To release or not to release?
Arkadiusz Krześniak is chief economist at Deutsche Bank Polska.
It appeared that the period of increased tension between the cabinet and the National Bank of Poland had ended sometime last November, just before the European Union accession talks in Copenhagen. A gasp of relief could almost be heard on the market, tired with the drawn-out discussion on the proper way to conduct the country's monetary policy.
An unbiased observer might have supposed that the prospects of early EU accession would alleviate potential conflicts of interest between the cabinet and the central bank. There was a chance that political rationale would appease existing tensions and prevent further conflicts from being the subject of public discussion.
Finance minister Grzegorz Kołodko limited his remarks on the issue to the proper value of the złoty's exchange rate, while the members of the Monetary Policy Council (RPP) refrained from warnings that the independence of the central bank was endangered.
It should be well understood that there is some potential conflict between central banks and governments in all democratic countries. Central banks control the money supply, and hence inflation in the long term, which also influences economic activity. Governments control public spending, an important part of aggregate demand, and income distribution via taxes, thereby influencing inflation in the short term.
In many countries, including the U.S. and the U.K., central banks and government cabinets have worked out implicit or explicit procedures to allow for a smooth resolution of potential conflicts. Poland adopted a conceptually clear approach, giving constitutional responsibility for inflation to the central bank. Unemployment reduction remains the cabinet's responsibility. The basic goals of the government and the central bank are in the short term a trade-off between inflation and unemployment, which creates some tensions.
Besides these basic areas of competence, there are fields where responsibilities are not so clearly separated. Exchange rate policy has to be conducted jointly by the cabinet and the central bank, leaving enough scope for potential conflicts.
It seems that despite some institutional deficiencies the cabinet and the central bank could find a common language. The finance ministry accepted the NBP's solution to purchase hard currencies on the foreign exchange market to service the country's foreign debt in order to relieve appreciation pressure from the złoty. The verbal intervention of the finance ministry proved to be effective with a lag of a couple of months, when the złoty easily reached Kołodko's target of zł. 4.35 to the euro, and even temporarily depreciated further to the weaker side of the old parity.
While exchange rate policy can be only loosely affected by the NBP or by government actions, there is a more problematic issue - that of the revaluation reserve. This is the difference between the złoty value of the central bank's foreign exchange assets at the time of purchase and its złoty value at a specified time. The country's revaluation reserve currently amounts to more than €6.5 billion (zł. 27.4 billion), or 3.6% of GDP.
The revaluation reserve is an accounting concept securing the NBP's profit. In ordinary circumstances, when the cabinet purchased hard currencies in the NBP, part of the corresponding revaluation reserve was released, and 85% of related NBP profit was transferred to the central budget the following year. Kołodko proposed to divide the revaluation reserve into three parts: one-third to finance the budget deficit; one-third to increase the NBP's capital; and one-third to be left unchanged as a new, much smaller revaluation reserve. The NBP strongly opposed this solution, arguing that it would increase the money supply and trigger unnecessary inflation as well as possibly ruin its credibility.
Certainly, there is a danger that the revaluation reserve may be treated as a "cheap" source of financing the budget deficit by delaying necessary adjustments on the expenditure side of the budget. Therefore, the following questions can be raised: Is the revaluation reserve too high? Can it be released in accordance with existing law? If the answers to these two questions are affirmative, what is the best way then to release the revaluation reserve?
The answer to the first question depends on the point of view. From the NBP's point of view, the higher the revaluation reserve, the better since the central bank's profit is better secured. Using the revaluation reserve would require reducing the level of the NBP's foreign exchange reserves, so the question is tantamount to the issue of whether the stock of the country's foreign exchange reserves is too high. The government claims that maintaining a high revaluation reserve means incurring the cost of not using central bank funds in a better way elsewhere. The central bank argues that the level of foreign exchange reserves is adequate under international standards.
The answer to the second question should be left to lawyers. Under the existing law, releasing part of a revaluation reserve requires the NBP's consent and excludes unilateral action by the cabinet.
Even if the answers to both questions were positive, it would be difficult to determine which part of the foreign exchange reserves is redundant. It seems that the best solution would be to retain as high foreign exchange reserves as possible. The only non-inflationary way of using part of the revaluation reserve would be to use released funds to buy back foreign debt. This would lead to a decrease in both the foreign exchange reserves and outstanding public foreign debt. The money supply would not change, as funds released from the revaluation reserve would be used for repurchasing foreign debt. The net gain would equal the difference between the cost of the repurchased debt and the income generated by the sold part of the NBP's foreign assets.
Releasing part of the revaluation reserve could at best provide one-time funds that could easily be misused. Therefore, a balanced and cautious approach is required. What the country's economy really needs though is a systemic change in public finances and more balanced budgets in the coming years.
