- Tomás Baliño, Charles Enoch, and William Alexander
- Published Date:
- July 1995
Poland had a centrally planned economy until the late 1980s when it undertook comprehensive economic and financial reforms, including adoption of indirect instruments of monetary policy. The transition to indirect instruments of monetary control has met with notable success, although some refinements are still necessary. The reform has been multifaceted, covering several central banking functions simultaneously as well as parallel reforms to strengthen the payments system and modify the regulatory framework. Important strides have been made in strengthening the institutional framework, improving the accounting and payments system, fostering the development of money markets, and widening the array of instruments available to the central bank for the conduct of monetary policy.
The National Bank of Poland (NBP) now relies on open market operations as its main instrument of monetary control. Banks have also adapted well to the new monetary policy instruments and the new legal framework and have begun to compete actively in terms of price, quality, and diversity of banking services. For most banks, interbank and treasury bill rates—which reflect market conditions—have become the key benchmark rates for pricing both lending and deposit rates.
Motivation for Reform
The economic situation in Poland deteriorated in the late 1980s. Large fiscal deficits financed primarily by the domestic banking system contributed to substantial increases in broad money and an acceleration of inflation. A large float, which was partly due to an inefficient payments system, complicated monetary management. Thus, a primary objective of the reform was to reduce domestic disequilibria and improve efficiency. The need to control inflationary pressures underscored the requirement to develop more effective means of absorbing liquidity, limiting access to central bank credit, and financing the government from less inflationary sources.
After a series of attempts to move to a more decentralized market-oriented economic system, a new momentum for reform was initiated in late 1988. The new government, which took office in October 1988, committed itself to establishing a market economy while at the same time stabilizing the economy. In this context, comprehensive reforms were introduced to restructure the financial system and more generally to improve the allocation of financial resources.
In pursuing these reforms, many structural obstacles had to be overcome to facilitate the emergence of a competitive commercial banking system, to strengthen monetary management techniques, and to modernize the operations of the NBP. For example, the supporting legal framework needed to be changed. The NBP, which previously operated as a monobank, had its central banking functions formally separated from commercial bank activities, with the creation of nine state-owned commercial banks in 1989. The NBP was also granted formal independence from the government through legislation enacted in December 1989, and a new NBP act and a new banking law were passed in January 1990 to accord greater autonomy to the NBP in formulating and implementing monetary policy.
In order to implement monetary policy using market-based instruments, the mix of monetary instruments, the institutional arrangements for money and interbank markets, the central and commercial bank accounting system, and the payments system needed to be strengthened. In addition, the structural dependence on refinance of many banks necessitated a reform of refinancing arrangements. Moreover, the NBP had to strengthen its research capability in order to support market-based monetary and exchange rate policies and enhance the quality of monetary policy decisions.
Process of Reform
Until 1989, credit policy in Poland was based on a plan drawn up annually by the NBP. The plan specified limits on total credit expansion based on macro-economic considerations, and, once approved by Parliament, it was translated into informal credit ceilings for state-owned banks. Similarly, banks relied heavily on central bank refinance—the allocation of which was based on specific agreements with each bank obtaining refinancing to meet the projected gap between deposits and credits. The NBP also prescribed the interest rates for various types of credit and deposits and defined priority sectors, which received finance at favorable rates. The authorities specified floors on deposit rates and a ceiling on general lending rates.
In practice, the credit ceilings were difficult to administer—since, legally, they could not be imposed on private banks14—and distorted the financial system. They negatively affected deposit mobilization and limited interbank competition: they discouraged banks from mobilizing deposits that they could not lend. As well, detailed ceilings by economic activity and regions impeded the free flow of capital through the economy and thereby reduced efficiency. Moreover, interest rates played no allocative role, while preferential refinancing from the NBP transferred substantial subsidies to enterprises, outside the budget. Financial disintermediation took place in the form of flight to foreign currency.
These drawbacks underscored the need to change the conduct of monetary policy in Poland, placing greater emphasis on indirect instruments of monetary management. In February 1989, reserve requirements were introduced. Interest rates were liberalized in August 1989, and henceforth banks were allowed to set deposit and general lending rates freely, while some key interest rates—refinance and preferential loan rates—were specified by the central bank.
Beginning in January 1990, the basic refinance rate was adjusted monthly based on a set of indicators, which included current and projected inflation, developments in net domestic assets of the banking system, and growth in external reserves. The structure of penalty interest rates for overdrafts by banks on their current accounts with the NBP—so-called payment on current account credit—was streamlined. In July, about 60 percent of outstanding refinance was converted into a medium-term credit, and the remainder was flexibly provided at short term and carried market interest rates. All additional refinance needs were met either in the form of bill rediscounts or as refinance against the collateral of eligible bills (Lombard credit). In order to enable banks to cope with the large share of loans at fixed, below-market interest rates (particularly for housing and agriculture) and cushion the shock of higher interest rates on borrowers, part of the cost of interest rate increases was recapitalized and part was explicitly borne by the budget.
The NBP needed an instrument that it could use at its initiative in order to absorb (or inject) bank reserves in the short term, after interest rates were liberalized. In July 1990, the NBP issued central bank bills to absorb excess liquidity. In 1991, it replaced the original one-month bill with bills of three- and six-month maturities.
In May 1991, the Ministry of Finance began auctioning treasury bills of 1-month maturity, and later of maturities of 2, 6, and 12 months. Given the increasing emphasis on treasury bills for financing the budget deficit and the resulting sensitivity of debt service to changes in market-related interest rates, the NBP, at the behest of the Ministry of Finance, suspended issuance of NBP bills, which were in direct competition with treasury bills.
With auctions of treasury bills used mainly for treasury financing requirements, and given the suspension of NBP bills, the NBP introduced auctions of repurchase agreements for both NBP and treasury bills as an instrument to adjust bank liquidity in 1991. Concurrently, in support of these open market operations and the further development of the secondary market, the NBP introduced a specialized group of primary dealers, or market makers in government securities. In addition, it developed an operational framework for reserve forecasting to derive the quantities of repurchase agreement transactions to be auctioned. In early 1993, the NBP introduced reverse repurchase agreements, increasing the scope of the central bank to affect short-term liquidity conditions. As a consequence, it was able to remove its informal ceilings on the amount of credit that state-owned banks could extend. In summary, open market operations—in the form of repurchase and reverse repurchase agreements in treasury bills—have grown in size and importance and have become the main tool for achieving monetary objectives.
A number of other financial sector reforms also facilitated the implementation of monetary policy. During the early stages of reform, the smooth functioning of Poland’s banking system and the shift to indirect monetary instruments were impeded by a slow and unreliable paper-based payments system. Thus, the improvement of the clearing and settlement system became a priority and later permitted a reduction in the daily float. A better payments system, a more competitive banking system, and increased reliance on indirect instruments helped to develop a competitive market in interbank deposits.
By 1993, the Warsaw interbank offered rate was an established benchmark for the cost of short-term funds, and certain treasury bill rates were the benchmarks for longer-term funds. Thus, banks increasingly moved away from the practice of tying the level and timing of changes in interest rates to the NBP refinance rate. Although the refinance rate still has an important signaling effect, it has little relevance for the pricing of deposits and loans. However, it still matters to banks that have large amounts of loans that are subsidized through the budget and for which the subsidy is linked to the refinance rate.
The NBP has made remarkable progress in introducing new instruments of monetary policy and in streamlining existing instruments, but some items remain on the agenda. In particular, some structural and institutional rigidities continue to hamper effective monetary management and the efficient functioning of the financial system.
Despite a large number of banks, market segmentation and specialization has led to limited competition. The spread between the deposit and lending rates remains very large, reflecting the poor state of loan portfolios of some banks and some remaining inefficiencies in the payments system. (At present, banks are not allowed to deduct provisions for bad loans for tax purposes.) Thus, the level of banking system intermediation remains relatively low.
An important objective of open market operations and debt-management operations is to develop government securities markets and market-based interest rate determination. In Poland, however, concerns over debt-service costs complicate debt management; as a result, the Ministry of Finance has tended to cap interest rates on treasury bill auctions below the level needed to fully meet the government’s finance requirements on a regular basis. In 1993, this was largely due to the Polish Budgetary Law, which limits the annual total size of debt service.
Secondary-market trading in treasury bills is still limited, owing to this impediment and to the absence of a book-entry system for clearing and settlement of treasury bills. The legal and technical modalities for a book-entry system have been finalized, and its implementation is expected in July 1995. Also, this will facilitate outright transactions in treasury bills by the NBP, which are needed to enhance the NBP’s capacity to sterilize liquidity efficiently.
The NBP has been improving its data collection and processing capabilities to serve as a basis for day-to-day operations. However, the ten-day information system—which still provides the most frequent data for a number of series—does not provide the daily information that would be more suitable. Moreover, the forecasting of the government daily cash flow needs to be improved.
Poland’s experience points to a large degree of interdependence of central banking reforms. In addition, successful modernization of the central banking functions relies to a large extent on parallel reforms in other areas of the financial system. Importantly, the use of indirect monetary instruments requires a high degree of coordination between the central bank and the Ministry of Finance in the use of monetary and debt-management instruments and a sharing of mutual objectives and strategies for the development of treasury bill and interbank markets. Such coordination should begin as early as possible.
Overall, financial sector liberalization and the attainment of the objectives for macro stabilization have been mutually reinforcing. The early development of indirect instruments by the NBP facilitated a transition from direct monetary controls to market-based instruments, thereby enhancing the price rationing mechanism for credit allocation and encouraging deposit mobilization and financial intermediation. The liberalization of interest rates, the development of market-based monetary and debt-management instruments, and improvements in the payments system have led to a rapid development of the money market and the establishment of benchmark market-based interest rates. In addition, auctions of government securities have contributed to the overall economic stabilization by developing budget financing alternatives to central bank credit.
The banking crisis in the early 1980s was attributed to a combination of factors, including high real interest rates that aggravated the situation of borrowers in distress. For a discussion of these factors, see Velasco (1991).
Interest rates increased in 1990 chiefly because the central bank terminated interest payments on reserve requirements. As a result, commercial banks increased their spreads and raised their lending rates.
The sizable depreciation of the cedi led to large exchange losses for banks and enterprises with high foreign exchange exposure.
During the interim period from June 1983 to February 1984, the central bank curbed possible expansionary effects of the removal of credit ceilings by not renewing 60 percent of the liquidity credits outstanding.
Following a policy adopted in the late 1960s, the “Guidelines of State Policy” have stipulated that the central government budget has to be balanced by programming total expenditures equal to revenues and foreign borrowing, and the government is not permitted to undertake any domestic borrowing.
The format of the auction has varied. In the past, the rate of discount on the CETES was targeted, and the quantity auctioned was determined by demand at the particular discount targeted. Sometimes, bids were accepted at different rates of discount; at other times, investors were offered the average discount on all bids accepted. Another format currently used is to assign at the highest yield of the accepted bids, the total quantity to be auctioned.
For some types of deposits, the interest rate ceiling was zero.
However, the actual sequences of particular reforms emerged as a product of circumstances rather than as an a priori commitment to a particular path, given that the overall reform strategy was one of exploiting all opportunities for change when circumstances presented them.
For a more detailed discussion, see Swinburne (1993).
The RBNZ has two primary policy instruments: the supply of settlement cash and the supply of discountable government securities. The supply of settlement cash is controlled mainly through open market operations, while the supply of discountable securities is controlled through regular tenders.
To offset the unpredictable, day-to-day effects of the transfer of government revenues into the RBNZ’s accounts on the cash market, each morning the bank tenders out to the settlement banks the previous day’s government revenue flow. These are called “float tenders.”
To be registered as a bank, a financial institution will generally be in the business of providing financial services. Moreover, the bank must be in strong repute and “standing” (which, in broad terms, means having respectable and substantial owners, being able to demonstrate an ability to carry on business in a prudent manner, maintaining an adequate level of capital, and cooperating with the Reserve Bank in carrying out its functions, including prudential management).
In the 1986 amendment to the Reserve Bank of New Zealand Act, the RBNZ’s supervisory powers were extended to cover banks and the larger nonbank financial institutions. In the 1989 amendment, the RBNZ’s responsibility for prudential supervision was confined to registered banks.
Credit ceilings for state-owned banks were agreed to informally, and the NBP relied largely on moral suasion.