Monetary Policy in Hungary

Home , 1999 in Hungary, Monetary authority, Monetary base, Policy mix

May 2000 Produced by staff members of the Monetary Policy Department of the National Bank of Hungary

Edited by: Ilona Bozó

The publication presents an overview of the monetary policy of the National Bank of Hungary. This, however, does not preclude the manifestation of personal views of the authors in certain chapters. These do not necessarily reflect the official standpoint of the NBH.

Produced by the Monetary Policy Department of the National Bank of Hungary Headed by György Sándor, Managing Director Published by the Secretariat of the National Bank of Hungary Publisher in charge: Dr. József Kajdi Translated by Németh & Pásztor International Kft Design typography and typesetting by the Publications Group of the Information Division 1850 Budapest, V. Szabadság tér 8–9. Internet: http://www.mnb.hu ISBN: 963 9057 72X CONTENTS

FOREWORD ...... 5

I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

A BRIEF HISTORY OF THE NATIONAL BANK OF HUNGARY (Ilona Bozó, József Szabó ) ...... 9 The Austrian National Bank and the Austro-Hungarian Bank...... 9 The Independent Hungarian Central Bank ...... 11 Preparations ...... 11 From the Foundation of the NBH until the Second World War ...... 12 Shift to a Command Economy ...... 13 The Central Bank in the Period of the Socialist Command Economy ...... 13 The Transformation of the National Bank of Hungary and the Banking Sector in 1987...... 15

THE ROLE OF THE NATIONAL BANK OF HUNGARY IN THE FINANCIAL SYSTEM (Ilona Bozó, Zsolt Érsek, József Szabó , Henrik Tóth) ...... 17 The Functions and Role of the Central Bank in the Financial System...... 17 Issue of Banknotes and Coins ...... 19 The Central Bank as the Banker of banks ...... 20 The Lender of Last Resort Function ...... 21 The Central Bank as the Government’s banker...... 23 Foreign Exchange Reserve Management at the NBH ...... 25 The Regulatory Function ...... 27 Bank Supervision...... 29 Maintenance of the Payment System ...... 30 Statistics ...... 34 Organisational Structure and Decision-Making ...... 35 The Bodies of the NBH Defined by the Act on the Central Bank ...... 35 Central Bank Independence ...... 38 The Importance of Independence...... 38 Personal Independence...... 39 Operational Independence ...... 40 Financial Independence ...... 41 The Requirement of Transparency in Central Banks ...... 42

MONETARY POLICY IN HUNGARY 3 II. THE OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

THE OBJECTIVES OF MONETARY POLICY (Áron Gereben, Zsolt Kondrát) .... 45 The Ultimate Goal of Monetary Policy ...... 45 Price Stability versus Economic Growth ...... 47 The Ultimate Goal of Hungarian Monetary Policy...... 49 Intermediate Targets ...... 51 The Hierarchy of Objectives ...... 51 The Intermediate Target of the NBH ...... 53 The Lower Level of the Set of Objectives ...... 56 The Operating Target of the NBH ...... 57 INDICATORS (Gyula Barabás, Emma Boros, Csaba Horváth, Anna Kerekes) ... 59 Monetary Aggregates...... 59 Credit Aggregates and the Net Financing Capacity...... 62 The Information Content of the Yield Curve for Monetary Policy ...... 63 MONETARY TRANSMISSION (András Kármán) ...... 68 The Channels of Monetary Transmission ...... 68 Interest Rate Transmission ...... 71 The Effectiveness of Transmission ...... 71 The Effectiveness of Interest Rate Transmission in Hungary ...... 72 The Interest Rate Policy of the NBH ...... 73 Transmission Along the Yield Curve ...... 75

III. THE INSTRUMENTS OF MONETARY POLICY A HISTORICAL OVERVIEW OF THE DEVELOPMENT OF THE INSTRUMENTS (Ilona Bozó) ...... 81 The Use of Direct Monetary Instruments ...... 81 Money Market Development—Use of Indirect Instruments ...... 83 THE OPERATION OF THE INSTRUMENTS TODAY (Ilona Bozó, Tamás Glanz, Henrik Tóth) ...... 87 Foreign Exchange Market Intervention ...... 87 The Operation of the Forint Instruments ...... 88 Reserve requirement system ...... 89 The Basic Set of Current Central Bank Instruments ...... 94 Interest Rate Corridor...... 97 The Policy Instrument ...... 99 The Instruments of Sterilisation...... 101 Liquidity Planning and Fine-Tuning (Quick Tender) ...... 104 Individual Elements in Operating the Instruments ...... 111

BIBLIOGRAPHY ...... 113 ANNEX...... 115 GLOSSARY ...... 117 INDEX ...... 129

4 NATIONAL BANK OF HUNGARY FOREWORD

Hungary’s transition to a market economy has by now essentially come to an end. The judicious conduct of monetary policy has been an important factor in help- ing the economy develop along a balanced and sustainable path.

he National Bank of Hungary (NBH) re- households, have a good understanding of Tlies on an established and properly func- our intentions and of the conditions for the tioning set of instruments in the pursuit of its achievement of our objectives of maintain- monetary policy objectives. The success of ing economic equilibrium and reducing in- monetary policy depends, however, not only flation. Transparency and predictability im- on the instruments available to the central prove the effectiveness of monetary policy, bank and the experience gained in using because they enable economic agents to these instruments. External shocks and the anticipate monetary policy actions and cal- economy’s ability to withstand them, the culate with their effects in their economic stability of the financial sector and the matu- decisions. rity of the money and capital markets are To ease finding their way and with an equally important factors which influence intention of providing a compass, we annu- and constrain monetary policy decision- ally present the Monetary Policy Guidelines making. to the public in general and to Parliament in Hungary has coped successfully with particular. The NBH regularly publishes its the challenges of economic transition. The Inflation Report. Communications disclosed economy is now growing at a relatively fast about specific steps of the Central Bank and rate, inflation is declining steadily and the communiqués issued after meetings of the current account deficit is at a manageable Central Bank Council are discussed exten- level. Monetary policy has promoted this sively by the press. Once approved by its process through the deployment of mone- General Meeting, the NBH presents its An- tary policy instruments which have sup- nual Report to Parliament. Nevertheless, we ported Hungary’s fixed exchange rate re- feel that this publication, which focuses not gime. on the peculiarities of the momentary situation but on the operating framework and the The expert deployment of monetary general features of the Central Bank instru policy instruments is a necessary, but not - sufficient condition for the effective func- ments, fills a vacuum. tioning of the transmission mechanism of This publication, Monetary Policy in monetary policy. An equally important fac- Hungary, was compiled by members of the tor is that economic agents, ranging from Monetary Policy Department of the NBH, professional financial organisations to who themselves are party to the everyday

MONETARY POLICY IN HUNGARY 5 workings of monetary policy, decision sup- tion first and foremost to readers interested port activities and the formation and opera- in the subject matter of this publication. tion of the set of applied instruments. This is I trust that, in its own way, this hand- intended as a summary based on practical book will render the transmission mecha- experience which, by virtue of its very sub- nism of monetary policy smoother and, al- ject, cannot in all of its parts be regarded as beit indirectly, may contribute to the future easy reading. While required to report on its development of the Hungarian economy. activities to society at large, the National Bank of Hungary desires to provide informa- Werner Riecke

6 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

MONETARY POLICY IN HUNGARY 7 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

8 NATIONAL BANK OF HUNGARY A BRIEF HISTORY OF THE NATIONAL BANK OF HUNGARY1

lthough historically the Sweden’s control by setting up an independent gov- ASveriges Riksbank, established in 1668, ernment’s banker. is the oldest central bank, institutions acting The Austrian National Bank (ANB), es- as the government’s banker came into being tablished by the Emperor’s patent on 1 June all over Europe, modelled in general on the 1816, was “a patented private institution Bank of England, which was established in under the special protection of public ad- 1694. ministration”2 whose business relations to On the continent, the Austrian central the state were very close and secret. During bank was one of the first to be established; those hard times, the Austrian National owing to the political framework, its scope Bank regarded providing assistance to the of authority also extended to the territory of state “as its obligation” and these “highly the Hungary of those days. Hungary’s politi- important services” were “acknowledged cal significance, which increased within the with gratitude” by the monarch.3 ANB en- empire as a result of the historic Compro- joyed a monopoly position regarding issu- mise of 1867, was also expressed by the ing banknotes and setting up branches in dual structure of the central bank, in accor- the territory of the Austrian Empire. In addi- dance with the dualistic principles of the tion to lending to the state, the discounting structure of the state. An independent Hun- of commercial bills of exchange and lending garian central bank came into being only af- on collateral security grew into important ter the break-up of the Monarchy. lines of business. Uniquely among Euro- pean central banks – owing to a mixture of central banking and commercial banking The Austrian National Bank functions – ANB also pursued mortgage lending and debenture issues. and the Austro-Hungarian The Banking Act of 1862 was intended Bank to regulate the relationship between the state and the central bank, not least with a view to dismantling the considerable accu- he Habsburgs regarded Hungary as a mulated state debt. According to the spirit of Tland conquered by arms while fighting the Banking Act, the Austrian National Bank the Turks and, in conducting their economic could be regarded as more independent policy, they focused primarily on the interests of the Austrian hereditary provinces. 1 For an explanation of the terms printed in bold in the The Napoleonic wars went hand in hand with text, see the glossary in alphabetical order. inflation and an erosion of the value of 2 A Magyar Nemzeti Bank Története (History of the Na- tional Bank of Hungary) I, KJK, Budapest, 1993, p.155. money across Europe, hence the Austrian 3 Expressions used in the Emperor’s patent of 20 June, 1849; source: A Magyar Nemzeti Bank Története (History of government attempted to keep the state the National Bank of Hungary) I, KJK, Budapest, 1993. p. debt and the issue of paper money under 157.

MONETARY POLICY IN HUNGARY 9 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY than the Prussian Bank or even the Banque the Governor and the committees of the Su- de France of the Second Empire in those preme Board were centralised, while there days. The Emperor’s right to appoint the were two Boards of Directors functioning at bank’s governor and the government com- each of the two headquarters, each headed missioner was merely formal. According to by a Deputy Governor. The Supreme Board the intention of the legislators, the bank performed general supervisory functions could take action only as a commission over the entire banking operation. Each of agent handling the state’s transactions and the countries elected two representatives to was under the obligation to discount only the Supreme Board, who were also mem- the bills regularly presented by the state. bers of the Boards of Directors. The repre- The acceptance of government papers as sentatives of the Boards of Directors and collateral for credit was excluded. This inde- even the government commissioners of the pendence was maintained with minor modi- state participated in the meetings of the Su- fications until 1878 when the Austro-Hun- preme Board. The government commis- garian Bank was established. sioners were also members of the commit- Right from the very beginning, the Hun- tees, increasing in number as time passed garian Estates disputed whether the Vien- (Executive, Mortgage, Administration and nese bank’s issuing powers extended to Hun- Foreign Exchange Committees). Of the ex- gary in terms of public law. The Batthyány ecutive bodies, management and the cen- government attempted to issue its own cur- tral service functioned in Vienna with local rency through the Pesti Magyar Kereske- services present in both capitals within the delmi Bank (Hungarian Commercial Bank of framework of a head institute in both cities. Pest). However, this experiment failed to- At the time the Austro-Hungarian Bank gether with the 1848–49 War of Independ- was set up, the coverage system inherited ence. The question of an independent Hun- from the practice of the Austrian National garian central bank was raised during the ne- Bank was in operation with silver coins in gotiations of the Compromise. Eventually, circulation. Owing to the stocks of silver ac- the issue was closed with a compromise with cumulated, compliance with the coverage the establishment of the dually structured requirement did not impede increasing the central bank of the Dual Monarchy under the volume of banknotes, aligned with payment name of Austro-Hungarian Bank (AHB). The needs, at first. However, in addition to silver bank held its statutory meeting on 30 Sep- coins and banknotes, government notes tember 1878. AHB’s Deed of Foundation also were also in circulation, conversion on de- bore this dual nature: on the one hand, it mand was not typical, hence it cannot be re- functioned as the central bank of the Monar- garded as an unadulterated silver standard.4 chy covering its entire territory, on the other After 1878, European countries mi- hand, however, in the spirit of equality in or- grated towards the gold standard one after ganisation and management, Budapest, like the other and, beside the rise in the output of Vienna, acquired rights of administration and silver, this also led to a decline in the price of possibilities of influence. silver. By 1878, the premium on silver Owing to the dualistic state establish- against the paper currency disappeared, ment, the organisation of the Austro- moreover, a disagio of the silver florin Hungarian Bank was complex. The man- evolved, that is, the face value of the silver agement of the bank was divided into deci- florin exceeded its intrinsic value. Minting of sion-making and executive arms, the lower coins by individuals for speculative pur- levels of which were dualised. Of the deci- poses began to take on substantial dimen- sion-making bodies, the Supreme Board, sions, which was subsequently suspended.

4 Conversion on demand was suspended on 29 April 1859 It was under these conditions that the and this did not change in the course of the subsequent history of the Monarchy, not even with the introduction of the new monetary system of the Monarchy, the gold currency system (the aranykorona) in 1892. aranykorona (gold crown) system, was de-

10 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY veloped. Due to the absence of conversion impeded the recovery of the financial system, on demand and the use of silver coins as le- hence they made efforts to curb its political gal tender, it could not be regarded as a pure influence in general and to reinforce the cen- gold standard (limping gold currency). Fol- tral banks independence in particular. lowing the example of the German It was during this period that the Na- Reichsbank, a 5 per cent banknote tax was tional Bank of Hungary was established with introduced as an indirect instrument. With substantial international, particularly Brit- this transformation of the coverage system, ish, support. the Austro-Hungarian Bank set out on the By the mid-1920s, the victorious west path of becoming a genuine central bank, European states overcame the economic the banker of banks. and political crisis following the war and sta- The Deed of Foundation of the Bank bilisation of the entire continent became was suspended in the middle of 1914 after their primary concern. One of the precondi- the outbreak of the First World War, and the tions of the loan to be granted by the League disbursement of government loans began. of Nations to promote stabilisation in Hun- The principles of coverage for the gold cur - gary was the setting up of an independent rency were gradually softened. The Austro- Hungarian central bank. Hungarian Bank accepted war bonds as collateral up to 75 per cent of their face The Austrian peace treaty, signed on value, whereby the central bank covertly fi- 10 September 1919, provided for the liqui- nanced the government’s military expendi- dation of the Austro-Hungarian Bank. The ture. The continuous deterioration in the ex- Hungarian peace treaty took over the rele- change rate of the korona (crown) and the vant part verbatim. The temporarily ex- depletion of the stock of precious metals ne- tended licence of the joint central bank ulti- cessitated the setting up of the Foreign Ex- mately expired on 31 December 1919. change Centre on 1 February 1916, follow- The Austrian and the Hungarian man- ing the similar German example with a de- agement of the joint bank were separated as lay of one month. of 1 January 1920 and banking operations The successor states of the Monarchy, were pursued separately even in accounting falling apart in the wave of revolutions fol- terms with headquarters in Vienna and in lowing the Great War, created their inde- Budapest, albeit retaining the name of pendent currencies one after the other. The Austro-Hungarian Bank. Hungarian economy was in a difficult posi- The Magyar Királyi Állami Jegyintézet tion. The level of investments declined, for- (Royal Hungarian Note Issuing Institute) eign exchange reserves were depleted and was established in August 1921 with Dr. the sources of foreign capital ebbed away. Sándor Popovics, the former finance minis- Inflation ran high because the war was fi- ter of the third Wekerle government and nanced by running the banknote presses head of the financial mission of the Hungar- and heaps of banknotes flew in from the ian peace delegation, at its head. successor states. According to the idea entertained by Minister of Finance Lóránt Hegedûs, the Note Issuing Institute was called upon to The Independent Hungarian prepare for the migration from the korona Central Bank to the new legal tender in support of the consolidation. The Note Issuing Institute Preparations took over the assets, employees and part of the business of the former joint central n the wake of the Great War, European bank. Ibankers felt that the political powers of the To curb profiteering in currency and to European Reparations Commission greatly halt the erosion of the value of the korona,

MONETARY POLICY IN HUNGARY 11 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY the Foreign Exchange Centre5 was called The state was the largest of the Bank’s back to life on 8 August 1922. founders with its 39.5 per cent holding. In addition to the community of the Budapest- From the Foundation based financial institutions (TEBE – Taka- rékpénztárak és Bankok Egyesülete – Asso- of the NBH until ciation of Savings Banks and Banks), Aus- the Second World War trian, Swiss, Dutch, Romanian and Czecho- slovak financial institutions and companies In February 1924, the Reparations Commit- subscribed to the Bank’s shares. The shares tee accepted the Hungarian reorganisation of the National Bank were introduced to the programme and, in order to re-establish the Budapest Stock Exchange7 on 21 Septem- creditworthiness of the Hungarian State, re- ber 1925. The National Bank of Hungary leased the rights of pledge for reparations. took over the management of the state’s ac- As part of the legislation package on reor- count and the national debt. It has been a ganisation, Act V determined the establish- shareholder in and an active member of the ment and scope of operations of the National Bank of International Payments (BIS) right Bank of Hungary on 26 April 1924. In this from the foundation of the latter (1930). Act, the state conferred the exclusive right By the summer of 1924 inflation had of issuing banknotes on the NBH until 31 De- declined significantly, the NBH stabilising cember 1943. The statutory meeting was the exchange rate of the korona, pegging it held in the Ceremonial Hall of the Academy to the British pound. In April 1925, the gold on 24 May 1924; Sándor Popovics took the standard was adopted again for the pound position of President and Béla Schróber sterling, consequently the korona again be- was appointed Director General. The Bank came a gold-based currency. The new cur- began its operation on 24 June 19246 and rency, the pengõ, which was founded on the published its opening balance sheet on stabilisation of the korona, was introduced 30 June. in November 1925, although it entered circulation only from 27 December 1926.

5 The Institution existed from 1 January 1916 until 25 No- The stabilisation of the 1920s relied to vember 1925 within the framework of the National Bank of a great extent on foreign funds. Short of fun- Hungary. At first, the intention was but to maintain a registry of demand and supply and an organised, transparent market damental structural reforms, the world eco- of foreign currencies, hence those acceding to the Institution nomic crisis, which exploded in the autumn had to make their receipts of foreign currencies intended for sale available to the Centre and to obtain their foreign ex- of 1929, hit a Hungarian economy deeply in change and currency needs from the Foreign Exchange Cen- tre indicating the purpose of use. Foreign currencies required debt and non-competitive in many respects. for the purposes of the state were handled separately from The financial crisis reached Hungary in July the Foreign Exchange Centre. The Austro-Hungarian Bank was given the management of the Foreign Exchange Centre. 1931 and there was a run on the banks by The bank agreed to make available the cash it had from ex- deposit holders. To protect reserves, foreign port transactions to the Centre and also to satisfy the needs of its clients from the Centre. As the Foreign Exchange Centre exchange controls were reintroduced and was already running a deficit in the first months of its opera- maintained over the long term.8 tion, the AHB used its own stocks and later borrowing from abroad also became necessary. Central exchange rates With the shift to a wartime economy, broke away from market rates (for greater detail, see the His- tory of the NBH, pp. 373–377). By a decree, issued on announced in the 1938 Gyõr Programme, 23 December 1916, trading in foreign currencies was made - subject to official licensing and the independence of the there was a sudden surge in printing bank Foreign Exchange Centre was abolished. notes and the national debt began to in- 6 The base rate was set at 10% and the korona was pegged to the British pound (pound sterling 1 = 346,000 pa- crease. In order to finance the budget, the per korona, 1 aranykorona (gold crown) = 17,000 paper independence of the NBH was curtailed and korona). 7 The consideration behind taking the Bank’s shares to the the Bank was obligated to finance the state. stock exchange was that the state should divest itself of the With the declaration of war, the state be- shares it had received in exchange for transferring assets of the Bank to private hands as soon as possible, thus guaran- came the most important consumer and a teeing the central bank independence from the state. 8 From then on, the National Bank of Hungary continued major portion of industrial output was put to to apply foreign exchange controls until the early 1990s. satisfy the state’s needs.

12 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

Lending by private banks was also cial banking activities in preparation for the made subject to state control. War spending subsequent nationalisation of the banks and was financed by issuing short-term govern- the large companies held by them (Act XXX ment papers, which were discounted by the of 1947). During 1947–48, the NBH was central bank. Increasing the money supply turned practically into an absolutely new or- in this manner stoked inflation from ganisation subject to the supervision of the 1941–42, resulting in unprecedented accel- Ministry of Finance. The NBH was given ex- eration and hyperinflation from 1944. clusive rights to control the financial activi- With the conclusion of the armistice ties of plants accounting for 80 per cent of agreement, the tasks of the NBH were taken the country’s industrial output. The NBH su- over by coalition committees set up on po- pervised lending and the management of litical grounds; all the central bank was al- state-owned companies, which contributed lowed to do was to run the banknote half of the product turnover. Companies presses. Control of the economy was al- were obligated to manage their financial and ready divided politically at that time. lending activities through their NBH single account. Investments originally planned to Shift to a Command Economy have been financed by credit soon became gratuitous (that is, financed by budgetary funds). With the rebuilding of the economy in the In the one-tier banking system thus wake of the war, industrial output increased established, in addition to the commercial gradually and agriculture also became more banking functions performed by the NBH, organised. With gold stocks returned and additional specialised financial institutions short-term foreign loans, there seemed to were set up (Investment Bank, Co-operative be a chance of stabilisation. To support this, Credit Institution, National Savings Bank, lending was made subject to close control and Foreign Trade Bank) in the spirit of pro- and companies were instructed to accumu- file clean-up. late stocks of the most important articles. The NBH reorganised its functions of By limiting the amount and the period of foreign exchange authority, managed the lending to the state, the NBH contributed pre-war debts as well as the obligations significantly to the successful introduction of war reparations. Although it aimed at pru- of the new currency, the forint9 on 1 August dent loan appraisal to protect the stability 1946. A banknote ceiling was set at Ft1 bil- of the forint, the political criteria of the agen- lion and strict compliance with the ceiling cies of public administration prevailed also supported the strength of the new cur- to an increasing extent over the views of the rency. Bank’s experts in 1947–1948. During the period of the first five-year plan (1950–1954), the monetary policy of the NBH had to support investments, the forced The Central Bank military development programme of the in the Period Cold War and the reorganisation of agriculture. The NBH had but an administrative, of the Socialist Command mechanical role in implementing these. Pur- Economy suant to the 1949 Constitution, nominally, the NBH retained its legal form as a company limited by shares, while it was placed he artificial shortage of money, created Tby restricting banking activity and lending, aimed not only at keeping the money 9 The exchange rate of the forint was determined on the basis of the consumer prices of the last peace years, supply and inflation under control, but also 1938–1939; on that basis, one dollar was equivalent to at restraining stock exchange and commer- Ft11,739.

MONETARY POLICY IN HUNGARY 13 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY under government control.10 Because of its This decree clearly separated the central commercial banking activities, the Bank’s banking and other national economic func- branch network expanded substantially: by tions of the Bank, leaving the one-tier 1952, there were 134 NBH branches operat- banking system and the principle of governing all over the country (as against the ment supervision of the NBH intact. Once 21 branches functioning at the time of na- again, the central bank’s legal form of oper- tionalisation), while the number of its em- ation was that of a company limited by ployees reached 9,000. shares. Execution and licensing of foreign ex- Under the New Economic Mechanism, change operations became an exclusive credit policy guidelines were developed an- right of the NBH from 1950. At the same nually by the newly established Credit Policy time, the new management of the NBH (in contrast with the Soviet example of 1917) Council of the NBH. Based on the guide- endeavoured to repay its foreign loans and lines, the NBH was responsible for its imple- to compensate the foreign owners of nation- mentation and supervised its execution. alised assets, which was implemented by This meant greater scope for making deci- 1970.11 sions based on economic rationality and With the establishment of the CMEA, profitability. The so-called supervision by the NBH was made responsible for the fi- the Bank, which, in practice, meant admin- nancial transactions between the member istrative intervention in the management of states. Although in the course of the consoli- companies and the levying of fines, was dation of the economy after 1956 the sepa- abolished. Steps were also taken towards ration of the tasks of the central bank from liberalising foreign trade by slightly stream- commercial banking functions was raised lining import licensing and by adjustment of on several occasions, this was never imple- the exchange rate of the dollar. The organi- mented. However, the economic reforms sational units responsible for central bank- enhanced the significance of the monetary ing functions were more markedly divorced policy instruments available to the NBH from those in charge of commercial banking and, with the recovery in foreign trade in the functions. 1960s, the Bank expanded its domestic for- The historical events of 1968 consti- eign exchange market activities. tuted a turning point for the Hungarian eco- In the last quarter of 1960, the network nomic reform, which appeared, inter alia,in of regional directorates was gradually dis- the form of endeavours to re-centralise the mantled and 19 county-based directorates economy. From January 1972, the NBH were set up. had exclusive responsibility for financing To find a way to improve the align- the invested and the current assets of or- ment of the command economy and the ganisations pursuing economic activities. market, the experts of the NBH also partici- The role of the State Development Bank was pated in the development of the “New Eco- restricted to financing specific major invest- nomic Mechanism” of 1968. The monopoly ment projects from the state budget. The rights of the NBH awarded after 1948 con- deterioration in the terms of trade due to the cerning issuing, the regulation of payments, oil crisis narrowed the elbowroom of the re- account management and foreign exchange form, which was limited in any case, and the management were reinforced by decree. debt crisis of the early 1980s was an unmis- takable sign of economic tension. The NBH 10 The post of the President was abolished, the Director General was appointed upon the recommendation of the financed the external disequilibrium by bor- Minister of Finance by the Council of Ministers. The posts of rowing from abroad and issuing bonds, the President, Vice President and Managing Director were re-established by a law-decree of the Presidential Council in which was far from being general practice in April 1956. an central-east European country of those 11 The process of compensating the foreign shareholders of the NBH was completed somewhat earlier, by 1967. days.

14 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

In parallel with its international bor- banking and commercial banking functions rowing, the NBH developed its network of would have to be separated within the NBH international representative offices in the and preparations for the establishment of a major financial centres of the world two-tier banking system would have to be- (1967–1995 Paris, 1970–1995 Zurich, gin. The Hungarian banking sector was 1973–1995 London, 1973–1998 Frankfurt, transformed into a two-tier one as of 1 Janu- 1974–1975 Beirut, 1977–1996 New York, ary 1987. Under the new regime, the Na- 1983-to date Tokyo). The NBH provided a tional Bank of Hungary was designated channel for continuous communication with as the central bank, that is, the bank of is- the advanced countries and it was partly sue.12 due to this that Hungary acceded to the In- Under the new system, the NBH be- ternational Monetary Fund and the Interna- came the bank of the banks and of the state; tional Bank for Reconstruction and Devel- it was subject to the control of the President opment in 1982. of the Council of Ministers. Its responsibili- ties included influencing the money supply and facilitating the achievement of the economic policy objectives of the government The Transformation with the traditional instruments of monetary of the National Bank and credit policy (interest rate policy, reserve policy, refinancing, open market op- of Hungary and the Banking erations). The NBH continued to be respon- Sector in 1987 sible for managing the state’s account and lending to the budget and it retained the licensing of foreign exchange turnover. The n the 1980s the country had to adjust to an NBH regulated and controlled the activities Ialtered international economic environ- of the commercial banks. Three of the five ment. As a result of this, the inflexibility of commercial banks established with the the financial system was also softened: new transformation of the banking system into a institutions came into being, securities in the two-tier one (the Hungarian Credit Bank, the form of bond issues appeared, a trade law Hungarian Commercial and Credit Bank was enacted, credit lines were extended and and Budapest Bank) came into being by factoring was launched. The artificial boost separating the General Credit Directorate, to growth led to significant additional debt the Pest County Directorate and certain accumulation in the short term. It was the branches of the NBH. recognition of the unsustainability of this process that led to reform of the banking The commercial banks came into being not sector. with a regional or sectoral character (even The basis for the change was provided though the predominance of one or the other by a change in the approach of economic sector could be observed in the case of the policy: in the 1980s, when genuine steps newly established banks), which implied the possibility of genuine competition among were taken to develop market conditions, it them. Foreign examples, by which banking became evident that a radical transforma- systems organised on a sectoral or regional tion of the banking sector was also required. basis could be studied, showed that in those The inflexibility of the one-tier banking sys- cases banks enjoying virtual monopolies tem and the absence of lending based on stood against the companies, and the differ- business criteria under “quasi market” con- ing needs of the sectors and regions impeded ditions obviously impeded the development of the market elements of the economy. In 12 The term “bank of issue” was used extensively in Hun- garian literature on banking even before the transformation its December 1984 resolution, the Central of the banking system into a two-tier one, which arose from a decisive classical function, that is, the monopoly of issuing Committee of the Hungarian Socialist banknotes, instead of the term “central bank” used mainly in Workers’ Party declared that the central other languages.

MONETARY POLICY IN HUNGARY 15 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

the establishment of uniform and normative tions. The central bank has an obligation to regulation. After the original central distribu- report to Parliament and has become inde- tion, the banks were free to develop their cli- pendent of the government. The Bank au- entele. The banks established with na- tonomously develops and implements its tion-wide scope were founded in the form of monetary policy. companies limited by shares with the state as their majority shareholder, represented by the With the institutional reform in the sec- Ministry of Finance. Companies and co- ond half of the 1990s, non-central banking operatives held minority portfolios. functions were dismantled. As part of this After the 1990 elections, in the spirit of process, foreign representations and stakes the transition to a market economy, Parlia- were liquidated with one exception. In No- ment enacted Act LX of 1991 on the Central vember 1996, the 18 county-based director- Bank and Act LXIX of 1991 on Financial In- ates were wound up to be replaced by eight stitutions and Banking, since then both regional directorates. From 1 January 1999, amended several times. The new Act on the the number of regional directorates de- Central Bank re-established the independ- creased to four, with their seats in Debrecen, ence of the NBH and re-regulated its opera- Gyõr, Kecskemét and Székesfehérvár.

16 NATIONAL BANK OF HUNGARY THE ROLE OF THE NATIONAL BANK OF HUNGARY IN THE FINANCIAL SYSTEM

The Functions and Role manage either a part or all of the country’s debt. Units to analyse the economy and to of the Cental Bank conduct research are also required for the in the Financial System performance of the tasks of a central bank. The above list illustrates how manifold the functions of central banks may be. The he tasks of the central bank are set forth question, however, is which of these func- Tin most countries in some form of legal tions are the ones through which a central regulation (generally an Act of Parliament). A comparative analysis of the central banks bank can exert influence on the economy of of different countries reveals that central a given country. banks strongly differ from one another in The history of central banks reveals terms of their powers and structure, due to that there are tasks which are common to the fact that their functions may also range most of them, affecting the very heart of over a wide scale. their operation. Effective instruments of Traditionally, central banks have a central banks to influence the financial envi- monopoly of issuing money. Through this ronment, in which their respective econo- function, it is the task of every central bank mies operate, include the right and possi- to mould the supply of credit and money bility of controlling the money and credit and, in relation to this, to influence market supply and, consequently, of influencing rates, that is, to pursue monetary policy. market rates. The monopoly of issuing A central bank may have full or partial re- banknotes and the banker of banks func- sponsibility for shaping exchange rates tion – the management of the banks’ ac- and managing the foreign exchange re- counts, fixed and free reserves and their fi- serves of a country. nancing (which, typically, is concomitant Central banks manage the payment with the role of the lender of the last re- (settlement) accounts of commercial banks sort) provide this opportunity to a central and safeguard the fixed and freely disposable reserves of the banks. They play an im- bank. Management of the exchange rate portant role in the maintenance of payment regime and foreign exchange reserves can systems. Most of them are responsible for hardly be separated from setting interest the stability of the financial system, partly rates, although the treasury often plays a through controlling and supervising banks part in this process. These days, manage- and other credit institutions and partly ment of the accounts of the budget has through being the lender of last resort. Most less of an influence over the money and of the time, the central bank is also the bank credit supply. Nevertheless, being the of the government. Its tasks may include ex- state’s banker is a classic and emphatic change controls; in some countries they role for most central banks.

MONETARY POLICY IN HUNGARY 17 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

In countries where the central bank The objective set by law for the cen- has sufficient independence to set interest tral banks of many a country may differ rates, legislation frequently specifies the ob- from that of achieving price stability (there jectives, for the achievement of which the may be other macroeconomic objectives bank may use this power. As in the case of included in the set of objectives, whether most central banks of the world, the funda- subordinated or on an equal footing) but mental task of the National Bank of Hun- central banks can realise the objectives set gary, as set forth by law, is to protect the through their monetary policies every- purchasing power of the local currency. The where. powers given to the central bank (its func - The first and most important task tions), employed in the interest of protecting among the functions of the National Bank of the purchasing power of the currency, con - Hungary is of a macroeconomic nature: the stitute the monetary policy of the central operation of monetary policy, that is, influ- bank. encing the money and credit supply with a In addition to protecting the purchas - view to safeguarding the value of the local ing power of the forint, another task of the currency. The central bank may implement NBH is to support the implementation of the this task based on the following classic cen- government’s economic policy programme tral banking functions: with the instruments of monetary policy available to it. That is to say, the NBH plans and im- • issuing, that is, monopoly over is- plements its monetary policy harmonised suing banknotes, with the economic policy developed by the • the banker of banks – lender of the government. last resort function, • the government’s banker, and • management of foreign exchange reserves. Abstract 1: The Legal Standing Central banks, however, have a sec- and Fundamental Function of the NBH ond set of functions, which includes all the Act on the Central Bank, Chapter I tasks required for the maintenance of the sound operation of a banking system and fi- §1. The National Bank of Hungary (here- nancial stability. When a bank functions inafter the “NBH”) is the bank of issue poorly, it makes a loss and may even lose its of the Republic of Hungary, the central equity, its consequences are highly detri- bank of the national economy. mental to the entire economy. It may imperil confidence in the banking system and, … through this, confidence in the currency as well as the propensity to save. Depending §3 The NBH shall support the implemen- on the magnitude of the problem, it may dis- tation of the government’s economic pol- turb the operation of the entire banking icy programme with the instruments sector. of monetary policy (money and credit As a central agency, the bank of issue policy) available to it. establishes the conditions which attempt to minimise the risk factors which might en- §4 (1) The fundamental function of the danger the safe operation of the banks. Thus NBH is to protect the domestic and exter- the role of the central bank in supporting the nal purchasing power of the national cur- banking sector goes further than assisting rency. them when needed by being their lender of last resort.

18 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

The functions of the National Bank of struments of monetary policy and its impact Hungary, which assist in the sound opera- mechanism. tion of the banking sector, include the following: Issue of Banknotes and Coins • regulatory functions, Under the Act on the Central Bank, the • bank supervisory functions, and National Bank of Hungary has exclusive • maintenance and development of authority to issue domestic legal tender – the payment system. forint banknotes and coins – to determine its denominations and to withdraw them As it was indicated at the beginning of from circulation in Hungary. When mak- this chapter, the central banks of the various ing payments in the Hungarian legal ten- countries of the world may perform a num- der, the banknotes and coins issued by ber of additional functions, but the range the NBH must be accepted by all at face of the tasks allotted to them may also be value. narrower. The functions required for the sound operation of the banking sector may be – and in many places are – performed by organisations other than the central bank, Abstract 2: The Legal Standing which are independent from it. It is disputed of the NBH and its Fundamental Task to this day how these tasks may be per- Act on the Central Bank, Chapter I formed with the greatest efficiency – whether inside or outside the central bank. The list assigned to the two groups of func- §4 (2) The NBH has exclusive authority tions reflects the tasks of the National Bank to issue banknotes and coins. of Hungary as set forth in the Act on the Central Bank which, in the main, coincides with the functions of the central banks of most industrially advanced nations. At the time when payments were ef- Both knowledge and analysis of the fected largely in cash, central banks were appropriate indicators of the economy, the able to directly influence the total amount of money and capital markets and the perfor- money in circulation through their issuing mance of the banking sector are required monopoly. equally for pursuing monetary policy and Banknote issue was a key function of maintaining financial stability. By virtue of central banks. With the technical develop- its position, the National Bank of Hungary is ment in payments and the proliferation of an institution belonging to the official statis- forms of cashless payments, the share of tical service, collecting as well as supplying cash – taking longer-term trends into ac- data. Data collection and reporting are spe- count – has been declining in the economy. cial tasks of the central bank linked to both (For categories of money supply, i.e. the sets of its functions. monetary aggregates, the monetary base The following sections provide an and its relation to the money supply see the overview of the tasks of the National Bank of section on “Monetary Aggregates” for Hungary based on Act LX of 1991 on the greater detail.) Although the regulation Central Bank. The subsequent chapters will of money supply cannot be limited to con- unfold the functions, serving as the basis for trolling cash turnover, i.e. to the amount pursuing monetary policy, in greater detail of cash in circulation, the changes of cash in focusing on the objectives and the set of in- circulation arising from changes in payment

MONETARY POLICY IN HUNGARY 19 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY habits, the technical changes of the pay- value of Ft810 billion, within which the ment systems and their forecasting con- share of banknotes was 98 per cent, that of tinue to play an important role in monetary coins, 2 cent. About 10 per cent of the policy. The central bank is responsible value of the cash in circulation can be for fully satisfying the cash needs of turn- found with financial institutions and 90 per over by up-to-date banknotes and coins cent outside the banking sector (in house- in an adequate series of denominations. holds, retail trade, cash desks of business The production of banknotes used as organisations, etc.). legal tender is a complicated technical process, ranging from design to the de- struction of banknotes that have become The Central Bank superfluous or unsuitable for use. (Preven- as the Banker of banks tion of counterfeiting is an important criterion in banknote design and production.) In addition to issuing banknotes, the Na- The special position of the National Bank of tional Bank of Hungary also issues and Hungary – and that of the other central puts into circulation forint coins. The com- banks – arises from the fact that commercial prehensive renewal of the legal tender was banks depend to some extent on central completed in 1999, which began with the bank money.13 replacement of coins in circulation in 1993 First, the banks need cash to disburse and continued with the introduction of the deposits placed with them by their clients first element of the new series of bank- and the loans granted to them, which they notes – the 10,000-forint denomination – can obtain only from the central bank. in 1997. The National Bank of Hungary withdrew all the denominations of the old series of banknotes and coins from circulation by October 1999; now only the six Abstract 3: The Tasks denominations in the new series of bank- of the NBH: notes and the seven denominations in the The Account Management Activity series of coins are available for cash pay- of the NBH ments. Act on the Central Bank, Chapter II The banknotes of the new series were made using modern base materials, new technologies and state-of-the-art security §26 (1) Unless another credit institution elements. is authorised, the NBH shall manage Currency denominations shifted to- the settlement accounts of credit institu- wards growing face values in accordance tions. with the requirements of turnover: the face (2) The NBH shall manage the payment value of the highest and the lowest banknote accounts of clearing houses. denominations doubled, while fillér coins were eliminated from circulation. (3) The NBH shall manage the payment As the banknotes of new denomina- accounts of the National Deposit Insur- tions gained ground and as a result of the ance Fund and the Investor Protection withdrawal of denominations not required in Fund. circulation, the overall amount of banknotes and coins in circulation has decreased over the past few years while the value repre- 13 Financial literature tends to mention central bank sented by them has increased dynamically. money as “the monetary base”, which includes cash outside Early in 2000, the banknotes and the central bank and the banks’ reserves kept with the central bank. For greater detail, see the section on “Monetary coins in circulation represented a total Aggregates” in the chapter on “Indicators”.

20 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

Second, the central bank manages the The Lender of Last Resort payment accounts of credit institutions, Function which means that these accounts of the credit institutions always have some kind of a balance (stock) to settle cashless interbank transactions. Abstract 4: The Tasks Third, banks in Hungary must place of the NBH: deposits with the NBH corresponding to a Extraordinary Credit in the event specified ratio of their stock of liabilities (for of an Emergency at a Credit Institution greater detail, see the section on “Regula- Act on the Central Bank, Chapter II tion of the Reserve requirement”). Until the autumn of 1994, the reserve requirement accounts and the banks’ payment accounts §17 (1) In the event of an emergency, the were separated. With the introduction of the NBH may extend an extraordinary credit giro system, the two accounts were merged to the credit institution. Availability of and the banks may use the outstanding bal- such NBH credit may be subject to the ances of their payment accounts in excess measures to be taken by the State of the reserve requirement in the interbank Banking Supervision in an emergency clearing system. and the implementation by the credit institution of the measures initiated by the The above three factors taken together State Banking Supervision. – cash in circulation, the banks’ required reserves and their balances to be used freely in payments – constitute the monetary base, over which the central bank exercises control. By influencing these stocks through Liquidity needs arising from time to time various instruments, the central bank can among banks are part of the ordinary act upon the amount of money in circulation course of business. Banks have several (the money supply). market instruments to cover such needs (selling government papers or foreign ex- An important question of monetary change assets, etc.) and the central bank as policy is to what extent is this relationship – the banker of banks may also extend a for instance, between changing the central credit to a financial institution. It may, how- bank rates and the change in the money supply – close and calculable under given ever, happen that a bank’s liquidity short- conditions (see the chapters on monetary age becomes permanent or it may suddenly aggregates and transmission). get out of hand. The central bank has the opportunity to provide banks, struggling un- Not every bank depends directly der a transitory or lasting liquidity crunch, on the money provided by the central bank. with central bank money under an extraor- The amount of central bank money, re- dinary procedure. Therefore, this function quired for the appropriate magnitude of bal- is closely related to that of ensuring money ances, is not necessarily obtained from the supply to the banks (“banker of banks”) central bank. Banks, which for a transitory and that of maintaining a sound banking or even a sustained period have more central bank money (liquidity) than necessary, system. may lend to banks struggling with transitory The question may arise why the cen- liquidity shortages through the interbank tral bank should bail out an ill-functioning money market. All in all, however, the bank struggling with liquidity shortages, money market does not have more central which may be attributed to mistakes in bank money than that created by the central conducting business. Beyond the funda- bank. mental problem that, in the event of a bank

MONETARY POLICY IN HUNGARY 21 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY failure, deposit holders may lose their sav- necessary funding in most countries.) ings, there is the odd chance that, depend- Secondly, deposits with a value above ing on the size of the bank, the crisis may Ft1 million are not insured by the deposit spread to other banks as well. A run on the insurers. The shaking of large deposit banks may lead to serial insolvency, which holders’ confidence in the banking sys- may paralyse a part or all of the banking tem could easily lead to a run on the system, and thereby violently retard the banks, so bank failures may arise in spite economy. of the deposit insurance system. Therefore, when considering the res- The role of lender of the last resort cue of a bank, the implications of a bank may not only protect the economy from the failure, which may shake confidence in the detrimental effects of bank failures but also banking system and the currency, de- provide protection against money market crease savings and imperil economic sta- crises caused by them. bility, should also be considered in all A financial panic will always have a cases, in addition to protecting investors. highly detrimental impact on an economy To illustrate the importance of preventing as it impedes the fundamental task of fi- bank failures, the economic crisis of nancial markets of channelling free funds 1929–33 is usually referred to as an exam- to efficient investment opportunities. In the ple. case of a stock exchange collapse, a large It was bank failures which triggered a number of broker firms may find that they major decline in money supply seen in the need supplementary financial assets to fi- United States during this period, which nance their activities. Banks may deny the many economists regard as the cause possibility of additional financing for broker and driving engine of the economic col- firms precisely because of the impending lapse which took place in the course of the failures. crisis. As far as its form is concerned, the The question may also arise: why res- lender of last resort function rarely means cue these banks in order to protect deposi- some kind of extraordinary lending irre- tors when the institution of deposit insur- spective of the monetary policy instru- ance stands between them and any dam- ments available; it is always closely related age they might sustain? At first sight, it to the monetary policy instruments of cen- may seem that a deposit insurance fund, tral bank money supply that characterises which exists in most countries to protect the given country (see the chapter on “The and insure deposit holders against losses Instruments of Monetary Policy”). arising from bank failure, could render the The techniques of central bank role of the central bank as lender of the last money supply may be manifold (auctions, resort superfluous. rediscounting, standing facility) just as it This, however, is not true for two varies from country to country how a cen- reasons. On the one hand, deposit insur- tral bank may want to influence use of cen- ers insure deposits only up to a certain tral bank money via interest rates or other limit – in Hungary, up to Ft1 million – and direct regulatory instruments (quotas) or although the small amounts of deposits any combination thereof. Choice among constitute only a very small fraction of the and regulation of these instruments is part total deposit portfolio, should bank fail- of regulating money supply, that is, of ures occur in large numbers, the insur- monetary policy. ance funds would be unable to fully cover When, however, the central bank lifts even the small-value deposits. (Most some restriction specified in the regulations probably, however, the central bank, as with respect to a single bank to rescue it, lender of the last resort, would stand be- the instrument will fulfil the lender of last hind the insurance funds and put up the resort function.

22 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

Assistance may also come in the form The Central Bank of a transitory exemption from the reserve as the Government’s banker requirement. Although banks may use their required reserves to cover their payments, There are several aspects to the relation- by the end of the month they must, on aver- ship between the NBH and general govern- age, meet the reserve requirement. In the ment. First, the NBH as the government’s case of an exemption, liquidity depending banker manages the single account of the on the magnitude of the reserve require- Treasury. ment will be released for the given bank. In Hungary, central bank money thus released may substantially expand the liquid- Abstract 5: The Tasks of the NBH: ity of any given bank, owing to the ratio which is deemed high in international com- Relations to General Government, parison (12 per cent). the Account Management Activity of the NBH Although the role of the central bank as the lender of the last resort has the ad- Act on the Central Bank, Chapter II vantage of preventing bank failures and financial panic, the declaration of this possi- § 18 (1) The NBH manages the Unified bility may also have detrimental aspects. Treasury Account and other state ac- It may be that banks, expecting to receive counts designated by the Minister of Fi- assistance from the central bank, under- nance. take higher than prudential risk in various fields of banking operations, largely in (2) The NBH manages the payment ac- lending. count of the State Privatisation and This risk is likely to be higher in the Holding Company, whose balance shall case of major banks because they may be- continuously be included in the balance lieve that they are too large and too impor- of the Unified Treasury Account at all tant for the central bank to deny them as- times. sistance, for their eventual failure would, with much greater probability, lead to a run Second, in relation to the account on the bank and the probability of the panic management function, the NBH may have a rolling on to other banks is also higher. This financing relationship with the budget. explains why a central bank uses the instru- The financing relationship between the ment of lending as a last resort only when it state budget and the central bank has long really is the last resort. traditions in most advanced European There is an aspect of the lender of last countries. In view of past experience, how- resort function which is closely related to ever, legislators may set strict limits for this the maintenance and operation of the pay- activity so as to prevent the infringement of ment system: the NBH may provide bor- the rights of central banks to pursue autono- rowing facilities with a view to the smooth mous monetary policy. operation of the payment system. Should a Pursuant to the Treaty establishing bank wrongly assess its liquidity position in the European Union (the Maastricht advance and should its liquid assets fail to Treaty), neither the ECB nor the central provide coverage for the items to be trans- banks of the member states may extend ferred at the time of settlement in the clear- current account financing or other types of ing system, the central bank ensures the credit to community institutions or agen- continuous administration of interbank cies, central, regional or local authorities or payments by lending. But the rate on such other central agencies or publicly owned loans is above the money market interest companies of the member states; it is also rate. prohibited for them to directly purchase

MONETARY POLICY IN HUNGARY 23 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY debt securities from these institutions and month. This loan, which may be extended agencies. The intention of this provision is up to 2 per cent of the annual revenue esti- on the one hand to reinforce budgetary dis- mate of the central budget, may be out- cipline in the member states while eliminat- standing for no more than 15 days in any ing one of the main sources of inflation. On month, either on several occasions or on the other hand, the prohibition on the dis- end. bursement of direct credit by the central The central budget pays the base rate bank to the government is an important set by the central bank on its debt of liquid- factor with regard to the independence of ity credit to the NBH at all times. The prac- the national central banks and the Euro- tice of the past few years, however, showed pean Central Bank (ECB). that the budget did not make use of this Over the past few years, the financing credit facility, as together with the account relationship between the NBH and the Hun- of ÁPV Rt., the balance of KESZ has been garian budget has also undergone major positive. changes. In 1990, placements by the central The 1996 amendment of the Act on bank to general government exceeded the Central Bank (§19 (3) of Act CXXIV of 70 per cent of its total placements (balance 1996 amending Act LX of 1991), which sheet total). constitutes the legal regulation currently in The restructuring of the economy in force, prohibits lending by the NBH to the subsequent years necessitated that the central budget, with the liquidity credit be- credits of the central bank be redirected in ing the only exception. favour of the business sector. The prohibition of direct central bank The Act on the Central Bank, enacted financing could come into being only be- in 1991, still reflects the practice which pre- cause, with the development of the domes- vailed at the time of the adoption of the Act, tic capital market, the budget had increas- namely, that the NBH financed the central ing opportunity to finance its deficit without budget by way of lending (on the basis involving the central bank directly from of loan agreements), albeit putting a ceiling the market through issuing government on financing the central budget through papers. central bank credit, declaring that the incre- The central bank may also finance the ment in the portfolio of credit extended to budget not only by direct lending but also the central budget in a given year may not through purchasing government papers. It exceed, even on a single day of the year, does make a difference, however, whether three per cent of the estimated revenue of this is done in the primary market – which the central budget in the given year. in practice would mean that the NBH could So that the central budget would not participate in government paper auctions – enjoy a privileged position relative to the or whether government papers are bought other agents of the money market, the base only in the secondary market. In the first rate of the central bank – that is, a mar- case, there is a possibility for the central ket-based interest rate – governed lending bank to finance the deficit through the auc- to the central budget. tions under pressure from the eventually The 1994 amendment of the Act on growing financing requirement of the bud- the Central Bank (Act IV of 1994) enabled get, which implies the threat of distorting the restricted financing of the ‘current fund yields away from market levels. Purchases of the budget’ (today termed as the Unified in the secondary market, i.e., when the cen- Treasury Account – KESZ) in the event of a tral bank buys government papers which transitory liquidity crunch of a few days in had already been acquired by market order to ensure continuous money supply agents, have less influence on government because of the asymmetric flow of budget- paper yields than buying them upon issue in ary revenues and expenditures within the the primary market, which in fact consti-

24 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY tutes a form of direct financing of the bud- curities. Because of these considerations, get. the Act on the Central Bank prohibits the The central bank’s participation in se- NBH to directly purchase securities from the curities trading in the secondary market is, state, i.e., to buy in the primary market. in contrast, necessary for the efficient im- According to an amendment, however, plementation of monetary policy (for the there is nothing to impede the NBH from operation of the instruments and for the purchasing government papers in the sec- open-market operations) since the central ondary securities market in the form of bank may need an adequate portfolio of se- open-market operations while pursuing its monetary policy objectives. This regulation is also in harmony with the principles set forth in the Maastricht Abstract 6: The Tasks of the NBH: Treaty establishing the European Union, un- Relationship to General Government, der which the central bank is not prohibited from financing the budget, but it is prohib- the Account Management Activity ited from doing so by avoiding the capital of the NBH market. Act on the Central Bank, Chapter II These principles have the purpose of safeguarding the independence of the cen- §19 (1) The NBH may have a financing tral banks in the member states of the Euro- relationship exclusively with the central pean Union and help to prevent wrong eco- budget of the subsystems of general gov- nomic policy decisions being made because ernment. of distorted information. At the same time, the elbowroom provided to central banks to (2) With respect to its financing relation- perform operations in the secondary market ship to general government, the NBH may be exploited only to achieve the objec- shall be responsible to Parliament. tives of monetary policy and may not serve to bypass the prohibition on the direct fi- (3) With the exception mentioned under nancing of the central budget. Subsection (4), the NBH shall not extend any credit to the central budget. The NBH may purchase government papers under Foreign Exchange Reserve open-market operations. The NBH shall not purchase government papers directly Management at the NBH from the state. One of the most important tasks of central (4) To overcome the transitory liquidity banks throughout the world is the manage- difficulties in the Unified Treasury Ac- ment of the foreign exchange reserves count, the NBH may extend a liquidity of their countries. The objectives of main- credit to an amount not exceeding two taining reserves are nearly identical in per cent of the revenue estimate of the each country, although the relative impor- central budget in the given year. The tance of individual objectives may be dif- central budget may have such debt on ferent depending on the situation of the liquidity credit outstanding on several given state. The main objectives of main- occasions or on end, but never exceed- taining reserves are intervention, transac- ing 15 days in a calendar month; the tion and asset accumulation. The predom- central budget may not have any debt inance of any objective for any central on liquidity credit on the last day of the bank at any given point in time is deter- year. mined by a number of factors, including the exchange rate regime applied, the

MONETARY POLICY IN HUNGARY 25 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY magnitude of debt and the balance of pay- tries can do with 1–2 months of import re- ment. In ultimate cases, when economic quirement, while in the case of the less de- agents are for some reason (such as war, veloped countries, 6–8 months’ imports is crisis or natural calamity) no longer able the characteristic magnitude. Naturally, the to do so, the foreign exchange reserves of desirable magnitude of foreign exchange re- the central banks are put towards effecting serves depends on a number of factors, the foreign exchange payments of the such as the applied exchange rate regime, country (imports, etc.). the ability of the country to draw in funds, the openness of the economy and the vola- In Hungary’s case, all three fundamen- tility of the balance of payments. The tal objectives obtain. Under the current ex- three-month import requirement is pre- change rate regime, the NBH, in principle, sented as the minimum figure in the reserve assumes unlimited obligation to buy or sell policy of the NBH. The external debt ser- at the two edges of the fluctuation bands vice, which debits the central bank’s re- permitted around the centre rate determined serves, raises the reserve level regarded as by the currency basket. To meet this obliga- desirable by the value of three-month’s re- tion, it must have foreign exchange reserves payment on average. In stipulating the final in an appropriate amount. The interest and reserve level, the central bank also takes principal repayments for foreign exchange into account potential short-term capital credits taken out by the NBH and the state flows. are also effected directly from such reserves. A sufficiently high reserve enhances The currency structure of the reserves the confidence of foreign investors and lend- generally reflects the direction of the foreign ers vis-à-vis the country, which eases and trade relations of individual countries. Ow- renders cheaper the raising of funds abroad ing to this, the share of the dollar and the for all economic agents. yen is higher in the foreign exchange re- Ultimately, the source of increasing reserves of Far Eastern countries, while in Eu- serves may be a positive balance of the cur- rope this role is taken over by the euro. It is a rent account or an influx of capital. The in- general tendency that the role of gold in re- vestments of foreigners and the foreign ex- serve management has declined to the min- change funds of the domestic private sector imum in most countries. The NBH keeps its are converted into forints in the interbank foreign exchange reserves in the major cur- foreign exchange market. To reach (or to rencies, primarily in euro and dollar, while maintain) the desirable level of reserves, the share of gold is minimal. The currency foreign exchange credit may need to be structure reflects the composition of the ex- raised. The state may raise foreign external payments of the country and of the fo- change credits in the domestic or foreign rint’s basket. money and capital markets or from large in- From the viewpoint of investment ternational organisations (IMF, World guidelines, central banks tend to place the Bank). Until 1999, it was the NBH, currently main emphasis on security within the “holy it is directly the state that appears in the for- trinity” of investors: security, liquidity and eign markets. yield. This is understandable as central There is no generally accepted for- banks manage the foreign exchange re- mula, valid for every country, to determine serves of their country, which usually repre- the optimum amount of reserves. The most sents a significant amount both in absolute frequently used “unit of measurement” is value and as a percentage of GDP. It is the import requirement. According to this, therefore no accident that these institutions the average amount equivalent to three are regarded as the largest and at the same months’ imports can be regarded as an ac- time most conservative investors of the ceptable reserve level. This is but an aver- world. Accordingly, apart from a very few age figure. In practice, the advanced coun- exceptions, they do not invest in, for in-

26 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY stance, shares or real estate. Characteris- tically, they seek papers of the highest Abstract 7: Miscellaneous Provisions: credit rating in the securities markets and Powers they generally buy the government papers of the advanced countries.The criterion of li- Act on the Central Bank, Chapter V quidity is important because, in the event of intervention or an eventual crisis, the re- §71 (1) Within the limits of the law, the serves must be deployable immediately and NBH may issue mandatory requirements without any substantial loss of value in order via central bank instruments to financial to meet their fundamental functions. Yet institutions, legal entities which do not again, by virtue of their size, it is only the qualify as financial institutions perform- government papers of the largest and most ing supplementary financial services, in- advanced countries that can meet this re- vestment service providers and clearing quirement. Bearing in mind the criteria of houses, … security and liquidity, reserve managers aim at investing the reserves in assets (2) With respect to payments, central promising the highest possible yield. The bank instructions shall apply to legal enti- foreign exchange reserve management ties, business organisations that are not guidelines of the National Bank of Hungary legal entities and natural persons. are in line with international central banking practice. Only the largest commercial and investment banks and securities houses are listed as counterparties licensed for trad- processing, clearing activity) referred by le- ing. gal regulation to the licensing authority of the NBH, the assessment of the license applications and decision-support are the re- The Regulatory Function sponsibility of the NBH. Under this function, The regulatory activities of the central bank the NBH organises the review and assess- are divided between licensing cases requir- ment of the applications received by the Bank as well as the necessary consultations ing operative measures and theoretical ac- and, on the basis of its findings, it puts for- tivity, i.e. the development of regulatory ward recommendations for granting the li- proposals applicable to businesses operat- cense or refusing to do so. ing in the money and capital markets and providing opinions on these. Although the independent regulatory Licensing powers with respect to ac- authority of the NBH extends only to subject tivities performed in the money and capital matters related to the central banking tasks markets are traditionally divided in Hungary taken stricto sensu, prudential regulation between the State Money and Capital Mar- aimed at the safe and sound operation of the ket Supervision (SMCS) and the NBH. money and capital market is of outstanding Hence, in spite of the fact that the SMCS li- importance for the NBH with regard to all censes the vast majority of financial and the domestic financial markets, particularly supplementary financial services which the banking system. Therefore, with a view may be pursued by financial institutions un- to reducing systemic risk, the central bank der the statutory provisions in force since participates in the preparation and evalua- 1997, the NBH continues to be the licensing tion of proposals concerning prudential reg- authority with respect to certain services. ulation and, in this context, in supervisory As for the specific range of financial activity. and supplementary financial services (such The legislative function includes a re- as the issue of means of cashless payment view of existing legal regulations, the devel- and the provision of related services, cash opment of proposals for amendment and

MONETARY POLICY IN HUNGARY 27 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY the preparation, development and reconcili- NBH and, subject to the licensing or re- ation of new ideas. While doing this, the cen- porting obligation as set forth in Subsec- tral bank utilises information obtained in the tion (3), by credit institutions and other course of assessing and evaluating license legal entities. applications and gleaned from the day-today activities of the bank’s other lines of (3) Credit institutions, authorised to per- business, together with the relevant regula- form foreign exchange operations, may tory recommendations of the various inter- take out foreign credits subject to a re- national bodies and the publications ap- porting obligation to the NBH. The NBH pearing in financial literature. may authorise credit institutions to ex- With respect to the last-mentioned, tend credit to non-residents and other le- analysis of the relevant rules of the EU gal entities to extend and raise credit and harmonisation of related fields in the abroad. domestic legal system are of key importance. A special field of central banking activities is the foreign exchange licensing Act XCV of 1995 on Foreign Exchange function based on the powers of the NBH as entered into force on 1 January 1996. This foreign exchange authority. enabled convertibility in a wide range for the so-called current payment operations for both residents and non-residents according Abstract 8: The Tasks of the NBH: to foreign exchange regulations, thereby satisfying the requirement of convertibility Foreign Exchange Management Tasks according to Article VIII of the Articles of Act on the Central Bank, Chapter II Agreement on the International Monetary Fund, which was also a precondition of obtaining OECD membership. With respect to §28 The NBH is the central agency of for - capital operations, rules were substantially eign exchange management. The powers liberalised in the case of the direct invest- of the NBH as foreign exchange authority ments of residents abroad (direct acquisi- are specified by the legislation on foreign tion of businesses) and raising and extend- exchange. ing foreign exchange credits abroad matur- §29 (1) In agreement with the State ing over a year, while the foreign exchange Money and Capital Market Supervision, authority maintained the licensing of short- the NBH regulates the banking activities term capital import and export in order to of credit institutions, financial enterprises pre-empt the non-desirable effects of hectic and legal entities which do not qualify as capital inflow. financial institutions providing supple- When the criteria of assessing an ap- mentary financial services in foreign cur- plication with a view to licensing by the for- rencies and, furthermore, in applying foreign exchange authority are not determined eign exchange legislation, banking activi- by foreign exchange legislation, the foreign ties performed with foreigners in forint exchange authority must consider the inter- terms. The NBH shall participate in the de- ests of the national economy or the circum- velopment of the principles and conditions stances of the applicant or the beneficiary of extending export credit. when forming its resolution. Bearing in mind the interests of the national economy, the (2) With the exception of the government foreign exchange authority does not issue li- credit specified under §24, foreign credits censes for operations which contradict the may be taken out and extended by the monetary policy objectives of the National Bank of Hungary.

28 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

Bank Supervision in electronic clearing systems, and cash processing. Supervision by the central bank is ef- The operation of financial institutions regu- fected fundamentally on the basis of the lated by laws and decrees is supervised by central bank’s data collection system, that two institutions: the State Money and Capi- is, the data provided by the financial institu- tal Market Supervision, an agency directly tions. The possibility for off-site inspection is subordinated to the government, and the provided by the daily, monthly, quarterly National Bank of Hungary, which has a re- and annual reports required to be sent to the porting obligation vis-à-vis Parliament. two supervisory organisations. The order of The State Money and Capital Market reporting set forth by regulations provides Supervision controls compliance with the the basis for the central bank whereby it can requirements of Act CXII of 1996 on Credit monitor the condition of the system of finan- Institutions and Financial Enterprises (capi- cial intermediation. In the course of inspec- tal adequacy ratio, principles of asset valua- tion, however, the NBH is entitled to request tion, requirements concerning their man- supplementary data, reports, balance agement, profits, liquidity, solvency, etc.). sheets, vouchers and other audit materials. The expectation of efficiency set On-site inspections are performed by against monetary and central bank regula- the division of the central bank established tions presupposes that the NBH should sat- for this purpose. In the course of an on-site isfy itself that the relevant legal regulations inspection, meeting the reserve require- and the central bank’s instructions issued on ment, compliance with the rules of foreign the basis of authorisation conferred by these exchange management and payments, and legal regulations are enforced in the every- the accuracy of the various types of reports day practice of financial institutions and, if are examined. so, in what way. This is done in the course of central bank supervision. The scope of the central bank’s super- Abstract 9: The Tasks of the NBH: vision extends to compliance with the in- Supervision by the Central Bank structions of the President of the NBH con- Act on the Central Bank, Chapter II cerning the reserve requirement and with legal regulations concerning payments, bank credits and foreign exchange management, §35 (1) Supervision by the central bank as well as the central bank’s requirements shall extend to reviewing compliance on issued to implement them. Thus, according the part of financial institutions and legal to the current practice of supervision by the entitles which do not qualify as financial central bank, this kind of inspection primar- institutions providing supplementary fi- ily involves examining compliance with leg- nancial services, investment service pro- islation concerning the reserve requirement, viders and clearing houses with the provi- the interest rates to be applied on a manda- sions of this Act, the legal regulations tory basis according to legislation, and the concerning payments, and foreign ex- regulations concerning information to be change and the central bank require- provided under the central bank’s informa- ments issued for their implementation. tion system. Under this, the NBH is entitled to request There are certain financial services for data, reports, balance sheets, vouchers which only the NBH may issue a license, and audit materials. which it may withdraw. These include the is- (2) In the course of supervision by the sue of instruments of cashless payments central bank, the NBH is entitled to per- and related services, money exchange ac- form on-site inspection. tivity, operations which may be performed

MONETARY POLICY IN HUNGARY 29 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

The Act on the Central Bank also The State Money and Capital Market specifies the legal consequences of viola- Supervision may issue various licences re- tions of the law established in the course quired for the foundation and operation of fi- of inspections by the central bank. nancial institutions only in possession of the opinion of the NBH obtained in advance. Regular information exchange serves Abstract 10: The Tasks of the NBH: as the safeguard of substance for co- operation between the NBH and the State Supervision by the central bank Money and Capital Market Supervision. The Act on the Central Bank, Chapter II two organisations make data and information, obtained on the activities of financial institutions and the issue of and trading in §36 (1) When a credit institution puts the securities, available to one another on a mu- central bank funds extended by the NBH tual basis and inform each another of the to lending activities which violate a legal findings of their inspections and, if neces- regulation, the NBH may charge a pen- sary, they may initiate procedures by the alty rate in addition to the rate specified other entity. in the refinancing credit contract up to the amount used in contravention of the law. Maintenance of the Payment (2) When a credit institution violates the System legal regulations and requirements re- The vast majority of cash put into circula- ferred to under §35 (1), the NBH may tion under the issuing activity of the central charge a penalty rate in addition to the transaction rate and may enforce shorter bank (of banknotes and coins) is used by maturities in its refinancing credit con- households. Payments among the other tracts to be concluded with the credit in- agents of the economy, e.g. various firms, stitution for a year, starting from the es- companies and general government are ad- tablishment of the fact of violation of the ministered largely through the transfer of law; in recurrent or severe cases, it may, funds between bank accounts. In addition to in part or in full, exclude the credit institu- changes in the balances of clients’ action from refinancing. counts, turnover of account money also results in debit and credit positions between the banks concerned. Credits and debits A system of supervision, based on uni- generated in the interbank clearing are set- form requirements avoiding duplications, as tled on the settlement accounts of the finan- reflected in the Act on the Central Bank, re- cial institutions held by the central bank. quires that the operation of the State Money Settlement is preceded by clearing, that is, and Capital Market Supervision and the sending payment instructions to their desti- NBH be harmonised. Thus, co-operation nation and the calculation of mutual debts with the State Money and Capital Market Su- and claims within interbank clearing. pervision has priority among the organisa- The stability and safe operation of the tional relations of the NBH. An organisa- interbank payment system is the precondi- tional safeguard of co-operation is that the tion of the stability of the entire domestic fi- head of the Supervision must be invited to nancial system. This is reflected by both the participate in the discussion of agenda Constitution and the Act on the Central items at the meetings of the Board of Direc- Bank, according to which the NBH is re- tors of the NBH which affect the functions of sponsible for the development and smooth the State Money and Capital Market Super- operation of the payment and clearing sys- vision. tems.

30 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

tem. Its shareholders include the financial Abstract 11: The Tasks of the NBH: institutions and the NBH, which is its largest Tasks related to Payments shareholder holding 14.7 per cent of its equity. Risks similar to those in clearing Act on the Central Bank, Chapter II among financial institutions may arise in the activity of Központi Elszámolóház és Érték- §33 (1) The NBH shall develop the na- tár Rt. (KELER – Central Clearing House tional payment and clearing system. and Depository Ltd.) supervised by the State Money and Capital Market Supervi- (2) The NBH shall regulate payments. sion. KELER is responsible for the processing of payments related to stock exchange §33/A (1) Approval from the NBH shall transactions with securities and derivatives. be required for the entry into force of the The NBH holds 50 per cent of the shares in rules of business of the clearing house of KELER. credit institutions, or any amendments thereof, which operate the transfer system administering clearing; the clearing KELER house for credit institutions shall publish its rules of business in the “Pénzügyi In countries having highly developed financial Közlöny” (Financial Journal). markets, there are institutions which – as a service – perform, as their main function, all (2) The NBH may require the clearing the tasks necessitated by the management house for credit institutions to set aside a and clearing of the vast quantities of market securities. risk fund and may issue mandatory provisions concerning the mode and rate of With the explosive expansion of trad- provisioning and the use of the fund. ing in the stock exchange, the need for setting up an independent clearing house and depository to provide a wider range of services efficiently, quickly and safely for the participants of stock exchange transactions The President of the NBH may issue also arose in Hungary. As a result of thor- instructions which, as far as payments are ough professional preparatory work, the concerned, also apply to individuals. Cen- Central Clearing House and Depository (Bu- tral bank instructions specify the forms of dapest) Ltd., was established on 12 October 1993, referred to as KELER by its abbrevi- payment that may be applied in domestic ated name. KELER was established and is payments as well as the essential rules of still owned by the National Bank of Hungary, their administration, including, inter alia, the the Budapest Commodity Exchange and the process and due dates of settlement. Budapest Stock Exchange. Beyond its regulatory powers, the cen- - The founders specified KELER’s main tral bank also pursues a specific type of su function as facilitating safe, rapid and cheap pervisory activity, the objective of which is clearing and settlement of transactions on the first and foremost to guarantee the effi- security market in Hungary by running a ser- ciency and stability of the clearing systems, vice centre supporting primarily the activities operating as the system of financial con- of the members of the capital market commu- tacts among financial institutions. The cen- nity (securities traders and banks). KELER, tral bank licenses the operation of the clear- therefore, acts as a central depository, keeps ing houses of financial institutions and security accounts and provides other relating supervises their activity. Giro Elszámolás services. Under its clearing house functions, it - not only provides services to the prompt mar- forgalmi Rt. (Giro Clearing House Ltd.) was ket of the Budapest Stock Exchange, it also founded in 1989 for the purpose of setting operates as the clearing house for the forward up and operating the interbank clearing sys- market of both the Budapest Stock Exchange

MONETARY POLICY IN HUNGARY 31 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

and the Budapest Commodity Exchange. It lower the transaction costs and financial carries the greatest risks in its latter function risks are. Through this and the increasingly as in the case of forward transactions the fast data and information flows, the effi- clearing house becomes a contracting party ciency of the central bank’s steps, designed in the transaction between the buyer and the to influence the ultimate interest target seller, similarly to international practice, and guarantees the settlement of transac- through various market rates and variables, tions. In addition, KELER provides clearing may improve. services for the government security market On the other hand the payment sys- outside the stock exchange (OTC market) tem is also a channel through which un- and has increasingly extensive functions of sound financial institutions may jeopardise a banking nature (keeping exchange cash the stability of the entire payment system. In accounts, interest payment, technical lending related to clearing, etc., treasury activ- such cases, to counter these kind of risks , ity). central banks are forced to act as lender of With the establishment of KELER and last resort. the development of the payment system, the implementation of DVP (Delivery versus Pay- ment)14 based clearing has become increasingly possible. The risk arising in relation to The Interbank Clearing System payments may be substantially reduced (BKR) when the operation of the payment and the security clearing systems satisfies the principle of Delivery Versus Payment (DVP), The interbank clearing system, run by the that is, a mechanism is applied under which Elszámolásforgalmi Rt., is the giro clearing securities are delivered only if and when system (Interbank Clearing System – BKR). consideration is also paid. The system handles transfers gross, al- The securities settlement system (the though it does not dispatch transfers institution performing it) and monetary pol- promptly when receiving an order, they are icy (the central bank) are connected in a cleared on the day in question at a specified number of areas. The central bank itself par- point in time. ticipates in transactions covered by govern- Commercial banks are direct mem- ment papers and KELER clears some of its operations. The cash leg of the securities bers of the clearing system, other financial transactions is often settled through the ac- institutions, such as savings co-operatives, counts managed by the central bank. link up with the giro clearing system through the commercial banks as so-called In relation to the payment system, the correspondent members. In the interbank task and objective of the NBH is to guaran- clearing turnover, the system accepts only tee the sound operation of the domestic those orders whose cover has been payment system and to develop a national provided by the credit institution in ad- payment and settlement system running at vance. minimum risk. This cover consists of the balance of There is a close relationship between the settlement account held with the central the efficient operation of clearing systems bank and the securities kept with KELER and financial markets because the more de- pledged by the bank prior to clearing. The veloped the payment system is, the more giro system processes the transfer orders liquid the financial assets become, the more received after the turnover of the day, late in integrated financial markets are, and the the afternoon and at night. If sufficient funds are not available for an item of a financial institution for any rea- 14 The DVP principle: in the case of security transactions, son whatsoever, the system holds these or- settlement is effected only when securities on the part of the seller and the necessary money on the part of the buyer are ders pending in a queue. In such an event, available in the appropriate accounts. the bank may either release additional li-

32 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY quidity (of its own) to resolve the queue or it between VIBER and BKR. VIBER’s mes- has various instruments (credit facilities) sage communication network is S.W.I.F.T. available to obtain additional liquidity from (S.W.I.F.T. – Society for World-wide Inter- the central bank. bank Financial Telecommunication – an in- The NBH has a dual role to play in the ternational communication network). clearing system: on the one hand, it clears The participants of VIBER include, on and books the positions generated in the the one hand, credit institutions and, on course of the overnight operation of the in- the other, KELER (since it manages collat- terbank giro system and it directly settles eral for intraday credits and clears securi- and books the orders of its own account ties turnover), the Hungarian Treasury and holders (financial institutions) against one the NBH, as a system operator and an another during the day. agency which manages accounts, provides correspondent banking services and acts as a regulatory and supervisory VIBER agency. VIBER’s direct members are those To modernise its services provided to credit banks and other institutions which keep institutions, the NBH introduced a new ser- their accounts with the NBH and are able to vice in the autumn of 1999 – the Real Time receive and send payment orders through Gross Settlement System (RTGS – or, in its their own interfaces. The correspondent Hungarian abbreviation, VIBER). The es- customers of direct VIBER members are not sence of the real time gross settlement sys- members in VIBER, hence they do not have a VIBER account. tem is that the moments of clearing and settlement are not separated in time, booking VIBER was so developed that the is effected item by item continuously and in technical requirements of joining TARGET, real time. the common European payment system, were in place already upon start-up. Gross systems are generally based on (TARGET – Trans-European Automated the central bank’s account management Real-Time Gross Settlement Express service. VIBER is also a gross settlement Transfer – is the common European pay- system, in which the processing of payment ment system introduced in the third phase orders and their final settlement takes place of EMU, established with a view to the inte- continuously, while notifying participants gration and harmonisation of the national concerned in real time. Payment transac- payment systems.) tions are settled immediately by the NBH provided that there is coverage and the sys- With the implementation of VIBER payments are speeded up, consequently it tem notifies the debited and the credited is expected that banks will need less banks. money for arranging the same size of pay- In Hungary, VIBER was established to ment turnover. Evidently VIBER has process and settle urgent, typically large- brought about technical changes as well value interbank payment orders. From as reduced risks and has introduced March 2000 optionally and from July 2000 greater efficiency in comparison to the on a mandatory basis, VIBER also performs earlier system. The items which had earlier the urgent large-value orders of the bank’s been booked directly by the NBH in the customers. banks’ accounts, without the involvement Small-value payment orders will con- of the giro system in the morning or early tinue to be administered in BKR in the fu- in the afternoon, have been settled in real ture, but there is no mandatory value limit time through VIBER since September or other criterion for channelling turnover 1999. These operations include, for in-

MONETARY POLICY IN HUNGARY 33 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY stance, the payment operations between banks having settlement accounts, DVP se- and legal entities which do not qualify as curities transactions, cleared by KELER, financial institutions providing supple- transfer orders, where the beneficiary is an mentary financial services, investment account holder bank, payments arising service providers and clearing houses from transactions concluded with the NBH shall supply information required by the (disbursement and repayment of refinanc- NBH. The NBH shall develop the con- ing credits, open-market operations, for- tent and methodology of the central eign exchange operations, etc.), settlement bank’s information system, inviting the of cash turnover administered through the opinion of the Ministry of Finance and intermediation of the Post Office or cash the State Banking Supervision in turnover affecting the account of a com- agreement with the Central Statistics mercial bank. Office. Net bankcard settlements are also per- (2) The NBH shall publish all the impor- formed in VIBER (at 10.00 a.m.). In VIBER, tant information concerning the opera- as before, all settlements are effected after tion of the banking system and the fi- examination of coverage. nancial position of the country and it shall make their detailed data regularly available to Parliament, the government Statistics and the ministries (agencies with nation-wide authority).

Pursuant to the Act on Statistics, the NBH (3) Data may be disclosed only in a is an institution, which is part of the offi- form which prevents such information cial statistical service. Accordingly, it being traced back to individual data closely co-operates with the Central Sta- providers. tistics Office and other institutions of public administration concerning methodol- (4) Credit institutions shall publish the ogy, data collection and the transfer of data specified by the NBH in the format data. In the course of its statistical activi- determined by the NBH. ties, it collects data and issues publications about financial institutions in Hun- gary, financial relations between Hungary and the rest of the world, and other pro- Monetary statistics produced by the cesses important for decision-making by NBH present the claims and debts of the economic agents. banking system, i.e., the credit and money stocks, using the balance sheet data of the credit institutions and the central bank. In addition, it publishes data on the banks’ lending and deposit rates. Abstract 12: The Tasks of the NBH: Based primarily on the reports of the The Central Bank’s Information System banks, the balance of payments statistics describe changes in the export and import Act on the Central Bank, Chapter II of goods and services, income flows between residents and non-residents and §34 (1) To perform its tasks, the NBH changes in the claims and debts against operates the central bank’s information non-residents. The same statistics present system, for which financial institutions foreign exchange reserves and Hungary’s foreign debt and other financial claims and debts.

34 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

The statistics presenting the financing its Monthly Report. In addition to the sta- capacities of households15 describe the tistics already presented, the Monthly Re- claims and debts of households incorpo- ports disclose data regularly on real eco- rated in various financial assets and the nomic processes, inflation, exchange components of their changes. In this case, rates, general government and the capital the sources of data are manifold, ranging markets. from the reports of credit institutions Press releases on statistics, which con- through the data of insurers and pension tain up-to-date information on the current funds to information published in the daily account, the consolidated balance sheet of press. the central bank and the banking system, Securities statistics – based on the re- savings, interest rates, cash stocks and se- ports of investment fund managers, stock curities, are designed as rapid vehicles for exchange companies and custodians of se- the supply of information. curities – provide an overview of the stocks The calendar forecasting the dates of of government papers, investment units publication of the Monthly Reports, press re- and shares on the stock exchange, as well leases and statistical communications is as their distribution among economic also accessible through the Internet on the agents. In contrast to the statistics listed NBH website. above and produced monthly, securities statistics are available to users on a quarterly basis. The statistics of financial accounts Organisational Structure present the stocks and flows of financial as- and Decision-Making sets and liabilities of economic agents within the system of national accounts. The accounts reflect the changes during the accounting period, while balance sheets dis- The Bodies of the NBH close the stocks outstanding on the opening and closing days of the accounting period. Defined by the Act Within the accounts, those presenting trans- on the Central Bank actions and other stock changes can be distinguished. Similarly to the other parts of the he bodies of the NBH as defined by law16 national accounts, accounts and balance Tinclude the General Meeting, the Central sheets can be compiled by institutional sec- Bank Council, the Board of Directors and the tors as well as for the whole of the national Supervisory Board. economy. Currently, as a pilot project, accounts are compiled for annual accounts; at a later date, they will be produced on a quar- The General Meeting terly basis. In addition to the above, the Statis- It follows from the legal form of the Na- tics Department of the National Bank of tional Bank of Hungary, which is a com- Hungary receives a raft of data describing pany limited by shares, that the supreme economic processes and conditions from decision-making body of the NBH with re- other organisations, which are published spect to its fundamental conditions of op- regularly together with its own statistics in eration and management is the General Meeting.

15 For greater detail concerning the concept of financing The shares of the Bank are held by the capacity, see the section on “Credit Aggregates and Net Fi- state. The Minister of Finance represents nancing Capacity” in the chapter on “Indicators”. 16 Act LX of 1991 on the National Bank of Hungary (Act the state as shareholder. Rather than con- on the Central Bank). vening the General Meeting, the Minister of

MONETARY POLICY IN HUNGARY 35 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

Finance – acting with an authority that is The President of the NBH is responsi- narrower than the competence of the Gen- ble for implementing the resolutions of the eral Meeting – may bring founder’s resolu- Central Bank Council. tions. The Central Bank Council itself deter- The ordinary General Meeting of the mines its statutes within the limits of the Act Bank must be held at least once a year at on the NBH and the Deed of Foundation. the latest by the end of May. General Meet- ings are convened by the Bank’s President. Board of Directors Apart from the Minister of Finance, the members of the Central Bank Council, the The Board of Directors is the advisory body Board of Directors, the Supervisory Board of the President of the Bank; its primary task and the auditor must be invited to the Gen- is to support the President in performing his eral Meeting. tasks. In general, it meets every two weeks. The President of the Bank may con- The total number of the Board mem- vene an extraordinary General Meeting bers is at most eleven, consisting of the whenever the need arises. President, the Vice Presidents and other members employed by the NBH and elected by the General Meeting upon the recom- The Central Bank Council mendation of the President of the NBH. In its capacity as the main advisory The Central Bank Council is the supreme body, the Board discusses the drafts, rec- body of the NBH, governing monetary pol- ommendations, submissions and reports in icy. The Central Bank Council meets as a wide range of topics related to the tasks of needed but at least once every quarter. Its the central bank and the management and members are the President of the NBH as organisational operation of the NBH. the chairman of the Central Bank Council, The Board itself determines its statues the Vice Presidents of the NBH, additional within the limits of the Act on the NBH and members in a number one more than the the Deed of Foundation. number of the Vice Presidents of the NBH appointed or recalled by the President of the Supervisory Board Republic upon the recommendation of the Prime Minister, who must first solicit the The Supervisory Board (hereinafter the opinion of the President of the NBH. “SB”) is the controlling body of the NBH. Its The representative of the government must members include the Chairman of the Su- be invited to the meeting of the Central Bank pervisory Board elected by Parliament, Council with the right of being consulted. three additional members elected by Parlia- The Central Bank Council makes deci- ment, the representative of the Minister of sions on the annual Monetary Policy Guide- Finance and an expert appointed by the lines of the NBH, the central bank’s position Minister of Finance. concerning exchange rate policy and any The primary task of the Supervisory significant changes in the instruments of the Board is to control whether the NBH oper- central bank’s policy, which go beyond the ates in accordance with the provisions of the framework of the monetary policy adopted. law, its Deed of Foundation and the resolu- The Central Bank Council is in quorum tions brought by the General Meeting. It when at least five of its members are pres- must immediately inform the Board of Di- ent. It can adopt resolutions by a simple ma- rectors whenever it learns of any violation of jority of the votes of those present; in case of the law or any fact, omission or abuse in a tie vote, the vote of the member chairing conflict with the Deed of Foundation or any the meeting decides. resolution of the General Meeting.

36 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

Any member of the SB may request for a term of six years. When entering office, the chairman to convene the meeting of the the President of the NBH is sworn in the Supervisory Board, indicating its reason and presence of the President of the Republic. objective. The Supervisory Board may meet The President represents the Bank in in privy when only those invited to the meet- the meetings of the government and the ing may participate. Any member of the SB economic cabinet and in front of other agen- may initiate that the meeting be held in cies in matters of outstanding significance, privy. When not all the members are present including the meetings of international or- at the meeting, only the agenda items indi- ganisations of which the Bank is a member. cated in the invitation may be discussed. The President decides in all matters which The President of the NBH and other he has not delegated to the Vice Presidents, persons indicated in the Statutes of the Su- other managers or committees. pervisory Board must be invited to the SB meetings. The Supervisory Board is in quorum when at least two-thirds of its members The Vice Presidents of the NBH (four persons) are present; it brings adopts The Vice Presidents of the NBH, at most five resolutions by open ballot with a simple main number, are appointed and recalled by jority of the votes. In case of a tie vote, the vote of the Chairman of the Supervisory the President of the Republic. The recom- Board decides. The members are entitled to mendations are made by the President of annex their written statements containing the NBH, which are, if agreed, submitted by their different positions to the minutes of the the Prime Minister to the President of the Re- meeting. public. The recommendation must indicate The Supervisory Board itself deter- the functions of the Vice President to be ap- mines its statutes within the limits of the Act pointed. The mandate of the Vice Presidents on the NBH, the Act on Business Organisa- of the NBH is for a term of six years. tions and the Deed of Foundation which is to The Vice Presidents participate in the be approved by the General Meeting. governance of the Bank, including strategic Based on the rotation principle, either decisions, developing the position of the the Chairman or a member of the Supervi- NBH related to governmental and other doc- sory Board shall participate in the meetings uments affecting the functions of the Bank; of the Board of Directors in an advisory ca- they supervise the bank units subordinated pacity. to them, govern and control the lines of business subordinated to them and take The President of the NBH action to have the necessary decision-support activities completed, the inter- The NBH is headed by the President who is nal and external measures made that are required for performing these tasks and for responsible for the performance of the tasks implementing measures within their own assigned to the NBH and governs the opera- scope of authority. The Vice Presidents tion of the Bank. make decisions in matters referred to their A Hungarian national with outstanding authority and represent the Bank in front of theoretical knowledge and practical exper- other agencies within the limits of their func- tise in issues related to monetary, financial tions. and banking activities may be appointed as President of the NBH. The relevant committee of Parliament hears the person nomi- Standing Committees nated. The President of the Republic appoints There are various standing committees in and recalls the President of the NBH upon the National Bank of Hungary, responsible the recommendation of the Prime Minister for decision support and providing grounds

MONETARY POLICY IN HUNGARY 37 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY for decision-making. With respect to con- markets, the changes in the exchange rates ducting monetary policy, the Monetary of important currencies and money and Committee is of the highest importance. Its capital market rates, the preparation for task is to regularly review the monetary situ- drawing in funds, and changes in the cash ation and, within the limits of its flow position of the NBH in the light of debt authorisation, to develop and make operat- and reserve management. ing monetary policy decisions. In addition, it The committee is chaired by the Presi- has to harmonise domestic foreign ex- dent of the Bank. change and forint market operations. The competence of the committee extends to all the matters with respect to which the Central Bank Council did not reserve the Central Bank right of decision-making and which were not Independence referred to the authority of other committees or specific managers by the President of the Bank. The Importance of Independence The committee is chaired by the Presi- dent of the Bank, its members include central bank is regarded as autono- the Vice Presidents and the permanent Amous when it does not have to submit to invitees. either the direct or indirect pressure or the The task of the Banking Committee is expectations of any body, organisation or to facilitate decision-making and the adop- person outside the Bank in the course of pur- tion of measures and statements by the suing monetary policy and, if it refuses NBH, and the improvement of the operation to submit, its action has no detrimental con- of the banking system by monitoring and sequence of any kind with respect to the discussing the subject matters specified in Bank. its statutes and by making recommenda- The independence of the central tions. According to the priority subject mat- bank is a highly important criterion with ters specified in its statutes, its competence respect to the economic stability and exter- extends to: the banking system and legal nal rating of individual states, because po- and other regulations concerning credit in- litical cycles are relatively short and, in stitutions; the operation of the central some cases, are not suitable for enforcing bank’s rating system of credit institutions; the long-term interests of the monetary the experience of supervising credit institu- economy, which a strictly professional in- tions by the central bank; significant individ- stitution without any political ties is able to ual cases related to the foundation, transfor- implement more efficiently. mation and modification of the scope of op- The primary role of central banks eration of credit institutions; and adopting a lies in driving inflation down to a low level position concerning recommendations and keeping it there in the long run in the aimed at individual exemptions from central interest of the optimal and smooth devel- bank measures. opment of the real economy. In periods of The committee is chaired by the Presi- parliamentary elections, however, gov- dent of the Bank. ernments frequently experience great The function of the Asset and Liability pressure to raise nominal incomes partic- Committee (ALCO) is to direct and harmo- ularly because – based on the principle of nise the management of reserves and debt, money illusion – a political organisation based on the approved guidelines. In partic- may benefit from the fact that a nominal ular, it monitors changes in foreign ex- increase in incomes may be followed by a change reserves and net debt, the condi- rise in the price level only after an elections in international money and capital tion.

38 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

It has been demonstrated that autono- its target, whereas it can be regarded as au- mous central banks have been more suc- tonomous with respect to the instruments it cessful in curbing inflation. Analyses reveal uses). a strong negative correlation between the This approach, however, examines degree of central bank independence and only the independence of the activity (oper- the rate of inflation and a slightly reversed ation) of the central bank, which is not correlation between the central bank inde- equivalent to full independence. It is in vain pendence and the rate of unemployment.17 for a central bank to choose its targets and Independence, however, has no demon- instruments with legal independence, since strable impact on changes in national in- if it is not independent in terms of its person- come. nel or financing, it will not fully meet the cri- In order to be able to call a central teria of independence. bank fully autonomous, a large number of When examining independence, there criteria must be examined. Analyses of this are three areas worth examining: independ- kind tend to examine only independence in ence in operation, personal independence the legal sense. There are cases when the and financial independence. Their criteria central bank is relatively independent in le- are meaningful only in countries where the gal terms, but its authority is insufficient to foundations of the legal system are secure enable it to behave fully independently and are widely accepted and honoured. vis-à-vis a less constructive governmental A central bank can be regarded as inde- system. pendent or autonomous only if it proves to At such times, it frequently happens be such in all three of these areas. that the management of the central bank, whether voluntarily or upon request, also leaves when there is a change of govern- Personal Independence ment or a change merely at the head of the Ministry of Finance. A central bank is regarded as having per- In other words, the de jure and the de sonal independence when the persons in- facto independence of central banks can be volved in the bank’s leadership cannot be distinguished. In the case of states enjoying influenced in their decision-making on polit- a stable legal system, legal independence ical grounds and their attitude is profession- and de facto independence coincide. In a number of developing countries, however, ally impeccable. Of course, when viewed the legally autonomous bank cannot be re- from this aspect, it is not only the president garded as de facto autonomous. (For in- (or governor) of the bank who needs to be stance, in the period between 1950 and independent but any other person or mem- 1989 in Argentina presidents of the central ber of any body involved in deci- bank had a four-year guaranteed mandate, sion-making. but they hardly acted for a year on average Among the criteria of personal inde- because the president resigned whenever pendence, the following are the most impor- there was a change in government or minis- tant: ter of finance.) The mandate of the bank’s president When measuring independence, we and the supreme decision-makers must be may witness a number of approaches in the longer than a parliamentary cycle. In ap- advanced countries. There is an approach pointing senior officials, continuity must be which distinguishes independence in the aim in some form (e.g. relying on the “choice of target” and in “choice of instrument” and examines whether these criteria 17 Full reference to the analyses by Alberto Alesina, Law- are met (e.g. in the United Kingdom, the rence H. Summers and Alex Cukiersman, Steven Webb, and central bank does not independently choose Bilin Neyapi is presented in the bibliography.

MONETARY POLICY IN HUNGARY 39 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY principle of rotation18). These two condi- ident of the Republic. For the appointment tions guarantee that the decision-making of the Vice Presidents by the President of the bodies of the central bank should not be- Republic, the proposal of the President of come captive all at once and collectively to the central bank and the agreement of the the same allegiances even after the expira- Prime Minister are needed. The President of tion of their members’ mandates. There the central bank designates the Vice Presi- should be no possibility for recall for politi- dent substituting for him. cal reasons, that is, the possibilities for recall The members of the governing bodies must be specified and limited. Appoint- of the NBH having the right to vote may not ments must be based on a broad consensus hold any office in any political party and of the profession. may not undertake a public role in the inter- It is an important precondition to both est of any parliamentary party. According to personal and institutional independence the rules governing conflict of interest, set that the decision-makers of the central bank forth in the Act on the Central Bank, the should neither request nor accept instruc- above persons may not become members tions from any organisation or person while of any entity, have an employment relation- discharging their functions. This may be ship or any other legal relationship concom- guaranteed if no member of the deci- itant with the performance of work, or serve sion-making bodies has any stake in politi- as senior officials or be members of supervi- cal or economic institutions. (They may not sory boards of credit institutions and the – be members of parliament, municipalities National Deposit Insurance Fund. or public administration or political group- Pursuant to the Act on the Central ing, etc. They may not have a stake in Bank, the President and the Vice Presidents business either as shareholders or as em- may be recalled only in well-defined cases. ployees.) The supreme monetary decision- Neither the government nor its repre- making body is the Central Bank Council, sentative may participate in the deci- whose members include the President of the sion-making bodies, and even if they do, Central Bank, the Vice Presidents and addi- they cannot have a right to vote. The gov- tional members, whose number may be one ernment, government agencies or parlia- more than the number of appointed Vice ment should have only limited rights, or Presidents. The Prime Minister puts forward none at all, to call the bank to account for its a proposal for the appointment of the latter, decisions – with respect to monetary policy, inviting the opinion of the President of the no political forum of any kind should be al- NBH. The representative of the government lowed to override the decisions of the central may participate in the meetings of the bank. Central Bank Council in an advisory capac- As far as the above aspects are con- ity. cerned, the NBH meets the criteria of personal independence because the mandates of the President and the Vice Presidents of the Bank exceed the four-year parliamen- Operational Independence tary cycle by two years. The President of the central bank is appointed upon the recom- Operational independence (or independ- mendation of the Prime Minister by the Pres- ence in action, functions or in the monetary field) obtains when the central bank makes - 18 By the principle of rotation we mean that the appoint- its decisions on the objectives of its mone ment of the members of the Central Bank Council or of tary policy and the development and de- the Vice Presidents is effected not all at once but with an even time lag. For instance, an expert is appointed to the su- ployment of its instruments independently preme monetary decision-making body of the United States of any external institutional or personal fac- (Board of Directors) once every two years for a term of 14 years. tor and, in doing so, is not under any obliga-

40 NATIONAL BANK OF HUNGARY I. THE ROLE OF THE CENTRAL BANK IN HUNGARY tion to accept requests or instructions from tral Bank still specifies the support of the any entity whatsoever. (Independence in the economic policy of the Government as an- choice of targets and the use of instru- other fundamental task. It is expected that ments.) this provision will be amended in relation to The most important elements of oper- Hungary’s accession to the EU in order to ational independence include the follow- comply with the EU requirements concerning: ing central banks. The proposed amendment: “The central bank shall support the An important criterion is how the ob- implementation of the economic policy jectives of a central bank specified by law programme of the Government without vio- relate to one another and what is the rela- lating its ultimate goal (i.e. the protection of tionship of the ultimate goal to the other ob- the domestic and external purchasing jectives. The ultimate goal of independent power of the national currency) with the central banks generally relates to inflation. help of the monetary policy instruments When that is not the only ultimate goal, it is available to it.” necessary to examine what the relationship It is an important provision of the Act is between this and the other objectives. on the Central Bank that the Government When they contradict one another or may may not instruct the central bank in its activ- become contradictory in certain situations, ities. the priorities between the ultimate goals The Government is not in a position to must be scrutinised. When, for instance, directly influence the development of mone- supporting the government’s economic pol- tary policy. Indirectly, it may exert some in- icy or curbing unemployment are stronger fluence through its natural role played in ap- (or perhaps identical) objectives of the cen- pointing the members of the central bank tral bank than curbing inflation, the pursuit bodies and the President and the Vice Presi- of an autonomous monetary policy may be dents. The Government has an opportunity, endangered. however, to expound and represent its opin- Another essential element of opera- ion vis-à-vis the central bank through its tional independence is the agency, which participation in the Central Bank Council in develops monetary policy. When the gov- an advisory capacity. ernment has the possibility to interfere with The NBH provides an opinion on the monetary policy issues,19 the given central Government’s economic policy prog- bank cannot be regarded as autonomous. ramme, the decisions and legal regulations In the case of central banks regarded related to the Government’s economic pol- as the most autonomous, there is a charac- icy and reconciles the ideas concerning the teristic right to give advice to the govern- financing of the budget deficit. ment concerning current issues of economics, to participate in the meetings of the government or individual departments in an ad- Financial Independence visory capacity and to have a say in legisla- A central bank enjoys financial independ- tive activities. This right is not a condition of independence but precisely by virtue of the ence when it can obtain the funding required central bank independence, there tends to for the performance of these tasks in the be a demand for it. course of its operation automatically, with- The Constitution specifies the “protec- out depending on the government’s ap- tion of the stability of the value of the national currency” as the task of the NBH in the field of monetary policy. Accordingly, 19 For instance, when the central bank is organisationally subordinated to the government or the Ministry of Finance; driving inflation down to a permanently low when the minister of finance may veto the decisions of the level is the primary objective or ultimate central bank; or when the representatives of the government participate in the decision-making bodies of the monetary goal of the NBH. The 1999 Act on the Cen- authority with the right to vote.

MONETARY POLICY IN HUNGARY 41 I. THE ROLE OF THE CENTRAL BANK IN HUNGARY proval. Financial independence, therefore, requirement of controllability vis-à-vis cen- means that the central bank always has the tral banks is designed to guarantee that the authorisations required for its operation as entities responsible for all of the institutions well as the assets based on its own capital, of economic policy (Parliament, Govern- without being dependent on the budget. ment) have an adequate overview of the op- The Act on the Central Bank provides eration of the central bank. for the funding called to ensure the condi- Pursuant to the Act on the Central tions of operation of the NBH. The central Bank, the President of the NBH reports to bank pays its profits – which remain after Parliament on the activities of the central the amounts retained for development, bank annually. Parliament may also request provisioning and other purposes – as divi- ad hoc information. The NBH provides infor- dend to the central budget and the budget mation to Parliament about its monetary reimburses the NBH for the losses it incurs. policy by presenting the “Monetary Policy Currently, this is effected by monthly settle- Guidelines”. ment. In the course of law harmonisation, as The expectation set against the central part of the process of accession to the EU, bank to disclose its decisions and their probably the settlement process will also be grounds is important not only because of the amended by reviewing the Act on the Cen- controllability of the central bank’s activities tral Bank, for instance, by doing away with but also because it assists in the efficiency of monthly settlements and setting aside re- the transmission mechanism (the impact serve funds, in order to harmonise Hungar- of the central bank’s interest rate and other ian legislation with the regulations applied measures exercised on the real economy to national banks within the European through market yields). (For an accurate ex- Union. planation of the term and the description of the mechanism, see the relevant section.) Disclosure of the objectives and the argu- The Requirement ments laying the foundations for decisions of Transparency clarifies the central bank’s policy and leaves no uncertainty in market agents about the in Central Banks motives behind the central bank decisions. They can learn how the central bank as- An important expectation vis-à-vis an auton- sesses the market processes which have omous central bank is transparency, i.e. the taken place and, what is even more impor- requirement that the tasks and objectives of tant, the forecasts and expectations of the the central bank, their performance and the central bank concerning processes ex- instruments used to achieve them be well de- pected in the future. Information of this kind lineated and information about them be speeds up the adjustment of market agents available to all. The condition of meeting this to changing circumstances and central requirement is that the central bank publish bank decisions, suitably influencing their its objectives, the decisions made to achieve expectations, which greatly improves the ef- them and the grounds for its decisions. The fectiveness of monetary policy.

42 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

THE OBJECTIVES OF MONETARY POLICY

alone determine the output of the economy The Ultimate Goal and monetary actions only influence the of Monetary Policy price level. Classical macroeconomics was unable to provide an explanation for the events he primary objective of economic policy of the world economic crisis of 1929–33 and Tis to achieve sustainable and rapid eco- the prolonged recession and long-term unemployment arising in its wake. The turning - nomic growth, which increases employ point in the history of economic theory was ment, raises the standard of living and helps the emergence of the Keynesian school. close the development gap between the na- Keynes and his followers went beyond the tional economy and the economies of ad- classical concept of perfect markets. Ac- vanced countries. What is the role of cording to their assumption, wage rigidities monetary policy in this quest? Economic and long-term employment contracts pre- theory has long been trying to determine vent nominal wages from adjusting to changes in demand and supply conditions in what objectives monetary policy should the short term. As a result, sustained strive to achieve. This question generally disequilibria may evolve in the labour mar- arises in the context of whether it is possible ket. Consequently, with wages fixed nomi- to influence the real economy (economic nally, a boost in aggregate demand (which growth and unemployment) with monetary may be effected using both monetary and policy instruments or their impact is limited fiscal instruments) leads to a decline in real to affecting the price level (inflation) and wages by raising the price level. At lower real wages companies are willing to employ other nominal variables. more labour, thus production increases. Eventually, the economy achieves a new equilibrium at a higher price level, higher The Development of Theory output and employment. In the Keynesian At the end of the last century the views of model, therefore, monetary policy is able “classical” economists concerning mone- to determine not only the price level but the tary policy were based on the doctrine of the level of output and employment as well. neutrality of money with respect to the real The trade-off between the price level (infla- economy. According to classical econo- tion) and employment is described by mists prices and wages adjust immediately, the so-called Phillips curve: higher infla- hence demand and supply are in equilibrium tion goes with lower unemployment and in all market segments of the economy. lower inflation goes with higher unemploy- Changes in the money supply are immedi- ment. ately reflected in the changes of the price The emergence of the monetarist level, therefore there is no relationship be- school at the end of 1960s was another turn- tween the nominal variables (money supply, ing point in macroeconomic theory. The mon- price level) and the real economy. This is etarists questioned Keynes’ short-term ap- the condition of the so-called “classical di- proach and the assumption of slowly adjust- chotomy”, where the factors of production ing nominal wages. In the monetarist model,

MONETARY POLICY IN HUNGARY 45 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

wage negotiations focus on future real wages long-term objectives of monetary policy. The in contrast with the Keynesian assumption, idea that monetary policy is unable to influ- where myopic trade unions negotiate about ence real economic variables in the long run nominal wages. The problem here is that to be is widely shared by economists. The effi- able to determine future real wages it is nec- ciency of short-term anti-cyclical policy essary to know or at least to forecast in some (which aims at reducing the periodical fluc- way the future price level. According to the tuations of economic output), however, con- monetarist assumption, the inflation expecta- tinues to be the subject of debate to this day. tions of economic agents adjust adaptively According to the advocates of the activist to actual price changes, i.e., they continu- theory, because of market imperfections, in- ously rectify the forecasting errors of the cluding wage and price rigidities, monetary past. policy may have an impact on real variables in the short term and central banks can take In the monetarist model monetary pol- advantage of this fact to reduce economic icy can, in the short run, influence the real cycles. In response to that the opponents of economy. Increased money supply and the activist monetary policy point out that owing resultant rise in the price level temporarily re- to the long and variable lags of the monetary duce real wages and thereby increase em- transmission mechanism, monetary actions ployment and output. Wage demands, how- risk having effects that are contrary to those ever, soon adjust to the higher price level and originally intended. Beyond all this, rational nominal wages rise to restore the former level economic agents will incorporate the of real wages. Output and employment return expected moves of the central bank in their to their the pre-monetary stimulus values, but expectations, thereby neutralising their im- the price level remains higher. Owing to this, pact. monetarists discard monetary policy as an instrument for stimulating the economy, as it has temporary effects only. According to the The theoretical view that monetary monetarist approach, the economy would be policy best serves economic development in the best position were the central bank to and growth by pursuing price stability as expand the money supply evenly, in line with - the growth of output. its primary goal has gained increasing ac ceptance in the practice of central banks. New-classical macroeconomics, which The development of theory and the failure evolved in the 1970s, took an even more radi- of activist monetary policy strategies con- cal stance regarding the relationship between vinced the central banks of advanced coun- monetary policy and the real economy. New-classical economics returned to the con- tries – and to an increasing extent those of cept of the perfect market and, in addition, developing countries – to accept price sta- adopted the assumption of so-called rational bility as the ultimate goal of monetary pol- expectations. Rationality in expectations icy and place less emphasis on output and means that economic agents prepare fore- employment targets, and to refrain from at- casts by efficiently using all the relevant infor- tempts to even out the business cycle. mation available to them at the time. Accord- By maintaining price stability, the central ing to the new-classicals, the information which serves as a basis for monetary policy bank creates a predictable environment in decisions is also available to rational eco- which economic agents can make sound nomic agents. Thus they will be able to pre- economic decisions without having to be dict with reasonably certainty the policy too concerned about future changes in the moves of the central bank and alter their infla- price level. tion expectations accordingly. Predictable monetary policy will therefore have no impact When reducing inflation and establish- on the real economy. ing price stability, the central bank has, however, to take into account the con- In the course of the theoretical debates straints arising from the economic environ- of the various schools, positions evolved on many issues, which the vast majority of the ment and the need to maintain external and profession is now willing to accept. Thus internal equilibrium. In general, curbing in- there is virtually unanimous consensus in flation is concomitant with a rise in real in- monetary economics regarding the desirable terest rates. When domestic state debt is

46 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY high, rising real interest rates increase gov- lysing the welfare effects of price stability, ernment interest expenditure, which may the non-recurrent cost of disinflation further increase state debt. In addition, un- should be set against the long-term perma- der a flexible exchange rate regime, nent benefits arising from price stability. anti-inflationary policy erodes the competi- In general, this tips the scales towards tiveness of the economy vis-à-vis the rest of curbing inflation. the world through the real appreciation of the currency induced by the rise in real interest rates. The Long-Term Benefits This poses a problem primarily for of Price Stability countries with high foreign debt. Declining The fundamental argument for achieving competitiveness may lead to a deterioration and maintaining price stability is that infla- in the current account and raise foreign in- tion is concomitant with social and eco- debtedness to an unsustainable level. nomic costs. Finally, disinflation generally brings about a The social costs of inflation can be per- temporary decline in output and incomes, ceived first and foremost through their ef- which may lead to social tensions. To be fects on income distribution, although these successful, an anti-inflationary programme effects are hard to quantify. Inflation hits the must take into account these constraining social strata the most in need and the least factors and define a path for disinflation able to enforce their interests. In general, which is optimal for the given economy and state transfers and other benefits constitut- society. ing parts of the welfare net usually follow inflation with a time lag, thus the rise in the price level withdraws income from the social Price Stability versus groups which are dependent on these Economic Growth services (pensioners, the unemployed, etc.). Accepting the long-term neutrality of Generally, a sudden leap in inflation money, i.e., that monetary policy has no affects those living off wages and salaries long-term impact on the real economy, a more painfully than entrepreneurs capable central bank may best contribute to the of more flexible adjustment, lenders more achievement of sustainable economic than debtors and those having financial sav- growth by reducing high inflation and the ings more than those accumulating real as- social and economic costs arising from this. sets. Over the longer term, an artificial boost to When indexing is used in a wide demand or monetary expansion is unfeasi- range, these risks can be mitigated but can- ble. Nevertheless, the real economic costs not be fully eliminated in the development of of disinflation, which may be substantial in prices and wages. Moreover, a practice of the short term, particularly when an indexing based on ex post (backward look- anti-inflationary policy is not credible, must ing) inflation may substantially impede the also be taken into account. reduction of the rate of inflation. Above an inflation level of 8–10 per The economic costs of inflation are cent, inflation perceptibly decreases the also substantial. The fundamental conse- growth potential of the economy. Reduc- quence of the absence of price stability is tion in inflation also means a non-recurrent that economic decisions concerning the fu- welfare benefit as it not only increases ture become more difficult to make and the rate of long-term growth but also raises more uncertain in their outcome. Because the level of GDP. The benefits of curbing in- of higher inflation, forecasting not only the flation are permanent, while the costs envisaged average price level but also en- of disinflation are transitory. So, when ana- visaged relative prices and wages, orient-

MONETARY POLICY IN HUNGARY 47 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY ing economic agents, becomes more diffi- Inflation also has an impact on social cult, owing to which the risks implied welfare through the system of taxation. in wage contracts and the production and When tax systems are not indexed at all or investment decisions of companies grow. when they are indexed with a time lag only,1 Consequently, the period of contracts the acceleration in inflation increases the and the horizon of planning become cost of capital, hence the extent of invest- shorter. ment falls below the optimal level. A higher The example that strikes the eye the general tax burden leads to inefficient most in this respect is the shortening of the capital allocation among the various sec- duration, i.e. the re-pricing period, of sav- tors. ings and credits. (In Hungary, for instance, bank deposits and credits are largely short-term and the average duration The Short-Term Costs weighted with the present value of dis- of Disinflation bursements even in the most embedded, Empirical analyses in several countries most developed financial market, that of have pointed out that the real economic fixed government papers, is no more than costs of reducing inflation exceed the 1,4–1,5 years.) short-term growth advantages obtained by Another detrimental consequence of raising inflation. inflation is that capital investments flow to the financial sector to an excessive extent The reason for this is that economic - thus violating the requirement of efficient al- agents tend to adjust their inflation expecta location of resources. With a higher rate of tion more rapidly when inflation is growing - inflation, the profitability of financial inter- than when it is declining. According to inter mediation increases relative to productive national experience, a 2–3 per cent decline activities. This distortion in allocation can in the rate of inflation tends to lead to a be considerable. 1 percentage point decline in the growth According to estimates, even at a rela- rate in the short term. tively low level of inflation, the share of the The challenge for an economic policy financial sector in GDP increases by 1 per- endeavouring to curb inflation is that eco- centage point with every 10 per cent in- nomic agents tend to be distrustful concern- crease in inflation. ing the change in the priorities of monetary In the event of inflation, the cash-flow policy. It can be observed that the longer an of the credit extended at the same real inter- economy has been characterised by high est rate will be higher thereby reducing the rates of inflation, the longer it takes to con- borrowing capability of the debtor (credit vince the public and to cool down their ex- crunch). pectations of inflation. This is a particular problem in the case The task of monetary policy is to re- of housing construction and purchase cred- duce inflation in steps that are, first, suffi- its, where the borrower does not realise the cient to modify expectations in the desirable value of the property increased due to infla- direction and, second, are not too large in tion, while it is included in the nominal rates comparison to that anticipated by society, on the credit. Consequently, with the decline that is, do not lead to serious growth sacri- in inflation, the portfolio of consumer and fice. Whether the reduction in the rate of in- housing loans is expected to grow signifi- flation is “sufficient” or “excessive” depends cantly, together with real estate prices. on the speed of the adjustment of expectations. Besides taking stock of the costs and 1 Although it did happen that tax bands were adjusted by advantages of reducing inflation, one should the rate of inflation only with a time lag, the indexing of the tax systems is a method applied also in Hungary to counter- not neglect the preferences of society act the negative effects of inflation. and economic policy in its entirety. No

48 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY country has ever undertaken to break mod- mitigate inflation (e.g. reduction in world erate inflation all at once. Countries explic- market energy prices, lower rate of infla- itly pursuing inflation related targets (for in- tion among trading partners), it resists stance, Israel, New Zealand, the United ones which would increase it, such as Kingdom, Sweden, etc.) all voted for gradu- unsustainably high economic growth or alism. fiscal pressures. The slowdown in inflation The conditioning of society to inflation in 1996–97 indicated that the inflationary and its relatively high level forced Hungary shock generated by the 1995 stabilisation by necessity also to adopt the gradual ap- measures was dying down: the stringent proach. fiscal, income and monetary policy mix The employees who suffered severe did not accommodate the higher level of losses in real wages in 1995–96 are advo- inflation. Inflation expectations also mod- cates of the policy of small steps even in the erated gradually with the decline in infla- case of adopting ex ante (forward-looking) tion. indexing because that provides security The NBH attempted to lock in the against major losses in position. disinflationary gains coming from the slump in world energy and food prices in 1998 through reducing the devaluation rate of the forint more rapidly than before. (See The Ultimate Goal Figure 1) of Hungarian Monetary Policy In curbing inflation, attention must also be paid to the real economic costs of doing so. These may be significant, particu- Sustainable Reduction larly when the anti-inflationary policy lacks in Inflation credibility. The country’s foreign debt and additional external financing needs also The ultimate goal of the National Bank of constrain attempts to reduce inflation. Hungary is to bring about a sustainable reduction in inflation. Sustainable reduction in inflation means that the path for disinflation is defined in such a way that it does Figure 1 Changes in the consumer price not threaten external or domestic equilib- index and in core inflation* in Hungary (month/same month of the preceding rium. year) The NBH not only desires to reduce inflation, it also sets the continuity of disinflation as its objective. This means that the % central bank will evaluate the same rate of 35 inflation differently when it is realised along 30 a continuously declining inflation path from 25 when it is a move up from a previously 20 achieved lower level. The central bank must keenly guard 15 Consumer price index the continuity of the disinflation process, be 10 - Core inflation cause it could quickly lose the public’s 5 hard-won confidence in monetary policy’s 0 resolve to combat inflation. JMSJMSJMSJMSJMSJ This requires seemingly contradic- 1995 1996 1997 1998 1999 2000 tory behaviour from the central bank in its reactions to external shocks which influ- * The methodological description of core inflation calculated by the NBH can be found in the September and ence inflation. While it attempts to accom- December 1999 issue of the “Quarterly Report on Infla- modate favourable external shocks that tion”.

MONETARY POLICY IN HUNGARY 49 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

The Role of the External mentals that influence external equilib- Equilibrium rium and competitiveness sound, and by holding adequate levels of foreign External equilibrium has been traditionally exchange reserves, which enable the cen- a concern for Hungary’s monetary policy. tral bank to meet its obligation of interven- The maintenance of external equilibrium tion. is prima facie not a typical central bank The various real exchange rate indi- objective, but in Hungary’s case it is insep- cators faithfully track the evolution of the arable from the objective of reducing infla- domestic export and import sector’s com- tion and achieving price stability. Hungary petitiveness, which is a crucial determi- is a small open economy, where tensions nant of the country’s external balance arising from imbalances in domestic pro- from the real economy side. Because of duction and absorption typically first lead this, preventing the excessive real appre- to the deterioration of the current account. ciation of the forint is an important goal of Inflationary pressures only appear later the central bank. when measures (such as devaluation, the The fact that while Hungary’s econ- raising of customs duties and taxes, etc.) omy is catching up with more advanced are taken to address the problem of exter- economies its productivity growth will out- nal disequilibrium. Hungary’s relatively strip that of its trading partners is, however, high foreign indebtedness and the use of not ignored. This process inevitably leads to the nominal exchange rate as an interme- the appreciation of the real equilibrium ex- diate target of monetary policy further change rate. Though neither this equilib- limit the extent to which the NBH can toler- rium level, nor the requisite magnitude of ate fluctuations in the balance of pay- the real appreciation in a given period can ments and the real exchange rate. be accurately quantified, it is certain that a The objective concerning the exter- drastic and sustained real appreciation must nal equilibrium cannot be expressed as a be avoided by all means. The central bank’s single figure. The central bank aims to views concerning the desirable extent of real achieve and maintain a level in the current appreciation can be seen from the discrep- account balance, competitiveness (real ancy between the announced rate of devalu- exchange rate), debt indicators and for- ation and the expected rate of inflation. The eign exchange reserves, which are aligned forint’s fluctuations within the band carry no with the long-term macroeconomic course information concerning the central bank’s of the economy. intentions. The predictable nature of the Hun- The weight of the indicators of exter- garian exchange rate regime (narrow nal debt, particularly of the state’s foreign band, the rate of devaluation announced in exchange debt, is still higher in the “objec- advance) and the nominal exchange rate tive function” of the NBH than in that of the target (see the next chapter on “Intermedi- central banks of advanced countries. This ate Targets”) in themselves justify the em- is a heritage of the past. In the early 1990s, phasis monetary policy places on indica- practically only the state had access to tors of external equilibrium. the international capital markets, thus With the introduction of the crawling the NBH raised all the foreign funding that peg exchange rate regime, the NBH’s abil- the economy needed. Today, with the ity to avoid a forced devaluation of the fo- liberalisation of the greater part of current rint or a widening of its exchange rate band account operations, economic agents are has risen to paramount importance in able to do so on their own. This process is preserving the credibility of economic pol- also reflected in the changing structure of icy. Such speculative attacks can be best Hungary’s foreign exchange debt: the pre-empted by keeping economic funda- share of the state has declined, while that

50 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY of the private sector has increased. Mar- higher perceived exchange rate risk,do- kets pay special attention to the foreign mestic interest rates would rise as well, exchange debt of the state because the pri- putting further strain on the government vate sector is thought to assess and manage budget. risks associated with increasing its liabilities To re-establish fiscal balance, it would more adequately.2 be inevitable to raise taxes and curb expen- In advanced industrialised countries diture. Ultimately this would lead to a re- the share of national debt denominated in newed increase in inflation and a halt in eco- foreign exchange is low, which means that nomic growth. For this reason the NBH must depreciation or devaluation of the ex- take a much tougher stance on signs of de- change rate does not significantly worsen a clining competitiveness than its counter- country’s fiscal balance and the authorities parts in more established economies and can leave it to the markets to re-establish it can use the current account to only a external equilibrium at relatively low cost lesser extent as a buffer against negative by giving up the fixed exchange rate re- shocks. gime. In Hungary’s case, however, the government would need to raise foreign funds to meet its debt obligations even under a float- Intermediate Targets ing exchange rate regime (although to a much lesser extent than before), hence a The Hierarchy of Objectives forced abandonment of the fixed exchange rate regime would have high economic ll this is to say that the implementation costs. Not only would the forint value of the Aand maintenance of price stability can foreign exchange component of debt ser- be regarded as the ultimate goal of monetary vice increase substantially but, owing to the policy (see Figure 2). The instruments avail-

Figure 2 The Objectives of Monetary Policy

Ultimate goal (price stability)

Intermediate target (nominal anchor)

Operative target

Central bank instruments Indicators

2 Yet the Asian crisis demonstrated that even this is relative.

MONETARY POLICY IN HUNGARY 51 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY able to the central bank, however, are unable The Nominal Anchor to exert a direct and immediate impact on the price level. In general, the intermediate target serves as The connection between the ultimate a nominal anchor for economic agents. The goal and the instruments of the monetary nominal anchor is an economic variable ca- authority is rather indirect and also depends pable of stabilising the expectations of eco- on stochastic factors. In addition, monetary nomic agents (producers, consumers, em- policy decisions taken today will have an ployers, employees, etc.) with respect to fu- impact with a time lag, which may fre- ture inflation. quently involve years. Owing to the compli- When the nominal anchor is credible, cated nature of the relationship between the i.e. economic agents have confidence in the instruments and the ultimate goal of mone- capability of the monetary authority to meet tary policy, central bank decision-makers the intermediate target, they will form their closely track the evolution of variables that inflation expectation in accordance with that play a role in the transmission mechanism anchor. This can be of tremendous assis- and serve as a link between the instruments tance to the central bank particularly when it and the ultimate goal. sets out to establish price stability after a prolonged inflationary period. By using a - These variables can be put in the cate credible nominal anchor and cooling over- - gories of intermediate target, operating tar heated expectations of inflation, the mone- get and indicators. tary authority may substantially mitigate the The intermediate target is an eco- economic and social costs of reducing infla- nomic variable, which is closely related to tion. the ultimate goal but can at the same time be relatively well influenced by the instruments of monetary policy. In general, the Choosing the Intermediate growth rate of the money supply in the Targets economy or the exchange rate is chosen as such a target. Central banks tend to deter- One of the possible intermediate targets is mine target values for the intermediate tar- the amount of money available in the entire gets with respect to the future. economy and its growth rate. According to the tenets of classical economics, there is an The level of the target values is deter- unambiguous congruence between the mined so as to be optimal from the view- money supply and the price level, hence the point of the ultimate goal; then the central central bank is able to control the price level bank attempts to influence the intermediate through influencing the money supply. target variable with the instruments avail- The use of the money supply as an interme- able to it so that it should meet the desig- diate target was a popular instrument nated target value. among central banks until the 1980s. In A properly chosen intermediate target the course of the 1980s, however, many a can be better controlled by the central bank central bank saw that the causal relation- than the ultimate goal itself; at the same time, ship between growth in the money supply the intermediate target reflects the changes in and inflation, which used to function well the external factors (that is, factors, outside previously, was upset and they were unable the control of the central bank) influencing the to control the price level through the money ultimate goal even before they would actually supply. This failure could be attributed pri- influence the price level. With the help of a marily to financial innovation: paying inter- well selected intermediate target, the central est also on sight deposits and the increas- bank can, for instance, introduce measures to ingly intensive use of the various means of stabilise the price level even before the un- cashless payment (e.g. credit cards) led to folding of an inflationary shock. an erosion of the boundaries between cash

52 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY and non-cash type instruments, thus central addition, the mathematical econometric banks were less and less able to influence models used for producing inflation fore- broad money. Consequently, central banks casts can be used effectively only in the in several countries (including the United countries where adequately long, uniform States and the United Kingdom) gave up the data series are available about the eco- system of monetary control based on the nomic processes. money supply. In the case of countries running a fixed exchange rate regime, the exchange The Intermediate Target rate plays the role of the intermediate tar- of the NBH get. Pegging the exchange rate is generally applied by countries having a small, A number of intermediate targets are used open economy. By pegging its currency to in international practice. For today’s Hun- that of a large country enjoying a stable garian economy the one that has the most price level, the central bank practically favourable characteristics is the nominal ex- “imports” the low rate of inflation of the change rate. The popularity of the exchange large country. In addition, pegging the ex- rate target, particularly in emerging econo- change rate substantially reduces the risks mies, can be frequently explained by the ab- arising from exchange rate fluctuations, sence of the conditions for alternative mon- which may facilitate the development of etary regimes. foreign trade as well as international in- In Hungary, for instance, the instabil- vestments. In return for these advantages, ity of the money demand function in the pe- fixing the exchange rate presupposes ad- riod of the transition ruled out monetary tar- justment to the monetary policy of the geting as an option for the central bank. It is large country, which is not advantageous therefore not by chance that the NBH has when the two countries are subject to dif- used the exchange rate as its intermediate ferent economic shocks. target since the birth of the two-tier banking From the end of the 1980s, several system. central banks switched to the system of di- The use of the nominal exchange rate rect inflation targeting. In this framework or exchange rate path as the intermediate of monetary policy, the central bank un- target has several advantages. The ex- dertakes an explicit commitment to main- change rate directly influences the price of tain the rate of inflation within a given tar- traded products. Also, provided that the ex- get band. Here, the inflation forecast pro- change rate target is credible, the pre- duced by the central bank plays the role of announced devaluation rate (in the case of a the intermediate target. The inflation fore- crawling peg regime) may efficiently condi- cast meets the characteristics expected tion inflation expectations and the prices of from an intermediate target because it is non-traded products and services. A credi- closely related to the ultimate goal and it ble exchange rate target means that the ex- can be influenced by the central bank be- change rate will evolve along a foreseeable cause, when producing the forecast, the path and therefore is not an additional central bank instruments are also taken source of uncertainty affecting returns on into account. Thus, in parallel with the investments. steps of the central bank, the forecast is The exchange rate path as an interme- also modified. The system of inflation tar- diate target has yet another advantage, geting proved to be an efficient anti- namely, that it is transparent: all economic inflationary instrument in a number of agents can continuously observe it. The re- countries. Its application, however, pre- lationship between the exchange rate and supposes that the central bank establish the rate of inflation is widely known among its own credibility in the eyes of society. In economic agents, therefore the exchange

MONETARY POLICY IN HUNGARY 53 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY rate target is capable of anchoring their in- dictable and economic calculations could flation expectations. not be based on it. The public’s ability to continuously Regular devaluation resulted in disrup- monitor whether or not the central bank tive speculation that threatened the financial meets its target enhances the central bank’s system and also perpetuated higher infla- accountability, which in turn boosts its cred- tion. Hungary needed an exchange rate re- ibility and the public’s confidence in eco- gime which was predictable, helped disinfla- nomic policy. tion, but also allowed the economy to run a Exchange rate targeting is not synony- higher rate of inflation than its main trading mous with maintaining a fixed-type ex- partners for a sustained period of time. change rate regime. Several countries pur- The examples of Chile, Poland and Portugal, sue an exchange rate target even with for- among others, demonstrated that the crawl- mally more flexible exchange rate regimes ing peg/band exchange rate regime fulfilled (floating, wide-band exchange rate re- these expectation. (See Figure 3) gimes) and maintain a form of implicit ex- The use of the exchange rate as the change rate band or limit the actual move- nominal anchor, the predictability of deval- ments of the exchange rate through man- uation coupled with stringent fiscal and in- aged float. come policies opened up the way to gradual A fixed exchange rate or a narrow ex- disinflation. Announcing the rate of devalu- change rate band is, however, a stronger ation in advance (first until the end of 1995) commitment to implementing the exchange assisted in making expectations forward- rate target, consequently its ability to orient looking, and the restrictive fiscal and in- expectations is stronger. come policies pursued guaranteed that the surge in inflation induced by cost-side pres- The Pre-announced sures created by the radical stabilisation measures remained temporary (and was not Crawling Band Exchange Rate in excess of what cost side pressures war- Regime ranted) and could be gradually reversed following the shock. The crawling band regime, introduced in March 1995, allowed economic policy- This significantly contributed to solidi- makers to reconcile as much as possible fying the credibility of economic policy. the often conflicting objectives of fostering Under the pre-1995 exchange rate regime, growth and reducing inflation. Pegging investors expected higher yields from forint means that a country sets a fixed value denominated financial assets owing to the for its currency vis-à-vis the currency of a uncertainties surrounding the date and large, low inflation economy.3 With a fixed magnitude of prospective devaluations: exchange rate, domestic inflation ultimately forint yields contained a substantial pre- and gradually approaches the inflation of mium. This was particularly burdensome for the country of the anchor currency; yet in- the budget, the state being Hungary’s larg- ternational experience shows that this con- est debtor. The success of the stabilisation vergence tends to be rather slow and the measures and the impeccable track record costs of disinflation can be substantial. of the exchange rate regime reduced this In the wake of several unexpected de- premium for the risk of an unexpected ex- valuations the earlier fixed, but adjustable change rate realignment to a negligible exchange rate regime lost its credibility. The level. evolution of the exchange rate was unpre- The other component of exchange rate risk, the possible change of the exchange rate within its fluctuation band, remained, but, until the end of 1997 it was not 3 Or to a currency basket, but this does not alter the heart of the matter. considered to be significant as the exchange

54 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

Figure 3 The Exchange Rate of the Hungarian Forint, January 1994–January 2000*

The logarithm of the basket exchange rate (reversed scale) 4.5 4.5

4.6 4.6

4.7 Band width 4.7 +/- 0.5% 4.8 4.8 Russian 4.9 Czech crisis Stock exchange crisis 4.9 Band width Asian crisis Russian 5.0 +/- 1.25% 23 Oct. 1997 devaluation 5.0 Band width 5.1 +/- 2.25% Brazilian 5.1 devaluation 5.2 5.2

5.3 5.3

5.4 5.4 . . . . . b b b e pr e ept. ept. ept. Jan. Jan. Jan. Jan. Jan.

A Jan. Oct. Oct. July Oct. Oct. F F Feb. July July July May Nov. Apr. May Apr. Fe

June May Aug. Dec. Aug. Dec. Aug. Nov. Dec. Aug. Nov.

June Aug. Nov. Dec. May June May Sept. Sept. S S S

June March

March March

March 1994 1995 1996 1997 1998 1999March 2000

* Composition of the basket: August 1993-May 1994: 50% DEM+50%USD. May 1994–December 1996: 70% ECU+30% USD. January 1997–December 1998: 70% DEM + 30% USD. January 1999–December 1999: 70% EUR+30% USD. Since January 2000: 100% EUR rate stayed almost permanently at the the country. This also holds for a crawling strong edge of the band. The country’s for- peg regime. eign exchange default risk also declined A rise in domestic rates nudges the ex- rapidly after the introduction of the new re- cess return on the local currency over for- gime. The reduction in the risk premium eign assets higher and leads to substantial and the concomitant decline in domestic capital inflows and surplus liquidity, unless interest rates contributed to the acceleration the devaluation rate is also increased simul- of growth and helped reduce the fiscal defi- taneously. cit. The monetary tightening imposed through the interest rates channel is then, however, offset by the loosening through the ex- The Constraints change rate channel. (With a higher rate of a Monetary Policy in Pursuit of devaluation the real exchange rate is also of an Exchange Rate Target temporarily devalued due to the stickiness of prices.) In such a situation the burden A fixed exchange rate regime limits mone- of monetary tightening falls on companies tary policy’s ability to set interest rates and which are not exposed to competition in pursue domestic macroeconomic goals in- external markets and so are less sensitive dependent of monetary conditions outside to changes in exchange rates (the

MONETARY POLICY IN HUNGARY 55 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY non-tradable sector), because for compa- economic costs of defending the exchange nies that sell to export markets (the trad- rate regime. The possibility of raising inter- able sector) the devaluation of the ex- est rates notwithstanding, the central bank change rate neutralises the restrictive im- needs to maintain a level of foreign ex- pact of higher real interest rates on mone- change reserves deemed sufficient to ward tary conditions. This also means that should off unfavourable external shocks. What level other elements of economic policy generate is considered sufficient is determined by the inflation expectations that are not consis- current account position, the intensity and tent with the announced rate of devaluation, continuity of capital inflow, and the stock of monetary policy, under the current ex- state debt to foreigners. change rate regime, could not in itself coun- A fixed exchange rate poses additional ter these inflationary tendencies. But even threats to countries with high foreign ex- under a more flexible exchange rate regime change debt and to ones that are importers monetary policy cannot suppress inflation- of capital. Through its promise to maintain ary pressures, if all other components of the exchange rate regime, the central bank economic policy work in the opposite direc- provides insurance against exchange rate tion. Thus the consistency of economic pol- risks to the economy. When economic pros- icy, particularly of monetary and fiscal pects are uncertain and longer maturity in- policy is of paramount importance for Hun- struments are not available in the domestic gary. currency, companies, banks and even the Another problem with the fixed-type state find it easier and cheaper to borrow in exchange rate regime is that shocks that im- foreign markets, which may lead to a sub- pinge on the economy of the anchor cur- stantial build-up in foreign currency open rency are directly transmitted to the country positions. In a situation like this the econ- pursuing the exchange rate target, because omy could incur tremendous losses on domestic interest rates must remain aligned these open positions should a devaluation with foreign rates. occur, leading to a financial crisis and recession. From this point of view, the increased The ERM was plagued by exactly this phe- volatility of the forint during the Asian nomenon in the wake of Germany’s sustained and Russian crises was beneficial for Hun- monetary tightening which attempted to gary’s financial markets, because they counter the impact of the expansionary fiscal prompted economic agents to assess risks policy which reunification necessitated and of more thoroughly and to hedge them more the erroneous conversion rate applied to the prudently. East German Mark. Other countries in the ERM were also pressured to raise interest rates and pursue a monetary policy which was more stringent than what domestic processes would have warranted. The ERM crisis The Lower Level occurred because some of the countries were unwilling to further increase domestic interest of the Set rates and bear its economic costs. of Objectives An improvement in debt indicators, the growth in foreign exchange reserves and n addition to the intermediate targets, the the economic stability of a country are not Imajority of central banks also use operat- always sufficient safeguards against capital ing target variables. Most of the time this role flight and speculation against the exchange is played by short-term money market rates. rate. The central bank at such times can There are two fundamental differences be- demonstrate its commitments to the fixed tween the operating target and the interme- exchange rate by raising interest rates, diate target. On the one hand, the operating thereby stating that it is not deterred by the target has, generally, a direct relationship

56 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY with the available instruments of the central variable; at the same time, it is not a direct bank, so monetary policy steps are immedi- and declared objective of monetary policy ately reflected in the values of the operating to influence them. Such a variable can be target variables, while in the case of interme- the difference between long-term and diate targets this usually takes some time. short-term rates, changes in industrial out- On the other hand, in most cases the operat- put, or the agricultural price index, etc. The ing target is unable to fill the role of thenomi- indicators, however, assist in the choice of nal anchor. the central bank’s steps by enabling the Short-term interest rates are suitable as central bank to take the measures that best operating targets because they play a prior- serve the different purposes; at the same ity role in the impact mechanism of mone- time, the central bank’s policy has no inten- tary policy. Most corporate credits bearing tion to directly adjust the values of the indi- variable interest are linked to some cators. short-term rate, thus the central bank is able With the help of the central bank’s to directly influence the liability costs of monetary policy instruments, the monetary companies and consequently the demand authority is able to directly influence the for investment goods by influencing the amount and/or cost of bank money avail- level of these interest rates. In addition, the able to commercial banks. Through these rates on household deposits also tend to fol- instruments, the central bank is at the same low changes in short-term rates. By control- time able to exert an indirect influence on ling household rates, the central bank influ- the other elements of the set of objectives: ences the public’s decisions on saving and the operating and intermediate targets and consumption. Therefore, by influencing in- the ultimate goal. A detailed description of terest rates, the central bank is able to influ- the central bank instruments is presented ence the aggregate demand for investment in the last chapter. and consumer goods throughout the economy. The level of short-term rates (or to be The Operating Target more precise, the real yield that may be achieved on short-term rates) provides in- of the NBH formation concerning the restrictive or ex- The interest rate moves of the NBH, which pansive nature of monetary policy. tend to track changes in market yields, at- In countries employing a floating ex- tempt to meet the dual objective of main- change rate regime, monetary policy deci- taining domestic real interest rates at a level sions affect aggregate demand not only high enough to keep savings at the level through interest rate movements but also consistent with external equilibrium and dis- through shifts in the exchange rate. In small, inflation, and of keeping returns on Hungar- open economies where the weight of foreign ian securities for foreign investors aligned trade in the national economy is very high with the expected returns in that asset class. and the effect through the exchange rate is The latter means that domestic interest considerable, the level of short-term rates rates adjusted for the announced devalua- does not characterise the restrictive or ex- tion rate contain a sufficiently high premium pansive nature of monetary policy to an ad- over foreign interest rates to keep the ex- equate extent. In some countries, therefore, change rate of the forint within its band. the weighted average of short-term rates The NBH uses the rate on its two-week and the exchange rate are used as an oper- (earlier one-month) deposit facility to steer ating target. This is referred to as the Mone- market yields, especially the 3–6-month in- tary Conditions Index (MCI). terbank and government security market Indicators are macroeconomic vari- yields, which it views as the most important ables which provide a signal concerning the determinants of both domestic savings and expected development of the ultimate goal of the volume of interest rate sensitive capi-

MONETARY POLICY IN HUNGARY 57 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY tal flows, which strongly influence the ex- misalignment, foreign exchange interven- change rate. tion evolves at the edges of the fluctuation With the liberalisation of money and band. capital markets the relationship between The NBH sterilises the liquidity effects domestic and foreign interest rates became of its foreign exchange market interven- tighter through unhedged interest rate par- tions through its deposit facilities, bonds ity, reducing the NBH’s room for manoeuv- and open-market operations performed ring in setting interest rates. Under the with government papers. Sterilised inter- crawling peg regime the central bank’s in- vention stabilises the monetary base in pe- dependence in setting interest rates is deter- riods of substantial capital flows and gives mined by the exchange rate and the country some latitude to the NBH to set interest rates risk that investors perceive and the width of with a focus on developments in the domes- the exchange rate’s fluctuation band. When tic economy. Since the spring of 1998, the interest rates fail to coincide with the yields NBH has allowed longer term yields to be expected by foreign investors – for instance, determined by market forces and fixed the because of changes in the risk premium – interest rate only on its short term sterilisa- the forint moves within the exchange rate tion instruments. Longer maturity NBH band and eventually, in case of a significant bonds have been offered in free tenders.

58 NATIONAL BANK OF HUNGARY INDICATORS

Monetary Aggregates The monetary base is an important indicator for monetary policy because this is the only monetary aggregate which is directly controlled by the central bank and, xcessive money supply may increase at the same time, this is the category which, Einflation and deteriorate the current ac - through the money multiplier, constraints count. Consequently, monetary policy al- the money supply in the economy. Conse- ways, even when it does not specify a money quently, changes in the monetary base indi- supply target, attempts to prevent excessive rectly influence economic activity; it influ- expansion of monetary aggregates. How - ences inflation, the interest rates and the ever, the exchange rate regime significantly current account. The monetary base influences the autonomy of monetary policy marked as M0 consists of cash outside the and the role of the monetary aggregates in central bank and banks reserves held at the policy formation.The exchange rate of the central bank. forint plays the role of an intermediate target in the current Hungarian system. The ex- Funds of credit institutions placed at change rate system is a crawling peg, and the central bank are usually regarded as the NBH has no explicit money supply tar- part of the monetary base depending on gets. Nevertheless, in examining the net fi- whether or not they constitute a basis for nancing requirements of the corporate and money multiplication. The central bank the households sectors, the central bank may control the impact of foreign capital in- pays particular attention to the analysis of flow on the money supply by using various claims belonging to different money catego- instruments of sterilisation. Sterilisation in- ries. struments and the commercial banks’ foreign exchange deposits kept at the central Various components of money, such bank, although they are liabilities of the as banknotes and coins, cheques, foreign central bank’s balance sheet (see Figure 4) exchange, current account, time deposit, certificate of deposit or bank bond, etc., ap- as they do not participate in money multipli- pear on the liability side of a bank’s balance cation, they are not considered to be com- sheet. The monetary aggregate, containing ponents of the monetary base. the liability-side items of the central bank’s The averaging period for commercial balance sheet, represents the monetary banks required reserves is one-month. Ac- base, while the liabilities of the consolidated cordingly when calculating the monthly balance sheet of the banking sector lead to a monetary base, as currently published by wider definition of the money supply. The the NBH, the end-month stock of cash in cir- money supply taken in the broadest sense, culation is added not to the end-month points beyond even the banks’ balance stock of reserves and other forint accounts sheets, is also used. of the credit institutions held at the central

MONETARY POLICY IN HUNGARY 59 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

Figure 4 The Balance Sheet of the NBH (30 November 1999) Forint billion E.1. Refinancing credits 130 Monetary base (M0), (F.1 + F.2) 1,323 F.1. Cash 833 E.2. Net lending to governent 1873 F.1.1.Vault cash 73 F.1.2.Cash outside the banking 760 system E.3. Net foreign assets 915 F.2. Banks’ reserves 490 F.2.1. Required reserves 485 E.4. Net other items –458 F.2.2. Free reserves 5 F.3. Foreign exchange deposits 619 of banks kept with the NBH F.4. Sterilisation instruments 518 bank, but to the average of the reserve pe- inverse proportion with changes in the share riod. of cash (KP/BF): the money multiplier de- The relationship between the liability clines when the share of cash in the banks’ side of the central bank’s balance sheet and liabilities increases. the liability side of the consolidated balance Broader monetary aggregates can be sheet of the banking sector represents the constructed using items on the liability impact of monetary policy on money sup- side of the consolidated balance sheet of ply. This relationship is described by the the banking system. When consolidating money multiplier. Changes in the money the balance sheets of the central bank and multiplier can be traced back to changes in the commercial banks, the money opera- the share of cash (cash related to the banks’ tions of the central bank and the commer- liabilities) and the reserves ratio (the re- cial banks with one another are netted out, serves relative to the banks’ liabilities). thus the central bank’s refinancing credit Money multiplier = Broad money / allocated to commercial banks is no longer Monetary base = M3 / M0 included in the consolidated balance sheet where the money in circulation can be of the banking sector. Similarly vault expressed as the sum of cash and other cash, banks’ reserves and the sterilisation bank liabilities. When both the numerator instruments kept at the central bank can- and the denominator are divided by the cel each other on the commercial banks amount of banks’ liabilities, then and central bank balance sheets (see Money multiplier = (KP + BF) / (KP + Figure 5). TR) = KP/BF + 1) / (KP/BF + TR/BF), The various monetary aggregates can where KP = cash, be defined according to the degree of li- TR = required reserves at the central quidity of assets. The supply of M1 in- bank, and cludes the perfectly liquid means of pay- BF = commertial bank liabilities. ment, that is, those forms of money which The formula above shows that money meet the payment function without any multiplier increases with the decline of the limitation. M1 includes cash in circulation reserve requirement (TR/BF), hence the re- and household, corporate or municipal cur- serve requirement ratio limits the money rent accounts, transfer accounts and creation. Money multiplier also moves in an checking accounts.

60 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

M3 or broad money in addition to bank accounts but represent other bank se- M1also covers the items that directly fulfil curities, certificates of deposits, letters of the function of money and can be turned savings or bank bonds. into cash relatively easy. These additional Hungarian monetary statistics do not items include fixed forint deposits and for- calculate M2, the monetary aggregate gen- eign exchange deposits, which are the erated as the sum of narrow money (M1) so-called quasi money. In addition to all of and quasi money (that is the category simi- this, M3 also contains those financial assets, lar to M3, but from which bank securities are which, with respect to their form, are not excluded). The reason for this is that several

Figure 5 The Balance Sheet of Commercial Banks (30 November 1999) Forint billion E.1. Credits 3,847 F.1. Forint deposits 3,378 E.1.1. Credit to households 461 F.1.1. Sight deposits 1,179 E.1.2. Credit to corporations 2,323 F.1.2.Time deposits 2,200 E.1.3. Credit to municipalities 48 E.1.4. Net credit to general government 1,015 F.2. Foreign exchange deposits 904 E.2. Vault cash 73 F.3. Bank securities 51 E.3. Banks’ reserves at the central bank 490 E.4.Banks’ foreign exchange deposits 619 F.4. Refinancing credits 130 placed at the NBH E.5. Sterilisation instruments 518

Figure 6 Consolidated Balance Sheet of the Banking System (30 November 1999) Forint billion E.1. Credits Broad money (M3 (F.1.+F.2.+F.3.) 5,094 5,720 E.1.1. Credit to households 461 F.1. Narrow money (M1) 1,939 E.1.2. Credit to corporations F.1.1.Cash outside the banking 760 2,323 system E.1.3. Net credit to general F.1.2.Sight forint deposits 1,179 government 2,935 F.2. Quasi money 3,103 E.2. Net foreign assets –125 F.2.1.Term forint deposits 2,200 F.2.2. Foreign exchange deposits 904 E.3. Other assets –501 F.3. Bank securities 51

MONETARY POLICY IN HUNGARY 61 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY bank securities do not differ from term de- Credit Aggregates posits in terms of maturity or liquidity.Soby function they are not real securities, but they and the Net Financing are rather similar to deposits. The difficulties Capacity involved in separation of these makes the calculation of M2 less meaningful, consequently only M3 is published in the Hungar- imilarly to monetary aggregates, NBH ian practice. Shas no target concerning the stock of An even wider money category, M4, credit under the current framework of the goes beyond the consolidated balance sheet monetary policy. Yet changes in the stock of of the banking system and in addition to M3 credit may signal important information on it also includes non-bank instruments like the changes in the environment of monetary the stock of government papers and the policy. Normally, the central bank does not bonds issued by the NBH and held by agents concentrate solely on credit when analysing outside the banking system. the effects of credit on the money supply Although bonds issued by the NBH and on the balance of investments and sav- could be included as part of M3 as bonds of ings. Analysis of changes in the credit port- financial institutions, they are, nevertheless, folio is linked to the examination of the presented under the broader money cate- consolidated balance sheet of the banking gory M4 reflecting the fact that the central sector and the net financing capacity of bank bonds are largely substitutes for gov- major sectors. ernment papers of the same maturity bear- Net financing capacity of a given sec- ing the same risk (in the final analysis, the tor means the balance of transactions re- ultimate debtor is the state as the share- lated to the claims and liabilities of the sec- holder of the central bank). tor. The balance of transactions corre- As M4 covers all forms of savings, it is sponds to the increment in the stock of not sensitive to portfolio rearrangements, claims and liabilities net of the exchange consequently it is the most stable monetary rate and other volume changes. aggregate (see Figure 7). The balance of transactions linked to the claims of households normally exceeds that of transactions linked to the credits Figure 7 Growth Rates of the sector, hence the households sector, of the Monetary Aggregates Relative is net lending. In the case of the corporate to the Same Date sector, however, the situation is exactly of the Preceding Year the reverse: owing to the net inflow of external funds to finance investments of the sector, so the corporate sector is net borrow- Per cent ing. 35 The net lending/borrowing balance of 30 the domestic sectors is equal to the foreign 25 financing requirement, which corresponds to the deficit in the current account. Accord- 20 ingly, the changes in the current account 15 deficit may be broken down to the changes 10 in the net lending/borrowing position of the

5 Monetary base M1 various domestic sectors. M3 M4 Under the current exchange rate sys- 0 tem the central bank monitors the credit al- Jan. July Jan. July Jan. July Jan. July Jan. July Jan. Apr. Oct. Apr. Oct. Apr. Oct. Apr. Oct. Apr. Oct. location to corporate and households sec- 1995 1996 1997 1998 1999 2000 tors because it influences the financing capacity at these sectors as well as the current

62 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY account. Faster credit growth also influ- Figure 8 Zero-Coupon Yield Curves ences inflation through investment and con- in Hungary at Various Points in Time sumption demand, but at a quasi fixed exchange rate a substantial portion of the inflationary impact finds it way only after the Per cent unavoidable devaluation, a result of the de- 25 teriorating current account deficit caused by October 1997 July 1998 the credit expansion. 20 July 1999 March 2000

10 The Information Content 5 of the Yield Curve 0 1 2 3 4 5 6 7 8 9 10 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 for Monetary Policy Maturity (years)

he term “yield curve” (or “term structure market expectations in a sustained man- Tof interest rates”) refers to the relation- ner. ship between interest rates of different matu- Longer maturities are not influenced rities. In most cases, when yields of different directly through the control implemented maturities are compared, investments with through the set of instruments but through 4 the same risk level are considered. The the signals concerning the (future) conduct analysis of the yield curve provides impor- of monetary policy. By “signals”, we mean tant information in relation to expectations changes in the policy, i.e., very short-term concerning the future evolution of inflation, interest rate. real interest rates and growth. In addition, The interpretation of the interest rate the yield curve is a useful signal for the cen- measure and its reasoning provides infor- tral bank concerning the effectiveness mation to economic agents concerning the and credibility of the monetary policy it pur- position taken by monetary policy, who will sues. develop their expectations concerning In properly functioning money and future inflation, nominal and real interest credit markets, monetary policy with the rates on that basis. That is to say, change help of an appropriately designed set of in longer-term rates is a function much monetary policy instruments has a signifi- more of the expectations of economic cant impact on the shorter maturities of the yield curve in the case of both structural li- 5 quidity surplus and shortage. Short-term is 4 Market agents and the central bank generally examine generally interpreted as up to one year. (See the structure of the yield curve obtained from the risk-free government paper market yields because high-frequency Figure 8) price information observed easily and accurately can be Yields on longer maturities, however, provided best by the government paper market. 5 According to the Hungarian terminology, we speak are strongly dependent on expectations con- about an active-side regulation when, characteristically, the banking sector struggles with a structural liquidity cerning future interest rates. In countries shortage for administering payments and in obtaining with developed financial markets, the central bank money required for meeting the reserve requirement (wherever it exists). Then the central bank ef- central bank, although able to influence fects liquidity and short-term yields using its credit-side the yield curve, is unable to keep it fully instruments. In the opposite case, when (“passive-side regulation”), the banking sector is in structural liquidity under control: on maturities longer than surplus on central bank money and the central bank with- 3–6 months, the central bank is unable draws the excess liquidity through its facilities of deposit acceptance in the course of which it also determines to maintain interest rates different from short-term yields.

MONETARY POLICY IN HUNGARY 63 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY agents thanof theshort-term rates of central cording to this theory, these two effects over- banks. compensate for the disadvantage that, by purchasing shorter-term papers, by the more frequent roll-over of investments, it is necessary to assume the risk of renewal: we under- Yield Curve Theories take uncertainties in relation to the yield of The interpretation of the shape (slope) of investments to be made in the future. Inves- the yield curve is not unambiguous, basi- tors therefore invest for the longer term only cally it depends on economic theory. when they can achieve a higher yield. There- Testing of the theories has revealed that not fore, the theory makes a yield curve of a pos- even the most widely accepted theories hold itive slope probable. true in all markets and at all times, neverthe- The third theory is referred as the mar- less, they provide some kind of a basis for ket segmentation theory. It presupposes interpretation. In the course of the compari- that various maturities have their own sepa- son of rates on various maturities, that is, rate markets and the yields on individual the interpretation of the shape of the yield maturities evolve as a result of equilibria curve, most frequently three theories are evolving independently of one another. In mentioned. other words, the slope of the yield curve is According to the expectations hypoth- determined by the investors’ term prefer- esis, the yield curve reflects the expectations ences. of market agents concerning future inflation. This approach is criticised largely be- Nominal yields are usually observed also as cause of its excessive discretion in distin- indicators of economic activity because guishing individual maturities. If we accept present yields of vigorously positive slope the probable assumption that individual in- can be interpreted as harbingers of higher vestors are willing to deviate from the invest- economic growth and higher inflation. The ment period they would otherwise prefer current Hungarian situation (i.e. a yield curve against an adequate consideration, i.e. yield with a negative slope) does not mean, how- premium, then we arrive at the theory of pre- - ever, that economic agents anticipate a re ferred habitats. The theory of preferred habi- cession. What stands behind the phenome- tats says that yields on individual maturities non is that the continuous decline in inflation evolve subject to what maturities investors over the past few years contributes to the re- prefer the most and for what premium they duction of inflation and interest rates ex- are willing to deviate from that preference in a pected in the future, which is stronger than specific direction. the impact of economic growth on the yield curve. By comparing rates on various maturities, rates expected in the future (implicit for- From the viewpoint of monetary pol- ward rates) can be calculated from the spot icy, knowing the inflation expectations of yields (from the shape of the yield curve). A market agents is useful for several reasons. spot yield curve of negative slope renders a First, this provides additional information future decline in short-term rates probable. concerning the expected real economic ef- Naturally, there is nothing to guarantee that we shall be able to actually observe these fects of monetary policy steps because, for rates in the future but, according to this hy- instance, unexpected price changes have a pothesis, this is the best estimate that we can much greater real impact. Thus, to be able make based on information available in the to forecast the expected real effects of present. anti-inflationary policy, we must have reli- According to the liquidity preference able estimates about the inflation expecta- theory, investors are willing to accept lower tion of market agents. Second, these ex- yields on short term investments because pectations play an important role in the as- they regard shorter-term securities as less sessment of the credibility and effective- risky (as compared to longer term investments). Shorter-term investments can be ad- ness of monetary policy. When an vantageous for two reasons: first, they offer anti-inflationary policy is successful, long- greater liquidity, second, their price is less term expectations of inflation and nominal sensitive to interest rate fluctuations. Ac- rates are low.

64 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

A common method of analysing ex- Figure 9 The Policy Rate pectations is the analysis of implicit for- of the NBH and Its Future Course ward yields. Forward yields can be calcu- Derived from the Yield Curve lated by comparing the rates on various maturities, which are normally broken down Per cent Per cent into expected inflation, real interest rates 24 24 6 23 NBH policy rate 23 and premium for the purposes of the analy- 22 22 21 21 sis. 20 20 19 19 A decline in long-term rates indicates 18 18 17 17 the credibility of the anti-inflationary policy 16 16 15 15 and expectations of low inflation and inter- 14 14 13 13 est rates, while their rise points towards an 12 3 April 2000 12 11 11 increase in inflation (and interest rates) 10 6 March 2000 10 9 9 expected in the future (see Figure 9). 8 8 .

One can draw conclusions concerning Jan. Jan. ept . ept .

July July Feb. Feb. Apr. Oct. Jan. Jan.

June July May June May Aug. Nov. Dec. Oct. Apr. Oct. Feb Apr.

June May Aug. Nov. Feb. S Nov. Dec. S

March March inflation expectations and real interest rates March 1998 1999 2000 2001 when assumptions are made concerning the development of the other two factors. According to international experience, we can draw conclusions from the term struc- ous, furthermore, that the internal rate of re- ture of shorter rates concerning the develop- turn – owing to its definition and method of ment of future real interest rates and the real calculation – does not enable the calculation growth, while medium and long-term rates of forward yields, or the monitoring of ex- contain information about inflation expecta- pectations. tions and, consequently, future inflation. The other group of yield curves con- 8 There is no single preferred method for sists of the zero-coupon type curves. the calculation of the yield curve. The nec- They are characteristically continuous essary calculations can be performed (can be interpreted for any maturity) and in several ways; the purpose of application what is a truly useful feature of these types should determine the procedure chosen. is that they are suitable for extracting in- Most of the time, there is a trade-off between formation about market expectations con- the accuracy, stability and reliability of indi- cerning the development of future interest vidual methods (one criterion can be en- rates and inflation. They can be used more forced only to the debit of another) and sig- extensively because in contrast to the type nificant differences can be observed with re- referred to above, these methods are spect to the technical apparatus required as based on much more sophisticated esti- well as complexity. mating procedures (which are also more The yield curves used in economic analyses can generally be grouped into two 6 Most frequently, “term premium” and “liquidity pre- types. The first type is the internal rate of mium” are distinguished. The term premium means that the investment risk is higher in the case of longer-term in- return (IRR) yield curve, which compares vestments (the price volatility of bonds is more signifi- yields calculated until maturity. This type cant than that of shorter-term papers). The liquidity premium compensates the investor against fixing an can be calculated the most easily (all that is amount for a longer term (in general, economic agents needed is the internal rates of return of indi- characteristically prefer to borrow for a term longer than 7 others wish to fix their deposits for, thus generally, a vidual bonds). relative shortage evolves in funds fixed for longer periods). Nevertheless, this is the type that is the 7 The internal rate of return of a bond means the yield at least suitable for purposes of analysis be- which its present value (thus also market price) is equal to its face value. cause of its numerous theoretical and prac- 8 The description originates from the estimation procedure, which simulates bonds not having coupons (of the type tical disadvantages. The most significant of the discount treasury bill) out of interest bearing bonds disadvantages include that it is not continu- and makes calculations on these.

MONETARY POLICY IN HUNGARY 65 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY complicated and require greater atten- fluctuate around the policy rate as the tion). Typically, central banks prefer sta- benchmark interest rate. With this, shaping ble estimates that lend themselves to eco- short-term interest rates provides the cen- nomic interpretation, therefore, character- tral bank with an instrument through which istically they use the zero-coupon yield it can influence consumption and invest- curves.9 ment decisions as well as inflation and the The National Bank of Hungary applies external equilibrium of the economy. In con- the Svensson method – first published by trast, yields on maturities of over a year are Lars Svensson – which is considered as one determined not by monetary policy but by of the most widespread procedures among the expectations of market participants con- central banks. The zero-coupon yield curve cerning the future conduct of monetary pol- estimated according to the Svensson icy and interest rates. This provides an op- method is suitable for the analysis of expec- portunity for the central bank to obtain im- tations of interest rates and inflation, moni- portant information from the yield curve toring the changes therein, i.e. all the factors concerning the expected inflation and nomi- which a central bank needs in order to be nal interest rates. able to evaluate the economy in general In Hungary’s case, of the three factors terms and to consider the effectiveness (inflation, real interest rates and liquidity and credibility of monetary policy (see premium) the volatility of expected inflation Figure 10). was much greater than that of the other two In Hungary, the rate of the two-week factors in the 1990s. Hence the assumption deposit facility can be regarded as the pol- that could be regarded as the most icy rate of the central bank. well-founded one was that the expected real The NBH exerts significant influence interest rate and the liquidity premium were on short-term yields through its deposit rate. relatively stable. Under these assumptions, The rates on 3–6-month government pa- information could be obtained concerning pers, which have an outstanding role to play the development of expected inflation by in pricing credits and deposits, generally analysing money and capital market yields and comparing short-term and long-term rates. Figure 10 Historical Development Conclusions concerning the relation- of Forward Zero-Coupon Yields ship between expectations of inflation in the in Hungary future and current inflation could be drawn without any particular calculation, simply Per cent Per cent 24 24 from the slope of the yield curve (see the 23 23 NBH policy rate 22 22 expectations hypothesis under the presen- 21 21 20 20 tation of yield curve theories). 19 19 18 18 A yield curve with a positive slope 17 17 16 16 does not necessarily mean expectations of 15 15 14 14 rising inflation but a curve of a negative 13 13 12 3 April 2000 12 slope can, with a high degree of probability, 11 11 10 6 March 2000 10 be interpreted as a signal of belief in declin- 9 9 8 8 ing inflation. Jan. Jan. By the beginning of 1999 inflation in

July July Jan. Jan. Feb. Apr. Oct. Feb.

June June Feb. Apr. Oct. Apr. Oct. Aug. Nov. Dec. July May May Nov. Feb. Sept. Nov. Dec. Aug. June May Sept.

March March

March 1998 1999 2000 2001 Hungary had dropped to a single-digit rate and, in parallel, the fluctuation of expectations of inflation subsided considerably (a few years earlier, at the time of the then 9 For greater detail on estimating procedures, see Attila Csajbók: Zero-coupon Yield Curve Estimation from a Cen- characteristic 20–30 per cent inflation, un- tral Bank Perspective, NBH Working Papers, 1998/2 certainty concerning the inflation of the

66 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY coming period was measured in percentage ket, increasingly more reliable information points; at present, this has declined sub- can be extracted from the changes in the stantially and can now be measured only in yield curve with respect to the expectations tenths of percentages). Thanks to the more of market agents concerning the evolution favourable inflationary environment and the of real interest rates, inflation and economic development of the domestic capital mar- growth.

MONETARY POLICY IN HUNGARY 67 MONETARY TRANSMISSION

The Channels Monetary transmission exerts its effect of Monetary Transmission though five channels: • With increased government paper market and deposit rates, the yield ne of the key issues in the operation on postponed consumption (sav- Oof the instruments of monetary policy ings) increases. This prompts is monetary transmission. The term ‘mone- households to reduce present con- tary transmission’ indicates the mecha- sumption whereby they are able to nism whereby the quantitative and interest increase the present value of their rate decisions brought by monetary policy total current and future consump- influence macro demand and inflation in the tion (intertemporal optimisation of economy through various transmissions. consumption). In the short term economic policy in- • A rise in credit rates reduces largely fluences economic growth and inflation fun- housing construction and the pur- damentally through the development of chase of consumer durables fi- macro demand. In general it can be said that nanced by consumer credits in the due to an increasingly more restrictive case of households, while in the monetary policy, higher interest rates de- case of companies, as a result of crease the consumption and investment de- short-term working-capital loans mand of the private economy which, re- becoming more expensive, it di- garding the supply side of the economy as rectly puts the brakes on expansion granted, mitigates both economic growth in the business sector (income ef - and inflation. fect). Over the long term, however, the nom- • With the increase in interest rates, inal value of products and services (the the present value (price) of the fi- price level) and their changes (inflation) are nancial assets of households de- purely monetary phenomena and monetary creases, which can be replenished policy has the important role in their formu- only with a consumption course lation. In contrast, economic growth is de- lower than planned (wealth effect). termined by the supply side of the economy; of necessity, the central bank can exert only • The rise in the rates on investment indirect influence on it. A central bank may credits prompts companies to miti- positively influence the long-term growth gate their fixed asset accumulation course of an economy by reducing inflation primarily because of the decrease in and thereby the loss of efficiency caused by the net present value of planned inflation. projects (discount factor effect).

68 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

• Finally, increased domestic rates inflation, out of his current income. There- also have an impact on the ex- fore, this does not mean classical insol- change rate. The appreciation of the vency – it merely means that his nominal in- local currency alters the relative terest expenditures clash into the cash-flow prices of domestic and foreign prod- constraint. ucts and services which, on the one In addition to the direct effects referred hand, reduces demand for the for- to, expectations and the credibility of eco- mer and, on the other, directly re- nomic policy have a paramount and duces the prices of tradable prod- ever-increasing role to play in the assertion ucts (real exchange rate effect). of the transmission mechanism. The theo- retically expected effects (as detailed To this point, we have not distin- above) of an interest rate measure by the guished real and nominal rates. In relation to central bank may be significantly modified, the income effect, however, a subcase could in an unfavourable case, decreased or even be distinguished when a higher nominal rate reversed by the changes taking place in the restraints the borrower even under a given expectations concerning future interest rate real interest rate owing to his liquidity con- decisions or the development of economic straint. For instance, when inflation is at processes. In the event of vigorous expecta- 15–20 per cent, a housing construction tions of devaluation, for instance, an interest credit means a great burden for an individ- rate increase introduced to protect a fixed ual even if the real interest rate is low. The exchange rate may increase the costs of price of the house will rise in proportion to maintaining the exchange rate to the extent inflation in vain because he has little oppor- that will only reinforce market agents in their tunity to realise that gain from time to expectations of pending imminent devalua- time,10 while he has to continuously finance tion and consequently rising inflation. (See the nominal interest, kept high because of Figure 11)

Figure 11 The Impact Mechanism of Monetary Transmission

Bank and money market yields

Asset prices Central bank rate Macro demand Exchange rate Inflation

Import prices Expectations

10 In principle, he could do so not only by renting a property, whose value is nominally increasing. In prac- room or two in the house from time to time, but also by tice, however, banks shy away from this type of lending taking out new credits from time to time to debit his real practice.

MONETARY POLICY IN HUNGARY 69 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

Taking explicit account of the inflation capital market processes and the monetary expectation of economic agents is particu- policy instruments, with which it influences larly important in an economy where dou- processes in the desired direction. In most ble-digit inflation has a fairly long history countries, central banks have publications and the credibility of economic policy is not which present their declared main objec- yet fully established. tives in reducing inflation, describe the rele- What counts in making decisions vant instruments and publish their analyses about savings and lending is the real inter- and forecasts regularly, all of which is done est rate expected by economic agents. in the light of the ultimate goal. When the credibility of economic policy is Such a publication of the NBH is its low, the inflation incorporated in the expec- “Monetary Policy Guidelines”, which de- tations of market participants may be sub- scribes the economic environment in which stantially higher than that announced in the monetary policy must operate and provides monetary programme. information about the objectives and instru- The real interest rate content of the ments of monetary policy. The Guidelines nominal rate, assumed by market agents, are published once a year. The “Quarterly consistent with the inflation target of the Report on Inflation” is a quarterly publica- central bank will, of necessity, be lower than tion of the NBH providing an overview of what would match the saving and borrowing changes in inflation to date and as expected, behaviour intended by economic policy. and on how the NBH evaluates the macro- Higher macro demand, arising as a conse- economic processes which determine infla- quence, presents economic policy deci- tion. sion-makers with a choice of alternatives. In When assessing the effectiveness of case of an unchanged interest rate policy, monetary transmission, the issue of the inflation expected by market agents, higher transmission lag cannot be avoided. than the inflation target of the monetary au- Money market and government paper mar- thority, evolves as a self-fulfilling prophecy. ket yields tend to follow the interest mea- With nominal – and ultimate real – rates sures of the central bank immediately or higher than otherwise necessary, the with a slight time lag; adjustment in the case growth-restraining impact of the planned in- of corporate and retail lending and deposit flation reduction will be stronger. rates may, however, take several months. Therefore, the resolve of economic A change in interest rate policy exerts policy and consistency in its objectives are its full impact on growth and inflation only in required for substantially reducing the ef- 1.5–2 years according to the empirical stud- fects of the disinflationary policy expressed ies of a number of countries. This is pre- in a short-term slowdown in economic cisely why monetary policy must, as far as growth in an economy with a long history of possible, be forward-looking in the course of inflation, so that adjustment to the lower in- its operation. flation course should take place more rap- The appropriate steps will have to be idly and less painfully through expectations. taken at the time when an unfavourable in- Communication by the central bank flationary process has not even genuinely has a major role to play in shaping expecta- unfolded, and only the signs foreshadowing tions. it can be perceived. The central bank must establish its The leading indicators discussed in the anti-inflationary credibility in which the previous chapter provide a great deal of outward communication of the bank has a help in this; their changes tend to manifest pivotal role to play. In its publications and themselves before the inflationary process analyses, it declares its goals and commit- and the change in macro demand condi- ment, presents macroeconomic money and tions defining it appear. There is a wealth of

70 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY indicators of this kind, their choice and spe- get. The yields evolving in the money mar- cific application greatly depend on the given ket then ripple on to create changes in the economic environment. deposit and lending rates of commercial In addition to the monetary aggregates banks with more or less of a time lag. This (some kind of money or credit aggregate), priority area of monetary transmission is detailed in the previous chapter, and infor- referred to as the mechanism of interest rate mation derived from financial products transmission. (changes in the yield curve, the forward There are several factors which influ- curve, etc.), data forecasting changes in an ence the effectiveness of interest rate trans- element of macro demand (for instance, or- mission, i.e. the simultaneous and propor- ders from the viewpoint of industrial output tionate movement of money market yields, or the number of building permits from the influenced directly by the central bank, and viewpoint of household investments) may the banks’ deposit and lending rates: also serve as indicators. Coincident indicators have a peculiar • the degree of competition in the sys- role to play: they do not precede the process tem of financial intermediation, intended to be forecast but move along with them and the relevant data are available • the re-pricing period (duration) of earlier (VAT receipts or statistics on car bank products, and sales in respect of changes in household • the volatility of the lending risk pre- consumption). mium. In spite of this, those in charge of for- mulating monetary policy are frequently forced to take interest rate or money supply A segmented system of financial inter- decisions when the actual processes can be mediation with a high degree of monopoly is forecast only with a substantial margin of er- unable to effectively mediate the impulses of ror. It is therefore no surprise that, as a gen- the central bank towards ultimate savers eral characteristic, interest rate measures and borrowers. taken by the central bank are frequently fol- Without the driving force of competi- lowed by additional ones, that is, a change tion, the monopolist can easily “swallow” intended in the monetary conditions is ef- the interest rate reduction by the central fected not at once but in a series of subse- bank, increasing his profits. In developed quent small steps. countries, however, not only the banks compete against one another, the possibility of direct financial investments and fund- raising, which bypasses the banking sys- Interest Rate tem, also forces them to pursue an inten- sively compliant behaviour when pricing Transmission their products. The time central bank measures take The Effectiveness to ripple on (the lags in transmission) is fun- of Transmission damentally influenced by the average maturity and structure of the banks’ assets and li- n a country with an advanced system of fi- abilities. Inancial intermediation, monetary policy The shorter the duration of assets and is able to influence (bank deposit, credit liabilities, the higher the share of variable in- and government paper) yields only indi- terest bearing instruments and the greater rectly. As we have seen, central banks re- the frequency of interest review dates, the gard the shaping of 3–6-month interbank or shorter the lags may be expected to be in government paper yields as their direct tar- general.

MONETARY POLICY IN HUNGARY 71 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

The final price of a credit is determined ties is short, which naturally reduces the lag as the sum of the bank’s liability costs (in- in the transmission mechanism. cluding the cost of intermediation and In the context of the effectiveness of profit) and the lending risk premium. The the transmission mechanism, it is necessary latter depends on the risk of the debtor, his to mention a specific feature in the liquidity capability to repay the credit. When the pre- position of the Hungarian banking sector mium changes frequently and with great noted since the autumn of 1995 in compari- volatility for a major part of debtors, the son with the advanced economies. Since the lending rate intended to be influenced will autumn of 1995, as a result of substantial in- move together with the liability costs that terventions by the central bank, the Hungar- can be influenced by the central bank only ian banking sector has had surplus liquidity partially, resulting in a low effectiveness of which is withdrawn by the central bank interest rate transmission. from the banking sector through its pas- The effectiveness of transmission also sive-side instruments (reverse repo, de- deteriorates when dynamic banks intent posit, bond). (See the section on the instru- upon market acquisition can be found in a ments of sterilisation.) banking system with a large weight, as they Consequently, commercial banks are aim at implementing their longer-term strain a net lender position vis-à-vis the cen- tegic objectives instead of maximising their tral bank in contrast to the net borrower current profits when pricing their deposits position, which can be regarded as general and credits. internationally. In principle, this need not give rise to any difference in the effectiveness of transmission, as banks interested in increasing their profits should react the The Effectiveness same way to interest rate measures taken of Interest Rate Transmission by the central bank affecting their costs of financing through shaping the price of li- in Hungary quidity still necessary, as in the event of The risk premium on lending rates relative to the yield on government papers has fluctuated substantially over the past few Figure 12 The Spread between years. Corporate Lending Rates The difference in yields on corporate on Loans Maturing credits maturing in less than a year and in Less than a Year three-month discount treasury bills rose and the 3-Month Discount Treasury Bill above +5 per cent from the earlier negative figure in 1995, then declined gradually until early 1998 to +1 per cent. As corporate Per cent lending rates followed government paper 6 5 yields only in part at the time of the 1998 4 Russian crisis, the spread declined again in 3 October, then jumped back to the figure 2 characterising the preceding period in a 1 short while. (See Figure 12) 0 It is a natural consequence of Hun- -1 gary’s high and volatile inflation that the -2 share of facilities maturing within a year -3 . . . . . Jan. Jan. Jan. Jan. May Jan. Jan. bearing variable interest is high on both the May May May May Sept Sept Sept Sept Sept credit and the deposit side. Owing to this, 1995 1996 1997 1998 1999 2000 the duration of the banks’ assets and liabili-

MONETARY POLICY IN HUNGARY 72 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY offering alternative investment opportuni- Figure 13 The Trend of Core Inflation* ties to them through the yield on the place- and the Rate of Devaluation ment of their surplus liquidity. Neverthe- less, experience shows that banks tend to Per cent react to changes in the effective cost of 35 financing more sensitively in the course 30 Rate of devaluation Core inflation of their everyday operations than to 25 changes in their profits lagging behind their potential. 20 15

The Interest Rate Policy 0

of the NBH Jan. July Jan. July Jan. July Jan. July Jan. July Jan. Apr. Oct. Apr. Oct. Apr. Oct. Apr. Oct. Apr. Oct. 1995 1996 1997 1998 1999 2000 In developing its interest rate policy, the Na- * The methodological description of core inflation as cal- tional Bank of Hungary pursues a dual inter- culated by the NBH can be found in the September and est rate objective. Under the crawling peg December 1999 issues of its publication “Quarterly Re- exchange rate regime, it aims at shaping port on Inflation”. money market yields through its policy rates, which, together with the premium expected by investors, guarantee a yield ad- Comparing the exchange rate course vantage for the forint against the dollar and announced in advance with the appropri- the euro. On the other hand, however, by in- ately weighted foreign interest rates of the fluencing money market yields the NBH in- currency basket of the forint and the extends to guarantee a real interest rate level pected interest premium (for its factors, see for banking rates that favours household the next paragraph) in accordance with the savings and does not lead to a credit expan- logic of interest rate parity, the exchange sion, which could endanger the inflation tar- rate course determines the desired extent of get and the external equilibrium. short-term (3 or 6-month) forint rates. The exchange rate target is the ex- When monetary policy, focusing on domes- change rate course of the central rate of the tic processes, deviates from this, then: forint relative to the currency basket implied by the rate of devaluation announced in ad- • the forint shifts within the band, vance. Together with the government, the and/or NBH adjusts the announced monthly rate of devaluation to changes in expected infla- • either the central bank intervenes at tion. This allowed for a tenth of a percentage the edge of the exchange rate band decrease annually on two-three occasions or the extent of intervention em- on average in recent years. With the in- ployed until then changes. crease in the credibility of the exchange rate regime over the past few years, the pricing The expected interest premium is behaviour of market agents was aligned in- shaped by the exchange rate risk premium creasingly to the pace of devaluation: given by the risk of an extraordinary devalu- changes in the nominal exchange rate in- ation or shifts within the exchange rate band dex, which characterise competitiveness, or the premium on the risk of solvency of a arising from the shifts of the exchange rate given country interpreted by foreign inves- within the band, and changes in the dol- tors in terms of foreign exchange. Following lar-deutschmark cross rates did not appear the introduction of the exchange rate rein the development of inflation. gime, the magnitude of the risks and conse-

MONETARY POLICY IN HUNGARY 73 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY quently the extent of the premium charged the forint – particularly at times of interna- by investors decreased radically. The cen- tional turmoil – does not require the immedi- tral bank increased the elbowroom of its in- ate adjustment of interest rates; the ex- terest rate policy by loosening the “an- pected and the factual premium arrive at an nounced in advance” character of the ex- equilibrium through shifts within the exchange rate regime from early 1996: from change rate band. then on, neither the period for the an- Should the exchange rate of the forint nounced extent of the rate of devaluation, reach the edge of the fluctuation bands, the nor the date of the next modification have central bank intervenes at the strong been declared. This increased the exchange (weak) edge of the band by purchasing rate risk in a characteristically asymmetric (selling) foreign exchange in order to stabi- manner, as an increase in the rate of devalu- lise the exchange rate. ation was outside the intentions of the mon- Until the summer of 1998, substantial etary authority, but it could “surprise” mar- strong-edge interventions took place in ket agents by reducing the pace at any time. certain periods, in the course of which the (See Figure 14) forint liquidity flowing out was tied down by The 1998 international exchange rate the central bank using its sterilisation crisis in general and the August Russian ex- instruments (reverse repo, deposits, NBH change rate crisis in particular constituted a bonds). relatively novel situation as it reduced glob- This practice of sterilised interven- ally the willingness of investors to assume tion enabled the maintenance of forint rates risk, which led to an increase in the extent higher than those called for by foreign pro- and volatility of the expected premium also cesses, thereby facilitating a reduction in in- in Hungary’s case. flation. The exchange rate of the forint is allowed to fluctuate in a band of ±2.25 per Relative to the exchange rate regime in place cent around the centre rate; in the past, the before March 1995 (fixed exchange rate with NBH had no intention to influence the ex- unexpected devaluations at variable rates), change rate of the forint by intervening the nature of the crawling peg exchange rate within the band. The advantage of the vola- regime in Hungary and the reduction of the monthly rate of devaluation by small steps tility thus arising is that the fluctuating pre- provides opportunities for forint and foreign mium expected by foreign investors against exchange market speculation that are smaller by orders of magnitude. Over the past few years, when the forint stuck to the strong edge Figure 14 Changes in the Interest of the band in the long term, one could still ob- Premium on the 3-month Discount serve a more sophisticated version of specu- Treasury Bill lation linked to expectations concerning interest rates and devaluation. Basis points Two different circles aimed at speculation 900 in two different ways. Approaching the ex- 800 pected date of interest rate reduction, the 700 banks placed increasingly large amounts 600 into the fixed central bank deposit facility, 500 which at the time matured in four weeks, fi- 400 nanced partly by acquiring funds from 300 abroad, trusting in the stable position of the 200 forint within the band. Hungarian regulations, 100 however, strongly limit the open foreign exchange position which the banks may under- 0 . . t. t. take, so they hedged against their open for-

c Jan. Jan. Jan.

July July Feb. O Feb Apr. Dec. Apr. O Dec. Feb

June May June Aug. June Aug. Sept. Nov. Aug. Sept. Nov. May eign exchange positions according to their

March March March 19971998 1999 2000 balance sheets in the OTC market or in the forward foreign exchange markets of the Bu-

74 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

dapest Commodity Exchange or the Buda- sterilisation stock increased suddenly. When pest Stock Exchange. The other circle or the central bank warded off the surplus steri- market agents undertook to sell foreign ex- lisation burden caused by higher conversion change forward to the banks. by reducing its policy rates (as happened on As the period of validity of the current rate several occasions), the expected decline - of devaluation is not declared according to in yields was realised and the market in Hungarian practice, when quoting dollar and duced expectation became a self-fulfilling deutschmark rates for the various maturities prophecy. in the forward foreign exchange market, the forint yields of similar maturities proved to be Transmission Along governing. Because of this, when the central bank reduced its rates and consequently the Yield Curve government paper yields declined – similarly to the announcement of reducing the rate of It is general practice among today’s central devaluation – the forward rate of the forint banks that a central bank will intervene only strengthened relative to the currencies in the at the very short end of the yield curve going currency basket. Making use of this interrela- up to a maximum of a month, quoting inter- tion, those trading in the forward market est rates. This has a two-fold reason: first, could make significant profits by forward selling dollar and deutschmark in proportion this is where the central bank is strongest to the currency basket – exploiting the lever- against other market agents (because the age increasing effect of the forward market – shorter period means a lower profit by spec- even at times of expectations of minor reduc- ulation for market agents when they “hit” tions in the interest rate or the rate of devalu- the central bank’s interest rate measures; in ation. this way, there is no need to calculate with When the interest rate reduction hit the unmanageable outflows of credit or place- mark, the banks naturally won in the spot ment of deposits due to speculation); sec- market (conversion of foreign exchange and ond, this enables the part of the yield curve placement of the proceeds at the still higher longer than a year to purely reflect the ex- forint rate), while they lost against the specu- - lators in the forward market owing to the pectations of market agents concerning in strengthening of the forint. We could say that flation, which is a source of information of the banks were willing to cede a part of their paramount importance for any central profits to the market agents trusting in the bank. (See Figure 15) strengthening of the forint in the forward foreign exchange market in order to expand the amount of funds available for the deposit facility prior to the reduction of the interest rate. Naturally, the process could be initiated Figure 15 The Period of the Policy both by the banks (conversion, deposit Rate Applied by Individual Central placement, forward purchase of foreign ex- Banks change) and the speculators in the forward market (forward sale of foreign exchange,11 Period (day) conversion, deposit placement), though the 14 end result was always the same. When an in- EMU terest rate reduction was expected, the open Germany* 14 foreign exchange position of the banks ac- 7 cording to their balance sheets increased and France* the sale of foreign exchange against the cen- Italy* <30 tral bank strengthened and the short-term United Kingdom 1–33 USA 1

11 As banks quote prices in this forward market, in the Japan 1 case of major sales investors ultimately conclude transactions on a massive scale with them. On the other hand, the Canada 1 banks sell foreign exchange in the spot market in proportion to the increase in their forward position to hedge their open * Prior to 1 January 1999. foreign exchange positions.

MONETARY POLICY IN HUNGARY 75 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

Partly for similar considerations, in than in the case of credits, as a great many March 1999 the NBH shortened the period Hungarian banks also follow strategic ob- of its policy instrument in the course of the jectives (market acquisition, enforcing of last few years to two weeks, similarly to that monopoly prices) in the field of collecting of the European Central Bank. With the rate household funds. quoted for this period, the central bank is Owing to the substantial part played able to effectively influence the 3–6-month by discount treasury bills in household sav- interbank and secondary government paper ings, it may, however, be assumed that market yields, of outstanding importance in changes in the yields of government papers Hungary from the viewpoint of interest rate maturing in less than a year govern transmission under balanced market condi- household deposit collection as well, even tions. though it is relatively less exposed to com- The 3–6-month period (benchmark or petition. BUBOR) has an outstanding role in pricing The shortest-term, and therefore most bank credits with respect to both working sensitive, rate in the money market is the capital finance maturing in less than a year overnight (O/N) rate evolving in the inter- and development credits maturing over a bank market. year, as the vast majority of these credits Central banks, whose policy rate is the bear variable interest. A pricing practice of overnight rate, obviously intend to tolerate within a year also characterises household only the least possible volatility in the O/N deposits even though more than half the interbank market. (See Figure 16) stock is fixed for a period of more than half a For central banks whose governing ar- year (between 6 and 12 months). Here, pol- rangement is for a longer term (two weeks), icy rates have a less significant role to play like the NBH, the O/N interbank yield is important from the viewpoint of the transmission mecha- Figure 16 The Policy Rate of the Central Bank, nism to the extent that it is the O/N Interbank Rate, and the 3-month Government able to shift the longer-term Paper Market Benchmark Yield within the Interest Rate market yields on arrange- Corridor of the Central Bank ments maturing in less than a year in some direction. Because of this, the NBH Per cent 28 maintains an interest rate 26 Central bank policy rate corridor symmetric to the 24 O/N central bank deposit rate two-week governing yield O/N central bank lending rate on the O/N maturity 22 O/N interbank rate 20 3-month reference yield through its repo and deposit 18 arrangements. This is 16 called to ensure that the 14 O/N interbank rates remain 12 within the relatively narrow 10 band determined around 8 the two-week deposit rate, apart from cases of extreme pr. ct. ep. an. Jan . ept.

July Feb.

Feb. J

Feb. June

May June Dec. A S O No v.

Aug.

Nov. 12 S liquidity shortage. -

March March In prin 1998 1999 2000 ciple, however, the O/N yields may give rise to un-

12 As against the deposit arrangement, there is a credit line broken down for banks, attached to the repo facility, hence it is possible that in case of a substantial liquidity shortage, the interbank rate may shoot out from the corridor upwards.

76 NATIONAL BANK OF HUNGARY II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY desirable effects spilling over to the longer Figure 17 Pivoting of the Yield Curve terms, when, during the reserve period, they in Case of Expectations of Changes stick to one half of the band in a sustained in the Interest Rate by the Central Bank manner and, because of this, the rollover yield on O/N credits or deposits differs from the effective central bank rate. To manage Interest rate such exceptional situations, the NBH has a short, but variable term, quick tender that is capable of managing liquidity situations, which differ vastly from that expected by the banks within the reserve period (for greater detail see the chapter on the set of instruments). Ultimately, the central bank is able to exert an impact on longer-term yields through the short rates using the forward in- 3 6 9 12 month terest parity. Maturity Accordingly, the three-month yield level settles at a level so that the yield on 3-month investments should correspond to which drives (pushes) the price (yield) of the expected yield of rolling a two-week in- these papers upwards (downwards) even vestment through three months. When for before the interest rate reduction. The effi- instance the market expects stable two- ciency of this speculation strategy can be weekly central bank rates, the 3-month improved when the investor uses nominal yield must exceed that of the short-term – for instance, interbank – loans two-week, as the rollover investment means to purchase longer-term papers in the that a compound interest is mopped up. knowledge that, after the interest rate re- When the market expects a general trend of duction, the yield level will also decline on interest rate reduction, the yield curve will the shorter maturities, so later he will be naturally be inverted because, in the course able to finance the longer-term investment of rolling the two-week investment, rein- with cheaper, short-term funds. vestment will be possible only at increasingly lower rates. When an interest rate reduction is expected, the growing demand for short-term When the market expects an interest funds triggers an increase in very short-term rate reduction with a high degree of proba- yields. bility, the yield curve will pivot around the policy rate of the central bank. All in all, therefore, the yield curve piv- The explanation of this phenomenon ots as a result of the expectations of interest is that market agents would like to make rate reduction and the shift in the yield curve the largest possible profit from the on longer maturities precedes the expected re-pricing expected because of the interest change in interest rates. Because of this, rate reduction. When the yield curve is ex- when the central bank does not alter interest pected to shift downwards in a parallel rates, the expectations of interest rate re- fashion as a result of an interest rate reduc- duction will grow stronger again and again, tion, the price of financial assets with a high and the volatility of longer-term yields in- duration will increase substantially. creases even when the central bank rate is Knowing this, market agents attempt to stable. (See Figure 17) purchase securities with the longest possi- The fluctuation in interest rates caused ble term, bearing fixed interest, at times of by pivoting is not necessarily bad because it expectation of interest rate reduction, contains information for the central bank

MONETARY POLICY IN HUNGARY 77 II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY with respect to expectations concerning the pumping additional liquidity into the sys- interest rate level. If in such a case the cen- tem – it will only increase the speculation tral bank intends to blunt the shift in over- opportunities for money market agents, night yields with the “traditional” instru- who will be able to obtain short-term funds ments – narrow interest rate corridor or more cheaply.

78 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

III. THE INSTRUMENTS OF MONETARY POLICY

MONETARY POLICY IN HUNGARY 79 III. THE INSTRUMENTS OF MONETARY POLICY

80 NATIONAL BANK OF HUNGARY A HISTORICAL OVERVIEW OF THE DEVELOPMENT OF THE INSTRUMENTS1

uring the history of the one-tier banking the magnitudes of the variables it intended Dsystem, the main instrument of mone- to regulate. The most frequently used direct tary policy was the system of credit quotas: instruments were direct interest rate regula- in the course of economy planning, credit tion, setting interest rate ceilings (or eventu- lines were specified to finance state invest- ally interest rate floors, interest margins) ment programmes, private housing con- and lending ceilings (credit quotas). struction and other preferred investments, The indirect instruments attempt to such as export development, import substi- exert an effect on the money supply through tution, etc. The preferred objectives were influencing the supply components of the supported by interest rate subsidy or subse- monetary base and the multiplier, i.e. their quent interest reimbursement by the budget. use is based on the central bank’s ability to Credit quotas were also applied in work- influence money market conditions. Indirect ing-capital loans , which, however, fell within instruments include the various types of the competence of the NBH in contrast to the open-market operations, credit auctions plan reconciliation procedure of long-term and deposit tenders. The use of direct in- lending. struments was inevitable in the conduct of From 1 January 1987, the organisa- monetary policy when it was not possible tional separation of the banking system to deploy indirect instruments in the finan- was in place but actual competition among cial system due to the underdeveloped na- commercial banks evolved only gradually. ture of the markets. Nevertheless, countries with an developed financial system also apply them frequently, for instance in The Use of Direct Monetary the event of a vigorous credit expansion. Yet, they have lost significance every- Instruments where for several reasons: for instance, direct limits deprive banks of the incentive The instruments of monetary policy can be to collect deposits once the credit ceiling classified in several ways (described in was reached; they reduce competition greater detail in the next chapter), but in among the banks; the banks develop inno- Hungary’s case from the viewpoint of the vations tailored to local conditions and development of the instruments it is relevant constraints, with which they are able to get to draw a distinction between direct and in- around regulations; and they act as incen- direct instruments. During the initial period tives for the establishment of a system of the use of direct instruments was typical, financial intermediation outside the banks. the essence of which was that the central bank, as the monetary authority, was enti- 1 An accurate description of the monetary policy instru- - ments mentioned in this chapter can be found in the next tled to issue binding rules for the commer chapter, which addresses the concepts of the instruments cial banks and thereby it directly delineated and its current operation.

MONETARY POLICY IN HUNGARY 81 III. THE INSTRUMENTS OF MONETARY POLICY

Together with the appearance of foreign in- limited, as the “soft budget constraint” in stitutions in an economy with increasing corporate financial management was still openness, new techniques and innovations upheld (the bankruptcy and liquidation evolved; as a result of deregulation in the fi- rules already in force were not yet effec- nancial system, new institutions being not tively enforced). In contrast, the pruden- subject to direct regulation could be estab- tial rules, regulations concerning debtor lished; and the banking sector subject to di- rating and provisioning, which would have rect control also became capable to inno- minimised the losses of the banks, were vate, evading the restraining instruments, not yet in place. Owing to the unlimited de- or, if viewed from a different angle, they mand for credit and the flow of all the free were forced to act this way as otherwise funds to lending, the central bank had they would have been driven out of the to sterilise free liquidity in order to achieve market. Until the early 1990s, the central the macroeconomic objectives. As de- bank was strongly restricted in developing mand was interest rate insensitive, interest its monetary policy instruments, partly be- rate policy was not a suitable instrument. cause of the absence of a money market As the banking sector was still strongly and partly because of the limited nature of dependent on central bank funding, the competition among the banks. regulation of liquidity by direct instru- A decisive constraint was that com- ments was evident through the reduction mercial banks were not permitted to engage of the normative short-term refinancing in retail banking in the first two years of their credit lines of the banks and raising the re- operation, they were licensed to collect de- serve requirement. posits only from the corporate sector and to In the initial years, when the central lend only to them. Until the spring of 1989, bank was able to use genuinely indirect in- commercial banks had no license to admin- struments only in a very limited way be- ister foreign exchange operations or to col- cause of the underdeveloped markets, the lect foreign exchange funds. Hungary had a instrument of the reserve requirement or, substantial net foreign debt and this stock to be more accurate, liquidity management appeared in the balance sheet of the NBH at achieved through altering the reserve rate the time when the banking sector was trans- through the impact on money multiplication formed into a two-tier one. With the separa- within the functions of the reserve system, tion of the commercial banks, the NBH gained a role greater than at present. stock of claims against companies was (The instrument of the reserve requirement taken over by the banks, but the net foreign can be grouped under both direct and indi- debt, which represented the source of fi- rect instruments as in the course of its appli- nancing for a considerable part of corporate cation the central bank, in its capacity as loans, remained in the balance sheet of the monetary authority, provides for the obliga- NBH. tion of setting aside reserves while it influ- Under such conditions of strongly re- ences money in circulation indirectly strained competition and a macroeconomic through the money multiplier.) situation characterised by significant cur- To offset the acceleration of multipli- rent account deficit, sustained double-digit cation and to absorb liquidity, the central inflation and frequent and major devalua- bank raised the reserve rate both in 1989 tions, commercial banks had to rely on the and 1991. The central bank has paid com- central bank to provide them with funding pensation on the reserve stock deposited and this channel of refinancing was the fun- by commercial banks since September damental instrument of central bank regula- 1990. This was called to partially offset the tion until 1991. loss of income owing to the reserve rate re- From the demand side, demand for garded as high in an international compari- central bank refinancing was virtually un- son.

82 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

Money Market Development – freely buy and sell foreign exchange from Use of Indirect Instruments one another. The then limited interbank foreign exchange market began to operate in July 1992, where the exchange rate of the Changes in macroeconomics, institutions forint developed in response to demand and and regulation, launched in the first few supply. This meant that monetary policy years of the operation of the two-tier bank- could use the instrument of conversion. ing system, provided an opportunity and Once this was in place, the central bank lim- called for the development of monetary pol- ited the risks arising from the banks’ foreign icy instruments in the early 1990s. exchange positions not directly, but through Although the distinction between the banks’ open foreign exchange posi- corporate and retail banking operations tions.2 ceased as from 1 January 1989, for some Certain forms of the money market ap- time integration was made more difficult peared as early as the beginning of the by the fact that special reserve require- 1980s, with the licensing of intercompany ment provided protection to the deposit lending (the interest rate and other condi- portfolio of OTP, i.e. to the financial tions of intercompany lending, however, resources of households, primarily housing mained largely hidden to monetary policy) construction credits. This regulation was, and the institution of the bill of exchange. however, not extended to certificates of With the establishment of a two-tier banking deposit, hence this opened the floor for the system and the liberalisation of domestic in- evolution of competition for the increment terest rates, the floor was opened for the de- in household savings. Corporate deposit velopment of money markets. This, how- and lending rates were liberalised as early ever, did not begin because of the liquidity as 1987, retail rates were liberalised only shortage, the lack of confidence and the after the integration of bank operations problems in liquidity management and re- but, until 1991, the central bank used the demption risks. Consequently no character- instrument of an interest rate ceiling on istic short-term market rate could evolve. household deposit and lending rates, and In order to create a properly functioning certificates of deposit. money market, the National Bank of The decentralisation of foreign ex- Hungary, by virtue of its central role, began change operations of commercial banks to organise the auction market of treasury was a process that took several years, be- bills and a centralised interbank money ginning in 1989 with the step of permitting market. the banks to collect foreign exchange de- In the centralised interbank market, posits, which entitled the banks to use for- market agents stood in a contractual rela- eign exchange credits in a limited range, tionship not with one another but with the and swap operations. In the first half of central bank, which meant that the NBH 1990, banks properly prepared to perform paid whenever a borrower bank was unable foreign exchange operations were licensed to pay on time (at the same time, the central to administer trade-related foreign ex- bank could exclude banks in default from change transactions administered in con- this market). This was an off-balance sheet vertible currencies. In 1991–92 restrictions activity for the central bank. It acted as an on foreign exchange operations were fur- agent driven exclusively by the desire to ther softened and, in fact, both the place- build the market. ment and collection of foreign exchange The National Bank of Hungary oper- funds became unrestricted. Until then, for- ated the auction market for discount trea- eign exchange over and above that in- sury bills from December 1988. As the tended for permitted placement and limited use had to be sold to the NBH. From then 2 The total open position of a credit institution may not ex- on, however, banks were permitted to ceed 30 per cent of its guarantee funds.

MONETARY POLICY IN HUNGARY 83 III. THE INSTRUMENTS OF MONETARY POLICY yields evolving in the auctions could not these securities established the technical break away from deposit rates (particu- and professional background required for larly corporate deposit rates), the yields using similar money market instruments at evolving in the auctions had an impact on both the central bank and the commercial the general interest rate. The still accept- banks. From 1993 the NBH introduced able yield maximum (i.e. the minimum central bank quotations for repurchase price that could be accepted at the auc- agreements (repo) and reverse repurchase tion) was determined by the Ministry of Fi- agreement (reverse repo) with respect to nance; the main criterion in making this government papers. This indirect instru- decision was the development of the gen- ment was aligned to the process of financial eral financing requirement. It is important liberalisation and deregulation, and it con- to emphasise this because during this pe- stituted a more sophisticated tool of regula- riod, when the market was characterised tion than the opportunities provided by al- by ample liquidity and the central bank tering refinancing credit lines. had no other instrument to tie down excess From 1993 the central bank satisfied liquidity (1992), the sale of the discount treasury bills in the primary market played the short-term liquidity needs of financial institutions, i.e. short-term refinancing (or tied the role of sterilisation. The impression down excess liquidity) in the form of repo that the discount treasury bill auctions transactions. The central bank, however, were part of the central bank’s set of in- developed their conditions so that the banks struments was reinforced by the coinci- dence of the endeavour by monetary pol- should find it more worthwhile to turn to the icy to generally reduce lending rates and interbank market in the event of a liquidity the natural need of the budget to reduce shortage. the costs of financing. (This impression The portfolio of medium and long- was further reinforced by the fact that the term refinancing continued to represent a discount T-bill auctions were organised substantial share in the central bank’s as- and administered by the central bank.) Is- sets. The NBH played only an intermediary sue, however, was determined not by role in distributing these credits. These monetary criteria but the financing re- were largely foreign credits (i.e. foreign ex- quirement of the budget, which did not change funds), which the commercial necessarily coincide with the requirements banks were unable to raise directly (for a of monetary policy. (This became evident long time, only the National Bank of Hun- in the following year, when the central gary had connections with foreign lenders bank decided to raise interest rates owing because building up confidence, a name to the deteriorating macroeconomic pro- and network of connections takes a long cesses, but the budget continued to time, particularly for an economy in transi- endeavour to finance the budget deficit as tion). Hence the NBH channelled these cheaply as possible.) credits to the commercial banks. These The large-scale issue of treasury mainly medium and, less frequently, bills, which had a history of several years long-term credits did not constitute part by then, the appearance of commercial of the monetary instruments as the central bills, and early in the 1990s that of com- bank undertook only an intermediary role mercial bonds and the substantial quantity for historical and institutional reasons. of government bonds issued for the pur- The greater part of these credits served poses of bank consolidation all represented project financing or some kind of a selec- a stock of securities of a volume and qual- tive purpose (export promotion, moderni- ity that provided an adequate base for per- sation, acceleration of the establishment forming open-market operations. In addi- of modern forms of ownership, etc.). (See tion, organising the issue of, and trading in, Figure 18)

84 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

To expand their forint liquidity, com- change funds to long-term Forint-denomi- mercial banks could also use the foreign ex- nated credits. The essence of the arrange- change deposits placed with them. When ment was that the NBH extended me- the central bank expands the range of trans- dium-term or long-term forint refinancing actions covered by foreign exchange – that credits against foreign exchange deposits is, renders its conditions more favourable – kept with the central bank to an amount cal- it facilitates the expansion of liquidity in the culated with the exchange rate quoted on banking sector. This is also an incentive for the day of their placement, in a period when commercial banks to raise funds abroad. long-term funds had not yet been generated The purpose of the foreign exchange de- domestically. This arrangement also did posit swap was to transform long-term for- away with the exchange rate risk, arising eign credits and short-term foreign ex- upon the onlending of the foreign and do-

Figure 18 Changes in the Medium and Long-Term Refinancing Portfolio, 1991–98 (Data as at 31 December) Ft billion 1991 1992 1993 1994 1995 1996 1997 1998 Investment and other refinancing credits* 145.3 138.9 91.2 74.1 58.8 8.9 5.7 2.8 Arrangements assisting companies 17.5 27.1 104.7 134.4 137.9 127.6 110.4 91.1 – Refinancing credits of international financial institutions 0.0 0.0 7.4 6.5 11.9 10.4 7.8 4.1 – World Bank refinancing credits 0.0 0.0 40.4 32.8 29.7 20.9 16.2 12.7 – Development purpose refinancing credits for small businesses 3,0 3,2 1,3 0,9 0,5 0,4 0,4 0,4 – Start up Refinancing credits 10.5 7.0 3.6 1.4 0.9 0.5 0.3 0.1 – START refinancing credits 3.0 7.6 8.7 8.8 7.3 6.4 6.8 8.9 – Refinancing credits linked to reorganisation and privatisation 1.0 9.4 32.2 60.4 60.6 54.8 46.1 36.7 – Japanese refinancing credits 0.0 0.0 11.2 23.7 26.9 34.4 32.9 28.1 Refinancing credits extended in foreign currency** 24.3 33.2 24.3 19.1 15.7 11.7 12.6 11.5 Refinancing credits extended against foreign exchange deposits 10.6 7.2 21.1 130.3 79.7 77.5 49.0 50.6 Total 197.7 206.3 241.3 357.8 292.1 225.7 177.7 156.0 NBH balance sheet total 2,553.1 2,688.9 3,468.8 4,024.2 5,420.4 5,119.3 5,338.1 5,930.5 Share of refinancing credits in the balance sheet of the NBH (%) 7.7 7.7 7.0 8.9 5.4 4.4 3.3 2.6

* Largely pre-1987 investment and shorter-term credits linked to the initial period of the two-tier banking system. ** Fixed-purpose financing credits extended by foreign governments and banks generally for the purchase of capital goods from the lender countries.

MONETARY POLICY IN HUNGARY 85 III. THE INSTRUMENTS OF MONETARY POLICY mestic foreign exchange funds in forint ated manner gradually came into existence, terms, which would have been substantial the instrument of the reserve requirement under the given conditions of economic pol- continued to be used by the central bank to icy and the absence of instruments suitable adjust liquidity in the banking sector owing for the management of long-term exchange to the relative underdevelopment of the rate risk. The development of the interbank money markets. The impact of changing the foreign exchange market and the widening reserve rate is immediate and “vigorous”, of possibilities for placing foreign exchange hence the central bank made use of the pos- abroad enabled the central bank to gradu- sibility of raising the reserve rate in the initial ally subdue this channel of refinancing (first period of capital inflow. with respect to shorter maturities, terminat- In the longer term, however, the objective is to ing the arrangement in 1993 and then also significantly reduce the reserve rate, which will on medium maturities), closing it altogether decrease the loss of income arising from set- in 1995. ting aside the reserve and thereby improve the competitiveness of domestic banks. In 1996, Futures and Forward markets provide an opportunity for hedging against exchange rate the NBH created a reserve requirement system, where the expansion of the range of liabil- risk. Their limited nature, particularly with re- ities subject to the reserve requirement made spect to maturity and the shortage of long- avoidance of setting aside the reserve more term funds, called for a foreign exchange de- difficult, and terminated the preference of cer- posit swap arrangement in force from 1995 to 1998. This arrangement could then be used tain groups of liabilities, which enabled a reduction in the ratio (to 12 per cent) without re- exclusively for project financing under ducing the effective placement of reserves. strongly delineated conditions. As seen from The chapter on the set of instruments dis the preceding paragraph, this arrangement - cusses in greater detail the new reserve re- could not be regarded as part of the monetary policy instruments. quirement system developed in 2000, to be introduced gradually by the summer of 2001. Short-term foreign exchange swap ar- rangements3 did in turn constitute part of the Over the past ten years, the instru- instruments. From 1993 foreign exchange ments of monetary policy in Hungary have swap transactions had a role identical with undergone rapid developments. Starting out that of repo transactions in monetary policy; from the initial distribution of credit lines, their conditions were adjusted to those of the central bank deliberately aimed at ap- the repo transactions. plying market methods. The applicable in- With the Hungarian banking system struments, however, are greatly dependent gaining muscle, the conditions for the on the macroeconomic and institutional banks’ direct entry to foreign markets were conditions. The need to develop the instru- gradually put in place. The NBH ende- ments frequently preceded the development avoured to dismantle the above activities of the institutional system and interventions – re-channelling of foreign government and in conformity with market principles experi- bank credits, transformation of foreign ex- enced significant constraints. The budget, change deposits into long-term forint credits or rather its financing, frequently influenced – which could not be reconciled with its cen- processes in a decisive manner. tral banking functions and to entrust them to In 1991–92 the neutralisation of the the market, purging them from its balance excess liquidity caused by the budget defi- sheet. cit and capital inflows created problems for Although the instruments with which the central bank as its instruments em- the central bank could regulate the demand ployed until then were fundamentally de- for money by the banks in a more differenti- signed for liquidity expansion. Based on these experiences, the central bank, giving up quantitative regulation, gradually moved 3 For more detail on the instrument of the swap see the towards interest-rate-driven monetary con- section on “The Basic Instruments of the Current Central Bank” in the chapter “The Set of Instruments”. trol.

86 NATIONAL BANK OF HUNGARY THE OPERATION OF THE INSTRUMENTS TODAY

lthough the term ‘central bank mone- dervalued in the foreign exchange market. Atary policy instruments’ can be read The point of reference relative to which the and heard frequently, it is not always clear local currency may become either under or what the users of this expression mean. One over is determined by the exchange rate re- of the main reasons for this could be that the gime. instruments of monetary policy are strongly Until the end of 1999, the exchange specific to the central bank in question, ad- rate of the forint was pegged to a currency justed to the targets marked in the hierarchy basket, which, in 1999, consisted of of objectives in the monetary policy of the 70 per cent euro and 30 per cent US dollar. given bank. Hereafter, there is a description From 2000 the forint has been fully of the instruments, based on the practice of pegged to the euro. Under this regime, the NBH, using categories based on the op- since March 1995, the NBH has been exe- erating target to be achieved by the instru- cuting crawling exchange rate devalua- ment, proceeding from general aspects to tions announced in advance, applying a actual practice. fluctuation bands of ±2.25 per cent. Deval- In a primary breakdown, we can distin- uation is effected daily, based on the guish the instruments directly linked to crawl, determined for a month in advance the maintenance of the exchange rate but announced months before. This means regime (foreign exchange market interven- that the exchange rate, pegged to the cur- tion) from the forint money market and reg- rency basket till the end of 1999 and then ulatory instruments in the practice of the on the euro, is devalued daily by a specific NBH. rate; the market exchange rate of the forint may be 2.25 per cent weaker or stronger than this centre rate, i.e. the market rate of Foreign Exchange Market the forint may fluctuate within a band of Intervention 4.5 per cent. At the two edges of the band of devaluation the NBH is at the banks’ disposal. At o maintain the given exchange rate re- the strong edge, it automatically offers to Tgime, whenever there is a danger that the purchase foreign currency, while at the currency of a country becomes overvalued, weak edge, it offers to sell foreign currency the central bank buys foreign exchange with no ceiling on amounts. In these cases in the foreign exchange market, i.e. it inter- the lowest transaction amount is USD4 mil- venes in the course of which it increases lion or EUR3.5 million which may be raised the amount of the local currency in circula- by steps of 0.1 million. Consequently, it is tion. It intervenes in the opposite direction also possible for transactions to be con- when the local currency may become un- cluded in the event of trading in substan-

MONETARY POLICY IN HUNGARY 87 III. THE INSTRUMENTS OF MONETARY POLICY

Figure 19 Changes in the Exchange Rate tablishment and use of which is of the Forint and Foreign Exchange Market provided for in the Act on the Central Bank. The set of business instru- Per cent USD billion ments is narrower than the po 2.25 0.5 - tential set of central bank in- 0.4 1.75 struments, as it refers to all the 1.25 0.3 instruments for which the cen- 0.2 0.75 tral bank has developed its 0.1 business conditions in force or 0.25 0.0 there is a central bank (NBH) -0.25 -0.1 regulation in place, regardless -0.75 of whether or not the central -0.2 Intervention (weekly data, bank uses the given instrument. -1.25 right-side scale) -0.3 Deviation of the exchange rate These are the instruments, -1.75 from the centre of the band -0.4 (left-side scale) which the monetary decision- -2.25 -0.5 . .

. making body uses, or may use, . r r b b p p e e Jan. Jan. Feb. Jan. F Oc t. Oc t.

A at any time as their framework Oc t. Oc t. F May July De c. De c. A

De c. May July June Nov. Nov. Aug. Aug. Aug.

June Nov. Sept. Sept.

March March conditions are continuously in 19971998 1999 2000 force. When thinking of the instruments, we most frequently tially lower amounts outside the exchange mean the business instruments. The applied rate band to a minimal extent. instruments constitute that part of the busi- The central bank is available to traders ness instruments which contain elements at the edges of exchange rate band from continuously applied by the central bank. 9.00 to 12.00 hours and again from 13.00 to This includes those tenders, which need to 15.00 hours.4 Settlement (debiting and be separately and individually announced crediting the forint and foreign exchange ac- (which is part of their application); but the counts of the commercial banks) is effected arrangement is continuously available, so on the second workday after the day of the there is no need to separately announce the transaction. arrangement itself. To protect the value of the currency, The elements of the set of instruments the NBH also has an opportunity to trade can be grouped using a number of criteria: within the band. Examples of this have been exceedingly rare and they occurred only in the form of selling foreign exchange: up to Figure 20 The Structure of the Forint 1999 it happened only as a result of the Rus- Instruments of the NBH early in 2000 sian crisis.

Potential Instruments

The Operation of the Forint Business instruments Interest rate ceiling Delivery repo Instrumentarium Applied instruments Reverse repo Interest rate floor Deposit Repo NBH bond Lombard loan Refinancing facility Reserve rate he potential (possible maximum) cen- Credit without NBH bond collateral Ttral bank instruments represents the Purchase and sale set of monetary policy instruments, the es- of government papers

4 The table showing the hours of business of the NBH is presented in the Annex.

88 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY they can be distinguished by maturity; Functions of the Reserve requirement by their objective or role; by their form of The original function of the reserve re- sale or introduction to the market; and by quirement can be traced back to pruden- their availability or the eligibility of the tial factors. Upon its appearance it consti- counterparties. The instrumentarium is fre - tuted a reserve against deposit withdraw- quently broken down into direct and indirect als. The purpose of its use has, however, instruments based on their impact mecha- changed and the area of its application ex- nism. Direct instruments include the highest panded. The tasks of reserve requirement lending rate or the lowest/highest deposit are multifarious, changing from country to rate which commercial banks may apply, country, depending on which function is the use of credit or deposit quotas appearing preferred by the central bank. Reserve re- at the regulatory level, with the regulation of quirement regulation may have the follow- the reserve rate frequently put in this category as well. ing functions: The indirect instruments include • As the reserve requirement means open-market operations with the standing stable demand for central bank facility lumped together with them, or put money, it withdraws a certain into a category of its own under indirect in- amount of money from circulation, struments. Classic open-market operations thereby directly reducing liquidity are the outright sale or purchase of securi- in the banking sector. The reserve ties, tendering (repo, reverse repo or deposit requirement, when it creates a li- tenders) and the issue of bonds. quidity shortage in the banking sec- Below, the instruments will be pre- tor, prompts banks to turn to the sented primarily in a breakdown by objec- central bank for funding. The central tives. bank uses the demand for central By their functions and objectives, we bank money to effectively influence may distinguish: the rates applied by the banks through its interest rate policy – that • the reserve rate, is to say, it improves the effective- and the groups of instruments playing a di- ness of the transmission mecha- rect role in the development of interest rate nism. When the banking sector of a policy, such as country has a sustained liquidity • the instruments used to maintain the surplus in a given period – for interest rate corridor, instance, in the event of major • the instruments used as key instru- capital inflows – the reserve requirements, ment assists in absorbing excess li- • the instruments used for sterilisation quidity. purposes, and • The reserve requirement can assist the elements used for adjusting li • - in the banks’ liquidity manage- quidity. ment. When the reserve requirement must be met at an average of the reserve period, this mechanism Reserve Requirement provides an opportunity for the System banks to hold, for a transitory period of a few days, reserves lower or When employing the reserve requirement higher than the reserve requirement regulation, financial institutions subject to level in the given reserve period. the regulation must place a specific portion Consequently, the reserve require- of their liabilities in central bank money on ment as a buffer reduces the volatil- the account kept at the central bank. ity of interbank rates.

MONETARY POLICY IN HUNGARY 89 III. THE INSTRUMENTS OF MONETARY POLICY

• It may serve as collateral in the other financial institutions operating as a event of a decrease in liabilities. bank. • It may be used as an indirect tax in The base of the reserve is generally the the event of the payment of interest amount of external liabilities, which may below the market rate or the non- change according to the national prefer- payment of interest. ences of individual countries (exemption • It provides information on changes from the reserve requirement for external li- in the liabilities of the banks. abilities originating from abroad or foreign exchange funds). Elements of the Reserve System To measure the base of the reserve, The Reserve requirement system has sev- the stock of liabilities subject to the reserve eral features, which may differ from country requirement in one or more selected days of to country. The most important elements a given period may be designated; most fre- of the reserve system are the reserve rate, quently, however, every day of a given pe- the reserve bases, the objective form of the riod is considered and an average of the placement of the reserve, the entities sub- stock of liabilities subject to the reserve re- ject to regulation, the interest paid on quirement is calculated (this period is the the reserve, the form of meeting the require- period of calculation). The reserve calcu- ment or the relationship between the period lated in this manner must be placed for a of calculation and the period of place- given period in central bank money (the pe- ment. riod of placement). Most frequently, the pe- As to the form of placing the reserve, riods of calculation and placement are equal the reserve may be placed in local currency, in length, but they do not necessarily coin- foreign currency or different currencies by cide. The periods may be successive, stag- liability in accordance with the regulations gered (not overlapping), semi-overlapping prevailing in the given country. The place- or overlapping periods. ment may include vault cash or only the The advantage of overlapping periods amount kept with the central bank may is that the reserve must be deposited on the be regarded as eligible for meeting the recurrent stock of external liabilities. As, serve requirement. A solution whereby the however, it is difficult to ensure accurate amount corresponding to the amount of the meeting of the requirement at the end of the reserve requirement must be transferred to period, the semi-overlapping period is ap- a separate account for placing the reserve is plied, which provides an opportunity for ac- also possible. However, in most countries, curately meeting the average requirement the settlement deposit account fulfils this that cannot be foreseen at the beginning of function. the period of placement. The successive The rate of reserve (the reserve rate) period is better than the semi-overlapping is a percentage of the external liabilities held period in the sense that the periods of cal- by the entities subject to the reserve require- culation and placement are separated. ment as specified by the central bank, which However, frequently, at the beginning of determines the amount of the reserve the period, it is unknown on what amount of to be placed by the given institution for a average liabilities must the required sum be given period. The rate and the base of placed. This can be particularly problem- the reserve – or rather the amount of the atic when banks must meet a part or all of reserve determined by them – are important the reserve requirement daily. That is why from the viewpoint of the withdrawal of the non-overlapping period is also applied, liquidity. when the extent of the reserve requirement The entities subject to the reserve re- is known at the beginning of the period of quirement are the members of the financial placement. The disadvantage of this system, most frequently the banks only, and method is that–in a comparison of the four

90 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

Figure 21 The Relationship of the Periods of Calculation and Placement to One Another

Overlapping Semi-overlapping

Period of calculation

Period of placement

Successive Non-overlapping

Period of calculation

Period of placement methods–the period of calculation is fur- contribute to safely tying down a part of ex- thest away in time from the period of place- cess liquidity. ment. (See Figure 21) When reserve regulation exists and it is also flexible, then its task, in addition to the The Flexibility of Reserve Regulation former function, is to provide some elbow- The reserve requirement ratio regulation room to the banks’ liquidity management. fundamentally determines the central At such times the reserve requirement need bank’s instruments. The other elements of not be met daily, only in the average of the the instruments will have to be structured period. With this, the banks’ treasuries may differently depending on whether handle the balance of their reserve account kept with the central bank as a buffer and • there is no reserve requirement reg- may replenish the reserve or draw funds ulation, from it above or below the average within • reserve regulation exists, but it is in- the period of placement. It may well be en- flexible, or visaged at system level that the banks may • it exists and it is flexible. have problems in replenishing the reserve or When there is no reserve requirement in tying down liquidity released by the with- regulation, the central bank has to facilitate drawal of the excess reserve at the end of stable demand for central bank money and the period. The central bank attempts to re- the smooth operation of the banks’ liquidity solve such problems either on a continuous management with other instruments. or on an ad hoc basis.5 Reserve regulation is said to be inflexi- A reserve system with limited flexibility ble when the requirement must be met in full is built up of the elements of the fully flexible every day. In this case the monetary role of the reserve is to reduce market liquidity 5 Carrying over the surplus (or deficit) accumulated by the permanently. The reserve requirement may end of one period to the next or inviting (quick) tenders in the appropriate direction and amount and, as a final resort, the create sustained demand for central bank O/N instruments of the central bank interest rate corridor money or, in a period of sterilisation, may may be used as possible solutions.

MONETARY POLICY IN HUNGARY 91 III. THE INSTRUMENTS OF MONETARY POLICY and inflexible reserve regulation. Under such practically on every bank liability. Now, under regime the central bank provides for the av- the system, which in the meantime underwent eraging method, while specifying a daily minor modifications only, even forint vault - minimum to be met in a given percentage of cash is included in meeting the reserve re quirement. Reserves by certain credit institu- the reserve. When there is no such manda- tions and on certain liabilities had to be set tory daily minimum requirement, the banks’ aside at different ratios. In view of their funda- internal regulations frequently prohibit them mentally different activities (drawing in from going below a certain part of the pre- long-term funds), housing saving funds and scribed reserve requirement on a daily basis the Hungarian Development Bank set aside re- even if it means failure to exploit the opportu- serves at 4%. The ratio for at least 3-year securities, publicly issued by credit institutions, was nities given by the current money market sit- also 4%. The reserve requirement need not be uation for reasons of risk management. set aside on interbank liabilities, foreign ex- When the averaging method is used, it is fre- change liabilities maturing in more than a year, quently provided that the balance of the re- originating from abroad, and liabilities col- serve account cannot be in the red, which lected by way of letters of mortgage, issued for may also be interpreted as the zero balance at least 5 years. (See figure 22) being the daily minimum. The surplus or def- Gradually, the NBH will introduce a icit generated in the reserve period and kept new reserve requirement system from July with the central bank may be carried forward 2000. The purpose of changing the reserve to the next period in some countries, pro- requirement system is to create regulations vided certain conditions are met. which improve the competitiveness of the According to one regulation, the reserve re- banks. The objective is that the reserve reg- quirement ratio is zero but this requirement must be met in average within the period, ulation should approximate the reserve re- which means that the balance of the account of quirement system applied by the European the financial institutions kept with the central Central Bank (ECB), thereby easing the bank may also be negative (zero averaging). shift later. With this the costs of harmonisation will not arise all at once. The Current Practice The new regulation will do away with the structural disparity arising from different of the NBH reserve requirement ratios set for foreign In Hungary, the Act on the Central Bank pro- and domestic liabilities; the criterion for ex- vides an opportunity for the NBH to impose emption from the reserve requirement will the reserve requirement on investment busi- no longer be the origin of the liabilities, but nesses in addition to credit institutions. Nev- their maturity. That is, liabilities shorter than ertheless, NBH Ordinance 1/1996/PK.1 on the reserve requirement extends only to Figure 22 Changes in the Reserve credit institutions including the Hungarian Requirement Ratio in Hungary branches of credit institutions with their Per cent headquarters abroad. 16

The nominal reserve requirement ratio de- 15 clined gradually from 17% to 12% in 1996. This was concomitant with widening the reserve 14 base so that the effective reserve requirement ratio did not change. With the last change im - 13 plemented in 1996 every liability item, within the M3 monetary aggregate and those close to 12 it, came to be included in the base of the reserve. Asset side items ceased to be deduct- 11 ible. Thus, with the exception of internal liabili- Jan. Jan. Jan. Jan. Jan. Jan. July Oct. July Oct. July Oct. July Oct. July Oct. ties, interbank liabilities and liabilities originat- Apr. Apr. Apr. Apr. Apr. 1995 1996 19971998 1999 2000 ing from abroad, reserves must be set aside

92 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

2 years would be subject to the reserve re- To that end, the NBH would set the extent of quirement and those longer than two years the compensation paid on the reserves, set will be exempt (in accordance with ECB aside on foreign exchange funds (whether practice). This will abolish the preferential obtained from residents or non-residents), ratios for the Hungarian Development Bank gradually so as to pay 1.5 percentage point and the housing savings banks as institu- higher interest by the end of the transition tions, but as they basically collect long-term process. In the first phase and the second funds by far the greater part of their liabili- phase, the NBH would pay 0.5 and 1.5 per ties will be exempt from the reserve require- cent higher interest, respectively, on re- ment. serves set aside on foreign exchange funds Gradual introduction means that from than on reserves on forint funds. 1 July 2000, 50% of the funds originating Under the Hungarian reserve regime, from abroad and maturing within a year will the reserve period is one calendar month, be subject to the reserve requirement; and which follows the month of the period of cal- 50% of the forint vault cash may be taken culation (successive period). Every day of into consideration for meeting the reserve the month of the calculation period must be requirement; the nominal ratio will be re- taken into account for determining the base duced from 12% to 11%. From 1 July 2001 of the reserve. The one-month reserve pe- all foreign exchange funds maturing within riod was introduced in September 1998 to two years and originating from abroad will replace the former two-week period. In addi- be subject to the reserve requirement, and tion to providing a higher degree of freedom forint vault cash will no longer be an accept- for banks, the shift was justified by the fact able asset in which to meet the reserve re- that the one-month period coincided with quirement. The level of the nominal ratio to the frequency of tax and contribution pay- be in force from 1 July 2001 will be deter- ments. Thus the banking sector must adopt mined by 1 June 2001. similar scheduling to manage the approxi- The NBH pays interest on the reserve mately similar waves of liquidity within the requirement placed with it. Although its rate month. is lower than the market rate, the income ef- Under the former regime, comprising two pe- fect (indirect tax) of having to set aside a re- riods in one month, it was observed that in the serve is no higher than 0.8% even with the second placement period of the month there high nominal ratio. To offset the additional was a higher degree of uncertainty in liquidity costs caused by the reserve requirement, management (owing to tax payments due on the 20th day of the month), reflected also in commercial banks increased the margin be- the changes of the interbank O/N rates. Be- tween their deposit and lending rates, i.e. cause of this, one could envisage a reserve banks ultimately shift the losses suffered in period beginning on the 15th day of the calen- the course of setting aside the reserve to dar month, covering a whole month, which their clients. would provide a longer period for the banks to overcome the shock arising at the beginning By subjecting the full range of short- of the period. term foreign exchange funds to the reserve requirement, these liabilities will also be Within the period, a bank may freely burdened by income withdrawal. This alter the balance of the settlement account mark-up will have a more vigorous effect in as it needs to meet the requirement only in foreign exchange markets because they are an average of the month, but the balance of characterised by a lower nominal interest the account may never be negative. This rate and a narrower margin. It is not an ob- rule and the high level of the reserve, taken jective of the NBH to make short-term for- together, provide a flexible liquidity man- eign exchange funds more expensive agement possibility for the banks. and thereby to encourage the creditworthy The series of the NBH data published clients of the banks to raise credit abroad. in Reuters, which contains the reserve re-

MONETARY POLICY IN HUNGARY 93 III. THE INSTRUMENTS OF MONETARY POLICY quirement of the banking sector and the fine-tuning of monetary regulation, the regu- stocks placed up to the given date in a time lation of liquidity in the banking sector. Such a series, also promotes the accuracy of the typical instrument is the repurchase of securi- - banks’ liquidity management. With this, the ties or the repo transaction (see, in greater de tail, under the heading “Repo”). In most coun- banks’ treasuries obtain important assis- tries central banks create the necessary stock tance to estimate the liquidity position of the of securities by organising the primary gov- banking sector expected by the end of the ernment paper market or by issuing their own reserve period and, in the light of this, to securities. prepare for making up the deficit or placing At the end of the 1980s the conditions the surplus. in Hungary for performing open-market operations did not yet obtain. The regular Treasury bill auctions (from 1989) and the introduction The Basic Set of Current Central of the central bank securities account (1992) enabled the central bank to launch repo quo- Bank Instruments tations. Over the years the conditions also matured for performing outright operations Before discussing the specific money mar- and the NBH made active use of this instru- ket instruments the NBH employs, we shall ment for a longer period. Nevertheless, it describe the basic types of instruments and never became important in its monetary pol- their defining features. icy. This is attributable partly to the fact that, by the time the central bank was able to ac- Open-Market Operations: tively use the instrument of selling and buying Outright and Repo Transactions securities, the repo was already in place, Under the outright purchase and sale of gov- which proved to be an efficient instrument for ernment papers (outright operations), which regulating the money supply. (Repo transac- count as classical open-market operations, tions are not restricted by the maturity of the the central bank trades in securities, primarily available securities and, through them, it is government papers with a view to regulating possible to efficiently influence the central money in circulation. bank’s operating interest rate target evenly Over the past decade, open-market and constantly over the short term; with the operations have gained in importance in the repo, the central bank can be available di- conduct of monetary policy. This is due to the rectly at the announced interest rate or it can fact that they have several advantages over issue an interest rate tender). The environ- other instruments such as refinancing, ment of monetary policy has also changed rediscounting operations, or the adjustment over time: in the wake of the sustained liquid- of reserve requirement. They can be flexibly ity surplus and the necessary sterilisation by applied for implementing even daily mone- the central bank, the government paper port- tary control tasks; they do not have an “an- folio of the central bank decreased vigorously, nouncement” impact (as have, for instance, thereby limiting the possibility of using the interest rate decisions). Outright operations outright (and repo) instruments. The limita- are initiated by the central banks; they do not, tions were reinforced by the Act on the Central however, put pressure on the market because Bank, according to which the central bank they are realised through decisions guided by may not buy government papers in the pri- yields. Their precondition is, however, the ex- mary market. This provision was introduced istence of an adequate amount of securities, to adjust to the criteria of the European Union i.e. the existence of an advanced liquid pri- and to keep central bank lending to the mary and secondary securities market in the budget outside the money market under con- given country. In the absence of this condi- trol. tion, classical outright operations became important instruments within the monetary policies of relatively few countries (United States, Repo United Kingdom). With the development of The term is an abbreviation for the “sale and the securities market, however, innovations repurchase agreement”. A repo transaction and methods came into being which did not is, in actual fact, the result of two transactions require similarly high volumes of free liquidity whereby the counterparties handle the trans- and securities stock as did outright opera- actions as a single package. The first leg of tions; yet they proved to be successful in the the transaction is the prompt sale or purchase

94 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

of a given security (most of the time some As far as title to the security used as col- government paper), followed by the reverse of lateral is concerned, we may distinguish the the prompt transaction after the lapse of a delivery repo and hold-in-custody repo. In the specific period of time. case of delivery repo, title is transferred for the In a repo transaction, the prompt period of the transaction by the seller to the money and securities movements are re- buyer, who may have free disposal over the se- peated in the opposite direction at a subse- curity during this period. At the time of the for- quent date specified in advance, hence the ward repurchase, the buyer has to return the transaction could be interpreted as the result original papers or – depending on the agree- of a securities loan and a money loan in re- ment – papers with corresponding conditions verse. In general, under repo contracts, the to the seller. In the case of hold-in-custody rights linked to the lent security (price and in- repo, title is retained by the seller, but the seller - terest income) are due to the original holder. places the securities in a separate deposit ac Repo transactions are always motivated by count for the buyer (i.e. blocks them). Should taking out or extending a money loan (under the seller be unable to honour the payment ob- the collateral of adequate securities) or the ligations at the date of the repurchase, title to borrowing of specific securities. The counter- the securities is transferred to the buyer. parties agree on the original sales and forward Repo transactions have been used by repurchase prices at the very beginning of the central banks as part of their monetary policy transaction. The two prices are set so that instruments, but their application has also their difference coincides (conceptually) with quickly spread to the business sector. Deliv- the rate on a loan secured by collateral, which ery type repo transactions are more wide- is referred to as the repo rate. spread in commercial life, because this form provides an opportunity for a multifarious ex- The two counterparties to a classical ploitation of the transactions: in the event of repo transaction are the seller (or lender) who delivery-type transactions, money market sells his security at the initial date and then re- agents can obtain possession of the paper purchases it at a later date and a buyer (or used as collateral, they may sell them, per- borrower or investor) who practically extends form additional repo transactions with them, a money loan under the collateral of securi- lend them and put them up as collateral. ties. It is important to note that the above de- In Hungary, the use of repo transactions scriptions follow the terminology of the bond has been relatively limited in the money mar- market and not that of the money market. Ac- kets, although they play a central role in the cording to the terminology of the money mar- NBH instruments. The NBH uses the pledge- ket, the lender of the money, i.e. the borrower type repo. From the viewpoint of the central of the security, is referred to as the lender. bank, there is no difference of substance be- Repo appears in the Terms and Condi- tween the delivery repo or the hold-in-custody tions of Business of the NBH in several forms. repo on the active side because the central The central bank’s repo terminology distin- bank does not use the security used as collat- guishes the repo and the reverse repo. Repo eral during the period of the transaction, thus it is a transaction (in which the counterparty of has no significance whether it possesses the the central bank is the active party) under paper during that period or not. Depositing the which the central bank finances the given pledge-type securities is the simpler solution. counterparty with the backing of government The delivery-type reverse repo of the central papers. The reverse repo is the reverse of the bank would have the advantages listed above former when the central bank performs a repo for the counterparties of the central bank. Its transaction with an eligible counterparty in application is, however, impeded by the lim- the course of which the central bank extends ited stock of securities that may be used as government paper collateral against liquidity repo collateral (and another problem may be tied down with it for a specific period of time. when the existing stock is not homogeneous), The NBH may perform repo transac- i.e. by the constraints, which, inter alia, led to tions employing four forms of sale (see the the replacement of the reverse repo with the details below): central bank deposit. The value of the securities put up as • continuously available standing facility collateral in the course of repo transactions • intermittently available standing facility, may change during the period of the transac- • tender, and tion with the movement in prices. To offset • quick tender. this, it may be useful to review the value of

MONETARY POLICY IN HUNGARY 95 III. THE INSTRUMENTS OF MONETARY POLICY

collateral (collateral assessment) to check the counterparties swaps his assets, denomi- whether the value of the collateral corresponds nated in forints, with the other against assets to the amount of the loan. In the event that the denominated in some other currency. Gen- loan is not covered, the seller of the security erally, this is a forint initiated transaction as must effect additional payment which, subject most frequently the counterparty borrowing to agreement, may be made by paying cash or forints uses the foreign exchange as collateral blocking government papers. In the opposite and pays interest on the forint credit. Cur- event, i.e. when the price of the security rises, rently, swaps are available only on the over- the lender of the security may claim reim- night maturity with the same conditions as the bursement or request that a part of the blocked O/N repo. In this way the counterparties of the amount be released. Collateral reassessment central bank may consider whether they prefer is generally performed daily although, if the se- to put up foreign exchange or government pa- curity margin (haircut or initial margin) ap- per collateral for the overnight credit taken out plied initially is sufficiently wide, it is not cer- from the central bank. Swap transactions repre- tain whether daily re-assessment is necessary. sent a negligible volume within the NBH instru- The disadvantage of a sizable haircut primarily ments. effects the borrower of the money who can obtain a lower amount of cash against the same The Central Bank Deposit in Hungary security than what he could have obtained had As a result of the current structural liquidity there been daily assessment. The use and size surplus, this instrument – with a maturity of of the haircut depends on the system of collat- two weeks – is the policy instrument of the eral assessment and the creditworthiness of central bank. Central bank deposit means the counterparties. that a counterparty of the central bank places The NBH introduced the so-called nor- a certain amount with the central bank under mative collateral assessment system in Febru- specified or evolving conditions (term, inter- ary 1999, whereby the NBH assesses the value est rate). As against the reverse repo, the cen- of securities accepted as collateral based on a tral bank does not provide any collateral uniform method in the case of its active-side whatsoever as backing for the amount placed. lending transactions. The discount applied in The types of deposits sold include the collateral assessment was set broken down continuously available standing facility, the into two parts depending on the period of the intermittently available standing facility, the transaction for O/N and longer maturities. tender and the quick tender. Similarly to repo The central bank set the objective of mi- transactions, there are quantitative and inter- grating to daily collateral assessment in the est rate tenders, interest rate tenders with a medium term. A daily collateral assessment quantitative limit, and free forms of tendering regime is highly efficient and up-to-date and among tenders and quick tenders. guarantees the daily automatic review of the In 1997, the NBH deposit was available value of the collateral, its adjustment in case of first for terms of six months, then for twelve any deviation, also providing an opportunity months. At the time, its role was to influence for security substitution, which practice is interest rates and to reinforce sterilisation. widespread abroad in the case of repo transac- With the introduction of the NBH bond – as its tions. It is hoped that the NBH collateral as- role was completely taken over – the rela- sessment system will also serve as a model for tively longer-term deposit arrangement was repo transactions concluded by and between terminated. market agents because of the daily reassess- In the autumn of 1997 the suspension ment of collateral facilitates and the use of of reverse repo transaction was necessitated, genuinely low initial discounts (i.e. less gov- on the one hand by the fact that the stock of ernment paper collateral for the same transac- government papers available within the cen- tion). In addition, this implies the lowest risk tral bank decreased greatly because of the among all collateral assessment systems. sterilisation of the liquidity surplus evolving Swap Transactions6 as a result of the inflow of capital (reverse The foreign exchange-forint swap transaction repo and government paper sales), and there is a transaction in the course of which one of was a danger that homogeneous government paper collateral could not be put up to back 6 In theory and strictly speaking, swap transactions do not some major transactions which, in a technical constitute part of the forint instruments. Nevertheless, they sense, made the administration of the trans- are discussed here because they constitute part of the interest rate corridor and are fitted into the framework conditions actions more difficult. On the other hand, of the repo. there was no reason why the NBH – as a

96 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

debtor that will certainly pay – should provide tently available standing facility means avail- collateral for the amounts kept with it. The ability on automatically determined days. role of the reverse repo could be fully substi- Terms may change even on every occasion in tuted with the deposit facilities, offering simi- the case of tenders, while this is only a theo- lar terms and conditions, while the technical retical possibility in the case of the intermit- administration of these transactions was tently available standing facility. much simpler. From that date, the 28-day The essence of a variable rate (interest money market NBH deposit became the pol- rate) tender is that the issuer announces the icy instrument of the central bank. The first amount intended to be sold and bids must significant change in the instrument was the contain, in addition to the amount, the offered shift from continuous availability to intermit- (or rather the expected) yield. In the course of tent availability. The second change took bid evaluation, bids are ranked according to place in March 1999 when, in order to ease li- how favourable they are for the issuer, moving quidity management by the banks, the central from the most favourable towards the least fa- bank shifted from a 28-day deposit to a term vourable. Bids are accepted in this order but of 14 days. Transactions may be concluded at the amount indicated in the invitation to ten- the central bank at a fixed interest rate on the der constitutes a top limit. The NBH invites given dates from 10.00 to 12.00 hours. tenders on the preceding day, administers the The interest rate on the central bank O/N tender on the day in question and perfor- deposit facility serves as the floor of the interest mance is effected on the day following. rate corridor. This is the O/N fixed-interest NBH The central bank handles this instrument deposit facility, which is continuously available. as a bid price (Dutch type) tender, i.e. the Transaction times range from 8.30 to 10.00 on counterparties of the central bank get (pay) every day of business. the interest rate offered in their bid on the amount won in the course of the tender. The Forms of Sale central bank always has the right to deviate The NBH may invite tenders or quick tenders from the amount announced. for deposit facilities at any time, for any of the In the case of a fixed rate tender with forms (described above) for the purposes of limited volumes, the issuer, in addition to the sterilisation, interest rate adjustment or conditions announced for the ordinary inter- fine-tuning. est rate tender, specifies the amount it intends Until 1999 the central bank did not use to accept. This means that when the amount tenders in the case of shorter-term governing of the bids submitted is higher than the and sterilisation instruments, although it had amount indicated, the amount is distributed the opportunity to introduce them at any time. pro rata to all the bids. Pursuant to the Terms and Conditions of Busi- When free tenders are invited, the is- ness of the NBH, there may be several types suer does not announce either a limit amount of tender. They include the interest rate ten- or an interest rate. This means that the issuer der, the variable rate tender, the interest rate decides on the accepted bids enforcing inter- tender subject to quantitative limits and the est rate or quantitative preferences (or some free tender. The central bank may use these combination of these according to some crite- forms of tendering at its own discretion on ria) with respect to the bids ranked in accor- both the deposit and the lending sides. dance with the allocation procedure de- A fixed rate (volume) tender means scribed under the variable rate tender. The that the issuer sets the interest rate in advance free tender is administered in the bid price and accepts bids at this rate for the specified form. amount during a given period. In terms of eco- Many central banks apply interest rate nomic content, this in itself does not differ tenders regularly in pure or quantitative limit greatly from the intermittently available forms because through them they can influence standing facility but, owing to a few technical interest rates in a more transparent manner. deviations, the difference is indeed significant. One such difference is that there is an announcement of the outcome in the case of the tender from which it follows that the tender Interest rate corridor may be declared unsuccessful and all the accepted amounts are disclosed to the public. The purpose of the central banks’ interest Tenders must be invited separately (that is, rate corridor is to prevent wide fluctuations at discretionary dates), while the intermit- in the interbank interest rate level. The top

MONETARY POLICY IN HUNGARY 97 III. THE INSTRUMENTS OF MONETARY POLICY of the interest rate corridor (the interest rate (for instance, one-week active and reverse ceiling) means, in this context, that the bank repo). determines the lending rate at which it ex- Generally, the most frequent transac- tends credits to eligible counterparties for a tions at the top of the interest rate corridor are O/N repo, lombard loan, overdraft or swap. term of one day without limitation. When Of the instruments on the passive side, the banks have an extraordinary need of O/N reverse repo or the deposit are typical. In short-term liquidity but, for some reason, all these cases, the transaction is concluded have no opportunity to obtain it from the at a predetermined rate upon the initiative of banking sector, interest rates in the inter- the eligible counterparties (generally, credit bank money market cannot go up to ex- institutions). treme heights, because the central bank satisfies all demand at a relatively high interest The Current Practice rate level. This means that the interbank O/N rate cannot be higher than the interest of the NBH rate ceiling. In Hungary the interest rate corridor as it is Similarly, the rate indicated by the understood today, i.e. an instrument which central bank at eligible counterparties are involves the top and bottom limit for inter- entitled to perform overnight deposit or de- bank rates, has been in existence since posit-type transactions with the central 1993. Although the band was, at times, bank is referred to as the bottom of the inter- rather wide, it operated with instruments of est rate corridor (interest rate floor).At various maturities, so it did not always con- times, the interest rate declines in the O/N stitute an effective constraint for O/N interbank market when liquidity, which can money market rates. be tied down only with difficulty, is available to the money market for a transitory period. At present the ceiling of the interest The purpose of the interest rate floor is to rate corridor is the O/N repo (swap) rate, halt the decline in the interest rate at a rela- while the floor is the O/N deposit rate. The tively low point. At this rate, credit institu- ceiling is atypical in international practice in tions may place their superfluous funds the sense that even though the instrument overnight with the central bank without limi- behind it is a standing facility, its use is sub- tation, thus banks have no interest in con- ject to a quantitative limits. Under the cur- cluding overnight interbank transactions at rent system this means that every credit in- a rate lower than the bottom of the interest stitution is allocated a repo and swap line rate corridor. (See Figure 16 for changes in based on its balance sheet total and they may make use of repo borrowing at the the interest rate corridor.) 7 The instruments of the interest rate given interest rate up to that amount. corridor apply virtually without exception to Should that be insufficient, the counterparty active or passive overnight operations, may resort to additional repo beyond the whereby extreme interbank interest rate vol- repo line allocated to it, relying on the freely atility can be contained. disposable government paper stock of the central bank. This, however, is available at a It happened – inter alia, in Hungary from the substantially higher interest rate. Another middle of the 1990s until September 1998 – important point to note is that transactions that the interest rate corridor could be inter- concluded for such instruments are settled preted for longer than overnight maturities on the day of the transaction. The rate on the overnight deposit of 7 Repo lines are determined automatically once every quarter. The base of the repo line calculation is the lower of the central bank constitutes the floor for the balance sheet totals of the last two balance sheets sub- overnight interbank rates. With this, the mitted to the Supervision in every quarter. The bank’s repo line increases with Ft200 million for every Ft10 billion of the NBH is available to the banks without limita- balance sheet total, although it may never exceed Ft30 bil- tion (continuously available standing facil- lion. Having set the new repo line, it enters into force on the 10th day of the second month following the quarter. ity). Fluctuation in interbank rates is also re-

98 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY duced by the gradual approximation of the Figure 23 Elements of the O/N O/N central bank deposit rate and the level Interest Rate Corridor in Hungary* of the repo rates. Owing to this, the NBH Form gradually reduced the width of the effective - Frequency Name of in Direction availavle - - of applica interest rate corridor from the second half of strument of operation on the mar tion 1998. ket O/N active side standing ad hoc The purpose of narrowing the interest (active) facility in the event rate corridor is to decrease the overnight in- repo up to the of liquidity terest rate volatility of the Hungarian money and swap amount shortage market, as is done in the advanced coun- of the repo tries. (See Figure 23) line Repo sup- active side standing not used Earlier, the central bank used to offer the con- plementing facility since 1995 tinuously available standing facilities at sev- the (active) eral maturities. Currently, in its pure form, it reo line exists only in the case of overnight deposits. O/N de- passive standing ad hoc The O/N repo facility at a standard interest posit side facility in periods rate was available to counterparties up to the of abount repo limit, above which they could use supplementary repo. In the case of supplemen- liquidity tary repo facility, the top limit for transactions * Until 1997 the central bank offered pledge-type re- is the freely disposable government paper verse repo facilities on a continous basis atthe bottom of stock held by the central bank. In terms of the the interest rate corridor. sales channel, O/N swap transactions, which constitute part of the repo line, are treated the same way as the repo. There have been examples when the central bank sold NBH bonds or other government papers as a stand- The central bank endeavours not only ing facility at dictated yields; this deviates to reduce the width of the interest rate corri- from the pure form in that the depletion of the dor to the optimal level but also to keep the stocks may disrupt continuous availability (as rate on the policy instrument in its centre, so happened in relation to the prompt security that the rates on the two O/N instruments, sale and purchase transactions of the central working in opposite directions be located bank). symmetrically around it.

For a long time the Hungarian interbank interest rate corridor was extraordi- The Policy Instrument narily wide by international standards (a In the case of countries pursuing a monetary width of 8–12 percentage points was also policy with the interest rate as their operat- noted). One of the underlying reasons was ing target, the policy instrument is the one that from the summer of 1995 active-side whose purpose is to assert the interest rate rates were not genuinely effective owing to which the central bank regards as optimal, their relatively high level, i.e. practically and which it also intends to mediate in the neither of the instruments played the role of market at the maturity that is most impor- an interest rate ceiling. So, the active O/N tant from the viewpoint of transmission, tak- rates did no more than follow the frequent ing into account the effectiveness of central re-pricing of the main (governing) instru- bank intervention, without eroding it. This is ment or that of the passive-side O/N instru- most frequently done with a posted interest ment in steps of adjustment. (Keeping ac- rate when the central bank determines the tive-side rates at an artificially high level rate on the given instrument. was warranted by the need for sterilisa- When there are no extraordinary tion.) events to disturb the money market, i.e. a

MONETARY POLICY IN HUNGARY 99 III. THE INSTRUMENTS OF MONETARY POLICY condition of peace prevails, a portion of means that the maturity of the central bank transactions come into being between the facility, which is closest to the period over central bank and its counterparties at the which banks re-price their variable long- policy rate, through which the monetary au- term rate loans, can have the most direct thority is able to exert a direct and highly ef- impact on the real economy. At the same fective influence on the money market. time, it should also be taken into account Similarly, the signalling role of the in- that central bank transactions become less terest rate (change in the interest rate) of the effective and highly costly for longer maturi- policy instrument is also important. Fre- ties whenever the expectations of the mar- quently, expectations concerning changes ket differ from those of the central bank. in the key interest rate have an impact on Therefore an equilibrium maturity must be the interest rates in themselves. When the found, with which the central bank is able to central bank’s policy coincides with the ex- influence changes in market yields with ad- pectations of the market, another signal is equate effectiveness. emitted indicating that the assessment of the financial and economic processes by the market and the central bank is similar. The The Current Practice signal is more spectacular when the central of the NBH bank takes an interest rate step that deviates from market expectations (or when it The maturity of the deposit instrument re- does not take the decision expected by the garded as governing in Hungary is two market). At such times market agents, in weeks with settlement and payment on the addition to having access to central bank in- day following the conclusion of the transac- struments at terms and conditions different tion. The NBH chose the two-week facility from their expectations, experience that the as its policy instrument because this is the central bank evaluates macroeconomic optimal maturity for the central bank for the processes differently, which motivates them following reasons: to re-evaluate their own interest rate policies. Thus, the central bank is able to gener- • it enables the central bank to exert a ate changes going significantly beyond the still adequate impact on the direct market impact of the interest rate 3-month maturity, which is of out- change in the money market. standing importance for transmis- Internationally it is not typical for the sion (see the discussion under the policy instrument to have no predetermined Transmission Mechanism), interest rate, being left to evolve in the mar- • it should not be so long as to force ket (e.g. in the course of auction sales). the central bank to move in a direc- However, we can find examples of no being tion corresponding to expectations linked to the policy rate, which is published because of the strong effect of ex- by the central bank as the one deemed de- cessively large or low deposit place- sirable by it over the short-term and which ments based on excessive expecta- the market takes into account. tions concerning the interest rate The particular form (especially the measures of monetary policy (spec- lags) of the transmission mechanism has a ulation), and fundamental significance in determining the • it should provide adequate assis- maturity of the policy instrument. This tance to banks in liquidity management; as the reserve period is one 8 Until the autumn of 1998, the policy instrument and the calendar month, the two-weekly in- instrument used for liquidity management within the reserve strument is expedient for tying down period were separate. Until then the reserve period lasted two weeks (or to be more accurate, there were two reserve peri- liquidity in an adequately safe man- ods every month), during which banks could bridge liquidity ner.8 Using the two-week instru- problems using the one-week deposit (or repo). The policy instrument was the 28-day deposit. ment, the central bank may effec-

100 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

Figure 24 Instruments Determining the Policy Rate Used in Hungary from 1993

Direction Form available Frequency Name of instrument of operation on the market Term of application

Repo* active side standing facility 1 week, or 28 days 1994-middle of 1995 Reverse repo passive side standing facility 28 days from mid-1995 to October 1997 28-day deposit passive side standing facility 28 days from October 1997 (1 month) to 1 March 1999 14-day deposit passive side intermittently 14 days from 1 March 1999 (2 weeks) available standing facility

* In the course of 1994 and 1995, first the 1-week then the 28-day repo dominated the transactions of the NBH. This, however, cannot be unambiguously attributed to its function as policy instrument but to the secure income which can be achieved by buying government papers, and the financing needs of the banks with liquidity shortage.

tively influence the 3-month market facility available intermittently. Thus, apart yield and the pricing behaviour of from extraordinary cases, the central bank banks. assists credit institutions in balancing their liquidity positions only at the edges of the in- The central bank was available with terest rate corridor, on three out of five work- the policy instrument twice a week in 1999 ing days a week, and on four days a week as of March 2000. and once a week from March 2000, when the 3-month NBH bond was introduced (intermittently available standing facility). Eli- The Instruments of Sterilisation gible counterparties could conclude transactions with the NBH between 10.00 and 12.00 hours at the interest rate announced Generally, sterilisation is effected in coun- in advance. The financial settlement of the tries where capital inflow through foreign transactions was effected on the following exchange market intervention leads to day. such an expansion in the money supply that, without its neutralisation, it would have The intermittently available standing facility an inflationary impact. Neutralisation (steri- means that the central bank is available dur- lisation) of excess liquidity arising from the ing the day, similarly to the continuously conversion of foreign exchange flowing in available standing facility, but only on prede- from abroad by central banks has been par- termined days (e.g. on Tuesdays and Thurs- ticularly characteristic in the countries of days). The advantage of the intermittently available standing facility over the continu- central and eastern Europe in the transition ously available one is that the direct setting period. The reason for this includes the fact of interest rates becomes more moderate that the countries of the region have used owing to the less frequent possibility of exe- the exchange rate as the nominal anchor in cuting transactions. Also, it encourages most periods; consequently, they were banks to be more active in their liquidity forced to effect foreign exchange market in- management, i.e. to assess their liquidity positions in advance and develop their expecta- terventions from time to time. Also, to curb tions accurately, which improves the effec- inflation and to maintain the external equi- tiveness of the transmission mechanism. The librium at the desirable level, central banks NBH makes its governing two-week deposit attempted to dampen the pace of interest

MONETARY POLICY IN HUNGARY 101 III. THE INSTRUMENTS OF MONETARY POLICY rate decreases, hence the so-called sterili- lower point of intervention through the sation instruments offered attractive rates. standing facility and, in the course of the In the course of sterilisation, the cen- sale, the Bank must also be available at the tral bank must take safety and cost consid- edge of the band.) Therefore, in order that erations into account. With a view to the the foreign exchange reserve should not be safety of the exchange rate regime, the cen- depleted quickly, the NBH attempted to tral bank, in the course of sterilisation, at- lengthen the duration of the sterilisation tempts to tie down excess liquidity in the stock using various instruments (6-month banking sector on longer maturities so that, and 12-month deposit and the NBH bond).9 in the event of the withdrawal of foreign ex- These efforts of the central bank went hand change not justified by the main macroeco- in hand with a rearrangement in the struc- nomic indicators, the position against the ture of the sterilised stock by maturity. (See central bank should not be suddenly dis- Figure 25) mantled, and foreign exchange movements not supported by the macro indicators The NBH Bond should take place more slowly. In addition, The NBH bond is a debt security issued by the the central bank, besides considerations of central bank which, pursuant to the ordinance determining the range of securities accept- inflation and the balance of payment, has able as for repo transactions, may be used by also to bear in mind the costs of sterilisation. its owner for repo transactions with the central By keeping the costs of sterilisation at as bank. (Ultimately, NBH papers are just as low a level as possible (taking into account risk-free as government papers as the owner from another aspect that there must be an of the central bank is the state, the NBH pays adequate real interest rate as well), the its profits to the budget and the budget covers central bank’s aim is that the spread be- its eventual losses.) The NBH bond was first issued in June 1997, in addition to meeting tween the yield on risk-free papers denomi- the sterilisation need also with a view to en- nated in the local and foreign currencies suring sterilisation on longer maturities. Then should not generate capital inflow for specu- the central bank was continuously available lative purposes, which should later be steri- with the bond, limited only by the amount is- lised. sued for the given period. The NBH chose the issuing technique according to which it placed the bonds in its own account and sold The Current Practice them from there for a month. At the end of the given month, the bonds remaining in its own of the NBH portfolio were annihilated and a new series was issued. In this way intervention at a fixed The operation of the crawling exchange rate was effected practically at an interval of rate of the forint within a band of interven- between 11 and 12 months. tion means that the NBH has an automatic By April 1998, it was no longer neces- obligation to buy or sell (to intervene) at sary for the central bank to directly set rates the edges of the band. This also means that on the maturity of between 11 and 12 months, although excess liquidity still had to be tied incoming foreign capital appears at the down permanently. Thus, the new series of central bank, increasing foreign exchange NBH bond were placed on the market using reserves. A sudden reduction in the foreign auction sales. Auctions were held every two exchange reserves of the NBH, caused by weeks and the central bank again offered the any external or domestic shock, consti- bond from its own account until the stock was tutes a risk. (The weakening of the ex- depleted or the period to maturity reached change rate may induce the sale of foreign 10 months. At the auction the central bank exchange for some period of time at the announced the amount intended to be sold, and the banks could submit their bids between 9.00 and 11.00 hours. Once the bids 9 In the case of the government paper outright transac- were submitted the Auction Committee ex- tions applied in 1997 for the last time; government papers with a period to maturity of 9 to 15 months bearing fixed in- amined whether it was necessary to alter the terests were sold. amount by a maximum of ±25 per cent rela-

102 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

tive to the amount offered or whether the auc- plied for reasons already discussed (the tion should be declared unsuccessful in the limited government paper stock of the event where bids were found to be extremely NBH). In addition to the 2-week deposit, different from market conditions. The NBH the 3-month NBH bond has assisted sterilisation since March Figure 25 Changes in the Sterilisation Stock in Hungary 2000. When issuing the bond the central bank invites free ten- Forint billion ders to tie down liquid- 200 ity (without determining either the amount 0 or the interest rate), i.e. it applies an auc- -200 tion technique whereby it affects in- -400 terest rates only indirectly. (See Figure 26.) -600 Repo/deposit stock As far as the elements -800 NBH bond of the instruments used for sterilisation -1000 are concerned, the period of the instruments -1200 and the method of setting the interest rate Jan. Jan. Jan. Jan. July Oct. July July Oct. July Oct. Feb. Apr. May Feb. May Apr. Feb. Apr. Feb. May Dec. June Aug. June Dec. Aug. Dec. Aug. Dec.

Sept. Sept. Nov. Sept. Nov. are important. In the March March March 1995 1996 19971998 1999 2000 case of dictated (fixed) interest rates, the

bond is financially settled on the second day following the Figure 26 Potential Instruments of Sterilisation transaction.

Name Form available Maturity Characteristic In the potential instru- of instrument on the market period ments of the NBH there are 28-day reverse standing facil- 28 days from March three types of instruments suit- repo ity 1995 to Sep- able for sterilisation. These in- tember 1997 clude the reverse repo, the 28-day and first standing 28 days, then from Septem- standing deposit and the NBH 14-day facility, then from 1 March ber 1997 bond. Their method of issue deposit intermittently 1999, 14 days and period differ substantially. (the policy available Since one-year NBH bond auc- instrument) standing facil- tions were terminated in Octo- ity ber 1998 and they matured 6-month standing facil- 6 and from Janu- one year later, the sterilisation and 12-month ity 12 months ary–June 1997 instrument within the NBH in- deposit struments was the 1-month availability, between 12 from July 1997 and, subsequently, the 14-day NBH bond then auction and 11 months, to October deposit, which also played the auction then 12 and 1998 role of the policy instrument. 10 month, from March The reverse repo is not 3 months 2000 among the instruments ap-

MONETARY POLICY IN HUNGARY 103 III. THE INSTRUMENTS OF MONETARY POLICY monetary decision-making body must ences in the banks’ reactions to the steps of continuously review the interest rate and the central bank (transmission). introduce changes from time to time in ac- When commercial banks can meet their re- cordance with expectations concerning serve obligations or have the settlement de- the real interest rate and the spread. In the posit stock required for the safe administra- case of the sterilisation instrument sold in- tion of business through short-term credits directly – largely by way of quantitative (shorter than the reserve period) (for in- auctions – the interest rate evolves at the stance, repo), we may speak about a situation of liquidity shortage. In most countries where auction (in the case of deposits, at the ten- there is no considerable foreign exchange der). The NBH makes sure that, if possi- market intervention, central banks attempt to ble, nobody should obtain the bond at a create such situations of liquidity shortage. level above the equitable yield. To that The Bank of England, for instance, ensures li- end, the central bank is entitled to deter- quidity shortage in the very short term by is- mine the amount issued in 75–125 per suing 3-month securities, thereby guarantee- ing the effectiveness of short-term active in- cent of the amount offered. By using the struments. free tender, the central bank, while main- In contrast, in countries – including taining its intention to effect sterilisation, Hungary – where there is significant foreign refrains from directly influencing the yield exchange market intervention, the interbank curve. market is characterised by ample liquidity. This means that commercial banks are able As already mentioned in the chapter to meet the reserve requirement without bor- on transmission, the extent to which the rowing from the central bank, i.e. they are central bank ties down free liquidity in the able to have the required settlement deposit banking sector may have significance for stock. In this case commercial banks place the effectiveness of regulation. Active-side their free reserves in the form of assets bear- operations may be more effective from the ing market interest (sterilisation instrument) outstanding against the central bank. viewpoint of the central bank in influencing interest rates because they force credit insti- The size of the sterilised stock at the - - NBH is so large that the creation of a struc tutions more strongly to apply the rates dic tural liquidity shortage is not on the agenda in tated by the NBH: their liquidity position 2000. In the event of a lower stock, when it does not enable them to make up for the will be possible to transform the sterilised structural deficit from other sources in the stock kept with the NBH into longer-term in- banking sector. From the viewpoint of the struments at relatively low cost, a sustained li- transmission, the rippling on of lending rates quidity shortage can be created, leading to the policy instrument of the NBH operating to the real sector presumably takes place again on the active side. more rapidly in the event of active regulation. When the liability costs of the banks are raised (for instance, because of an in- Liquidity Planning crease in the rate on the active central bank and Fine-Tuning instruments), the bank suffers an effective loss unless it raises the price of financing. In (Quick Tender) the event of passive-side operations, however, the banks, when they do not follow the The Role of Liquidity interest rate measures of the central bank, management “only” lose a surplus revenue when they fail to place their excess liquidity using the opti- As discussed in the chapter concerning their mal facilities. It should, however, be noted objectives, in order to implement their ulti- that in the case of cost-sensitive banks mate goals central banks follow operating competing against one another the two li- targets in their day-to-day operation. Their quidity situations should not result in differ- continuous market presence is called to fa-

104 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY cilitate the realisation of these targets. These transactions are the first steps in Pursuing an operating target, whether it is the transmission mechanism. The perma- the interest rate of a preferred maturity nent alteration of the liability costs of com- (characteristically from 3 months to 6 mercial banks or of the yield of the central months) or influencing the growth rate of the bank instruments available to them in- monetary base, they exert their influence duces different stock and yield changes, through the transmission mechanism on the which ultimately result in a modification of variables relevant with respect to the inter- the course of the real economic variables. mediate targets and the ultimate goal. The With some simplification it may be stated counterparties of central banks are the com- that the central bank reaches its ultimate mercial banks, hence it is obvious that the goals by influencing the yields evolving in operating target is formulated in terms of the the interbank market. Liquidity manage- achievement of a level of a quantitative or ment can therefore be regarded as the low- yield variable, regarded as optimal, which is est level of monetary policy, which is an in- of crucial importance for the banks. Con- dispensable condition of the implementa- cretely, the operating target of the central tion of the ultimate goal. bank is to influence the amount or cost of the Liquidity management may be dis- reserve money (central bank money) avail- cretionary or accomodative. When discre- able to the commercial banks. tionary regulation is applied, the central As mentioned when discussing the bank decides in what amount it accepts de- banker of banks function, the demand of the posits (or sells government papers) banks for reserve money stems from three from/to the banking sector or offers credits sources. First, banks need vault cash to sat- to them under various facilities (or buys isfy the cash needs of their clients. Second, government papers). In short, it is the deci- administration of day-to-day transactions sion of the central bank and not that of the necessitates that the banks have claims commercial banks that determines the li- against the central bank, which can be quidity of the banking sector. promptly exchanged for cash. Third, the The objective of the accomodative banks must meet the reserve requirement regulation is also to influence the liquidity of prescribed by the central bank. The reserve the banking sector. In this case, however, requirement sets the level of the stock of the central bank operates with standing fa- bank money at a higher level than what cilities. would evolve without it. This means that the central bank offers Through its open-market operations, funds and accepts deposits at pre- the purchase and sale of government pa- determined interest rates, but the banks can pers and its own instruments, the central make use of these according to their needs. bank provides or withdraws bank money In this way liquidity management is in the from the interbank market. The objective of hands of the banking sector and we cannot these measures is that, through modifying speak about active liquidity management the demand and supply conditions in the by the central bank. reserve money market, the central bank directly or indirectly influences the funding The two regimes, although they funda- costs of the commercial banks or the yield mentally differ in their operating mecha- of the assets of the banks placed with the nisms, serve the same purpose, namely to central bank. With this, the central bank reach a level of interbank rates which is in prompts banks to restructure their balance line with the central bank’s targets. With dis- sheets or, on the contrary, prevents a bal- cretionary regulation, the central bank influ- ance sheet restructuring regarded as unde- ences indirectly through volumes; under the sirable from the viewpoint of monetary accomodative regulation it influences them policy. directly.

MONETARY POLICY IN HUNGARY 105 III. THE INSTRUMENTS OF MONETARY POLICY

The precondition of discretionary li- The method of administering quick quidity management is liquidity planning by tenders – generally with a different eligibility the central bank. In the case of criteria for counterparties and dates – is sim- accomodative regulation, what the central ilar to that of the ordinary tender. bank does is more in the nature of liquidity monitoring, an examination of the self- The Current Practice regulatory behaviour of commercial banks within the framework conditions created by of the NBH the central bank’s rules and instruments. The monetary policy instruments of the When liquidity forecasts are of appro- NBH – with one exception – operate in the priate quality, the central bank may supple- form of standing facilities: the central bank ment the interest rate corridor and the key accepts overnight or two-week deposits (on policy instrument with the quick tender this maturity, availability is intermittent) or used for the fine-tuning of liquidity. Quick grants overnight credits at a given rate in ac- tenders are generally applied in two cases. cordance with the needs of the banks. The If, at the end of the reserve maintenance pe- latter facility is available to the banks only riod, the banks would not be able to meet within the limit specified in proportion to the reserve requirement owing to some li- their balance sheet total (repo line) but, quidity cutting shock (or because they sim- within this limit, they are free to decide on ply have miscalculated) the interbank de- the amount. mand for free liquidity in the banking sector When, as a result of unforeseeable may rise and this may, for a transitory pe- events, the supply of central bank money riod, induce exceedingly high interest rates significantly decreases, the reserve stocks (generating volatility). Then a situation of li- of a few banks may sink so low that they are quidity shortage may arise, which may be unable to meet their reserve requirement remedied by an money providing quick ten- without getting founds through repo. The der. The other case may arise owing to un- negative impact of the factors influencing li- expected, significant capital movements quidity may be so great that commercial abroad. In such cases, in the event of major banks are unable to raise their reserve capital inflows over a short period of time, stocks to a level corresponding to the re- an additional sterilisation pressure, difficult serve requirement even by exhausting their to plan for in advance, would be exerted on repo line in the remaining part of the reserve the central bank, which may induce the period. In such a situation interbank rates bank to apply a quick tender for deposits. may rise above the overnight repo rate (that is, outside the interest rate corridor). Central banks must be highly circum- The January 1999 introduction of the spect with the regular use of the quick ten- quick tender aimed to eliminate such situa- der because when it is frequently invited a tions of temporary liquidity shortage. The kind of moral hazard may arise; the banks NBH, depending on whether or not it re- will make less of an effort to manage their li- gards a rise in interbank rates desirable, quidity position perfectly during the period, may decide whether or not to provide liquid- as they can be sure that they can rely on the ity to the banking sector in the form of a central bank. quick tender. The quick tender is the only In countries where they have intro- typical discretionary element of the central duced the quick tender and the central bank’s instruments, which also provides an banks’ liquidity management functions ef- opportunity for active liquidity manage- fectively, the decision on inviting quick ten- ment. In addition, the business conditions of ders can be made on the basis of very money market operations enable the NBH short-term liquidity forecasts, even over an to offer the two-week deposit, which is its hour. policy instrument, not at a given interest

106 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY rate but by announcing its amount to the sufficiently reliable, the use of a free tender banks. In Hungary there were fundamentally is more expedient. two reasons for including the quick tender in Approaching the end of the reserve the set of instruments. On the one hand, it period, it happened that banks tried to find was introduced to reduce the impact of un- the missing reserve amounts and place expected, significant money movements them “fighting the fires”. In the event of low justified by international events but not sup- system liquidity, they could obtain these ported by changes in macroeconomic pa- amounts only at high interbank or repo rates rameters. The other reason was to facilitate (at the level of the interest rate ceiling), liquidity management, particularly with re- which introduced considerable volatility to spect to the last days of the reserve period, interest rates and substantially diverted the which are difficult to plan for. interbank money market. At other times All the types listed under tenders also exist for banks set aside excessively large amounts quick tenders on both the active and the pas- early in the period in the belief that they sive sides. The advantage of the quick tender would be able to place their excess liquidity is that it can be administered even in a single profitably by the end of the period. These day as it is announced before 8.00 a.m. and situations can best be remedied by an inter- results are declared as early as 9.00 a.m. Fi- nancial settlement is effected the very same est rate tender subject to quantitative limit day. Bids to the quick tender can be submit- as the liquidity shortage or surplus can be ted only through Reuters; any one counter- quantified at the level of the system. The party (which must be a bank) can submit only central bank can determine the interest rate one bid and the bid must be fully divisible by and can force the banks to accept it. The Ft500 million. quantitative limit serves the purpose of pre- The series of international events in venting tensions in the system caused by 1997–98, which resulted in a decline in in- the liquidity deviation appearing at the level ternational confidence in the region and in- of the banking sector, and the deviation of vestors having a propensity to overreact to the accumulated liquidity shortage or sur- the effects of the crisis and to assess the sta- plus of individual banks. The first two repo bility of the countries of the region not on the quick tenders invited at the end of January basis of real threats or the fundamentals, fa- 1999 in Hungary were also implemented in cilitated the introduction of the quick tender the form of interest rate tenders subject to in Hungary. quantitative limits. At such times, the central bank may, Fine-tuning requires proper liquidity with a view to protecting the interest rate monitoring and forecasting at the level of and the exchange rate, perform rapid and the banking sector. Proper information flow transitory intervention. between the central bank and the budget is The central bank may intervene in the important for this. foreign exchange market, may reduce the The NBH daily monitors changes in extent of intervention or may even substi- the banks’ payments and their tied-down li- tute intervention by inviting quick tenders in quidity and continuously updates the liquid- the forint market. Then the quick tender ity forecasts for the immediate future. must be of a rate taker type, that is, only Whenever the banking sector lands in a situ- quantitative and free tenders can be consid- ation of transitory liquidity disturbance (low ered. or abound liquidity), the central bank may When the central bank is able to prop- consider whether it will leave interbank rates erly quantify the expected outflow of foreign to significantly shift within the boundaries of exchange in a situation near to crisis, then it the interest rate corridor, or to let changes in is worthwhile to tie this (or a part of it) down the forint money supply be dealt with in the forint market through a variable rate through foreign exchange market interven- tender. When, however, the forecast is not tion, or to prevent transitory interest rate

MONETARY POLICY IN HUNGARY 107 III. THE INSTRUMENTS OF MONETARY POLICY volatility (which may have a disturbing ef- Liquidity planning involves the sys- fect and may be unjustified) by way of a tematic ordering of the factors which are ex- quick tender. pected to shape demand for and supply of central bank money, i.e. taking stock of the Liquidity Planning asset and liability side items of the central bank balance sheet. Figure 27 presents the Owing to the largely adjusting nature of its schematic central bank balance sheet which instruments, the significance of liquidity the NBH uses for liquidity forecasting. planning pursued at the NBH is substantially From the viewpoint of liquidity plan- less than in the case of central banks pursu- ning, the banks’ reserve stock is of interest ing discretionary regulation. At the same because that determines the demand of the time, the continuous monitoring of the li- whole banking sector for bank money. In the quidity and behaviour of the banking sector course of liquidity management and moni- provides valuable information concerning toring the liquidity position, the central bank the expectations of the market and the examines every factor from the viewpoint of eventual need to modify the instruments or how a change in the given item of the central the framework conditions of the interbank bank balance sheet affects the banks’ re- market. serve stocks. Liquidity planning at the central bank Changes in some of the balance sheet fulfils its classical function not in ordinary items do not influence the account balance situations but when quick tenders are an- of the commercial banks. The most impor- nounced. The decision on the amount of tant of these items are the transactions be- credit offered through the tender may be tween the budget and the central bank. made after assessment of the factors influ- When for instance, the Treasury repays a encing the reserve stocks of the commercial loan to the NBH, this reduces the balance banks in the remaining part of the reserve of credits to the budget (asset side) and period. the balance of the Unified Treasury Account

Figure 27 The Simplified Balance Sheet of the NBH

Assets Liabilities Claims on general government General government deposits Forint credits Treasury Unified Account* Foreign exchangre credits Claims on banks Bank deposits Refinancing credits Settlement deposit account (reserve account) Repo Vault cash Claims on non-residents (foreign exchange Two-week deposit reserve)* Other Overnight deposit NBH bond Banknotes and coins outside the banking sector Foreign debt Other Equity

* Together with the deposit of ÁPV Rt.

108 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

(liability side). Net interest payments being sector can, however, do so only by plac- tween the central bank and the budget alter ing deposits with the central bank. The two liability-side items which do not affect two-week deposits account for by far the commercial banks: the balance of the majority of placements, because their rate is Unified Treasury Account and the central substantially higher than that of the over- bank’s profit. When the foreign exchange night instrument. position of the central bank changes, again The banks’ objective is to gradually di- only the transactions vis-à-vis commercial vest themselves of their surplus liquidity to banks are of interest (foreign exchange achieve the highest possible interest in - market intervention), as the transactions of come. By the last day of the month, they the central bank and the budget in relation must reduce their free liquidity to a minimal to the foreign exchange debt have no liquid- level, because the NBH does not pay an in- ity impact, i.e. they do not influence the re- terest on the average account balance over serve position of the commercial banks. and above the reserve requirement. To predict the bank money stock of commercial banks a forecast must be pre- The free liquidity of the banks is the pared for each of the above-mentioned vari- amount which, according to the current ex- ables. With the forecast it is possible to cal- pectations concerning changes in the fac- culate the monthly average expected bal- tors forming liquidity, is not needed for ance of the reserve accounts without place- meeting the reserve requirement. Changes ment of deposits and borrowing by com- in the factors influencing liquidity cannot mercial banks. Then this stock can be com- be forecasted with absolute certainty, pared to the reserve requirement to be met hence free liquidity can also not be accu- by the commercial banks in the remaining rately determined. Banks are well aware of part of the month. the fact that a number of unpredictable fac- The difference between the two figures tors influence liquidity until the end of is the free liquidity in the banking sector, the reserve period, which may divert free that is the amount which the banking sector liquidity from its value expected at the must place at the central bank until the end moment. of the reserve period. When the monthly ex- The real problem for the banking sec- pected reserve stock is short of the reserve tor arises when their free reserves at the end requirement to be met, a liquidity shortage of the month are in the red, i.e. they need to has arisen. Then commercial banks must take out expensive central bank credit to borrow from the NBH in the form of a repo meet the reserve requirement level. To in order to be able to meet the reserve re- avoid this, banks attempt to keep the level quirement. of their free reserves at a positive level throughout, that is, they build up a security stock capable of absorbing negative effects Liquidity Surplus affecting the reserve account (such as the and O/N Rates impact of tax payments substantially higher than expected). As a result of the capital inflow of the past few years, the Hungarian banking sector has With the progress of the reserve pe- been characterised by a substantial liquid- riod, the uncertainty around the end of the ity surplus, that is, banks have more central month reserve position declines, thus even a bank money than would be necessary to lower free liquidity stock will provide a suffi- meet the reserve requirement. In this way, cient margin of safety. free liquidity is largely positive, the banking The level of free liquidity in the bank- sector has superfluous reserves. Individual ing sector has a close inverse relation to in- banks may reduce their surplus reserves by terbank rates. When banks have ample free offering interbank credits, the entire bank- reserves, they place their money in central

MONETARY POLICY IN HUNGARY 109 III. THE INSTRUMENTS OF MONETARY POLICY

Figure 28 Individual Functions and the Basic Forms of the Assigned Instruments

Interest rate corridor Policy instrument Sterilisation Fine-tuning

Repo O/N repo 7-day maturity until quick repo tenders the summer of 1995

Reverse repo O/N reverse repo from the summer until October 1997, possibility of invit- until October 1997 of 1995 to October maturity of 28 days ing quick reverse 1997 with 7, repo tenders then 28 day maturity

Swap O/N swap

Deposit O/N deposit from 28-day maturity 28-day from Octo- possibility of quick October 1997 from October 1997, ber 1997, 14-day deposit tenders 14-day from March from March 1999 1999

Sale of government in 1997 for the last can be announced papers time when needed

Purchase can be announced of government when needed papers

NBH bond standing facility with a maturity of one year from July 1997 to April 1998, then auction sale until October 1998. From March 2000, free tender with a maturity of three months

bank deposits and its yield will govern inter- Accordingly, the NBH is able to fore- bank rates. cast the movement of interbank rates with- When, however, the majority of banks out examining the positions of individual banks, merely on the basis of the forecast of are dissatisfied with their own reserve posi- global liquidity. tions, i.e. they assess their free liquidity as insufficient, their growing demand for re- The NBH discloses the reserve stock serves will drive interbank rates above the of the commercial banks via Reuters. Sup- plementing the public information disclosed level of the central bank deposit rate. by the NBH with individual information The equalising mechanisms of the in- about liquidity among their own clientele, terbank market guarantee that the global li- banks are able to draw conclusions con- quidity surplus of the banking sector will ap- cerning the liquidity position of the banking proximate to the positions of individual sector and also the expected movements in banks. O/N rates. (See Figure 28)

110 NATIONAL BANK OF HUNGARY III. THE INSTRUMENTS OF MONETARY POLICY

Individual Elements The NBH separately specifies its eligi- in Operating the Instruments ble counterparties for every one of its monetary policy instruments. (See Figure 29) The full group of eligible counterparties, which Eligible Counterparties covers every institution that enters into for the NBH some kind of a business relationship with the NBH in relation to the central bank’s monetary policy transactions, includes the The counterparties of the NBH eligible for banks, the specialised credit institutions monetary transactions generally include all (Hungarian Development Bank, Eximbank, legal entities that are or may be in some kind of a business relationship with the cen- Mortgage Bank, housing savings funds), the tral bank while it performs its monetary primary government paper dealers, savings functions. This exceedingly broad interpre- banks and saving co-operatives, and tation covers not only the multitude of KELER Rt. counterparties who enter into contact with Certain conditions of the given facility the central bank in relation to implementing may, however, restrict individual counter- the objectives of monetary policy, but also parties in concluding transactions with the those whose accounts are managed by the central bank. NBH. For instance, the minimum transac The central bank is able to determine - the group of eligible counterparties for a tion amount or an increase in the transac- given type of transaction in order to tion amount or its “tick” may also act as de- achieve its monetary policy objectives. terrents. Strikingly high requirements ap- First, it can directly determine this circle pear in the case of quick tenders, when a and second it may include conditions bank needs to be able not only to make a among the Terms and Conditions of Busi- decision on whether or not to participate in ness for the given instrument, which either the auction and under what conditions bar certain institutions, otherwise eligible, within 30 minutes following the invitation to from entering into the given transaction or tender by the NBH, but it must also have ad- render it very difficult for them to deal with equately rapid data transmission channels the central bank. and at least Ft500 million per bid.

Figure 29 The Eligibility of Individual Groups of NBH Counterparties to Enter into Business

Purchase Reserve O/N deposit O/N repo and and sale of NBH Deposit and repo requirement and deposit repo tender bond, government quick tenders tender papers

Banks XXXXX HDB, Exim, Mortgage Bank XXX Housing savings banks XXX Savings co-operatives, saving banks, X Primary dealers X

MONETARY POLICY IN HUNGARY 111 III. THE INSTRUMENTS OF MONETARY POLICY

NBH Channels party fails to sign the contract, it thereby de- of Communication prives itself of eligibility. Banks and other concerned credit institutions are notified of changes in interest The central bank notifies its counterparties conditions by way of a faxed circular. Notifi- of its decisions through various channels: by cation concerning changes in business rates mail, facsimile, dailies and Reuters. The is sent to the banks’ treasuries, that on principle is that new information should changes in the base rate to the CEOs of the reach those most concerned as quickly as banks. possible. Changes in interest rates, invitations to The central bank notifies those con- tender, to buy or sell government papers cerned of any changes in its Terms and Con- and the results of tenders and auctions are ditions of Business by fax or mail. published in the Reuters pages of the central Counterparties are required to confirm the bank (NBHJ, NBHK) and in daily newspa- amended conditions and it is only thereafter pers. Thus information reaches those di- that they may deal with the NBH pursuant to rectly concerned and financial experts in the the amended conditions. When a counter- most rapid way and at the very same time.

112 NATIONAL BANK OF HUNGARY BIBLIOGRAPHY

A Magyar Nemzeti Bank 70. éves évfordulós Crockett, Andrew, “Rules versus Discretion in kiadványa (The 70-year Anniversary Monetary Policy”, in J. Onno de Beau- Publication of the National Bank of Hun- fort Wijnholds, S. C. W. Eijffinger and L. gary), Budapest, 1994 H. Hoogduin (eds.): A Framework for A Magyar Nemzeti Bank története I (History of Monetary Stability, Dordrecht and the National Bank of Hungary I), KJK, Boston, Kluwer Academic Publishers, Budapest, 1993 1994 The Statutes of the National Bank of Hungary Cukierman Alex, Steven Webb, Bilin Neyapi: as of 13 March 1999 The measurement of central bank inde- - A monetáris politika céljai és eszközei (Objec- pendence and its effects on policy out tives and Instruments of Monetary Pol- comes. The World Bank Review, 6, icy) by members of the Department of 1992, pp 353–398 3.3.3, 4.2.6 Monetary Analyses of the NBH, Attila Csajbók: Zéró-kupon hozamgörbe Bankszemle, 36, 1992 becslés jegybanki szemszögbõl (Esti- mating the Zero Coupon Yield Curve Alberto Alesina, Lawrence H. Summers: Cen- from the Viewpoint of a Central Bank), tral Bank Independence and Macroeco- NBH Füzetek, 1998/2 nomic Performance – Some Compara- tive Evidence. Journal of Money, Credit Dale, Spencer: The effect of official interest and Banking, May 1993, pp 151–152 rate changes on market rates since 1987 Zsófia Árvai: A piaci és a kereskedelmi banki David W. Pearce (ed.): A modern közgaz- kamatok közötti transzmisszió 1992 és daságtan ismerettára, McMillan Dictio- 1998 között (Transmission between nary of Modern Economics, KJK, Buda- Market Rates and Commercial Bank pest, 1993 Rates between 1992 and 1998), NBH Ederington, Louis-Goh, Jeremy: A Variance Füzetek, 1998/10 Decomposition Analysis of the Informa- Banaian, King, Leory O’Laney, Thomas D. tion in the Term Structure, Journal of Willett: Central Bank Independence, An Financial Research, vol. 20 (1), Spring International Comparison–Federal Re- 1997, pp 71–91 serve Bank of Dallas Economic Review – Estrella, Arturo- Mishkin, Frederic: The Pre- March 1983, pp 1-13 dictive Power of the Term Structure of In- Borio, Claudio E.V: The Implementation of terest Rates in Europe and the United Monetary Policy in Industrial Countries: States: Implications for the European A Survey, BIS Economic Papers Central Bank, European Economic Re- Burda, M. and C. Wyplosz: Macroeconomics: view, 1997, vol. 41, pp 1375–1404 A European Text, Oxford, Oxford Uni- Fischer, Stanley: Modern Central Bank- versity Press, 1993 ing–Prepared for the Tercentenary of the

MONETARY POLICY IN HUNGARY 113 III. THE INSTRUMENTS OF MONETARY POLICY

Bank of England Central Banking Sym- – Journal of Monetary Economics, 25, posium, 1994 1990, pp. 166-176 Freedman, Charles: “The Use of Indicators and Mrs. József Romhányi: A Magyar Nemzeti of the Monetary Conditions Index in Can- Bank történetének kronológiája (Chro- ada”, in Balino and Cottarelli (eds.): nological History of the National Bank of Frameworks for Monetary Stability: Pol- Hungary), NBH, Budapest, June 1999 icy Issues and Country Experiences, In- Svensson, Lars E.O.: Estimating and Inter- ternational Monetary Fund, Washington preting Forward Interest Rates: Sweden, D.C., 1994 1992-1994, International Monetary Gerlach, Stefan: The Information Content of Fund Working Paper No. 114, Septem- the Term Structure: Evidence for Ger- ber 1994 many, Empirical Economics, 1997, vol István Szalkai: A monetáris irányítás 22 (2), pp 161–179 (Bevezetés a monetáris közgazdaság- tanba) (Monetary Control – Introduction Magyar Nemzeti Bank Általános Tájékoztató to Monetary Economics), Second re- (National Bank of Hungary General In- vised, expanded edition, 1995 formation), Budapest December 1998 Imre Tarafás: Monetáris Politika – eszközök és McCallum, Bennett T., Monetary Economics: feltételek (Monetary Policy – Instru- Theory and Policy, New York, Macmillan ments and Conditions), Közgazdasági Publishing Company, 1989 Szemle, 1995, No. 11, pp 1024-1043 Mishkin, Frederic S.: The Economics of The Federal Reserve System – Purposes and Money, Banking and Financial Markets, Functions, Washington D.C., 1994 Third Edition The Monetary Policy of the Bundesbank, Deut- Pénzügytan (Finances) – university notes, sche Bundesbank, Frankfurt am Main, BKE, Saldo, 1992 October 1995 Robert L. Hetzel: Central Banks’ Independence The Transmission Mechanism of Monetary in Historic Perspective – a Review Essay Policy, Bank of England, May 1999.

114 NATIONAL BANK OF HUNGARY ANNEX

ANNEX

MONETARY POLICY IN HUNGARY 115 ANNEX

116 NATIONAL BANK OF HUNGARY Standard Business Hours for the Instruments of the Central Bank and Other financial Marketplaces from May 8 2000 Hour 7 8 9 10 11 12 13 14 15 16 17 Minute 0 1530450 1530450 1530450 1530450 1530450 1530450 1530450 1530450 1530450 1530450 153045 Longer availabilityonthelast O/Ninstruments Tdaysettlement dayofthereserveperiod Prolongation facility Preparingnextday Quicktender Announcement® Tday ¬ Announcementoftheresults formaturing decisions Tender Announcement® T+1day Announcementoftheresults ® repo transaction Intermittentlyavailable onT-1day standingfacility T+1day NBHbondauction Announcementon T-5day T+2 ¬ Announcementoftheresults Outrightsale T,T+1 orT+2settlement

SWAP T+2 FXinterventionattheedges oftheexchangeratebond T+2 Incaseoflackofquicktenders Timeforinterestrate changes Periodduringswaptransactions Moreintensetrading HUFinterbankbusinesshoursmaylengthenduetoKELERDVP HUFinterbankmoneymarket O/N with settlement onT-day T/N withsettlementonT+1day FXinterbankMM TransactionsmaybecontinuouslymadeontheinterbankFXmarket,butmoreactiveperiodscoincidewiththeinterventionperiodofthecentralbank

Hour 7 8 9 10 11 12 13 14 15 16 17 Minute 0 1530450 1530450 1530450 1530450 1530450 1530450 1530450 1530450 1530450 1530450 153045 Auctions of the Government AnnouncementontheThursdayoftheprecedingweekinthecaseofdiscountT-bills,onFridayinthecaseofT-bonds ¬ Announcementoftheresults Debt Management T-bonds ¬ Announcementoftheresults(T-bond reverseauction) GDMAreverseauctions T-bills ¬ Announcementoftheresults(T-bill reverseauction) PD mandatory quotation (OTC) ON the BSE throughMMTS ONtheBSEthroughMMTS KELERDVPtransactions(OTC) Also fixed price deals; T day settlement BSE governmentpapersection Freeandfixedpricestage T+2 settlement BSEindividualsharessection Opening 10:00–10:05openingstage,afterthatfreeandfixedpricestage; T+5 day settlement Thereisnoclosingontheoptionsmarket 16:30–16:40arrivalofbidsfor BSEBUX,share,interestratefutures,optionsArrival of bids in opening 10:00–10:05openingstage,from10:05freestage; T+1daysettlement closing 16:40closing 10:00–10:05 openingstage,from10:05 BSEFXfutures Arrival of bids in opening Freepricestage 15:00–15:10 arrival of bids for closing,15:10closing freestage; T+1day settlement OnTuesdays BCEmeatsection andThursdays BCEgrainsection BCEfinancial section Open outcry Computerisedtrading(onFridaysonlyto13:35)

GLOSSARY

MONETARY POLICY IN HUNGARY 119 GLOSSARY

120 NATIONAL BANK OF HUNGARY GLOSSARY

aggregate demand: the sum of conversion on demand: in the case of planned consumption, investment and gov- monetary systems based on precious metal, ernment purchases of goods and services the obligation of the central bank to ex- and the net export of goods and services change the money substitutes in circulation (the difference between export and import); into monetary precious metal on demand. aggregate supply: the total volume of Although the precious metal does not par- goods and services intended to be sold by ticipate in circulation or only to a limited ex- producers at a given price level; tent, the characteristics of a classical gold-based monetary system prevail balance of payments: the total volume through payment on demand (see gold of real and financial transactions of a coun- standard); try vis-à-vis the rest of the world. Its most important components are the current ac- conversion: conversion of forint to for- count, the capital account and the financial eign exchange (or the other way round). account; Conversion by the central bank includes, in addition to foreign exchange market inter- banknote tax: a statutory provision to vention, the foreign exchange-forint conver- control the money supply. The financial in- sion related to the foreign exchange opera- stitution authorised to issue money (the tions of the state (debt service, borrowing, bank of issue) had to pay a tax to the state in privatisation); proportion to the money supply when the money in circulation exceeded the coverage core inflation: a special inflation indi- defined by the regulation plus a certain cator which shows changes in inflation net tax-free amount; of the impact of the most volatile factors, which are independent of monetary policy business cycle: subsequent periods of (seasonal foodstuff, fuel, pharmaceutical economic boom and recession (or slow- prices); down in growth) in the course of which the coverage system, banknote coverage, growth rate fluctuates around its long-term currency-banking debate: in the era when trend; currencies were convertible into precious capital operations: transactions affect- metals, the amount of banknotes and coins ing the capital account of the balance of issued was restricted on the basis of the payments (foreign direct investment, port- quantity of precious metals held by the bank folio and other capital flows); of issue. Full coverage could not (in gen- central bank independence: the cen- eral) be implemented, but a specified share tral bank as the organisation responsible for of banknotes and coins in circulation had to monetary policy must have adequate free- have adequate precious metal coverage dom and independence from personal, fi- held by the central bank. The central bank nancial and professional aspects in taking could issue money only when it was already monetary policy decisions. In most ad- in possession of the precious metal cover- vanced countries legal independence is es- age. The coverage of additional cash in tablished by law or statute; money circulation was ‘bank-type cover- central bank instruments: the range of age’, generally the discounting of good- instruments available to a central bank to quality commercial bonds; achieve its objectives. The central bank can credibility: the extent to which market influence the level of interbank rates and the agents trust that economic policy deci- amount of the central bank money circulat- sion-makers will react to various economic ing in the interbank market directly with its events in accordance with their declared instruments. The most important instru- principles. For instance, a credible central ments are the open-market (forint and for- bank which sets price stability as its goal, eign exchange) operations and the reserve should respond with more restrictive mone- requirement; tary policy to signs of growing inflation;

MONETARY POLICY IN HUNGARY 121 GLOSSARY

currency basket: in a fixed exchange duration of a financial asset, the more sensi- rate regimes the domestic currency is fixed tive its price to shifts in the yield level; against either a single currency or a com- exchange rate risk: the risk on foreign posite of currencies. In the latter case, the exchange denominated financial assets central bank keeps the weighted average arising from the fact that the value of the as- exchange rate of the domestic currency rel- set expressed in terms of domestic currency ative to several different currencies at a des- changes with a shift in the exchange rate; ignated level. The set of these currencies expansionary monetary policy: a and the corresponding weights make up the monetary policy resulting in the expansion currency basket; of aggregate demand (faster growth in the current account, deficit: the balance of money supply, lower real interest rates or trade in goods and services (exports minus depreciating exchange rate); imports), current transfers and income fixed or floating exchange rate regime: transfers vis-à-vis non-residents; in a fixed exchange rate regime, the central current payment operations: transac- bank undertakes the obligation to keep the tions affecting the current account (trade exchange rate of the domestic currency rel- transfers, income transfers vis-à-vis non- ative to a given currency or currency basket residents, transfers); on a predetermined path with the help of for- denomination: the currency of finan- eign exchange market interventions. In the cial claims and debts. Settlement is to be ef- case of a floating exchange rate regime, the fected in the currency of the denomination central bank has no target with respect to upon the due date; the level of the exchange rate, which thus deposit insurance fund: the fund pro- may freely move depending on the demand vides security to deposit holders in the event and supply conditions of the market. The of the insolvency of a bank. Compensation type of the exchange rate regime funda- is available on registered deposits up to the mentally determines the way monetary pol- insured amount (according to current Hun- icy can be conducted; garian regulation up to Ft 1 million); foreign exchange deposit swap: a cen- discount factor: a conversion ratio at tral bank instrument, which provides which cash-flow items at different points of long-term forint financing to commercial time exchange hands; banks against the placement of a foreign ex- discount rate: the interest rate used in change deposit with the central bank. The the calculation of the discount factor; NBH terminated its use in March 1998; discount treasury bill: a debt security. foreign exchange market intervention: A special form of government paper gener- see ‘intervention’ ally of a maturity of less than one year, forward interest parity: a function de- which does not pay interest. It is sold at a scribing the relationship between spot and price below its face value and repays forward rates: it expresses that the total the face value upon maturity. It is issued yield on subsequent short-term forward in- by the Treasury with maturities of 3, 6 and vestments (to be launched in the future) 12 months; must equal the yield on a spot long-term in- disinflation: reduction or decline of investment of corresponding maturity; flation; forward rate: the interest rate on in- duration: the average maturity of a vestments starting at a future date. For in- cash-flow stream (for instance, interest pay- stance, the 6-month forward rate beginning ments and redemption of a bond) weighted in one year’s time is the expected interest with the present value of the cash-flow rate on a 6-month investment starting after items. Its magnitude reflects the sensitivity one year. In other words, the forward rate is of the price of the given financial asset to the interest rate for a future period of time changes in market yields. The higher the (in the previous example, for the period of

122 NATIONAL BANK OF HUNGARY GLOSSARY starting at one year’s time and ending in one indicators: economic and financial and half year’s of time from now on). The variables, which provide preliminary infor- forward interest parity establishes the rela- mation on the state of the economy and the tionship between spot and forward yields; evolution of fundamental variables; forward transaction: a transaction inflation expectation: inflation ex- where the purchase or sale is carried out at a pected for a future point in time or period; predetermined price at a specified future inflation targeting: a monetary policy date (see prompt transaction); framework in which the central bank explic- founders’ resolution: its scope may ex- itly declares its targets concerning the evo- tend to the election and recall of the elected lution of inflation in the future and under- members of the Board of Directors, deter- takes an obligation to meet those targets; mining the remuneration of the President, inflation: continuous and sustained the Vice President and the members of the rise in the general price level of goods and Central Bank Council, the Board of Direc- services; tors and the Supervisory Board; and to the alienation of a stake in a business organisa- interbank market: a segment of the tion to be regarded as non-resident accord- money market; the market of central bank ing to foreign exchange regulations. In addi- funds, where banks are the participants. tion, the General Meeting determines and Transactions concluded in the interbank amends the Articles of Association, deter- market are usually very short-term; the vast mines the equity and reserve capital, the majority of transactions are o/n transac- balance sheet, the statement of net assets, tions; the income statement and the distribution of interest rate corridor: the corridor profits. The General Meeting also approves marked by the central bank’s O/N (over- the statutes of the Supervisory Board; night, one-day) repo and/or deposit rates; gearing ratio: the ratio of the internal restrains movements of overnight interbank and external liabilities of a business; rates. Central banks use it in order to blunt gold standard: a monetary system in the undesirably large fluctuation of short- which the value of the currency of a country term rates; is equal to a fixed quantity of gold deter- interest rate premium: the part of the mined by law and the domestic currency ap- yield on domestic currency denominated in- pears in the form of banknotes which can be vestments in excess of the foreign yield and converted into gold at a specified rate. This the expected devaluation in the exchange system provides that the exchange rate re- rate. Investors demand higher yield when in- mains fixed within narrow limits against vesting into forint assets compared to dollar other gold-based currencies; or euro investments to compensate for the hyperinflation: extremely high infla- higher risk involved. This difference in de- tion. Generally, the term is used to charac- manded nominal yields corresponds to the terise a rise in the price level in excess of interest premium; 50% a month. Money does not fulfil or only interest transmission: see: ‘monetary partially fulfils its traditional functions (legal transmission mechanism’; tender, form of savings); intermediate target: a variable which implied forward yields: (implied) for- has a clear-cut influence on the ultimate ward yields calculated from the spot yield goal of monetary policy, and at the same curve according to the forward interest rate time which is under the control of the central parity; bank. Intermediate target may be a mone- indexation: linking the value of finan- tary aggregate (money or credit), nominal cial claims, prices or wages to some domes- exchange rate or even the central bank’s in- tic price index or exchange rate; flation forecast;

MONETARY POLICY IN HUNGARY 123 GLOSSARY

internal rate of return (IRR): the rate at determined by its current income position which the present value of an investment is and not its income flow expected over a lon- equal with its market value (its price); ger time horizon; intervention: central bank intervention liquidity management: in a broader on the foreign exchange market. The central sense, the activity of financial and bank influences the exchange rate of the do- non-financial enterprises in the course of mestic currency by buying or selling foreign which they ensure the liquid assets required exchange on the market. As a result of the for administering their business at the least intervention, the amount of central bank possible cost. In a stricter sense, the activity money in the economy changes (declining of the commercial banks in the course of with the sale of foreign exchange and grow- which they provide the liquid assets re- ing with its purchase); the effect of that can quired for the transactions of their clients be offset by sterilised intervention (see and the reserve requirement regulated by ‘sterilised intervention’); the central bank at the least possible cost; issue: issuance of money (banknotes liquidity situation, liquidity manage- and coins); ment of the central bank: the relationship lender of last resort: the central bank. between the actual and desirable level of To safeguard the stability of the financial bank reserves. There is a liquidity shortage sector (in particular the banking sector), the when the desired level is higher than the ac- central bank undertakes an implicit obliga- tual and the banks have to turn to the central tion to protect bank clients and provides bank for credit. Liquidity management is the banks in difficulties with sufficient liquidity money market activity of the central bank; it (central bank money) in order to avoid the shapes the demand for or supply of central bank’s collapse. When this obligation is ob- bank money so as to align them with the vious, a moral hazard situation may arise; central bank’s operating target, be that a limping gold standard: in the case of quantitative or an interest rate target; the Hungarian aranykorona (gold crown) monetary authority: the institution introduced in 1892 some of the specific fea- having a monopoly in issuing money (bank- tures of the classical gold standard were notes and coins), characteristically the bank missing, therefore, it was referred to as the of issue or the central bank; limping gold standard. Monometallism was monetary base (M0): the narrowest not enforced, which means that, apart from monetary aggregate, which contains cash gold, the silver coins minted earlier were and the commercial banks’ balance of the also accepted as legal tender and the stock forint accounts at the central bank. The cen- of silver was also included in the coverage. tral bank has a direct influence on the vol- Payment on demand, that is, the mandatory ume of the monetary base. The monetary conversion of banknotes into gold, was also base is also referred to as central bank not implemented and government papers money, base money or high-powered lacking coverage also remained in circula- money; tion; monetary conditions: variables de- liquid asset: an asset which can be scribing the stance (expansionary, restric- converted into cash quickly and at low cost tive) of monetary policy; generally the real (including exchange rate loss); interest rate and the real exchange rate; liquidity constraint: the maximum monetary transmission mechanism: amount of domestic and external liabilities the chain of effects in the course of which that may be used by an economic agent. changes in central bank instruments (policy For instance, we speak about a household rate) influence the consumption and invest- under liquidity constraint when, in the ab- ment decisions of the private sector, and sence of the possibility of borrowing, its thereby ultimately the central bank’s main consumption or investment decisions are goal (inflation);

124 NATIONAL BANK OF HUNGARY GLOSSARY

money illusion: this term is used to de- mented at a market price lower than its scribe the phenomenon when economic present value; agents are unable to distinguish nominal nominal anchor: nominal macroeco- and real changes. Owing to the money illu- nomic variables (e.g. exchange rate, wages, sion, an increase in the money supply can, money supply) directly targeted by an eco- for a transitory period, increase aggregate nomic policy, which aims at stabilisation, demand; in the longer term, however, the planned development of which serves as money illusion fades out and growth in the guidance or reference for setting other nom- money supply results in inflation; inal prices. Through this it helps in ‘anchor- money multiplier, money multiplica- ing’ inflation and inflation expectations. The tion: the money multiplier is the quotient of nominal anchor generally coincides with the a monetary aggregate (M1 or M3) and the intermediate target variable of monetary monetary base (otherwise central bank policy; money). Money multiplication is the pro- nominal variables: variables, which re- cess in the course of which a unit expansion flect changes in both prices (inflation) and in the monetary base increases the broader volume; monetary aggregate by a multiple—pre- one-tier banking system: the central cisely the value of the money multiplier—as bank responsible for monetary policy has a a result of the lending and money creating direct lending relationship with companies activities of commercial banks; and a wide range of the public; moral hazard: arises when certain open foreign exchange position: a for- agents of the economy can fully retain the eign exchange position is open when the profits of their activities, and at the same sum of the foreign exchange assets and for- time are able to shift their potential losses ward foreign exchange claims of a credit in- onto others at least in part. Such situations stitution in a currency does not correspond generally lead to excessive risk-taking. In to the sum of its foreign exchange liabilities relation to the banking sector, it arises when and forward foreign exchange debts. The to- banks can be certain that the government or tal open position of a credit institution is the the central bank would bail them out in an sum total of its (long and short) positions eventual crisis, therefore motivated by po- outstanding in the various foreign curren- tentially large profits, pursue a lending prac- cies expressed in domestic currency terms. tice which involves risks higher than the The open position according to the balance prudential level; sheet is the sum of the net open positions moral suasion: using its authority, the calculated on the basis of the foreign ex- central bank may persuade banks to alter change assets and liabilities presented in their behaviour informally (through bilateral the balance sheet of a credit institution; discussions, written warnings, etc.); open-market operations: the activity of net financing capacity: the final bal- the central bank in the course of which it ance of transactions in a given period linked sells or buys securities (primarily govern- to the claims and debts of a given sector. ment bonds) in order to influence the For instance, the net financing capacity of a amount of central bank money or the inter- household is that part of its income which is est rate level; not spent on consumption and investment, operating target: a variable on which and thus is available to finance other sectors the central bank is able to exert an effect di- of the economy; rectly and immediately and whose change net present value: the difference be- influences the intermediate target of mone- tween the present value and the current tary policy. Most frequently it is some kind market price. An investment is worth imple- of short-term money market yield; menting when its net present value is posi- outright operation: a transaction of tive, that is, if it can be bought or imple- purchase and sale where the asset constitut-

MONETARY POLICY IN HUNGARY 125 GLOSSARY ing the subject of the purchase and sale (se- assumption of excessive risk by credit insti- curity, foreign exchange) changes hands for tutions (for instance, the limits on capital good (see repo); adequacy and large credits). By complying overnight (O/N rate): the rate on with prudential rules, the credit institution (characteristically interbank) placements or must maintain its immediate and continu- credits maturing in one day, that is, starting ous creditworthiness (that is, its liquidity today and maturing tomorrow; and solvency); payment and clearing system: the set real exchange rate: the quotient of the of instruments, agreements, organisations exchange rate and the ratio of the domestic and institutions engaged in the intermedia- price level to the foreign price level. This is tion and settlement of payments; it enables an indicator of the competitiveness of an the administration of payments and the ex- economy as it presents the value of foreign change of the various assets in the financial goods expressed in terms of domestic markets (securities and foreign exchange goods. An appreciation of the real exchange transactions); rate implies monetary conditions becoming policy instrument: the instrument ap- more stringent, a deterioration in competi- plied by the central bank to set the interest tiveness and a reduction in aggregate de- rate deemed to be optimal for the state of mand and inflation, while devaluation the economy. Using it, the central bank in- means easing of monetary conditions, tends to exert a direct and effective impact which generally has the effect of improving on the money market yields and subse- competitiveness but also of raising the price quently on the interest rates charged by level. Monetary policy is able to influence banks to their customers; the development of the real exchange rate policy rate: the interest rate which best only in the short term; reflects the stance of monetary policy. This real interest rate: the part of nominal is usually the interest rate set on the central rates in excess of expected inflation. The bank’s main policy instrument; level of the real interest rate has an impact premium (lending risk, liquidity pre- on consumption, savings and investment mium): the surplus yield on a given asset decisions and thereby on aggregate de- relative to the yield on a risk-free asset, mand and inflation. By influencing the level which investors expect to compensate them of the real interest rate in the economy the for the various (political, counterparty, li- monetary policy aims to influence its inter- quidity, etc.) risks of the given asset. The mediate targets. expected (ex ante) and actually realised (ex post) yield may differ; real variables: variables net of price changes reflecting the volume effect only; present value: the value of future cash-flows today; real-time gross settlement system: a price stability: an economic environ- gross payment system (which performs ment characterised by a stable price level or clearing and settlement at the same time) in very low (0-2 per cent) inflation, so that in- which the processing of payment orders and flation is not a factor in the consumption and their final settlement take place continu- investment decisions of economic agents; ously with the immediate notification of the primary market: the market for issuing concerned participants in contrast to the net securities for the first time; system (where the moment of settlement prompt transaction: a foreign ex- and of clearing are separated in time) or the change or security transaction where settle- gross systems with delayed settlement ment is simultaneous with the conclusion of (such is, for instance, the interbank clearing the contract (see also ‘forward transaction’); system earlier referred to as the giro); prudential regulation: regulation by redemption yield: see ‘internal rate of the supervisory authority which curtails the return’;

126 NATIONAL BANK OF HUNGARY GLOSSARY

refinancing credit: forint credit ex- shock: an external effect reaching the tended by the central bank to commercial economy, which displaces macroeconomic banks in order that they onlend them to variables from the equilibrium courses; business organisations (under specified short- or long-term: relative terms. In fi- programmes); nancial terminology, short-term is shorter repo transaction: security repurchase than one year, long-term is longer than one agreement. A combination of two purchase year. In economics, short-term refers to a and sale transactions of opposite directions, time interval within which the supply side of where an asset (generally a government pa- the economy is able to respond to demand per) exchanges hands in the present and at effects only partially, because a part of the the same time a reverse future transaction is factors of production are given, while in the also concluded for a pre-specified date and long term, all production factors may adjust; price. Its purpose is to extend a short-term small, open economy: economic the- credit or to place a short-term deposit; ory regards a country small when it is in a repo: security repurchase agreement price taker position in its export and import where one party (e.g. the central bank) buys markets. The measure of openness is the securities (generally government papers) extent of the country’s economic relations and sells them forward to the other party (a with non-residents, i.e. its foreign trade; bank) from whom it had bought them at a characteristically, it is defined by the share date and price specified upon conclusion of of the sum of export and import in GDP; the transaction. The repo may be inter- spot transaction: see ‘prompt transac- preted as lending against collateral of secu- tion’ rities (see also reverse repo; repo transac- sterilisation: all the central bank oper- tion); ations, the purpose of which is to offset the reserve requirement (ratio): commer- effect of foreign exchange market interven- cial banks must hold a portion of their de- tion on the domestic money supply. For in- posits and other liabilities as reserves at the stance, by increasing the central bank stock central bank, the portion is determined by of deposits or bonds to an extent identical the reserve ratio. Raising the reserve ratio with that of the foreign exchange market in- decreases, reducing it increases the money tervention; supply in the economy; sterilised intervention: a harmonised restrictive monetary policy: a mone- series of central bank operations, in the tary policy which results in a decline in ag- course of which the central bank intervenes gregate demand (slower increase in the in the foreign exchange market to maintain money supply, higher real interest rates or the exchange rate target and at the same more appreciated exchange rate); time offsets the liquidity impact of interven- reverse repo: a security repurchase tion with open-market or other operations; agreement, where one party (e.g. the cen- supervision by the central bank: su- tral bank) sells securities (generally govern- pervision of compliance with reporting obli- ment papers) and repurchases them at a fu- gations and provisions of certain legal regu- ture date and price specified upon conclud- lations (for instance, central bank ordi- ing the transaction. A reverse repo con- nances); ducted by the central bank can be inter- sustainable inflation reduction: a term preted as an acceptance of a deposit, in the used by the NBH to describe its objective course of which the central bank withdraws function. The ultimate goal of reducing infla- liquidity from the banking sector (see also tion is constrained by the need to maintain repo); external equilibrium; secondary market: the market for the swap transaction: a purchase and sale purchase and sale of securities issued ear- agreement, pursuant to which the contract- lier; ing parties swap future cash-flows under

MONETARY POLICY IN HUNGARY 127 GLOSSARY conditions specified in advance. In a foreign the agents of the economy. Transparent op- exchange swap transaction, the contracting eration contributes to the establishment and parties contract to exchange cash-flows maintenance of a credible monetary policy; specified in different currencies. Swap two-tier banking system: the bank of transactions (beside futures and options) issue responsible for monetary policy is in are the fundamental instruments of risk direct relationship only with banks and other management; financial firms (eligible counter-parties). time inconsistency: a term used to de- These counter-parties mediate the mone- scribe all or certain parts of economic pol- tary policy measures to the companies and icy. Time inconsistency is mentioned when a wide range of the public; an economic policy, which is optimal at yield curve: yields (interest rates) plot- present, is expected to be sub-optimal in the ted against maturity; yields represented as a future and thereby the government feels function of maturity. Central banks most tempted to deviate from its declared poli- frequently calculate the yield curve from cies. The most characteristic example is government securities market data; when following wage negotiations the gov- zero-coupon yield: the yield (discount ernment, which aims at curbing inflation, rate) at which a zero-coupon security can be makes measures that lead to higher than ex- issued under the given market conditions. pected inflation with a goal to achieve Zero-coupon assets repay their face value in higher growth or better external equilibrium; a single amount at maturity. Zero-coupon tradable goods: goods and services yields can also be calculated from financial actually or potentially participating in for- assets, which pay interest and principal sep- eign trade; arately. When the cash-flow stream from a transmission lag: the time necessary financial asset is discounted with the corre- for a monetary policy measure to reach its sponding zero-coupon yield, the sum of the full impact; present value of the cash-flow items (that is transparency: transparency of the op- the present value of the asset) will be equal eration of the central bank as perceived by to the market price of the asset.

128 NATIONAL BANK OF HUNGARY INDEX

A competitiveness 50 consolidated balance sheet of the banking accomodative regulation 105 sector 62 Act LX of 1991 on the Central Bank 16 continuously available standing facility 98 Asset and Liability Committee (ALCO) 38 convertibility 28 Austro-Hungarian Bank 10 correspondent members 32 averaging method 92 crawling exchange rate 102 crawling peg exchange rate regime 50, 73, 74 B credibility of economic policy 54, 69 credit crunch 48 bank failure 22 credit quota 81 Bank of International Payments (BIS) 12 currency basket 54, 87 bank of the banks 15 current account 62 bank supervision 29 Banking Committee 38 banknote issue 18, 19 D board of directors 36 broad money (M3) 61 daily coverage assessment 96 Budapest Commodity Exchange (BCE ) 32 data collection and reporting 19 Budapest Stock Exchange (BSE) 31 debt crisis 14 de facto independence 39 default risk 55 C delivery-type repo 95 deposit insurance fund 22 Central Bank Council 35, 40, 41 direct instruments 81, 89 central bank independence 12, 39, 41 discount factor effect 68 central bank instruments 53, 57, 88, 94, 100 discount Treasury bill auctions 84 central bank money 20, 89, 90, 91, 108 discretionary regulation 105 Central Depository and Clearing House disinflation 47 (Budapest) Co. Ltd. (KELER) 31 duration 72 Central Statistics Office 34 DVP (Delivery Versus Payment) 32 centralised interbank money market 83 change in interest rates 100 coincident indicators 71 E collateral assessment 96 communication by the central bank 70 ECB (European Central Bank) 92 compensation paid on the reserves 93 economic costs of inflation 47

MONETARY POLICY IN HUNGARY 129 INDEX eligible counterparties 111 inflation targeting 53 exchange controls 12 Interbank Clearing System 32 exchange rate 53 interbank payments 30 exchange rate course 73 interest rate ceiling 98, 107 exchange rate risk 73 interest rate corridor 76, 97 exchange rate risk premium 74 interest rate floor 98 exchange rate target 53 interest rate tender 97 exemption from the reserve requirement 92 interest rate transmission 71 expected interest premium 73 intermediate target 52 external equilibrium 50 intermittently available standing facility 101 internal rate of return (IRR) 65 F International Monetary Fund 15, 28 intertemporal optimisation of consumption financing the central budget 24 68 fixed exchange rate regime 51 intervention 72, 74, 87, 101, 107, 109 forecast 109 issue 18 foreign exchange centre 11, 12 issue of coins 19 foreign exchange debt 51 foreign exchange deposit swap facility 85 K foreign exchange licensing authority 27 foreign exchange reserve 18, 25, 102 KELER Rt., Central Depository and Clearing foreign exchange structure of reserves 26 House (Budapest) Co. Ltd. 31, 111 foreign exchange swap 86 KESZ, Unified Treasury Account 24, 109 forward foreign exchange market 75 Keynesian school 45 forward interest parity 77 free liquidity 109, 110 L free tender 97 law harmonisation 42 leading indicators 70 G legal (de jure) independence 39 general meeting 35 legislative function 27 giro (Interbank Clearing System–BKR) 32 lender of the last resort 17, 21 Giro Payments Co. Ltd 31 lending risk premium 72 gold standard 10 licensing 27 government paper market outside the stock liquidity management 93 exchange (OTC) 32 liquidity management at a bank 91 government’s banker 23 liquidity planning by the central bank 106, 108 liquidity shortage 21 H haircut 96 M hold-in-custody repo 95 hyperinflation 13 monetarist school 45 monetary aggregates 59 I monetary base 59 Monetary Committee 38 implied forward yields 65 Monetary Conditions Index (MCI) 57 income effect 68 Monetary Policy Guidelines 70 indexing of tax systems 48 monetary transmission 68 indicators 57 money in circulation 60 indirect instruments 81, 89 money market crises 22 inflation expectation 66 money multiplier 60

130 NATIONAL BANK OF HUNGARY INDEX money supply 21 reducing the rate of devaluation 75 monopoly of issuing 17 refinancing channel 82 Monthly Report 35 repo 84, 94,109 moral hazard 106 repo line 106 Report on Changes in Inflation 70 N reserve base 90 reserve period 93, 100, 107 narrow money (M1) 61 reserve requirement 21, 23, 82, 86, 89, 109 NBH bond 58, 74, 96, 102, 103 reserve requirement ratio 91, 92 new-classical macroeconomics 46 reverse repo 84, 95 net financing capacity and requirement 62 Royal Hungarian Note Issuing Institute 11 New Economic Mechanism 14 Russian exchange rate crisis 74 nominal anchor 52 non-tradable sector 56 S

O S.W.I.F.T. Society for Worldwide Interbank Financial Telecommunications 33 OECD membership 28 secondary securities market 94 one-tier banking system 13 settlement account 20, 30 open foreign exchange position 74, 75, 83 short-term costs of disinflation 48 open-market operation 89, 94, 105 signalling 100 operating target 52, 56, 57, 104 small, open economy 50 operational independence 40 social costs of inflation 47 outright operations 94 soft budget constraint 82 overdraft 98 speculation 74, 100 speculation against the exchange rate 56 P State Money and Capital Market Supervision (SMCS) 27, 29, 30 period of placement 90 statistical service 34 personal independence 39 sterilisation 94, 96, 101, 103 Phillips curve 45 sterilisation costs 102 pivoting 77 sterilisation instruments 58 policy instrument 76, 96, 99, 103 sterilised intervention 58, 74 Post Office 34 supervision by the central bank 29 president 37 supervisory board 36 price stability 18, 46 surplus cost caused by the reserve requirement 93 surplus liquidity 72, 73 Q sustainable reduction of inflation 49 Ouarterly Report on inflation 70 swap 96 quick tender 77, 91, 95, 96, 97, 104, 106, 107, 111 T

R TARGET 33 target value 52 rate of devaluation 50, 54, 56 tender 95, 96, 97 rational expectations 46 Terms and Conditions Of Business 97 real exchange rate effect 69 tradable sector 56 real-time gross settlement system (VIBER) transmission mechanism 46, 52, 69, 72, 33 100, 101, 105

MONETARY POLICY IN HUNGARY 131 INDEX transparency 42 W treasury 108 treasury bill 83 wealth effect 68 treasury bill auction 94 World Bank 26 two-tier banking system 15 Y U yield curve 63, 65 ultimate goal 41, 45 yield curve theories 64

Z V zero averaging 92 variable rate tender 97, 107 zero-coupon yield curve 66 vice president 36 zero-coupon yield curve estimated volatility 106 by the Svensson method 66

132 NATIONAL BANK OF HUNGARY