1. Monetary Policy and Exchange Rate Policy in Small and Open Economies
Velimir Šonje, Arhivanalitika
CBBH, Sarajevo, 9 July 2018

2. Questions •
Which are the differences between „the big stories“ (US FED, ECB) and us „the small ones“?
• All the economies and financial systems do not function in the same way •
To what extent is the currency board in BH special?
• It isnot, as a large majority of small and open economies restricts the exchange rate volatility
• EU perspective confirms it •
What are the possibilities in the currency board and what is the perspective?
• Money cannot be freely created in long-term which brings more benefits than damage
• Paradox: by the accession to the monetary union,the range of instruments expands 2

3. How Do the Largest Central Banks Operate: Decision of the ECB Governing Council dated 14 June 2018•
Purchase of securities. “The purchase of securities in the current monthly amount of EUR 30 billion will be continued by the end of September 2018”
Announcement of further purchase measures. “If new data confirm medium term inflation outlook, in the period from October to the end of December 2018, the monthly net purchase of securities will be perfomed in the reduced amount of EUR 15 billion which will end after that period .”
Interest Rate Policy. “The interest rate on the main refinancing operations and the rates on the constantly available marginal lending facility will remain the same at the level of %, 0,25 % i.e. –0.40 %.”
Interest rate announcement. “The Governing Council expects the ECB key interest rates to remain at the present levels at least during the summer of 2019 and certainly as long as necessary in order to ensure harmonized inflation trends with current expectations on steady adjustment.” • • • 3

4. Point No 1.: We are a Water Drop by the Big Pool
BDP u mln EUR ,9 ,0
15.500,0
EU Eurozona BiH •
What is best by a per thousand?
To stop the waves and create one‘s own?
Or to learn using and mitigating them (“surfing” the waves)? 4

5. Point No 2: Why Does Not the ECB Speak about the Exchange Rate?
“THE IMPOSSIBLE TRINITY”
FREEDOM OF INTERNATIONAL CAPITAL FLOW
DOMESTIC MONETARY POLICY (purchase of government bonds)
= interest rates 5

6. Point No 3: You Always Need to Sacrifice Something
EXCHANGE RATE
EXCHANGE RATE
“THE IMPOSSIBLE TRINITY”
“THE IMPOSSIBLE TRINITY”
INTERNATIONAL CAPITAL FLOWS
DOMESTIC MONETARY POLICY
INTERNATIONAL CAPITAL FLOWS
DOMESTIC MONETARY POLICY 6

7. Summary of Initial Messages
(where is currency board?) •
A: Free flows of capital + domestic monetary policy = no possibility to control the exchange rate •
B: Free flows of capital + exchange rate control = no possibility for domestic monetary policy •
C: Domestic monetary policy + exchange rate control = no free international capital flows 7

8. Free capital flows + domestic monetary policy = no possibility for the exchange rate control
Free capital flows + exchange rate control= no possibility for domestic monetary policy
Domestic monetary policy + exchange rate control = no free international capital flows
“+”
“+”
“+” •
Weaker domestic currency = more competitive exports and more expensive imports
Central bank may ensure liquidity at its discretion •
Low inflation, stable expectations
Long investment horizons Financial stability
Stimulating for capital inflow •
Central Bank may ensure liquidity at its discretion •
“-” • “ •
“-” •
One cannot join the EU with such policy
Large interest rate volatility
Attraction of a part of foreign capital is missed
Weaker domestic currency spills over to more expensive imports (technologies, energy) and inflation
Predictibility and investment horizons decrease
Inflationary expectations, instability risk
Major part ofthe adjustment burden is shifted to fiscal and structural policies
In case of liquidity crisis we have to rely on external sources
(IMF, EU, etc...,which does not need to be
“minus”) • • • • 8

9. The smaller and the more open the country
Free capital flows + domestic monetary policy = no possibility for the exchange rate control
Free flows of capital + exchange rate control = no possibility for domestic monetary policy
Domestic monetary policy+ exchange rate control = no free international capital flows
The smaller and the more open the country •
The lower the chances to be specialized in many production branches, so the weaker currency potentially brings less benefits (e.g. when kuna depreciates, Croatian cars and computers are not more competitive since we do not know how to produce them) •
The higher the chances it will have to import some of the critical goods (energy, technology) so potenitially a weaker currency is harmful •
The higher the chances it is going to be financially integrated with a broader currency area and that the households and businesses will be more sensitive to exchange rate volatility (danger of instability) •
The higher the chances that there will be a tight correlation of economic trends and mobility of citizens (with the EU) 9

10. The Range of Exchange Rate Policies (Regimes)
Floating rate
Inflation targeting
(occasional
interventions)
Dirty or
controlled
floating rate
(“dirty float”)
Fixed exchange rate
regime
„Currency
board”
Monetary union
Like US FED ECB, POL, CZ, ROM, SRB HR DK, LIT, LT
BIH, EST, BG, HK
red – before euro
Currency board is a fixed exchange rate regime the credibiilty of which is strengthened by legally limited authorities of the Central Bank
U 20g. 7,0-7,7, cca +/- 5% 10

11. Min 2 years. exchange rate max +/- 15%
Digression: Euro Area
The formal way: -
- Accession
Entry into the EU
ERM II
(European exchange
rate mechanism
Euro
Paradox (in monetary union we have more freedom than within the fixed exchange rate or currency board):
DK (opt out)
Min 2 years. exchange rate max +/- 15%
They want to be part of ERM II: HR, BG
By entering the euro area, the range of instruments expands
They do not want to be part of ERM II: POL,
ROM, CZ, HUN, SWE -
ECB includes government bonds into the eligible instrument list
Bank union: participation in colleges
Eurosystem: participation in decision making
European stability mechanism -
The informal way:
CG, KOS - - 11

12. Fundamental Sense of the Currency Board and Fixed and Dirty Exchange Rates (I)
S = supply of EUR,
demand for KM
EUR/ KM
1 – market pressure
2 – central bank purchases foreign exchange 2
1,95583 1
D = supply of KM, demand for EUR
Cash quantities 12

13. Balance of Payments is Crucial – All Flows with Foreign Countries•
As long as net foreign exchange inflow lasts (on any basis) - the supply of money increases, when the net foreign exchange outflow starts, the money supply decreases
BH already has large experience with the fluctuations of net foreign exchange flows– the currency board has undergone a “stress test” •
Change of Reserves mln KM
1400
1200
1000
800
600
400
200
-200
-400
-600 13

14. Fundamental Sense of the Currency Board and Similar Exchange Rate Regimes (II)
A VIEW THROUGH THE CBBH BALANCE SHEET
ASSETS FXR > M0
LIABILITIES
FOREIGN EXCHANGE RESERVES (FXR)
EXCESS RESERVES IN BANK ACCOUNTS
REQUIRED RESERVE
PRIMARY MONEY OR M0
CASH
CAPITAL ACCOUNTS AND OTHER
CBBH Gain and Loss Account:
MONTHLY REPORT ON THE CURRENCY BOARD ON 31 MAY 2018
MLN KM
FOREIGN EXCHANGE RESERVES OF THE CBBH
i*DR – C
i*DR = earnings from investments of foreign exchange reserves and fees (mainly depending on the interest rate in Europe)
C = operative costs
A positive balance is allocated to reserves or the state budget
MONETARY LIABILITIES
- GOVERNMENT DEPOSITS ETC 14

15. Interest Rates in European Market
(lower interest, lower earnings)
EONIA: very short-term investments
Still negative interest rates
”Thin” profit and loss account of the central bank, but monetary policy must never be implemented with an eye on profits, and besides … - 15

16. Stambeni krediti (> 10 godina)
A Gain on the Other Side: BH “Imports” European Interest Rates
Stambeni krediti (> 10 godina)
Bugarska Češka Estonija Mađarska Litva Latvia Slovenija Slovačka Hrvatska Eurozona MIN Eurozona MA
, , , , , , , , , , ,5
, , , , , , , , , , ,4
, , , , , , , , , , ,1
, , , , , , , , , , ,6
, , , , , , , , , , ,2
, , , , , , , , , , ,4
ožu , , , , , , , , , , ,8
Average interest rates on new loans 9 8 7 6 5 4 3 2 1 %
Izvor: ECB DataWarehouse •
Methodologically, it is not fully comparable with BH
12/ /2014
12/2015
12/2016
12/2017
4/2018 •
Stambeni promjenjiva ks
Ostali promjeniva ks
But it is clear that the interest rates in BH are not significantly diferrent from those in other New Europe countries 16

17. Pay attention to interest rates
Back to the Exchange Rate Policy: the Country‘s Size Has Impact
Population Exchange rate
Germany Euro
France Euro
UK Inflation Targeting
Italy Euro
Spain Euro
Poland Inflation Targeting
Romania Inflation Targeting
Netherlands Euro
Belgium Euro
Greece Euro
Czech Inflation Targeting
Portugal Euro
Sweden Inflation Targeting
Hungary Inflation Targeting
Austria Euro
Switzerland Inflation Targeting
Bulgaria Currency Board
Serbia Inflation Targeting
Denmark Fixed Exchange Rate
Finland Euro
Slovakia Euro
Ireland Euro
Croatia Dirty Float
BH Currency Board
Albania Dirty Float
Lithuania Euro
Macedonia Fixed Exchange Rate
Slovenia Euro
Latvia Euro
Estonia Euro
Cyprus Euro
Montenegro Euro
Luxembourg Euro
Malta Euro
Iceland Inflation Targeting
Andorra Euro
Liechtenstein Euro
Pay attention to interest rates 17

18. Real GDP per capita in dollars 2011, "multiple
The Way Back Is a Way to Instability
(The Argentine abandoned the currency board in 2002)
Real GDP per capita: BH vs Argentine
25.000
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
20.000
15.000
Real GDP per capita in dollars 2011, "multiple
benchmark"
10.000
5.000
Source: Maddison Project Database, 2018. 18

19. ECB includes government bonds in eligible instruments list
Conclusion (I)
It is expensive to go back
Paradox (in monetary union we have more freedom than within the fixed exchange rate or currency board):
European perspective
“Imports” of European interest rates
Entry into
the EU
By entering the euro area, the range of instruments expands
ERM II
(European Exchange
Rate Mechanism
Euro
ECB includes government bonds in eligible instruments list -
Bank union: participation in colleges
Eurosystem: participation in decision making
European stability - -
mechanism 19

20. Conclusion(II) How are we going to respond to future crises? •
Populists offer magic solutions, but they „change the story“ once they find themselves in high positions which include responsibility
Cipras, Cinque Stelle • •
We should build our own experiences : currency depreciation is a very risky response to the crisis in a small and open economy •
You do not repair what is not broken •
You have already been through one (big) crisis without any costs for tax payers •
A student having passed an exam goes on •
The answer is in what is very frequently called “reforms”, which is out of the scope of monetary policy •
Competitiveness + good policies + responsible fiscal policy + institutional progress + integration and cooperation with international financial institutions 20

21. Thank you! 21