Av Oana Gherghinescu
This paper aspires to highlight two of the main cha(lle)nges that Romanian monetary policy will face starting in 2004, namely: 1. shifting in monetary policy framework from monetary targeting to inflation targeting and 2. applying denomination, that is cutting off the last 4 zeros of national currency amounts and shifting from the “light” ROL1to the “hard” ROL.
The Shift in Monetary Policy Framework
Theoretical and Empirical Background
It is obvious that one of the most important consequences of macroeconomic principles upon monetary policy is the focus on price stability as a fundamental objective. This objective is targeted by central banks either in an explicit way – through direct inflation targeting (Great Britain, New Zealand etc.), or in an implicit way – through targeting monetary aggregates (Sweden, European Monetary Union, United States of America etc.).
According to the present institutional arrangement, the fundamental objective of monetary policy in Romania is ensuring the stability of the national currency, thus providing price stability in the economy. This fundamental objective is to be achieved in an implicit manner, by establishing certain intermediary objectives – the monetary aggregates.
The adverse macroeconomic environment during transition prevented the National Bank of Romania (NBR) from exclusively focusing on the objective of disinflation, given the evolution in certain periods of the current account, which has forced the monetary authority to pay attention to another target – that of keeping the current account deficit between sustainable limits by promoting an adequate management of the exchange rate. We herewith encounter a concluding example on the complexity of monetary policy choices: to fight inflation no matter what happens with the current account or to give a helping hand to exporters by devaluating the national currency although this might annul the disinflation efforts?
Beside that, the persistency of high inflation in Romania during the transition period can be explained through the contribution of four main responsible factors, namely:
1. the inertial component – inflation expectations have played a crucial part, as population and enterprises began to feed a certain routine specific to inflationist environments, learnt to give their own interpretations to monetary authority declarations and punished the lack of credibility and time consistency of monetary policy;
2. disobeying the correlation between labor productivity and wages, given the weak budgetary constraints, especially in the relationship between the government and non-government sectors. In an economy characterized by precarious financial discipline, liquidity is only directed towards paying wages, enterprises cease to produce added value and start generating arrears – false money, very difficult to sterilize. The main cause is the state-owned sector, which, on the background of weak savings, preserved a single function – the wage policy;
3. the threat represented by the increase in unemployment rate – applying the policy for reducing internal absorption in order to achieve disinflation would have led to a spectacular increase in unemployment, given the fact that the negative correlation between inflation and unemployment has worked, at least in a short run, in Romania;
4. imported inflation – that is an increase in the costs of intermediary consumption because of the national currency depreciation.
The successful use of the monetary anchor as a monetary policy objective within the framework of monetary targeting has been diminished by the fact that the monetary base contributed largely to the unjustified increase in broad money rather than the money multiplier.
The main destinations of monetary base injections, leading to an increase of 31.96% in this indicator value (in comparable prices) between 1993 and 2001 included:
- the credit to Government granted by the National Bank of Romania in order to cover the state budget deficits;
- the credit to banks confronted with difficulties or in process of restructuring;
- purchasing foreign currency by the NBR in order to promote the competitiveness of exports, by preventing the nominal appreciation of the ROL.
In these circumstances, the possibility of shifting to an alternative monetary policy framework has been suggested – direct inflation targeting, starting with 2005.
Rationale, pre-requirements and impediments
Within the framework of inflation targeting, the explicit target set for inflation imposed by the Government to the Central Bank, for which the latter is made directly and solely responsible, represents the final objective of monetary policy.
Cukierman2 considers that the choice between monetary targeting and inflation targeting implies a compromise between controllability and visibility. He suggests that the shift to inflation targeting regimes must occur when monetary authorities have a strong enough reputation in order to keep control upon broad money evolution.
In order to establish the opportunity of shifting to inflation targeting in Romania, the following institutional pre-requirements have been analyzed:
- the independence of NBR in promoting monetary and exchange rate policy – it is promoted by the statute of the NBR, but still incompletely put into practice because of the lack of fiscal discipline, the persistence of fiscal dominance and the incipient infrastructure of financial markets in Romania;
- NBR should focus on achieving only one objective – that of price stability and consolidate the interest rate channel as an efficient instrument for promoting monetary policy decisions;
- the banking system must function properly from the point of view of capitalization and profitability and NBR must keep on improving the prudential and supervision regulations;
- another aspect that should be taken into account is the high degree of “dollarization” within the economy. In the context of implementing inflation targeting, special attention should be paid to the financial institutions that would be able to protect the system form exchange rate generated shocks;
- monetary policy decisions should become more transparent and NBR should be made accountable for the degree in which the targeted objectives have been accomplished.
On the other hand, implementing inflation targeting requires a set of technical premises such as:
- the shift from the Consumer Price Index as indicator for inflation to the Core Inflation Rate, which eliminates the influences of seasonal and subsidized prices;
- building up an econometric model for establishing the correlation between nominal and real variables as well as the trend of prices for at least 12 months in advance, taking into account economic agents’ inflationist expectations.
It is expected that all these pre-requirements should be met by the end of 2004, thus leaving free way for adopting inflation targeting starting with 2005.
Denomination of the Romanian Leu or “The Hard ROL Tales”
It is more than obvious that the amounts denominated in Lei have too many zeros in the end, which only make it difficult to work with national currency and could be thus ignored. The process of cutting off these digits is neutral in the sense that it generates neither losses nor gains. Nevertheless, beside the practical reasons of facilitating the operations with national currency, it has a strong psychological connotation – that of marking up the beginning moment of sustainable macro stabilization.
The signal sent to both Romanian population and the international business community is extremely important: the state declares that it keeps fighting inflation, which is supposed to create a climate of trust, to confer credibility, facilitating the promotion of sometimes unpopular actions required by the anti-inflation policies.
The issues related to adopting the “hard ROL” have been tackled since 1997 but it was only in November this year that NBR Governor, the Prime Minister and the Minister of Finance have decided on the opportunity of this measure and pointed out the beginning of 2005 as the most appropriate moment for initiating the process.
The main pro for denomination in Romania is making the work with national currency more efficient. Banking is not only confronted with 10-15 digit amounts which are too large for the computer displays.
Although at first glance denomination seems to be a solely technical process, the issue is more complex, taking into account the fact that inflation comprises, beside the structural and corrective components, a very strong psychological component. All the countries that have adopted this measure got gains in fighting inflation because the psychological reaction vis-à-vis a nominally stronger currency has been proved in practice by the impetus for savings and investments.
The main costs incurred by this operation include:
- The exchange costs – for issuing, inventorying and transporting the new bank notes and coins;
- The attractive price channel – the shift from “weak lei” to “hard lei” can lead to an increase in the so-called “attractive” prices (the ones that end by 0, 5, 9 or 98). Thus, a product whose old price is 230,000 lei and should cost 23 new lei would probably cost 25 new lei (an increase with approx. 9%);
- The channel of prices set up by monopolies – denomination would give monopoly enterprises the opportunity to increase prices to a higher extent than justified.
Although it has been criticized because of the costs incurred by changing all the banknote and coin structure, denomination must be also analyzed from the perspective of optimizing this structure in the Romanian economy.
The costs must not be estimated as gross amounts (their level is said to be somewhere between 20 and 30 million USD), but as net amounts as compared to the much higher expenses incurred by issuing the necessary bank notes.
In the context of strong nominal depreciation of the ROL during the last three years (with almost 120% vis-à-vis the EURO) the banknote with the highest nominal value is worth less than 13 EURO. Normally speaking the most valuable banknote should be worth at least 40-50 EURO. The 1,000,000 lei banknote (which is worth approx. 25 EURO) is about to be issued and if denomination was not adopted, it would have been necessary to issue the 5,000,000 lei banknote in the near future.
As NBR has not the full power to decide on proceeding to denomination, a law adopted by the Parliament in this respect is needed.
The National Bank of Romania needs around 12 months in order to prepare the operation. The new bank notes will be made of paper, not of plastic like the ones in circulation at the moment, because of the pressure exercised by European producers. The most expensive will probably be the issuing of coins.
During the first year following denomination, old and new money will circulate simultaneously.
If Romania had not achieved denomination by 2005, it would have remained the only candidate country which needs 5 digits in order to express its exchange rate vis-à-vis the main foreign currencies.
I hope that this article managed to catch a “bird’s eye view” over the present and near future of monetary policy in Romania.
I intended to highlight two main challenges that monetary policy will be confronted with starting with 2005, the first one is especially well known in Sweden.
Last but not least, I wish to show that efforts to fight inflation in Romania have become more and more consistent during the last three years and that further decisive steps are about to be taken.
1 Romanian Leu – Romania’s national currency; singular Leu – plural Lei
2 A. Cukierman, Towards a Systematic Comparison between Inflation Targets and Monetary Targets, from Sylvester C.W. Eijffinger and Jakob de Haan, European Monetary and Fiscal Policy, Oxford University Press, 2000, p.60