View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Policy Documentation Center GERMAN ECONOMIC TEAM IN BELARUS 76 Zakharova Str., 220088 Minsk, Belarus. Tel./fax: +375 (17) 236 1147, 236 4395 E-mail: [email protected]. Internet: http://research.by/ PP/17/04 Monetary and Exchange Rate Policy in Belarus: Analysis and Recommendations Summary This paper describes and evaluates the current monetary and exchange rate policy of the National Bank of Belarus. After a short description (Part 1), an assessment of the National Bank's policy is provided by means of raising and answering three questions. First, we ask whether the current focus on external (i.e. exchange rate) rather than on internal (i.e. price) stability is appropriate (Part 2). Several arguments are pre- sented in support of the existing focus on external stability. Second, the question on the right implementation of external stability is raised (Part 3). Instead of the current practice of targeting the US Dollar, we recommend to target a currency basket con- sisting of three currencies: Russian Ruble, US Dollar and Euro. Besides, we agree in principle with the usage of a crawling band, but the public should be informed more accurately about it. Finally, we examine whether the current level of the exchange rate is suitable (Part 4). Devaluation will only become necessary, if the government fails to improve the investment climate and to attract foreign capital as a source of current account deficit financing. Contents 1. The current monetary and exchange rate policy in Belarus..................................2 2. Should the focus be on internal or external stability? .........................................3 2.1. Arguments in favor of external stability as the predominant objective ............3 2.2. Arguments against internal stability as the predominant objective .................4 3. How should the goal of external stability be implemented? .................................5 3.1. Choice of anchor currency........................................................................5 3.2. The fluctuation band and the development of the central parity.....................7 3.3. Announcement of the exchange rate policy ................................................8 4. Should the Belarusian Ruble be devalued?........................................................9 1. The current monetary and exchange rate policy in Belarus According to article 25 of the Banking Code, the goal of the National Bank of Belarus (hereafter: NBB) is to ensure the stability of the Belarusian Ruble, including both its purchasing power and the exchange rate to other currencies. In the long term, i.e. pe- riods of more than five years, these objectives can be considered as complementary.1 However, a key insight from economic theory and practice is that it is usually not pos- sible to simultaneously satisfy these objectives in the short term. The coexistence of multiple objectives may become a source of policy conflict, which has to be avoided by setting a clear hierarchy of priorities. Consequently, the NBB has to make the funda- mental decision, whether its policy should be focused on reaching internal (i.e. price) or external (i.e. exchange rate) stability. The NBB chose for the time being to concen- trate on external stability. Chart 1. Exchange rate of the Belarusian Ruble to the US Dollar and the Russian Ruble 130 Index 125 120 115 110 105 100 Nov- May- May- Jul-03 Jul-04 Jan-03 Jan-04 Oct-03 Jun-03 Jun-04 Apr-03 Apr-04 Feb-03 Feb-04 Mar-03 Mar-04 Dec-02 Dec-03 Sep-03 Aug-03 Aug-04 BYR/USD BYR/RUB Source: National Bank of Belarus. Note: December 2002 = 100. The concrete implementation of this fundamental decision can be described using Chart 1. The development of the BYR/USD exchange rate is very smooth and espe- cially much smoother than the BYR/RUB exchange rate. This clearly indicates that the Belarusian Ruble is pegged to the US Dollar (and not to the Russian Ruble). Further- more, one can see that the BYR/USD rate is not constant over time. Thus, we are dealing with a crawling peg to the US Dollar. Besides, the rate of devaluation is not constant over time. While in 2003 the Belarusian Ruble depreciated at a monthly rate of 1% vis-à-vis the US Dollar, the exchange rate has practically remained unchanged since the start of 2004. Apparently, the devaluation rate can be adjusted on short no- tice, if the monetary authorities consider this to be justified. As is usual the case with crawling pegs, a band exists within which the exchange rate is allowed to fluctuate. This band seems to be rather tight. Since 2004 the observed fluctuations around the central parity did not surpass 1%. To sum up, a crawling band based on the US Dollar seems to be in place. But this crawling band seems to be rather flexible in the sense that the devaluation rate can be adjusted on short notice. Furthermore, the existence of this crawling band has not been communicated to the public in an explicit manner.2 1 This view is empirically supported by the fact that economies with a focus on internal stability, i.e. a low rate of inflation, normally exhibit also a high degree of external, i.e. exchange rate, stability in the long-term. Vice versa, countries with chronically high rates of inflation tend to have weak currencies. 2 De jure (as stated in the Monetary Policy Guidelines for 2004), the NBB targets the Russian ruble according to a smooth path of devaluation with a fluctuation band of 4–5%. The chart makes clear that this guideline has not been followed in 2004, as the Belarusian Ruble has revalued vis-à-vis the Russian Ruble. 2 After this short description of the current monetary and exchange rate policy, we move on to evaluate the policy of the NBB on the basis of the following three key questions: Question 1: Is the NBB right to focus on external (i.e. exchange rate) stability or should it consider a strategic shift towards internal (i.e. price) stability? Part 2 ad- dresses the fundamental choice between internal and external stability. Question 2: Is the current implementation (definition) of the external stability appro- priate? In Part 3 we discuss alternative exchange rate policies. Question 3: Does the NBB target the proper level of the exchange rate? Part 4 exam- ines whether a depreciation of the national currency is necessary to achieve an exter- nal equilibrium. 2. Should the focus be on internal or external stability? As described above, the NBB faces the fundamental choice between the objectives of internal and external stability. For Belarus, we recommend that external stability should be the predominant objective of the NBB, which is in line with its actual policy. It follows then that the internal stability objective has to be subordinated to this ob- jective. Our recommendation is based on two arguments in favor of external stability (2.1) as well as on two arguments against internal stability (2.2) as the predominant objective. 2.1. Arguments in favor of external stability as the predominant objective Fixed exchange rates and disinflation Many emerging markets that have suffered chronically from very high or even hyper- inflation have adopted a fixed exchange regime in the hope of rapidly reducing their rate of inflation. General arguments in favor of pursuing fast disinflation are better al- locative efficiency and signaling effect of prices. Fixing the value of the own currency to that of a more stable currency, which is ex- actly what an exchange-rate peg involves, provides a stable and credible nominal an- chor for the economy that has several important benefits. First, the exchange-rate peg fixes the inflation rate for internationally traded goods, and thus directly contrib- utes to keeping inflation under control. Second, a credible exchange rate peg will also reduce domestic inflation expectations to the inflation rate in the anchor country. The lower inflation expectations will then bring the domestic inflation rate in line with that of the stable anchor country relatively quickly. Finally, an exchange rate peg may be more transparent than an internal policy target (e.g. monetary and credit aggregates or the inflation rate). The simplicity and clarity of a peg that is easily understood by the public enhances the credibility of such a policy target. However, an exchange-rate peg has certain implications for domestic policymakers. The regime is inherently fragile, because an attack on a pegged exchange rate can force the abandonment of the peg by stripping away the country’s foreign reserves. Policymakers must therefore be able to convince the public that they are willing and able to defend the fixed exchange rate. The commitment to a pegged exchange rate is implicitly a commitment to monetary and fiscal stability, without which a fixed ex- change rate cannot be sustained. High level of foreign trade The Belarusian economy shows a high degree of openness to foreign trade (Chart 2). In this context, the generally cited advantages of fixed exchange rates are the elimi- nation of exchange rate risk that should stimulate increased trade and investment. Fixed exchange rate regimes provide greater certainty for exporters and importers and can exert a strong discipline on domestic firms and employees to keep their pro- 3 duction costs under control in order to remain competitive in international goods mar- kets. This argument is especially important for an open economy such as Belarus. Chart 2. Openness of the Belarusian economy (merchandise trade turnover in % of GDP) 170 % of GDP 160 150 140 130 120 110 100 2000 2001 2002 2003 Source: calculations based on data of the NBB and the Ministry of Statistics and Analysis. Another potential benefit of a fixed exchange rate regime is that by providing a stable foreign value of the currency, this might lower risk for international investors and thus encourage capital inflows, which could stimulate growth.