of the informa- representing the fraction of the popu- tion is hidden, political business cycles lation aged 15–64 and 65+, and will happen: the cost of the deficit is to create supply and demand shocks computed delayed and inflation or devaluation in the framework of a VAR, as a will ensue after elections. Empirical (the illusion of) measure of the output gap8. Our studies show that the deficit tends to sources are Eurostat, IMF, OECD, and increase during an election in both the World Bank. developed and developing countries, an economic The empirical analysis includes 28 but significantly more in the latter3. European countries, EU-25 members Furthermore the result is driven by new expansion. (including EMU members, EU-15, and democracies4, while in well-estab- some CEECs), plus Romania, Croatia, lished democracies, whatever devel- and Bulgaria, which are not yet mem- oping or developed, it does not hold. Transition countries bers of the EU. It is based on a sam- This has important consequences and the enlarged EU ple of 28 quarterly observations for economic policy and politicians in covering 1990 (first quarter) –2005 transition countries. First it implies that The evidence of transition and European economies echoes this over- (fourth quarter), which makes a maxi- all pattern with specific features. An- mum number of 1792 observations. 2 Lewis-Beck (1988) for Britain, France, West Germany, Italy and Spain, and Madsen (1980) drikopoulos, Loizides and Prodronidis There are three fiscal instruments: for Denmark, Norway, and Sweden. (2004) examine whether EU member total expenditure of the general gov- 3 See Shi, M., Svensson, J. (2002a, b). states manipulated the fiscal policy ernment, total revenue of the general 4 See Adi Brender, Drazen, Allan (2005). to create national political business government, surplus (deficit), all three 5 See section 5 of Adi Brender, Drazen, Allan cycles (PBCs), opportunistic or parti- in percent of GDP, and one monetary (2005) and for Russia Akhmedov, A., Zhuravska- instrument, the growth of M3. All vari- ya, E. (2004). san, in the 1970–1998 period. Their ables are quarterly. 6 Russia is a very interesting example of a analysis shows that governments have transition country, which became suddenly a implemented stabilization policies In the first column of Table 1, we democracy. Using monthly Russian data bet- rather. This finding is in contrast with present fixed-effects regressions for ween 1996 and 2003, Akhmedov and Zhurav- skaya (2004) found sizable and short-lived that of Mink and De Haan (2006), the fiscal balance, revenues and ex- political budget cycles which become smaller who argue that fiscal policy-makers penditures, all as a percentage of over time, suggesting a learning-by-doing in the euro area have pursued expan- GDP, and the rate of growth of M3. process of voting. sionary policies before elections. 7 Who follow Persson and Tabellini (2003). We find a highly significant political “In an election year – but not in the 8 For the methodology see Babetski, Boone and cycle in the fiscal balance, with the Maurel (2004). year prior to the election – the budget deficit rising in an election year by

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Table 1: The political budget cycle across countries, fixed effects We run the same equation but estimates, 1990–2005 within the sub-sample of transition All European Countries countries, which are both developing Dependent variablea Exp Rev Bal tM3 countries and new democracies. We want to test the assumption that a 0.679** 0.193 -0.512* 0.002 ELECTb 9 (0.307) (0.202) (0.295) (0.003) voter in a developing country or in a 10 R2 within 0.3165 0.525 0.163 0.138 new democracy has a lower ability to process the information correctly F-Stat 67.55 161.74 28.42 23.33 and therefore to punish incumbents N° of countries 26 26 for opportunistic deficits and wasteful N° of observations 1201 1192 spending. In the developed old Eu- Average time series length 46.2 4538 rope instead, voters are provided by CEECs experience with the electoral process, Dependent variablea Exp Rev Bal tM3 they benefit from institutions that collect and provide the relevant data, 0.775* 0.181 -0.556* 0.002 ELECTb (0.483) (0.341) (0.354) (0.007) and from media, which disseminate R2 within 0.4722 0.6647 0.2243 0.240 and analyse the information. Results F-Stat 40.70 90.18 13.15 14.06 do not support this story. Although completely new democracies and N° of countries 10 10 also developing countries, incumbent N° of observations 382 374 governments in CEECs do neither Average time series length 37.4 manipulate the economy in a more 38.2 systematic way nor more efficiently After the introduction of the euro than their Western counterparts. This Dependent variablea Exp Rev Bal tM3 of course has to be related to the fact -0.156 -0.203 -0.163 -0.001 that the EU enlargement has been ELECTb (0.240) (0.220) (0.268) (0.002) processed under the tacit application R2 within 0.3701 0.4397 0.1031 0.019 of the Maastricht criteria, even though F-Stat 40.25 53.75 7.88 1.32 those criteria were heavily criticized N° of countries 26 26 as being not relevant for transition N° of observations 582 576 countries, catching-up the EU hub. It can be also related to the very limit- Average time series length 22.4 22.2 ed room for adjusting external shocks After 1995 given the trade dependence and the Dependent variablea Exp Rev Bal tM3 fact that monetary policy may create 0.710** 0.326 -0.373 0.002 more volatility and noise in emerging ELECTb (0.316) (0.231) (0.300) (0.003) countries, even in the short run11. R2 within 0.2182 0.3742 0.090 0.1804 As emphasised in Hallerberg and F-Stat 30.78 65.93 11.02 24.09 Vinhas de Souza (2000), in a world N° of countries 26 26 26 26 of capital mobility and fixed ex- N° of observations 916 916 916 910 change rates running larger deficits in election time is more likely than Average time series length 35.2 35.2 35.2 35.0 having a loose monetary policy. We The covariates include one lag of the dependent variable, the log of per-capita GDP, the replace fiscal variables by the rate ratio of international trade (sum of merchandise exports and imports) to GDP, the fraction of growth of M3 (columns 4), and of the population over age 65, the fraction of the population between ages 15 and 64, find indeed that the latter is not used and the supply and demand shocks, using the VAR methodology. For a presentation of this methodology in the present context, see Babetski, Boone and Maurel (2004). in order to manipulate the economy. * Significant at the 10 percent level; **significant at the 5 percent level; ***significant at This reflects the fact that the number the 1 percent level. of instruments available to the manip- a Variable definitions (all in percent of GDP): balance—central government surplus; Exp ulation is constrained by the monetary —total expenditure by the central government; Rev—total revenue and grants of the central government; tM3– rate of growth of M3. regime and the construction of the b ELECT—a dummy variable with the value 1 in the election year and 0 otherwise. euro zone. We test also the fear that once the currency has been introduced, about five-tenths of one percent of comparable to -0.49, which is the nothing impedes the governments to GDP relative to non-election years. coefficient found by Shi and Svensson resort again to economic manipula- The political budget cycle is driven by (2002a, b), who considered a cross- tion. This would translate into higher expenditure, which increases by six- section of both democracies and non- levels of expenditures and deficits tenths of one percent of GDP relative democracies over the period 1975– during election quarters after Decem- to non-election years, it is not driven 1995. The same equation over the by revenue, which remains at the same 20-year period is run by 9 As suggested by Shi and Svensson (2002a, b). same level whatever the period under Brender and Drazen (2005), who ob- 10 As demonstrated by Brender and Drazen consideration, electoral or not. Our tain a significant coefficient of -0.632, (2005). coefficient of -0.512 (equation 1) is insignificantly different from -0.49. 11 See Coricelli, Jazbec and Masten (2004).

40 BV 11/2006 MACROECONOMIC FRAMEWORK OF SMALL OPEN ECONOMY

ber 1999 (columns 3). But somehow ern European countries, fiscal manipu- Established Democracies”, Journal of surprisingly, the idea that free rider lation is not rewarded more than in Monetary Economics, 52: 1271–1295. behaviours are more likely to occur other European countries and incum- 5. Fabrizio Coricelli, Bostjan Jazbec, Igor once the monetary union has been bents do not engage more in it. Masten, 2004, »l’inﬂuence du régime de change sur l’inﬂation dans l’es pays achieved is not supported by the re- The question of the participation adhérents«, Economie et Prévision, 163: sults. This of course may be due to of accession countries in EMU 51-61. the time span available, only 5 to 6 remains unsolved. It depends upon 6. Gérard Duchêne, Mathilde Maurel, years. many other costs and benefits which Boris Najman, 2004, »Elargissement de according to a recent literature have l’UE: présentation générale«, Economie Conclusion been shown to be endogeneous. et Prévision, 163: 1-16 For instance, the decision of entering 7. Mark Hallerberg and Lucio Vinhas de This paper argues that the process a currency union has a significant Souza, “The political Business Cycles of EU of monetary integration across the 25 Accession Countries”, Tinbergen Institute impact on the degree of openness, Discussion Paper 2000-085/2. countries, which constitute the en- on the symmetry of shocks, if intra 8. Jan Fidrmuc, Mathilde Maurel, 2004, larged EU, has been successful in the trade increases as a result of the sense that the budget cycle which “Optimum Choice of the exchange-rate adoption of a common currency, on regime for the accession candidate was active at the beginning of the capital mobility, etc. But couldn’t this countries”, Journal of Comparative nineties vanished after the lunch of decision itself be delayed if politi- Economics, 32: 197-201. the euro. Moreover, the magnitude of cians were tempted to keep an instru- 9. Lewis-Beck, M., 1988, Economics and the fiscal manipulation or the increase ment of re-election? Such a question Elections, University of Michigan Press, Ann Arbor. in deficit in a year of election does is beyond the scope of the paper not appear to be higher within the of course... 10. Madsen, H., 1980, Electoral outcomes sub-sample of CEECs, which are both and macroeconomic policies: the developing and new democracies. Scandinavian cases, in: Whitely, P. (Ed.), REFERENCES: Models of Political Economy, Sage, London, It has important implications for 1. Akhmedov, A., Zhuravskaya, E., 2004, pp. 15–46. the perspective of the EMU extension “Opportunistic political cycles: test in a 11. Mark Mink and Jacob de Haan, “Are to Eastern European countries. If we young democracy setting”, Quarterly Journal there Political Business Cycles in the Euro assume that part of the asymmetry in of Economics, Vol 119: 1301–1338. Area?”, European Union Politics, Vol 7(2): business cycles is due to opportunistic 2. Andrikopoulos, Loizides and Prodronidis 191-211. behaviour during election times, more (2004), “Fiscal policy and political business 12. Persson, T., Tabellini, G., 2003, The particularly in developing and new cycles in the EU”, European Journal of Economic Effect of Constitutions: What do democracies where the public is more Political Economy, Vol.20: 125-152. the Data Say? MIT Press, Cambridge, MA. likely to believe that fiscal manipula- 3. Jan Babetski, Laurence Boone, and 13. See Shi, M., Svensson, J., 2002a, tion can create jobs, then the partici- Mathilde Maurel, 2004, “Exchange Rate “Conditional political budget cycles”, CEPR Regimes and Supply Shocks Asymmetry: the Discussion Paper #3352. pation in EMU of those new democra- Case of the Accession Countries”, Journal of 14. Shi, M., Svensson, J., 2002b, “Political cies can embody costs to the mone- Comparative Economics, Vol 32: 212-229. business cycles in developed and developing tary union as a whole. Our results do 4. Adi Brender, Drazen, Allan, 2005, countries”, working paper, IIES, Stockholm not support this view. In the new East- “Political Business Cycles in new versus University.

BV 11/2006 41

FINANCIAL MARKETS AND FINANCIALINSTITUTIONS IN EMU

UDC 338.2:339.9:336.7 Small Countries, Big Markets: Achieving Financial Stability in Small Sophisticated Economies Kevin R. James *

The financial system nstability in the restaurant sector!!! Food crisis on the hori- provided tools to the real economy. A zon! You think I exaggerate? Well, did you know that around financial system is 1 stable if actors in the 60% of restaurants fail within a 3-year period? If the bank- real economy have access to the tools that ing sector experienced failure rates of this order, there would the financial system Ibe no doubt but that a financial crisis was occurring, and the only provides at an efficient price in a continuous question would be: what can the government do? Since restau- manner. Two crucial tools, the “store rants too create valuable social externalities (romantic dinners purchasing power” tool and the “provide are not just about dinner!), let us ponder an appropriate response. investment” tool, are provided by “wide” Perhaps the government should sponsor cooking (and decorating) banks that combine classes so that one could prepare those crucial romantic dinners deposit taking and lending. Banking crises on one’s own, or maybe the government should provide a “Roman- cause instability by restricting access to tic Restaurant of Last Resort” in case the private sector fails to these tools, and are caused by an inherent provide suitable establishments, or perhaps... Wait. You say that incentive problem in wide banks, namely, you haven’t even noticed the great restaurant crisis? How could that bank owners that be? How should one think about a “restaurant crisis”? have strong incentives to divert investor When people choose restaurants, they are choosing to wealth towards their own ends. Hence, purchase a bundle of services at some price. So, one might think: regulators can enhance financial stability by: is there an establishment that provides a good food/service/ 1) creating narrow banks (that invest in atmosphere combination in the 40 euro/person (or whatever one’s only safe assets) to budget) range? From this perspective, one would decide that a provide the “store purchasing power” restaurant crisis is occurring only if one can not find such a place tool and 2) designing a regulatory regime that for dinner−whether or not the set of establishments that meet provides access to investment by your criteria is exactly the same set as 3 years ago is irrelevant. promoting direct and And, indeed, looking at the world in this way, there is not much indirect access to global capital markets. evidence of a restaurant crisis despite the enormous turmoil in This approach eliminates the inherent the restaurant business (well, unless you live in London). So, in incentive problem in wide banks. fact, we have “restaurant stability”.

* Kevin R. James, Financial Markets Group, London School of Economics

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With this insight in mind, let us re- synergies. A huge amount of money the losses if the loans fail), etc. These think our ideas of “financial stability”. in a vault is an even bigger invitation less than ideal incentives have led to The financial sector provides the real to theft than that amount of money numerous and extremely costly bank- economy with a set of tools that facili- widely distributed under pillows, after ing crises all over the world.2 tate the operation of business and, all, and so could hardly be consid- So, if the economy must have indeed, life more generally. For ered to be “purchasing power safely wide banks for the reasons discussed example, there is the “raising capital” stored”. Money loaned out to numer- above, and if the incentive structure tool, or the “insurance” tool, or the ous borrowers for many different pur- inherent in a wide bank inevitably “cash management” tool. From the poses, on the other hand, is both im- leads the banks to act in a way that perspective of the real economy, all possible to steal and invested in a di- increases the probability of a disas- that matters is the tools. The financial versified portfolio. A depositor’s cash trous banking crisis, then we have a system is therefore stable if the real is then protected against both theft problem. The solution to this problem economy has access to the financial and (a wide variety of) economic would seem to be government inter- tools it requires at an efficient price shocks. Indeed, it is only by lending vention (in the form of financial regu- in a continuous manner. the money out that a bank can credi- lation) to somehow stop banks from It follows from this approach to bly be said to provide a store of value acting upon their flawed incentives. thinking about financial stability that function at all. Since lending the There are three broad approaches the task of financial market regulators money out creates this enormous that regulators can take to deal with is to promote and protect access to the wide bank incentive problem: financial services rather than to pro- 1) let the market sort it out; 2) ham- tect financial institutions. Traditionally, mer on the financial system to mini- of course, regulators have operated The money mize the opportunities to act upon under the presumption that protecting flawed incentives; and 3) supervise the institutions ensures that the servic- banks to prevent them taking socially es those institutions provide will be the bank poor decisions. Alas, none of these available to the real economy. Yet, methods works particularly well. while there is something to this pre- is lending out If banks are not supervised or sumption, it is far from clear empiri- regulated, then depositors (and other cally that this strategy has worked. is not the bank creditors) will obviously have More importantly, financial markets stronger incentives to monitor banks have moved on, so the idea that themselves. This monitoring will of the financial services an economy money of the course constrain the ability of bank requires are inextricably tied to a owners to divert borrower wealth into handful of (supervised) institutions is bank’s owners. channels that benefit them at the just no longer tenable (especially in expense of depositors, and so will Small Sophisticated Economies such reduce the probability of banking as Slovenia, as I shall discuss in more benefit for the banks and its deposi- crisis/bank failures. Yet, we have detail below). So, I think that we as tors, banks will naturally be extremely extensive data from the pre-regulation regulators can do better by focusing keen to get the loans out. Competing period in numerous countries, and upon the services themselves. What against such an institution in the even with these stronger monitoring might this approach to financial regu- provision of loans will therefore be incentives banking crises were far lation entail? To make this discussion extremely difficult, as a bank will from infrequent. Indeed, it was these more concrete and to see where this derive greater benefits from extend- failures that led to the demand for approach might lead, let us consider ing a loan at any given interest rate regulation in the first place! Second, the regulation of the banking sector. than will a pure loan making institu- even if private monitoring works well, tion. Naturally, then, banks came to it is still very costly. Most individuals THE PROBLEM WITH BANKS dominate the loan market. So, one find life too short to develop any can see why banks evolved into great expertise in financial econom- Banks provide two key tools to being wide. ics. Forcing them to gain this exper- the real economy. First, they endow However, wide banks have a well- tise (or see their savings evaporate money with a “store of value” func- known design flaw. The money the in a bank failure) will thus decrease tion. Money under your pillow is an bank is lending out is not the money welfare. invitation to theft, money in a bank is of the bank’s owners. Hence, a If the problem is that banks can safely stored purchasing power. Sec- bank’s owners have very strong in- divert depositor wealth into inefficient ond, they channel savings into invest- centives to divert lending activity into investments, government could make ment. Historically, combining these channels that benefit them at the ex- doing this impossible by tightly regu- two functions into a single institution pense of their depositors. Acting upon lating the entire financial system. The (a “wide” bank) created significant this incentive, bank managers can di- downside from this approach is that vert loans towards business from by stopping banks from engaging 1 See http://reserachnews.osu.edu/archive/ which they derive direct benefits in risky (and so possibly deleterious) restfail.htm for the study. (“connected lending”), or into exces- activities, one inevitably prevents the 2 Bordo, Eichengreen, Klingebiel, and sively risky activity (owners get the financial system from financing good Martinez-Peria, “Is the Crisis Problem Growing risky projects as well. Here, the case More Severe?”, Economic Policy 24 (2001), upside if the risky lending activity pp. 51 - 82 goes well, depositors get stuck with of India is instructive. India has histori-

44 BV 11/2006 FINANCIAL MARKETS AND FINANCIALINSTITUTIONS IN EMU

cally exerted extremely tight control tual cause of the problem itself. But, if wealth to their own ends (monitoring over its financial system, and by so we could somehow fix the fundamen- compliance with this requirement will doing has avoided a major financial tal incentive problem inherent in the be trivial, and so will eliminate the crisis. Yet, by restricting financial sec- nature of wide banks, then we would over-powerful supervisor problem tor development and depth, this poli- not need costly (and prone to failure) identified by Barth, Caprio, and cy has significantly reduced India’s regulatory intervention to deal with Levine). Narrow banks therefore cure rate of economic growth in the period this problem. Is fixing the wide bank the wide bank incentive problem. since independence. Reducting the incentive problem directly possible? To create a narrow bank, regula- risk of financial crisis by hammering tors could enable existing wide banks on the financial system is therefore NARROW BANKS to create narrow bank subsidiaries. very costly.3 Or, regulators could create a national Historically, the pool of very safe The third regulatory approach narrow bank (with an ATM network) assets in the world has been small is to supervise banks with the idea and auction off the right to run the relative to the amount of depositor of giving them the freedom of action narrow bank to a large international wealth. Consequently, wide banks necessary to pursue good (even if bank.6 The crucial point is that depos- were the only way to provide a store risky) opportunities while monitoring itors have to know when they are de- of value tool to the economy. But, them to ensure that they don’t take positing funds into a guaranteed nar- thanks to the miracle of government excessive risks/engage in connected row bank account. Other non-narrow lending/etc. Unsurprisingly, this is a bank accounts will not be guaranteed very difficult trick to pull off as it puts (just like there is no deposit insurance enormous demands upon the supervi- protection scheme now when one sory regime (witness the fact that all »Wide« banks invests in an equity mutual fund). of the countries that have experi- People can then choose how to enced financial crises did supervise provide the allocate their savings. their banking systems). Looking at the If depositor wealth is stored in overall record, Barth, Caprio and Lev- safe assets via a narrow bank, it ine find no evidence that supervision »store follows that these deposits are not reduces the probability of a financial available to meet local borrowing crisis occurring.4 Indeed, and even purchasing demand. Historically, removing such more troubling, they also find that the funds from the pool of capital availa- more powerful the supervisor, the ble to local borrowers would also less efficient the banking system. It power« tool and have created big problems, as local appears that powerful supervisors (or investment needed to be financed by governments acting through powerful the »provide local pools of capital. But such is no supervisors) also have strong incen- longer the case. In Central and East- tives to divert depositor wealth into investment« ern Europe today a considerable pro- channels that benefit themselves. portion of total lending is provided And, the more power the supervisors by large international banks. These have, the more ability they have to tool. banks operate as global entities, allo- divert banking system resources. Of cating their capital to the market with course, absent supervisory power, the highest returns independent of the supervisors will not be able to prevent budget deficits and new develop- source of the funds. Consequently, if bank owners from acting upon their ments in financial engineering (e.g., Slovenia (for example) provides good own flawed incentives. Here, though, Collateralized Mortgage Obliga- investment opportunities, international the solution may be worse than the tions), the pool of safe assets is now banks will find the capital needed to exploit them. Furthermore, firms now disease. very large. These developments sug- have far greater access to non-bank What these three (failed) ap- gest that the store of value tool is no financing than was the case in the proaches have in common in this: longer inextricably tied to the wide past. Firms can now tap into venture they leave the wide bank incentive bank institution. capital or private equity funds, or structure in place, and somehow seek One way to provide the store of even raise capital on public markets to prevent bank owners from acting value tool to the real economy without via an IPO. The pool of capital now upon these very strong incentives. going through a wide bank is to cre- available in the world financial mar- That is, none of them address the ac- ate “narrow banks”. A narrow bank is an institution that accepts deposits ket to finance worthwhile investment 3 See Eichengreen’s chapter in Global Crisis, and invests these deposits in only projects is so deep that there is little Global Solutions (edited by Bjorn Lomborg), very safe assets (which governments danger that Central and Eastern Eu- Cambridge University Press, 2004, for a good can guarantee through deposit insur- rope will drain it (or, for that matter, discussion of this topic. 5 dent it) even if all countries in the 4 Barth, Caprio, and Levine, Rethinking Banking ance). So, depositors can be confi- Regulation: Till Angels Govern, Cambridge dent that narrow banks will safely region opt for narrow banking. University Press, 2005 store purchasing power. However, the To access this world pool of 5 The idea of a narrow bank is due to Litan, requirement that narrow banks invest capital, domestic institutions must What Should Banks Do?, Brookings, 1987 in only very safe assets completely be sound. So, for example, firms are 6 Demsetz suggested taking this approach in his famous article “Why Regulate Utilities?”, Journal eliminates the ability of the owners of more likely to get financing if domestic of Law and Economics 11 (1968), pp. 55 - 65 the narrow banks to divert depositor laws provide protection to minority

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shareholders, if domestic accounting tool. Sadly, wide banks necessarily Narrow banking is an idea partic- regulations are up to world standards embody a serious design flaw, as the ularly suited to Small Sophisticated (and are enforced), etc. For example, combination of these two activities in Economies such as Slovenia and during the Scandinavian banking cri- a single institution necessarily creates other countries in Central and Eastern sis of the early 1990s, the Norwegian an incentive for the wide bank’s own- Europe. These economies are sophis- corporate sector was largely unaffect- ers to divert depositor wealth towards ticated enough develop regulatory ed by the collapse of the Norwegian their own ends. Historically, there has regimes that will enable local firms banking system because Norway’s ex- not been much that regulators could and households to tap into global cellent corporate governance and ac- do to work around wide banks. So, financial markets. Yet, these econo- counting regime enabled these firms taking the fact that wide banks were mies are small enough that they to tap into international capital mar- the only institution capable of provid- can go down the narrow banking kets.7 In keeping with the “focus on ing these tools as given, regulators path without worrying that their the tools the financial sector provides” struggled (with limited success) to actions will significantly affect the to financial regulation that I advocate control the extent to which bank own- structure of the global markets them- here, then, regulators should seek to ers diverted depositor wealth to their selves. Narrow banking therefore ensure that firms have access to capi- own ends. offers these economies an opportuni- tal not by regulating the institutions Narrow banks provide a way out ty to significantly enhance economic that provide capital, but by creating a of this struggle. By exploiting recent welfare. regulatory regime that enhances the developments in financial markets, a ability of local firms to tap into global country can create an institution that REFERENCES: financial markets. provides the “store purchasing power” 1. Bordo, Eichengreen, Klingebiel, and tool to the real economy without any Martinez-Peria, “Is the Crisis Problem CONCLUSION of the downside of a wide bank. By Growing More Severe?”, Economic Policy 24 (2001). working to provide the economy with By exploiting the synergy between 2. Global Crisis, Global Solutions (edited by deposit taking and lending, wide sound corporate governance/account- Bjorn Lomborg), Cambridge University Press, banks provided economies with both ing/etc. regimes, regulators can en- 2004. a “store purchasing power” tool and sure that local firms and households 3. Barth, Caprio, and Levine, Rethinking a “raise capital” tool at a cost far can tap into global financial markets Banking Regulation: Till Angels Govern, Cambridge University Press, 2005. lower than would have been possible (directly or indirectly). Thus, both of if separate institutions provided each the tools traditionally provided by 4. Demsetz, “Why Regulate Utilities?”, Journal of Law and Economics 11 (1968). wide banks can now be provided by 7 Ongena, Smith, and Michelsen, “Firms and separate institutions at a far lower 5. 5. Ongena, Smith, and Michelsen, “Firms Their Distressed Banks: Lessons from the and Their Distressed Banks: Lessons from the Norwegian Banking Crisis”, Journal of Financial overall cost (by eliminating the wide Norwegian Banking Crisis”, Journal of Economics, 2003 bank incentive problem). Financial Economics, 2003.

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UDC 336.7:061.1 EU Financial Crisis Management in the European Single Financial Market Garry J. Schinasi and Pedro Gustavo Teixeira *

The paper examines INTRODUCTION challenges in effectively implementing crisis management in the EU inancial crisis management in the single financial mar- single financial market, focusing in particular on ket of the European Union (EU) is a subject attracting the lender-of-last-resort function. It highlights the increased attention. As one of the key objectives of the complexities of the EU’s financial-stability political, economic, monetary, and legal integration of architecture for preventing and resolving Fthe EU’s 25 (and soon to be 27) Member States, the single finan- financial problems. The paper examines how the cial market is becoming a reality with the progressive expansion lender-of-last-resort function might materialize of cross-border financial services and the increased integration in practical terms during a systemic financial of national financial systems. disturbance affecting more than one EU While EU market liquidity and efficiency are no doubt Member State. The paper identifies challenges and improving, financial disturbances are now more likely to affect possible ways of more than one Member State. Moreover, although European enhancing the effectiveness of the national financial systems are becoming systemically integrated, existing architecture. the EU’s financial-stability architecture is still based primarily on the exercise of national responsibilities. The extent to which the EU architecture of purely national responsibilities and tasks is also capable of addressing cross-border (and perhaps pan- European) financial disturbances is often discussed and questioned, in part because it has not yet been tested. In this context, the main question addressed in this paper is how might the lender-of-last-resort function materialize during a systemic financial disturbance affecting more than one EU Mem- ber State. The paper is organized as follows. Section II briefly describes the EU’s architecture for financial crisis management.

* Garry J. Schinasi is an Advisor in the Finance Department of the International Monetary Fund. Pedro Gustavo Teixeira is Principal Expert in the Directorate Financial Stability and Supervision of the European Central Bank (ECB). This paper is based on an earlier paper – prepared for a U.S. Federal Reserve Bank of Chicago/World Bank conference held on October 6–7, 2005 – published in a conference volume Cross Border Banking: Regulatory Challenges edited by Gerard Caprio, Douglas D. Evanoff, and George G. Kaufman. The authors thank the publisher, World Scientiﬁc Publishing Company, for granting permission to reproduce material from that paper. The views expressed are those of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management, or to the ECB or the Eurosystem.

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Section III runs through the fundamen- wise a national responsibility. This is supervisors, which have limited pow- tal issues that are likely to arise in im- also the case in the euro area, where ers to override decisions by individual plementing the lender-of-last-resort the provision of emergency liquidity authorities. In the single monetary ju- function in the EU context. Section IV assistance (ELA) is the responsibility risdiction of the euro governed by the discusses the main challenges. Section and liability of national central banks. ECB, banking supervision and ELA V identifies ways forward for enhanc- It is a unique circumstance in which are the responsibility and liability of ing the effectiveness of the existing a central bank may be providing ELA national authorities. Lastly, although architecture.1 but has no monetary-policy (as op- some elements of deposit guarantee posed to monetary-operations) re- schemes are harmonized at the EU ARCHITECTURE FOR FINANCIAL sponsibilities. There are arrangements level, they have broadly developed in CRISIS MANAGEMENT for adequate information flows within different ways in each Member State. IN THE EUROPEAN SINGLE the Eurosystem to manage the poten- Third, a number of cooperation FINANCIAL MARKET tial liquidity impact of ELA operations structures are in place for bridging in the context of the single monetary the potential gaps of coverage be- The EU’s institutional architecture policy (ECB 2000). tween national responsibilities and for financial crisis management re- Second, financial stability func- the several functions. These structures flects three principles: decentraliza- tions are segmented across sectors range from legal provisions (e.g., con- tion, segmentation, and cooperation and Member States. Banking supervi- solidated supervision) to committees 2 (see Table 1). First, the performance sion is exercised by single (cross-sec- and memoranda of understanding. of financial stability functions relevant toral) supervisory authorities and for crisis management is decentral- national central banks and, in some 1 In this paper, “lender of last resort” and ized and based in large part on the cases, is shared between the central “emergency liquidity assistance” are used exercise of national responsibilities by bank and the supervisor.4 The pruden- interchangeably. banking supervisors, central banks, tial framework followed by supervi- 2 Lastra (2003) uses this triad to describe ﬁnancial supervision in the EU. treasuries and deposit insurance sors is largely harmonized by EU leg- 3 The Eurosystem comprises the European schemes. The European Central Bank islation, although its practical applica- Central Bank (ECB) and the national central (ECB) and the national central banks tion may vary given the decentralized banks (NCBs) of countries that have adopted (NCBs) of the Eurosystem3 have finan- setting. Supervision of banking the euro. This contrasts with the European System of Central Banks (ESCB) comprised of cial-stability-related responsibilities, groups and financial conglomerates the ECB and the NCBs of all EU Member States notably in the field of oversight of is conducted separately by each of whether or not they have adopted the euro. payment systems and contribution to the supervisors that licensed each 4 NCBs perform supervisory functions in 13 of national policies on financial stability entity of the group. Coordination the 25 Member States: Austria (in part), Cyprus, the Czech Republic, Germany (in part), Greece, and supervision. The performance of between supervisors is achieved by Italy, Lithuania, the Netherlands, Poland, the lender-of-last-resort function is like- »consolidating« and »coordinator« Portugal, Slovakia, Slovenia, and Spain.

Table 1. The Institutional Architecture of the Single Financial Market

Levels FUNCTIONS DECISION-MAKERS COOPERATION STRUCTURES EU – EU legislation (minimum harmoniza – ECOFIN Council – Economic and Financial Committee (25 Member tion) – European Parliament – Financial Services Committee States) – Policy-coordination – European Commission: i) legislative – Regulatory committees – Policy-shaping proposals/ ii) competition authority – State aid control EMU – Single monetary policy – ECB’s Governing Council – Eurosystem committees (12 Member – Payment systems’ oversight States) – Contribution to financial stability and supervision National – National legislation – 25 finance ministries – At the EU level – Use of public funds – 25 national parliaments

– Banking supervision – 13 national central banks – Home– /host-country relationships – Insurance supervision – 13 single (cross-sectoral) supervisory – Consolidated supervision of banking – Securities regulation agencies groups – Supervision of financial conglome- – 1 banking supervisor – Supplementary supervision of finan- rates – ca. 12 insurance and pensions cial conglomerates supervisors – Supervisory committees – ca. 12 securities regulators – Bilateral, banking groups’, regional and EU-wide MoU – Central banking functions (Member – 25 national central banks – ECB’s Governing Council (euro area) States outside euro area) and General Council (EU) – Lender of last resort (emergency – Eurosystem committees (euro area liquidity assistance) or EU) – EU-wide and regional MoU – Deposit insurance – Ca. 35 schemes (with diverse – Informal features)

Legal framework: EU Treaty + directly applicable national laws and regulations (minimum harmonization through EU legislation) enforced by national authorities and courts

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Table 2. The Committee-Structures of the Single Financial Market

ECB’s Governing Council Decision-making ECOFIN Council European Parliament (euro area of 12 Member States)

Finance Ministries ECOFIN Council Economic and Financial Financial Services Committee (policy-making) (Informal Eurogroup) Committee

Commission and European Insurance and European Banking European Securities Financial Conglomerates Finance Ministries Occupational Pensions Committee Committee Committee (regulatory) Committee Committee of European Insurance Supervisors Committee of European Committee of European and Occupational Pension (operational) Banking Supervisors (London) Securities Regulators (Paris) Supervisors (Frankfurt) Central banks Committees of the Eurosystem/ESCB – in euro area or EU-wide compositions (market operations, (operational) payment and settlement systems, banking supervision and financial stability)

Cooperation between functions There are two MoUs currently in ering how each of its components through committee-structures place on financial crisis manage- at the EU and national levels would ment.6 The first MoU was adopted in come together to produce solutions Given the decentralization and 2003 between EU banking supervi- to financial stability problems as they segmentation of financial stability sors and central banks under the arise. In other words, the workability functions, several committees organ- aegis of the Banking Supervision of the architecture will be determined ize cooperation at the EU level be- Committee of the Eurosystem/ESCB. to a large extent by the outcomes tween authorities (see Table 2). It should apply in crises with a possi- of the domestic, cross-border, and These include supervisory, treas- ble cross-border impact involving indi- cross-functional interplay between the ury, and central banking functions. vidual banks or banking groups, or different EU and national authorities In supervision, there are committees relating to disturbances in money and involved. in the areas of banking, securities, financial markets and/or market infra- and insurance, which provide structures with potential common FINANCIAL CRISIS technical advice to the European implications for Member States. This MANAGEMENT IN PRACTICE: Commission on regulation and pur- MoU is designed to facilitate the inter- THE OPERATION OF THE sue the convergence of supervisory action between central banking and LENDER OF LAST RESORT practices. Cooperation between supervisory functions in terms of as- FUNCTION treasuries takes place at the highest sessing the systemic scope of a crisis level through the Council of the EU, What would happen if a pan- and taking actions. Its provisions in- consisting of the Economics and European banking group – with banks clude principles and procedures on Finance Ministers (Ecofin Council) licensed and operating in several identifying the authorities responsible that decide the EU policy on financial Member States – suddenly experi- and on the cross-border flow of infor- markets. The Economic and Financial enced a liquidity shock? Banking mation.7 The second MoU was adopt- Committee (EFC) – comprising finance groups play an important role in ed in May 2005 between the EU ministries and central banks – pro- European money markets, often acting banking supervisors, central banks, vides advice to the Ecofin, also on as providers of liquidity in the and finance ministries.8 The explicit financial stability issues, including cri- interbank markets – acting thus as objective is to preserve the stability sis management.5 In central banking, »money-centers« – to smaller banks of the financial systems of both indi- the committees are established under (Cabral et al 2002). They are also vidual Member States and of the EU the Eurosystem/ESCB to advise the counterparts to other large European as a whole, thus acknowledging the decision-making bodies of the ECB. and global financial institutions span- need to consider how to balance the ning a large set of markets. And they different dimensions of systemic risk. Cooperation agreements are key participants in the main pay- This MoU aims in particular at provid- at the EU level ing initial conditions for policy coordi- 5 Economic Paper No. 156, European The architecture also comprises nation between all these authorities in Commissi1on, July 2001, (available at http:// EU-wide cooperation agreements be- the case of systemic crisis with spillo- www.europa.eu.int/comm/economy_ﬁnance/ tween authorities – Memoranda of vers in several countries. publications/economic_papers/ economicpapers156_en.htm). In summary, the financial crisis Understanding (MoU) – in crisis situa- 6 In addition to these MoU, the EU banking tions. The general aim of MoUs is to management architecture in the supervisors and central banks also adopted in set out basic principles and proce- European single financial market is 2001 the MoU on cooperation between payment systems overseers and banking dures for disseminating information a complex composite of national and supervisors in stage three of economic and once disturbances are apparent and European institutions, committees, and monetary union, which sets out arrangements to support the performance of finan- MoUs. Likewise, implementation deci- for co-operation and information in relation to large-value payment systems. Press release cial stability tasks in the single finan- sions within it will be determined by available at http://www.ecb.int/press/pr/ cial market. However, this is without the complex interactions of national date/2001/html/pr010402.en.html. prejudice to the discretionary exercise and European incentive structures that 7 Press release available at http://www.ecb.int/ press/pr/date/2003/html/pr030310_3.en. of responsibilities by national authori- may not always be compatible. The html. ties, particularly since MoUs are non- potential effectiveness of this architec- 8 Press release available at http://www.ecb.int/ legally binding and are voluntary. ture can only be assessed by consid- press/pr/date/2005/html/pr050518_1.en.html.

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ment systems as well as clearing and Given the systemic inter-linkages structures, and any combination settlement systems. Therefore, a shock described above, the local knowledge of these. In addition, central banks affecting such banking groups could gathered by central banks would need would have recourse to sources of in- potentially lead to systemic implica- to be considered at the EU level. In the formation beyond their tasks, notably tions in both national markets and the case of the euro area, the existing in- supervisors, foreign central banks, European financial system as whole, frastructure of the ECB/Eurosystem or market participants. Depending on notably in terms of impact on the would certainly play a major role. the magnitude of the shock, this exer- liquidity distribution channels. In particular, the Eurosystem commit- cise could be quite challenging to The key transmission channels that tees would have an operational role coordinate. could increase the potential that a in collecting local information and thus Furthermore, the potential for sys- shock affecting a financial market or in detecting and assessing the extent temic risk can be considered in differ- banking group would be transmitted of the disturbances for the euro money ent dimensions. It may be considered and amplified across the EU can be markets and market infrastructures. in terms of the impact on other banks, summarized as follows: In the case of the central banks outside markets, and infrastructures wherever • Integrated money markets and the euro area, more bilateral or re- they are located in Europe or global- other financial markets gional cooperation could be expected, ly; or it may be considered in terms of • Integrated financial market infra- although the Eurosystem/ESCB com- the components of the national finan- structures: mittees could also be involved. cial system. The national scope of sys- – Payment systems temic risk would likely diverge across – Securities clearing and settle- countries, given, for instance, the im- ment systems and other market infra- portance of the banking group’s activ- structures (trading systems, OTC The ities in each national market, its coun- markets) terparty relationships, or participation • Major banks in concentrated performance in payment or settlement systems. domestic markets Some central banks could therefore • Emergence of pan-European have different perceptions on systemic banking groups with systemic rele- of the lender-of- risk, which may have a bearing on vance in several Member States (con- the process leading to the provision tagion through intragroup linkages last-resort of ELA (if systemic risk is indeed a and exposures among network of criterion for providing it). counterparties) • Centralization of business func- function Jurisdiction tions in banking groups • Emergence of large and com- is likewise With regard to the banking group plex financial institutions with systemic affected directly by the liquidity relevance in several Member States a national shock, if it is not able to obtain collat- • Increased foreign ownership of eralized funding from the markets – in financial institutions and assets (as in- spite of the central banks’ supply of tensified by the recent EU enlarge- responsibility. aggregate liquidity – it could warrant ment) or expressly request ELA from a central bank. Detection of a shock Assessment of systemic risk The preliminary issue is jurisdiction. Which national central bank Central banks would likely be the Central banks are also the authori- would be the lender of last resort vis- first authorities to detect disturbances ties in an advantageous (and perhaps à-vis a banking group, and on what at the level of liquidity in money mar- the best) position to assess the poten- terms? There are two alternatives. kets, payment systems, and common tial implications for systemic stability. The first is that the lender of last resort market infrastructures. Disturbances They have a clear mandate for pre- operates with regard to the group as would be first detected at the nation- serving financial stability and have a whole, thus meeting its total liquidity al level, also in the euro area given the competences required for assess- needs. Considering factors such as the decentralized setting for the ing the possible systemic implications national brands, consolidated supervi- conduct of operational tasks by the of a financial problem or crisis both sion, or the trend of centralisation of central banks of the Eurosystem. on the real economy and in terms of liquidity management, the banking Central banks could detect warning spillovers to other financial institutions group could request ELA from the cen- signs such as intra-day or overnight and/or markets. tral bank of the jurisdiction of the par- liquidity shortages in individual Understanding the potential sys- ent or main bank. The liquidity provid- banks; delays or failures to settle in- temic extent of disturbances affecting ed could then be channelled intra- terbank transactions or collateral in a banking group present in more than group to the banks in other countries. monetary policy operations; settle- one Member State would involve a The other alternative is that each of ment delays; or the failure of a cen- complex mapping of the relevant the banks of the group requests sepa- tral counterparty, clearing house, transmission channels. This may in- rate ELA from the national central or securities-settlement systems to clude intra-group (across jurisdictions) bank of the jurisdiction where they are process securities transfers, which and inter-group relations (interbank/ licensed, on the basis of each bank’s could spillover to payment systems. intercountry), market exposures, infra- specific liquidity needs and assets.

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These jurisdictional possibilities rules that provide that relevant infor- banks but rather of the state. More- would represent different criteria for mation should be gathered by the over, the EU Treaty provides that state providing emergency-liquidity assist- consolidating supervisor, normally aid may only be provided if it com- ance and different forms of credit risk at the level of the parent bank. In plies with certain conditions and after sharing among central banks. turn, this supervisor has the duty to a process of approval by the Centralized ELA without limiting the disseminate such information in emer- European Commission; in addition, supply of liquidity to its jurisdiction gency situations to all the supervisors the Treaty’s prohibition of monetary would mean that one national central and the central banks concerned. financing also prevents central banks bank would bear the full credit risk Cooperation structures, such as from incurring financial costs to be with regard to a banking group that committees or MoUs may facilitate borne by the state. could be present in more than 6 and the interaction between authorities, As a lender of last resort, central up to 19 countries (Schoenmaker and but they may also add a layer of banks may incur greater credit risk – Osterloo, 2005). The backing of complexity. on an exceptional basis in order to cross-border externalities by a nation- National central banks would ease liquidity constraints – by accept- al central bank would correspond to therefore rely to a large extent on ing collateral below the standards a sort of exercise of »federal« respon- banking supervisory information and required for monetary policy opera- sibilities. In the decentralized option, related assessments on the financial tions. The exact degree of credit risk differences in criteria for providing condition of the banks. This might be incurred may be difficult to assess in ELA could entail a misalignment of practice given the nature of banks’ objectives in providing ELA that assets (e.g., loans which may not be would need to be considered and disposed of swiftly enough without coordinated. There would be some Coordination loosing value). If the ELA operation degree of risk-sharing among the results in losses, national budgets will central banks, which would be not between bear such losses either by the need to straightforward in case the group has compensate central banks or via the centralized liquidity management: lower return on dividends. liquidity needs would relate to the supervisors Therefore, the provision of ELA in group as a whole and not to individu- situations of significant credit risk may al banks, and collateral could be is achieved by warrant some degree of interaction also centralized and may not be with treasuries, given that public funds easily transferable. »consolidating« might ultimately be put at risk. For in- Assessing the solvency stance, in the UK it is explicitly stated position of a pan-European that the Chancellor would be given banking group and the option of refusing a financial-support operation proposed by the Bank A national central bank consider- of England or the Financial Services ing ELA would also need to assess the »coordinator« Authority.9 In other countries with less solvency position of the banking explicit terms, this understanding is group and/or of the individual banks supervisors. probably implicit. This interaction of the group. While central banks could potentially lead to national have direct access to information biases in assessing the degree of a from their operational tasks, they a challenge because the pursuit of the systemic threat, given that national would need to enhance their under- respective mandates of central banks budgets will ultimately cover losses. standing of the banking group’s prob- and supervisors might not be perfectly In a cross-border systemic crisis, coop- lem, notably by requesting informa- aligned, given the different nature of eration between treasuries – along the tion from the group itself and more such mandates. In particular, central lines of the 2005 MoU – may thus be crucially from supervisors. How this banks will be concerned about assess- warranted to dispel such a bias. would be organized in practice ing rapidly the degree of credit risk In summary, several pressure would probably very much depend that might be involved in providing li- points can be identified in the on the specific features of the situa- quidity to individual banks. European financial crisis management tion. Obtaining comprehensive infor- Supervisors, on the other hand, might arrangements and in the performance mation on a pan-European banking have constraints in terms of the super- group would, however, require good of the lender of last resort function in visory process and timing in providing coordination between the central particular: their assessment to central banks. banks and supervisors. • Detection of disturbances at the European level (sharing of local On the central banking side, the Interaction with treasuries trend towards centralization of liquidi- knowledge) ty and risk management by banking Credit to individual banks can • Jurisdiction for banking groups: groups suggests that the central bank only, in principle, be provided against – Centralization vs. decentraliza- of the jurisdiction where such centrali- adequate collateral and at market tion zation takes place would have an in- rates or higher penalty rates. A credit formational and logistical advantage. operation below market rates would 9 Memorandum of Understanding (MoU) between HM Treasury, the Bank of England and On the supervisory side, as analyzed represent an injection of public funds, the Financial Services Authority, 1997, above, there are EU coordination which is not a function of central available at http://www.bankofengland.co.uk.

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– Misalignment of objectives of my (Schinasi, 2006, especially authorities to intervene, ambiguity and criteria for providing emergency- Chapter VI). Within the EU architec- about the allocation of responsibilities liquidity assistance ture, this is seen as a joint objective or the mechanisms in place for crisis – Terms of providing assistance of the authorities responsible for fi- situations is not constructive ambigui- • Assessment of systemic risk at nancial stability, including central ty, which relates, instead, to the con- the European level: banks, supervisors, and treasuries to ditions in which public support may – Complexity in mapping propa- varying degrees. Within Europe, sev- be given to institutions in difficulties. gation channels eral pre-conditions seem necessary to Against this background, the pres- – Multiplicity of sources of informa- support this objective: (i) a clear assure points (discussed above) for fi- tion signment of responsibilities to the var- nancial crisis management in Europe, – Uneven systemic implications ious authorities within the architec- and for the lender of last resort in par- across countries ture; (ii) the effective collection, dis- ticular, suggest three main challenges • Assessment of the solvency posi- semination, and sharing of informa- for coordination. First, financial crisis tion of pan-European banking groups: tion in crisis situations; and (iii) the management and the lender of last – Coordination in gathering infor- coordination of decisions by different resort are performed to a large extent mation (from the banking group, mar- authorities to the extent necessary at the national level. Authorities’ deci- ket participants, supervisors) and possible, so that the pursuit of re- sions will be guided by their national – Access and reliance on supervi- spective mandates can be aligned for mandates (circumscribed to their juris- sory information diction) and institutional frameworks. • Interaction between central In the case of a financial-stability banking and supervisory functions – problem affecting a pan-European mandates may not be perfectly Financial crisis banking group, authorities may have aligned to deal with significant cross-border • Interaction with treasuries externalities. For instance, the decision The common denominator to these management of one central bank to perform or not pressure points is that in stress situa- the function of the lender of last resort tions the potential cross-border exter- in the single will necessarily affect the other central nalities will need to be adequately con- banks’ jurisdictions. Coordination sidered by all the authorities involved, financial between the central banks involved in particular with regard to major play- may not be straightforward, however. ers, such as pan-EU banking groups. More precisely, the assessments of the market of credit risk and systemic risk involved CHALLENGES in the ELA may differ among central banks from their respective national Given that the expansion of cross- the European perspectives. For instance, the system- border banking activities is also ob- ic risk of the banking group in a served in other regions and globally, Union certain Member State may not be what is distinct about the challenges deemed important, although it might to the EU’s financial stability architec- is a subject be systemically relevant in the other ture? The answer is that the single fi- countries involved. The potential nancial market is a declared objec- contagion to national systems may be tive of the EU. A framework compris- attracting uneven, or there might be different ing rules, tools, and incentives (such macroeconomic considerations in as the single passport) is specifically increased each system. The credit risk may be set up for cross-border financial serv- considered too high. Or a central ices. The pursuit of financial stability bank may not deem itself lender of should be one of its basic compo- attention. last resort to the group. This balancing nents. In addition, there are suprana- act of central banks as potential lend- tional mechanisms available for ers of last resort will involve careful dealing with coordination problems safeguarding stability across the assessments of their responsibilities for between authorities. Such mecha- single financial market. cross-border externalities, which may nisms include EU legislation and, The credibility of the public-policy require close coordination between at the limit, may involve the perform- architecture for assessing and con- them. This may apply more generally ance of financial stability functions taining systemic risk relates to its to the other responsible authorities in- at the EU level. effectiveness in a real crisis. The pre-conditions mentioned above may volved in financial crisis management. Institutional coordination be decisive, for instance, in terms of Second, the responsible authorities issues supporting private sector solutions, – banking supervisors, central banks, preventing the breakdown of liquidity and treasuries, separately or collec- Safeguarding financial stability distribution channels, avoiding bank- tively – would need to effectively generally, and crisis management runs, or facilitating the orderly wind- process the available information into specifically, require the assessment ing down of institutions in difficulties. a cohesive assessment of the systemic and containment of financial prob- Moreover, transparency of the archi- ramifications of a crisis situation lems before they become systemic tecture is also linked to its credibility. throughout the EU. The distribution of and adversely affect the real econo- Regarding the predisposition of responsibilities is based on the home-

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country principle for supervisors, and may be designated as the ry model«. This model is being put while central banks perform their tasks »Nordic model.« It is set out in the into practice as a result of the EU’s im- in their respective jurisdictions. In the MoU between the Nordic central plementation of Basel II, which could case of a banking group, the consoli- banks10, which apply in the event of possibly reinforce the coordination dating supervisor is expected to gath- a crisis of a bank with operations in tasks of the consolidating supervisor er and disseminate micro-prudential two or more Nordic countries.11 It con- (vis-à-vis the other supervisors of the information, while macro-prudential sists of the establishment, once a crisis group). It can be argued that this information will be gathered by the is detected, of a »crisis management model might be extended to the other central banks with jurisdiction over the group« among the central banks in- authorities responsible for crisis man- markets and infrastructures in which volved. Under the leadership of the agement. Regarding the lender of last the banking group is a key player. The central bank where the management resort function, this would imply that mismatch between home-country con- of the banking group is domiciled, the national central bank of the juris- trol of supervision and host-country this crisis management group central- diction of the consolidating supervisor (central bank) operational conduct of izes the gathering and analysis of in- could also assume coordinating tasks financial market surveillance, may po- formation on the financial condition vis-à-vis the other central banks con- tentially give rise to a gap between of the banking group and the poten- cerned. This model would be consist- micro – and macro-prudential con- tial systemic implications. In addition, ent not only with the supervisory trols. Overcoming this mismatch would it centralizes the contacts with the framework but also with the centrali- be essential for effectively dealing zation of liquidity management in with a crisis since home– and host- banking groups. However, this implies country cooperation would be re- that one central bank would take a quired for mapping and understand- Banking groups higher degree of responsibility for the ing the relevant transmission channels. banking group. It would, for instance, In addition, treasuries would also have to consider with greater intensity need to obtain both national and EU- play an the group– and EU-wide – vis-à-vis wide assessments of the systemic the domestic – perspective in terms scope of a crisis situation. The existing important role of solvency and systemic risk. It would MoUs are designed to facilitate the attribute to the national central bank assessment of systemic risk for the EU to some extent – as it does to the as a whole, which could also be sup- in European consolidating supervisor – limited EU ported by the EU committees and the »federal« tasks with regard to the Eurosystem/ESCB arrangements. A money markets. banking groups under its jurisdiction. formal mechanism at the EU level for Lastly, there is the possibility of no assessing systemic risk as such is how- ex ante coordination arrangements ever not yet in place. banking group’s management. It will between the responsible authorities in Third, it follows that the actual de- also be responsible for briefing the terms of tasks and risk sharing, but cisions of central banks and supervi- decision-making bodies of each cen- the commitment of the authorities in- sors (and eventually treasuries) in- tral bank. The briefing will include involved to exchange information and volved vis-à-vis a European banking formation on the systemic relevance coordinate their policy measures on group or its components may need to of the crisis, the solvency position of the basis of the existing cooperation be coordinated at the cross-border the bank(s) affected, and, most impor- structures. level in order to be aligned towards tantly, clarify any differences of opin- common objectives (or at least for fa- ion between the central banks. The WAYS FORWARD: cilitating instead of cancelling each aim is that each central bank takes in- COORDINATION other’s out). Central bank macropru- formed and possibly coordinated de- VS. CENTRALIZATION dential responsibilities may need to be cisions. The main advantage of this OF POLICY-MAKING coordinated with supervisory micro- model is that it attempts to minimize prudential responsibilities. This may informational and analytical asym- One of the conclusions of this be challenging as responsibility for metries among central banks and thus paper is that each of the public policy a bank or a particular market at the mitigate prisoners’ dilemma type situ- functions that may intervene in finan- national level may not translate well ations. On the other hand, the extent cial crisis management in Europe can- to cross-border spillovers. The more to which an effective coordination not be disentangled from the overall diffuse the responsibility (with a structure could be set-up for all EU number of different authorities in banking groups can be questioned, 10Available at http://www.riksbank.com/ upload/Dokument_riksbank/Kat_AFS/ several countries) the harder it could if not disputed. The Nordic context is samradsdok_kris_eng.pdf. be to achieve cross-border coordina- characterized by strong systemic (but 11 Nordea is the largest Nordic banking group tion of decisions. also cultural and linguistic) inter-link- with approximately €250 billion in assets. Its ages. This is not applicable to other market shares in domestic markets range Coordination models between 15-40 percent. The holding company, regional markets or the EU as a established in Sweden, owns Nordea Bank in There are alternative models of whole, where the systemic impact Finland, as well as Nordea’s securities, asset management and insurance arms established in coordination for the performance of would probably differ considerably Sweden and Denmark. In turn, the Nordea financial crisis management functions among countries. Bank (Finland) owns banks in Sweden, Denmark, and Norway. Recently, Nordea move vis-à-vis a banking group. The first re- The second model of coordination to a single company with a cross-border lies on detailed ex ante arrangements may be designated as the »superviso- branching structure.

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architecture for financial stability. This markets can act as both vehicles of assess how cooperation might work applies in particular to the lender of contagion as well as stabilizing forc- in practice,12 and agreements on best last resort function. The efficient oper- es. In the case of the near collapse of practices in crisis management. ation of this function in a systemic cri- Long Term Capital Management, The second option is centraliza- sis will crucially depend on the effec- there was a simultaneous crisis of tion, or federalization, of financial tiveness of the other financial stability markets and institutions very much stability functions. This option might functions, notably supervision and po- driven by the strong inter-linkages be- emerge if coordination issues are not tentially the treasuries. In an optimal tween participants in derivatives and adequately resolved. Given the de- setting, the authorities’ mandates other markets. Greater coordination centralized banking supervision and should be aligned in the pursuit of the at the EU level could also aim at pro- financial market surveillance, it may stability of the single financial market. viding an effective multilateral surveil- prove difficult to work out responsibil- Thus, short of reforming the existing lance mechanism over pan-European ities on an ad-hoc basis in the midst architecture, the overall challenge is markets as well as the institutions of a crisis. This may be particularly its effective implementation. within them. Given their vital role in valid in view of the potentially in- Two options are apparent for opti- ensuring both financial and monetary creasing number of European bank- mizing the current framework. First, stability, central banks have a natu- ing groups. In terms of business func- coordination between authorities – ral, if not central role to play in this tions, banking groups are increasing- central banks, supervisors, and treas- effort (Schinasi, 2003). This applies ly integrated (notably in liquidity uries – could be ensured. The expan- management) and also may establish sion of cross-border business increas- themselves under a single legal enti- es the likelihood of conflicts of interest ty. The question is whether financial between the pursuit of national man- The prudential stability functions should mirror such dates and the need to consider the an environment and thus be federal- wider cross-border systemic implica- framework ized. This could happen either at tions in decision-making. It might be il- the national level, with the extension lusory to believe that conflicts of inter- of the home-country control to all est may be resolved ex ante or opti- followed the components of a banking group, mally during a crisis in view of the or at the EU level, with a transfer present architecture. Even if the au- of competence to supranational thorities had the benefit of complete by supervisors authority(ies). The analysis in this and perfect information, reliance on paper suggests that such an institu- the pursuit of national mandates may is largely tional move, if ever required by still leave gaps in the consideration of potential coordination issues, would the systemic impact of a crisis. A pos- need to involve all financial stability sible means to help manage conflicts harmonized by is to make clear the possible cross- functions. For example, if the option border systemic implications of the cri- EU legislation. for »federalization« of the lender-of- sis to all authorities involved. This may last-resort function is elected – at the help avoid the most serious and costly national or EU level – it could usefully also involve similar arrangements outcomes. Mechanisms may include – in particular to the ECB and the na- for supervision of banking groups, following the »Nordic« model – pool- tional central banks of the which could involve some degree of ing of information on systemic risk, Eurosystem, which comprise a supra- mutualization among Member States joint assessments of systemic implica- national network that is well placed of the contingency public funds to be tions associated with the failure of a to assess the systemic nature of a li- potentially employed in a systemic large institution, procedures for con- quidity shock and generalized finan- crisis. sideration of EU-wide systemic threats, cial market disturbances. and regular stress-testing and simula- A coordination model should opti- BIBLIOGRAPHY: tion exercises. The implementation of mize the advantages of decentraliza- Basel II is also an opportunity to en- tion in preserving financial stability, in 1. Aglietta, Michel, 1999, »A lender of last hance coordination, because a con- resort for Europe,« Working Paper no. 12, particular local knowledge on the CEPII. solidating supervisor will be nominat- features of the components of the fi- 2. Cabral, Inês, Frank Dierick, and Jukka ed for each banking group, and the nancial system. The wealth of knowl- supervisors involved will adopt written Vesala, 2002, »Banking integration in the edge associated with EU decentrali- euro area,« Occasional Paper no. 6, coordination agreements. zation can be seen as particularly European Central Bank. More generally, as markets be- valuable, provided that effective coor- 3. Dermine, Jean, 2003, »Banking in come more integrated and pan- dination procedures and mechanisms Europe: Past, Present and Future,« in The European, the nature of systemic risk are in place to tackle the systemic im- transformation of the European financial will continue to change, because system, European Central Bank, pp. 31–95. plications of a crisis. Accordingly, banking supervisors, central banks, 4. Enria, Andrea, and Jukka Vesala, 2003, 12 See Financial Times, “Europe simulates and finance ministries are working to- »Externalities in Supervision: the European financial meltdown,” April 10, 2006, p.2: “The Case,« in Financial Supervision in Europe, exercise involved simulating the collapse of a wards enhancing substantially their (Kremers/Schoenmaker/Wierts, eds.), Elgar, big bank with operations in several large coordination arrangements, which in- pp. 60–89. countries to see whether the ECB, national central banks and finance ministries could work clude the 2005 MoU, a crisis simula- 5. European Central Bank, 2000, »Annual together to contain the crisis.” tion exercise to test the MoU and to Report 1999.«

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6. European Central Bank, 2004, »Report on Exploring the Land in Between,« in The 22. Schinasi, Garry J., 2003, »Responsibility EU Banking Structures.« Transformation of the European Financial of Central Banks for Stability in Financial System, eds. Vitor Gaspar, et al. (Frankfurt: Markets,« IMF Working Paper 03/121 7. European Central Bank, 2005, »Report on European Central Bank), pp. 269–310. (Washington: International Monetary EU Banking Structures.« Fund, June). Available at http://www.imf. 16. Padoa-Schioppa, Tommaso, 2004, 8. European Commission, 2004, »Financial org. Integration Monitor,« Commission Staff »How to deal with emerging pan-European 23. Schinasi, Garry J., 2005, »The Euro at Working Document, available at http:// financial institutions?«, speech at the Five: Ready for a Global Role?« Chapter 5 www.europa.int. Conference on Supervisory Convergence, organized by the Dutch Ministry of Finance, in Euro at Five: Ready for a Global Role, ed. 9. Financial Times, »EU agrees financial The Hague, November 3, 2004. Adam S. Posen (Washington, D.C.: Institute crisis plan,« May 16, 2005, p. 15. for International Economics) April. Available 17. Padoa-Schioppa, Tommaso, 2004, at http://www.imf.org. 10. Freixas, Xavier, Curzio Giannini, Glenn Regulating Finance, Oxford. Hoggarth, and Farouk Soussa, 1999, 24. Schinasi, Garry J., 2006, Safeguarding »Lender of Last Resort: a Review of the 18. Praet, Peter, 2005, »A central bank Financial Stability: Theory and Practice, Literature,« Financial Stability Review, Issue perspective on large banks in small countries Washington, D.C.: International Monetary 7, November 1999, Bank of England. and crisis resolution,« presentation at the Fund. Norges Bank, June 2005, available at www. 11. Garcia, Gillian G. H., 2005, »Preserving norgesbank.no. 25. Schinasi, Garry J. and Pedro Gustavo Financial Stability: A Dilemma for the EU,« Teixeira, »The lender of last resort in the paper prepared for the Western Economic 19. Prati, Alessandro, and Garry J. Schinasi, European single financial market,« Association, July 2005, mimeo, October. 1998, »Will the European Central Bank Be published in Cross-Border Banking: the Lender of Last Resort in EMU,« in The Regulatory Challenges, edited by Gerard 12. Goodhart, Charles, and Gerhard Illing, Euro: A Challenge and Opportunity for Caprio, Douglas D. Evanoff, and George 2002, Introduction to »Financial Crises, Financial Markets, eds. Artis, Weber, and G. Kaufman (World Scientific Publishing Contagion, and the Lender of Last Resort, A Hennessy (Frankfurt: Routledge and SUERF), Company, 2006). Also IMF Working Reader,« (Goodhart/Illing eds), Oxford. pp. 227–256. Paper 06/127, available at http://www.imf. 13. International Monetary Fund, 2003, 20. Prati, Alessandro, and Garry J. Schinasi, org. »Managing systemic banking crises,« 1999, Financial Stability in European 26. Schoenmaker, Dirk, and Sander Occasional Paper no. 224, Washington, Economic and Monetary Union, Princeton Oosterloo, 2005, »Financial supervision in D.C. Studies in International Finance, No. 86, an integrating Europe: measuring cross- 14. Lastra, Rosa, 2003, »The Governance August 1999. border externalities,« International Finance Structure for Financial Regulation and 8:1, pp. 1–27. 21. Rochet, Jean-Charles, and Xavier Vives, Supervision in Europe,« Columbia Journal of 2004, »Coordination Failures and the Lender 27. Sveriges Riksbank, 2003, »The European Law 10, pp. 49–68. of Last Resort : Was Bagehot Right After Riksbank’s role as a lender of last resort,« 15. Padoa-Schioppa, Tommaso, 2003, All?,« IDEI Working Papers 294, Institut Financial Stability Review no. 2, 2003, »Central Banks and Financial Stability: d’Économie Industrielle (IDEI), Toulouse. Riksbank.

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UDC 336.7(497.4):061.1 EMU Consolidations and Diversifications in Financial Sector Franjo Štiblar *

This paper deals with I. INTRODUCTION recent financial sector developments in the world, the EU and n recent decades, financial institutions are experiencing Slovenia. Special emphasis is on immense changes related to the process of globalisation. consolidation and diversification of financial With simultaneous goals to satisfy clients and at the same institutions. Possible impact of Slovenia’s time to achieve good results, requested by owners, they coming membership in European Monetary Iconsolidate, diversify and converge. They diversify products and Union is also discussed. Paper starts with services offered, cooperate in business and make capital linkag- introduction which overviews developments es up to mergers and acquisitions. But, more recently, supervi- in financial sector, gives definition of financial sors started to perceive all dangers, which arise from such link- institutions and makes comparison between ages. The emerging large and complex financial institutions (the them. Next, theoretical framework for World Bank term) can influence on stability of financial system consolidation and diversification is discussed, first for the and thus the economy in individual country, region and even in economy on general, and then for financial sector. the whole world. For that reason, for instance, the European Third part presents normative framework in Union (EU) adopted in 2002 the Directive. on the supplementary which institutional arrangements in financial supervision of credit institutions, insurance undertakings and sector take place today. Part four describes investment firms in a financial conglomerate. institutional structures of EU financial sector and Slovenian financial sector General overview of recent developments in financial sector in specific. Paper concludes with some summarized remarks and Fast global development of the financial sector and liberali- relates to potential consequences Slovenia’s zation of financial markets led to institutional linkages intra sub- membership in European Monetary Union on sectors of financial sector and cross-border linkages (consolida- developments in its financial market. tion into financial groups), while at the same time into cross- sector linkages (diversification). The latter can be in the form of business co-operation, regarding common functions, in creation of hybrid products and services, or it can be institutional connection intra and inter country (convergence in creation of large and

* Franjo Štiblar, Professor, Faculty of Law, University of Ljubljana, and Economic Institute of the Faculty of Law, Slovenia

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complex financial institutions, includ- risks regarding reduction of competi- between brokerage and representa- ing financial conglomerates). Mergers tion, protection of clients, double tion on capital markets, appearance and acquisitions are the ultimate form counting of capital, possibility of of competitors in supply of financial of linkages in which one partners contamination within financial group services from non-financial compa- loses its legal identity. and lack of transparency in business nies, emergence of special financial Globalisation and convergence activity within such large financial boutiques: and diversification associated with it, group and with it problem with its – internationalisation: growth of bring new risks, which require better supervision. commercial finances, international is- protection. For that reason, activities Banking (commercial and invest- sues and trading with securities, inter- to adopt new standards for banks ment) and insurance business have nationalisation of payment flows and started in mid-1990s and resulted in more in common as one could con- fund management, international merg- adoption of new Basel II standards clude on first sight. Tradition view is ers and acquisitions; (for all countries) in December 2004. that banks manage financial resourc- – de-regulation: elimination of wall Their implementation is foreseen for es while insurance companies under- between commercial and investment 2007/2008. Similarly, again with take risks. But both are active in these banking in the USA, declining control delay of 4-5 years, insurance sector activities. Banks and insurance com- (liberalization) of international finan- follows (in the EU only for now) with panies collect financial resources to cial flows in the EU, elimination or mit- preparation of new Solvency II stand- protect financial security (banks) or igation of credit ceilings, liberalization ards. The framework directive is to protect against damage (insurance expected to be adopted in October companies). Frequently they are com- 2007, while its implementation is plements, for instance in mortgages, envisaged for 2010-2011. Globalisation which require credit as well as insur- Critical for credibility of financial ance. This is why bankassurance or system and capital markets as the insurance banking is natural develop- whole is solvency of financial institu- and ment. Result of their association are tions, while the other two indicators, common products, their common dis- profitability and liquidity are more convergence tribution, which could lead to capital important for owners and managers linkages up to mergers and acquisi- of financial institutions. New solvency and tions (Genetay N., Molyneux,P.: Ban- standards are expected to provide cassurance, MacMillan, London, higher sensibility for specific form of 1998). risks undertaken in activities of finan- diversification Financial sector development is cial institutions, especially un-expect- result of changes in demand for finan- ed. The question is certainty to fulfil associated cial services by clients and adequate obligation of financial institutions to adjustments in supply of financial their clients. Insolvency of one institu- services by financial institutions. tion leads to bankruptcy, which can with it, bring Changes in demand are caused by damage credibility in financial sector demographic changes (aging of pop- of one country, but could be easily new risks, ulation), changes in saving habits transferred to other countries in glo- (wealthier population) and higher ed- bal financial markets. That would ucation of population. lead to collapse of the world financial which require On supply side, there are changes system (butterfly effect). For that rea- in competitive business environment, son, prudence regulation is very im- better defined by 5 elements (according to portant for financial institutions. Porter, 1980): increasing competition Major trends on financial markets protection. among existing actors in the sector, are characterized by development of threat of new entries, threat of substi- financial structure, which is shown in tute instruments, re-enforced negotia- internationalisation, de-specialization tion power of suppliers and increas- on one hand, in business innovation in formulation of deposit interest rates, ing negotiating power of clients. on the other. This leads to de-regula- approval for introduction of new finan- The large and complex financial tion with its influence back on behav- cial products as, for instance, future, institutions obtained special names, in iour of financial institutions. options, and other new instruments of the EU they are »financial conglomer- Specific elements of these trends financial markets, elimination of fixed ates«, in the USA they are »large and are: provisions for financial services and complex banking organizations«. – innovation: growth of syndicated liberalization of capital market rules. They are result of consolidation loans, euro-markets, securitization and This way two trends are present at and convergence in financial sector dissemination, derivatives, options the same time in financial sector: (Financial Sector Assessment, The and swaps and development of other structural de-regulation and additional World Bank, 2005). They carry addi- modern (hybrid) financial instruments; supervisory re-regulation, which in- tional risks stemming from cross-sector – de-specialization in direction of cludes regulation of production, distri- and cross-border activities. Their main inter-sector linkages: extent of univer- bution of services and ownership of fi- characteristics are: sal banking, linkages between banks nancial institutions. Emergence of fi- – they are becoming an important and insurance companies, linkages nancial groups is creating additional actor on detailed and wholesale fi-

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nancial markets, with significant influ- can have lead supervisor (as coordi- analyse of general framework of ac- ence in countries they do business; nator of supervision of different group tivity, organizational structure and – they can have seat at home or activities), and at the same time one managerial characteristics of the su- abroad, the from of their organization or more supervisors in each country, pervisory institution, building and ac- influences their regulation; where it is present. tivity of protection company, current – their business includes commer- There are three degrees in evalua- surveillance, affirmation of prudence cial and investment banking, securiti- tion of activity of such financial in insurance company, analysis of in- zation of loans, securities trading and group: surance markets and clients of the in- other capital market activities, life – First, the estimation of risk in the surance company. and non-life insurance, custody and framework of local financial system, For successful execution of consoli- management of capital, payments, – Second, estimation of systemic dated supervision (as additional, not but also non-financial activities (for risks of activity of the whole group, as substitute for individual supervision) instance in trade, industry). – Third, the success of the finan- of the financial group among the most In balance of these groups liabili- cial authorities in evaluation of these important factors are: legal frame- ties include different domestic and for- risks. work, business independence and suf- eign sources, while assets include the A need for consolidated supervi- ficient financing of supervisory agen- whole “assortment” of domestic and sion of such financial group appears. cies, and adequate co-operation be- foreign financial instruments. Their out It means quantitative (the quality of tween domestic and foreign superviso- of-balance positions can be very im- assets, capital adequacy, liquidity, ry authorities (based on the signed portant, because they indicate the large exposure) and qualitative (com- Memorandum of Understanding). complex financing of these groups, plex evaluation of groups risks) esti- made through regulated markets or mation of the strength of financial Types of ﬁnancial institutions over the counter (OTC). Such finan- group, consisted from several entities cial groups consist of many different under joint ownership or control. Financial institutions are part of legal entities, which are inter-connect- The goal of such supervision is to financial system. They can be divided ed by various forms, so that the com- evaluate the safety of the financial by different criteria. The mostly used plexity of financial group per se be- system, in which financial group oper- is division by institutional criteria, comes additional risk. ates, and the strength of the whole regarding the form of transition of Success of emerging financial financial group. financial savings from savers to users groups depends on three major fac- In 2000, the IAIS (International of credit: tors: their acceptance by clients, the Association of Insurance Supervisors) – financial intermediaries, choice of organizational structure developed 28 insurance principles, – agent financial intermediaries. (they originate by business agree- grouped in 7 groups for specially for Financial intermediaries can be ments, with mergers and acquisitions, evaluation of insurance companies: further divided into: as joint ventures or as newly born groups) and cultural conflicts, caused Scheme 1: Classification of financial institutions by institutional criteria by their emergence in the environment (modes of payments, etc.). Financial groups emerge frequently with diversification. Their success depends on five factors (Gilbert 1998): relative size of business, profitability of individual components in the group, risk of individual activities in the group, correlation between financial flows of separate sub-activities and synergies among activities in the group. The main stimulations for creation of financial groups with diversification are: – different risk of different financial activities, – decreasing risk stemming from low correlation regarding profits of different financial sub-activities, – risk, defined as increased volatility, can grow with merging, but it is more than compensated by higher returns, related also to declined risk of capital destruction. The activity of group can depend on different legal (regulatory, tax, accounting) regimes, which influences its balances and results. The group Source: Ribnikar, 2003, page 229.

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– deposit taking institutions, which assets remains un-changed. This trans- introduction of new products and collect savings in form of deposits fer does not belong to direct finances. services and with entrance to new with different term structure and invest Agent financial intermediaries work markets. them in form of short or long-term in an alien name on an alien account. In literature, different divisions of loans and securities. Among these are They are present in primary and sec- corporate diversification are known commercial banks, savings houses, ondary market of securities and earn ((Genetay N and all, 1998). The most credit unions; provisions for their services. Here are frequent division to into 4 forms: – non-deposit or investment finan- brokers, dealers, specialized in secu- – horizontal: new products and cial institutions, which consist of: rities management , and investment services to existing clients in new or -contractual financial institutions, banks, which help companies in the same institutions; which collect savings on contractual primary issues of securities (IPOs). – vertical: expansion to the activi- basis. People have their property ty of suppliers or buyers with mergers invested in these institutions, while Comparison of ﬁnancial or internal diversification; contracts assure them different money institutions – concentric: expansion with payments in the future. Contractual new products, which are connected financial institutions need to invest Financial institutions differ in the with old products by technology or collected savings in the best possible way they transfer financial resources marketing; way, to be able to fulfil the obliga- from savers to users, from balance – conglomerate diversification: tions (pension payments or damag- sheet and risks to time horizon and non-linked diversification, expansion es). Among these institutions are insur- supervisory instruments. The main to new areas. ance companies and contractual pen- differences are the following: The accepted strategy of corpo- sion funds; rate expansion or diversification can II. THEORY OF CONSOLIDATION -investment financial institutions be made in two ways, with internal are collecting savings through issued AND DIVERSIFICATION development of company or with its securities, which enable investment in inter-linkages with other companies. The theory of corporate more risky securities, in which individ- The third, alternative way is gradual, diversiﬁcation ual will not invest due to lack of sequential entrance. These approach- knowledge and information. Among Economic entities can grow and es have all different consequences, investment companies are open in- develop in different ways. The best costs and time for completion. vestment funds (mutual funds) and known among strategies of enterprise Two main forms of corporate di- closed investment companies and development are generic growth and versification regarding organizational funds of instruments of money corporate diversification. In the first structure are: differentiation (defines markets. one, an enterprise increases its size, the way people are allocated to dif- Agent financial intermediaries production and income of one kind ferent tasks in the company) and inte- help transfer of financial assets only of already produced product of the gration (defines the way corporation with creating contact between savers same “assortment” and in the same tries to coordinate people and func- and users. They do not work on their market. Corporate diversification tions to fulfil organizational tasks). own account and their balance of means expansion of enterprise with Decision needs to be made about

Table 1: Comparison of financial institutions

Criterion Bank Insurance company Institution of capital market Assets* - reserve money at the central - investments in land - securitized earnings bank and buildings - financial instruments - loans to banks and clients - financial investments - securities - claims from insurance undertakings Liabilities* - deposits from banks and clients - technical reservations, - liabilities to clients - debt securities - liabilities from insurance - provisions contracts - capital - capital Distribution channels - agency - insurance representative, agent - financial intermediary Time horizon - middle - long (life), - short - short (non-life) Major risks - credit, liquidity - undertaking, investment - market, liquidity Risk transfer - securitization, derivatives - re-insurance - derivatives, OTC mechanisms Capital/provisions - both - more provisions - more capital Supervisory concern - systemic risk, protection - protection of insurees - protection of investors, systemic of depositors and market risk Supervisory instru- - capital requirements, restrictions - capital requirements technical - capital requirements, separation ments about activities, sound provisions, principles of assets, evidence, control procedures and policies of investment and re-insurance of business Source: Supervisory reports and European Central Bank, 2005

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vertical differentiation (decision mak- which are named financial conglom- mergers or acquisition is not allowed, ing authority is allocated in vertical erates in the EU (if special criteria are because legislation in the developed or more horizontal way, decentral- fulfilled) or large and complex bank- countries does not allow providing fi- ized or centralized) and horizontal ing organizations in the USA (World nancial services of different sectors differentiation (division of tasks Bank, 2005). under one legal entity. among groups of people, which can A large and complex financial LCFI can have different organiza- be functional, geographic, multi-divi- institution is defined as a group of tional structures:9 integration, parent- sional or conglomerate). companies, which execute financial daughter model (English model), Diversification and growth of com- services in at least two sectors of the holding company (American model) panies is stimulated by different fac- financial system6 and cross-sector or horizontal group. tors. According to agent theory they services have to be significant. Three In concrete, in linkages between are managerial reasons of affirmation basic financial sub-sectors are bank- insurance companies and banks or protection. Other factors can be ing, insurance and capital market in- diversification in question is concen- expected above average profitability stitutions. According to the EU legisla- tric (Anshoff), where distribution and of acquired company, decreasing tion at least one enterprise needs to marketing are two most important business risks, financial or business be from insurance sector (Directive fields of communality. Entrance mech- synergies or use of market power. 2002/87/EC). In the USA, at least anisms can be: cooperative contracts, one institution should be a bank. joint ventures, mergers and acquisi- Application of the theory tions, or green field investments. to the ﬁnancial sector Positive and negative implications Intra-sector linkages: consolidation Economic of linkages into LCFIs Intra-sector linkages, which can be Expected positive results generic growth of company, means is entities The most frequent motives, reasons horizontal integration (existing prod- for inter-linkages in financial sector ucts on existing markets), which leads can grow are expected benefits from economy to intra-sector financial groups with of scope and decreasing business one institution being leader and other risks, but there are some other. subordinated. These groups appear and develop Synergies. Synergic effect of when the influence of one institution economy of scope are represented in in competitive institution increases in different supply in investment activity (one de- with the help of acquiring majority partment for all investments), informa- (controlled) ownership share. But they tion technology (consolidated informa- can appear also as mergers1 or as ways. tion about clients, available to larger acquisitions.2 number of clients), in distribution First motive for generic growth is (the same distribution channels for all economy of scale, correlated with Inter-sector linkages of financial in- types of financial services and prod- synergies. Second motive for appear- stitutions are in two forms. Final result, ucts), and in increasing reputation (if ance of homogeneous financial achieved by inter-connection, is 7 one institution in the group has good groups is decreasing business risks. common offer of hybrid products. First form is contractual cooperation, When it comes to mergers on level 1 where financial institutions agree to Merger is creation of new company with of individual type of risks, at the first transfer of assets of both companies which are level of risk management, decline of use common distribution channels, merged. The shareholders of old companies 8 obtain shares of new company in negotiated systemic risk can be up to 50%.3 On or common databases , or intermediation, where financial institution from ration. second level (merging risks of differ- 2 Acquisition means transfer of assets of one ent types of products or services with- one sector (for instance bank) repre- company for shares of other company. Sp[ecial in one financial intermediary) decline sents financial institution of other sec- contracts are behind it. In difference to merger, tor (insurance company). there is no new company, but aftwer trasfer in risk can be up to 40% for insur- there exist only the companies which aquired ance, 21% for banks.4 At the third The second group of inter-connec- other company. level of mergers of different risks be- tion are capital (ownership) linkages. 3 Kuritzkes (2002), str. 24. tween different financial institutions, Among possible arrangements are: 4 Kuritzkes (2002), str. 24–27. where risks factors are strongly corre- one financial institution establishes 5 Kuritzkes (2002), str. 33. lated the benefits of action measured a new entity in other financial sector, 6 Skipper Harold D.: Financial services two financial institutions establish integration worldwide: Promises and Pitfalls. in declined risks (and thus required Paris, OECD, Organisation for Economic capital) can reach only 5%-10%.5 a new entity through joint venture. Co-operation and Development, Insurance and These two approaches are related to Private Pensions Compendium for Emerging Economies, Book 1, Part 1:5)b, 2000, str. 3. Inter-sector linkages: convergence high costs. Mostly used approach is 7 More Gliha, Urška: Uveljavitev bančnega direct ownership participation of one zavarovalništva, Pravna fakulteta v Ljubljani, Inter-sector linkage (convergence) financial entity in other from different 2004, str. 24–26. means conglomerate form of compa- financial sector, or it can be cross- 8 Gliha, Urška: Uveljavitev bančnega ny growth, as new products are ownership, both leading to decreas- zavarovalništva, Pravna fakulteta v Ljubljani, 2004, str.20. added to old “assortment” in expan- ing costs due to synergies used. But, 9 Skipper D. Harold jr.: Financial Services sion. New large and complex finan- full integration of companies from Inegration Worldwide: Promises and Pitfalls. cial institutions (LCFI) are emerging, different financial sub-sectors through Paris, OECD, 2000 , str. 5.

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reputation, this expands to all institu- Growth. The size if determinant companies by using existing common tions in the group). On demand side, for inter-linkages, but it can have also distribution channels. In France, for synergic effects come from cross-sell- negative effects of declining organi- instance, the network of insurance ing of different financial products or zational consistency and smaller flex- agents is much more costly than services, which are usually comple- ibility. European internal market ena- selling of insurance services through mentary. Income potential of financial bles possibilities for use of synergies existing banking counters (Leach, group increases as wider “assortment” among financial activities within one 1993). of products and services is distributed. financial entity. Bankers and insurers Financial motives. Interconnec- Buyers are willing to pay even more, if have business based on rule of large tion of banks and insurance compa- they are able to get all products, serv- numbers. Attainment of critical mini- nies increased potential to borrow ice, in one place and thus with less mal (optimal) size of company is pre- money (better credit rating due to transaction costs.10 condition for its international activity, cheaper loans for larger units on Bergandahl found (1995) that based on criteria of minimal average financial markets, Cooper, Lybrand, bankassurance strategies are the most total costs. Its quantification can be a 1994). Sometimes, integrated units profitable for banks with large problem, but several years ago that used lower leverage of one of the number of clients per agency and size was defined for banks with entities in the group (Pitt, 1990). high sector cross-selling coefficients. assets value of at least $ 10 billion, According to Pitt (1990) defensive Investment in new technology is need- for insurance companies with strategy is present in banks due to the fact that the growth of bankassurance Scheme 2: Risks in LCFIs Financial Conglomerates is related to increase in the share of life insurers in savings market and their higher profits. Dispersion of risks and source of income remains important motive for linkages between banks and insurance companies (Cazalet, 1991, Holsgoer, 1993). Major motives of banks and insurance companies in corporate diversification are above average profit expectations, synergies, financial motives and decreasing risks. Empirical analysis shows that defensive mergers are frequent and that linkages of similar activities are more successful than linkages among non-similar activities (due to business and financial synergies).

Potentially negative consequences of linkages in ﬁnancial sector

For transparency, potential problems are presented separately, although they are interconnected Source: Kuritzkes, 2002, and frequently appear together. They are11: ed for efficient linkages and that are collected gross premiums of at least 1/ Regulatory arbitrage: transac- small banks and insurance companies $ 500 million. tions are transferred to other entity in unable to do. The motive is, therefore, Defense against hostile the group, double counting of capital, the synergy of cross-sector selling and takeovers. Banks and insurance too high indebtedness; common distribution channels. companies like to make friendly link- 2/ contamination problem: prob- Inter-linking.They are large differ- ages just to prevent to become victims lems of one entity in the group are ences in structure of risks of entities of hostile takeover. But, this carries extended to other entities; from different financial sector. For the danger of „cannibalism”: growth banks, the most important is credit of insurance premiums with return 10 Skipper Harold D.: Financial services integration worldwide: Promises and Pitfalls. risk, more important are becoming (unit products) can decrease at the Paris, OECD, Organisation for Economic Co- market and operational risks. In life same time the size of banking depos- operation and Development, Insurance and insurance companies market risks are Private Pensions Compendium for Emerging its, especially if premiums are con- Economies, Book 1, Part 1:5)b, 2000, str. 10. prevailing, in non-life the underwriting nected with tax relieves. 11 Dierick Frank: Dierick Frank: European Central risks (risk of un-expected large loss) Profitability. A motive can be Bank: Occasional Paper No. 20. Avgust 2004. are most important. In dealing with increase in profit, when entrance into Frankfurt am Main, Avgust 2004, str. 15 in 16. Skipper Harold D.: Financial services integration capital, views of different stakehold- more profitable financial sector is en- worldwide: Promises and Pitfalls. Paris, OECD, ers differ: creditors, depositors, super- visaged, for instance in life insurance. Organisation for Economic Co-operation and visors want better solvency, owners Some banking managers want to Development, Insurance and Private Pensions Compendium for Emerging Economies, Book 1, are led by profitability above all. increase efficiency of life insurance Part 1:5)b, 2000, str. 42 – 46.

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3/ moral hazard: too large finan- and inter-connections of financial the fact, that in Anglo-Saxon financial cial institutions cannot be liquidated: institutions are financial institutions, system the role of banks in financial its non-supervised units are able to leading to integration within the intermediation is comparable much reach reserves of all institutions in the financial sector. smaller. In the USA more authorization group; group members with difficul- is given to Federal Reserve System. A ties expect to be bailed out by good III. NORMATIVE FRAMEWORK deposit institution must be a member members; of a group for this to be proclaimed 4/ Transparency problem: trans- Regulation in the USA as financial conglomerate; in Europe actions within the group remain Cross-sector linkages, especially the insurance company is “conditio hidden; therefore risks are not trans- between banks and insurance com- sine qua non”. Non-financial commer- parent; panies, are only at the initial stage in cial companies cannot be owners of 5/ conflict of interest, because the USA, in difference to develop- banks in the USA, as it is possible in large financial group represents the ments in Europe, especially in South- Europe (Dierick, ECB, 2004). same client in different roles, which ern Europe. The reason is legislation, Thus, first larger financial con- can be conflicting (insurance, bank- which has been liberalized, only in glomerate appeared in 1998, which ing); last decade. Before that laws made banking holding Citicorp acquired 6/ misuse of market power: larger walls among commercial banking, insurance company Travelers Group, concentration decreases market com- creating holding Citicorp. Such con- petition, while large size makes dras- solidation intra sectors and diversifi- tic sanctions impossible. cation cross sectors continues so that With increasing dangers created the number of financial units in the by linkages into LCFI new requests ap- They are large USA fell in last 20 years from 14500 pear to strengthen their supervision to 9000. Concretely, insurance poli- and for better information of supervi- differences cies with saving components at- sors and general public about organi- tached are sold predominantly in zational structures of these institutions bankassurance in the USA, but devel- and their risk exposure. in structure of opment of new products is expected, Transparency and consolidated especially in asset management and supervision can be achieved more risks of entities securities. easily with united supervision body. The role of a supervisor/coordinator Normative framework in the EU financial system is the first from different in the EU step in this direction. Diversifications with similar finan- financial The insurance group directive cial entities have better result than (98/78/EC) was first step in the way diversifications with non-similar enti- to large and complex financial groups ties, because better managers can sectors. (conglomerates). Clear consolidation change risk profile of firms, use syn- rules were given for banks in directive ergies, increase returns and improve from 1992 (92/30/EC), but for insur- their competitive position. Vertical in- insurance and investment banking ance companies they did not appear tegrations bring economies in gener- (or capital market institutions). Glass- before 1998, when partial solutions al functions (administration, distribu- Steagal Act from 1930s did not allow were introduced. tion), but diseconomy appears in in- links between commercial and invest- Insurance groups tegration back, if decline of competi- ment banking, while continental Eu- tion between suppliers, caused by in- rope and Japan practiced universal Insurance groups are regulated tegration, leads to higher costs and banking. The law on bank holdings with Directive 98/78/EC, which prices of supplier’s production. Costs has prevented them in their attempts speaks about additional supervision of administration needed for diversifi- to enter insurance or other non-bank- of insurance companies in insurance cation strategies can be above their ing activities. groups. Re-insurance companies are benefits. Then, defence motives Modernization of legislation in equalized with insurance companies. prevail. 1990s, initiated due to losing of com- It requires calculation of adjusted sol- Diversification of other financial petitive position of the US banks, ap- vency in insurance group. institutions into real sector is not natu- peared in the form of Law on modern- Linkages between insurance com- ral successful strategy due to enor- ization of financial intermediation panies bring income and cost syner- mous differences in their business (Gramm-Leach-Bliley Act). It allows gies, because they usually offer simi- programs. It can happen in special capital linkages between banks and lar products. The economy of scope circumstances (debt-equity swap, insurance companies in the form of happens only if life and non-life insur- acquisition of damaged object with financial holdings, which are owners ance company are linked. payment of damage) and for a short- of all types of financial institutions, Participation of one insurance er period (new re-sale, possible after but they are not allow to enter trade company in other has consequences successful rehabilitation). or other real sector activities. for its solvency, as regulation in the Thus, theory of diversification con- In difference to Europe, the US EU does not allow that capital from firms well-known rule that the best legislation is more banking oriented, the first insurance company, allocated possible partners for cooperation which is a surprise taking into account in second, can be count as available

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capital of the first insurance company. mon financial unit. It can be capital For definition of diversity through This decreases capital adequacy of participation of one financial institu- sector activities at least two sectors the first insurance company. tion in other, of the same kind (con- should be included and one must be Participation of one insurance solidation) or different kind (diversifi- insurance. company in other has consequence cation). The intention of directive is to pro- for its solvency, because the EU rules vide stability on European financial do not allow calculation of capital al- Financial conglomerates markets, establishment of standards located in other insurance company for supervision, creation of level play- Brouwer’s committee prepared to be added to its capital, which ing field and higher legal security for foundations for directive on financial leads to decline in capital adequacy clients and financial entities. conglomerates with its first report in of participated insurance company. The basic goals of directive are: April 2000, which included coordina- Therefore insurance company – buyer – Financial conglomerate should tion of supervisors for conglomerates needs additional capital to make ac- have secured capital, without its dou- and use of consolidated supervision. quisition. ble use; Management of conglomerates in – Calculation of capital in con- Insurance and re-insurance crisis is important for liquidity reasons glomerate should be made in accord- companies related to banking units in conglomer- ing to allowed methods; ates. The report required timely – Exposure to individual risks Insurance and reinsurance compa- information among banking units. should be observed within total nies have tight business cooperation Directive on financial conglomerates group exposure; in protection of risks. They can be was adopted in November 2002 – Adequate management should also institutionally linked. (2002/87/EC) and should be imple- manage the whole conglomerate; a) Insurance company can estab- mented among EU members by – Adequate internal control mech- lish its own reinsurance company August 2004. It regulates all fields anisms should be established in con- (Captive) for equilibration of risks and important for a large and complex glomerate; transfer of excess risks. Thus either financial group. – Special supervisor – coordina- profit or loss of reinsurance adds to Directive has new requirements for tor should be established for each result of insurance company. The in- conglomerates with super-imposed conglomerate. surance company is thus double ex- company outside EEA, because EU The main elements of directive posed. In addition, solvency is affect- member should overtake the whole which establish additional supervi- ed, because capital invested in rein- supervision. One way is to establish sion of entities in financial conglom- surance is not recognized as availa- a holding of such group in the EU. erate are: ble capital of insurance company. Major worries are conglomerates, -definition of financial conglomer- b) Reinsurance companies can ac- which are present in the USA and ates and entities in them, as well as quire or invest into insurance compa- the EU at the same time. criteria and procedures to find out ny. This makes reinsurance sure that Financial conglomerate according whether certain groups are a finan- insurance company will insure excess to point 14, proposition 2 of Directive cial conglomerate; risks with her. In addition, it can influ- is a group, which fulfils the following -provisions on additional supervi- ence the politics of insurance compa- conditions: sion, with calculation of capital ade- ny by its knowledge and thus enable – supervised entity is in the top of quacy adjusted for the group with competitive advantage of insurance group or at least one subordinated different techniques, overview of company in the market. entity is group member; intra-group transaction and potential – when supervised entity is on top concentration of risks, risk manage- Insurance companies and banks of group, it should be company-moth- ment and adequate personal man- er of legal entity in financial sector, agement in group; They can be inter-linked institution- company with participation in such -provisions regarding determination ally, contractually (business) or by entity or related to such entity; of coordinator-supervisor and its tasks, product. For client the most important – if the company on top is not su- -coordination among all supervi- is distributive and product connection. pervised (mixed conglomerates), and sors involved in supervision of con- Optimal entrance into bankassur- activities in the group are predomi- glomerate, ance depends on pre-conditions: dis- nantly in the financial sector, they -changes in sector provisions for tribution channels, market position of should represent at least 40% of bal- banks, insurance companies and in- bank or insurance company, availabil- ance sheet total; vestment companies to establish level ity of adequate partner, organization – at least one entity in group is playing field for all. and ability of management, needed from insurance sector and at least There are some problems related to after merger is done. one from banking or investment directive on financial conglomerates: Banks and insurance companies sector; 1. definition does not include enter into bankassurance with estab- – consolidated or accumulated mixed financial and real groups, lishment of new legal entity or by cap- activities of legal entities inside insur- which do not fulfil definition of finan- ital inter-linkages, especially devel- ance or inside banking or investment cial conglomerates, because 40% oped in France. sector are important, which means limit is not achieved, Bank can establish its own insur- that their assets represent at least 2. transparency in publication of ance company or vice versa, or it is 10% or over €6 billion of the finan- names of conglomerate members is joint venture – establishment of com- cial conglomerate’s assets each. not required;

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3. supervision of prudence is 20% share in its management. A distribution channels and supplies weak regarding large exposure bank has a qualified holding, if it the insurance company with its own (required for banks and funds, not has a 10% share in voting rights or channels. for insurance companies), intra- in capital of insurance company. b) Production cooperation hap- group transactions (limitations for in- pens also in case when insurance surance companies exists, for banks Connected entities company acquires a bank, because and funds not), non-harmonized of expanding its business to banking risks, integrative supervision; According to the Insurance Act, services and products. It is, again, a 4. the role of supervising coordi- connected entities function as legally large financial, organizational and nator is not well defined and rules independent entities, which are managerial effort, because manage- about coordination of supervisors inter-connected in management, ment should now manage bank in are not clear; capital and other way, so that due addition to insurance company. With 5. financial stability is not to these connection the form common such acquisition the insurance compa- assured. business politics and coordinate with ny now obtains new distribution chan- Three possibilities of such common a purpose to achieve common busi- nels and new approach to client, supervision are possible: ness goals, or in the way that one which were not attainable before. -lead supervisor, entity can influences the other in a On the other hand, the bank supplies -increasing credentials according group. the insurance company its distribution to Lamfallusy process, channels. -establishment of European super- The linkage is especially interest- visor in new institution. ing, if bank has investment banking, There are positive and negative Cooperation because insurance company gets this consequences of each of these pro- was a possibility to place its assets on posals, mostly related to the wish of capital market. Bank can also acquire national supervisors to control finan- of banks management of investment fund to cial entities on their territory. which life insurance products are re- with investment lated, or establish a new fund with Regulation in Slovenia the policy and structure appropriate for insurance business. According to the Slovene banking funds is much law from 1999, banks can provide Reciprocal capital participation services other than banking ones, more common including selling insurance policies In this case it is concern with rela- (Insurance Act) and management of tion of equality. Bank and insurance pension or investment funds. For non- in Europe. company have to have more than a banking services banks need to be 25% share in each other, according to authorised by the Bank of Slovenia. article 464 of the Companies Act of On the other hand, 2000 Insur- Acquisition Slovenia. In this case both entities are ance Act defines conditions for insur- legally independent without common ance business. Banks are envisaged a) In case of acquisition (buy) when management but without inter-depend- as possible agents in selling insurance a bank acquires majority or all shares ence. Contract is a base for decision- products, but only the Bank of Slove- of an insurance company, concern is making. Danger is that this form en- nia, which calls for a prior authorisa- de facto established, which includes dangers de facto capital payment, tion by the Insurance Supervision production linkages in addition to insti- protection of basic capital and mysti- Agency. Banks can be only intermedi- tutional linkage. Commanding entity – fies the real source of capital. The aries, not representatives in insur- bank, has majority shares in the de- consequence can be »risk of contami- ance, because bankers should get pendent entity– insurance company, nation«. Advantages of this form, on special knowledge and special per- where they have united leadership. other hand, are: dispersion of income, mission for that. Coordination of decisions is needed in decreasing volatility of money flows, In case of financial groups and both banking and insurance. If they increased profitability due to new ac- conglomerates, supervisors from all sign a contract on command, de facto tivities and new distribution channels three fields (Bank of Slovenia, Insur- concern is reformulated into contractual and better service for clients. ance Supervision Agency and the Se- concern, where the insurance company curities Market Agency) cooperate in need to follow bank advices, only inde- Holding accordance to the Statute on coopera- pendent judgment of their legality re- tion they signed. It includes strategic mained with the insurance company. Holding is a model of acquisition matters, organization of common su- Acquisition is a large project, or merger, where the group is the pervision, information about irregulari- which requires large financial poten- owner and the executor of internal ties. tial from the bank, which also needs supervision of the bank and the insur- to analyse the insurance company ance company. Both made agreement Participation and all consequences of acquisition, about cooperation within financial including its profitability. This requires conglomerate. In this case, the role of According to article 9 of the Insur- high professional abilities of manag- leading management is especially im- ance Act, a bank participates in an ers. With acquisition, the bank ac- portant. To realize advantages, they insurance company, if it has at least a quires new knowledge and new should have good communication.

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Table 2: The value of mergers and acquisition of financial institutions of Slovenia declined from 99% in in the EU, 1990-2003, billion € 1992 to 88% in 2002 (the seventh largest among all members). Domestic Intra EU Extra EU Total The largest mergers and acquisi- ACQUIERER tions in the EU in 1990-2003 period ACQUIEREE were: 1. Allianz – Dresdner Bank (2001, Bank Insur. Bank Insur. Bank Insur. Bank Insur. €22.3 billion), Bank 446 41 75 4 60 5 581 50 2. Lloyds – Scottish Widows Fund (2000, €12.0 billion), Insurance company 52 115 20 37 4 73 77 226 3. Fortis – General de Bank (1998, Source: Thomson Financial, 2004 €10.5 billion).

Insurance companies/banks Table 3: Identified financial conglomerates in the EU, 2006 and institutions of capital market Country # Conglomerates Country # Conglomerates Insurance companies cooperate 1 Erste Bank 37 Delta Lloyd with investment funds within the 38 Eureko framework of the life insurance prod- Austria 2 GRAWE 39 ING uct, linked to the investment fund 3 Wuestenrot Netherlands 40 Rabo-Interpolis points/units (unit linked products). Cyprus 4 Universal Life Group 41 Robein They can be linked also to pension 5 Ceska pojistovna funds, because pension insurance has 42 SNS-Reaal 6 Cespo a lot in common with life insurance. Czech 43 VVAA Republic It requires from insurance companies 7 Petr Kellner 44 DnB-NOR to have enough knowledge to estab- 8 PPF Group 45 Jernbane-personalets lish a new pension fund, alone or in 9 Alm. Brand Norway 46 Sparebank1 Denmark cooperation with some other entity. 10 Danske Bank 47 Storebrand Cooperation of banks with invest- 11 OP Bank Group 48 Terra Group ment funds is much more common in Finland Agrupacion 12 Sampo 49 Europe (universal banking), but it has Mutua/Bankpyme spread also across the USA over the 13 ABN AMRO France Banco Bilbao 50 Vizcaya Argentaria last decade (liberalization). 14 Banque Postale Banco Santander Spain 51 IV. SITUATION IN FINANCIAL 15 Banques Populaires Central Hispano 16 BNP Paribas 52 Caja Madrid MARKETS France 17 Caisses d’Epargne 53 Caja Terrassa Development of inter and intra 18 Credit Agricole 54 La Caixa sectoral linkages in the EU 55 Laensfoersakringar 19 Credit Mutuel Financial conglomerates are usual- 56 Nordea 20 Societe Generale ly born through mergers and acquisi- 57 Resurs tions, leading to bankassurance or 21 Bank of Ireland 58 SalusAnsvar Sweden assur-banking. The size of these link- Ireland Irish Life 22 59 Skandia ages is given in table 2. and Permanent 60 SEB In comparison, in the USA acqui- 23 Gruppo Banca Intesa Svenska sitions with insurance companies as 61 24 Gruppo Carige Handelsbanken buyers were much larger, while with 62 Abbey banks as buyers much smaller than 25 Holmo 63 Barclays in the EU during this period. Non-do- Italy 26 Mediolanum 64 Cooperative Group mestic acquisitions were much small- 27 Monte Paschi Siena 65 HBOS er in the USA. 28 San Paolo – IMI 66 Hermes Critical question regarding finan- 29 Unicredito 67 HSBC cial conglomerates is their influence Julia Hodge Bank Hungary 30 OTP 68 on market concentration and thus on Great Group 31 Allianz competition. Thus, for instance, Britain 69 Liverpool Victoria among 30 members of the European 32 DEBEKA Group 70 Lloyds TSB Federation of National Insurance As- 33 DZ Bank Gruppe 71 Old Mutual sociations (CEA) Slovenia decreased Germany 72 Provident Financial 34 Inter Group concentration of life insurers (the 73 Prudential share of the first five in the market) 35 Munich RE Royal Bank of Scot- 74 Wuestenrot und land from 100% in 1992 to 94% in 2003 36 – still the second highest among all Wuerttembergische 75 Standard Life member countries. In concentration of Source: Mixed Technical Group on the Supervision of Financial Conglomerates: non-life insurers market concentration Identiﬁcation of ﬁnancial conglomerates, 24 April 2006

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The largest bankassurance groups 9. Credit Agricole (France) €563.3 Some countries do not have con- in EU-15 are: billion glomerates, some, as mentioned 1. Deutsche Bank (Germany) €917.7 10. Societe Generale (France) €512.5 above, did not yet complete their billion billion identification. 2. Allianz (Germany) €911.9 billion In April 2006, the Mixed Techni- Situation in Slovene 3. BNP Paribas (France) €825.3 bil- cal Group on prudential regulation ﬁnancial market lion for financial conglomerates established that there are 75 financial con- 4. HSBC Holdings (Great Britain) glomerates in the EU, without Bel- The number of financial institutions €778.6 billion gium, Greece, Portugal and Slovenia in the Slovene financial market has 5.ING Group (Netherlands) €705.1 being included in the list. They did decreased since1997. In 2001, mutual billion not capture their conglomerates. pension funds and pension compa- 6.ABN AMRO (Netherlands) €597.4 Some Austrian and French conglom- nies started to operate. The Slovene billion erates are also not included. Slovenia financial market is characterized by 7.Royal Bank of Scotland (Great is expecting to define them by No- relatively high concentration, which Britain) €590.0 billion vember 2006. is expected for a small country. The 8.Barclays (Great Britain) €573.5 The following table lists identified largest bank share in total assets was billion financial conglomerates in EU-25. 32% in 2004, while the largest insur-

Table 4: Structure of the Slovene financial system, 1997-2004

1997 1998 1999 2000 Total assets in SIT mn % in SIT mn % in SIT mn % in SIT mn % Central bank 597.719 17.0 618.700 15.4 677.177 14.8 768.889 14.6 Other financial corporations 2.2.028.266 57.7 2.354.613 58.7 2.686.744 58.8 3.195.182 60.7 Commercial banks 1.987.988 56.6 2.302.682 57.4 2.629.240 57.5 3.125.289 59.4 Savings banks 7.137 0.2 9.333 0.2 10.817 0.2 12.057 0.2 Savings and loans undertakings 33.141 0.9 42.598 1.1 46.687 1.0 57.836 1.1 Non-monetary financial corporations 886.429 25.2 1.038.323 25.9 1.206.247 26.4 1.299.074 24.7 Insurance companies 140.362 4.0 178.880 4.5 222.620 4.9 273.761 5.2 Re-insurance companies 32.453 0.9 38.406 1.0 41.938 0.9 48.061 0.9 Pension companies ------Mutual pension funds ------Authorised investment funds (PIDs) 526.303 15.0 576.908 14.4 599.165 13.1 566.937 10.8 Investment companies ------Mutual funds 2.814 0.1 4.368 0.1 8.821 0.2 10.737 0.2 Brokerage companies 16.063 0.5 22.003 0.5 39.017 0.9 23.177 0.4 Others 168.434 4.8 217.758 5.4 294.686 6.4 376.401 7.2 Total 3.512.414 100.0 4.011.636 100.0 4.570.168 100.0 5.263.145 100.0

2001 2002 2003 2004 Total assets in SIT mn % in SIT mn % in SIT mn % in SIT mn % Central bank 1.141.031 17.3 1.601.506 20.2 1.677.978 19.3 1.620.944 16.7 Other financial corporations 3.954.032 60.0 4.623.219 58.2 5.099.010 58.7 5.677.301 58.6 Commercial banks 3.876.768 58.9 4.556.637 57.4 5.033.805 58.0 5.644.744 58.3 Savings banks 14.889 0.2 15.006 0.2 19.661 0.2 26.693 0.3 Savings and loans undertakings 62.375 0.9 51.576 0.6 45.544 0.5 5.864 0.1 Non-monetary financial corporations 1.492.179 22.7 1.719.321 21.6 1.907.068 22.0 2.381.840 24.6 Insurance companies 336.945 5.1 441.051 5.6 522.554 6.0 610.594 6.3 Re-insurance companies 54.143 0.8 60.632 0.8 66.424 0.8 73.832 0.8 Pension companies 6.962 0.1 16.651 0.2 31.409 0.4 54.239 0.6 Mutual pension funds 38.655 0.6 38.890 0.5 48.755 0.6 72.508 0.7 Authorised investment funds (PIDs) 548.096 8.3 324.052 4.1 131.804 1.5 - - Investment companies - - 138.500 1.7 214.259 2.5 289.816 3.0 Mutual funds 14.686 0.2 55.422 0.7 93.118 1.1 210.149 2.2 Brokerage companies 19.936 0.3 22.826 0.3 21.459 0.2 23.040 0.2 Others 472.756 7.2 621.297 7.8 777.286 9.0 1.047.662 10.8 Total 6.587.242 100.0 7.944.046 100.0 8.684.056 100.0 9.680.085 100.0

Source: Financial markets 2006, Bank of Slovenia , Ljubljana, February 2006

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ance company share in gross premi- lion), which is 6.9% growth with transformation of investment compa- ums was 43%. Money institutions pre- respect to 2004. Non-life premiums ny Triglav Pillar 1 into mutual fund, vail among institutions in the market. increased by 5.3% in that period, which became the largest among Among non-monetary institutions in- life premiums by 10.7%. all of them. surance companies are the strongest c) Market of supplementary insur- In September 2005 13 manage- with 29% among them, followed by ance for retirement (third pillar) is di- ment companies managed 44 mutu- investment companies with 12% and vided among mutual pension funds, al funds. The largest share belongs mutual funds with 9% share. insurance companies and pension so- to Triglav Pillar 1 and KD Galileo. Formation of financial pillars is be- cieties. Additional pension insurance Total assets of mutual funds totalled coming important. They are expected was offered by 7 mutual funds, 4 pen- 300 billion tolars (€1252 million), to link banks, insurance companies sion companies and 2 insurance com- which is a 43% increase in compari- and other financial institutions. Finan- panies at the end of 2004. son to 2004. Without the transfor- cial pillars are heterogeneous finan- Four pension companies control mation of Triglav Pillar 1, the in- cial groups, but not necessary finan- almost half of the market of supple- crease is still 13%. cial conglomerates yet. mentary pension insurance. e) There were 33 mandatory par- In 2005, the Slovene financial Among 7 mutual pension funds ticipants (brokers) on the stock ex- market consisted of: the leading role goes to Kapitalska change, of which 18 banks and 15 – 20 banks, among them two for- družba, d.d. (Pension Fund Manage- stockbroker houses. Their number eign subsidiaries, 2 savings banks increased from end-2004 by 4. and 2 savings and loan undertakings; In mid-2005 the total value of in- – 13 insurance companies, two vestments of mandatory participants foreign subsidiaries and 2 reinsur- Number was 2109 billion € (8800 million €) ance companies; at the end of 2005, 4% decline in – 4 pension companies, 7 mutual of insurance comparison to the end of 2004. pension funds managed by banks, Broker houses increased their invest- insurance companies, ments by 7%, but banks decreased – 8 investment companies and companies theirs by 12%. 79 mutual funds, managed by 15 management companies doubled Financial groups – 18 brokerages and 11 banks that participate on stock exchange. There are many financial groups in Slovenia operating in Slovenia, most of them Individual ﬁnancial institutions in banking. between 1991 1. NLB group: parent Nova a) The banking sector is com- Ljubljanska Banka plus 58 financial posed of banks, savings banks and and non-financial entities, at home savings and loans undertakings. Total and 1997. and abroad assets of the banking sector account 2. NKBM group; parent Nova for 58.7% of total assets of the finan- Kreditna Banka Maribor plus 13 cial sector. Within the banking sector, ment with an 88% share. It manages financial and non-financial entities, 99.4% of assets belong to banks. The two mutual funds, of which the fund at home and abroad. number of banks is decreasing, while for public servants has a 46% market 3. Banking Group Abanka Vipa the market concentration increasing. share. 4. Gorenjska Banka with shares in b) There are 13 insurance compa- Supplementary pension insurance 15 other financial and non-financial nies, 2 foreign subsidiaries, Kapital- is increasing. In September 2005, companies ska družba, d.d. (pension insurance), 464,376 insured persons were in- 5. Probanka group: with 6 finan- Fund for Craftsmen and Entrepre- cluded in additional voluntary insur- cial companies, neurs, 2 re-insurance companies, 4 ance schemes. This is an increase of 6. Bank Austria Creditanstalt is pension associations and 7 pension 3.5% in comparison to 2004. The subsidiary of BA-CA Vienna and thus funds. largest share goes to mutual funds member of banking group HVB from Seven out of 13 insurance 3 com- (54%), of which the First Pension Germany panies are composite insurers offering Fund accounts for 41%. 7. Banka Koper belongs to San- both life and non-life insurance, two d) At the end of January 2006, paolo IMI Group, and has an open- are only in non-life business, two only investment funds were managed by end mutual pension fund in health insurance and two sell only 14 management companies, with as- 8. BAWAG bank is in 100% own- life insurance. sets value of 512 billion tolars (€2137 ership of BAWAG group, Austria, The number of insurance companies million). 10 investment companies 9. Hypo Alpe-Adria Group in doubled in Slovenia between 1991 were managed by 9 management Slovenia consists of Hypo Bank and and 1997. After that, consolidation companies, with NFD having the Hypo leasing and Hypo consultants started: the last merger was between highest 30% share. Their total assets and represents sub-group of Hypo Adriatic and Slovenica insurance were in September 2005 212 billion Alpe-Adria Group from Austria. companies. In 2005, insurance tolars (€885 million), which is 27% 10. Raiffeisen Krekova Banka is companies collected for 371.4 billion decline in comparison to the end of member of Raiffeisen Zentralbank tolars of gross premiums (€1548 mil- 2004. The main reason for decline is Group (RZB), Austria.

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11. SKB bank is in ownership of ments, brokerage house, consulting, European market. At the same time, Societe Generale (SG) Group, France pension society, real estate company the Slovene financial institutions will and has two subsidiaries: SKB Leas- and management company in Nether- continue their penetration of East and ing in ALD Automotive and enterprise lands. South European markets. PLASIS for payments systems. 6. The Perspektiva Group includes 12. Volksbank – Ljudska Banka is a brokerage company and a man- V. CONCLUSIONS in majority ownership of Volksbank In- agement company. ternational AG with seat in Austria. 7. Holding Publikum includes a Positive developments in financial The remaining banks do not have brokerage company, a management market (deregulation, increasing and banking group created (Factor company and auxiliary companies changing demand) stimulate intra or banka) or they are included in other Publikum Fin and Publikum tresor inter-sector linkages of financial insti- financial groups (Deželna banka). It is expected that at the start in tutions. This leads to financial univer- One bank is in the process of liquida- November 2006 only two financial salism. Intra-sector linkages present tion. groups will be qualified as financial horizontal integration with economy conglomerates: Triglav Group as fi- of scale as the main motive. Ade- Insurance groups nancial conglomerate and KD Group quate sector laws regulate homogene- as mixed financial conglomerate. ous financial groups. 1. Insurance company Triglav The largest financial group NLB bank But cross-sector linkages lead to Group: parent plus 15 financial creation of large and complex finan- companies at home and abroad. cial institutions (LCFI), for which econ- 2. Reinsurance company Sava omy of scope and other motives are with shares in two domestic insurance In the future, important. For them additional super- companies Tilia and Maribor and in vision is needed. In the EU they are reinsurance company Helios in already regulated through special Croatia, in addition the group also inter-linkages Directive on financial conglomerates. includes Moja naložba, a pension In the future, inter-linkages among company. among financial financial institutions in financial sector 3. Insurance company Maribor will continue. group is member of financial group Further consolidation and conver- NKBM bank and at the same time institutions gence is expected. As banks are los- subordinated company in Sava ing monopoly in collecting savings, group. It has shares in 6 other finan- in financial they need to expand into insurance cial companies. and capital market institutions. 4. Until merger in 2005 the insur- Additional cost cutting measures ance company Adriatic Slovenia ex- sector will will be needed. isted. In a small country as in the case 5. Generali Ljubljana is a subsidi- continue. of Slovenia, financial institutions will ary of parent Generali from Vienna. needed to specialize or to get inter- 6. Insurance company Grawe is connected with larger institutions in a subsidiary of parent Grawe from does not fulfil the condition of the size the EU, or, to increase their size by Austria. for its life insurance company Vita. expansion into East European mar- 7. Merkur insurance company be- Current consolidation and conver- kets, as domestic market is too small longs to parent Merkur from Austria. gence of financial institutions in Slove- for the minimum required size to sur- nia leads to their declining number vive as independent institutions. Groups on capital market (which halved between 1997 and They will be two opposite trends 1. KD Investments is the largest 2003, from 222 to 120) and this in Slovenia’s financial sector : merg- group on capital market, included in trend is not yet completed. ing of existing institutions, which will KD group. It includes 28 financial In difference to banking, the decrease possibility of cross-owner- and non-financial entities at home number of institutions in insurance re- ship within financial sector as a way and abroad. mained more or less constant during to retain control over financial institu- 2. Holding Activa invest consists this period. Only few new institutions tions. Life insurance undertakings of four financial companies. from abroad entered the market, but have great potential for development 3. The international network of their share remained small. Some de- in Slovenia (as in all other transition the Ilirika Group consists of compa- cline happened in 2005 with division countries). nies in Slovenia, Croatia, Bosnia and of composite insurance companies In addition to intra-sector consoli- Herzegovina, Serbia, Montenegro, into two parts (life and non-life) at the dation, which is already well ad- Macedonia and Romania. same time. vanced in Europe all around the 4. The Medvešek Pušnik Group The Slovene financial market will world, the model of cross-sector link- consists of three specialized compa- experience further rationalization, as ages is already affirmed, especially nies: stock broking house, manage- well as cooperation and linkages with in the EU. Thus, development of finan- ment company and corporation advi- foreign financial institutions, especial- cial integration already covered all sor. ly from EU-15. The final solution will phases: 5. The Poteza Group is a holding be either total integration or full spe- 1. distribution contracts (“cross- enterprise, consisting of Poteza invest- cialization, to remain competitive on shareholding”),

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2. parent– daughter relation – es. Reasons for that are in fact that Ljubljani, Ekonomska fakulteta, Ljubljana subsidiary, the inclusion of Slovenia into Euro 2004. 3. holding arrangement, and region will: 11. Genetay, Nadege, Molyneux, Philip: 4. LCFI – financial conglomerates – decrease transaction costs stem- Bancassurance, Macmillan Press Ltd, London,1998. (including full integration of back-of- ming from exchanges of currencies fice activities, IT systems and distribu- (within EMU), 12. Gliha, Urška: Model bančnega zavarovalništva, Bančni vestnik (2005), št. 6. tion channels, etc.) – decrease foreign exchange Selection of the best institutional rate risk, 13. Hodošček, L.: Finančni konglomerati s poudarkom na bančnem zavarovalništvu, form of common additional supervi- -improve international rating of magistrsko delo, Ekonomska fakulteta v sion of LCFI is not yet made. The ques- Slovenia and consequently rating of Ljubljani, Ljubljana, 2005. tion is should it be one united supervi- all institutions (including financial) 14. International Bank for Reconstruction and sory unit for all types of financial insti- with the head office in Slovenia. Development, World Bank, International tutions within financial group or many But, due to the small size of the Monetary Fund: Financial Sector Assessment, supervisors with one having coordina- Slovene financial market and not es- Washington, 2005. tion mandate? pecially advantages position of the 15. Kuritzkes, Andrew, Schuermann, Til, BIS II for banks and Solvency II Slovene financial institutions in mar- Weiner, M. Scott: Risk measurement, Risk for insurance companies will bring kets of other countries (notably the Management and Capital Adequacy in Financial Conglomerates, Brookings- new additional tasks to management Eastern Europe and Western Balkans Wharton Papers on Financial Services, of LCFI and their supervisors. Special no foreign institutions “invasion” of Washington, 2002. regulation of new solvency standards Slovenia is to be expected. They 16. Mixed Technical Group: Identification for LCFI will be needed. Future devel- could come in the form of individual of financial conglomerates. opment will be result of power strug- greenfield investments, contractual 17. Morrison, A. D.: The Economics of gle between goals of supervisors to business linkages or capital inter-con- Capital Regulation in Financial increase supervision (and security), nections with mergers and acquisi- Conglomerates, University of Oxford, and goals of regulators (Govern- tions as their ultimate phase. Oxford, 2002. ments) to liberalize use of capital and 18. Ribnikar, I.: Medsebojno in navzkrižno that way increase its economic effi- CITED LITERATURE AND RESOURCES: lastništvo v finančnih institucijah, Bančni vestnik, Ljubljana, 2002. ciency and growth. 1. Agencija za trg vrednostnih papirjev: Impact of the Slovenia’s member- Poročilo o stanju na trgu vrednostnih papirjev 19. Ribnikar, I.: Monetarne finančne ship in the European Monetary Union v letu 2004. Ljubljana, 2005. institucije (MFI), Bančni vestnik, Ljubljana, 2002. Slovenia’s membership in the EU 2. Ayadi, R.: The Future Of Insurance Regulation And Supervision In The EU: New in May 2004 had significant conse- 20. Sterzynski M.: Capital solvency and Developments, New Challenges; CEPS, June supervisory requirement on the European quences for its regulation of financial 2006. Single Insurance market– the Solvency II sector and for its cross-sector and 3. Banka Slovenije: Finančni trgi, Januar Project, Ljubljana, February 2005. cross border– integrations. All the EU 2006, Banka Slovenije, Ljubljana, 2006. 21. Sterzynski M.: Development of cross Acquis Communautaire has been 4. Bank of International Settlements: sectoral capital linkages in EU, mimeo, transposed into Slovenia’s body of Supervision of Financial Conglomerates. Ljubljana, 2005. legislation, including the normative Basel, 1999. 22. Štiblar F. : Financial Conglomerates and framework for financial sector. 5. Benkovič, Matej: Skupni nadzorni organ EMU, Banking Newsletter, Ljubljana 2005. On contrary to that, Slovenia’s nad finančnimi institucijami v Evropski uniji, 23. Štiblar, F.: Povezovanje finančnih entry into Economic and Monetary Bančni vestnik (2005), št. 10. institucij in varnost njihovega poslovanja, Union (EMU) in 2007 is more a tech- 6. Borak, Neven: Bančne direktive Evropske s posebnim ozirom na banke, Bančni dnevi, 2005. nical question, after pre-conditions in skupnosti. Ljubljana, Zveza ekonomistov Slovenije, 1996. the form of Maastricht criteria are ful- 24. Štiblar F., Šramel F.: Solventnost II in filled. It will have little normative con- 7. CEPS: The New Basel Capital Accord and slovensko zavarovalništvo, GG, EIPF, the Future of the European Financial System, Ljubljana, julij 2005 sequences. Brussels, 2004. But certain positive consequences 25. Thompson, A. Arthur, Strickland, A.J.: 8. CEPS: EU Financial regulation and Strategic management – concepts and cases, are expected for functioning of finan- Supervision beyond 2005, Brussels, 2005. Singapur, McGraw-Hill Book Co, 1999. cial market, including linkages among 9. European Commission: White Paper on 26. Veselinovič, D.: Slovenski finančni trg in financial institutions. The new mem- Financial Services Policy (2005-2010). EU, Bančni vestnik, Ljubljana, 2004, št. 5. bership in “Euroland” can increase 10. Filipčič Marko: Finančni posredniki v 27. Završnik, Neža: Finančni konglomerati, integration in the Slovene financial Zruženih državah Amerike, v Evropski Uniji diplomska naloga, Pravna fakulteta v sector, especially cross-border linkag- in Sloveniji, magistrsko delo., Univerza v Ljubljani, Ljubljana, 2006.

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UDC 339.923:336.7:061.1 EMU Financial Deepening and Financial Integration of New EU Countries Fabrizio Coricelli *

New European ne of the distinguishing features of the New European Union members and candidate countries members (NEU) and of countries candidate to entry have made significant progress in deepening the EU in 2007 is their low level of financial depth, their financial markets. However, the measured by the ratio of bank credit to GDP and by experience has been mixed. Countries with O stock market capitalization to GDP. However, both credit and currency board or entering EMU more stock markets increased rapidly in recent years, although with quickly have shown the most significant improvements. sharp differences across countries. Is the presence of shallow Entry of foreign banks and cross-border flows financial markets a cause for concern? Or, alternatively, is the have also been a powerful engine for rapid growth of credit, the so-called credit boom, a cause of accelerating financial development. concern? Or, finally, should not one be concerned as the contin- Nevertheless, these external forces have uing process of integration with the EU-15 will ensure that NEU been complementary rather than substitutes will have access to the same financial markets as the other EU of the development of domestic markets. members states? Not only the rate of real convergence to the incomes per capita of richer EU countries is negatively affected by underdeveloped financial markets, but also the transmission of monetary policy for those countries that are entering the Eurozone is likely to work less effectively in countries with shallow financial markets. Financial integration may help reduce the adverse effects of shallow domestic financial markets, but should not be considered as a substitute for the development of domestic markets and for further reforms in institutions that would ensure deeper and more efficient financial markets. Section 2 reviews recent development in financial markets in NEU countries. Section 3 discusses the dynamics of financial integration of NEU. Section 4 concludes.

* Fabrizio Coricelli, University of Siena, University of Ljubljana and CEPR

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Financial markets What can we infer from such ing in total lending to the private sec- in New European Union and country variation in the dynamics of tor remains quite small, if compared candidate countries credit? Looking at the countries in to more advanced market economies. which credit has increased more, we The growth in household loans ap- Financial markets in NEU coun- note that they have all opted for a pears largely driven by supply fac- tries remain shallow, as indicated in currency board arrangement, or have tors, with foreign banks being particu- Table 1, even though in recent years entered ERM II, like Slovenia or are larly aggressive in this market. The there has been an impressive increase mimicking ERM II, like Hungary. rapid growth of household loans have 1 in both credit and stock markets . Countries that have opted for more raised concern about the risks, both in terms of macroeconomic imbalanc- Table 1: Domestic credit to private sector and stock market capitalisation, es and of excessive risk taking in the 2005 (in per cent of GDP) financial sector. Even though in terms of GDP credit to households remains Domestic credit to private sector Stock market capitalisation rather low in most NEU, it should be taken into account that, in terms of fi- 2000 2005 2000 2005 nancial wealth, the ratio is much high- Latvia 16.9 60.1 7.4 17.4 er, ranging from a low of 21 percent Estonia 24.0 60.0 32.4 26.5 for the Czech Republic and to a high of 46 percent for Croatia, whereas in Lithuania 11.4 35.1 13.9 31.8 the Eurozone the average is about 25 Hungary 30.1 51.1 25.8 31.9 percent.2 This has implications for the Croatia 36.0 55.6 14.5 35.2 assessment of credit risk. Indeed, a Slovenia 35.8 53.8 13.6 23.8 high ratio of debt to financial wealth implies that households may incur re- Bulgaria 12.6 44.5 4.8 20.1 payment difficulties in the event of Romania 7.2 10.2 3.4 22.3 negative shocks to their incomes, as Poland 26.6 27.8 17.9 31.6 households cannot use their financial Slovak Republic 51.3 36.2 3.5 9.5 wealth to service their debts. Another Czech Republic 49.9 37.6 19.3 31.8 source of risks is due to the large share of loans denominated in for- European Union 74.4 85.8 78.7 67.0 eign currency. The share of foreign Source: World Bank

New member states display Table 2: Domestic credit to households and mortgage lending (in per cent) greater financial depth than candidate countries, with the exception of Average 2000-2005 Croatia. The financial sector in NEU Domestic credit to households Mortgage lending to households continues to be mainly bank-based, Share in domestic Share in domestic even though stock market capitaliza- Share in GDP credit to private Share in GDP credit to private tion has sharply increased as a sector sector percentage of GDP. Turning to the CEB 10.1 31.5 5.2 15.7 dynamics, during the period 2000- SEE 19.5 47.0 6.3 13.4 2005 credit markets have grown very CIS 1.4 15.8 0.5 5.1 rapidly. The Central-Eastern European countries have narrowed the gap with Source: EBRD, Banking survey data the European Union. The rate of growth of credit to the private sector, flexible exchange rate regimes, such currency loans in total loans to house- in terms of GDP, has been spectacu- as the Czech Republic and Poland, holds is particularly high in the Baltic lar in Estonia and Latvia, followed by have seen stagnating credit markets. countries, in Croatia, in Romania and large increases in Hungary, Croatia, Within credit aggregates, credit to to a lesser extent in Poland. For Lithuania, Slovenia and Bulgaria. The households has been the most dynam- Croatia, however, there is little curren- Czech Republic and Slovakia actually ic component in the overall increase cy mismatch in the asset-liability posi- show a decline in credit ratios in the in bank loans. During the period tion of banks, as a large share of period 2000-2005 and that is attrib- 2000-2005, the rate of growth of household deposits are denominated utable to the writing off of bad loans household credit as a proportion to in foreign currency. However, this from banks’ balance sheets. In any GDP has been high throughout the re- does not completely insulate house- event, until 2005 they display very gion and much higher than the holds from exchange rate risk, as low ratios of credit to GDP. In Poland growth of loans to enterprises. As a households with foreign currency and Romania credit-to-GDP ratios result, the share of household loans in loans are not necessarily the same as marked only a small increase. total loans has sharply increased. those that have foreign currency de- Table 2 also indicates that mort- posits. In the event of a currency de- 1 Corporate bond markets do not exist in most transition countries or are very small in those gage lending has been growing valuation the debt burden for indebt- where they exist. at a fast pace in recent years. Never- ed households will be adversely af- 2 Coricelli et al. (2006) theless, the share of mortgage lend- fected by the risk of insolvency. For

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the Baltic countries, the currency Figure 1: Financial integration (Fin. Assets+Fin liabilities)/GDP board insulates the financial sector and the borrowers from currency risk. Thus, the risks appear larger in Roma- nia and Poland that are still subject to possible wide fluctuations of their exchange rate. In summary, financial markets in general and credit markets in particular remain shallow in many transition countries. However, there has been clear increase in financial depth over the past five years. Indeed, recent rapid rates of growth of credit aggregates, in countries like Bulgaria, Hungary and Romania, have raised concerns over stability and risk-taking. High growth rates of credit aggregates, even if welcome from the point of view of the long-term development of transition Figure 2: Stock of foreign loans to non-bank economies, might create short run private sector, % of GDP risks of financial and balance of payments crises. Rapid growth of credit has been found to be a good predic- tor of balance of payments and financial crises, even though most episodes of rapid credit growth do not end in a crisis. Evidence from the transition countries has found a significant and large effect of the increase of credit on the external accounts, especially the trade balance.3 For a subset of transition countries, belong- ing to the CEB and SEE regions, during the period 2000-2004 it has been found that only in three out of ten cases of observed credit booms was there an associated consumption boom, as in Hungary in 2003 or Ro- stock market indices and interest Financial integration can take the mania in 2003-20044. Therefore, al- rates, both short-term and long-term, form of foreign direct investments, though in some cases credit growth in NEU and relevant partners, such as portfolio investments and loans. FDIs can be considered excessive from the countries of the Eurozone. These and direct loans from foreign banks point of view of financial and macr- measures are affected by different li- play a significant role in many NEU. oeconomic risks, in most cases the in- quidity of markets across countries Direct lending through cross-border crease in credit-to-GDP ratios has and thus do not provide a significant flows is important for several NEU reflected an equilibrium tendency perspective on financial integration. (Figure 2). The share of foreign loans toward higher financial deepening. More relevant appear quantity meas- in total domestic credit, a measure of ures, that refer to the gross financial integration of the domestic with for- Financial integration flows of a country, or in some cases eign markets, is particularly high in to the gross stocks of foreign assets Slovenia, characterized by high ratios Problems in developing domestic and liabilities, in terms of GDP.5 Fig- of domestic credit-to-GDP, as well as markets could in principle be over- ure 1 shows that financial integration, in Slovakia, which has a low ratio for come by accessing foreign markets, measured in terms of gross stocks of domestic credit. As we will show or allowing entry of foreign actors foreign assets and liabilities, has sig- below, it appears that Slovenia substi- into the domestic market. NEU had to nificantly increased in NEU during the tutes with direct borrowing from for- open their capital account of the bal- period 2000-2005. Except for Slove- eign banks the presence of foreign ance of payments as a pre-requisite nia, we also note that countries that 3 for entry the European Union. Thus, expanded more domestic credit mar- Coricelli et al. (2006), and Duenwald et al. (2005) provide evidence of such effect. de jure they are countries fully open kets are those who have increased 4 Both credit and consumption boom are to foreign participation. their degree of financial integration. deﬁned as large (greater than 1.75 standard Financial integration can be meas- Therefore, it appears that internation- deviations) deviations from the trend of the variables. These booms represent exceptional ured in several ways, including price al financial integration is a comple- realization of both consumption and credit (see and quantity measures. Price meas- ment rather than a substitute for the Coricelli et al. 2006). ures focus on correlations between development of domestic markets. 5 See Lane and Milesi-Ferretti (2006).

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banks in their domestic market, while the case of Slovenia we have already ing the ERM II systems (Hungary). for most other countries cross-border noted that relevance of direct borrow- By contrasts, countries that have loans complement domestic markets. ing from foreign banks. In addition, retained flexible exchange rates have This seems to apply especially to it is possible that the level of institu- shown much slower progress in finan- Estonia and Latvia. tional development in Slovenia is suffi- cial deepening. Whether this would In addition to the variables dis- ciently high and thus the low share of prove a constraint in their real growth cussed above, one striking feature assets owned by foreigners might not or whether it will protect them from of NEU and candidate countries has hinder the functioning of credit mar- potentially volatile financial markets been the rapid growth in the pres- kets. However, one should also take remains to be seen. However, at this ence of foreign banks. With the ex- into account the effects of foreign stage it seems that deepening of the ception of Slovenia, in NEU foreign bank entry on the level of competition financial sector could play an impor- banks account for a dominant share in the domestic banking sector. tant role in accelerating real conver- of assets in domestic markets. Foreign gence to richer EU countries. Conclusions banks can introduce into the host country the skills and the range of In summary, it seems that the small REFERENCES: services that prevail in the country of size of most new EU member states 1. Coricelli, F., Mucci, F., and Revoltella, D. origin and thus apply a more efficient has made foreign banks dominant (2006). »Household Credit in the New banking technology.6 However, for- players, either through loans from Europe: Lending Boom or Sustainable abroad or through entry in the domes- Growth?,« CEPR Discussion Papers No. eign banks – particularly greenfield 5520. ones – tend to have poor information tic market. In most cases this has contributed to accelerating the growth 2. Duenwald C, Gueorguiev N, Schaechter on local borrowers, especially small A (2005): Too Much of a Good Thing? firms and may restrict their lending to of domestic markets. Credit Booms in Transition Economies: larger firms, often branches of multi- In addition, in recent years there The Cases of Bulgaria, Romania, and national firms. All in all, it appears has been a very rapid increase in Ukraine, IMF Working Papers, June. that in new EU member states entry of financial depth, especially through 3. Giannetti, M., and Ongena, S. (2005), foreign banks has fostered the devel- credit markets. This phenomenon has “Financial Integration and Entrepreneurial Activity: Evidence from Foreign Bank Entry opment of domestic credit markets. In affected especially small countries, such as the Baltic States and Slovenia in Emerging Markets”, CEPR Discussion Paper Series, 5151. 6 Financial integration may be a powerful force and, to a smaller extent Bulgaria and increasing competition in local financial markets Hungary. All these countries share an 4. Lane, P. R. and Milesi-Ferretti, Gian Maria (2006), “The External Wealth of Nations and limiting the role of connected lending, exchange rate regime that is either related to loans allocated because of political Mark II: Revised and Extended Estimates of influence and monopolistic positions of firms based on a currency board or the Foreign Assets and Liabilities, 1970-2004”, (Giannetti and Ongena 2005). participation in (Slovenia) or mimick- IMF Working Papers, No. 06/69.

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THE CASE OF SLOVENIA

UDC 33:336.7(497.4)) Slovenian »Transition« and Monetary Policy Ivan Ribnikar *

At the begining of here are at least two reasons why it makes sense to transition there was nothing to be privatized. link the Slovenian »transition« and monetary policy in There were nonfinancial business enterprises to be Slovenia, i.e. monetary policy conducted by the Bank trasformed from socially owned into simply owned of Slovenia (the BoS). A characteristic of the economic either privately or by the Government. How we Tsystem from which Slovenia’s economy had to develop was a came to nonfinancial business enterprise, special or unusual interconnection between (non-financial) enter- banks and insurance institutions, we have prises and banks, and via banks with the monetary policy. The today, and how, nevertheless, the room first two chapters address the particularities of an economic sys- has been found for experts on privatization, tem based on social ownership of non-financial business enter- is explained in the first part of the paper. prises, and the role of banks in such a system. It would probably Even at the beginning of transition the economy be appropriate to disentangle this unusual relationship between was not ruined but functioning and non-financial enterprises, banks and monetary policy the same therefore not any monetary arrangement way they were created, however, there is another raison d’être was suitable. In the second part of this interconnection. The monetary system and the monetary monetary system, introduced in October policy since October 1991 have not only been determined by the 1991, is explained. Base money has been created small size of the tolar area and by the fact that Slovenia was a mostly via purchases of foreign exchanges within transition country, but also by the fact that the economy was not a managed floating exchange rate regime. in such a bad shape as other transition economies. Taking into The Bank of Slovenia (BoS) has been absorbing account these conditions, not all possible solutions were accepta- surplus liquidity, created via those purchases, by ble, for instance a radical approach in the form of a currency issuing and/or selling to banks short-term bills. board or some of the other extreme monetary arrangements. The If we put aside a lot of important details, these third chapter looks at how the ownership transformation of busi- are two most important activities of the BoS. ness enterprises should have been done, and how it was done. In the fourth chapter we analyse the monetary system in Slovenia after October 1991, defined by the exchange rate regime and the exchange rate policy. The fifth chapter deals with the structural position of the money market, instruments of monetary policy,

* Dr Ivan Ribnikar, Professor at the Faculty of Economics of the University of Ljubljana

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and monetary policy. Finally, the sixth was a utopic economic system, which Nevertheless, in this case, as in chapter deals with the end of the short was only discussed in 1984 (Ribnikar, many other cases with important deci- history of the tolar and the BoS as an 1984) and then in more detail by Rib- sions (for example Gorbachev proba- independent central bank. nikar (1989 and 1994). An enterprise bly did not know what was going to cannot come to life and generally happen), it was good that it was not 1. Characteristics cannot grow if there is no inflow of known or was not clear what it was of the Slovenian economy permanent funds in the form of equity all about, namely the introduction of before »transition« capital. What would be the bank ac- a utopic economic system. An impor- count number of such an enterprise? tant dimension was that the centrally Of course in general the charac- There is of course no address and no planed economic system with state teristics analysed in the paper ap- bank account number, and thus we ownership was abolished, and that plied to all countries of the former Yu- can say that everyone implicitly count- the high growth rates that followed goslavia, but one had to keep in mind ed on altruism of people and/or insti- were not the result of the new that the Slovenian economy also had tutions. If someone had been so kind economic system but the result of the some particular characteristics, most to permanently transfer his funds to abolition of the non-utopic economic of which did not stem from the eco- the enterprise, then these funds would system with state ownership. nomic system itself. have become funds of the enterprise. The key element that determined It was a utopia. 2. Economy with social the role of banks, the monetary sys- ownership of non-ﬁnancial tem and the monetary policy, was the enterprises; banks so-called “social ownership”. When and monetary policy talking about social ownership we al- It was crucial ways think of non-financial enterprises It was straightforward to transform because, as we will see later, there by means of a decree all state-owned was no social ownership of banks to abolish enterprises into socially owned enter- and insurance companies. Social prises and to elect the so-called work- ownership was introduced at the be- social ers’ boards (“delavski svet”). But the ginning of the 1950s when it was be- functioning of the new system was coming clear that the central planning ownership not so straightforward. Under the as- model of the economy together with sumption that nowhere there are state ownership could not be the ap- many altruists, the normal source of propriate model for a socialist econo- and introduce inflow of permanent funds into enter- my in a multi-national country, in prises was closed. In particular, no which there is no dominant nation. either private new enterprises could have been This view was further strengthened created. But as the existing enterpris- by the break-up with the Soviet Union. es have to grow and new enterprises However, as the new economic or state have to be established, the economy, system still had to be based on social- which always finds a way around, ism, the logical alternative of a mar- ownership had to find a way out. ket based economy with private The way out was obvious. These ownership, i.e. capitalism, could not were bank loans. It looked perfectly be the alternative. The result was of non-financial normal for banks to finance enterpris- the “third” economic system with the es with loans, as this is the case else- key characteristic that the owners of enterprises. where in the world in the so-called enterprises were neither private bank based economies. However, the persons nor the state. size of the financing needs of enter- It was relatively easy to find the The owner of a company had prises was such that the situation raison d’être of the new (third) eco- control over it, but in an enterprise was completely different from other nomic system for all those who did with social ownership this could not countries. not know much about the economy. be the case. The control can be exer- Since there was no other option The owner of enterprises was the cised by someone on behalf of the for external financing of enterprises society. The social ownership was society. The closest to this role were other than with bank loans, funds born. In contrast to capitalism, where employees or workers, and hence the could not have come into enterprises owners of enterprises are mainly expression “delavsko samoupravljan- as permanent funds, and the financial private entities, and in contrast to the je”. The English translation “workers’ structure of newly established enter- central planning system, where the self-management” caused confusion prises or enterprises which have done state owns enterprises, in the new because there was in fact no connec- large investments, was unusual. The third economic system the society tion to self-management by workers share of loans, which were not really acts as the owner. in its proper sense. The extensive liter- long-term loans, was 90% and more. If people with solid background ature on workers’ self-management This solved the problem of establish- in economics and finance had had a contributed to this confusion. Enter- ing new and enlarging existing enter- say, there would probably not have prises of course had a professional prises. However, this solution brought been social ownership. They could “management”. However, such an en- about the problem of servicing of have shown that social ownership terprise could not have come to life. debt. Enterprises with loans account-

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ing for 90% or more of their balance decline foreign currency deposits, have ended differently than by ever sheet could not service their debt, but at the same time they could not increasing bad loans on the assets even if they were viable enterprises extend foreign currency loans. More- side of the balance sheet and/or with a solid performance. They simply over, interest rates for foreign curren- companies not taking new debt and did not have enough cash flow. Enter- cy loans had to be negative in real not investing. No solution could be prises were supposed to repay bank terms. fund within the framework of social loans as soon as possible because The central bank had been ownership. This was formally ac- workers’ self-management should maintaining a normal habitat for knowledged by a law on enterprises not have been based on bank loans. functioning of socially owned enter- passed in 1988, which enabled a Problem with debt servicing was prises by means of an adequate permanent participation of (private) particularly pressing for newly created inflationary policy. The government entities in the funds of enterprises. enterprises, despite the fact that they sanctioned the re-distribution of This law could be seen as the start of had new technology and low produc- wealth in favour of bank debtors transition if the former Yugoslavia, tion costs. also for loans extended on the basis which continues – with some breaks – If prices had been administratively of foreign currency deposits. The as the Slovenian transition, in which set, then enterprises could have al- government recognised loses stem- we are interested in this paper. ways asked for an increase of prices ming from foreign currency deposits, as these was seen as “justified” be- resistant to inflation, and loans in 3. Ownership transformation cause of the way they were financed. of business enterprises This was one of reasons, although not formally scientifically justified, which Before transition there were three had been for a prolonged period of Up to the types of ownership of enterprises. time causing such inflation that nomi- Non-financial enterprises were, as nally positive bank interest rates were already discussed, socially owned. in fact negative in real terms. As inter- introduction Banks had their owners, at first only est rates had been barely tolerated the so-called social legal entities, by the authorities, the nominal interest of the euro the primarily non-financial enterprises. rates of course could not have been Insurance companies were mutual high. Inflation was reducing the bur- institutions. The principle of mutual den of debt and enabled enterprises BoS will not ownership did not apply for individu- a relatively easier servicing of their als and private legal entities. debt. be able to It was crucial to abolish social The result was an inflationary ownership and introduce either pri- environment as the normal habitat for repay all vate or state ownership of non-finan- socially owned enterprises. Of course cial enterprises. Banks had been not because of inflation, but because changed into share companies al- of the redistribution of wealth from short-term bills ready at the time of the former Yugo- lenders (banks) to debtors (enterpris- slavia by a simple decree (or a near es), which implied that there could and bank decree), as it had been the case with not have been any indexation of bank transforming state enterprises into so- loans. Because it was abnormal that cially owned enterprises in the 1950. enterprises could not increase their deposits. The value of banks had not been es- permanent funds, this inflationary en- tablished and no account was taken vironment, abnormal for an economy, for the fact that former owners had became normal. Enterprises could in- domestic currency, exposed to ero- been liable for banks’ liabilities with crease permanent funds, which had sion due to inflation, as public debt. all their wealth. Insurance companies different names, by means of infla- The cause of the inflationary could have stayed mutual companies tion, which had been transforming monetary policy was through this – all insurance takers would need to loans into gifts. As this could not have chain of connections the social own- have been recognised as mutual own- been done on the basis of the ership. Social ownership did have ers, but they had been transformed economic interest of investors, it had an important function as it enabled into shareholder companies. This hap- to be achieved by forcing the lender the abolition of the state ownership pened already in the independent to change a part of its loan into a gift and the central plan based economy, Slovenia or just before the independ- via negative real interest rate. This is but it could not have been an eco- ence, but it had not been done the the “second best” outcome. nomic system to last. same way as elsewhere, i.e. no proc- As long as banks had extended The experiment of having normal ess of demutualisation took place. domestic currency deposits, they were financial environment through indexa- As shown in Figure 1, Slovenia merely an intermediary in transferring tion of bank deposits and loans, and originally did not have enterprises funds from their savers to their bor- at the same keeping the social owner- which would have been state owned. rowers. When foreign currency de- ship – for many, especially those who For this reason the issue of privatisa- posits were introduced, banks were knew the Western economy and who tion was not important at the begin- facing increasing loses because they studied abroad, the problem of the ning of transition. As to the non-finan- were forced to take excessive foreign Yugoslavian economy was only the cial enterprises, their privatisation be- currency exposure. Banks could not negative real interest rates – could not came an issue only for those enter-

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Figure 1: Three types of business enterprises that existed before sales in a significantly shrunk domes- the transition started tic market. Despite the aforementioned new rich people Slovenia faced much lower social differences then other countries in transition. The social cohesion remained solid. The process of setting up a monetary system and a monetary policy has taken course in a relatively normally functioning and not in a destroyed and non-functioning economy.

4. Monetary system after October 1991

Because of the decentralised monetary system of the former Yugoslavia, as it is common in federalist countries, the monetary independence of Slove- nia was straightforward. Almost all relations among legal entities in Slov- enia and the Yugoslav central banking system, i.e. almost all claims on the one hand and all liabilities towards the Yugoslav central banking system on the other, were shown in the balance sheet, or the so-called prises, which during the process of uity of enterprises, after bank rehabil- “balance sheet”, of the National Bank the abolition of social ownership itation, had been transferred to the of Slovenia, which was renamed the transformed into state owned enter- pension fund; and (3) if insurance Bank of Slovenia (the BoS). What prises. Most enterprises became pri- companies had been transformed was not reflected in the balance sheet vately owned during the process of from mutual organisations to share- were claims arising from currency in abolition of social ownership. holder companies in a correct way. circulation (banknotes and coins) in Before transition banks in Slove- As none of these three conditions possession of legal entities and pri- nia were organised as share compa- was fulfilled, there was ample room vate individuals on the territory of nies with almost no state ownership. for privatisation, and also room for Slovenia. These claims were known Banks need not to be privatized at the second generation of privatisation and this item in the balance sheet of all if through the process of bank experts. Moreover, a small group of the newly created central bank was rehabilitation two banks had not people was allowed to become rich established three days after the dead- been transferred to government own- without taking any risk, if we disre- line for the conversion of dinars to ership. With insurance companies gard the fact that they had not paid tolars had expired. there would have been no scope for almost anything for the assets that Foreign exchange or international privatisation if they had been trans- made them rich. Probably because monetary reserves were held with the formed from mutual institutions to of this none of the three conditions National Bank of Yugoslavia, which is shareholder companies through an above, which would have sidelined common for a decentralised monetary appropriate and just method. And the privatisation, could have existed. system. This is different with the Euro- this would have been the only legally Leaving aside everything that was pean Central Bank and the Eurosys- correct approach. done wrong, it is worthwhile high- tem because these arrangements are When the whole world has been lighting two specificities that have not a simple decentralised monetary talking about privatisation, it would been of importance in setting up the system. From a balance sheet point of have probably been unacceptable monetary system and in conducting view there is no difference between not to do so in Slovenia. In addition, monetary policy in Slovenia. There assets abroad and denominated in the first privatisation “specialists” had were relatively few enterprises in a foreign currency, and claims on do- already come around, as did recently desolate condition because relatively mestic entities and denominated in the second generation. But there few enterprises were limited merely to domestic currency. However, a dis- would have been not much scope for the market of Yugoslavia. Most of en- tinction between these two categories privatisation if (1) the social owner- terprises had to export goods and/or was made in 1991 and afterwards as ship of non-financial enterprises had services to the Western markets in a legacy of the past. For the BoS and been abolished by means that would order to get hold of foreign currency, for the other new central banks in the reflect the way how wealth of non-fi- and they were selling goods and/or former republics of Yugoslavia it was nancial enterprises, which at that services in the domestic market to important to know the net position be- time showed up as equity, had been make a profit. For these enterprises tween claims and liabilities vis-a-vis created – this way banks could have it was not impossible to increase ex- the Yugoslav central banking system. been fully rehabilitated; (2) if the eq- ports to make up for the domestic In the case of the BoS, this net posi-

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tion was known in only three days. If Because soon after the introduc- The BoS has been using short- we focus only on the central banking tion of tolar the German mark started term bills (»blagajniški zapisi«) to system, what was left was the foreign to depreciate in real terms, the above perform compensatory purchases or debt of the National Bank of Yugosla- mentioned freedom in conducting sales when it wanted to prevent its via, which could not have been easily monetary policy and exchange rate interventions on the foreign exchange and quickly allocated. However, this policy would mean that the BoS market to influence the base money. was no obstacle for the BoS to start would need either the exchange rate Short-term bills showed up in the BoS operating. of the German mark to float freely, or balance sheet as debt only after the The only problem or obstacle it would have to drop the control over BoS has sold them. The BoS started could have been the fact that the money in circulation, if it wanted to with sterilising interventions in the newly created central bank did not prevent a real depreciation of the foreign exchange market in the have foreign currency reserves, not German mark. beginning of 1992. Generally, steri- taking account around 90 million From theory and praxis we know lising interventions in the foreign tolars (around 3 million German the so-called sterilisation measures exchange market do not change the marks). This would have been a prob- by the central bank in the foreign size of balance sheet but they alter lem if Slovenia had wanted to intro- exchange market. But the BoS was its composition. Foreign assets induce a system of a conventional fixed never in the situation where it would crease and domestic assets decrease exchange rate. The problem would had had to choose between mone- and vice versa if the central bank have been even greater if Slovenia tary policy and exchange rate policy, performs a compensatory sale of for- had wanted to introduce the so-called which would mean a relatively large eign currency. In the case of the BoS “hard peg”. real appreciation of the domestic the sterilising purchases of foreign The fact that the BoS as a newly currency. The BoS only had to find currency, which were the largest cat- established central bank did not have assets to be sold or bought when it egory in terms of size, were reflected foreign exchange reserves was limit- would be buying or selling foreign in an increase of the balance sheet: ing the BoS in the choice of the ex- currency, because no such assets on the assets side foreign assets or change rate system. The BoS had to could be found in its balance sheet. foreign currency, and on the liabili- choose an arrangement where it In times of the gold standard central ties side short term bills. would not have had to sell foreign banks sterilised purchases of gold by The monetary system is closely currency but would have been buying reducing the volume of rediscounted connected to bank rehabilitation be- foreign currency and thus would have real bills, and after the Second cause as long as bank rehabilitation been building its foreign exchange World War they compensated had not been completed, the BoS reserves. A “pure floating regime”, purchases of foreign currency by could not have counted on appropri- where the BoS could have stayed without a foreign exchange reserves, Figure 2: Foreign and domestic currency denominated BoS short-term did not come into the question. At the bills (including deposits with BoS) from January 1995 introduction of tolar in 1991 monthly to January 2006 (in billion tolars) inflation amounted to 21.5%, to state only one fact against this arrangement. Slovenia introduced a “managed floating” exchange rate regime and kept it until the 28 June 2004 when it entered ERM II and the central rate for the tolar was set at 239.64 tolars for one euro. This system is formally a “target zone” regime with predefined margins of permissible deviations (+/– 15%) form the central rate. The monetary system with the “managed floating” regime allows the central bank relatively large independence in performing foreign exchange market interventions. This gives the bank a lot of free room for conducting monetary and exchange rate policy. However, after February 1999 when the liberalisation of the Source: Bank of Slovenia free flow of capital was completed, this freedom turned out to be limited selling government papers. Of course ate reactions of banks to its monetary to a choice of certain combinations of they could have also sterilised sales policy instruments. The BoS also took monetary policy (the level of interest of gold and/or foreign currency over important tasks such as monitor- rates) and foreign exchange policy by increasing of rediscounted real ing and ensuring sound and safe op- (the rate of the nominal appreciation bills and by buying government erations of commercial banks as well of euro). papers. as banking supervision. One impor-

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tant element is also control of foreign ise the effect of the BoS’ purchases been quite volatile. The third part exchange risk and safeguarding of foreign exchange on the quantity equals short-term foreign currency banks from a bank run during which of the base money bills and as such reflects the BoS reg- clients would withdraw their foreign After a while it became evident ulatory role by which the BoS control- currency deposits. Foreign currency that it was optimal for banks to keep led the safety of the banking system. denominated deposits had been a short-term foreign currency bills (at This part is relatively stable and big- legacy of the former Yugoslavia and first in German marks, later in euros) ger than the second part. It grew the BoS had tried to change by force to back foreign exchange deposits of slowly (Figure 2). this habit of the population. There- their clients. For these bills the BoS If we divide the BoS balance sheet fore, short-term foreign currency bills, paid as much as it earned by invest- into three parts, we can explain the which banks had to hold to back their ing these assets abroad. This was in unusual situation where the BoS had foreign currency denominated liabili- line with the principle of the so-called on the liabilities side much more short ties, had an important role for the »pass-through securities«. For the term bills than base money, and on safety of deposits and the soundness short term tolar bills the BoS had to the assets side almost only foreign as- of banks. Hence, a substantial part of pay as much as it had to offer to sets, i.e. foreign reserves. The reason the BoS balance sheet, i.e. foreign banks to sell as much bills as needed for this unusual situation is of course currency on the assets side and short- to sterilise the effect of buying foreign the fact that the BoS could only con- term foreign currency bills on the lia- exchange on the quantity of base duct an appropriate monetary policy bilities side, had been directly linked money, if of course this increase of and foreign exchange policy by steri- with the above-mentioned aspect of the base money had not been neces- lising interventions in the foreign ex- bank supervision and prudential con- sary. These transactions normally re- change market and by banking regu- trol (Figure 2). sulted in a loss for the BoS because lation that forced banks to hold short- The monetary system after Octo- the BoS was paying more as it term foreign currency bills, which neu- ber 1991 enabled the BoS to under- earned. The BoS’ liabilities side inter- tralised the effect of the growing for- take sterilising interventions in the est rate was higher that the assets eign currency deposits on the supply foreign exchange market to prevent side rate. of foreign currency. a too large real appreciation, which There are three parts of the BoS The reason for these particularities would have happened because of balance sheet, reflecting three differ- is also reflected in the structural situa- capital inflow and capital repatriation ent activities. The first part with no tion of the money market. If we adapt (sales of foreign currency from private short-term bills on the liabilities side the definition of the structural position holdings, i.e. »from socks«), and to reflects the general activities of a cen- of the money market to our environ- conduct the appropriate monetary tral bank. This part usually accounted ment by taking net foreign assets policy of gradual disinflation. From for less than a half of the balance as net foreign currency assets, this this we can see the first characteristic sheet. The second part equals short- way we subtract short-term bills from of the BoS, i.e. short-term tolar bills as term tolar bills and is a consequence foreign exchange reserves (Ribnikar, the most important monetary policy of sterilising purchases of foreign cur- 1999), we arrive at a smaller but still instrument, and short term foreign currency. This part was the most volatile relatively large surplus of the structur- rency bills through which the BoS con- one (Figure 2), which means that the al situation of the money market. This ducted supervision and prudential sterilising interventions of the BoS had is not unusual because it is simply a control of banks. The second characteristic was the composition of its as- Figure 3: Structural position of money market and the position sets. At the beginning the BoS had of short-term tolar bills and bank deposits with BoS from almost no foreign exchange reserves, January 1995 to January 2006 (in billion tolars) and later it had almost no domestic assets.

5. Structural situation of the money market and monetary policy instruments

In the framework of the only possible and only appropriate regime, i.e. a floating exchange rate regime, it soon became evident, as indicated before, that the BoS could not have conducted an appropriate disinfla- tionary monetary policy and exchange rate policy, which would not lead to a too large real appreciation of tolar, if it had not intervened in the foreign exchange market, predominantly as buyer. This way we arrived at the BoS’ short-term tolar bills, which were sold to banks to neutral- Source: Bank of Slovenia

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different expression of the sterilising not get a lucrative opportunity in BoS would need to engage in sterilis- intervention of the BoS in the foreign acquiring debt abroad, selling foreign ing interventions in the foreign exchange market. exchange to the BoS and using tolars exchange market. The quantity of the base money to buy short term bills. The difference It is important that the BoS applied had been increasing autonomously between the short term bills interest an appropriate dynamics of growth because the BoS was buying foreign rate and the so-called “swap” interest of the nominal euro (German mark) exchange. As the increasing base rate, i.e. how much more had banks exchange rate and an appropriate money was generally too large, the to pay to buy back from the BoS monetary policy, reflected in domestic BoS had been withdrawing excess foreign exchange which they had interest rates, to maintain the differ- liquidity from banks. This was done sold to the BoS seven days earlier, ence between domestic and euro by selling short-term tolar bills to could not have been larger the cost area interest rates at a level that cor- banks. In contrast with central banks of financing abroad. responds to a larger currency and in general, where monetary policy in- The excess liquidity of bank, country risk (Ribnikar, 2003). Ceteris struments are used to increase liquidi- which was the result of the surplus paribus this means that monetary poli- ty of banks, the BoS’ main monetary of the structural position, was partially cy could have been more restrictive policy instrument was withdrawing absorbed by the required reserves. (expansive) if the dynamics of euro liquidity of banks via selling short- However, the largest part was ab- exchange rate growth was larger term tolar bills. A part of the excess sorbed by the short-term tolar bills (smaller) in Slovenia. Monetary policy autonomously created liquidity was could have been more restrictive absorbed by the BoS mandatory re- (expansive) only in the case where serves. However, the level of these re- the dynamics of the nominal loss of serves was never used as a sterilising As already value of tolar was larger (smaller). instrument. The average percentage of mandatory reserves had been mentioned, 6. The end of the short history continuously decreasing. of tolar and the BoS as an The BoS was not buying foreign independent central bank exchange outright but temporarily for Slovenia had seven days. After seven days banks The gradual reduction of inflation had to buy back foreign exchange at a hard peg and the nominal appreciation of euro a slightly higher exchange rate. The had come to a point where shortly cost of the seven-day revolving loan after becoming an EU member state from the BoS was equal to the interest regime. Slovenia could become a member of rate banks would get if they had not ERM II (Bole and Mramor, 2006). As sold foreign exchange to the BoS, it was obvious already in 1991 that increased for the difference in the (Figure 3). Besides these two instru- the tolar was going to be merely a exchange rate at the beginning and ments there have been others, some short term or interim money, although the end of the seven day period. have been newly introduced, some it was very important that Slovenia in- There were also reverse deals, i.e. others have been abandoned, but troduced its own currency and central temporary sales of foreign exchange in terms of achieving changes in the bank, it did not make sense to prevent to banks, but their quantity was much base money they were far less impor- the use of German marks or euros as smaller. tant then short term bills. These bills a parallel currency. In fact this never With these temporary purchases have been and still are monetary poli- happened, as it was only a matter of of foreign exchange from banks, fol- cy instruments, which provide banks time when the transformation of the lowed by sales of foreign exchange with short-term liquidity, and enable euro form the parallel currency to the to banks at a higher exchange rate, them to reduce excess liquidity. All only legal tender would take place. the BoS was setting the dynamics these instruments are important for This will also happen with the of the nominal euro exchange rate functioning of banks. interim system of two currencies, growth (before euro the German After February 1999, when inter- the tolar and the euro. De facto it mark exchange rate). If the BoS was national flows of capital have been happened on 11 July 2006, and de not satisfied with this dynamics, fully liberalised, the BoS had to pre- iure it will happen two weeks after it made use of the so-called interven- vent that because of a larger expect- 1 January 2007. The central ex- tionary purchases or sales of foreign ed return of short-term financial invest- change rate has been set at tolar’s exchange as defined in a special ments in Slovenia there would be entry ERM II on 28 June 2004 at contract with banks on co-operation a large inflow of capital, or that 239.64 tolars for one euro. This is in foreign exchange market interven- because of a larger expected return also the irrevocably fixed conversion tions. of short term financial investments rate determined on 11 July 2006. The temporary purchases of for- abroad there would be an outflow Because during tolar’s participation eign exchange had the same effect of capital. If this happened, then the in ERM II the margins of allowed on the quantity of base money. The combination of monetary policy deviations from the central parity increase in the base money was gen- (domestic interest rates) and ex- are set at +/– 15%, this is formally erally too large and the BoS had to change rate policy of euro and be- a target zone regime, although we counter act by selling short-term bills fore that German mark exchange rate can also see it as a hard peg version to banks. When doing so the BoS (growth rate of the nominal exchange of the fixed exchange rate regime had to make sure that banks would rate) would be inappropriate and the (Ribnikar, 2004). Until 11 July 2006,

BV 11/2006 81 THE CASE OF SLOVENIA

from where on we have a de facto membership in ERM II and the qualifi- 2. ECB Monthly Bulletin, 2006, »Economic dual currency regime, the exchange cation for the introduction of euro, and Monetary Developments«, August, pp. 53. rate fluctuated merely in a range and the remaining time up to 1 Janu- 3. Miles, W., 2006, One Continent, One of 0.2%. ary 2007, is no proof that we can be Currency? Varieties of Common Experience in Europe and Latin America, Kyklos, No. 3, Up to the introduction of the euro indifferent to not having our own pp. 411-426. the BoS will not be able to repay all money, monetary and exchange rate 4. Mundell, R. S., 2001, Money and the short-term bills and bank deposits. policy. The time that we have spent in Sovereignty of the State, in: A. Leijonhufvud Many of these assets with the BoS, happiness, where the ECB describes (Editor), Monetary Theory and Policy which stem from the sterilisation poli- the enlargement of the euro area as Experience, Palgrave, pp. 291-337. cy of the BoS or banking supervision, a landmark (ECB Monthly Bulletin, 5. Ribnikar, I., 1984, Finansiranje privrede i will mature after 1 January 2007. 2006), is in fact a period of anxiety, inﬂacija (Financing of business enterprises Then everything will be paid out in expectations and fiscal self-control. and inﬂation), Socijalizam, Beograd, No. 9, pp. 1234-1261. euros. The BoS has two options how And this should end on 1 January to do it. First, it can reduce its hold- 2007? 6. Ribnikar, I., 1989, Money and Finance in Yugoslavia, In Honour of the Memory of ings with banks abroad and credit If this were the case, then it would Toussaint Hočevar, Slovene Studies, Vol. 11, commercial banks’ accounts abroad. be better if we stayed with our own No. 1-2, pp. 223-230. Second, it can increase commercial money and with an independent 7. Ribnikar, I., 1994, Prehod v tržno banks’ holdings with the BoS, i.e. it monetary and exchange rate policy gospodarstvo po slovensko (Transition into can increase their reserves. These (Miles, 2006). Of course this is only market economy in Slovenian way), CISEF, two approaches are not the same, hypothetical and unrealistic, as it Ekonomska fakulteta, Ljubljana, pp. 318. but whichever will be applied will would mean that we could not have 8. Ribnikar, I., 1999, Strukturni položaj not be of crucial importance even become an EU member state. denarnega trga v Sloveniji (Structural (Ribnikar, 2005). The only choice is the EU with euro, position of the money market in Slovenia), Bančni vestnik, Ljubljana, No. 6, p. 47, What is important is the fact that i.e. an economy where the state, that pp. 47-49. since 28 June 2006 the BoS cannot is the BoS, cannot help by changing 9. Ribnikar, I., 2003, Nepokrita (ne)enakost conduct independent monetary poli- monetary policy and hence interest obrestnih mer (Uncovered interset rate /non/ cy. As already mentioned, Slovenia rates relative to the euro area interest parity), Bančni vestnik, Ljubljana, No. 10, had a hard peg regime, which ac- rates, or by changing the exchange pp. 48-51. cording to Mundell means that the rate. 10. Ribnikar, I., 2004, Exchange Rate Regimes country is a member of a monetary and Monetary Arrangements, Proceedings of union (Mundell, 2001). Interest rates REFERENCES: Rijeka Faculty of Economics, Journal of Economic and Business, 2, Vol. 22. pp. 9-23. in Slovenia can only be that much 1. Bole, V. & D. Mramor, 2006, ‘Soft lending higher than those in the euro area to in the ERM2: Lessons from Slovenia, in: J. 11. Ribnikar, I., 2005, Banka Slovenije na Prašnikar, Competitiveness, Social poti v Evrosistem (Bank of Slovenia on the reflect the currency and country risk Responsibility and Economic Growth, New road to the Eurosystem), Bančni vestnik, premia. The two years of Slovenia’s Science Publishers, New York, pp. 97-117. Ljubljana, No. 7-8, pp. 3-9.

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UDC 338.2(497.4):061.1 EU Expected Stabilization Effects of Euro Adoption on Slovenian Economy Igor Masten *

This paper analyzes the lovenia is the first new EU Member State to adopt the effect the path of euro adoption has had on euro in January 2007. In the process of fulfilling the macroeconomic stabilization in Slovenia. major requirements – the Maastricht criteria, the most The link between the practice of real exchange challenging task was to cut the inflation rate. Figure 1 rate targeting within the managed float regime Sreveals that two years before entry into the ERM II system and inflationary developments is Slovenia’s inflationary performance was quite weak relative to supported by the analysis of exchange rate pass- the most developed new EU members even though its position through effect. It is shown that stabilization of was favourable back in 1996. Some argue that this had to do nominal depreciation and entry into ERM II with a large degree of monetary policy accommodation (Coricelli, sustainably stabilized inflation at the level Jazbec and Masten, 2006). Accommodative policy had to be compatible with the Maastricht criteria abandoned to a significant extent once the government and the without creating any significant imbalances in central bank agreed on the strategy of adopt the euro as early the economy. For this reason it can be expected as possible. This brought along a gradual decrease in the pace of that stabilization effects of exchange rate stability targeted depreciation of the nominal exchange rate that reduced will continue also in EMU. inflation to historically low levels. Complete exchange rate stability in the ERM II mechanism1 stabilized inflation even further without denting or jeopardizing real economic growth. This paper further examines the degree of policy accommodation that characterized Slovenian monetary policy prior to entry into ERM II. By means of a counterfactual policy experiment in the framework of cointegrated VAR it is argued that a different and stricter policy could have stabilized inflation around levels required for entry into the euro area much sooner than it actually happened. It is further shown that the cost of such policy would be negligible if present at all.

* Dr. Igor Masten, University of Ljubljana. I wish to thank Arjana Brezigar Masten, Fabrizio Coricelli and Maja Ferjančič for their suggestions, comments and help provided in preparation of this paper. This research has been partly ﬁnancially supported by the Bank of Slovenia and the Ministry of Finance of the Republic of Slovenia. 1 Slovenia entered ERM II at the end of June 2004.

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Figure 1: Inflation rates in selected new EU Member States Empirical evidence for Slovenia supports many of the latter views. By applying the conditions for controllability of inflation in a cointegrated VAR framework developed by Johansen and Juselius (2002) it can be shown that the empirical model of Bole (2003) designed to demonstrate the workings of the managed float regime in Slovenia suffers from the inability to control inflation due to weak exogeneity of inflation itself. Interesting observations emerge from Figure 2 that plots the transitory (or cyclical) component of the real exchange rate (together with CPI inflation and nominal depreciation of the tolar against the euro). In July 1999 Slovenia introduced the VAT system of indirect taxation. Usually this acts as a price shock that temporarily in- The same experiment also re- national flows of capital through creases inflation and overvaluation vealed that after the entry into ERM II, maintenance of a closed interest rate of the real exchange rate. In Figure 2 i.e. with the exchange rate completely parity (after correction for the country we can see a dip in the cyclical com- stable, monetary policy stance was risk premium), and to stabilize the ponent of the real exchange rate that close to optimal in terms of consisten- real rate of interest at the levels that occurred in the third quarter of 1999 cy with the price stabilization objec- would suppress price increases (Bole, when VAT was introduced. The effect tive. This leads to the conclusion that 2003). However, stabilization of the on overvaluation was not persistent stabilization effects exchange rate real interest rate at the levels that is at all, however. The figure reveals that stability has had on Slovenian econo- not consistent with the variations in is was immediately followed by a pro- my may continue to the period after the natural rate of interest may not longed period of undervaluation ac- adoption of the euro. be consistent with the objective of companied by an equally prolonged The paper is structured as follows. price stability (Woodford, 2003). surge in inflation. The phenomenon is Chapter 2 analyses the managed Moreover, in a managed float regime clearly related with policy response float regime in Slovenia from the it may be closely related with real and a sign of policy accommodation. 2 point of view of the degree of policy exchange rate targeting. Calvo, A glance at the cyclical compo- accommodation and links is to infla- Reinhart and Vegh (1995) show that nent of the real exchange rate and in- tionary performance. This section higher inflation should not come flation over the whole period reveals contains also the results of the coun- as a surprise in presence real ex- a finding analogous to the one in terfactual policy experiment by change rate targeting, even though Calvo, Reinhart and Vegh (1995) for Brezigar et al. (2006). Section 3 it may be in certain instances welfare countries targeting the real exchange 3 discusses performance of the econo- improving. rate. We can clearly observe that pe- my in the ERM II regime. Section 4 concludes. Figure 2: Real exchange rate gap and inflation

Managed ﬂoat and inﬂation in Slovenia

Prior to the entry into the ERM II Slovenia had a managed float exchange rate regime. Among its main objectives policymakers often quoted the concern to prevent excess real appreciation of the tolar, which can be directly viewed as implicitly following a real exchange rate target (Lavrač, 1999). More specifically, the managed float regime was designed to simultaneously aim to stabilize inter-

2 This argument follows the line of reasoning presented in Svensson (2000). Note: The real exchange rate gap was calculated from the log of CPI-based real ex- 3 This point was further reﬁned by Uribe (2003) change rate with unobserved components method (Morley, Nelson and Zivot, 2003) and who shows that real exchange rate targeting is measured as a percentage deviation from trend. Positive gap values represent real un- leads to indeterminacy of equilibria. dervaluation of the tolar and vice-versa.

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riods of undervalued real exchange tiveness. By stabilizing the deprecia- experiment of targeting the Maastricht rate correspond with periods of in- tion rate around zero only at the time level of inflation5 from mid-1999 on- creasing inflation and vice versa. The of entry into ERM II, however, the au- wards.6 The beginning of the experi- correlation coefficient between these thorities essentially implicitly relied on ment corresponds to the price shock two series is high, about 0.60. Figure expectations of a strong stabilization related to introduction of VAT. Figure 2 reveals also a highly aligned co- effect of exchange rate stability (or 3 plots the actual and counterfactual movement between inflation and high pass-through effect), which was, paths of the spread between domestic nominal depreciation. Building on first, contrary to the official position and foreign policy rate, nominal de- this rather crude evidence Coricelli, regarding exchange rate stability preciation rate, inflation rate, growth Jazbec and Masten (2003, 2006), and, second, risky due to unknown of total real credit and GDP. Upper based on a cross-country analysis of effects that the participation in ERM II right panel contains the required inter- exchange rate pass-through in cointe- as a structural break in policy would ventions to the interest rate. The grated VAR framework, argue that a have on exchange rate pass-through.4 model shows that inflation could have large degree of policy accommoda- To demonstrate the relevance of been controlled by the central bank tion embedded in implicit real ex- these policy recommendations I sum- had the Bank of Slovenia chosen a change rate targeting by the Bank of marize here the main findings of the more restrictive policy stance. Had Slovenia resulted in a virtually perfect counterfactual policy experiment con- there been a desire to ambitiously equilibrium exchange rate pass- ducted by Brezigar et al. (2006). stabilize inflation much earlier that is through effect. Moreover, Masten (2004a) shows that the estimates Figure 3: Targeting the Maastricht inflation criterion in cointegrated VAR of equilibrium pass-through effect in for Slovenia Coricelli, Jazbec and Masten (2003, 2006) can be interpreted as structural elasticities, which leads to the conclusion that permanent reduction of inflation could not be achieved without a corresponding and equal reduction in nominal depreciation rate. This led to a policy recommendation of a pre-an- nounced gradual but fast decline of nominal depreciation towards the levels compatible with ERM II participation. This essentially meant stabilization of the nominal depreciation rate around zero towards the end of 2003, which would eventually lower inflation through the stabilizing effect of exchange rate stability. Since both the government and the central bank officially maintained that Slovenia should stay in ERM II should be as short as possible, caution required to disinflate as much as possible prior to the entry into ERM II in order to avoid any drastic measures and excessive loss of competi-

4 It is true that in the joint euro adoption programme of the government and the central bank the government committed to control of regulated prices in order to prevent unnecessary inflationary pressures in the nontradable sectors. However, it must be noted that controlling prices cannot lower prices sustainably. Rather this measure should be seen as “negative price shock” that allowed the central bank to accommodate (with a decrease in nominal depreciation) as it used to in the Source: Brezigar, Coricelli, Ferjančič and Masten (2006) past. Hence, such cooperation is a way to lower inflation with accommodative policy but it should not be overlooked that it is nevertheless They analysed the transmission mech- actually occurred, the upper left the exchange rate stability that offers the anism of monetary policy in Slovenia panel shows the policy to be too ultimate anchor to inflation. by means of a structural error-correc- loose virtually until mid-2004, which 5 The Maastricht criterion was approximated as the euro area inflation plus 1.5 percentage tion model and found the exchange again confirms the argument that poli- points. rate channel as the most important. cy of the Bank of Slovenia was too 6 Since such an experiment is conducted without Following Johansen and Juselius accommodative. This would have re- altering any of the models parameters. The experiment is hence not subject to the Lucas (2002), their empirical model allows sulted in considerably lower nominal critique. also for simulation of a counterfactual exchange rate depreciation albeit not

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in nominal appreciation. The cost of Figure 4: Output gap estimates for Slovenia more ambitious inflation stabilization in terms of lower output growth would have been minor in certain periods and none in the long run.

Developments in ERM II

It is important to note that in the above experiment inflation becomes stationary around a chosen target. It can be seen from Figure 3 that since entry into ERM II the required policy interventions and difference between actual and simulated values of variables would have been very small. This indicates that the reduction of inflation to Maastricht levels is sustainable. Note: The following methods were used to estimate the output gap. BNcycle – Beveridge- Nominal stabilization can come Nelson decomposition, UCcycle – unobservable components method (see Morley, Nelson and at the cost of increased volatility of Zivot, 2003), HPcycle – Hodrick-Prescott filter, BQvar cycle – Blanchard and Quah (1989) long- the real economy, especially if it re- run restrictions in a VAR model of GDP and inflation quires fixing the exchange rate and relinquishing on the monetary policy 2004b, for example). The obvious 3. Brezigar, M. A., Coricelli, F., Ferjančič, flexibility. To probe into this angle in conclusion from this strand of litera- M. and Masten, I. (2006), “Transmission Mechanism of Monetary Policy in Slovenia”, ture would therefore be that stability a rather crude way, Figure 4 presents mimeo, Bank of Slovenia. several yardsticks of the output gap of Slovenian post-euro economy will depend of the degree and speed 4. Calvo, A.G., Reinhart, C.M., Vegh, C.A. in Slovenia. The estimates show that (1995), »Targeting the real exchange rate: entry into ERM II did not have any of endogenous convergence of its theory and evidence«, Journal of destabilizing effects on the economy. economic structure to the euro area Development Economics, 47, pp. 97 – 133. Indeed, growth of GDP actually average. 5. Coricelli, F. Jazbec and Masten I. (2003), reverted to potential. Empirical Many of the proponents of the »Exchange Rate Pass-Through in Candidate evidence available thus far hence endogenous optimal currency area Countries«, CEPR Discussion Paper, 3894. suggests that entry into the ERM II theory would argue this to be a high- 6. Coricelli, F. Jazbec and Masten I. (2006), mechanism had an important stabiliz- ly likely scenario. This view, however, »Exchange Rate Pass-Through in EMU ing effect on inflation without endan- can be elaborated further. It has been Acceding Countries: Empirical Analysis and gering real growth. argued in the literature that even prior Policy Implications«, Journal of Banking & to the entry into the ERM II Slovenian Finance, 30, 1375 – 1391. 7. Johansen, S. and K. Juselius (2001), Conclusions monetary policy did not have significant stabilization effects (Masten, »Controlling Inflation in a Cointegrated 2005, Coricelli, Jazbec and Masten, Vector Autoregressive Model with and Adoption of the euro and acces- Application to US Data«, EUI Working Paper sion to Economic and Monetary 2006). Therefore, cost in terms of sta- ECO No. 2001/2. bilization efficiency relative the exist- Union will not bring any changes in 8. Lavrač, V., 1999. Exchange Rate of the terms of exchange rate stability as it ing benchmark may be very limited if Slovenian Tolar in the Context of Slovenia’s has been practically rigidly fixed present at all. Adding to that the evi- Inclusion in the EU and in the EMU. IER since mid-2004. As of January 2007 dence we can collect from the period Working Paper No. 1. there will be a change in terms of spent in ERM II, where monetary sov- 9. Masten, Igor (2004a), »Identification of dynamics of the key interest rates. ereignty was already completely limit- Exchange Rate Pass-Through Effect in Convergence of nominal interest rates ed, we can conclude that euro area Cointegrated VAR: An Application to New EU Member Countries«, University of will be completed and subsequent set- membership will act as an anchor for the Slovenian economy. Stabilization Ljubljana, Faculty of Economics Working ting by the ECB will respond to char- Paper No. 161. acteristics of the euro area business of the nominal exchange rate brought about historically and sustainably low 10. Masten, Igor (2004b), »Inflation cycle. Macroeconomic stability of Targeting in Presence of Balassa-Samuelson- levels of inflation, while the focus on Slovenia’s economy in such circum- type Productivity Shocks«, University of policies fostering structural reform stances will crucially depend on the Ljubljana, Faculty of Economics Working and growth should be a cushion Paper No. 160. level of the scope of synchronization against excessive real volatility. of the Slovenian and euro-wide busi- 11. Masten, I. (2005), “How important is the ness cycle. Perfect synchronicity is shock-absorbing role of the real exchange REFERENCES: rate?” Business and Economic Review hard to be expected and if there is a 3/2005. yawning difference, it is well known 1. Blanchard, O.J., and D. Quah (1989). The 12. Svensson, L. E. O (2000), »Open- from the New Keynesian literature Dynamics of Aggregate Demand and Supply Disturbances. American Economic Review Economy Inflation Targeting«, Journal of that common monetary policy may re- 79: 655–673. International Economics, 50, pp. 155-183. sult in nominal and real indetermina- 2. Bole, V. (2003), “Managed Float as a 13. Woodford, M. (2003), Interest and cy of the equilibria in the economy Second Best Option: Lessons from Slovenia”, prices. Princeton University Press, New (see Woodfrod, 2003, or Masten, EIPF Working Paper No. 6. Jersey.

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UDC 336.2(497.4):061.1 EMU Fiscal Policy in Slovenia after Entering Euro – New Goals and Soundness? Velimir Bole *

Because of losing fter entering EMU, policy makers will face much monetary sovereignty and smaller room for bigger (more important) changes than enterprises and fiscal manoeuvre determined by the SGP, households. They will lose monetary sovereignty, while policy makers in Slovenia will have to have new external constraints on the room of manoeuvre of fiscal goal function after entering euro. Output Afiscal policy will considerably increase. stabilisation and efficiency will probably The scale of a reduction of the scope of economic policy have a dominant role in the new goal function of seems obvious. On the other hand, what will happen to policy fiscal policy. In the paper, possible interrelated makers’ goal function is far from clear. In other words, what role effects of new goals of fiscal policy and fiscal will fiscal policy have in the future and what type of institutional soundness are sketched, and necessary changes in changes in the fiscal policy implementation will be required? the fiscal policy strategy at entering euro As an EMU member, Slovenia will have its place in the ECB analysed. Because initial fiscal conditions at board. But because large countries (Germany, France, Italy) will entering the euro area could be considerably represent about 70% of Euroland also after all new members of affected by the 2006 tax reform proposal, the the EU join the euro area, large countries’ interests will be paper includes also brief discussion of possible served predominantly by decision making of the ECB. Because measures to overcome those tax reform effects symmetries of shocks and correlation of response functions (be- on fiscal soundness at entering euro. In addition tween Slovenia and EMU members) are, at best, below average, to EMU mechanism of controlling fiscal output stabilisation and growth (efficiency) terms will probably soundness, for small underdeveloped member have a dominant role in the new goal function of fiscal policy of EMU it is suggested also own institutionally makers in Slovenia. based mechanism. Important question is how fiscal soundness will figure in the new fiscal policy makers’ goal function. Will it take place in the new goal function explicitly, or will it be defended only ex post by the external constraints (enacted by the Stability and Growth Pact and Excessive Deficit Procedure). Fiscal performance in the transition to the new role of fiscal policy in the euro area will crucially depend on initial fiscal con-

* Velimir Bole, Economic Institute of the Faculty of Law, University of Ljubljana

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ditions (fiscal stance) at entering of comfortableness regarding fiscal although there will be additional the common currency area. Possible stance could be very short-sighted. significant (unexpected) increases in “unfavourable” effects of this initial Three important groups of facts- the tax revenue from corporate and fiscal stance document, that after en- performances do not permit policy personal income taxes caused by the tering EMU fiscal soundness has to be makers to enjoy a comfortable posi- tax reform in 2004 and some “crea- put in the policy makers reaction function even in the short run. By 2007, tive” accountancy made3. At entering tions explicitly, and that it is worth to after entering the euro area, external the euro area, fiscal soundness of complement fiscal soundness (ex post) formal constraints for fiscal policy Slovenia would be, therefore, good controlling mechanism of SGP and makers in Slovenia will significantly for the economy not in the EMU (and EDP also with own (ex ante) institution increase, while necessary (pending) having monetary sovereignty), but not based mechanism, which would make institutional changes caused by feasible for small economy in the new fiscal priorities safe from time in- integration of the Slovenian economy common currency area (without mon- consistent behaviour of policy makers, into EU will exert additional pressure etary sovereignty) and with fiscal poli- their fiscal illusion and common pool on fiscal policy, and so will effects cy burdened with short-term volatility problem. Besides, in such a case of standstill in the process of and high long-term growth targets, long-term fiscal sustainability (and improvement of the fiscal stance and finally, far from sustainable therefore adherence to SGP condi- caused by the policy measures in soundness according to the (new) tions1) would be enabled with lower the last period. SGP criteria used for EMU members. macroeconomic costs. On the medium term (SGP rele- In the paper, possible interrelat- vant) fiscal stance of the economy ed effects of new goals of fiscal policy could be further seriously jeopardized (short-term stability and efficiency) Important by several institutional changes and fiscal soundness are sketched, caused by the very entry (process of and necessary changes in the fiscal integration) into the EU economy; policy strategy at entering euro ana- question is, increased public investments and lysed. In addition to EMU mechanism decreased efficiency of tax adminis- of controlling fiscal soundness, for how fiscal tration are the most obvious chang- small underdeveloped member of es4. Significant increase in the public EMU it is suggested also own institu- infrastructure investment will be neces- tionally based mechanism. Because soundness will sary to accelerate real convergence initial fiscal conditions at entering of the economy and to support (e.g. the euro area could be considerably figure in road and railways network) integra- affected by the 2006 tax reform tion into EU markets. General govern- proposal, the paper includes also ment spending will therefore have to brief discussion of possible measures the new fiscal be, or restructured in the favour of to overcome those tax reform effects public investment, or increased as on fiscal soundness at entering euro. policy makers’ percentage of GDP5. After entering In the next section operative con- EU increased capital market efficien- straints and initial conditions of fiscal cy, cross border shopping, capital policy in the starting period of euro goal function. and labour mobility as well as area membership are briefly (transitional regime of) broken VAT sketched. In the third section effects According to the actual version collection process (because of of tax reform proposal on initial fiscal of Stability and Growth Pact (SGP), interstate trade) has been increasing conditions is discussed. Possible (in) cyclically adjusted deficit has to be deterioration of tax administration compatibleness of the fiscal sound- near equilibrium or in the surplus in efficiency. Both public investments ness and the new fiscal policy goals medium run. In the new version of and decreased efficiency of the tax is analysed, in the fourth section. SGP medium term objective for administration could additionally In the last section it is suggested, that the euro area economies will be deteriorate fiscal balance in the early because of the relative size and softened, but still cyclically adjusted years of euro-area membership. underdevelopment of Slovenia it is deficit (and net of one-off and tempo- A medium term fiscal stance could worth to think about creating rary measures) will have to be be lower than potential also because additional (beside SGP and EDP) own “between -1% GDP and in balance institutions for making trajectory of or surplus”2. Besides, the euro area 1 It seems that conditions of SGP are neither necessary nor sufficent for long-term fiscal Đfiscal soundness smoother and cor- (and ERMII) members which are not sustainability (do not imply and are not implied responding opportunity costs lower. on the medium term track will have to by debt transversality condition); see, for improve their cyclically adjusted fiscal example, Wyplosz(2005). 2 Initial conditions and operative balance by at least of 0.5% GDP per See, for example, Morris et al. (2006). 3 year; adjustment effort will have to be For example, DARS share in tax on gasoline constraints of fiscal policy was reduced and rechanneled to other at entering the euro area greater in the good times. government spending, while indebtedness of At entering the euro area, actual DARS was increased. Fiscal performance in Slovenia in general government balance in 4 See, for example, Cnossen(2003), Buiter and 2005 and 2006 was on the safe side, Slovenia will be in the deficit around Grafe(2004) and Bole(2005). 5 Some of investments could be, however, speaking about both deficit and debt 1% of GDP, although economy will realized as public private partnership projects, criteria. But any policy makers’ sense probably attain cyclical peak, and but the bulk would probably be public.

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of the effects of (erroneous) policy sequencing of measures (so tax cut sponding drop in tax revenues. measures launched in the period im- got politicians priority), without a Therefore prospects for convergence mediately before entering the euro clear idea how and for how much to medium term fiscal objective of the area. Although after 2007 significant to cut particular components of the new SGP by at least 0.5% of GDP acceleration of baby boom genera- government spending, and without per year (as the new SGP demands) tion retirements are expected, in clearly stated reform position that in the following several years does 2005 government not only blocked (because of entering the euro area) not seem probable. Even more, in the but even turned the parametric reform increased, or at least unchanged, case of stronger downswing in the process of the pension system into the fiscal soundness had to be the economic activity, also current (and opposite (backward) direction.6 In precondition of any fiscal reform10. not only structural) fiscal performanc- 2005, the government also prepared Final (politically watered) propos- es could considerably deteriorate. reform for increasing efficiency and al of the reform measures, launched After entering the euro area fiscal long-term growth7. From the very be- in September 2006, included almost policy makers could face significant ginning, the reform has focused on only tax-cutting measures. Reform backlash not only in (SGP deter- tax restructuring with only a vague package included tax rate cuts for mined) formal – structural but also in idea of how to offset the proposed household and corporate income tax, the nominal (current) fiscal perform- net tax cuts. The final reform proposal abolishing of wage bill tax and some ances. launched in September 2006 con- simplification in tax administering. It is necessary to underline once tained only tax cutting measures8 more, that feasible fiscal deficit of (with some tax legislative changes de- Slovenia outside EMU, does not neces- signed to simplify tax administering), sarily mean it could be sustainable without any measure for offsetting the Questionable also for Slovenia being member of increased structural gap in the fiscal EMU. Not only because of strict formal revenue by around 2% of GDP, which (EMU) fiscal soundness criteria, but would surface in two years’ time. are also above all, because of lack of monetary Possible deterioration of fiscal sovereignty and constrained, but with stance in the early years of EMU tax cut reform new goals burdened, fiscal policy. membership (caused by aforemen- Questionable are also tax cut tioned erroneous policy measures), effects reform effects on longer-term growth. combined with new fiscal goals after Specifically, empirical evidence entering the EU (short-term stabilisa- shows that beneficial effects of tax tion and long-term efficiency) and on longer-term cuts on growth could be expected more strict (rule based) constraints only if those cuts are accompanied imposed on fiscal policy after growth. by government spending cuts, which entering EMU, call for a reshaping neutralize possible deterioration in fiscal policy strategy and for the the fiscal stance12. Without cutting institutions of fiscal policy to de- Because no spending cuts or other spending, policy makers could eventu- crease (costs of) volatility of fiscal tax (high enough) increases is pro- ally face a loss of momentum in the adjustments and economy perform- posed, potential deterioration of the longer-term growth, and not only ance. But in implementing fiscal structural fiscal deficit at the very deterioration in the fiscal soundness. policy at entering the euro area, the entering euro could attain even 2% Because it could not be expected highest priority has to be given to the of GDP. any significant adjustment of the neutralisation of the effects of the Two tax-reform related questions government spending in one– or “bad” initial conditions on prospec- seem interesting for fiscal policy im- two-year-period, increase in other tive fiscal performances in the euro plementation and fiscal performances (probably consumption) taxes could area. in the next two or three years, when be only feasible solution for deterio- Tax reform – a possible “bad” Slovenia will be already in the euro 6 prelude for ﬁscal soundness area. First, what are the risks (real See Bole(2005). 7 at entering the euro area costs and credibility costs) for fiscal See the Slovenian Government’s “Budget Memorandum for the Period 2006-2007” and performance of such partial reform the Commission for Reform’s “Proposed After 2004 tax reform and its re- proposal and, second, what is a via- concepts of economic and social reform to vision in 2005, in the second half of ble solution for neutralizing possible increase the competitiveness of the Slovenian economy”; hereinafter “Budget Memorandum” 2005 and in 2006 policy makers bad consequences of such fiscal re- and “Proposed concepts”. prepared the third – “big bang”– form proposal? However, taking into 8 Main net tax cuts will be achieved by stepwise reform in effort to give impetus to account new goals and constraints abolishing tax on wage bill and trimming tax long run growth9. Macroeconomic of fiscal policy after entering the euro rates on the personal income tax. Effects on the consolidated general government budget will measures, mainly tax restructuring area. be, respectively, 1.2% of GDP and 0.7% of (with flat tax as a flagship proposal), Because policy makers spent a lot GDP. See Bole and Volčjak(2006). with only a vague role of the general of political capital on preparing only 9 See, for example, Proposed concepts and Budget Memorandum. spending cut, presented the crucial tax cutting (!) reform measures11, it is 10 See Proposed concepts, Budget part of the reform. highly questionable if in the second Memorandum, Bole(2005a) and Bole(2006a). The reform proposal had several, part of mandate they are able to ad- 11 Political capital was spent on (unsuccesfully) for fiscal soundness, crucial draw- just public spending, or to increase defending ﬂat tax proposal. backs: it was prepared without fixing taxes on consumption to offset corre- 12 See, for example, Tanzi and Zee(1997).

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Table 1: Effective tax rates Introduction of Scandinavian type dual personal income tax, with sepa- Consumption Capital tax. rate treatment of capital gains and Total Tax. Labour tax. tax (2003) interests, was the first step in such a 15 Italy 40.6 16.8 42.0 30.8 direction . Because mobility of the Hungary 39.1 28.6 40.8 - tax base is more harmful for smaller economies16, at responding on Austria 42.6 21.6 40.7 25.3 tax competition, policy makers in Slovenia 39.7 24.4 37.8 18.7 Slovenia would have to undercut tax EU-25 39.3 21.6 35.6 25.8 rates of bigger economies or to un- EU-15 39.6 22.3 36.0 29.9 dercut average tax rate of the same NMS-10 34.5 20.8 34.7 14.0 bigger economies in the EU (sepa- Source: Eurostat, SURS, own calculations. rately for each tax). As figures in the Table 1 document, adjustments of rated fiscal balance in the institution- times in border areas (for example, tax rates for consumption could have ally unchanged fiscal environment. at a distance less than 50km from the even higher priority than adjustments Nevertheless, because of its possible border) in comparison with the spend- of labour taxation. side effects, increasing of consump- ing size inside the country14. Because Closing (structural) fiscal deficit by tion taxation would not be a good increasing tax rates of consumption solution. taxes could have also harmful effects Increase in taxes on domestic on prices. Increased rates of con- goods and services (VAT and excises) After sumption taxes (which would have to could have harmful effects on tax bring additional tax revenue of 2% of revenue, prices and competitiveness. GDP) could push prices up by more entering EMU, 17 Upon accession to the EU, and than 2.5% . Because only fiscal especially after it joins the euro area, policy would be able to respond to a potential growth of the mobility of policy makers any asymmetric (supply) shock when domestic private consumption could Slovenia is in the euro area, a price be expected in Slovenia, at least will face jump caused by the aforementioned within the circle of its direct EU neigh- increase of consumption taxation bours. Increase in the consumption would not be neutralised (mitigated). taxation necessary to compensate much bigger Deteriorated foreign competitiveness reform’s deficit increment could, would, therefore, be additional macr- therefore, trigger significant tax changes than oeconomic cost of neutralizing possi- export. As figures in the Table 1 ble reform generated (structural) fiscal document, effective taxation of con- deficit by increasing consumption sumption in Slovenia is already much enterprises taxation. higher than in its much bigger and The proposed tax reform at enter- wealthier EU neighbours with whom and households. ing EMU (if not followed by spending the bulk of cross-border trade takes cuts) would, therefore, result, in the place. best case, in significant restructuring Theoretically, in Nash equilibrium of the dwarf size of the country, in of taxation with long-term deteriora- of tax competition driven cross-bor- Slovenia border area, according to tion of foreign competitiveness and, in der trading, a small country has to such a definition, covers almost 50% the worst case, in the strong increase strictly undercut tax rates of a large of population. of the structural deficit and fiscal country. If the difference in size is To mitigate possible problems unsustainability, which would addi- big enough, cross-border trading with the structural deficit at entering tionally constrained policy room for increases tax revenue of the small the euro area, for policy makers it manoeuvre when Slovenia will be country13. Decreasing rates, there- would be very important question already in EMU. Besides, possible fore, would not automatically lower what would be probable increase in positive effects of proposed fiscal tax revenue for the midget-size tax revenue (if there will be any at all) measures on higher long-term growth Slovenian economy. after increasing tax rates on consump- would be, in the best case, probably Table 1 illustrates that after in- tion taxes. Because higher consump- minor, in spite of the high political creasing consumption taxation high tion tax rates could increase tax base costs and probable deterioration enough to neutralize the 2% GDP gap mobility, ex ante determined tax rates of longer term fiscal balance. (for assumed unchanged size of the (at no tax base mobility assumption) 13 See, for example, Kanbur and Keen(1993). tax base), difference in effective taxa- might not be high enough to ex post Arguments are similar to those in the trade tion of consumption with Italy and neutralise possible reform caused theory, that optimal tariffs are closer to zero for drop in the tax revenue of around smaller economies (see, for example, Markusen Austria would be, respectively, over et al.(1989)). 12 and 8 percentages points. For 2% of GDP. 14 See, for example, Cnossen(2002) and such a difference in consumption tax- On stronger tax competition in the Cnossen(2003). ation (inside a common monetary EU, fiscal policy makers in Slovenia 15 See, for example, Zee(2005). area), cross border trading could will have to respond also with other, 16 See, for example, Kanbur and Keen(1993). change private spending size several not only consumption, taxes. 17 See Bole in Volčjak(2006).

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Fiscal soundness versus government (while keeping sound size) could be determined by tax rev- new fiscal goals in generating fiscal balance unchanged) does enue burden of around 35% of GDP efficiency and stability increase efficiency (long run growth), (“critical tax burden”). In the case of it is crucial question, what is the opti- larger government (and the same size For policy makers it is important mal reduction of the government. of the economy) automatic stabilizers question, how will be interrelated There are, namely, several arguments can lead to lower output stabilisation fiscal soundness and maintaining that cutting government size has under supply shocks and inflation stability and efficiency only with fiscal (highest) lower bound, under which destabilization under demand shocks policy after entering the euro area. induced macroeconomic costs are and, however, lower long-term Empirical evidence documents the higher than corresponding benefits. growth. That is, for sizes of the gov- key (switching) role of the fiscal Reducing the size of the govern- ernment greater than the critical tax balance for the direction in which tax ment causes also macroeconomic burden disappear trade-off between policy (changes in taxation) affects costs (not only benefits). Decreasing efficiency and short-term stabilisation growth. In economies with a negative the role of the government spending, role of the government. fiscal balance, increasing the tax it has as an automatic stabiliser, is Large country could “afford” burden with unchanged spending one of them. For Slovenia, as a small higher tax burden (threshold size promotes economic growth (reducing open economy, such costs could be of the government is higher) without the tax burden slows it down). high, because smaller and more open jeopardising properties of automatic Meanwhile, increasing taxation with stabilisers. an unchanged (or even balanced) fis- Presented arguments, therefore, cal deficit curbs growth18. In principle, document that in Slovenia, having therefore, soundness of fiscal policy Fiscal government size (measured by tax does not hamper (it is necessary burden) of over 40% GDP, reduction condition for) long run growth. in the size of a government (with Empirical evidence also shows performance unchanged fiscal balance) increases that merely tax restructuring, without potential short-term stabilisation capa- changes in the total volume of the in Slovenia in bility as well as its long-term growth tax revenue and public spending, has potential! no marked effects on the long-term After entering the euro area (los- growth, although such tax restructur- 2005 and 2006 ing monetary sovereignty), decrease ing might significantly alter the of short run stability could be caused structure of fiscal revenues and the was on the safe also by deterioration of fiscal sound- distribution of welfare among the ness (for example by implementation population19. side both in of procyclical EDP), because in such Quite opposite to the effects of a case the room for short-term fiscal tax restructuring, are the effects of the manoeuvre would be drastically government spending restructuring – terms of deficit constrained only for improvement significant effects on the long-term of fiscal stance. growth of the restructuring govern- and debt Symmetries of demand and ment spending could be detected. supply shocks as well as conformity Empirical evidence, namely, docu- of corresponding response functions ments that cutting transfers and public criteria. are crucial for final evaluation of the sector wage bill in favour of the importance of fiscal smoothing short public (infrastructure) investment spurs economies have bigger governments run shocks and, therefore, also of long-term growth. (fiscal sector), which enable them 18 See, for example, Tanzi and Zee (1997) or Such growth favourable restructur- to offset higher uncertainty and ing of the government spending Easterly and Rebelo (1993). Effects are instability of (externally determined) noticeable in economies with lower and would be favourable also for sound- demand.21 Reducing the size of the average levels of development, where a ness of the fiscal position20 and, there- percentage point of reduced taxation (in % of government (to increase its long-term GDP), with an unchanged (balanced) fiscal fore, for the accelerated convergence performances) too much could, balance, increases long-term real growth by to the medium term SGP fiscal objec- around 0.5 percentage points. In developed therefore, decrease short run stability economies the effect can no longer be tive. It would namely mitigate threat- across the business cycle. empirically identified. See Martin and ening problems with aging society But, in the common currency area, Fardmanesh (1990). as well as enable investments in the activity of the government to stabilise 19 Well known Harberger’s hypothesis of the infrastructure necessary to accelerate superneutrality of the tax structure (Harberger short-term (across the cycle) volatility (1964)) states that the structure of taxes does integration of less developed Slovenia of the economy decreases the govern- not influence long-term growth, but changes into the EU economy. ment potential to increase efficiency distribution of welfare. It has been empirically tested, for example, on OECD economies in the Increasing long run growth by (long-term growth) only under specific analysis of Mendoza et al. (1997); for a similar cutting spending while improving bal- threshold size of the government, argument for the effects of tax policy, see also ance or at least keeping it unchanged which depends on the relative size of Engen and Skinner (1992). 20 would be, obviously, compatible with See, for example, Perroti(1996) or Perotti et the member of the common currency al.(1997) the constraints SGP puts on the fiscal 22 area . Upper bound for such thresh- 21See, for example, Rodrik(1998) or Martinez- soundness after entering into the euro old size of the government for small Monday(2002). area. However, if reducing size of the members of EMU (of the Slovenian 22 See Buti et al. (2003).

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possible macroeconomic effects-costs Institutional strengthening liament a targeted band for cumula- of deterioration in the fiscal sound- of fiscal soundness tive fiscal deficit that would enable ness, after Slovenia enters the euro fiscal stance compliance with SGP area. To avoid effects of deficit bias constraints27. The Fiscal Policy Short-term demand shocks in of fiscal policy makers on fiscal Committee would commit itself to Slovenia are negatively but not soundness, which could entail much keep cumulative fiscal deficit within strongly correlated with those imping- higher macroeconomic costs when the band. Its role would be to evalu- ing on EMU members (weighted by Slovenia will be in the common ate ex ante the fiscal stance of the size), which are, in principle, currency area (for example, if put proposed budgets (including possible smoothed by the ECB. Besides, in the Excessive Deficit Procedure), rebalances) together with explicit price response functions are strongly it is worth creating new institutions GDP growth forecasts prepared by negatively correlated with price re- to keep cumulative fiscal balance the government. The Fiscal policy sponse functions on demand shocks within (ex ante) determined and Committee could veto budget propos- in EMU (-0.5)23. Therefore, even committed band. That would enable al or require only cut in the size of the if demand shocks in Slovenia become smoother dynamics of fiscal balance Pool funding if in its opinion a budget more symmetric with those in EMU, and, therefore, (as previously docu- proposal does not enable achieving after entering euro, activity of ECB mented) also lower macroeconomic the targeted band of cumulative could make (for Slovenia) more costs of short run instability. deficit28. The Fiscal Policy Committee damage than benefit at neutralizing decision could be overturned by price effects of common demand a 75% majority of votes of the parlia- shocks. ment. In the case of a veto, the budg- Supply shocks in Slovenia are At entering et would have to be adjusted or no more symmetric with EMU members (real) increase in spending budget (correlation with supply shocks in has to be accepted. EMU is 0.66). While output responses the euro area, Using cumulative (over longer to them are also considerably (posi- periods) deficit based target and tively) correlated with those in EMU actual general enacting Fiscal Policy Committee economies, price responses on supply could neutralise endogeneity of the shocks are strongly but negatively (!) annual budget and time inconsistency correlated with price responses on government behaviour of the government (and supply shocks in EMU members24. minister of finance). But to increase For Slovenia, lack of monetary balance controllability of the fiscal stance, it is sovereignty would, therefore, not be necessary also to increase flexibility offset (not even partly) by the ECB of the government spending (the activity. So, costs of short-term in Slovenia short-term leverage of the minister demand shocks could significantly of finance). Non-decision is the most increase after Slovenia enter euro will be in the common aspect of the government area and, therefore, also the need spending inflexibility29. In Slovenia for fiscal automatic stabilizers (social over 80% of the budget spending transfers spending) and fiscal price deficit around is fixed by different laws before the curbing. Monetary sovereignty at budget procedure starts. least partly explains, that pre-euro- 1% of GDP. Important generator of the spend- entering effect of automatic stabilizing biases of the politicians and of the ers is almost negligible on the spend- low flexibility of the government ing side and high on the revenue Two institutions seem important: spending can be described by the, so side, in Slovenia.25 the Fiscal Policy Committee and 23 Because of a strong but negative the Pool of adjustable spending See Frenkel and Nickel(2002). 24 correlation of price response functions components. See Frenkel and Nickel(2002). 25 Sensitivity of expenditure and revenue on between Slovenia and EMU, short The Fiscal Policy Committee would output gap is respectively - 0.05 and 0.4 run smoothing of supply shock effects have in the fiscal policy similar role (elasticity is -0.12 and 0.96). See EU on prices, similar to existing excise as independent Central Bank (board Commision(2005). based mechanism for smoothing of governors) has in the monetary 26 Presented is slightly modified idea of the 26 politically independent Fiscal Policy Committee volatility of oil prices, would be useful policy . Members of such a Fiscal described in Wyplosz(2005). also after entering EMU. Policy Committee would be experts, 27 Cummulative deficit seems better than debt After entering the euro area, appointed for a fixed term much (suggested by Wyplosz), because debt trajectory could be affected also by selling considerable deterioration in fiscal longer (e.g.6 to 8 years) than the government assets, but accountancy of the soundness would, therefore, leave term of government. The appointment government assets is much more »soft« in economy with no possibility to stabi- procedure could be the same as for comparison with accountancy of liabilities and current fiscal balance items. lize short-term demand shocks or members of the board of governors, 28 In the case of a veto, the Fiscal Policy to neutralize price effects of supply of judges of the constitutional court. Committee would have to document its decision; shocks. It means that smooth changes The Fiscal Policy Committee would the documentation would have to include at least improbable assumptions (conditional on in the fiscal soundness toward medi- be accountable to the parliament. the Government GDP forecast), creative um-term objective could prevent possi- At starting its term, the Fiscal Policy accountancy and errors. bly high macroeconomic costs. Committee would propose to the par- 29 See Perotti et al.(1997).

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called, “common pool problem”30. The content of the Pool would have increase, while pending institutional Because of the large fragmentation of to be defined only with the broadly changes caused by the integration the spending programmes31, benefits defined (economic) components of of the Slovenian economy into EU will of the particular programme reap the government spending32 and not exert additional pressure on the fiscal small (well defined) group of people. programmes. The minimal size of the policy, and so will effects of standstill Interest groups are, therefore, formed Pool (in percentages of GDP) would in the process of improvement of the to lobby politicians (“covering” corre- be determined by the Fiscal Policy fiscal stance caused by the policy sponding segments of voters or sec- Committee at starting its term, togeth- measures in the last period before tors of economy) for increasing (or to er with its proposal of the targeted entering EMU. prevent cutting) corresponding spend- band for cumulative deficit. Initial fiscal conditions at entering ing programme. Because costs (cur- Government would determine actual the euro area could be considerably rent and future taxes) of programmes’ economic components put into the aggravated by the 2006 tax reform spending are widely dispersed, but Pool (preferable for the horizon much proposal. The proposed tax reform the sizes of the particular programmes longer than budget planning period). at entering EMU, if not followed by are usually negligible in comparison By doing this government would make spending cuts, would result, in the with the total government spending, transparent its long-term priorities in best case, in significant restructuring programmes can pass the parliament restructuring the general government of taxation with long-term deteriora- “unnoticed”. Usual myopic behaviour spending. The Pool could, therefore, tion of foreign competitiveness and, in of politicians is, namely, exacerbated the worst case, in the strong increase by their inability to internalize costs of of the structural deficit and fiscal the particular programme. unsustainability, which would addi- To decrease common pool prob- The reform tionally constrain policy room for lem it would be worth to separate manoeuvre when Slovenia will be part of the government spending pro- already in EMU. grammes in the special Pool of adjust- proposal Because symmetries of shocks able spending components. and correlation of response functions At preparing the budget, particu- had several, between Slovenia and EMU members lar programme would be put in the are, at best, under-average, output Pool with its current entitled (for for fiscal stabilisation will have dominant role example, law determined) size-value. in the new goal function of the fiscal Minister of finance would determine policy in Slovenia. But, because of current year size of the actual funds soundness, possible “unfavourable” effects of ini- clearing the Pool. Particular pro- tial fiscal stance, in the starting period gramme in the Pool would participate crucial of EMU membership, temporarily, in the current year Pool spending fiscal soundness has to have the according to the aliquot share of its absolute priority. nominal (entitled) size in the total drawbacks. Short run smoothing of the supply nominal (entitled) size of the Pool. shock effects on prices, similar to Determining the size of the actual existing excise based mechanism for funding of the Pool would give minis- be also a powerful commitment de- smoothing oil prices, would be useful ter of finance leverage – necessary vice. An example of a feasible content also after entering EMU. flexibility of spending – to be able to of the Pool for Slovenia, after entering After entering the euro area, control total government spending EMU, could be: both components of smooth changes in the fiscal sound- (for example, to keep the fiscal the current spending (or only their ness toward medium-term objective balance inside the targeted band). entitled real increase in the current could prevent possibly high macr- The Pool would change also the year), grants, transfers to enterprises, oeconomic costs. perceived costs of the programmes transfers to households not included in In addition to existing mechanism in the Pool. Instead of (current and the minimal social safety net and of controlling fiscal soundness (SGP future) taxes, programme’s share in current year entitled (real) increase and EDP), it is worth creating also the entitled size of the Pool would in the minimal social safety net. own institutionally based mechanism, figure as a costs in the politicians cost- To prevent political (arbitrary) for small underdeveloped member of benefit analysis. Costs of the watering the Pool, the Parliament EMU. Two institutions seem important: programmes in the Pool would, could overturn the decision of the the Fiscal Policy Committee and the therefore, be much less dispersed and Fiscal Policy Committee on the size Pool of adjustable spending compo- more transparent. That would strength- of the Pool only with 75% majority. In nents. Implementing the Fiscal Policy en politician internalization of costs of such a case, (real) increases of pro- any spending programme in the Pool, grammes from all components except 30 See, for example, Morris et al. (2006). and so mitigate fragmentation effects. interest would be put into the Pool. 31 On fragmentation of spending see, for For the same reason, the Pool would example, Perotti et al. (1997). 32 also empower minister of finance Content of the Pool would be deﬁned by a Conclusion subset from the following items: current against spending ministers. Every min- spending for goods and services, compensation ister would, namely, internalize much After entering the euro area, exter- of employees, minimal social safety net transfers to households, other transfers to households, easier the costs of the particular (other nal formal constraints for the fiscal transfers to enterprises, grants, interests and ministers’) programme in the Pool. policy in Slovenia will significantly investments.

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Committee would eliminate effects Enhancing Fiscal Sustainability and 15. Markusen J. and H. Tulkens, 1986, of the politician’s time inconsistency Macroeconomic Stability in an Enlarged »Commodity Tax Competition Between EU”, Economics in Transition, 12, 67-102. Member States of Federation: Equilibrium caused spending bias on soundness and Efficiency”, Journal of Public Economics, 6. Buti M., C. Martinez-Mongay, K. Sekkat of the fiscal policy. Separating some 29, 133.172. and P. van den Noord, 2003, “Automatic government spending components Fiscal Stabilisers in EMU: A Conflilct 16. Martin R. and M. Fardmanesh, 1990, in the Pool, which would be cleared between Efficiency and Stabilisation?”, “Fiscal variables and growth: a cross-sectional with minister of finance determined CESIFO Economic Studies, 49, 13-140. analysis”, Public Choice, 64, 239-251. size of the funds (in the entitled 7. Cnossen,S., 2003, “How Much 17. Mendoza, E.G., G.M. Milesi-Ferretti and spending structure), would mitigate Coordination in the European Union?”, P. Asea, 1997, “On the ineffectiveness of tax common pool problem. Both institu- International Tax and Public Finance, 10, policy in altering long-run growth: 625-649. Harberger’s superneutrality conjecture”, tions together would enable easier Journal of Public Finance, 66, 99-126. controlling and smoother dynamics 8. Cnnosen, S., 2002, “Tax Policy in the European Union; a Review of Issues and 18. Morris, R., H. Ongena and L. of fiscal balance and, therefore, Options”,http://arno.unimaas.nl/. Schuknecht, 2006, “The Reform and lower macroeconomic costs. Implementation of the Stability and Growth Because mobility of the tax base 9. Easterly W. and S. Rebelo, 1993, “Fiscal Pact”, ECB, Occasional Paper Series, 47. policy and economic growth”, Journal of is more harmful for smaller economies Monetary Economics, 32, 417-458. 19. Perotti R., 1996, “Fiscal Consolidation in at responding on tax competition, Europe: Composition Matters”, AEA Papers 10. Engen E. M. and J. Skinner, 1992, and Proceedings, May, 105-110. after entering in EMU policy makers “Fiscal policy and economic growth”, NBER in Slovenia would have to systemati- working paper, no. 4223. 20. Perotti R., R. Strauch and J. von Hagen, cally undercut tax rates of bigger 1997, “Sustainability of Public Finances”, 11. EU Commission, 2005, “New and CEPR, 1781. economies in the EU. Updated Budgetary Sensitivities for the EU Budgetary Surveillance”, ECFIN. 21. Rodrik, D., 1998, “Why do More Open LITERATURE: Economies Have Bigger Governments”, 12. Frenkel, M. and C. Nickel, 2002, “How Journal of Political Economy, 106, 997-1032. 1. Bole, V., 2006a, “The Ease of Discussions Symmetric are the Shocks and the Shock on Shrinking Government Spending”, Adjustment Dynamics Between the Euro Area 22. Tanzi V. and H.H. Zee, 1997, “Fiscal Gospodarska Gibanja, 377, 7-20. and Central Eastern European Countries?”, policy and long run growth”, IMF Staff IMF Working Paper, 222. Papers, 44, 179-209. 2. Bole, V. and R. Volčjak, 2006, “Effects of Some 2006 Tax Reform Proposals”, 13. Harberger A.C., 1964, “Taxation, 23. Van den Nord, P. 2000, “The Size and Gospodarska Gibanja, 384. resource allocation and welfare”, published Role of Automatic Stabilisers in the 1990 and in The Role of Direct and Indirect Taxes Beyond”, OECD Economics Department 3. Bole, V., 2005, “Short-term Fiscal Risks in the Federal Revenue System, (NBER, Working Papers, 230. and Economic Policy Measures”, The Journal Brookings Institution eds.), Princeton for Money and Banking, 54, 0-27. 24. Wyplosz, C., 005, “Fiscal Policy: University Press. Institutions Versus Rules”, National Institute 4. Bole, V., 2005a, “Is Reform backing 14. Kanbur, R. and M. Keen, 1993, “ Jeux Economic Review, 191, 70-84. the right horse? Verifying the self-evident«, Sans Frontieres: Tax Competition and Tax Gospodarska Gibanja, 376, 5-14. 25. Zee, H.H., 2005, “Personal Income Tax Coordination When Countries Differ in Size”, Reform: Concepts, Issues, and Comparative 5. Buiter, W. H., and C. Grafe, 2004, The American Economic Review, 83, 877- Country Developments”, IMF Working Paper, “Patching up the Pact; Suggestions for 892. 87.

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UDC 336.1/.7(497.4):061.1 EMU Application of the Balance Sheet Approach to Slovenia Božo Jašovič and Borut Repanšek *

The Balance Sheet he historical process of economic integration of Slovenia Approach (hereafter BSA) is based on an intersecto- into the Central Europe will be completed in the financial ral matrix of a national economy’s assets and area by Slovenia’s entry into the Economic and Monetary liabilities. It is based on a complex system of gathering and aggregation of Union on 1 January 2007. The characteristic features and statistical data. In actual Tachievements of this demanding process which began by Slove- practice, its use is adjusted to the special features of each individ- nia’s gaining independence in 1991 are establishment and preser- ual economy. In recent years the BSA has been vation of macroeconomic stability including stability of the finan- increasingly employed by the International cial system. An increasingly globalized world faced several finan- Monetary Fund as a useful complement for deter- cial crises in that period. Because of the increasing importance of mination of intersectoral imbalances which might financial systems, greater interlinkage and complexity, the crises evolve into financial crises. This article presents were different from the preceding ones. It became evident that the concept of the BSA and an attempt of its the financial crises gave rise to direct (costs of saving financial application to Slovenia. The matrix was made on institutions) and indirect costs (loss of potential GDP due to the basis of data from the Financial Accounts, a sta- diminished role of financial intermediation). Resolving of financial tistical system developed by the Financial Statistics crises, therefore, led to further theoretical work focused on un- Dept. of the Bank of Slovenia. This article aims derstanding of the new type of financial crises and development to present some of the conclusions regarding the of the concept of financial stability as the focal point of the finan- interlinkages of the banking sector with the corpo- cial system analysis. In this framework the International Mone- rate and government sectors, which are derived tary Fund (IMF) and some countries began to develop and employ from this matrix. It can be concluded that because the BSA as an additional method for detecting and understanding of high concentration of data, the intersectoral of factors threatening stability of financial systems and potential- matrix gives a clear and complete picture of ly leading to financial crises. Although the method was initially intersectoral relations in the Slovene economy and developed to analyze more vulnerable emerging market econo- facilitates detection of imbalances that could mies, its use was later extended to other institutionally developed pose a threat to its financial stability. It has been and traditionally macroeconomically more stable economies. also confirmed that the BSA facilitates identifica- The purpose of the article is to explore how and to what ex- tion of factors and inter- linkages, which can be tent the BSA can be used to better understand the Slovene eco- further analyzed by classic analytical methods. * Božo Jašovič, MA; Borut Repanšek, MA, Bank of Slovenia.

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nomy from the financial stability point first, the needs for financing deficits focuses on presentation of intersecto- of view. The intersectoral matrix of occurred unexpectedly and at great ral financial assets and obligations assets and liabilities, which is the key extent; second, adjustment or equali- and assessment of risks occurring instrument of the balance sheet zation of imbalances after the out- as the consequence of accumulated approach helps to explain how the break of crises was fast and involved imbalances. This is why the BSA is accumulated imbalances of one major changes of key macroeconomic being included into the evolving con- sector can spill over into other sectors categories (e.g. currency rate, interest cept of financial stability as a comple- as a result of financial interlinkages. rate); and third, besides the relation ment to the classic analytical methods The article is divided into six between the residents and non-resi- based on the analysis of flows. sections. After the introduction, the dents, the relation between a national In contrast to the concept shown in BSA and the key factors that influ- economy’s sectors as well as imbal- Table 1, in actual practice the sectoral enced its development are presented. ances within the sectors themselves breakdown and breakdown of We have limited this second section also constituted an important element balance sheet categories (financial to what is necessary for understand- of the crises.1 instruments) are adjusted to the ing the rest of the article. The third The traditional systems for detec- context in which the matrix is made section is focused on possible appli- tion and prevention of financial crises and, especially, to the available data. cations of the BSA at the analysis of used methods that were based on No matter how the matrix is broken financial stability. The fourth section flow variables – from different meth- down, the BSA indirectly facilitates includes the sources and explains ods of analyzing the balance of pay- determination of balance sheet mis- limitations in the case of Slovenia. The ment and fiscal sector flows to the use matches within a sector or in intersec- fifth section gives a concrete example of the flow-of-funds matrix2. The basic toral linkages by giving insight into of the application of the BSA to Slove- difference between the flow-of-funds the size and structure of balance nia, being followed by the conclusion. matrix and the BSA is that the former sheets of the economy’s sectors. is based on financial flows and the The matrix is easy to understand: Brief description of the BSA latter focuses on data on stocks at the the values in columns represent the and factors having inﬂuenced end of periods. Both concepts are sector’s claims (financial assets), while its development nevertheless interlinked because the the rows state the sector’s liabilities. changes in stocks between the begin- As the data are not consolidated, the Major financial crises in the nine- ning and end of a certain period are matrix’s diagonals represent intrasec- ties of the 20th century (for example, the result of flows in that period, or, toral financial assets or liabilities. Mexico – 1995, the Asian crisis – to put it precisely, of the sum of flows The BSA has three key limitations3. 1997, Russia – 1998) differed from and changes in the values of asset First, as opposed to the early warning the preceding financial, or to simplify, and liability positions. As opposed systems, it cannot be reduced to a typically balance-of-payment crises: to the flow-of-funds matrix, the BSA smaller number of quantitative indicators reflecting the degree of vulnera- Table 1: Simplified conceptual presentation of the BSA matrix bility to risks; it is a rough conceptual framework whose quantitative values CREDITOR complement other methods for monitoring a national economy’s events. DEBTOR Financial Non-financial Rest Public sector sector sectors of the world Second, the BSA does not include off-balance sheet positions, and third, Public sector it does not include the distribution of Total liabilities probability of key risks or occurrence Short term of shocks. The BSA is oriented to Medium and long term three types of risks4: Equity a) Maturity mismatches arising Financial sector typically when assets are long term Total liabilities and liabilities are short term. The Short term debtor’s risk can be manifested in two ways. First, at the maturity date the Medium and long term debtor is not able to ensure refinanc- Equity ing of the debt and has to repay it Non-financial sectors earlier than planned (roll-over risk) Total liabilities and second, an increase in the inter- Short term est rate may increase the debt so that Medium and long term the debtor is no longer able to service Equity it (interest rate risk). Rest of the world b) Currency risk is caused by a Total liabilities disparity in the currencies in which as- Currency and short term 1 Allen et al., 2002. Medium and long term 2 More on the Flow-of-Funds Matrix – Bank of Slovenia. 1996. Surveys and Analyses IV/2. Equity 3 Rosenberg et al., 2005. Source: Rosenberg et al., 2005. 4 Allen et al., 2002.

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sets and liabilities are denominated. – a starting point for more compre- and maturity risks as the consequence It is characteristic of national econo- hensive analyses for analyzing and of dollarization of the economy (Peru, mies financed by borrowing in foreign assessing risks in the sectoral balance 2004; Ukraine, 2005) or assessment currency mainly (e.g. economies using sheets. of external sustainability and vulnera- the American dollar). It is vital to iden- A characteristic feature of the bility with the emphasis on the ex- tify the sectors where such risks exist balance sheet approach is that it ad- change rate risk (Bulgaria, 2004). as well the impact of a potential ex- justs to specific characteristics of each In some cases the method is applied change rate shock on other sectors. individual economy. The analyses are to one sector only, for example, the c) Capital structure mismatch risk not standardized and are as a rule public sector in Chile, which was resulting from relying excessively on adjusted to the characteristics of the analyzed from the aspect of external debt financing rather than equity in economy under study to the highest position and liquidity, or in the case any sector of the national economy possible extent. Through a more de- of Ecuador, from the aspect of fiscal (mostly in the corporate, but also in tailed access to the data that are less policy sustainability and determina- the banking sector). This risk can also aggregated it is possible to pursue tion of the public sector’s net value. be the result of inadequate economic specific goals in analyzing intersecto- In developed economies the analyses policy measures. ral imbalances. Owing to the lack of almost do not seem to be based on During the crises all these risks typ- data, comparisons by different time the BSA at the first glance, because ically manifest themselves as liquidity periods have been rarely possible. they focus on a certain sector from a or solvency problems. In the case of specific angle, so that they could be the solvency problems the value of also categorized as sectoral analyses assets (financial and non-financial) using the balance sheet approach: for falls below the value of liabilities. In A characteristic example, the analysis of international the general government sector this interlinkages of the German banking problem can manifest itself as a large sector or the analysis of foreign cur- increase in the state debt as the conse- feature of the rency denominated loans in Austria quence of unexpected depreciation or from the aspect of exchange rate risk devaluation of the domestic currency. balance sheet Liquidity and solvency problems of Application of the BSA the debtor constitute a credit risk for to Slovenia the creditor. In an intersectorally linked approach is Our presentation of the applica- economy the problems in one sector tion of the BSA is based on the can easily spill over into other sectors that it adjusts Financial Accounts issued by the as a result of financial interlinkages. Bank of Slovenia. They are based These interlinkages can be easiest on a complex and extensive system identified by a matrix of intersectoral to specific of reporting and processing of data. asset and liability positions; the details Initially, they were compiled by stocks of sectorization and the precision of characteristics at the end of years; since the begin- presentation by financial instruments ning of 2006 the data have been are, however, dependent on the avail- available quarterly. We decided to ability of data and analytical needs. of each use them as our primary data source In evaluation of the results in because of their quality and integrali- assessing vulnerability to risks or bal- individual ty, even though their contents en- ance sheet mismatches it is necessary tailed certain limitations for the pur- to make a distinction between the risks economy. pose of risk assessment. So far we or mismatches and the triggers of have used this data source only; financial crises. The mismatches reflect however, it can always be completed the order of magnitude of the potential There is also a substantive difference by other data if it would prove neces- damage and adjustments caused by between the use of the BSA in devel- sary and suitable. the financial crisis and not the proba- oping countries and in developed The tables of the Financial bility of the crisis and the presence of economies. For example, in the case Accounts differ from the tables used all possible elements that might trigger of Thailand the intersectoral matrix in the BSA basically by stating first the it. After all, a crisis can occur for totally was used to determine the decrease assets and then the liabilities of each non-economic (e.g., political) reasons. in the balance sheet mismatches and individual sector (in the rows by indi- Application of the BSA risks at the macro level in the period vidual categories). Therefore we had following the financial crisis and in to rearrange the data by consolidat- The BSA for determination of im- the case of Colombia for general as- ing the sectoral tables into one table balances by individual sectors of the sessment of mismatches and vulnera- to obtain the format of the balance economy is used to the greatest extent bility over a longer period (1996- sheet approach table. Both, the rows by the IMF. It has so far been used as: 2003). In numerous other cases the and the columns carry the respective – a diagnostic tool for understand- BSA helped to further explain certain values for each individual institutional ing former financial crises; characteristics of emerging economies sector. Whereas the rows present – a pattern or criterion for evalua- at the intersectoral level, which could financial liabilities of each individual tion and monitoring of current imbal- potentially lead to a financial crisis; sector by key categories, the columns ances; for example, the analysis of currency present the sectors’ assets.

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The financial accounts and the On the other hand, the sectoral using the BSA. However, further re- BSA are both limited to financial breakdown of financial accounts is search of the BSA use in more com- assets, for they do not include non-fi- much more detailed than is required prehensive analyses for identification nancial assets. However, the financial for the BSA. However, it also means and assessment of risks in intersectoral accounts were primarily developed that the BSA is more widely applica- relations can be interesting too. as a statistical system and not to sup- ble, which is especially characteristic port the balance sheet approach. of developed countries, which mainly Changing of the Structure When applying the BSA to Slovenia focus on balance sheets of narrowly of Assets and Liabilities of Banks we also tried to find out to what defined sectors first and explore inter- and Corporations extent the financial accounts could linkages with other sectors of the The analyses of the banking sector be used as the source of data if their economy. used to focus on research of the struc- limitations were taken into account. By means of data at the end of the ture of bank assets and liabilities. Three limitations are especially im- years 2001 to 2005 we have tried to By means of the balances sheet ap- portant. First, the financial accounts illustrate the changes in the structure of proach we can, for example, analyze are available for the period from assets and liabilities of four basic sec- financial relations between a certain tors of the national economy with the (incl.) 2001 only. Therefore, only sim- sector and the banking sector. We emphasis on the financial sector’s as- ple analyses are possible, and con- have focused on the sector of non-fi- sets and liabilities. Because of the conclusions, which are less reliable as if nancial corporations, as it is usually text within which this article has been the time series were longer. Second, one of the most important sectors published we have mainly focused on the financial accounts are not broken financed by banks. Traditionally, the banking sector, being aware that down by currencies. Because of the corporations are a deficit sector of the banking data are also available in the introduction of the euro this limitation economy, so it is not surprising that balance sheets of the banks. is losing importance. Third, the break- corporate claims on banks grew more down by instruments enables determi- Selected Presentations slowly than the gross domestic prod- nation of maturity mismatches to a and Findings uct. The corporate sector did not con- limited extent only. All three limita- tribute to financial deepening through tions could be mitigated to a certain The data presented in the follow- bank financing. The total net financial extent by additional data sources; ing section do not constitute a system- position (surplus of financial liabilities however, we would most probably atic approach to analysis of a certain over financial assets) of the corporate encounter some other deficiencies problem; they are only given as exam- sector was financed by other sectors due to inconsistency of data. ples illustrating some possibilities of of the economy and the external sec-

Table 1a: Structure of liabilities of banks to the corporate sector (in million EUR and in percent)

2001 2002 2003 2004 2005 2001 2002 2003 2004 2005

million EUR % Currency and deposits 2379 2576 2577 2649 3124 72.8 78.2 78.3 75.5 79.7 Securities other than shares 280 221 262 250 200 8.6 6.7 8.0 7.1 5.1 - Short term 117 43 40 57 20 3.6 1.3 1.2 1.6 0.5 - Long term 162 176 216 185 177 5.0 5.3 6.6 5.3 4.5 Loans 0 0 0 0 1 0.0 0.0 0.0 0.0 0.0 - Short term 0 0 0 0 1 0.0 0.0 0.0 0.0 0.0 - Long term 0 0 0 0 0 0.0 0.0 0.0 0.0 0.0 Shares and other equity 491 370 355 521 503 15.0 11.2 10.8 14.8 12.8 Other liabilities 120 127 99 89 92 3.7 3.9 3.0 2.5 2.4 Total 3269 3294 3294 3509 3920 100.0 100.0 100.0 100.0 100.0

Table 2: Structure of claims of banks on the corporate sector (in million EUR and in percent)

2001 2002 2003 2004 2005 2001 2002 2003 2004 2005 Million EUR % Currency and deposits 0 0 0 0 0 0.0 0.0 0.0 0.0 0.0 Securities other than shares 26 30 29 111 217 0.4 0.4 0.4 1.2 1.9 - Short term 3 4 2 17 1 0.1 0.1 0.0 0.2 0.0 - Long term 21 17 12 84 205 0.3 0.2 0.1 0.9 1.8 Loans 5663 6280 7387 8639 10483 89.4 89.9 92.6 92.5 92.8 - Short term 2948 2988 3204 3461 4093 46.5 42.8 40.2 37.1 36.3 - Long term 2716 3292 4184 5177 6389 42.9 47.1 52.5 55.5 56.6 Shares and other equity 420 448 402 438 468 6.6 6.4 5.0 4.7 4.1 Other claims 227 225 155 147 123 3.6 3.2 1.9 1.6 1.1 Total 6336 6984 7974 9335 11291 100.0 100.0 100.0 100.0 100,0

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tor. In the period between 2001 and arising from issued debt securities, for tors (other financial institutions, 2005, the liabilities of banks to the corporate bonds could, theoretically, abroad and by financing on the capi- corporate sector increased from €3.3 be also bought by the non-banking tal market). billion to 3.9 billion and the claims sector. The intersectoral matrix in The financial accounts for the peri- from €6.3 to 11.3 billion; the impor- Attachment 1 shows that corporations od 2001-2005 show an increase in tance of bank financing of the corpo- practically do not issue debt securi- the relative importance of the banking rate sector increased significantly. ties; the importance of the capital or financial sector in financing the Table 1 and Table 2 show the result- market in debt financing is thus insig- corporate liabilities in Slovenia (Table ing changes in the structure of banks’ nificant. Besides, banks’ share in the 3). It was the share of the government liabilities to and claims on corpora- equity of the corporate sector is de- that decreased while the share of tions. The liabilities mainly consist of creasing which proves a waning own- households remained at the same currency and deposits of corporations ership interlinkage of banks and non- level with only minor changes. The at banks (accounting for almost 80% financial corporations (stagnation has latter constitutes mainly the share of of liabilities at the end of 2005). The also been found in the share of corpo- households in the equity capital of share of non-financial corporations in rations in the equity capital of banks). corporations (as the consequence of the equity capital of banks has been Extension of maturities of claims on privatization) and, to a lesser extent shrinking. Among liabilities of banks corporations shows that the gap be- only, credit financing of corporations. to the corporate sector we have no- tween the maturities of claims and lia- The sectoral structure of financing cor- ticed a decrease in the share of secu- porations also shows that the share of rities at the expense of an increase in the external sector did not decrease the relative share of deposits of corpo- in this period; on the contrary, it even rations at the banks. Furthermore, Liabilities grew a little. However, it can be ac- equity holdings of non-financial cor- counted for by increased investing in porations in banks have decreased. of banks to the the equity capital, which more than Total financial claims of banks on doubled in that period. A declining the corporate sector were increasing share of the government in financing much faster than the gross domestic government corporations should be mentioned. product. In the forthcoming period we Also in this case it is mostly the gov- can expect the process of financial amounted ernment’s holding in corporate equity deepening to continue through in- rising insignificantly in nominal terms; creased financing of corporations. hence its relative share in corporate Financial intermediation through to €1.6 billion sector financing is shrinking. banks will continue to rise due to favourable economic conditions (eco- at the end Interlinkage of banking and general nomic growth) and because banks government sector 5 have become more efficient. On the assets side, claims on corporates have of 2005, which So far we have not paid much increased as corporations borrowed attention to presentation of financial more between 2001 and 2003 (long- was by €100mn assets and liabilities between the bank- term loans grew strongly over the pe- ing and the general government sec- riod under review). In addition, banks’ tor, which is interesting, especially be- security portfolios have increased re- less than cause the government has financed the cently, although they are still a small rehabilitation of the banking system. portion of assets. This could lead to in 2001. 5 the conclusion that corporations are fi- General government sector includes central government (recipients of budgetary funds at nanced by issuing debt securities to a the national level, public funds and SOD - the minor extent only. To be able to con- bilities of banks to corporations is Slovenian Restitution Fund), local government and social security funds (the Health Insurance firm this conclusion we have to check widening. Banks must thus secure sta- Institute, the Pension and Disability Insurance total liabilities of the corporate sector ble long-term sources from other sec- Institute and KAD – the Capital Pension Fund).

Table 3: Sectoral structure of corporate liabilities (in million EUR and in percent)

2001 2002 2003 2004 2005 2001 2002 2003 2004 2005 mio EUR % Corporations 14686 16744 18144 18704 20432 33.7 34.4 34.5 32.7 32.6 Financial sector 9436 10452 11637 13484 15417 21.6 21.5 22.1 23.6 24.6 - Banking sector 6336 6984 7974 9335 11291 14.5 14.4 15.2 16.3 18.0 Government 6428 6363 6284 7384 7430 14.7 13.1 11.9 12.9 11.9 Households 5921 6654 7171 7867 8452 13.6 13.7 13.6 13.8 13.5 Other 103 124 119 92 114 0.2 0.3 0.2 0.2 0.2 Rest of the world 7068 8275 9276 9678 10751 16.2 17.0 17.6 16.9 17.2 Total 43642 48612 52631 57209 62596 100.0 100.0 100.0 100.0 100.0

BV 11/2006 99 THE CASE OF SLOVENIA

Table 4: The structure of banks’ liabilities to the government (in million EUR and in percent)

2001 2002 2003 2004 2005 2001 2002 2003 2004 2005 million EUR % Currency and deposits 754 960 723 627 926 44.5 50.6 44.1 47.2 58.1 Securities other than shares 53 167 188 168 147 3.2 8.8 11.5 12.6 9.2 - Short term 3 18 3 2 0 0.2 1.0 0.2 0.2 0.0 - Long term 50 148 185 165 147 3.0 7.8 11.3 12.4 9.2 Loans 32 23 16 0 7 1.9 1.2 1.0 0.0 0.4 - Short term 0 0 0 0 0 0.0 0.0 0.0 0.0 0.0 - Long term 32 23 16 0 7 1.9 1.2 1.0 0.0 0.4 Shares 812 689 665 486 476 47.9 36.3 40.6 36.6 29.8 and other equity capital Other claims 44 60 48 48 38 2.6 3.1 2.9 3.6 2.4 Total 1696 1898 1639 1328 1595 100.0 100.0 100.0 100.0 100.0

Table 5: The structure of banks’ claims on the government (in million EUR and in percent)

2001 2002 2003 2004 2005 2001 2002 2003 2004 2005 million EUR % Currency and deposits 0 0 0 0 0 0.0 0.0 0.0 0.0 0.0 Securities other than shares 1796 1765 2111 2563 2833 69.4 67.3 77.8 79.1 79.6 - Short term 182 139 105 129 86 7.0 5.3 3.9 4.0 2.4 - Long term 1614 1626 2001 2434 2747 62.4 62.0 73.8 75.1 77.2 Loans 732 777 530 617 645 28.3 29.7 19.5 19.0 18.1 - Short term 143 139 119 12 66 5.5 5.3 4.4 0.4 1.9 - Long term 588 638 411 604 579 22.7 24.3 15.2 18.6 16.3 Shares 0 0 0 0 0 0.0 0.0 0.0 0.0 0.0 and other equity capital Other liabilities 60 79 72 61 82 2.3 3.0 2.6 1.9 2.3 Total 2588 2621 2713 3241 3559 100.0 100.0 100.0 100.0 100.0

Liabilities of banks to the govern- government equity holdings to the bonds (see Table 5). Most of the ment amounted to €1.6 billion at the private sector. More than in the bonds issued to finance the rehabili- end of 2005, which was by €100 structure of liabilities of banks to tation of banks were already called, million less than in 2001. Table 4 the government we are interested but the banks invested the funds from shows that on the liabilities side, the in the structure of banks’ claims on these bonds into new issues of share of currency and deposits in the the government and vice versa, the bonds. The banks were also among structure of liabilities has increased structure of the government’s liabili- the most important investors in regu- (even though the nominal value of ties to the banking sector. Because lar issues of government bonds and this item has varied over the years), of the rehabilitation of the Slovenian treasury bills. while shares and other equity capital banking system it is not surprising The government is mainly financed have decreased by 18 percentage that most of the banking sector’s by issuing fixed-term securities on the points between 2001 and 2005 claims on the general government capital market and to a lesser extent mostly as a result of the sale of the sector are claims arising from issued by borrowing. At least 93% of the

Table 6: Liabilities from issued long-term debt securities (in million EUR and in percent)

2001 2002 2003 2004 2005 2001 2002 2003 2004 2005 million EUR % Corporations 113 114 127 248 455 1.8 1.3 1.2 2.0 3.3 Financial sector 496 785 1060 1194 1280 8.0 9.0 10.0 9.4 9.2 - Banking sector 464 745 986 1123 1224 7.5 8.5 9.3 8.9 8.8 Government 2688 3475 4010 4732 5153 43.3 39.9 37.8 37.3 37.1 Households 0 0 0 0 0 0.0 0.0 0.0 0.0 0.0 Other 0 0 0 0 0 0.0 0.0 0.0 0.0 0.0 Rest of the world 2910 4342 5411 6504 6988 46.9 49.8 51.0 51.3 50.4 Total 6207 8716 10608 12678 13876 100.0 100.0 100.0 100.0 100.0

100 BV 11/2006 THE CASE OF SLOVENIA

Table 7: Claims in the form of long-term debt securities (in million EUR and percent)

2001 2002 2003 2004 2005 2001 2002 2003 2004 2005

million EUR % Corporations 252 305 351 399 408 4.7 4.7 4.8 4.8 4.6 Financial sector 2440 2888 3857 4691 5618 45.4 44.5 53.1 56.7 62.8 - Banking sector 1720 1779 2217 2779 3349 32.0 27.4 30.5 33.6 37.4 - Insur. and pension funds 594 866 1235 1466 1854 11.1 13.3 17.0 17.7 20.7 Government 251 561 404 382 374 4.7 8.6 5.6 4.6 4.2 Households 355 620 584 701 437 6.6 9.5 8.0 8.5 4.9 Other 0 0 2 1 50 0.0 0.0 0.0 0.0 0.6 Rest of the world 2074 2121 2071 2093 2061 38.6 32.7 28.5 25.3 23.0 Total 5372 6495 7269 8267 8948 100.0 100.0 100.0 100.0 100.0 banking system’s claims on the tic financial sector, especially banks. the share of the households is even government are long term. With re- The share of insurance companies more variable. Interestingly, in the last gard to their liquidity and the quality and pension funds is typically on the year of the period the share of house- of the government as the issuer, the in- holds was almost halved which can crease in the share of long-term bank be attributed to taxation of interest claims does not entail major risk. income which was introduced then. The financial There is also a marked tendency of Financing in the form of long-term decrease in the share of the rest of securities accounts the world in domestic issues of bonds, which is partly due to the conver- Financial accounts also facilitate gence of interest rates or yields, an intersectoral breakdown by instru- and the BSA which began to develop in this ment. The question, which sectors segment of the financial market first. have been the most important issuers If we focus only on the rest of the of bonds during the period under re- are both world with regard to issuing and view might be of interest here. Of all investing in bonds, we see that by sectors of the economy the govern- limited means of this instrument domestic ment has most liabilities from issuing sectors were net financers of the rest bonds. As the main issuer, it has driv- to financial of the world. At the same time, en other issuers out of the capital mar- however, we have to point out that the ket. Issues by other domestic issuers rest of the world also heavily financed have been insignificant, except for the assets, for they the domestic sectors, especially the bonds issued by banks, whose share banking sector, by long-term loans. accounted for nearly one tenth of all do not include bonds issued by the end of 2005. Conclusion A slight tendency of corporate bonds share to increase might mean that this non-financial The intersectoral matrix of finan- sector will increasingly finance itself cial assets and liabilities, which also on the capital market in the future. assets. offers a breakdown by financial in- Even though the corporate sector strument, is the basis for the research increased its liabilities from long-term of accumulated sectoral mismatches debt securities in the absolute amount increase too, most probably as a and financial interlinkages between from €113 million to €455 million in consequence of voluntary supplemen- the sectors of the domestic economy. that period, it represents only one per- tary pension insurance provided by While the national statistics and centage point more in the structure. these institutions; the financial savings accounts are traditionally based on The external entities have to be are largely invested in government examination of flow variables in a mentioned among the bond issuers bonds because of the government’s certain period, the balance sheet too, for they issued more than half guaranteed minimum yield pegged to approach focuses on examination of all issued bonds. These are bonds, the government bond yields. If these of stocks. The analysis of stocks facili- which were bought by domestic institutions invested in other financial tates determination of accumulated sectors. More than three quarters of assets, they would be exposed to the mismatches representing risks that bonds issued by the rest of the world risk that in certain periods they might might trigger a financial crisis in a were bought by the central bank not reach the guaranteed yield in sector. If these risks materialize, the managing the foreign reserve assets. which case they should cover it from negative impacts can quickly spread The other question we would like their own funds. The share of corpora- to other sectors as a result of finan- to address is which sectors have tions in investing in bonds was cial linkages. By means of the meth- financed issuing of bonds. In issuing constant for the whole period under odology of the BSA we can explain long-term debt securities the state has review; greater dynamics can be no- the factors that triggered the financial been mainly supported by the domes- ticed in the share of the government; crisis, in which case the methodology

BV 11/2006 101 THE CASE OF SLOVENIA

serves as a diagnostic tool for under- ing sectoral and intersectoral risks. 5. IMF 2003. “Ecuador: Selected Issues and standing of former crises. However, This very use opens wide opportuni- Statistical Appendix. IMF Country Report No. 03/91”. Washington. the matrix has other uses, too. We ties for further research and mapping can use past experience to monitor out of useful approaches for the 6. Bank of Slovenia. 2005. “Financial the current situation and assess the needs of financial stability. accounts of Slovenia 2001 – 2004”. Ljubljana. existing imbalances which might entail financial risks. The makers of LITERATURE AND SOURCES: 7. IMF. 2003. “Germany: Selected Issues. IMF Country Report No. 03/342”. Washington. macroeconomic policies can use 1. Allen, M., C. Rosenberg, C., Keller, B., these data to make better-informed Setzser, and N. Roubini. 2002. “A Balance 8. Lima. J. M., E. Montes, C. Varela, and J. Wiegand. 2006. “Sectoral Balance decisions and take appropriate Sheet Approach to Financial Crisis”. IMF, Washington. Mismatches and Macroeconomic measures to lessen the identified Vulnerabilities in Colombia, 1996-2003”. 2. IMF. 2005. “Austria: Selected Issues. IMF imbalances and neutralize the IMF, Washington. Country Report No. 05/249”. Washington. possible negative consequences, 9. IMF. 2004. “Peru: Selected Issues. IMF 3. IMF. 2004. “Bulgaria: Selected Issues and which is another practical value Country Report”. Washington. Statistical Appendix. IMF Country Report”. of this approach. And last but not Washington. 10. IMF. 2003. “Thailand: Selected Issues. least, the BSA can be an indispensa- IMF Country Report”. Washington. 4. Rosenberg, C. B., I. Halikias, B.E. Brett, C. ble basis for comprehensive analyses Keller, J. Nysted, A. Pitt, and B. Setser. 11. IMF. 2005. “Ukraine: Selected Issues. with the emphasis on a dynamic, 2005. “Debt-Related Vulnerabilities and IMF Country Report No. 05/20”. market approach (ex ante) to analyz- Financial Crises«. IMF, Washington. Washington.

Attachment: Intersectoral matrix for the year 2005 (million EUR)

HOLDER OF THE LIABILITY (Creditor) ISSUER OF THE LIABILITY (Debtor) Enterprise Financial Gen. gov- Rest of the LIABILITIES Households Others sector sector ernment World TOTAL S11 S12 S13 S14 S15 S2 (S1 + S2) S1 102693 28342 35793 13449 24589 520 25537 128231 CURRENCY AND DEPOSITS 18291 3158 2519 1218 11161 236 2344 20635 Securities other than shares 10840 499 9379 463 449 50 2098 12939 - Short-term 3934 87 3746 89 12 0 21 3956 - Long term 6887 408 5618 374 437 50 2061 8948 Loans S1 23424 2570 19059 920 861 14 12285 35709 - Short-term 7594 1451 5460 365 311 7 751 8345 - Long term 15830 1119 13599 554 550 7 11534 27364 Shares and other equity 33390 13094 3695 8090 8350 160 5742 39131 Insurance technical reserves 2723 297 213 1 2212 0 82 2805 Other accounts receivable 14026 8724 928 2758 1556 59 2986 17012

ENTERPRISE SECTOR S11 51846 20432 15417 7430 8452 114 10751 62597 Currency and deposits 0 0 0 0 0 0 0 0 Securities other than shares 513 98 351 33 31 0 17 530 - Short-term 46 31 3 7 4 0 0 46 - Long term 455 66 336 26 27 0 13 468 Loans 15079 2047 11927 281 810 13 3057 18136 - Short-term 5859 1254 4310 0 287 7 78 5937 - Long term 9220 793 7618 281 523 7 2979 12199 Shares and other equity 27120 11945 2748 5989 6373 65 4783 31903 Insurance technical reserves 0 0 0 0 0 0 0 0 Other accounts receivable 9134 6342 391 1128 1237 36 2894 12028

FINANCIAL SECTOR S12 33170 5156 9662 2509 15508 333 12545 45715 Currency and deposits 18276 3158 2519 1218 11146 236 2344 20620 Securities other than shares 4858 211 4466 153 28 0 351 5208 - Short-term 3572 21 3551 0 0 0 0 3572 - Long term 1280 187 912 153 27 0 338 1617 Loans 1572 87 1433 7 45 0 8752 10324 - Short-term 560 81 456 0 23 0 673 1233 - Long term 1012 7 977 7 21 0 8079 9091 Shares and other equity 5038 1147 948 872 1976 95 958 5997 Insurance technical reserves 2723 297 213 1 2212 0 82 2805 Other accounts receivable 702 256 85 259 102 1 58 761

102 BV 11/2006 THE CASE OF SLOVENIA

ISSUER OF THE LIABILITY (Debtor) Enterprise Financial Gen. gov- Rest of the LIABILITIES Households Others sector sector ernment World TOTAL S11 S12 S13 S14 S15 S2 (S1 + S2)

GENERAL GOVERNMENT S13 10869 1492 5386 3290 628 73 2162 13031 Currency and deposits 14 0 0 0 14 0 0 14 Securities other than shares 5469 190 4562 277 390 50 1731 7200 - Short-term 317 35 193 82 7 0 21 338 - Long term 5153 155 4370 195 383 50 1710 6862 Loans 1347 88 709 544 6 1 418 1766 - Short-term 442 11 66 365 0 0 0 442 - Long term 905 77 643 179 6 1 418 1324 Shares and other equity 1232 2 0 1229 1 0 0 1232 Insurance technical reserves 0 0 0 0 0 0 0 0 Other accounts receivable 2806 1213 114 1240 217 22 13 2819

HOUSEHOLDS S14 6703 1214 5299 189 0 0 75 6778 Currency and deposits 0 0 0 0 0 0 0 0 Securities other than shares 0 0 0 0 0 0 0 0 - Short-term 0 0 0 0 0 0 0 0 - Long term 0 0 0 0 0 0 0 0 Loans 5364 339 4965 60 0 0 55 5419 - Short-term 722 100 623 0 0 0 0 722 - Long term 4642 239 4342 60 0 0 54 4696 Shares and other equity 0 0 0 0 0 0 0 0 Insurance technical reserves 0 0 0 0 0 0 0 0 Other accounts receivable 1339 875 335 129 0 0 21 1359

OTHERS S15 106 47 29 30 0 0 4 110 Currency and deposits 0 0 0 0 0 0 0 0 Securities other than shares 0 0 0 0 0 0 0 0 - Short-term 0 0 0 0 0 0 0 0 - Long term 0 0 0 0 0 0 0 0 Loans 61 9 25 27 0 0 4 65 - Short-term 11 6 6 0 0 0 0 11 - Long term 50 3 19 27 0 0 4 54 Shares and other equity 0 0 0 0 0 0 0 0 Insurance technical reserves 0 0 0 0 0 0 0 0 Other accounts receivable 45 38 4 3 0 0 0 45

REST OF THE WORLD S2 20593 6339 11975 1102 1173 4 4945 Currency and deposits 3704 62 2875 7 760 0 -1360 Securities other than shares 7017 39 6888 71 19 0 -4919 - Short-term 10 7 2 0 1 0 12 - Long term 6988 26 6880 70 12 0 -4927 Loans 1511 576 925 0 11 0 10773 - Short-term 458 190 269 0 0 0 292 - Long term 1053 386 656 0 11 0 10481 Shares and other equity 3603 2077 1053 140 329 4 2139 Insurance technical reserves 14 0 14 0 0 0 68 Other accounts receivable 4744 3585 220 884 54 0 -1757

ASSETS TOTAL (S1 + S2) 123286 34681 47768 14551 25762 524 -4945 Currency and deposits 21995 3220 5393 1224 11921 236 1360 Securities other than shares 17857 538 16267 534 468 51 4919 - Short-term 3944 94 3748 89 12 0 -12 - Long term 13875 434 12497 444 449 50 4927 Loans 24935 3146 19984 920 871 14 -10773 - Short-term 8053 1641 5728 365 311 7 -292 - Long term 16883 1505 14255 554 560 7 -10481 Shares and other equity 36992 15171 4748 8230 8679 164 -2139 Insurance technical reserves 2737 297 227 1 2212 0 -68 Other accounts receivable 18769 12309 1149 3642 1610 59 1757

BV 11/2006 103

STATISTICAL APPENDIX

Selected Macroeconomic and Financial Indicators Matjaž Noč *

1. INDICATORS OF ECONOMIC DEVELOPMENT

GDP per capita (PPS, Euro area=100, 2005)

Comparision of price levels (Euro area=100, 2004)

* Matjaž Noč, Analysis and Research Department, Bank of Slovenia

BV 11/2006 105 STATISTICAL APPENDIX

2. ECONOMIC ACTIVITY AND MACROECONOMIC STABILITY

Real GDP growth (%)

Unemployment (%)

Inﬂation (HICP annual average in %)

106 BV 11/2006 STATISTICAL APPENDIX

General government balance (in % GDP)

Current account of balance of payments (in % GDP)

3. STRUCTURE OF THE FINANCIAL SYSTEMS (2005)

BELGIUM GERMANY

Investment funds Investment funds Insurance cor. Insurance cor.

Credit institutions Credit institutions

BV 11/2006 107 STATISTICAL APPENDIX

GREECE SPAIN Investment Investment funds funds

Insurance Insurance cor. cor.

Credit institutions Credit institutions

FRANCE IRELAND Investment Investment funds funds

Insurance cor.

Credit institutions Credit institutions

ITALY LUXEMBOURG

Investment Credit institutions funds

Insurance Investment cor. funds

Credit institutions

NETHERLANDS AUSTRIA

Investment Investment funds funds

Insurance Insurance cor. cor.

Credit institutions Credit institutions

108 BV 11/2006 STATISTICAL APPENDIX

PORTUGAL FINLAND

Investment Investment funds funds Insurance Insurance cor. cor.

Credit institutions Credit institutions

EURO AREA SLOVENIA Investment Investment funds funds Insurance Insurance cor. cor.

Credit institutions Credit institutions

4. BANKING SYSTEMS

Credit institutions’ intermediation* (total assets/GDP in %, 2005)

*Credit institutions are banks and savings banks.

BV 11/2006 109 STATISTICAL APPENDIX

Domestic ownership of banks (% of total national banking sector assets, 2005)

Return on equity (in %, 2004)

Return on assets (in %, 2004)

110 BV 11/2006 STATISTICAL APPENDIX

Cost-income ratio (in %, 2004)

5. FULFILMENT OF THE MAASTRICHT CRITERIA

Inflation Interest rates General g. balance Public debt (in %)(1) (in %)(1) (in % GDP, 2005) (in % GDP, 2005) Cyprus 2.2 4.20 -2.4 70.3

Czech Republic 2.3 3.64 -2.6 30.5

Estonia 4.4 3.97 1.6 4.8

Latvia 7.0 3.77 0.2 11.9

Lithuania 3.2 3.79 -0.5 18.7

Hungary 2.9 6.73 -6.1 58.4

Malta 3.1 4.35 -3.3 74.7

Poland 1.3 5.07 -2.5 42.5

Slovak Republic 3.9 3.93 -2.9 34.5

Slovenia 2.6 3.74 -1.4 29.1

Euro area 2.4 3.62 -2.4 70.8

Convergence criterion 2.8 6.03 -3.0 60.0

(1) Last 12-month average – untill July 2006. For Estonia interest rates untill June 2006.

STATISTICAL SOURCES:

1. Bančni vestnik (The Bank Association of Slovenia, different numbers). 2. Bulletin (Bank of Slovenia, different numbers). 3. Ekonomski indikatorji mednarodnega okolja (Bank of Slovenia, July-August 2006). 4. EU Banking Sector Stability (ECB, October 2005). 5. EU Banking Structures (ECB, September 2006). 6. Eurostat.

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