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M. Singer: Twin crisis in the Czech Republic 1
Twin crisis in the Czech Republic: Twin crisis in the Czech Republic: Causes, Consequences and LessonsCauses, Consequences and Lessons
KIMEP, Almaty23 November 2006
Miroslav Miroslav SingerSingerViceVice--Governor, Czech National BankGovernor, Czech National Bank
M. Singer: Twin crisis in the Czech Republic 2
ContentContent
• Introduction – heritage from the CPE• Macroeconomic, monetary and banking sector
developments in the pre-crisis period (1990-1996) • Main interactions during currency and banking
sector crises (1997-1999) and policy responses • Consequences and costs of the twin crisis• Lessons
The Czech Republic is almost a text-book example of a twin crisis
M. Singer: Twin crisis in the Czech Republic 3
Heritage from centrally planned economy Heritage from centrally planned economy (where we were in 1990)(where we were in 1990)
• Industrialised country (long tradition)• Stubborn regime of central planning (according to USSR model) • Population appreciated governments which guaranteed monetary
stability → relatively small “monetary overhang”• Negligible share of private ownership• Almost exclusive orientation to Eastern European (soft) markets • Relatively balanced macroeconomic development• Low foreign indebtedness• Relatively skilled and educated labour (though insufficient work
habits due to high social security)
The Czech Republic had relatively good starting conditionsIntroduction
M. Singer: Twin crisis in the Czech Republic 4
Macroeconomic, monetary and Macroeconomic, monetary and banking sector developments banking sector developments
in the prein the pre--crisis periodcrisis period(1990(1990--1996)1996)
Banking sector developments
M. Singer: Twin crisis in the Czech Republic 5
BBankinganking sectorsector developmentdevelopmentss: : introductory remarksintroductory remarks
• In the Czech Republic, banks are the backbone of the financial sector 75% of assets (simplification: financial sector = banking sector)
• Banking sector development reflected (mirrored) economic transformation with all its strengths and weaknesses
Banking sector development
M. Singer: Twin crisis in the Czech Republic 6
Restructuring of the banking sector:Restructuring of the banking sector:main stagesmain stages
• In 1990, the banking sector started from scratch• Split of the “monobank” (1990) “two-tier” system • Inherited deficiencies (under-capitalisation, bad loans, shortage
of long-term funds, inexperienced staff, legal loop-holes, non-existent risk management)
• Consolidation Programme I (clean-up of balance sheets of Komerční banka, Česká spořitelna, Investiční banka; establishment of Konsolidační banka in 1991 as a major vehicle for takeover of bad loans) (overall costs = 7% of 1995 GDP)
• Entry of small banks (13 in 1990, 13 in 1991, 17 in 1992, 10 in 1993 and 4 in 1994) (under-capitalised, unsound development strategies, often fraudulent behaviour, !benign licensing policy!)
Banking sector development
M. Singer: Twin crisis in the Czech Republic 7
• Consolidation Programme II (1996) (purpose: to prevent a domino effect within the small bank sub-sector; of a total of 18 banks, 15 were treated under CP II) (costs: similar to CP I)
• Stabilisation Programme (adopted in 1996) (was intended for 13 small banks; 6 banks joined but 5 were excluded stabilisation programme turned out to be unsuccessful)
• Four big state-owned banks: ownership was untransparent and diluted; state control was inefficient (“banking socialism”); profitability and competitiveness were low and worsened in the 2nd half of the 1990s
Restructuring of the banking sector:Restructuring of the banking sector:main stages main stages -- continuedcontinued
By 1996, the Czech banking sector was witnessing many unfavourable developments
Banking sector development
M. Singer: Twin crisis in the Czech Republic 8
Anatomy of banking sector crisisAnatomy of banking sector crisis
Bad loanaccumulation
Capital inflow Political pressures
Insufficient banking
supervision
Real estate-and capital
market bubbles
Fraudulent behaviour
Economic recession
Insufficient risk assessment
High lending
Banking sector development
M. Singer: Twin crisis in the Czech Republic 9
Implications of the bad loan Implications of the bad loan accumulationaccumulation
• Vulnerable banks • Underperforming credit channel of monetary policy• High fiscal costs of keeping the banking sector alive
(instead of having the budget revenue)
Around 1996, the banking sector was a serious bottleneck (Achilles heel) of the Czech economy
Banking sector development
M. Singer: Twin crisis in the Czech Republic 10
Banking sector performance: 1994Banking sector performance: 1994--19961996
-600
-400
-200
0
200
400
600
800
1 000
1 200
1 400
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 05H1
in 1
000
CZK
0
5
10
15
20
25
30
in %
Net profit per empolyee (left scale)Non-performing loans (as % of total loans) (right scale)
Non-performing loans hovered around 25% of the total and profitability was virtually zero
Source: CNB
Banking sector development
M. Singer: Twin crisis in the Czech Republic 11
Macroeconomic and monetary developments
M. Singer: Twin crisis in the Czech Republic 12
GDP in the Czech RepublicGDP in the Czech Republic
The economy overheated in 1995
2,2
6,9
4
-0,7 -0,8
1,3
3,6
2,51,9
3,64,2
6,16,6
-2
-1
0
1
2
3
4
5
6
7
8
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006H1
y-on
-y c
hang
e in
%
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 13
Overheating in midOverheating in mid--1990s: causes1990s: causes
• Strong demandHigh growth of wages (much higher than productivity growth)High growth of private and public investment (infrastructure)Strong credit growth (partly due to “banking socialism”) Strong capital inflow (high interest rate differential) → sterilisation
• Weak supply side (under-developed markets, badly-defined property rights, malfunctioning legal and institutional framework, etc.)
Emergence of external imbalance
In 1996-97 the overheating started to become unsustainable: the situation required adjustment and policy responses
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 14
Real wages and labour productivityReal wages and labour productivity
Wage-productivity mismatch peaked in 1995 and was still significant in 1996
-4
-2
0
2
4
6
8
10
12
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
y-o-
y ch
ange
s in
%
Real wages
Labour productivity
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 15
Gross fixed capital formation/GDPGross fixed capital formation/GDP31,5
32,1
29,9
28,2
27
28 2827,5
26,726,2
25,5
20
22
24
26
28
30
32
34
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
in %
, nom
inal
term
s
Investment was very high in 1995 and peaked in 1996
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 16
External imbalance External imbalance
Current account deficit reached 6.6% and 6.2% of GDP in 1996 and 1997 respectively – thus exceeding the critical level (5%)
-10
-8
-6
-4
-2
0
2
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
as %
of G
DP
Trade balance/GDPCurrent account balance/GDP
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 17
Monetary policy frameworkMonetary policy framework• Fixed exchange rate since 1991
(different baskets: initially to five currencies; later on to DEM and USD)• Monetary targeting:
Operational target: monetary base Medium-term target: M2
• Capital account liberalisation (basically finished in 1995) (driven by entry into the OECD)
• Emergence of “Impossible Trinity” = parallel existence of: a) free capital flows b) fixed exchange rate, c) independent monetary policy
Capital account liberalisation eroded the monetary frameworkMacroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 18
Vicious circle of monetary policyVicious circle of monetary policyHigher domestic
interest rates
Capital inflow
Appreciation pressures
Interventions: purchase of
foreign currencies
Pressures: increase of
monetary base and monetary aggregates
Sterilisation: sales of securities to
domestic banks
Pressures: increase of
domestic interest rates
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 19
Main interactions during the Main interactions during the currency and banking crises currency and banking crises
(199(19977--19919999) ) and policy responsesand policy responses
M. Singer: Twin crisis in the Czech Republic 20
Towards a speculative attack Towards a speculative attack
• To deal with imbalances some policy actions were adopted: Increase in interest rates (beginning of 1996) Widening of the koruna fluctuation band (end of February 1996 ± 7.5 %)1st stabilisation package in April 1997
However: this was not enough to calm the markets!→ speculative attack (in May 1997) → abandonment of the peg → managed float → depreciation of koruna → inflationary expectations → inflation
Impossible Trinity was not addressed sufficientlymarkets penalised
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 21
Loss of the nominal anchor in 1997Loss of the nominal anchor in 1997
-10
-5
0
5
10
15
%
Level of official exchange rate Fluctuation band - appreciation Fluctuation band - depreciation
Septem ber 27, 1992Sett ing of the band f or the f luc tuation of the exchange rate of koruna +/-0,5%
April 24, 1995Sett ing of the spread +/- 0,25%
February 28, 1996F luctuat ion band ex tended to +/- 7,5%
May 27, 1997C ancelation of the f luc tuat ion band
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 22
After speculative attack After speculative attack
• 2nd stabilisation package in June 1997:Macroeconomic measures: fiscal tightening, wage freeze, import deposits (acted rapidly)Microeconomic measures: legal and institutional reforms (were more time-consuming)
• Adoption of inflation targeting (in January 1998) – unilateral decision by CNB
Macroeconomic stabilisation started to exert the intended effects in 2H1997
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 23
Anatomy of currency crisis Anatomy of currency crisis
Capital inflow
Liberalisation of capital account
Interest rate differential
Vicious circle
Appreciation of currency
Deterioration of price competitiveness
Overheated economy
External imbalance
Fiscal imbalance
Bad assessment of economy by
markets
Speculative attack
Change of exchange
rate regime
Devaluation and
depreciation
Macroeconomic & monetary development
Preliminary data
M. Singer: Twin crisis in the Czech Republic 24
Measurement errors and preliminary Measurement errors and preliminary data may have been crucialdata may have been crucial
-6
-4
-2
0
2
4
6
8
95/I II III IV 96/I II III IV 97/I II III IV 98/I II III IV 99/I II III IV
y-o-
y ch
ange
in %
Data from 4Q/98
Data from 4Q/99
Deceleration was steeper
Depression instead of growth
Actual growth was faster
More precise and timely statistics would probably have implied less strict stabilisation policies
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 25
Measurement errors and preliminary Measurement errors and preliminary data may have been crucial data may have been crucial
Would the less acute external imbalance in 1996 have triggered a speculative attack?
-8,0
-10,6
-6,6
-9,2
-12
-10
-8
-6
-4
-2
0Current account balance/GDP Trade balance/GDP
as %
of G
DP
Preliminary data
Final data
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 26
Anatomy of currency crisis Anatomy of currency crisis –– contcont..
High interest rates
Recession Unemployment
Devaluation and
depreciation
Inflation
Fiscal and monetary tightening
Drop in profitability of enterprises
Expenditure cuts
Macroeconomic & monetary development
M. Singer: Twin crisis in the Czech Republic 27
Anatomy of twin crisisAnatomy of twin crisis
Recession
Drop in profitability of enterprises
Bad loansaccumulation
Drop in profitability of banks
Bank failures
Fiscal costs Distrust of financial sector
Multiple economic and institutional adjustments
Macroeconomic & banking development
M. Singer: Twin crisis in the Czech Republic 28
Banking sector performance: 1997Banking sector performance: 1997--19981998
-600
-400
-200
0
200
400
600
800
1 000
1 200
1 400
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 05H1
in 1
000
CZK
0
5
10
15
20
25
30
in %
Net profit per empolyee (left scale)Non-performing loans (as % of total loans) (right scale)
Economic
recession
Recession brought an increase in non-performing loans and negative profitability of banks
Source: CNB
Profitabilityplummeted
Banking sector development
M. Singer: Twin crisis in the Czech Republic 29
Privatisation of big banksPrivatisation of big banks
• The big state-owned banks were an impediment to the smooth functioning of the banking sector
• Privatisation of: IPB (Nomura) 1998 Agrobanka (GE) 1998 CSOB (KBC) 1999 CS (Erste Bank) 2000 KB (Societe General) 2001
• Privatisation costs during 1996-2004: ≈ 10% of GDP
Banking sector development
M. Singer: Twin crisis in the Czech Republic 30
Banking sector performance: 1999Banking sector performance: 1999--20052005
-600
-400
-200
0
200
400
600
800
1 000
1 200
1 400
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 05H1
in 1
000
CZK
0
5
10
15
20
25
30
in %
Net profit per empolyee (left scale)Non-performing loans (as % of total loans) (right scale)
Economic
recession
Privati-
sation
The clean-up of banks and their privatisation launched the banking sector on the path to success
Source: CNB
Profitabilityplummeted
Clean-up of CS and KB
Banking sector development
M. Singer: Twin crisis in the Czech Republic 31
Consequences of the twin crisis Consequences of the twin crisis and costsand costs
M. Singer: Twin crisis in the Czech Republic 32
Macroeconomic consequencesMacroeconomic consequences
• Exchange rate depreciation + increased ER volatility• High inflation expectations → increased inflation + increased
volatility of inflation • Fuzzy monetary framework (discretionary decision-making) in 97• Political crisis (fall of government in November 1997) • Increasing problems in enterprise sector (low or negative
profitability, inter-enterprise arrears, lower budget revenue)• Macroeconomic restriction (possibly too strong and too long)
negative growth in 1997 and 1998 (not seen elsewhere) and emergence of output gap (trend rise in unemployment)
The economy slipped into recession with many negative implications for the banking sector
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 33
GDP in the Czech RepublicGDP in the Czech Republic
The economy plunged into recession during 1997-98 …
2,2
6,9
4
-0,7 -0,8
1,3
3,6
2,51,9
3,64,2
6,16,6
-2
-1
0
1
2
3
4
5
6
7
8
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006H1
y-on
-y c
hang
e in
%
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 34
Output gapOutput gap
-5
-4
-3
-2
-1
0
1
2
3
1996
Q119
96Q3
1997
Q119
97Q3
1998
Q119
98Q3
1999
Q119
99Q3
2000
Q120
00Q3
2001
Q120
01Q3
2002
Q120
02Q3
2003
Q120
03Q3
2004
Q120
04Q3
2005
Q1A
s %
of G
DP
… and the cost of stabilisation was far from negligible
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 35
FollowFollow--up adjustments and policiesup adjustments and policies
• Substantial reduction of external imbalance in 1998 and 1999
• Establishment of consistent monetary framework (inflation targeting + managed float) since 1998
• Macroeconomic stabilisation • Accelerated microeconomic restructuring
(stronger competition, institutional and legal progress, etc.)• Privatisation + clean-up Banking sector restructuring• acceleration of growth of potential output
The economy embarked on a sustainable growth path
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 36
External imbalance External imbalance
The trade deficit was close to 2% of GDP in 1998 and the current account deficit about 3% of GDP in 1999
-10
-8
-6
-4
-2
0
2
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
as %
of G
DP
Trade balance/GDPCurrent account balance/GDP
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 37
Potential output in the Czech Rep.Potential output in the Czech Rep.
0
1
2
3
4
5
6
96/I III 97/I III 98/I III 99/I III 00/I III 01/I III 02/I III 03/I III 04/I III 05/I III 06/I
y-o-
y ch
ange
in %
Production function (CNB)
Kalman filter
Production function (MF)
Growth of potential output was slow during 1996-1999 but accelerated after 2000
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 38
Banking sector restructuring costs: Banking sector restructuring costs: volume volume (as % of 1995 GDP)(as % of 1995 GDP)
9,7
2,2
-0,4 -0,4
0,2
1,4
4,2
1,5 1,6
0,9
2,8
1,6
-1,0
-2
0
2
4
6
8
10
12
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
as %
of G
DP
(cur
rent
pric
es)
Total accumulated restructuring costs were substantial: 24% of GDP
Source: Ministry of Finance, CNB
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 39
Restructuring costs: structureRestructuring costs: structure
-4 0
-2 0
0
2 0
4 0
6 0
8 0
100
1 992 1 993 1 994 19 95 1996 19 97 1 998 1 999 200 0 2001 20 02 20 03 2 004
in b
n C
ZK
C onso lida tion and s tab ilisa tion o f banksP re-priva tisa tion ass is tanceR e la ted to centra lly p lanned econom y
CPE-related consolidation and stabilisation pre-privatisationSource: Ministry of Finance, CNB
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 40
The banking sector nowThe banking sector now
• Currently the banking sector in the Czech Republic is stabilised, produces healthy financial results, and has sufficient equity to cover the risks it undertakes
• 36 banks (27 foreign owned)• 4 big banks: 62% of total assets • Banks are fully integrated into the European financial system • No significant foreign exchange or country risk
Banking sector restructuring contributed significantly to the emergence of a market economy and to GDP growth
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 41
Ethical practices in bankingEthical practices in banking• As mentioned earlier – fraudulent behaviour was one of
the reasons of the bank failures during the 1990s:“Unfettered capitalism” and state ownership of major banksUnder-performing legal framework Misbehaviour was rarely penalised at the time
• Huge progress since then:Much tighter competition highly selective implications Dominant foreign (private) ownership of banks EU membership (since 2004)Enhanced incentives towards “self-regulation” of banks
The learning process: misbehaviour is more costly than obeying laws and following good practices
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 42
Ethical practices in bankingEthical practices in banking -- continuedcontinued
• Czech Banking Association: Banking Activities Standards (2005): Customer care and satisfaction is one of the major pillars of banks’business strategiesA relationship based on mutual trust and collaboration between the bank and its client is a core motive of banks’ activitiesClearly defined rules for establishing, maintaining and eventually terminating relationships … serving as a framework on which a solid, certain and mutually beneficial foundation can be built Banks are aware that clients may lack specific knowledge of banking and financial services
banks are ready to support the professional education of the public in the banking area
Banks are now customer-oriented
Consequences & costs
M. Singer: Twin crisis in the Czech Republic 43
LessonsLessons
M. Singer: Twin crisis in the Czech Republic 44
Lessons Lessons
• The economy paid the price for: Inconsistent policies (Impossible Trinity) Too relaxed a macroeconomic framework and external imbalanceAn unconsolidated banking sector (partly due to the heritage of central planning) The hesitation of policy-makers to act decisively in certain cases and at certain times
The problems were home-made and to a large extent avoidable!
Lessons
M. Singer: Twin crisis in the Czech Republic 45
What would have been advisable? What would have been advisable? • Earlier exit from the exchange rate peg (to avoid the
Impossible Trinity)• Appropriately tight macroeconomic policies (to deal
with the overheating)• Substantially better banking supervision (to mitigate
banking sector under-performance)• Much earlier privatisation of big state-owned banks
(to avoid inefficiency) • More appropriate (less misleading) statistical data
The Czech twin crisis provides very useful guidance as to how some things should not be done and how costly some mistakes can be
Lessons
M. Singer: Twin crisis in the Czech Republic 46
Thank youThank you
Miroslav SingerČeská národní banka
Na příkopě 28115 03 Praha 1
[email protected]: 2 2441 2008