X Monetary and Financial Issues in German Unification Garry J. Schinasi, Leslie Lipschitz, and Donogh McDonald This chapter examines some of the issues that arise in At a microeconomic level, it is important that the the process of integrating the monetary and financial restructuring of the east German financial system trans­ system of the former German Democratic Republic form it quickly into an efficientchannel of intermediation. (GDR) into that of the Federal Republic of Germany Given that the financial market is open to the participation (FRG). The topic is divided into three broad areas: an of banks from west Germany and other countries and is analysis of the currency conversion. an examination of subject to the same laws and regulations that govern the difficulties that will be faced in conducting monetary financial markets in west Germany. the efficiency of the policies in the new environment, and issues related to financial system is unlikely to be limited by its structure. the restructuring of the financial system and its prospec­ The principal concern is to ensure that bank lending and tive performance at a microeconomic level. deposit policies are responsive to market signals, eco­ The conversion of GDR marks into deutsche mark nomic incentives. and a proper evaluation of risks and was a monetary event and thus, in principle, should not returns. In particular, it is important thatlending decisions have a long-lasting effect on the real economy. However, are consistent with an efficient distribution of resources the conversion process will influence inflation. current and are not determined by a perception that the Trust payments (such as wages) in the very short run, and the Fund (Treuhandansta/t) or the Government will stand distribution of wealth between debtors and creditors . For behind certain preferred cred its. east Germany, the conversion rate has important impli­ cations for the distribution of wealth: between the State Mechanics of the Conversion and households on one level, and within the old state sector (comprising the Government, the banking system, Following the announcement of currency union, there and the state enterprises) on another. Under the old was widespread debate on the conversion rate. Some system. households were financial creditors (through considered a rate of M I = OM I to be appropriate, as their savings deposits). while the State was a net financial it was judged to be the rate that would set starting wages debtor; obviously the redenomination of the creditor and in the GDR relative to those in the FRG in line with debtor positions affects both. Within the old state sector. relative prod uctivity levels.1 Others suggested conversion the distribution of financial positions is important because rates ranging as high as the prevailing free-market rate. 2 the economic reform enrails a breaking up of this sector There was also some discussion of a schedule of con­ into a banking system and an enterprise system that are version ra tes varying by type of asset and liability, as independent of government. The financial solidity of the was done in the conversion of reichsmark to dcutsche banking system and the burden of debt on the enterprise mark in 1948.3 sector are the key considerations in this context. The broad outlines of two official proposals were made Monetary control will be more difficult. The Deutsche public before agreement was reached by the two Gov- Bundesbank is detern1ined to maintain a low-inflation ' Sec the discussion of wage and productivity leveb in the GDR in stable financial environment. A combination of higher Chapter lfl. section on "Economic Background ·· fiscal deficits, rapidly ri sing demand, and an anti-infla­ �In December 1988. the market rate in We�t Berlin averaged M 7.75 = OM I. In January 1990. it was about M 7 = OM I. The tionary monetary policy would create tensions in most mark appreciated following the announcement of currency umon to circumstances: given the limited guidance as to how the M 5.75 = OM I in February und to M 2.75 = OM I in June 1990. demand for money and credit will evolve in east Gem1any. ' For a discu�sion of the 1948 currency conver>ion �ec Thoma$ Mayer and Gunthcr Thumann. "Radical Currency Rctom1: Gcrm;my. the conduct of monetary policy will be even more 1948. ·' Finance & Del'e/opmem (Washington). March 1990. pp. challenging in the present circumstances. 6-8. l44 ©International Monetary Fund. Not for Redistribution Mechanics of the Conversion ernments: the Bundesbank's proposal and a proposal that The consolidated balance sheet for the banking system emerged from the Government in Bonn.�The Bundesbank of the GDR as of June 30. 1990 was not available at the proposal. published on April 2. 1990. called for a time of writing. However. the balance sheet implications conversion rate of M 2 = OM I for all assets and of the conversion agreement can be approximated from liabilities denominated in marks, except for bank accounts the position at the end of May (Table I). As of that date, up to M 2,000 per person, which would be converted at financial assets with a book value of M 447 billion were the rate of M I = OM I. Other important features of on the books of the various financial institutions in the the proposal were as follows: participation in GDR state GDR. Credit to enterprises amounted to OM 232 billion properties would compensate holders of bank accounts (52 percent of assets), balanced in part by enterprise in excess of M 2.000 for the less favorable conversion deposits of DM 57 billion. Credit to the housing sector rate: the Bundesbank would have full control over totaled DM 103 billion. On the liability side of the monetary policy in the GDR; the GDR would adopt FRG balance sheet, the largest single item was deposits of banking law. with banks from the FRG and abroad households totaling M 182 billion (40 percent of total allowed to set up establishments in the GDR: and interest liabilities). The other key liability for the conversion rates and fore ign currency transactions would be fully process was the liability position of the State Bank to liberalized. Current payments would also be converted future exporters-the Richrungskoeffi:ielllen (RIKOs). at the rate of M 2 = OM I. but wages and pensions see below- reflecting the difference between the official would be adjusted to compensate for subsidies removed exchange rate and the exchange rate used in fore ign before currency union and for the introduction of social trade. security contributions. Table I shows the results of applying the conversion The Bonn proposal, announced on April 23, 1990. rates to the balance sheet at the end of May. On this differed somewhat concerning the treatment of savings basis, the banking system would have had assets with a deposits and current payments. It called for a rate of M book value of OM 246 billion and a net worth of OM I = OM I for currency and deposits up to M 4.000 for 23 billion (91f2 percent of total assets). It is u eful to each individual and a rate of M 2 = OM I for the describe the key elements of the conversion of assets and remaining balances: a rate of M 2 = OM I for all other liabilities. assets and liabilities denominated in marks: and a rate of M I = OM I for wages and pensions, with no Liabilities compensation for the removal of subsidies. On May 2. 1990 the Governments of the GDR and Taking into account the favorable conversion rate For the FRG announced a jointly agreed plan for currency a portion of household deposits. the average conversion conversion that would take effect on July I , 1990. rate for GDR mark deposits was about M 1.6 = OM I. Financial t:laims and liabilities of permanent residents For fore ign currency liabilities. market rates were applied and enterprises would be converted at M 2 = OM I. as far as possible. while equity capital was converted at However. as an exception to this general fo rmula. M I = OM I. However. the average ovenrll conversion individuals would be allowed to convert limited sums at rate was M 1 .8 = OM I. This relkcted the nonconver­ a more favorable rate of M I = OM I, according to the sion-that is, a writing down to zero-of the RIKO fol lowing schedule: M 2.000 for persons under 14 years: fund. M 4.000 for persons of 14 to 58 years: and M 6.000 for The RIKO fund can be interpreted as a reserve to help persons 59 years and older. Wages. salaries, stipends, linance future export activities of GDR enterprise�. The rents. leases, and other maintenance payments would be valuation of the fund resulted from an internal accounting conv�rtcd at M I = OM I. with wages and salaries set system involving an official exchange rate and a more initially at their gros� lcveb as of May I. GDR pensioners depreciated commercial rate. The difference between the would be provided the same benefits in relation to earnings two exchange rates was in essence a tax on importers as in the FRG.' Deposits in marks held by persons with and a subsidy to exporters 6 The surplus in the fund residence outside of the GDR would be converted at M '' There arc lW!\ w�y� of viewing rhc opcrarion' ol rhc RI KO lund. 2 = OM l if acquired up to December 31. 1989. and Thar prcsenred here �larb \\'ilhrhc "''umprion thal rhe aclllal cxchang.: at M 3 = DM I if acquired between January I.