The Central Bank of Bosnia and Herzegovina has steadied the country’s currency, which has contributed to overall macroeconomic stability.

Senad Sofic main

Since its creation two decades ago, the Central Bank of Bosnia and Herzegovina (CBBH) has operated under the currency board regime, which limits its monetary flexibility but adds to its credibility. While banking supervision does not sit under the CBBH, but rather two other banking agencies, the central bank carefully monitors financial stability and regularly publishes reports on systemic issues. In addition to the legal limitations that the central bank faces when choosing its appropriate response, there are also country-specific limitations.

In terms of macroeconomic developments, Bosnia and Herzegovina has historically mirrored the trends of our large neighbour and main trading partner, the EU, with low inflation and rather sluggish economic growth, particularly for our level of development. However, liquidity remains high in both the banking sector and the government. Some fiscal space was created in the years before the Covid-19 pandemic, while the level, structure and maturity of the country’s public debt was favourable. The liquidity coverage ratio of our banking sector was more than double of that prescribed in the EU. The excess reserves (not the required ones) held at the central bank, including high-quality liquid assets, were also very high.

In such an environment, the central bank could not endorse an argument for lowering the rate of required reserves. It has to be noted that required reserves are the only monetary policy instrument available within the strict currency board rules. At the onset of the pandemic, our position was a difficult one to comprehend. The calls “to do anything to support the economy” were strongly repeated.

A brave stance

In retrospect, staying put with the only monetary policy instrument available was the right choice under the circumstances. We understood from the beginning that no matter what the CBBH did with the required reserves, it would not stimulate demand for loans. If consumers are uncertain about their future income, or companies are unsure about their business operations — as was the case in March and the second quarter of 2020 in particular — expansionary monetary policy would make no difference. The problem was not on the supply side.

It has to be noted that required reserves are the only monetary policy instrument available within the strict currency board rules

However, lowering the required reserves rate would prove costly for banks, as the excess reserves would rise and the remuneration rate on the excess reserves is linked to the European Central Bank deposit facility rate, which is negative. Such an action by the central bank would partially offset the measures introduced by the regulators (the two banking agencies), including allowing moratoria for loans when both parties agree, to help the banks and their clients weather the challenges posed by the pandemic.

The debate with banks and the general public was fierce. Regarding the supply of banknotes and coins, the central bank’s vaults were at the disposal of commercial banks, for both domestic and foreign currency withdrawals, during working hours without specific prior agreement. Finally, it was ensured that, should we need physical euro notes beyond what we had in our vaults, we could purchase some from our European System of Central Banks partners and then have them shipped to the country via cargo flight in record time. The stability of the banking system was preserved and is still maintained at a high level.

The activities of the CBBH were intense during the pandemic. The central bank ensured the business continuity of all its operations, payments systems, cash operations, banking and other processes in accordance with the law. At the same time, the CBBH improved operations, such as statistics, and added new functions, such as introducing a new approach to governance with committees, developing an integrated risk function and a new ethics framework.

Ensuring resiliency

The CBBH efficiently played its state fiscal agent role. In very short time, we were in co-operation with the International Monetary Fund (IMF). In April 2020, the IMF executive board approved special drawing rights (SDRs) of 265.2m ($361m) in emergency assistance for Bosnia and Herzegovina under the Rapid Financing Instrument, to help the country meet an urgent balance-of-payments needed due to the global outbreak of the Covid-19 pandemic.

In response to the latest crisis caused by the pandemic, the IMF board of governors decided on a new SDR allocation to IMF member countries on August 2. Bosnia and Herzegovina has been allocated 254m in SDRs.

Although there was no credit arrangement with the IMF, during the past year the CBBH completed the IMF’s safeguard assessment. The central bank implemented all necessary recommendations to insure a strong governance and control framework. In such complex circumstances as during the Covid-19 pandemic, it was proven that a strong and stable central bank with monetary and financial consistency has been a crucial stability factor for the country.

International rating agencies affirmed the credit rating of Bosnia and Herzegovina, preserving a stable outlook, and acknowledged the CBBH as an institution that effectively implements the currency board arrangement and enjoys a high level of credibility. The central bank is also recognised as a positive force for institutional strength and management. The rating agencies’ assessment states that the currency board arrangement, as implemented by the CBBH, is an important anchor of economic policy in the country.

Growth prospects

According to the latest CBBH forecasts, the country’s real economic activity in 2021 is expected to grow beyond the 3.4% projected in the first quarter of this year. The inflationary pressures are expected to strengthen in the second half of 2021, resulting in an estimated inflation of 1.2%. Again, these trends are in line with what the European Commission is expecting to occur in the EU by the end of the year. In the case of Bosnia and Herzegovina, postponed household consumption from 2020 is one of the key drivers of economic growth in 2021.

Household consumption in 2020 was 72% of real gross domestic product, while food and non-alcoholic beverages accounted for a third of final consumption expenditure of households. When the structure of an economy is such that a large fraction of disposable income is spent on necessities, rising costs will weaken personal consumption. If one also considers the second major reason for currently rising inflationary pressures — increasing food prices — the incentives for central banks to hike rates diminish further. The effectiveness of monetary policy is, all things being equal, greatly determined by the characteristics of a country’s population.

It is necessary to understand which sectors and types of companies are driving a current spike in exports. In the case of Bosnia and Herzegovina, and many countries in the region, firms’ deposits are still rising. This is unexpected in periods of economic upswing. One of the possible reasons is that growth is driven by activity in a small number of industries linked to foreign demand and that current production capacities are sufficient to meet this demand.

Depending on the sources of financing for banking lending activity, central banks have incentives to act in a hawkish manner with respect to inflation. In our specific case, with liabilities of commercial banks being mostly domestic over the past years, raising the rate of required reserves could result in increasing the cost of financing, when the majority of firms are still struggling with the consequences of the pandemic, or are expected to be affected by the scaling back of the emergency stimuli.

Finally, one must add the expected spill-over effects from the potential strong tapering of major central banks on the borrowing costs and interest rate pressures in emerging economies. With the majority of public debt being under concessional terms, and domestic sources of financing dominating the banking sector, there is not too much concern in the case of Bosnia and Herzegovina regarding public debt sustainability or immediate pressures on domestic borrowing costs. However, foreign investors and private creditors will require higher returns in emerging markets, as the reference rates increase in developed economies.

In such challenging and turbulent times, it is even more important to strengthen the capacities of the central banks which are providing the necessary stability in their countries.

Senad Softić is governor of the Central Bank of Bosnia and Herzegovina


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