MONETARY POLICY IN HUNGARY - MNBThe publication presents an overview of the monetary policy of the...

MONETARY

POLICY

IN HUNGARY

May 2000

Produced bystaff members of the Monetary Policy Department of the National Bank of Hungary

Edited by: Ilona Bozó

The publication presents an overview of the monetary policy of the National Bank of Hungary.This, however, does not preclude the manifestation of personal views of the authors in certain chapters.

These do not necessarily reflect the official standpoint of the NBH.

Produced by the Monetary Policy Department of the National Bank of HungaryHeaded by György Sándor, Managing Director

Published by the Secretariat of the National Bank of HungaryPublisher in charge: Dr. József Kajdi

Translated by Németh & Pásztor International KftDesign typography and typesetting by the Publications Group of the Information Division

1850 Budapest, V. Szabadság tér 8–9.Internet: http://www.mnb.hu

ISBN: 963 9057 72X

FOREWORD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

A BRIEF HISTORY OF THE NATIONAL BANK OF HUNGARY(Ilona Bozó, József Szabó ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

The Austrian National Bank and the Austro-Hungarian Bank. . . . . . . . . . 9The Independent Hungarian Central Bank . . . . . . . . . . . . . . . . . . . 11

Preparations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11From the Foundation of the NBH until the Second World War . . . . . . . 12Shift to a Command Economy . . . . . . . . . . . . . . . . . . . . . . . 13

The Central Bank in the Period of the Socialist Command Economy . . . . . . 13The Transformation of the National Bank of Hungary and the Banking Sector

in 1987. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

THE ROLE OF THE NATIONAL BANK OF HUNGARY IN THE FINANCIAL SYSTEM(Ilona Bozó, Zsolt Érsek, József Szabó , Henrik Tóth) . . . . . . . . . . . . . . 17The Functions and Role of the Central Bank in the Financial System. . . . . . 17

Issue of Banknotes and Coins . . . . . . . . . . . . . . . . . . . . . . . 19The Central Bank as the Banker of banks . . . . . . . . . . . . . . . . . 20The Lender of Last Resort Function . . . . . . . . . . . . . . . . . . . . 21The Central Bank as the Government’s banker. . . . . . . . . . . . . . . 23Foreign Exchange Reserve Management at the NBH . . . . . . . . . . . . 25The Regulatory Function . . . . . . . . . . . . . . . . . . . . . . . . . . 27Bank Supervision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Maintenance of the Payment System. . . . . . . . . . . . . . . . . . . . 30Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Organisational Structure and Decision-Making . . . . . . . . . . . . . . . . . 35The Bodies of the NBH Defined by the Act on the Central Bank . . . . . . 35

Central Bank Independence . . . . . . . . . . . . . . . . . . . . . . . . . . 38The Importance of Independence. . . . . . . . . . . . . . . . . . . . . . 38Personal Independence. . . . . . . . . . . . . . . . . . . . . . . . . . . 39Operational Independence . . . . . . . . . . . . . . . . . . . . . . . . . 40Financial Independence . . . . . . . . . . . . . . . . . . . . . . . . . . 41The Requirement of Transparency in Central Banks . . . . . . . . . . . . 42

MONETARY POLICY IN HUNGARY 3

CONTENTS

II. THE OBJECTIVES OF MONETARY POLICY

AND ITS IMPACT ON THE ECONOMY

THE OBJECTIVES OF MONETARY POLICY (Áron Gereben, Zsolt Kondrát) . . . . 45The Ultimate Goal of Monetary Policy . . . . . . . . . . . . . . . . . . . . . 45

Price Stability versus Economic Growth . . . . . . . . . . . . . . . . . . 47The Ultimate Goal of Hungarian Monetary Policy. . . . . . . . . . . . . . 49

Intermediate Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51The Hierarchy of Objectives . . . . . . . . . . . . . . . . . . . . . . . . 51The Intermediate Target of the NBH . . . . . . . . . . . . . . . . . . . . 53

The Lower Level of the Set of Objectives . . . . . . . . . . . . . . . . . . . . 56The Operating Target of the NBH . . . . . . . . . . . . . . . . . . . . . 57

INDICATORS (Gyula Barabás, Emma Boros, Csaba Horváth, Anna Kerekes) . . . 59Monetary Aggregates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59Credit Aggregates and the Net Financing Capacity. . . . . . . . . . . . . . . 62The Information Content of the Yield Curve for Monetary Policy . . . . . . . . 63

MONETARY TRANSMISSION (András Kármán) . . . . . . . . . . . . . . . . . . 68The Channels of Monetary Transmission . . . . . . . . . . . . . . . . . . . . 68Interest Rate Transmission . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

The Effectiveness of Transmission . . . . . . . . . . . . . . . . . . . . . 71The Effectiveness of Interest Rate Transmission in Hungary . . . . . . . . 72The Interest Rate Policy of the NBH . . . . . . . . . . . . . . . . . . . . 73Transmission Along the Yield Curve . . . . . . . . . . . . . . . . . . . . 75

III. THE INSTRUMENTS OF MONETARY POLICY

A HISTORICAL OVERVIEW OF THE DEVELOPMENT OF THE INSTRUMENTS(Ilona Bozó) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

The Use of Direct Monetary Instruments . . . . . . . . . . . . . . . . . . . . 81Money Market Development—Use of Indirect Instruments . . . . . . . . . . . 83

THE OPERATION OF THE INSTRUMENTS TODAY (Ilona Bozó, Tamás Glanz,Henrik Tóth) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87Foreign Exchange Market Intervention . . . . . . . . . . . . . . . . . . . . . 87The Operation of the Forint Instruments . . . . . . . . . . . . . . . . . . . . 88

Reserve requirement system . . . . . . . . . . . . . . . . . . . . . . . . 89The Basic Set of Current Central Bank Instruments . . . . . . . . . . . . 94Interest Rate Corridor. . . . . . . . . . . . . . . . . . . . . . . . . . . . 97The Policy Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . 99The Instruments of Sterilisation. . . . . . . . . . . . . . . . . . . . . . . 101Liquidity Planning and Fine-Tuning (Quick Tender) . . . . . . . . . . . . 104Individual Elements in Operating the Instruments . . . . . . . . . . . . . 111

BIBLIOGRAPHY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113ANNEX. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

4 NATIONAL BANK OF HUNGARY

Hungary’s transition to a market economy has by nowessentially come to an end. The judicious conduct ofmonetary policy has been an important factor in help-ing the economy develop along a balanced and sustain-able path.

The National Bank of Hungary (NBH) re-lies on an established and properly func-

tioning set of instruments in the pursuit of itsmonetary policy objectives. The success ofmonetary policy depends, however, not onlyon the instruments available to the centralbank and the experience gained in usingthese instruments. External shocks and theeconomy’s ability to withstand them, thestability of the financial sector and the matu-rity of the money and capital markets areequally important factors which influenceand constrain monetary policy decision-making.

Hungary has coped successfully withthe challenges of economic transition. Theeconomy is now growing at a relatively fastrate, inflation is declining steadily and thecurrent account deficit is at a manageablelevel. Monetary policy has promoted thisprocess through the deployment of mone-tary policy instruments which have sup-ported Hungary’s fixed exchange rate re-gime.

The expert deployment of monetarypolicy instruments is a necessary, but notsufficient condition for the effective func-tioning of the transmission mechanism ofmonetary policy. An equally important fac-tor is that economic agents, ranging fromprofessional financial organisations to

households, have a good understanding ofour intentions and of the conditions for theachievement of our objectives of maintain-ing economic equilibrium and reducing in-flation. Transparency and predictability im-prove the effectiveness of monetary policy,because they enable economic agents toanticipate monetary policy actions and cal-culate with their effects in their economicdecisions.

To ease finding their way and with anintention of providing a compass, we annu-ally present the Monetary Policy Guidelinesto the public in general and to Parliament inparticular. The NBH regularly publishes itsInflation Report. Communications disclosedabout specific steps of the Central Bank andcommuniqués issued after meetings of theCentral Bank Council are discussed exten-sively by the press. Once approved by itsGeneral Meeting, the NBH presents its An-nual Report to Parliament. Nevertheless, wefeel that this publication, which focuses noton the peculiarities of the momentary situa-tion but on the operating framework and thegeneral features of the Central Bank instru-ments, fills a vacuum.

This publication, Monetary Policy inHungary, was compiled by members of theMonetary Policy Department of the NBH,who themselves are party to the everyday


FOREWORD

workings of monetary policy, decision sup-port activities and the formation and opera-tion of the set of applied instruments. This isintended as a summary based on practicalexperience which, by virtue of its very sub-ject, cannot in all of its parts be regarded aseasy reading. While required to report on itsactivities to society at large, the NationalBank of Hungary desires to provide informa-

tion first and foremost to readers interestedin the subject matter of this publication.

I trust that, in its own way, this hand-book will render the transmission mecha-nism of monetary policy smoother and, al-beit indirectly, may contribute to the futuredevelopment of the Hungarian economy.

Werner Riecke




I. THE ROLE OF THE CENTRALBANK IN HUNGARY

Although historically the Sweden’sSveriges Riksbank, established in 1668,

is the oldest central bank, institutions actingas the government’s banker came into beingall over Europe, modelled in general on theBank of England, which was established in1694.

On the continent, the Austrian centralbank was one of the first to be established;owing to the political framework, its scopeof authority also extended to the territory ofthe Hungary of those days. Hungary’s politi-cal significance, which increased within theempire as a result of the historic Compro-mise of 1867, was also expressed by thedual structure of the central bank, in accor-dance with the dualistic principles of thestructure of the state. An independent Hun-garian central bank came into being only af-ter the break-up of the Monarchy.

The Austrian National Bankand the Austro-HungarianBank

The Habsburgs regarded Hungary as aland conquered by arms while fighting

the Turks and, in conducting their economicpolicy, they focused primarily on the inter-ests of the Austrian hereditary provinces.The Napoleonic wars went hand in hand withinflation and an erosion of the value ofmoney across Europe, hence the Austriangovernment attempted to keep the statedebt and the issue of paper money under

control by setting up an independent gov-ernment’s banker.

The Austrian National Bank (ANB), es-tablished by the Emperor’s patent on 1 June1816, was “a patented private institutionunder the special protection of public ad-ministration”2 whose business relations tothe state were very close and secret. Duringthose hard times, the Austrian NationalBank regarded providing assistance to thestate “as its obligation” and these “highlyimportant services” were “acknowledgedwith gratitude” by the monarch.3 ANB en-joyed a monopoly position regarding issu-ing banknotes and setting up branches inthe territory of the Austrian Empire. In addi-tion to lending to the state, the discountingof commercial bills of exchange and lendingon collateral security grew into importantlines of business. Uniquely among Euro-pean central banks – owing to a mixture ofcentral banking and commercial bankingfunctions – ANB also pursued mortgagelending and debenture issues.

The Banking Act of 1862 was intendedto regulate the relationship between thestate and the central bank, not least with aview to dismantling the considerable accu-mulated state debt. According to the spirit ofthe Banking Act, the Austrian National Bankcould be regarded as more independent


A BRIEF HISTORYOF THE NATIONAL BANK

OF HUNGARY1

1 For an explanation of the terms printed in bold in thetext, see the glossary in alphabetical order.

2 A Magyar Nemzeti Bank Története (History of the Na-tional Bank of Hungary) I, KJK, Budapest, 1993, p.155.

3 Expressions used in the Emperor’s patent of 20 June,1849; source: A Magyar Nemzeti Bank Története (History ofthe National Bank of Hungary) I, KJK, Budapest, 1993. p.157.

than the Prussian Bank or even the Banquede France of the Second Empire in thosedays. The Emperor’s right to appoint thebank’s governor and the government com-missioner was merely formal. According tothe intention of the legislators, the bankcould take action only as a commissionagent handling the state’s transactions andwas under the obligation to discount onlythe bills regularly presented by the state.The acceptance of government papers ascollateral for credit was excluded. This inde-pendence was maintained with minor modi-fications until 1878 when the Austro-Hun-garian Bank was established.

Right from the very beginning, the Hun-garian Estates disputed whether the Vien-nese bank’s issuing powers extended to Hun-gary in terms of public law. The Batthyánygovernment attempted to issue its own cur-rency through the Pesti Magyar Kereske-delmi Bank (Hungarian Commercial Bank ofPest). However, this experiment failed to-gether with the 1848–49 War of Independ-ence. The question of an independent Hun-garian central bank was raised during the ne-gotiations of the Compromise. Eventually,the issue was closed with a compromise withthe establishment of the dually structuredcentral bank of the Dual Monarchy under thename of Austro-Hungarian Bank (AHB). Thebank held its statutory meeting on 30 Sep-tember 1878. AHB’s Deed of Foundation alsobore this dual nature: on the one hand, itfunctioned as the central bank of the Monar-chy covering its entire territory, on the otherhand, however, in the spirit of equality in or-ganisation and management, Budapest, likeVienna, acquired rights of administration andpossibilities of influence.

Owing to the dualistic state establish-ment, the organisation of the Austro-Hungarian Bank was complex. The man-agement of the bank was divided into deci-sion-making and executive arms, the lowerlevels of which were dualised. Of the deci-sion-making bodies, the Supreme Board,

the Governor and the committees of the Su-preme Board were centralised, while therewere two Boards of Directors functioning ateach of the two headquarters, each headedby a Deputy Governor. The Supreme Boardperformed general supervisory functionsover the entire banking operation. Each ofthe countries elected two representatives tothe Supreme Board, who were also mem-bers of the Boards of Directors. The repre-sentatives of the Boards of Directors andeven the government commissioners of thestate participated in the meetings of the Su-preme Board. The government commis-sioners were also members of the commit-tees, increasing in number as time passed(Executive, Mortgage, Administration andForeign Exchange Committees). Of the ex-ecutive bodies, management and the cen-tral service functioned in Vienna with localservices present in both capitals within theframework of a head institute in both cities.

At the time the Austro-Hungarian Bankwas set up, the coverage system inheritedfrom the practice of the Austrian NationalBank was in operation with silver coins incirculation. Owing to the stocks of silver ac-cumulated, compliance with the coveragerequirement did not impede increasing thevolume of banknotes, aligned with paymentneeds, at first. However, in addition to silvercoins and banknotes, government noteswere also in circulation, conversion on de-mand was not typical, hence it cannot be re-garded as an unadulterated silver standard.4

After 1878, European countries mi-grated towards the gold standard one afterthe other and, beside the rise in the output ofsilver, this also led to a decline in the price ofsilver. By 1878, the premium on silveragainst the paper currency disappeared,moreover, a disagio of the silver florinevolved, that is, the face value of the silverflorin exceeded its intrinsic value. Minting ofcoins by individuals for speculative pur-poses began to take on substantial dimen-sions, which was subsequently suspended.

It was under these conditions that thenew monetary system of the Monarchy, thearanykorona (gold crown) system, was de-



4Conversion on demand was suspended on 29 April 1859and this did not change in the course of the subsequent his-tory of the Monarchy, not even with the introduction of thegold currency system (the aranykorona) in 1892.

veloped. Due to the absence of conversionon demand and the use of silver coins as le-gal tender, it could not be regarded as a puregold standard (limping gold currency). Fol-lowing the example of the GermanReichsbank, a 5 per cent banknote tax wasintroduced as an indirect instrument. Withthis transformation of the coverage system,the Austro-Hungarian Bank set out on thepath of becoming a genuine central bank,the banker of banks.

The Deed of Foundation of the Bankwas suspended in the middle of 1914 afterthe outbreak of the First World War, and thedisbursement of government loans began.The principles of coverage for the gold cur-rency were gradually softened. The Austro-Hungarian Bank accepted war bonds ascollateral up to 75 per cent of their facevalue, whereby the central bank covertly fi-nanced the government’s military expendi-ture. The continuous deterioration in the ex-change rate of the korona (crown) and thedepletion of the stock of precious metals ne-cessitated the setting up of the Foreign Ex-change Centre on 1 February 1916, follow-ing the similar German example with a de-lay of one month.

The successor states of the Monarchy,falling apart in the wave of revolutions fol-lowing the Great War, created their inde-pendent currencies one after the other. TheHungarian economy was in a difficult posi-tion. The level of investments declined, for-eign exchange reserves were depleted andthe sources of foreign capital ebbed away.Inflation ran high because the war was fi-nanced by running the banknote pressesand heaps of banknotes flew in from thesuccessor states.

The Independent HungarianCentral Bank

Preparations

In the wake of the Great War, Europeanbankers felt that the political powers of the

European Reparations Commission greatly

impeded the recovery of the financial system,hence they made efforts to curb its politicalinfluence in general and to reinforce the cen-tral banks independence in particular.

It was during this period that the Na-tional Bank of Hungary was established withsubstantial international, particularly Brit-ish, support.

By the mid-1920s, the victorious westEuropean states overcame the economicand political crisis following the war and sta-bilisation of the entire continent becametheir primary concern. One of the precondi-tions of the loan to be granted by the Leagueof Nations to promote stabilisation in Hun-gary was the setting up of an independentHungarian central bank.

The Austrian peace treaty, signed on10 September 1919, provided for the liqui-dation of the Austro-Hungarian Bank. TheHungarian peace treaty took over the rele-vant part verbatim. The temporarily ex-tended licence of the joint central bank ulti-mately expired on 31 December 1919.

The Austrian and the Hungarian man-agement of the joint bank were separated asof 1 January 1920 and banking operationswere pursued separately even in accountingterms with headquarters in Vienna and inBudapest, albeit retaining the name ofAustro-Hungarian Bank.

The Magyar Királyi Állami Jegyintézet(Royal Hungarian Note Issuing Institute)was established in August 1921 with Dr.Sándor Popovics, the former finance minis-ter of the third Wekerle government andhead of the financial mission of the Hungar-ian peace delegation, at its head.

According to the idea entertained byMinister of Finance Lóránt Hegedûs, theNote Issuing Institute was called upon toprepare for the migration from the koronato the new legal tender in support of theconsolidation. The Note Issuing Institutetook over the assets, employees and part ofthe business of the former joint centralbank.

To curb profiteering in currency and tohalt the erosion of the value of the korona,



the Foreign Exchange Centre5 was calledback to life on 8 August 1922.

From the Foundationof the NBH untilthe Second World War

In February 1924, the Reparations Commit-tee accepted the Hungarian reorganisationprogramme and, in order to re-establish thecreditworthiness of the Hungarian State, re-leased the rights of pledge for reparations.As part of the legislation package on reor-ganisation, Act V determined the establish-ment and scope of operations of the NationalBank of Hungary on 26 April 1924. In thisAct, the state conferred the exclusive rightof issuing banknotes on the NBH until 31 De-cember 1943. The statutory meeting washeld in the Ceremonial Hall of the Academyon 24 May 1924; Sándor Popovics took theposition of President and Béla Schróberwas appointed Director General. The Bankbegan its operation on 24 June 19246 andpublished its opening balance sheet on30 June.

The state was the largest of the Bank’sfounders with its 39.5 per cent holding. Inaddition to the community of the Budapest-based financial institutions (TEBE – Taka-rékpénztárak és Bankok Egyesülete – Asso-ciation of Savings Banks and Banks), Aus-trian, Swiss, Dutch, Romanian and Czecho-slovak financial institutions and companiessubscribed to the Bank’s shares. The sharesof the National Bank were introduced to theBudapest Stock Exchange7 on 21 Septem-ber 1925. The National Bank of Hungarytook over the management of the state’s ac-count and the national debt. It has been ashareholder in and an active member of theBank of International Payments (BIS) rightfrom the foundation of the latter (1930).

By the summer of 1924 inflation haddeclined significantly, the NBH stabilisingthe exchange rate of the korona, pegging itto the British pound. In April 1925, the goldstandard was adopted again for the poundsterling, consequently the korona again be-came a gold-based currency. The new cur-rency, the pengõ, which was founded on thestabilisation of the korona, was introducedin November 1925, although it entered cir-culation only from 27 December 1926.

The stabilisation of the 1920s relied toa great extent on foreign funds. Short of fun-damental structural reforms, the world eco-nomic crisis, which exploded in the autumnof 1929, hit a Hungarian economy deeply indebt and non-competitive in many respects.The financial crisis reached Hungary in July1931 and there was a run on the banks bydeposit holders. To protect reserves, foreignexchange controls were reintroduced andmaintained over the long term.8

With the shift to a wartime economy,announced in the 1938 Gyõr Programme,there was a sudden surge in printing bank-notes and the national debt began to in-crease. In order to finance the budget, theindependence of the NBH was curtailed andthe Bank was obligated to finance the state.With the declaration of war, the state be-came the most important consumer and amajor portion of industrial output was put tosatisfy the state’s needs.



5The Institution existed from 1 January 1916 until 25 No-vember 1925 within the framework of the National Bank ofHungary. At first, the intention was but to maintain a registryof demand and supply and an organised, transparent marketof foreign currencies, hence those acceding to the Institutionhad to make their receipts of foreign currencies intended forsale available to the Centre and to obtain their foreign ex-change and currency needs from the Foreign Exchange Cen-tre indicating the purpose of use. Foreign currencies requiredfor the purposes of the state were handled separately fromthe Foreign Exchange Centre. The Austro-Hungarian Bankwas given the management of the Foreign Exchange Centre.The bank agreed to make available the cash it had from ex-port transactions to the Centre and also to satisfy the needs ofits clients from the Centre. As the Foreign Exchange Centrewas already running a deficit in the first months of its opera-tion, the AHB used its own stocks and later borrowing fromabroad also became necessary. Central exchange ratesbroke away from market rates (for greater detail, see the His-tory of the NBH, pp. 373–377). By a decree, issued on23 December 1916, trading in foreign currencies was madesubject to official licensing and the independence of theForeign Exchange Centre was abolished.

6 The base rate was set at 10% and the korona waspegged to the British pound (pound sterling 1 = 346,000 pa-per korona, 1 aranykorona (gold crown) = 17,000 paperkorona).

7 The consideration behind taking the Bank’s shares to thestock exchange was that the state should divest itself of theshares it had received in exchange for transferring assets ofthe Bank to private hands as soon as possible, thus guaran-teeing the central bank independence from the state.

8 From then on, the National Bank of Hungary continuedto apply foreign exchange controls until the early 1990s.

Lending by private banks was alsomade subject to state control. War spendingwas financed by issuing short-term govern-ment papers, which were discounted by thecentral bank. Increasing the money supplyin this manner stoked inflation from1941–42, resulting in unprecedented accel-eration and hyperinflation from 1944.

With the conclusion of the armisticeagreement, the tasks of the NBH were takenover by coalition committees set up on po-litical grounds; all the central bank was al-lowed to do was to run the banknotepresses. Control of the economy was al-ready divided politically at that time.

Shift to a Command Economy

With the rebuilding of the economy in thewake of the war, industrial output increasedgradually and agriculture also became moreorganised. With gold stocks returned andshort-term foreign loans, there seemed tobe a chance of stabilisation. To support this,lending was made subject to close controland companies were instructed to accumu-late stocks of the most important articles.By limiting the amount and the period oflending to the state, the NBH contributedsignificantly to the successful introductionof the new currency, the forint9 on 1 August1946. A banknote ceiling was set at Ft1 bil-lion and strict compliance with the ceilingalso supported the strength of the new cur-rency.

The Central Bankin the Periodof the Socialist CommandEconomy

The artificial shortage of money, createdby restricting banking activity and lend-

ing, aimed not only at keeping the moneysupply and inflation under control, but alsoat restraining stock exchange and commer-

cial banking activities in preparation for thesubsequent nationalisation of the banks andthe large companies held by them (Act XXXof 1947). During 1947–48, the NBH wasturned practically into an absolutely new or-ganisation subject to the supervision of theMinistry of Finance. The NBH was given ex-clusive rights to control the financial activi-ties of plants accounting for 80 per cent ofthe country’s industrial output. The NBH su-pervised lending and the management ofstate-owned companies, which contributedhalf of the product turnover. Companieswere obligated to manage their financial andlending activities through their NBH singleaccount. Investments originally planned tohave been financed by credit soon becamegratuitous (that is, financed by budgetaryfunds).

In the one-tier banking system thusestablished, in addition to the commercialbanking functions performed by the NBH,additional specialised financial institutionswere set up (Investment Bank, Co-operativeCredit Institution, National Savings Bank,and Foreign Trade Bank) in the spirit of pro-file clean-up.

The NBH reorganised its functions offoreign exchange authority, managed thepre-war debts as well as the obligationsof war reparations. Although it aimed at pru-dent loan appraisal to protect the stabilityof the forint, the political criteria of the agen-cies of public administration prevailedto an increasing extent over the views of theBank’s experts in 1947–1948. Duringthe period of the first five-year plan(1950–1954), the monetary policy of theNBH had to support investments, the forcedmilitary development programme of theCold War and the reorganisation of agricul-ture. The NBH had but an administrative,mechanical role in implementing these. Pur-suant to the 1949 Constitution, nominally,the NBH retained its legal form as a com-pany limited by shares, while it was placed



9 The exchange rate of the forint was determined on thebasis of the consumer prices of the last peace years,1938–1939; on that basis, one dollar was equivalent toFt11,739.

under government control.10 Because of itscommercial banking activities, the Bank’sbranch network expanded substantially: by1952, there were 134 NBH branches operat-ing all over the country (as against the21 branches functioning at the time of na-tionalisation), while the number of its em-ployees reached 9,000.

Execution and licensing of foreign ex-change operations became an exclusiveright of the NBH from 1950. At the sametime, the new management of the NBH (incontrast with the Soviet example of 1917)endeavoured to repay its foreign loans andto compensate the foreign owners of nation-alised assets, which was implemented by1970.11

With the establishment of the CMEA,the NBH was made responsible for the fi-nancial transactions between the memberstates. Although in the course of the consoli-dation of the economy after 1956 the sepa-ration of the tasks of the central bank fromcommercial banking functions was raisedon several occasions, this was never imple-mented. However, the economic reformsenhanced the significance of the monetarypolicy instruments available to the NBHand, with the recovery in foreign trade in the1960s, the Bank expanded its domestic for-eign exchange market activities.

In the last quarter of 1960, the networkof regional directorates was gradually dis-mantled and 19 county-based directorateswere set up.

To find a way to improve the align-ment of the command economy and themarket, the experts of the NBH also partici-pated in the development of the “New Eco-nomic Mechanism” of 1968. The monopolyrights of the NBH awarded after 1948 con-cerning issuing, the regulation of payments,account management and foreign exchangemanagement were reinforced by decree.

This decree clearly separated the centralbanking and other national economic func-tions of the Bank, leaving the one-tierbanking system and the principle of govern-ment supervision of the NBH intact. Onceagain, the central bank’s legal form of oper-ation was that of a company limited byshares.

Under the New Economic Mechanism,credit policy guidelines were developed an-nually by the newly established Credit PolicyCouncil of the NBH. Based on the guide-lines, the NBH was responsible for its imple-mentation and supervised its execution.This meant greater scope for making deci-sions based on economic rationality andprofitability. The so-called supervision bythe Bank, which, in practice, meant admin-istrative intervention in the management ofcompanies and the levying of fines, wasabolished. Steps were also taken towardsliberalising foreign trade by slightly stream-lining import licensing and by adjustment ofthe exchange rate of the dollar. The organi-sational units responsible for central bank-ing functions were more markedly divorcedfrom those in charge of commercial bankingfunctions.

The historical events of 1968 consti-tuted a turning point for the Hungarian eco-nomic reform, which appeared, inter alia, inthe form of endeavours to re-centralise theeconomy. From January 1972, the NBHhad exclusive responsibility for financingthe invested and the current assets of or-ganisations pursuing economic activities.The role of the State Development Bank wasrestricted to financing specific major invest-ment projects from the state budget. Thedeterioration in the terms of trade due to theoil crisis narrowed the elbowroom of the re-form, which was limited in any case, and thedebt crisis of the early 1980s was an unmis-takable sign of economic tension. The NBHfinanced the external disequilibrium by bor-rowing from abroad and issuing bonds,which was far from being general practice inan central-east European country of thosedays.



10 The post of the President was abolished, the DirectorGeneral was appointed upon the recommendation of theMinister of Finance by the Council of Ministers. The posts ofthe President, Vice President and Managing Director werere-established by a law-decree of the Presidential Council inApril 1956.

11 The process of compensating the foreign shareholdersof the NBH was completed somewhat earlier, by 1967.

In parallel with its international bor-rowing, the NBH developed its network ofinternational representative offices in themajor financial centres of the world(1967–1995 Paris, 1970–1995 Zurich,1973–1995 London, 1973–1998 Frankfurt,1974–1975 Beirut, 1977–1996 New York,1983-to date Tokyo). The NBH provided achannel for continuous communication withthe advanced countries and it was partlydue to this that Hungary acceded to the In-ternational Monetary Fund and the Interna-tional Bank for Reconstruction and Devel-opment in 1982.

The Transformationof the National Bankof Hungary and the BankingSector in 1987

In the 1980s the country had to adjust to analtered international economic environ-

ment. As a result of this, the inflexibility ofthe financial system was also softened: newinstitutions came into being, securities in theform of bond issues appeared, a trade lawwas enacted, credit lines were extended andfactoring was launched. The artificial boostto growth led to significant additional debtaccumulation in the short term. It was therecognition of the unsustainability of thisprocess that led to reform of the bankingsector.

The basis for the change was providedby a change in the approach of economicpolicy: in the 1980s, when genuine stepswere taken to develop market conditions, itbecame evident that a radical transforma-tion of the banking sector was also required.The inflexibility of the one-tier banking sys-tem and the absence of lending based onbusiness criteria under “quasi market” con-ditions obviously impeded the developmentof the market elements of the economy. Inits December 1984 resolution, the CentralCommittee of the Hungarian SocialistWorkers’ Party declared that the central

banking and commercial banking functionswould have to be separated within the NBHand preparations for the establishment of atwo-tier banking system would have to be-gin. The Hungarian banking sector wastransformed into a two-tier one as of 1 Janu-ary 1987. Under the new regime, the Na-tional Bank of Hungary was designatedas the central bank, that is, the bank of is-sue.12

Under the new system, the NBH be-came the bank of the banks and of the state;it was subject to the control of the Presidentof the Council of Ministers. Its responsibili-ties included influencing the money supplyand facilitating the achievement of the eco-nomic policy objectives of the governmentwith the traditional instruments of monetaryand credit policy (interest rate policy, re-serve policy, refinancing, open market op-erations). The NBH continued to be respon-sible for managing the state’s account andlending to the budget and it retained the li-censing of foreign exchange turnover. TheNBH regulated and controlled the activitiesof the commercial banks. Three of the fivecommercial banks established with thetransformation of the banking system into atwo-tier one (the Hungarian Credit Bank, theHungarian Commercial and Credit Bankand Budapest Bank) came into being byseparating the General Credit Directorate,the Pest County Directorate and certainbranches of the NBH.

The commercial banks came into being notwith a regional or sectoral character (eventhough the predominance of one or the othersector could be observed in the case of thenewly established banks), which implied thepossibility of genuine competition amongthem. Foreign examples, by which bankingsystems organised on a sectoral or regionalbasis could be studied, showed that in thosecases banks enjoying virtual monopoliesstood against the companies, and the differ-ing needs of the sectors and regions impeded



12 The term “bank of issue” was used extensively in Hun-garian literature on banking even before the transformationof the banking system into a two-tier one, which arose from adecisive classical function, that is, the monopoly of issuingbanknotes, instead of the term “central bank” used mainly inother languages.

the establishment of uniform and normativeregulation. After the original central distribu-tion, the banks were free to develop their cli-entele. The banks established with na-tion-wide scope were founded in the form ofcompanies limited by shares with the state astheir majority shareholder, represented by theMinistry of Finance. Companies and co-operatives held minority portfolios.

After the 1990 elections, in the spirit ofthe transition to a market economy, Parlia-ment enacted Act LX of 1991 on the CentralBank and Act LXIX of 1991 on Financial In-stitutions and Banking, since then bothamended several times. The new Act on theCentral Bank re-established the independ-ence of the NBH and re-regulated its opera-

tions. The central bank has an obligation toreport to Parliament and has become inde-pendent of the government. The Bank au-tonomously develops and implements itsmonetary policy.

With the institutional reform in the sec-ond half of the 1990s, non-central bankingfunctions were dismantled. As part of thisprocess, foreign representations and stakeswere liquidated with one exception. In No-vember 1996, the 18 county-based director-ates were wound up to be replaced by eightregional directorates. From 1 January 1999,the number of regional directorates de-creased to four, with their seats in Debrecen,Gyõr, Kecskemét and Székesfehérvár.



The Functions and Roleof the Cental Bankin the Financial System

The tasks of the central bank are set forthin most countries in some form of legal

regulation (generally an Act of Parliament).A comparative analysis of the central banksof different countries reveals that centralbanks strongly differ from one another interms of their powers and structure, due tothe fact that their functions may also rangeover a wide scale.

Traditionally, central banks have amonopoly of issuing money. Through thisfunction, it is the task of every central bankto mould the supply of credit and moneyand, in relation to this, to influence marketrates, that is, to pursue monetary policy.A central bank may have full or partial re-sponsibility for shaping exchange ratesand managing the foreign exchange re-serves of a country.

Central banks manage the payment(settlement) accounts of commercial banksand safeguard the fixed and freely dispos-able reserves of the banks. They play an im-portant role in the maintenance of paymentsystems. Most of them are responsible forthe stability of the financial system, partlythrough controlling and supervising banksand other credit institutions and partlythrough being the lender of last resort. Mostof the time, the central bank is also the bankof the government. Its tasks may include ex-change controls; in some countries they

manage either a part or all of the country’sdebt. Units to analyse the economy and toconduct research are also required for theperformance of the tasks of a central bank.The above list illustrates how manifold thefunctions of central banks may be. Thequestion, however, is which of these func-tions are the ones through which a centralbank can exert influence on the economy ofa given country.

The history of central banks revealsthat there are tasks which are common tomost of them, affecting the very heart oftheir operation. Effective instruments ofcentral banks to influence the financial envi-ronment, in which their respective econo-mies operate, include the right and possi-bility of controlling the money and creditsupply and, consequently, of influencingmarket rates. The monopoly of issuingbanknotes and the banker of banks func-tion – the management of the banks’ ac-counts, fixed and free reserves and their fi-nancing (which, typically, is concomitantwith the role of the lender of the last re-

sort) provide this opportunity to a centralbank. Management of the exchange rateregime and foreign exchange reserves canhardly be separated from setting interestrates, although the treasury often plays apart in this process. These days, manage-ment of the accounts of the budget hasless of an influence over the money andcredit supply. Nevertheless, being thestate’s banker is a classic and emphaticrole for most central banks.


THE ROLE OF THE NATIONALBANK OF HUNGARY

IN THE FINANCIAL SYSTEM

In countries where the central bankhas sufficient independence to set interestrates, legislation frequently specifies the ob-jectives, for the achievement of which thebank may use this power. As in the case ofmost central banks of the world, the funda-mental task of the National Bank of Hun-gary, as set forth by law, is to protect thepurchasing power of the local currency. Thepowers given to the central bank (its func-tions), employed in the interest of protectingthe purchasing power of the currency, con-stitute the monetary policy of the centralbank.

In addition to protecting the purchas-ing power of the forint, another task of theNBH is to support the implementation of thegovernment’s economic policy programmewith the instruments of monetary policyavailable to it.

That is to say, the NBH plans and im-plements its monetary policy harmonisedwith the economic policy developed by thegovernment.

The objective set by law for the cen-tral banks of many a country may differfrom that of achieving price stability (theremay be other macroeconomic objectivesincluded in the set of objectives, whethersubordinated or on an equal footing) butcentral banks can realise the objectives setthrough their monetary policies every-where.

The first and most important taskamong the functions of the National Bank ofHungary is of a macroeconomic nature: theoperation of monetary policy, that is, influ-encing the money and credit supply with aview to safeguarding the value of the localcurrency. The central bank may implementthis task based on the following classic cen-tral banking functions:

• issuing, that is, monopoly over is-suing banknotes,

• the banker of banks – lender of thelast resort function,

• the government’s banker, and

• management of foreign exchangereserves.

Central banks, however, have a sec-ond set of functions, which includes all thetasks required for the maintenance of thesound operation of a banking system and fi-nancial stability. When a bank functionspoorly, it makes a loss and may even lose itsequity, its consequences are highly detri-mental to the entire economy. It may imperilconfidence in the banking system and,through this, confidence in the currency aswell as the propensity to save. Dependingon the magnitude of the problem, it may dis-turb the operation of the entire bankingsector.

As a central agency, the bank of issueestablishes the conditions which attempt tominimise the risk factors which might en-danger the safe operation of the banks. Thusthe role of the central bank in supporting thebanking sector goes further than assistingthem when needed by being their lenderof last resort.



Abstract 1: The Legal Standingand Fundamental Function of the NBH

Act on the Central Bank, Chapter I

§1. The National Bank of Hungary (here-inafter the “NBH”) is the bank of issueof the Republic of Hungary, the centralbank of the national economy.

…

§3 The NBH shall support the implemen-tation of the government’s economic pol-icy programme with the instrumentsof monetary policy (money and creditpolicy) available to it.

§4 (1) The fundamental function of theNBH is to protect the domestic and exter-nal purchasing power of the national cur-rency.

The functions of the National Bank ofHungary, which assist in the sound opera-tion of the banking sector, include the fol-lowing:

• regulatory functions,

• bank supervisory functions, and

• maintenance and development ofthe payment system.

As it was indicated at the beginning ofthis chapter, the central banks of the variouscountries of the world may perform a num-ber of additional functions, but the rangeof the tasks allotted to them may also benarrower. The functions required for thesound operation of the banking sector maybe – and in many places are – performed byorganisations other than the central bank,which are independent from it. It is disputedto this day how these tasks may be per-formed with the greatest efficiency –whether inside or outside the central bank.The list assigned to the two groups of func-tions reflects the tasks of the National Bankof Hungary as set forth in the Act on theCentral Bank which, in the main, coincideswith the functions of the central banks ofmost industrially advanced nations.

Both knowledge and analysis of theappropriate indicators of the economy, themoney and capital markets and the perfor-mance of the banking sector are requiredequally for pursuing monetary policy andmaintaining financial stability. By virtue ofits position, the National Bank of Hungary isan institution belonging to the official statis-tical service, collecting as well as supplyingdata. Data collection and reporting are spe-cial tasks of the central bank linked to bothsets of its functions.

The following sections provide anoverview of the tasks of the National Bank ofHungary based on Act LX of 1991 on theCentral Bank. The subsequent chapters willunfold the functions, serving as the basis forpursuing monetary policy, in greater detailfocusing on the objectives and the set of in-

struments of monetary policy and its impactmechanism.

Issue of Banknotesand Coins

Under the Act on the Central Bank, theNational Bank of Hungary has exclusiveauthority to issue domestic legal tender –forint banknotes and coins – to determineits denominations and to withdraw themfrom circulation in Hungary. When mak-ing payments in the Hungarian legal ten-der, the banknotes and coins issued bythe NBH must be accepted by all at facevalue.

At the time when payments were ef-fected largely in cash, central banks wereable to directly influence the total amount ofmoney in circulation through their issuingmonopoly.

Banknote issue was a key function ofcentral banks. With the technical develop-ment in payments and the proliferation offorms of cashless payments, the share ofcash – taking longer-term trends into ac-count – has been declining in the economy.(For categories of money supply, i.e. themonetary aggregates, the monetary baseand its relation to the money supply see thesection on “Monetary Aggregates” forgreater detail.) Although the regulationof money supply cannot be limited to con-trolling cash turnover, i.e. to the amountof cash in circulation, the changes of cash incirculation arising from changes in payment



Abstract 2: The Legal Standingof the NBH and its Fundamental Task

Act on the Central Bank, Chapter I

§4 (2) The NBH has exclusive authorityto issue banknotes and coins.

habits, the technical changes of the pay-ment systems and their forecasting con-tinue to play an important role in monetarypolicy. The central bank is responsiblefor fully satisfying the cash needs of turn-over by up-to-date banknotes and coinsin an adequate series of denominations.

The production of banknotes used aslegal tender is a complicated technicalprocess, ranging from design to the de-struction of banknotes that have becomesuperfluous or unsuitable for use. (Preven-tion of counterfeiting is an important crite-rion in banknote design and production.)In addition to issuing banknotes, the Na-tional Bank of Hungary also issues andputs into circulation forint coins. The com-prehensive renewal of the legal tender wascompleted in 1999, which began with thereplacement of coins in circulation in 1993and continued with the introduction of thefirst element of the new series of bank-notes – the 10,000-forint denomination –in 1997. The National Bank of Hungarywithdrew all the denominations of the oldseries of banknotes and coins from circu-lation by October 1999; now only the sixdenominations in the new series of bank-notes and the seven denominations in theseries of coins are available for cash pay-ments.

The banknotes of the new series weremade using modern base materials, newtechnologies and state-of-the-art securityelements.

Currency denominations shifted to-wards growing face values in accordancewith the requirements of turnover: the facevalue of the highest and the lowest banknotedenominations doubled, while fillér coinswere eliminated from circulation.

As the banknotes of new denomina-tions gained ground and as a result of thewithdrawal of denominations not required incirculation, the overall amount of banknotesand coins in circulation has decreased overthe past few years while the value repre-sented by them has increased dynamically.

Early in 2000, the banknotes andcoins in circulation represented a total

value of Ft810 billion, within which theshare of banknotes was 98 per cent, that ofcoins, 2 cent. About 10 per cent of thevalue of the cash in circulation can befound with financial institutions and 90 percent outside the banking sector (in house-holds, retail trade, cash desks of businessorganisations, etc.).

The Central Bankas the Banker of banks

The special position of the National Bank ofHungary – and that of the other centralbanks – arises from the fact that commercialbanks depend to some extent on centralbank money.13

First, the banks need cash to disbursedeposits placed with them by their clientsand the loans granted to them, which theycan obtain only from the central bank.



Abstract 3: The Tasksof the NBH:

The Account Management Activityof the NBH

Act on the Central Bank, Chapter II

§26 (1) Unless another credit institutionis authorised, the NBH shall managethe settlement accounts of credit institu-tions.

(2) The NBH shall manage the paymentaccounts of clearing houses.

(3) The NBH shall manage the paymentaccounts of the National Deposit Insur-ance Fund and the Investor ProtectionFund.

13 Financial literature tends to mention central bankmoney as “the monetary base”, which includes cash outsidethe central bank and the banks’ reserves kept with the cen-tral bank. For greater detail, see the section on “MonetaryAggregates” in the chapter on “Indicators”.

Second, the central bank manages thepayment accounts of credit institutions,which means that these accounts of thecredit institutions always have some kind ofa balance (stock) to settle cashless inter-bank transactions.

Third, banks in Hungary must placedeposits with the NBH corresponding to aspecified ratio of their stock of liabilities (forgreater detail, see the section on “Regula-tion of the Reserve requirement”). Until theautumn of 1994, the reserve requirementaccounts and the banks’ payment accountswere separated. With the introduction of thegiro system, the two accounts were mergedand the banks may use the outstanding bal-ances of their payment accounts in excessof the reserve requirement in the interbankclearing system.

The above three factors taken together– cash in circulation, the banks’ required re-serves and their balances to be used freelyin payments – constitute the monetary base,over which the central bank exercises con-trol. By influencing these stocks throughvarious instruments, the central bank canact upon the amount of money in circulation(the money supply).

An important question of monetarypolicy is to what extent is this relationship –for instance, between changing the centralbank rates and the change in the moneysupply – close and calculable under givenconditions (see the chapters on monetaryaggregates and transmission).

Not every bank depends directlyon the money provided by the central bank.The amount of central bank money, re-quired for the appropriate magnitude of bal-ances, is not necessarily obtained from thecentral bank. Banks, which for a transitoryor even a sustained period have more cen-tral bank money (liquidity) than necessary,may lend to banks struggling with transitoryliquidity shortages through the interbankmoney market. All in all, however, themoney market does not have more centralbank money than that created by the centralbank.

The Lender of Last ResortFunction

Liquidity needs arising from time to timeamong banks are part of the ordinarycourse of business. Banks have severalmarket instruments to cover such needs(selling government papers or foreign ex-change assets, etc.) and the central bank asthe banker of banks may also extend acredit to a financial institution. It may, how-ever, happen that a bank’s liquidity short-age becomes permanent or it may suddenlyget out of hand. The central bank has theopportunity to provide banks, struggling un-der a transitory or lasting liquidity crunch,with central bank money under an extraor-dinary procedure. Therefore, this functionis closely related to that of ensuring moneysupply to the banks (“banker of banks”)and that of maintaining a sound bankingsystem.

The question may arise why the cen-tral bank should bail out an ill-functioningbank struggling with liquidity shortages,which may be attributed to mistakes inconducting business. Beyond the funda-mental problem that, in the event of a bank



Abstract 4: The Tasksof the NBH:

Extraordinary Credit in the eventof an Emergency at a Credit Institution


§17 (1) In the event of an emergency, theNBH may extend an extraordinary creditto the credit institution. Availability ofsuch NBH credit may be subject to themeasures to be taken by the StateBanking Supervision in an emergencyand the implementation by the credit in-stitution of the measures initiated by theState Banking Supervision.

failure, deposit holders may lose their sav-ings, there is the odd chance that, depend-ing on the size of the bank, the crisis mayspread to other banks as well. A run on thebanks may lead to serial insolvency, whichmay paralyse a part or all of the bankingsystem, and thereby violently retard theeconomy.

Therefore, when considering the res-cue of a bank, the implications of a bankfailure, which may shake confidence in thebanking system and the currency, de-crease savings and imperil economic sta-bility, should also be considered in allcases, in addition to protecting investors.To illustrate the importance of preventingbank failures, the economic crisis of1929–33 is usually referred to as an exam-ple.

It was bank failures which triggered amajor decline in money supply seen in theUnited States during this period, whichmany economists regard as the causeand driving engine of the economic col-lapse which took place in the course of thecrisis.

The question may also arise: why res-cue these banks in order to protect deposi-tors when the institution of deposit insur-ance stands between them and any dam-age they might sustain? At first sight, itmay seem that a deposit insurance fund,which exists in most countries to protectand insure deposit holders against lossesarising from bank failure, could render therole of the central bank as lender of the lastresort superfluous.

This, however, is not true for tworeasons. On the one hand, deposit insur-ers insure deposits only up to a certainlimit – in Hungary, up to Ft1 million – andalthough the small amounts of depositsconstitute only a very small fraction of thetotal deposit portfolio, should bank fail-ures occur in large numbers, the insur-ance funds would be unable to fully covereven the small-value deposits. (Mostprobably, however, the central bank, aslender of the last resort, would stand be-hind the insurance funds and put up the

necessary funding in most countries.)Secondly, deposits with a value aboveFt1 million are not insured by the depositinsurers. The shaking of large depositholders’ confidence in the banking sys-tem could easily lead to a run on thebanks, so bank failures may arise in spiteof the deposit insurance system.

The role of lender of the last resortmay not only protect the economy from thedetrimental effects of bank failures but alsoprovide protection against money marketcrises caused by them.

A financial panic will always have ahighly detrimental impact on an economyas it impedes the fundamental task of fi-nancial markets of channelling free fundsto efficient investment opportunities. In thecase of a stock exchange collapse, a largenumber of broker firms may find that theyneed supplementary financial assets to fi-nance their activities. Banks may deny thepossibility of additional financing for brokerfirms precisely because of the impendingfailures.

As far as its form is concerned, thelender of last resort function rarely meanssome kind of extraordinary lending irre-spective of the monetary policy instru-ments available; it is always closely relatedto the monetary policy instruments of cen-tral bank money supply that characterisesthe given country (see the chapter on “TheInstruments of Monetary Policy”).

The techniques of central bankmoney supply may be manifold (auctions,rediscounting, standing facility) just as itvaries from country to country how a cen-tral bank may want to influence use of cen-tral bank money via interest rates or otherdirect regulatory instruments (quotas) orany combination thereof. Choice amongand regulation of these instruments is partof regulating money supply, that is, ofmonetary policy.

When, however, the central bank liftssome restriction specified in the regulationswith respect to a single bank to rescue it,the instrument will fulfil the lender of lastresort function.



Assistance may also come in the formof a transitory exemption from the reserverequirement. Although banks may use theirrequired reserves to cover their payments,by the end of the month they must, on aver-age, meet the reserve requirement. In thecase of an exemption, liquidity dependingon the magnitude of the reserve require-ment will be released for the given bank.In Hungary, central bank money thus re-leased may substantially expand the liquid-ity of any given bank, owing to the ratiowhich is deemed high in international com-parison (12 per cent).

Although the role of the central bankas the lender of the last resort has the ad-vantage of preventing bank failures and fi-nancial panic, the declaration of this possi-bility may also have detrimental aspects.It may be that banks, expecting to receiveassistance from the central bank, under-take higher than prudential risk in vari-ous fields of banking operations, largely inlending.

This risk is likely to be higher in thecase of major banks because they may be-lieve that they are too large and too impor-tant for the central bank to deny them as-sistance, for their eventual failure would,with much greater probability, lead to a runon the bank and the probability of the panicrolling on to other banks is also higher. Thisexplains why a central bank uses the instru-ment of lending as a last resort only when itreally is the last resort.

There is an aspect of the lender of lastresort function which is closely related tothe maintenance and operation of the pay-ment system: the NBH may provide bor-rowing facilities with a view to the smoothoperation of the payment system. Should abank wrongly assess its liquidity position inadvance and should its liquid assets fail toprovide coverage for the items to be trans-ferred at the time of settlement in the clear-ing system, the central bank ensures thecontinuous administration of interbankpayments by lending. But the rate on suchloans is above the money market interestrate.

The Central Bankas the Government’s banker

There are several aspects to the relation-ship between the NBH and general govern-ment. First, the NBH as the government’sbanker manages the single account of theTreasury.

Second, in relation to the accountmanagement function, the NBH may have afinancing relationship with the budget.

The financing relationship between thestate budget and the central bank has longtraditions in most advanced Europeancountries. In view of past experience, how-ever, legislators may set strict limits for thisactivity so as to prevent the infringement ofthe rights of central banks to pursue autono-mous monetary policy.

Pursuant to the Treaty establishingthe European Union (the MaastrichtTreaty), neither the ECB nor the centralbanks of the member states may extendcurrent account financing or other types ofcredit to community institutions or agen-cies, central, regional or local authorities orother central agencies or publicly ownedcompanies of the member states; it is alsoprohibited for them to directly purchase



Abstract 5: The Tasks of the NBH:

Relations to General Government,the Account Management Activity

of the NBH


§ 18 (1) The NBH manages the UnifiedTreasury Account and other state ac-counts designated by the Minister of Fi-nance.

(2) The NBH manages the payment ac-count of the State Privatisation andHolding Company, whose balance shallcontinuously be included in the balanceof the Unified Treasury Account at alltimes.

debt securities from these institutions andagencies. The intention of this provision ison the one hand to reinforce budgetary dis-cipline in the member states while eliminat-ing one of the main sources of inflation. Onthe other hand, the prohibition on the dis-bursement of direct credit by the centralbank to the government is an importantfactor with regard to the independence ofthe national central banks and the Euro-pean Central Bank (ECB).

Over the past few years, the financingrelationship between the NBH and the Hun-garian budget has also undergone majorchanges. In 1990, placements by the centralbank to general government exceeded70 per cent of its total placements (balancesheet total).

The restructuring of the economy insubsequent years necessitated that thecredits of the central bank be redirected infavour of the business sector.

The Act on the Central Bank, enactedin 1991, still reflects the practice which pre-vailed at the time of the adoption of the Act,namely, that the NBH financed the centralbudget by way of lending (on the basisof loan agreements), albeit putting a ceilingon financing the central budget throughcentral bank credit, declaring that the incre-ment in the portfolio of credit extended tothe central budget in a given year may notexceed, even on a single day of the year,three per cent of the estimated revenue ofthe central budget in the given year.

So that the central budget would notenjoy a privileged position relative to theother agents of the money market, the baserate of the central bank – that is, a mar-ket-based interest rate – governed lendingto the central budget.

The 1994 amendment of the Act onthe Central Bank (Act IV of 1994) enabledthe restricted financing of the ‘current fundof the budget’ (today termed as the UnifiedTreasury Account – KESZ) in the event of atransitory liquidity crunch of a few days inorder to ensure continuous money supplybecause of the asymmetric flow of budget-ary revenues and expenditures within the

month. This loan, which may be extendedup to 2 per cent of the annual revenue esti-mate of the central budget, may be out-standing for no more than 15 days in anymonth, either on several occasions or onend.

The central budget pays the base rateset by the central bank on its debt of liquid-ity credit to the NBH at all times. The prac-tice of the past few years, however, showedthat the budget did not make use of thiscredit facility, as together with the accountof ÁPV Rt., the balance of KESZ has beenpositive.

The 1996 amendment of the Act onthe Central Bank (§19 (3) of Act CXXIV of1996 amending Act LX of 1991), whichconstitutes the legal regulation currently inforce, prohibits lending by the NBH to thecentral budget, with the liquidity credit be-ing the only exception.

The prohibition of direct central bankfinancing could come into being only be-cause, with the development of the domes-tic capital market, the budget had increas-ing opportunity to finance its deficit withoutinvolving the central bank directly fromthe market through issuing governmentpapers.

The central bank may also finance thebudget not only by direct lending but alsothrough purchasing government papers. Itdoes make a difference, however, whetherthis is done in the primary market – whichin practice would mean that the NBH couldparticipate in government paper auctions –or whether government papers are boughtonly in the secondary market. In the firstcase, there is a possibility for the centralbank to finance the deficit through the auc-tions under pressure from the eventuallygrowing financing requirement of the bud-get, which implies the threat of distortingyields away from market levels. Purchasesin the secondary market, i.e., when the cen-tral bank buys government papers whichhad already been acquired by marketagents, have less influence on governmentpaper yields than buying them upon issue inthe primary market, which in fact consti-



tutes a form of direct financing of the bud-get.

The central bank’s participation in se-curities trading in the secondary market is,in contrast, necessary for the efficient im-plementation of monetary policy (for theoperation of the instruments and for theopen-market operations) since the centralbank may need an adequate portfolio of se-

curities. Because of these considerations,the Act on the Central Bank prohibits theNBH to directly purchase securities from thestate, i.e., to buy in the primary market.According to an amendment, however,there is nothing to impede the NBH frompurchasing government papers in the sec-ondary securities market in the form ofopen-market operations while pursuing itsmonetary policy objectives.

This regulation is also in harmony withthe principles set forth in the MaastrichtTreaty establishing the European Union, un-der which the central bank is not prohibitedfrom financing the budget, but it is prohib-ited from doing so by avoiding the capitalmarket.

These principles have the purpose ofsafeguarding the independence of the cen-tral banks in the member states of the Euro-pean Union and help to prevent wrong eco-nomic policy decisions being made becauseof distorted information. At the same time,the elbowroom provided to central banks toperform operations in the secondary marketmay be exploited only to achieve the objec-tives of monetary policy and may not serveto bypass the prohibition on the direct fi-nancing of the central budget.

Foreign Exchange ReserveManagement at the NBH

One of the most important tasks of centralbanks throughout the world is the manage-ment of the foreign exchange reservesof their countries. The objectives of main-taining reserves are nearly identical ineach country, although the relative impor-tance of individual objectives may be dif-ferent depending on the situation of thegiven state. The main objectives of main-taining reserves are intervention, transac-tion and asset accumulation. The predom-inance of any objective for any centralbank at any given point in time is deter-mined by a number of factors, includingthe exchange rate regime applied, the




Relationship to General Government,

the Account Management Activityof the NBH


§19 (1) The NBH may have a financingrelationship exclusively with the centralbudget of the subsystems of general gov-ernment.

(2) With respect to its financing relation-ship to general government, the NBHshall be responsible to Parliament.

(3) With the exception mentioned underSubsection (4), the NBH shall not extendany credit to the central budget. The NBHmay purchase government papers underopen-market operations. The NBH shallnot purchase government papers directlyfrom the state.

(4) To overcome the transitory liquiditydifficulties in the Unified Treasury Ac-count, the NBH may extend a liquiditycredit to an amount not exceeding twoper cent of the revenue estimate of thecentral budget in the given year. Thecentral budget may have such debt onliquidity credit outstanding on severaloccasions or on end, but never exceed-ing 15 days in a calendar month; thecentral budget may not have any debton liquidity credit on the last day of theyear.

magnitude of debt and the balance of pay-

ment. In ultimate cases, when economicagents are for some reason (such as war,crisis or natural calamity) no longer ableto do so, the foreign exchange reserves ofthe central banks are put towards effectingthe foreign exchange payments of thecountry (imports, etc.).

In Hungary’s case, all three fundamen-tal objectives obtain. Under the current ex-change rate regime, the NBH, in principle,assumes unlimited obligation to buy or sellat the two edges of the fluctuation bandspermitted around the centre rate determinedby thecurrency basket. To meet this obliga-tion, it must have foreign exchange reservesin an appropriate amount. The interest andprincipal repayments for foreign exchangecredits taken out by the NBH and the stateare also effected directly from such re-serves. A sufficiently high reserve enhancesthe confidence of foreign investors and lend-ers vis-à-vis the country, which eases andrenders cheaper the raising of funds abroadfor all economic agents.

Ultimately, the source of increasing re-serves may be a positive balance of the cur-

rent account or an influx of capital. The in-vestments of foreigners and the foreign ex-change funds of the domestic private sectorare converted into forints in the interbankforeign exchange market. To reach (or tomaintain) the desirable level of reserves,foreign exchange credit may need to beraised. The state may raise foreign ex-change credits in the domestic or foreignmoney and capital markets or from large in-ternational organisations (IMF, WorldBank). Until 1999, it was the NBH, currentlyit is directly the state that appears in the for-eign markets.

There is no generally accepted for-mula, valid for every country, to determinethe optimum amount of reserves. The mostfrequently used “unit of measurement” isthe import requirement. According to this,the average amount equivalent to threemonths’ imports can be regarded as an ac-ceptable reserve level. This is but an aver-age figure. In practice, the advanced coun-

tries can do with 1–2 months of import re-quirement, while in the case of the less de-veloped countries, 6–8 months’ imports isthe characteristic magnitude. Naturally, thedesirable magnitude of foreign exchange re-serves depends on a number of factors,such as the applied exchange rate regime,the ability of the country to draw in funds,the openness of the economy and the vola-tility of the balance of payments. Thethree-month import requirement is pre-sented as the minimum figure in the reservepolicy of the NBH. The external debt ser-vice, which debits the central bank’s re-serves, raises the reserve level regarded asdesirable by the value of three-month’s re-payment on average. In stipulating the finalreserve level, the central bank also takesinto account potential short-term capitalflows.

The currency structure of the reservesgenerally reflects the direction of the foreigntrade relations of individual countries. Ow-ing to this, the share of the dollar and theyen is higher in the foreign exchange re-serves of Far Eastern countries, while in Eu-rope this role is taken over by the euro. It is ageneral tendency that the role of gold in re-serve management has declined to the min-imum in most countries. The NBH keeps itsforeign exchange reserves in the major cur-rencies, primarily in euro and dollar, whilethe share of gold is minimal. The currencystructure reflects the composition of the ex-ternal payments of the country and of the fo-rint’s basket.

From the viewpoint of investmentguidelines, central banks tend to place themain emphasis on security within the “holytrinity” of investors: security, liquidity andyield. This is understandable as centralbanks manage the foreign exchange re-serves of their country, which usually repre-sents a significant amount both in absolutevalue and as a percentage of GDP. It istherefore no accident that these institutionsare regarded as the largest and at the sametime most conservative investors of theworld. Accordingly, apart from a very fewexceptions, they do not invest in, for in-



stance, shares or real estate. Characteris-tically, they seek papers of the highestcredit rating in the securities markets andthey generally buy the government papersof the advanced countries.The criterion of li-quidity is important because, in the event ofintervention or an eventual crisis, the re-serves must be deployable immediately andwithout any substantial loss of value in orderto meet their fundamental functions. Yetagain, by virtue of their size, it is only thegovernment papers of the largest and mostadvanced countries that can meet this re-quirement. Bearing in mind the criteria ofsecurity and liquidity, reserve managersaim at investing the reserves in assetspromising the highest possible yield. Theforeign exchange reserve managementguidelines of the National Bank of Hungaryare in line with international central bankingpractice. Only the largest commercialand investment banks and securities housesare listed as counterparties licensed for trad-ing.

The Regulatory Function

The regulatory activities of the central bankare divided between licensing cases requir-ing operative measures and theoretical ac-tivity, i.e. the development of regulatoryproposals applicable to businesses operat-ing in the money and capital markets andproviding opinions on these.

Licensing powers with respect to ac-tivities performed in the money and capitalmarkets are traditionally divided in Hungarybetween the State Money and Capital Mar-ket Supervision (SMCS) and the NBH.Hence, in spite of the fact that the SMCS li-censes the vast majority of financial andsupplementary financial services whichmay be pursued by financial institutions un-der the statutory provisions in force since1997, the NBH continues to be the licensingauthority with respect to certain services.

As for the specific range of financialand supplementary financial services (suchas the issue of means of cashless paymentand the provision of related services, cash

processing, clearing activity) referred by le-gal regulation to the licensing authority ofthe NBH, the assessment of the license ap-plications and decision-support are the re-sponsibility of the NBH. Under this function,the NBH organises the review and assess-ment of the applications received by theBank as well as the necessary consultationsand, on the basis of its findings, it puts for-ward recommendations for granting the li-cense or refusing to do so.

Although the independent regulatoryauthority of the NBH extends only to subjectmatters related to the central banking taskstaken stricto sensu, prudential regulationaimed at the safe and sound operation of themoney and capital market is of outstandingimportance for the NBH with regard to allthe domestic financial markets, particularlythe banking system. Therefore, with a viewto reducing systemic risk, the central bankparticipates in the preparation and evalua-tion of proposals concerning prudential reg-ulation and, in this context, in supervisoryactivity.

The legislative function includes a re-view of existing legal regulations, the devel-opment of proposals for amendment and



Abstract 7: Miscellaneous Provisions:

Powers

Act on the Central Bank, Chapter V

§71 (1) Within the limits of the law, theNBH may issue mandatory requirementsvia central bank instruments to financialinstitutions, legal entities which do notqualify as financial institutions perform-ing supplementary financial services, in-vestment service providers and clearinghouses, …

(2) With respect to payments, centralbank instructions shall apply to legal enti-ties, business organisations that are notlegal entities and natural persons.

the preparation, development and reconcili-ation of new ideas. While doing this, the cen-tral bank utilises information obtained in thecourse of assessing and evaluating licenseapplications and gleaned from the day-to-day activities of the bank’s other lines ofbusiness, together with the relevant regula-tory recommendations of the various inter-national bodies and the publications ap-pearing in financial literature.

With respect to the last-mentioned,analysis of the relevant rules of the EUand harmonisation of related fields in thedomestic legal system are of key impor-tance.

A special field of central banking ac-tivities is the foreign exchange licensingfunction based on the powers of the NBH asforeign exchange authority.

Act XCV of 1995 on Foreign Exchangeentered into force on 1 January 1996. Thisenabled convertibility in a wide range for theso-called current payment operations forboth residents and non-residents accordingto foreign exchange regulations, therebysatisfying the requirement of convertibilityaccording to Article VIII of the Articles ofAgreement on the International MonetaryFund, which was also a precondition of ob-taining OECD membership. With respect tocapital operations, rules were substantiallyliberalised in the case of the direct invest-ments of residents abroad (direct acquisi-tion of businesses) and raising and extend-ing foreign exchange credits abroad matur-ing over a year, while the foreign exchangeauthority maintained the licensing of short-term capital import and export in order topre-empt the non-desirable effects of hecticcapital inflow.

When the criteria of assessing an ap-plication with a view to licensing by the for-eign exchange authority are not determinedby foreign exchange legislation, the foreignexchange authority must consider the inter-ests of the national economy or the circum-stances of the applicant or the beneficiarywhen forming its resolution. Bearing in mindthe interests of the national economy, theforeign exchange authority does not issue li-censes for operations which contradict themonetary policy objectives of the NationalBank of Hungary.




Foreign Exchange Management Tasks


§28 The NBH is the central agency of for-eign exchange management. The powersof the NBH as foreign exchange authorityare specified by the legislation on foreignexchange.

§29 (1) In agreement with the StateMoney and Capital Market Supervision,the NBH regulates the banking activitiesof credit institutions, financial enterprisesand legal entities which do not qualify asfinancial institutions providing supple-mentary financial services in foreign cur-rencies and, furthermore, in applying for-eign exchange legislation, banking activi-ties performed with foreigners in forintterms. The NBH shall participate in the de-velopment of the principles and conditionsof extending export credit.

(2) With the exception of the governmentcredit specified under §24, foreign creditsmay be taken out and extended by the

NBH and, subject to the licensing or re-porting obligation as set forth in Subsec-tion (3), by credit institutions and otherlegal entities.

(3) Credit institutions, authorised to per-form foreign exchange operations, maytake out foreign credits subject to a re-porting obligation to the NBH. The NBHmay authorise credit institutions to ex-tend credit to non-residents and other le-gal entities to extend and raise creditabroad.

Bank Supervision

The operation of financial institutions regu-lated by laws and decrees is supervised bytwo institutions: the State Money and Capi-tal Market Supervision, an agency directlysubordinated to the government, and theNational Bank of Hungary, which has a re-porting obligation vis-à-vis Parliament.

The State Money and Capital MarketSupervision controls compliance with therequirements of Act CXII of 1996 on CreditInstitutions and Financial Enterprises (capi-tal adequacy ratio, principles of asset valua-tion, requirements concerning their man-agement, profits, liquidity, solvency, etc.).

The expectation of efficiency setagainst monetary and central bank regula-tions presupposes that the NBH should sat-isfy itself that the relevant legal regulationsand the central bank’s instructions issued onthe basis of authorisation conferred by theselegal regulations are enforced in the every-day practice of financial institutions and, ifso, in what way. This is done in the course ofcentral bank supervision.

The scope of the central bank’s super-vision extends to compliance with the in-structions of the President of the NBH con-cerning the reserve requirement and with le-gal regulations concerning payments, bankcredits and foreign exchange management,as well as the central bank’s requirementsissued to implement them. Thus, accordingto the current practice of supervision by thecentral bank, this kind of inspection primar-ily involves examining compliance with leg-islation concerning the reserve requirement,the interest rates to be applied on a manda-tory basis according to legislation, and theregulations concerning information to beprovided under the central bank’s informa-tion system.

There are certain financial services forwhich only the NBH may issue a license,which it may withdraw. These include the is-sue of instruments of cashless paymentsand related services, money exchange ac-tivity, operations which may be performed

in electronic clearing systems, and cashprocessing.

Supervision by the central bank is ef-fected fundamentally on the basis of thecentral bank’s data collection system, thatis, the data provided by the financial institu-tions. The possibility for off-site inspection isprovided by the daily, monthly, quarterlyand annual reports required to be sent to thetwo supervisory organisations. The order ofreporting set forth by regulations providesthe basis for the central bank whereby it canmonitor the condition of the system of finan-cial intermediation. In the course of inspec-tion, however, the NBH is entitled to requestsupplementary data, reports, balancesheets, vouchers and other audit materials.

On-site inspections are performed bythe division of the central bank establishedfor this purpose. In the course of an on-siteinspection, meeting the reserve require-ment, compliance with the rules of foreignexchange management and payments, andthe accuracy of the various types of reportsare examined.




Supervision by the Central Bank


§35 (1) Supervision by the central bankshall extend to reviewing compliance onthe part of financial institutions and legalentitles which do not qualify as financialinstitutions providing supplementary fi-nancial services, investment service pro-viders and clearing houses with the provi-sions of this Act, the legal regulationsconcerning payments, and foreign ex-change and the central bank require-ments issued for their implementation.Under this, the NBH is entitled to requestdata, reports, balance sheets, vouchersand audit materials.

(2) In the course of supervision by thecentral bank, the NBH is entitled to per-form on-site inspection.

The Act on the Central Bank alsospecifies the legal consequences of viola-tions of the law established in the courseof inspections by the central bank.

A system of supervision, based on uni-form requirements avoiding duplications, asreflected in the Act on the Central Bank, re-quires that the operation of the State Moneyand Capital Market Supervision and theNBH be harmonised. Thus, co-operationwith the State Money and Capital Market Su-pervision has priority among the organisa-tional relations of the NBH. An organisa-tional safeguard of co-operation is that thehead of the Supervision must be invited toparticipate in the discussion of agendaitems at the meetings of the Board of Direc-tors of the NBH which affect the functions ofthe State Money and Capital Market Super-vision.

The State Money and Capital MarketSupervision may issue various licences re-quired for the foundation and operation of fi-nancial institutions only in possession ofthe opinion of the NBH obtained in advance.

Regular information exchange servesas the safeguard of substance for co-operation between the NBH and the StateMoney and Capital Market Supervision. Thetwo organisations make data and informa-tion, obtained on the activities of financialinstitutions and the issue of and trading insecurities, available to one another on a mu-tual basis and inform each another of thefindings of their inspections and, if neces-sary, they may initiate procedures by theother entity.

Maintenance of the PaymentSystem

The vast majority of cash put into circula-tion under the issuing activity of the centralbank (of banknotes and coins) is used byhouseholds. Payments among the otheragents of the economy, e.g. various firms,companies and general government are ad-ministered largely through the transfer offunds between bank accounts. In addition tochanges in the balances of clients’ ac-counts, turnover of account money also re-sults in debit and credit positions betweenthe banks concerned. Credits and debitsgenerated in the interbank clearing are set-tled on the settlement accounts of the finan-cial institutions held by the central bank.Settlement is preceded by clearing, that is,sending payment instructions to their desti-nation and the calculation of mutual debtsand claims within interbank clearing.

The stability and safe operation of theinterbank payment system is the precondi-tion of the stability of the entire domestic fi-nancial system. This is reflected by both theConstitution and the Act on the CentralBank, according to which the NBH is re-sponsible for the development and smoothoperation of the payment and clearing sys-tems.




Supervision by the central bank


§36 (1) When a credit institution puts thecentral bank funds extended by the NBHto lending activities which violate a legalregulation, the NBH may charge a pen-alty rate in addition to the rate specifiedin the refinancing credit contract up tothe amount used in contravention of thelaw.

(2) When a credit institution violates thelegal regulations and requirements re-ferred to under §35 (1), the NBH maycharge a penalty rate in addition to thetransaction rate and may enforce shortermaturities in its refinancing credit con-tracts to be concluded with the credit in-stitution for a year, starting from the es-tablishment of the fact of violation of thelaw; in recurrent or severe cases, it may,in part or in full, exclude the credit institu-tion from refinancing.

The President of the NBH may issueinstructions which, as far as payments areconcerned, also apply to individuals. Cen-tral bank instructions specify the forms ofpayment that may be applied in domesticpayments as well as the essential rules oftheir administration, including, inter alia, theprocess and due dates of settlement.

Beyond its regulatory powers, the cen-tral bank also pursues a specific type of su-pervisory activity, the objective of which isfirst and foremost to guarantee the effi-ciency and stability of the clearing systems,operating as the system of financial con-tacts among financial institutions. The cen-tral bank licenses the operation of the clear-ing houses of financial institutions andsupervises their activity. Giro Elszámolás-forgalmi Rt. (Giro Clearing House Ltd.) wasfounded in 1989 for the purpose of settingup and operating the interbank clearing sys-

tem. Its shareholders include the financialinstitutions and the NBH, which is its largestshareholder holding 14.7 per cent of its eq-uity. Risks similar to those in clearingamong financial institutions may arise in theactivity of Központi Elszámolóház és Érték-tár Rt. (KELER – Central Clearing Houseand Depository Ltd.) supervised by theState Money and Capital Market Supervi-sion. KELER is responsible for the process-ing of payments related to stock exchangetransactions with securities and derivatives.The NBH holds 50 per cent of the shares inKELER.

KELER

In countries having highly developed financialmarkets, there are institutions which – as aservice – perform, as their main function, allthe tasks necessitated by the managementand clearing of the vast quantities of marketsecurities.

With the explosive expansion of trad-ing in the stock exchange, the need for set-ting up an independent clearing house anddepository to provide a wider range of ser-vices efficiently, quickly and safely for theparticipants of stock exchange transactionsalso arose in Hungary. As a result of thor-ough professional preparatory work, theCentral Clearing House and Depository (Bu-dapest) Ltd., was established on 12 October1993, referred to as KELER by its abbrevi-ated name. KELER was established and isstill owned by the National Bank of Hungary,the Budapest Commodity Exchange and theBudapest Stock Exchange.

The founders specified KELER’s mainfunction as facilitating safe, rapid and cheapclearing and settlement of transactions on thesecurity market in Hungary by running a ser-vice centre supporting primarily the activitiesof the members of the capital market commu-nity (securities traders and banks). KELER,therefore, acts as a central depository, keepssecurity accounts and provides other relatingservices. Under its clearing house functions, itnot only provides services to the prompt mar-ket of the Budapest Stock Exchange, it alsooperates as the clearing house for the forwardmarket of both the Budapest Stock Exchange




Tasks related to Payments


§33 (1) The NBH shall develop the na-tional payment and clearing system.

(2) The NBH shall regulate payments.

§33/A (1) Approval from the NBH shallbe required for the entry into force of therules of business of the clearing house ofcredit institutions, or any amendmentsthereof, which operate the transfer sys-tem administering clearing; the clearinghouse for credit institutions shall publishits rules of business in the “PénzügyiKözlöny” (Financial Journal).

(2) The NBH may require the clearinghouse for credit institutions to set aside arisk fund and may issue mandatory provi-sions concerning the mode and rate ofprovisioning and the use of the fund.

and the Budapest Commodity Exchange. Itcarries the greatest risks in its latter functionas in the case of forward transactions theclearing house becomes a contracting partyin the transaction between the buyer and theseller, similarly to international practice,and guarantees the settlement of transac-tions. In addition, KELER provides clearingservices for the government security marketoutside the stock exchange (OTC market)and has increasingly extensive functions ofa banking nature (keeping exchange cashaccounts, interest payment, technical lend-ing related to clearing, etc., treasury activ-ity).

With the establishment of KELER andthe development of the payment system, theimplementation of DVP (Delivery versus Pay-ment)14 based clearing has become increas-ingly possible. The risk arising in relation topayments may be substantially reducedwhen the operation of the payment and thesecurity clearing systems satisfies the prin-ciple of Delivery Versus Payment (DVP),that is, a mechanism is applied under whichsecurities are delivered only if and whenconsideration is also paid.

The securities settlement system (theinstitution performing it) and monetary pol-icy (the central bank) are connected in anumber of areas. The central bank itself par-ticipates in transactions covered by govern-ment papers and KELER clears some of itsoperations. The cash leg of the securitiestransactions is often settled through the ac-counts managed by the central bank.

In relation to the payment system, thetask and objective of the NBH is to guaran-tee the sound operation of the domesticpayment system and to develop a nationalpayment and settlement system running atminimum risk.

There is a close relationship betweenthe efficient operation of clearing systemsand financial markets because the more de-veloped the payment system is, the moreliquid the financial assets become, the moreintegrated financial markets are, and the

lower the transaction costs and financialrisks are. Through this and the increasinglyfast data and information flows, the effi-ciency of the central bank’s steps, designedto influence the ultimate interest targetthrough various market rates and variables,may improve.

On the other hand the payment sys-tem is also a channel through which un-sound financial institutions may jeopardisethe stability of the entire payment system. Insuch cases, to counter these kind of risks ,central banks are forced to act as lender oflast resort.

The Interbank Clearing System(BKR)

The interbank clearing system, run by theElszámolásforgalmi Rt., is the giro clearingsystem (Interbank Clearing System – BKR).The system handles transfers gross, al-though it does not dispatch transferspromptly when receiving an order, they arecleared on the day in question at a specifiedpoint in time.

Commercial banks are direct mem-bers of the clearing system, other financialinstitutions, such as savings co-operatives,link up with the giro clearing systemthrough the commercial banks as so-calledcorrespondent members. In the interbankclearing turnover, the system accepts onlythose orders whose cover has beenprovided by the credit institution in ad-vance.

This cover consists of the balance ofthe settlement account held with the centralbank and the securities kept with KELERpledged by the bank prior to clearing. Thegiro system processes the transfer ordersreceived after the turnover of the day, late inthe afternoon and at night.

If sufficient funds are not available foran item of a financial institution for any rea-son whatsoever, the system holds these or-ders pending in a queue. In such an event,the bank may either release additional li-



14 The DVP principle: in the case of security transactions,settlement is effected only when securities on the part of theseller and the necessary money on the part of the buyer areavailable in the appropriate accounts.

quidity (of its own) to resolve the queue or ithas various instruments (credit facilities)available to obtain additional liquidity fromthe central bank.

The NBH has a dual role to play in theclearing system: on the one hand, it clearsand books the positions generated in thecourse of the overnight operation of the in-terbank giro system and it directly settlesand books the orders of its own accountholders (financial institutions) against oneanother during the day.

VIBER

To modernise its services provided to creditinstitutions, the NBH introduced a new ser-vice in the autumn of 1999 – the Real TimeGross Settlement System (RTGS – or, in itsHungarian abbreviation, VIBER). The es-sence of the real time gross settlement sys-tem is that the moments of clearing and set-tlement are not separated in time, bookingis effected item by item continuously and inreal time.

Gross systems are generally based onthe central bank’s account managementservice. VIBER is also a gross settlementsystem, in which the processing of paymentorders and their final settlement takes placecontinuously, while notifying participantsconcerned in real time. Payment transac-tions are settled immediately by the NBHprovided that there is coverage and the sys-tem notifies the debited and the creditedbanks.

In Hungary, VIBER was established toprocess and settle urgent, typically large-value interbank payment orders. FromMarch 2000 optionally and from July 2000on a mandatory basis, VIBER also performsthe urgent large-value orders of the bank’scustomers.

Small-value payment orders will con-tinue to be administered in BKR in the fu-ture, but there is no mandatory value limitor other criterion for channelling turnover

between VIBER and BKR. VIBER’s mes-sage communication network is S.W.I.F.T.(S.W.I.F.T. – Society for World-wide Inter-bank Financial Telecommunication – an in-ternational communication network).

The participants of VIBER include, onthe one hand, credit institutions and, onthe other, KELER (since it manages collat-eral for intraday credits and clears securi-ties turnover), the Hungarian Treasury andthe NBH, as a system operator and anagency which manages accounts, pro-vides correspondent banking services andacts as a regulatory and supervisoryagency.

VIBER’s direct members are thosebanks and other institutions which keeptheir accounts with the NBH and are able toreceive and send payment orders throughtheir own interfaces. The correspondentcustomers of direct VIBER members are notmembers in VIBER, hence they do not havea VIBER account.

VIBER was so developed that thetechnical requirements of joining TARGET,the common European payment system,were in place already upon start-up.(TARGET – Trans-European AutomatedReal-Time Gross Settlement ExpressTransfer – is the common European pay-ment system introduced in the third phaseof EMU, established with a view to the inte-gration and harmonisation of the nationalpayment systems.)

With the implementation of VIBERpayments are speeded up, consequently itis expected that banks will need lessmoney for arranging the same size of pay-ment turnover. Evidently VIBER hasbrought about technical changes as wellas reduced risks and has introducedgreater efficiency in comparison to theearlier system. The items which had earlierbeen booked directly by the NBH in thebanks’ accounts, without the involvementof the giro system in the morning or earlyin the afternoon, have been settled in realtime through VIBER since September1999. These operations include, for in-



stance, the payment operations betweenbanks having settlement accounts, DVP se-curities transactions, cleared by KELER,transfer orders, where the beneficiary is anaccount holder bank, payments arisingfrom transactions concluded with the NBH(disbursement and repayment of refinanc-ing credits, open-market operations, for-eign exchange operations, etc.), settlementof cash turnover administered through theintermediation of the Post Office or cashturnover affecting the account of a com-mercial bank.

Net bankcard settlements are also per-formed in VIBER (at 10.00 a.m.). In VIBER,as before, all settlements are effected afterexamination of coverage.

Statistics

Pursuant to the Act on Statistics, the NBHis an institution, which is part of the offi-cial statistical service. Accordingly, itclosely co-operates with the Central Sta-tistics Office and other institutions of pub-lic administration concerning methodol-ogy, data collection and the transfer ofdata. In the course of its statistical activi-ties, it collects data and issues publica-tions about financial institutions in Hun-gary, financial relations between Hungaryand the rest of the world, and other pro-cesses important for decision-making byeconomic agents.

Monetary statistics produced by theNBH present the claims and debts of thebanking system, i.e., the credit and moneystocks, using the balance sheet data of thecredit institutions and the central bank. Inaddition, it publishes data on the banks’lending and deposit rates.

Based primarily on the reports of thebanks, the balance of payments statisticsdescribe changes in the export and importof goods and services, income flows be-tween residents and non-residents andchanges in the claims and debts againstnon-residents. The same statistics presentforeign exchange reserves and Hungary’sforeign debt and other financial claims anddebts.




The Central Bank’s Information System


§34 (1) To perform its tasks, the NBHoperates the central bank’s informationsystem, for which financial institutions

and legal entities which do not qualify asfinancial institutions providing supple-mentary financial services, investmentservice providers and clearing housesshall supply information required by theNBH. The NBH shall develop the con-tent and methodology of the centralbank’s information system, inviting theopinion of the Ministry of Finance andthe State Banking Supervision inagreement with the Central StatisticsOffice.

(2) The NBH shall publish all the impor-tant information concerning the opera-tion of the banking system and the fi-nancial position of the country and itshall make their detailed data regularlyavailable to Parliament, the governmentand the ministries (agencies with na-tion-wide authority).

(3) Data may be disclosed only in aform which prevents such informationbeing traced back to individual dataproviders.

(4) Credit institutions shall publish thedata specified by the NBH in the formatdetermined by the NBH.

The statistics presenting the financingcapacities of households15 describe theclaims and debts of households incorpo-rated in various financial assets and thecomponents of their changes. In this case,the sources of data are manifold, rangingfrom the reports of credit institutionsthrough the data of insurers and pensionfunds to information published in the dailypress.

Securities statistics – based on the re-ports of investment fund managers, stockexchange companies and custodians of se-curities – provide an overview of the stocksof government papers, investment unitsand shares on the stock exchange, as wellas their distribution among economicagents. In contrast to the statistics listedabove and produced monthly, securitiesstatistics are available to users on a quar-terly basis.

The statistics of financial accountspresent the stocks and flows of financial as-sets and liabilities of economic agents withinthe system of national accounts. The ac-counts reflect the changes during the ac-counting period, while balance sheets dis-close the stocks outstanding on the openingand closing days of the accounting period.Within the accounts, those presenting trans-actions and other stock changes can be dis-tinguished. Similarly to the other parts of thenational accounts, accounts and balancesheets can be compiled by institutional sec-tors as well as for the whole of the nationaleconomy. Currently, as a pilot project, ac-counts are compiled for annual accounts; ata later date, they will be produced on a quar-terly basis.

In addition to the above, the Statis-tics Department of the National Bank ofHungary receives a raft of data describingeconomic processes and conditions fromother organisations, which are publishedregularly together with its own statistics in

its Monthly Report. In addition to the sta-tistics already presented, the Monthly Re-ports disclose data regularly on real eco-nomic processes, inflation, exchangerates, general government and the capitalmarkets.

Press releases on statistics, which con-tain up-to-date information on the currentaccount, the consolidated balance sheet ofthe central bank and the banking system,savings, interest rates, cash stocks and se-curities, are designed as rapid vehicles forthe supply of information.

The calendar forecasting the dates ofpublication of the Monthly Reports, press re-leases and statistical communications isalso accessible through the Internet on theNBH website.

Organisational Structureand Decision-Making

The Bodies of the NBHDefined by the Acton the Central Bank

The bodies of the NBH as defined by law16

include the General Meeting, the CentralBank Council, the Board of Directors and theSupervisory Board.

The General Meeting

It follows from the legal form of the Na-tional Bank of Hungary, which is a com-pany limited by shares, that the supremedecision-making body of the NBH with re-spect to its fundamental conditions of op-eration and management is the GeneralMeeting.

The shares of the Bank are held by thestate. The Minister of Finance representsthe state as shareholder. Rather than con-vening the General Meeting, the Minister of



15 For greater detail concerning the concept of financingcapacity, see the section on “Credit Aggregates and Net Fi-nancing Capacity” in the chapter on “Indicators”.

16 Act LX of 1991 on the National Bank of Hungary (Acton the Central Bank).

Finance – acting with an authority that isnarrower than the competence of the Gen-eral Meeting – may bring founder’s resolu-tions.

The ordinary General Meeting of theBank must be held at least once a year atthe latest by the end of May. General Meet-ings are convened by the Bank’s President.Apart from the Minister of Finance, themembers of the Central Bank Council, theBoard of Directors, the Supervisory Boardand the auditor must be invited to the Gen-eral Meeting.

The President of the Bank may con-vene an extraordinary General Meetingwhenever the need arises.

The Central Bank Council

The Central Bank Council is the supremebody of the NBH, governing monetary pol-icy. The Central Bank Council meets asneeded but at least once every quarter. Itsmembers are the President of the NBH asthe chairman of the Central Bank Council,the Vice Presidents of the NBH, additionalmembers in a number one more than thenumber of the Vice Presidents of the NBHappointed or recalled by the President of theRepublic upon the recommendation of thePrime Minister, who must first solicit theopinion of the President of the NBH.The representative of the government mustbe invited to the meeting of the Central BankCouncil with the right of being consulted.

The Central Bank Council makes deci-sions on the annual Monetary Policy Guide-lines of the NBH, the central bank’s positionconcerning exchange rate policy and anysignificant changes in the instruments of thecentral bank’s policy, which go beyond theframework of the monetary policy adopted.

The Central Bank Council is in quorumwhen at least five of its members are pres-ent. It can adopt resolutions by a simple ma-jority of the votes of those present; in case ofa tie vote, the vote of the member chairingthe meeting decides.

The President of the NBH is responsi-ble for implementing the resolutions of theCentral Bank Council.

The Central Bank Council itself deter-mines its statutes within the limits of the Acton the NBH and the Deed of Foundation.

Board of Directors

The Board of Directors is the advisory bodyof the President of the Bank; its primary taskis to support the President in performing histasks. In general, it meets every two weeks.

The total number of the Board mem-bers is at most eleven, consisting of thePresident, the Vice Presidents and othermembers employed by the NBH and electedby the General Meeting upon the recom-mendation of the President of the NBH.

In its capacity as the main advisorybody, the Board discusses the drafts, rec-ommendations, submissions and reports ina wide range of topics related to the tasks ofthe central bank and the management andorganisational operation of the NBH.

The Board itself determines its statueswithin the limits of the Act on the NBH andthe Deed of Foundation.

Supervisory Board

The Supervisory Board (hereinafter the“SB”) is the controlling body of the NBH. Itsmembers include the Chairman of the Su-pervisory Board elected by Parliament,three additional members elected by Parlia-ment, the representative of the Minister ofFinance and an expert appointed by theMinister of Finance.

The primary task of the SupervisoryBoard is to control whether the NBH oper-ates in accordance with the provisions of thelaw, its Deed of Foundation and the resolu-tions brought by the General Meeting. Itmust immediately inform the Board of Di-rectors whenever it learns of any violation ofthe law or any fact, omission or abuse inconflict with the Deed of Foundation or anyresolution of the General Meeting.



Any member of the SB may requestthe chairman to convene the meeting of theSupervisory Board, indicating its reason andobjective. The Supervisory Board may meetin privy when only those invited to the meet-ing may participate. Any member of the SBmay initiate that the meeting be held inprivy. When not all the members are presentat the meeting, only the agenda items indi-cated in the invitation may be discussed.

The President of the NBH and otherpersons indicated in the Statutes of the Su-pervisory Board must be invited to the SBmeetings. The Supervisory Board is in quo-rum when at least two-thirds of its members(four persons) are present; it brings adoptsresolutions by open ballot with a simple ma-jority of the votes. In case of a tie vote, thevote of the Chairman of the SupervisoryBoard decides. The members are entitled toannex their written statements containingtheir different positions to the minutes of themeeting.

The Supervisory Board itself deter-mines its statutes within the limits of the Acton the NBH, the Act on Business Organisa-tions and the Deed of Foundation which is tobe approved by the General Meeting.

Based on the rotation principle, eitherthe Chairman or a member of the Supervi-sory Board shall participate in the meetingsof the Board of Directors in an advisory ca-pacity.

The President of the NBH

The NBH is headed by the President who isresponsible for the performance of the tasksassigned to the NBH and governs the opera-tion of the Bank.

A Hungarian national with outstandingtheoretical knowledge and practical exper-tise in issues related to monetary, financialand banking activities may be appointed asPresident of the NBH. The relevant commit-tee of Parliament hears the person nomi-nated.

The President of the Republic appointsand recalls the President of the NBH uponthe recommendation of the Prime Minister

for a term of six years. When entering office,the President of the NBH is sworn in thepresence of the President of the Republic.

The President represents the Bank inthe meetings of the government and theeconomic cabinet and in front of other agen-cies in matters of outstanding significance,including the meetings of international or-ganisations of which the Bank is a member.The President decides in all matters whichhe has not delegated to the Vice Presidents,other managers or committees.

The Vice Presidents of the NBH

The Vice Presidents of the NBH, at most fivein number, are appointed and recalled bythe President of the Republic. The recom-mendations are made by the President ofthe NBH, which are, if agreed, submitted bythe Prime Minister to the President of the Re-public. The recommendation must indicatethe functions of the Vice President to be ap-pointed. The mandate of the Vice Presidentsof the NBH is for a term of six years.

The Vice Presidents participate in thegovernance of the Bank, including strategicdecisions, developing the position of theNBH related to governmental and other doc-uments affecting the functions of the Bank;they supervise the bank units subordinatedto them, govern and control the linesof business subordinated to them and takeaction to have the necessary deci-sion-support activities completed, the inter-nal and external measures made that are re-quired for performing these tasks and forimplementing measures within their ownscope of authority. The Vice Presidentsmake decisions in matters referred to theirauthority and represent the Bank in front ofother agencies within the limits of their func-tions.

Standing Committees

There are various standing committees inthe National Bank of Hungary, responsiblefor decision support and providing grounds



for decision-making. With respect to con-ducting monetary policy, the MonetaryCommittee is of the highest importance. Itstask is to regularly review the monetary situ-ation and, within the limits of itsauthorisation, to develop and make operat-ing monetary policy decisions. In addition, ithas to harmonise domestic foreign ex-change and forint market operations.

The competence of the committee ex-tends to all the matters with respect to whichthe Central Bank Council did not reserve theright of decision-making and which were notreferred to the authority of other committeesor specific managers by the President of theBank.

The committee is chaired by the Presi-dent of the Bank, its members includethe Vice Presidents and the permanentinvitees.

The task of the Banking Committee isto facilitate decision-making and the adop-tion of measures and statements by theNBH, and the improvement of the operationof the banking system by monitoring anddiscussing the subject matters specified inits statutes and by making recommenda-tions. According to the priority subject mat-ters specified in its statutes, its competenceextends to: the banking system and legaland other regulations concerning credit in-stitutions; the operation of the centralbank’s rating system of credit institutions;the experience of supervising credit institu-tions by the central bank; significant individ-ual cases related to the foundation, transfor-mation and modification of the scope of op-eration of credit institutions; and adopting aposition concerning recommendationsaimed at individual exemptions from centralbank measures.

The committee is chaired by the Presi-dent of the Bank.

The function of the Asset and LiabilityCommittee (ALCO) is to direct and harmo-nise the management of reserves and debt,based on the approved guidelines. In partic-ular, it monitors changes in foreign ex-change reserves and net debt, the condi-tions in international money and capital

markets, the changes in the exchange ratesof important currencies and money andcapital market rates, the preparation fordrawing in funds, and changes in the cashflow position of the NBH in the light of debtand reserve management.

The committee is chaired by the Presi-dent of the Bank.

Central BankIndependence

The Importance of Independence

Acentral bank is regarded as autono-mous when it does not have to submit to

either the direct or indirect pressure or theexpectations of any body, organisation orperson outside the Bank in the course of pur-suing monetary policy and, if it refusesto submit, its action has no detrimental con-sequence of any kind with respect to theBank.

The independence of the centralbank is a highly important criterion withrespect to the economic stability and exter-nal rating of individual states, because po-litical cycles are relatively short and, insome cases, are not suitable for enforcingthe long-term interests of the monetaryeconomy, which a strictly professional in-stitution without any political ties is able toimplement more efficiently.

The primary role of central bankslies in driving inflation down to a low leveland keeping it there in the long run in theinterest of the optimal and smooth devel-opment of the real economy. In periods ofparliamentary elections, however, gov-ernments frequently experience greatpressure to raise nominal incomes partic-ularly because – based on the principle ofmoney illusion – a political organisationmay benefit from the fact that a nominalincrease in incomes may be followed by arise in the price level only after an elec-tion.



It has been demonstrated that autono-mous central banks have been more suc-cessful in curbing inflation. Analyses reveala strong negative correlation between thedegree of central bank independence andthe rate of inflation and a slightly reversedcorrelation between the central bank inde-pendence and the rate of unemployment.17

Independence, however, has no demon-strable impact on changes in national in-come.

In order to be able to call a centralbank fully autonomous, a large number ofcriteria must be examined. Analyses of thiskind tend to examine only independence inthe legal sense. There are cases when thecentral bank is relatively independent in le-gal terms, but its authority is insufficient toenable it to behave fully independentlyvis-à-vis a less constructive governmentalsystem.

At such times, it frequently happensthat the management of the central bank,whether voluntarily or upon request, alsoleaves when there is a change of govern-ment or a change merely at the head of theMinistry of Finance.

In other words, the de jure and the defacto independence of central banks can bedistinguished. In the case of states enjoyinga stable legal system, legal independenceand de facto independence coincide. In anumber of developing countries, however,the legally autonomous bank cannot be re-garded as de facto autonomous. (For in-stance, in the period between 1950 and1989 in Argentina presidents of the centralbank had a four-year guaranteed mandate,but they hardly acted for a year on averagebecause the president resigned wheneverthere was a change in government or minis-ter of finance.)

When measuring independence, wemay witness a number of approaches in theadvanced countries. There is an approachwhich distinguishes independence in“choice of target” and in “choice of instru-ment” and examines whether these criteriaare met (e.g. in the United Kingdom, thecentral bank does not independently choose

its target, whereas it can be regarded as au-tonomous with respect to the instruments ituses).

This approach, however, examinesonly the independence of the activity (oper-ation) of the central bank, which is notequivalent to full independence. It is in vainfor a central bank to choose its targets andinstruments with legal independence, sinceif it is not independent in terms of its person-nel or financing, it will not fully meet the cri-teria of independence.

When examining independence, thereare three areas worth examining: independ-ence in operation, personal independenceand financial independence. Their criteriaare meaningful only in countries where thefoundations of the legal system are secureand are widely accepted and honoured.A central bank can be regarded as inde-pendent or autonomous only if it proves tobe such in all three of these areas.

Personal Independence

A central bank is regarded as having per-sonal independence when the persons in-volved in the bank’s leadership cannot beinfluenced in their decision-making on polit-ical grounds and their attitude is profession-ally impeccable. Of course, when viewedfrom this aspect, it is not only the president(or governor) of the bank who needs to beindependent but any other person or mem-ber of any body involved in deci-sion-making.

Among the criteria of personal inde-pendence, the following are the most impor-tant:

The mandate of the bank’s presidentand the supreme decision-makers must belonger than a parliamentary cycle. In ap-pointing senior officials, continuity must bethe aim in some form (e.g. relying on the



17 Full reference to the analyses by Alberto Alesina, Law-rence H. Summers and Alex Cukiersman, Steven Webb, andBilin Neyapi is presented in the bibliography.

principle of rotation18). These two condi-tions guarantee that the decision-makingbodies of the central bank should not be-come captive all at once and collectively tothe same allegiances even after the expira-tion of their members’ mandates. Thereshould be no possibility for recall for politi-cal reasons, that is, the possibilities for recallmust be specified and limited. Appoint-ments must be based on a broad consensusof the profession.

It is an important precondition to bothpersonal and institutional independencethat the decision-makers of the central bankshould neither request nor accept instruc-tions from any organisation or person whiledischarging their functions. This may beguaranteed if no member of the deci-sion-making bodies has any stake in politi-cal or economic institutions. (They may notbe members of parliament, municipalitiesor public administration or political group-ing, etc. They may not have a stake inbusiness either as shareholders or as em-ployees.)

Neither the government nor its repre-sentative may participate in the deci-sion-making bodies, and even if they do,they cannot have a right to vote. The gov-ernment, government agencies or parlia-ment should have only limited rights, ornone at all, to call the bank to account for itsdecisions – with respect to monetary policy,no political forum of any kind should be al-lowed to override the decisions of the centralbank.

As far as the above aspects are con-cerned, the NBH meets the criteria of per-sonal independence because the mandatesof the President and the Vice Presidents ofthe Bank exceed the four-year parliamen-tary cycle by two years. The President of thecentral bank is appointed upon the recom-mendation of the Prime Minister by the Pres-

ident of the Republic. For the appointmentof the Vice Presidents by the President of theRepublic, the proposal of the President ofthe central bank and the agreement of thePrime Minister are needed. The President ofthe central bank designates the Vice Presi-dent substituting for him.

The members of the governing bodiesof the NBH having the right to vote may nothold any office in any political party andmay not undertake a public role in the inter-est of any parliamentary party. According tothe rules governing conflict of interest, setforth in the Act on the Central Bank, theabove persons may not become membersof any entity, have an employment relation-ship or any other legal relationship concom-itant with the performance of work, or serveas senior officials or be members of supervi-sory boards of credit institutions and the –National Deposit Insurance Fund.

Pursuant to the Act on the CentralBank, the President and the Vice Presidentsmay be recalled only in well-defined cases.

The supreme monetary decision-making body is the Central Bank Council,whose members include the President of theCentral Bank, the Vice Presidents and addi-tional members, whose number may be onemore than the number of appointed VicePresidents. The Prime Minister puts forwarda proposal for the appointment of the latter,inviting the opinion of the President of theNBH. The representative of the governmentmay participate in the meetings of theCentral Bank Council in an advisory capac-ity.

Operational Independence

Operational independence (or independ-ence in action, functions or in the monetaryfield) obtains when the central bank makesits decisions on the objectives of its mone-tary policy and the development and de-ployment of its instruments independentlyof any external institutional or personal fac-tor and, in doing so, is not under any obliga-



18 By the principle of rotation we mean that the appoint-ment of the members of the Central Bank Council or ofthe Vice Presidents is effected not all at once but with an eventime lag. For instance, an expert is appointed to the su-preme monetary decision-making body of the United States(Board of Directors) once every two years for a term of14 years.

tion to accept requests or instructions fromany entity whatsoever. (Independence in thechoice of targets and the use of instru-ments.)

The most important elements of oper-ational independence include the follow-ing:

An important criterion is how the ob-jectives of a central bank specified by lawrelate to one another and what is the rela-tionship of the ultimate goal to the other ob-jectives. The ultimate goal of independentcentral banks generally relates to inflation.When that is not the only ultimate goal, it isnecessary to examine what the relationshipis between this and the other objectives.When they contradict one another or maybecome contradictory in certain situations,the priorities between the ultimate goalsmust be scrutinised. When, for instance,supporting the government’s economic pol-icy or curbing unemployment are stronger(or perhaps identical) objectives of the cen-tral bank than curbing inflation, the pursuitof an autonomous monetary policy may beendangered.

Another essential element of opera-tional independence is the agency, whichdevelops monetary policy. When the gov-ernment has the possibility to interfere withmonetary policy issues,19 the given centralbank cannot be regarded as autonomous.

In the case of central banks regardedas the most autonomous, there is a charac-teristic right to give advice to the govern-ment concerning current issues of econom-ics, to participate in the meetings of the gov-ernment or individual departments in an ad-visory capacity and to have a say in legisla-tive activities. This right is not a condition ofindependence but precisely by virtue of thecentral bank independence, there tends tobe a demand for it.

The Constitution specifies the “protec-tion of the stability of the value of the na-tional currency” as the task of the NBH inthe field of monetary policy. Accordingly,driving inflation down to a permanently lowlevel is the primary objective or ultimategoal of the NBH. The 1999 Act on the Cen-

tral Bank still specifies the support of theeconomic policy of the Government as an-other fundamental task. It is expected thatthis provision will be amended in relation toHungary’s accession to the EU in order tocomply with the EU requirements concern-ing central banks. The proposed amend-ment: “The central bank shall support theimplementation of the economic policyprogramme of the Government without vio-lating its ultimate goal (i.e. the protection ofthe domestic and external purchasingpower of the national currency) with thehelp of the monetary policy instrumentsavailable to it.”

It is an important provision of the Acton the Central Bank that the Governmentmay not instruct the central bank in its activ-ities.

The Government is not in a position todirectly influence the development of mone-tary policy. Indirectly, it may exert some in-fluence through its natural role played in ap-pointing the members of the central bankbodies and the President and the Vice Presi-dents. The Government has an opportunity,however, to expound and represent its opin-ion vis-à-vis the central bank through itsparticipation in the Central Bank Council inan advisory capacity.

The NBH provides an opinion on theGovernment’s economic policy prog-ramme, the decisions and legal regulationsrelated to the Government’s economic pol-icy and reconciles the ideas concerning thefinancing of the budget deficit.

Financial Independence

A central bank enjoys financial independ-ence when it can obtain the funding requiredfor the performance of these tasks in thecourse of its operation automatically, with-out depending on the government’s ap-



19 For instance, when the central bank is organisationallysubordinated to the government or the Ministry of Finance;when the minister of finance may veto the decisions of thecentral bank; or when the representatives of the governmentparticipate in the decision-making bodies of the monetaryauthority with the right to vote.

proval. Financial independence, therefore,means that the central bank always has theauthorisations required for its operation aswell as the assets based on its own capital,without being dependent on the budget.

The Act on the Central Bank providesfor the funding called to ensure the condi-tions of operation of the NBH. The centralbank pays its profits – which remain afterthe amounts retained for development,provisioning and other purposes – as divi-dend to the central budget and the budgetreimburses the NBH for the losses it incurs.Currently, this is effected by monthly settle-ment. In the course of law harmonisation, aspart of the process of accession to the EU,probably the settlement process will also beamended by reviewing the Act on the Cen-tral Bank, for instance, by doing away withmonthly settlements and setting aside re-serve funds, in order to harmonise Hungar-ian legislation with the regulations appliedto national banks within the EuropeanUnion.

The Requirementof Transparencyin Central Banks

An important expectation vis-à-vis an auton-omous central bank is transparency, i.e. therequirement that the tasks and objectives ofthe central bank, their performance and theinstruments used to achieve them be well de-lineated and information about them beavailable to all. The condition of meeting thisrequirement is that the central bank publishits objectives, the decisions made to achievethem and the grounds for its decisions. The

requirement of controllability vis-à-vis cen-tral banks is designed to guarantee that theentities responsible for all of the institutionsof economic policy (Parliament, Govern-ment) have an adequate overview of the op-eration of the central bank.

Pursuant to the Act on the CentralBank, the President of the NBH reports toParliament on the activities of the centralbank annually. Parliament may also requestad hoc information. The NBH provides infor-mation to Parliament about its monetarypolicy by presenting the “Monetary PolicyGuidelines”.

The expectation set against the centralbank to disclose its decisions and theirgrounds is important not only because of thecontrollability of the central bank’s activitiesbut also because it assists in the efficiency ofthe transmission mechanism (the impactof the central bank’s interest rate and othermeasures exercised on the real economythrough market yields). (For an accurate ex-planation of the term and the description ofthe mechanism, see the relevant section.)Disclosure of the objectives and the argu-ments laying the foundations for decisionsclarifies the central bank’s policy and leavesno uncertainty in market agents about themotives behind the central bank decisions.They can learn how the central bank as-sesses the market processes which havetaken place and, what is even more impor-tant, the forecasts and expectations of thecentral bank concerning processes ex-pected in the future. Information of this kindspeeds up the adjustment of market agentsto changing circumstances and centralbank decisions, suitably influencing theirexpectations, which greatly improves the ef-fectiveness of monetary policy.



II. OBJECTIVES OF MONETARYPOLICY AND ITS IMPACT ON

THE ECONOMY

The Ultimate Goalof Monetary Policy

The primary objective of economic policyis to achieve sustainable and rapid eco-

nomic growth, which increases employ-ment, raises the standard of living and helpsclose the development gap between the na-tional economy and the economies of ad-vanced countries. What is the role ofmonetary policy in this quest? Economictheory has long been trying to determinewhat objectives monetary policy shouldstrive to achieve. This question generallyarises in the context of whether it is possibleto influence the real economy (economicgrowth and unemployment) with monetarypolicy instruments or their impact is limitedto affecting the price level (inflation) andother nominal variables.

The Development of Theory

At the end of the last century the views of“classical” economists concerning mone-tary policy were based on the doctrine of theneutrality of money with respect to the realeconomy. According to classical econo-mists prices and wages adjust immediately,hence demand and supply are in equilibriumin all market segments of the economy.Changes in the money supply are immedi-ately reflected in the changes of the pricelevel, therefore there is no relationship be-tween the nominal variables (money supply,price level) and the real economy. This isthe condition of the so-called “classical di-chotomy”, where the factors of production

alone determine the output of the economyand monetary actions only influence theprice level.

Classical macroeconomics was un-able to provide an explanation for the eventsof the world economic crisis of 1929–33 andthe prolonged recession and long-term un-employment arising in its wake. The turningpoint in the history of economic theory wasthe emergence of the Keynesian school.Keynes and his followers went beyond theclassical concept of perfect markets. Ac-cording to their assumption, wage rigiditiesand long-term employment contracts pre-vent nominal wages from adjusting tochanges in demand and supply conditions inthe short term. As a result, sustaineddisequilibria may evolve in the labour mar-ket. Consequently, with wages fixed nomi-nally, a boost in aggregate demand (whichmay be effected using both monetary andfiscal instruments) leads to a decline in realwages by raising the price level. At lowerreal wages companies are willing to employmore labour, thus production increases.Eventually, the economy achieves a newequilibrium at a higher price level, higheroutput and employment. In the Keynesianmodel, therefore, monetary policy is ableto determine not only the price level but thelevel of output and employment as well.The trade-off between the price level (infla-tion) and employment is described bythe so-called Phillips curve: higher infla-tion goes with lower unemployment andlower inflation goes with higher unemploy-ment.

The emergence of the monetaristschool at the end of 1960s was another turn-ing point in macroeconomic theory. The mon-etarists questioned Keynes’ short-term ap-proach and the assumption of slowly adjust-ing nominal wages. In the monetarist model,


THE OBJECTIVESOF MONETARY POLICY

wage negotiations focus on future real wagesin contrast with the Keynesian assumption,where myopic trade unions negotiate aboutnominal wages. The problem here is that to beable to determine future real wages it is nec-essary to know or at least to forecast in someway the future price level. According to themonetarist assumption, the inflation expecta-

tions of economic agents adjust adaptivelyto actual price changes, i.e., they continu-ously rectify the forecasting errors of thepast.

In the monetarist model monetary pol-icy can, in the short run, influence the realeconomy. Increased money supply and theresultant rise in the price level temporarily re-duce real wages and thereby increase em-ployment and output. Wage demands, how-ever, soon adjust to the higher price level andnominal wages rise to restore the former levelof real wages. Output and employment returnto their the pre-monetary stimulus values, butthe price level remains higher. Owing to this,monetarists discard monetary policy as an in-strument for stimulating the economy, as ithas temporary effects only. According to themonetarist approach, the economy would bein the best position were the central bank toexpand the money supply evenly, in line withthe growth of output.

New-classical macroeconomics, whichevolved in the 1970s, took an even more radi-cal stance regarding the relationship betweenmonetary policy and the real economy.New-classical economics returned to the con-cept of the perfect market and, in addition,adopted the assumption of so-called rationalexpectations. Rationality in expectationsmeans that economic agents prepare fore-casts by efficiently using all the relevant infor-mation available to them at the time. Accord-ing to the new-classicals, the informationwhich serves as a basis for monetary policydecisions is also available to rational eco-nomic agents. Thus they will be able to pre-dict with reasonably certainty the policymoves of the central bank and alter their infla-tion expectations accordingly. Predictablemonetary policy will therefore have no impacton the real economy.

In the course of the theoretical debatesof the various schools, positions evolved onmany issues, which the vast majority of theprofession is now willing to accept. Thusthere is virtually unanimous consensus inmonetary economics regarding the desirable

long-term objectives of monetary policy. Theidea that monetary policy is unable to influ-ence real economic variables in the long runis widely shared by economists. The effi-ciency of short-term anti-cyclical policy(which aims at reducing the periodical fluc-tuations of economic output), however, con-tinues to be the subject of debate to this day.According to the advocates of the activisttheory, because of market imperfections, in-cluding wage and price rigidities, monetarypolicy may have an impact on real variables

in the short term and central banks can takeadvantage of this fact to reduce economiccycles. In response to that the opponents ofactivist monetary policy point out that owingto the long and variable lags of the monetary

transmission mechanism, monetary actionsrisk having effects that are contrary to thoseoriginally intended. Beyond all this, rationaleconomic agents will incorporate theexpected moves of the central bank in theirexpectations, thereby neutralising their im-pact.

The theoretical view that monetarypolicy best serves economic developmentand growth by pursuing price stability asits primary goal has gained increasing ac-ceptance in the practice of central banks.The development of theory and the failureof activist monetary policy strategies con-vinced the central banks of advanced coun-tries – and to an increasing extent those ofdeveloping countries – to accept price sta-

bility as the ultimate goal of monetary pol-icy and place less emphasis on output andemployment targets, and to refrain from at-tempts to even out the business cycle.By maintaining price stability, the centralbank creates a predictable environment inwhich economic agents can make soundeconomic decisions without having to betoo concerned about future changes in theprice level.

When reducing inflation and establish-ing price stability, the central bank has,however, to take into account the con-straints arising from the economic environ-ment and the need to maintain external andinternal equilibrium. In general, curbing in-

flation is concomitant with a rise in real in-

terest rates. When domestic state debt is


II. OBJECTIVES OF MONETARY POLICY AND ITS IMPACT ON THE ECONOMY

high, rising real interest rates increase gov-ernment interest expenditure, which mayfurther increase state debt. In addition, un-der a flexible exchange rate regime,anti-inflationary policy erodes the competi-tiveness of the economy vis-à-vis the rest ofthe world through the real appreciation ofthe currency induced by the rise in real in-terest rates.

This poses a problem primarily forcountries with high foreign debt. Decliningcompetitiveness may lead to a deteriorationin the current account and raise foreign in-debtedness to an unsustainable level.Finally, disinflation generally brings about atemporary decline in output and incomes,which may lead to social tensions. To besuccessful, an anti-inflationary programmemust take into account these constrainingfactors and define a path for disinflationwhich is optimal for the given economy andsociety.

Price Stability versusEconomic Growth

Accepting the long-term neutrality ofmoney, i.e., that monetary policy has nolong-term impact on the real economy, acentral bank may best contribute to theachievement of sustainable economicgrowth by reducing high inflation and thesocial and economic costs arising from this.Over the longer term, an artificial boost todemand or monetary expansion is unfeasi-ble. Nevertheless, the real economic costsof disinflation, which may be substantial inthe short term, particularly when ananti-inflationary policy is not credible, mustalso be taken into account.

Above an inflation level of 8–10 percent, inflation perceptibly decreases thegrowth potential of the economy. Reduc-tion in inflation also means a non-recurrentwelfare benefit as it not only increasesthe rate of long-term growth but also raisesthe level of GDP. The benefits of curbing in-flation are permanent, while the costsof disinflation are transitory. So, when ana-

lysing the welfare effects of price stability ,the non-recurrent cost of disinflationshould be set against the long-term perma-nent benefits arising from price stability.In general, this tips the scales towardscurbing inflation.

The Long-Term Benefitsof Price Stability

The fundamental argument for achievingand maintaining price stability is that infla-tion is concomitant with social and eco-nomic costs.

The social costs of inflation can be per-ceived first and foremost through their ef-fects on income distribution, although theseeffects are hard to quantify. Inflation hits thesocial strata the most in need and the leastable to enforce their interests. In general,state transfers and other benefits constitut-ing parts of the welfare net usually follow in-flation with a time lag, thus the rise in theprice level withdraws income from the socialgroups which are dependent on theseservices (pensioners, the unemployed,etc.).

Generally, a sudden leap in inflationaffects those living off wages and salariesmore painfully than entrepreneurs capableof more flexible adjustment, lenders morethan debtors and those having financial sav-ings more than those accumulating real as-sets.

When indexing is used in a widerange, these risks can be mitigated but can-not be fully eliminated in the development ofprices and wages. Moreover, a practice ofindexing based on ex post (backward look-ing) inflation may substantially impede thereduction of the rate of inflation.

The economic costs of inflation arealso substantial. The fundamental conse-quence of the absence of price stability isthat economic decisions concerning the fu-ture become more difficult to make andmore uncertain in their outcome. Becauseof higher inflation, forecasting not only theenvisaged average price level but also en-visaged relative prices and wages, orient-



ing economic agents, becomes more diffi-cult, owing to which the risks impliedin wage contracts and the production andinvestment decisions of companies grow.Consequently, the period of contractsand the horizon of planning becomeshorter.

The example that strikes the eye themost in this respect is the shortening of theduration, i.e. the re-pricing period, of sav-ings and credits. (In Hungary, for instance,bank deposits and credits are largelyshort-term and the average durationweighted with the present value of dis-bursements even in the most embedded,most developed financial market, that offixed government papers, is no more than1,4–1,5 years.)

Another detrimental consequence ofinflation is that capital investments flow tothe financial sector to an excessive extentthus violating the requirement of efficient al-location of resources. With a higher rate ofinflation, the profitability of financial inter-mediation increases relative to productiveactivities. This distortion in allocation canbe considerable.

According to estimates, even at a rela-tively low level of inflation, the share of thefinancial sector in GDP increases by 1 per-centage point with every 10 per cent in-crease in inflation.

In the event of inflation, the cash-flowof the credit extended at the same real inter-est rate will be higher thereby reducing theborrowing capability of the debtor (creditcrunch).

This is a particular problem in the caseof housing construction and purchase cred-its, where the borrower does not realise thevalue of the property increased due to infla-tion, while it is included in the nominal rateson the credit. Consequently, with the declinein inflation, the portfolio of consumer andhousing loans is expected to grow signifi-cantly, together with real estate prices.

Inflation also has an impact on socialwelfare through the system of taxation.When tax systems are not indexed at all orwhen they are indexed with a time lag only,1

the acceleration in inflation increases thecost of capital, hence the extent of invest-ment falls below the optimal level. A highergeneral tax burden leads to inefficientcapital allocation among the various sec-tors.

The Short-Term Costsof Disinflation

Empirical analyses in several countrieshave pointed out that the real economiccosts of reducing inflation exceed theshort-term growth advantages obtained byraising inflation.

The reason for this is that economicagents tend to adjust their inflation expecta-

tion more rapidly when inflation is growingthan when it is declining. According to inter-national experience, a 2–3 per cent declinein the rate of inflation tends to lead to a1 percentage point decline in the growthrate in the short term.

The challenge for an economic policyendeavouring to curb inflation is that eco-nomic agents tend to be distrustful concern-ing the change in the priorities of monetarypolicy. It can be observed that the longer aneconomy has been characterised by highrates of inflation, the longer it takes to con-vince the public and to cool down their ex-pectations of inflation.

The task of monetary policy is to re-duce inflation in steps that are, first, suffi-cient to modify expectations in the desirabledirection and, second, are not too large incomparison to that anticipated by society,that is, do not lead to serious growth sacri-fice. Whether the reduction in the rate of in-flation is “sufficient” or “excessive” dependson the speed of the adjustment of expecta-tions.

Besides taking stock of the costs andadvantages of reducing inflation, one shouldnot neglect the preferences of societyand economic policy in its entirety. No



1 Although it did happen that tax bands were adjusted bythe rate of inflation only with a time lag, the indexing of thetax systems is a method applied also in Hungary to counter-act the negative effects of inflation.

country has ever undertaken to break mod-erate inflation all at once. Countries explic-itly pursuing inflation related targets (for in-stance, Israel, New Zealand, the UnitedKingdom, Sweden, etc.) all voted for gradu-alism.

The conditioning of society to inflationand its relatively high level forced Hungaryby necessity also to adopt the gradual ap-proach.

The employees who suffered severelosses in real wages in 1995–96 are advo-cates of the policy of small steps even in thecase of adopting ex ante (forward-looking)indexing because that provides securityagainst major losses in position.

The Ultimate Goalof Hungarian Monetary Policy

Sustainable Reductionin Inflation

The ultimate goal of the National Bank ofHungary is to bring about a sustainable re-duction in inflation. Sustainable reductionin inflation means that the path for disinfla-tion is defined in such a way that it doesnot threaten external or domestic equilib-rium.

The NBH not only desires to reduce in-flation, it also sets the continuity of disinfla-tion as its objective. This means that thecentral bank will evaluate the same rate ofinflation differently when it is realised alonga continuously declining inflation path fromwhen it is a move up from a previouslyachieved lower level.

The central bank must keenly guardthe continuity of the disinflation process, be-cause it could quickly lose the public’shard-won confidence in monetary policy’sresolve to combat inflation.

This requires seemingly contradic-tory behaviour from the central bank in itsreactions to external shocks which influ-ence inflation. While it attempts to accom-modate favourable external shocks that

mitigate inflation (e.g. reduction in worldmarket energy prices, lower rate of infla-tion among trading partners), it resistsones which would increase it, such asunsustainably high economic growth orfiscal pressures. The slowdown in inflationin 1996–97 indicated that the inflationaryshock generated by the 1995 stabilisationmeasures was dying down: the stringentfiscal, income and monetary policy mixdid not accommodate the higher level ofinflation. Inflation expectations also mod-erated gradually with the decline in infla-tion.

The NBH attempted to lock in thedisinflationary gains coming from the slumpin world energy and food prices in 1998through reducing the devaluation rateof the forint more rapidly than before. (SeeFigure 1)

In curbing inflation, attention mustalso be paid to the real economic costs ofdoing so. These may be significant, particu-larly when the anti-inflationary policy lackscredibility. The country’s foreign debt andadditional external financing needs alsoconstrain attempts to reduce inflation.



0

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%

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Figure 1 Changes in the consumer priceindex and in core inflation* in Hungary

(month/same month of the precedingyear)

* The methodological description of core inflation calcu-lated by the NBH can be found in the September andDecember 1999 issue of the “Quarterly Report on Infla-tion”.

The Role of the ExternalEquilibrium

External equilibrium has been traditionallya concern for Hungary’s monetary policy.The maintenance of external equilibriumis prima facie not a typical central bankobjective, but in Hungary’s case it is insep-arable from the objective of reducing infla-tion and achieving price stability. Hungaryis a small open economy, where tensionsarising from imbalances in domestic pro-duction and absorption typically first leadto the deterioration of the current account.Inflationary pressures only appear laterwhen measures (such as devaluation, theraising of customs duties and taxes, etc.)are taken to address the problem of exter-nal disequilibrium. Hungary’s relativelyhigh foreign indebtedness and the use ofthe nominal exchange rate as an interme-diate target of monetary policy furtherlimit the extent to which the NBH can toler-ate fluctuations in the balance of pay-ments and the real exchange rate.

The objective concerning the exter-nal equilibrium cannot be expressed as asingle figure. The central bank aims toachieve and maintain a level in the currentaccount balance, competitiveness (realexchange rate), debt indicators and for-eign exchange reserves, which are alignedwith the long-term macroeconomic courseof the economy.

The predictable nature of the Hun-garian exchange rate regime (narrowband, the rate of devaluation announced inadvance) and the nominal exchange ratetarget (see the next chapter on “Intermedi-ate Targets”) in themselves justify the em-phasis monetary policy places on indica-tors of external equilibrium.

With the introduction of the crawlingpeg exchange rate regime, the NBH’s abil-ity to avoid a forced devaluation of the fo-rint or a widening of its exchange rate bandhas risen to paramount importance inpreserving the credibility of economic pol-icy. Such speculative attacks can be bestpre-empted by keeping economic funda-

mentals that influence external equilib-rium and competitiveness sound, andby holding adequate levels of foreignexchange reserves, which enable the cen-tral bank to meet its obligation of interven-tion.

The various real exchange rate indi-cators faithfully track the evolution of thedomestic export and import sector’s com-petitiveness, which is a crucial determi-nant of the country’s external balancefrom the real economy side. Because ofthis, preventing the excessive real appre-ciation of the forint is an important goal ofthe central bank.

The fact that while Hungary’s econ-omy is catching up with more advancedeconomies its productivity growth will out-strip that of its trading partners is, however,not ignored. This process inevitably leads tothe appreciation of the real equilibrium ex-change rate. Though neither this equilib-rium level, nor the requisite magnitude ofthe real appreciation in a given period canbe accurately quantified, it is certain that adrastic and sustained real appreciation mustbe avoided by all means. The central bank’sviews concerning the desirable extent of realappreciation can be seen from the discrep-ancy between the announced rate of devalu-ation and the expected rate of inflation. Theforint’s fluctuations within the band carry noinformation concerning the central bank’sintentions.

The weight of the indicators of exter-nal debt, particularly of the state’s foreignexchange debt, is still higher in the “objec-tive function” of the NBH than in that of thecentral banks of advanced countries. Thisis a heritage of the past. In the early 1990s,practically only the state had access tothe international capital markets, thusthe NBH raised all the foreign funding thatthe economy needed. Today, with theliberalisation of the greater part of currentaccount operations, economic agents areable to do so on their own. This process isalso reflected in the changing structure ofHungary’s foreign exchange debt: theshare of the state has declined, while that



of the private sector has increased. Mar-kets pay special attention to the foreignexchange debt of the state because the pri-vate sector is thought to assess and managerisks associated with increasing its liabilitiesmore adequately.2

In advanced industrialised countriesthe share of national debt denominated inforeign exchange is low, which means thatdepreciation or devaluation of the ex-change rate does not significantly worsen acountry’s fiscal balance and the authoritiescan leave it to the markets to re-establishexternal equilibrium at relatively low costby giving up the fixed exchange rate re-gime.

In Hungary’s case, however, the gov-ernment would need to raise foreign funds tomeet its debt obligations even under a float-ing exchange rate regime (although to amuch lesser extent than before), hence aforced abandonment of the fixed exchangerate regime would have high economiccosts. Not only would the forint value of theforeign exchange component of debt ser-vice increase substantially but, owing to the

higher perceived exchange rate risk, do-mestic interest rates would rise as well,putting further strain on the governmentbudget.

To re-establish fiscal balance, it wouldbe inevitable to raise taxes and curb expen-diture. Ultimately this would lead to a re-newed increase in inflation and a halt in eco-nomic growth. For this reason the NBH musttake a much tougher stance on signs of de-clining competitiveness than its counter-parts in more established economies andit can use the current account to only alesser extent as a buffer against negativeshocks.

Intermediate Targets

The Hierarchy of Objectives

All this is to say that the implementationand maintenance of price stability can

be regarded as the ultimate goal of monetarypolicy (see Figure 2). The instruments avail-



2 Yet the Asian crisis demonstrated that even this is relative.

Ultimate goal(price stability)

Operativetarget

Central bankinstruments Indicators

Intermediatetarget

(nominal anchor)

Figure 2 The Objectives of Monetary Policy

able to the central bank, however, are unableto exert a direct and immediate impact onthe price level.

The connection between the ultimategoal and the instruments of the monetaryauthority is rather indirect and also dependson stochastic factors. In addition, monetarypolicy decisions taken today will have animpact with a time lag, which may fre-quently involve years. Owing to the compli-cated nature of the relationship between theinstruments and the ultimate goal of mone-tary policy, central bank decision-makersclosely track the evolution of variables thatplay a role in the transmission mechanismand serve as a link between the instrumentsand the ultimate goal.

These variables can be put in the cate-gories of intermediate target, operating tar-get and indicators.

The intermediate target is an eco-nomic variable, which is closely related tothe ultimate goal but can at the same timebe relatively well influenced by the instru-ments of monetary policy. In general, thegrowth rate of the money supply in theeconomy or the exchange rate is chosen assuch a target. Central banks tend to deter-mine target values for the intermediate tar-gets with respect to the future.

The level of the target values is deter-mined so as to be optimal from the view-point of the ultimate goal; then the centralbank attempts to influence the intermediatetarget variable with the instruments avail-able to it so that it should meet the desig-nated target value.

A properly chosen intermediate targetcan be better controlled by the central bankthan the ultimate goal itself; at the same time,the intermediate target reflects the changes inthe external factors (that is, factors, outsidethe control of the central bank) influencing theultimate goal even before they would actuallyinfluence the price level. With the help of awell selected intermediate target, the centralbank can, for instance, introduce measures tostabilise the price level even before the un-folding of an inflationary shock.

The Nominal Anchor

In general, the intermediate target serves asa nominal anchor for economic agents. Thenominal anchor is an economic variable ca-pable of stabilising the expectations of eco-nomic agents (producers, consumers, em-ployers, employees, etc.) with respect to fu-ture inflation.

When the nominal anchor is credible,i.e. economic agents have confidence in thecapability of the monetary authority to meetthe intermediate target, they will form theirinflation expectation in accordance with thatanchor. This can be of tremendous assis-tance to the central bank particularly when itsets out to establish price stability after aprolonged inflationary period. By using acredible nominal anchor and cooling over-heated expectations of inflation, the mone-tary authority may substantially mitigate theeconomic and social costs of reducing infla-tion.

Choosing the IntermediateTargets

One of the possible intermediate targets isthe amount of money available in the entireeconomy and its growth rate. According tothe tenets of classical economics, there is anunambiguous congruence between themoney supply and the price level, hence thecentral bank is able to control the price levelthrough influencing the money supply.The use of the money supply as an interme-diate target was a popular instrumentamong central banks until the 1980s. Inthe course of the 1980s, however, many acentral bank saw that the causal relation-ship between growth in the money supplyand inflation, which used to function wellpreviously, was upset and they were unableto control the price level through the moneysupply. This failure could be attributed pri-marily to financial innovation: paying inter-est also on sight deposits and the increas-ingly intensive use of the various means ofcashless payment (e.g. credit cards) led toan erosion of the boundaries between cash



and non-cash type instruments, thus centralbanks were less and less able to influencebroad money. Consequently, central banksin several countries (including the UnitedStates and the United Kingdom) gave up thesystem of monetary control based on themoney supply.

In the case of countries running afixed exchange rate regime, the exchangerate plays the role of the intermediate tar-get. Pegging the exchange rate is gener-ally applied by countries having a small,open economy. By pegging its currency tothat of a large country enjoying a stableprice level, the central bank practically“imports” the low rate of inflation of thelarge country. In addition, pegging the ex-change rate substantially reduces the risksarising from exchange rate fluctuations,which may facilitate the development offoreign trade as well as international in-vestments. In return for these advantages,fixing the exchange rate presupposes ad-justment to the monetary policy of thelarge country, which is not advantageouswhen the two countries are subject to dif-ferent economic shocks.

From the end of the 1980s, severalcentral banks switched to the system of di-rect inflation targeting. In this frameworkof monetary policy, the central bank un-dertakes an explicit commitment to main-tain the rate of inflation within a given tar-get band. Here, the inflation forecast pro-duced by the central bank plays the role ofthe intermediate target. The inflation fore-cast meets the characteristics expectedfrom an intermediate target because it isclosely related to the ultimate goal and itcan be influenced by the central bank be-cause, when producing the forecast, thecentral bank instruments are also takeninto account. Thus, in parallel with thesteps of the central bank, the forecast isalso modified. The system of inflation tar-

geting proved to be an efficient anti-inflationary instrument in a number ofcountries. Its application, however, pre-supposes that the central bank establishits own credibility in the eyes of society. In

addition, the mathematical econometricmodels used for producing inflation fore-casts can be used effectively only in thecountries where adequately long, uniformdata series are available about the eco-nomic processes.

The Intermediate Targetof the NBH

A number of intermediate targets are usedin international practice. For today’s Hun-garian economy the one that has the mostfavourable characteristics is the nominal ex-change rate. The popularity of the exchangerate target, particularly in emerging econo-mies, can be frequently explained by the ab-sence of the conditions for alternative mon-etary regimes.

In Hungary, for instance, the instabil-ity of the money demand function in the pe-riod of the transition ruled out monetary tar-geting as an option for the central bank. It istherefore not by chance that the NBH hasused the exchange rate as its intermediatetarget since the birth of the two-tier bankingsystem.

The use of the nominal exchange rateor exchange rate path as the intermediatetarget has several advantages. The ex-change rate directly influences the price oftraded products. Also, provided that the ex-change rate target is credible, the pre-announced devaluation rate (in the case of acrawling peg regime) may efficiently condi-tion inflation expectations and the prices ofnon-traded products and services. A credi-ble exchange rate target means that the ex-change rate will evolve along a foreseeablepath and therefore is not an additionalsource of uncertainty affecting returns oninvestments.

The exchange rate path as an interme-diate target has yet another advantage,namely, that it is transparent: all economicagents can continuously observe it. The re-lationship between the exchange rate andthe rate of inflation is widely known amongeconomic agents, therefore the exchange



rate target is capable of anchoring their in-flation expectations.

The public’s ability to continuouslymonitor whether or not the central bankmeets its target enhances the central bank’saccountability, which in turn boosts its cred-ibility and the public’s confidence in eco-nomic policy.

Exchange rate targeting is not synony-mous with maintaining a fixed-type ex-change rate regime. Several countries pur-sue an exchange rate target even with for-mally more flexible exchange rate regimes(floating, wide-band exchange rate re-gimes) and maintain a form of implicit ex-change rate band or limit the actual move-ments of the exchange rate through man-aged float.

A fixed exchange rate or a narrow ex-change rate band is, however, a strongercommitment to implementing the exchangerate target, consequently its ability to orientexpectations is stronger.

The Pre-announcedCrawling Band Exchange RateRegime

The crawling band regime, introduced inMarch 1995, allowed economic policy-makers to reconcile as much as possiblethe often conflicting objectives of fosteringgrowth and reducing inflation. Peggingmeans that a country sets a fixed valuefor its currency vis-à-vis the currency of alarge, low inflation economy.3 With a fixedexchange rate, domestic inflation ultimatelyand gradually approaches the inflation ofthe country of the anchor currency; yet in-ternational experience shows that this con-vergence tends to be rather slow and thecosts of disinflation can be substantial.

In the wake of several unexpected de-valuations the earlier fixed, but adjustableexchange rate regime lost its credibility. Theevolution of the exchange rate was unpre-

dictable and economic calculations couldnot be based on it.

Regular devaluation resulted in disrup-tive speculation that threatened the financialsystem and also perpetuated higher infla-tion. Hungary needed an exchange rate re-gime which was predictable, helped disinfla-tion, but also allowed the economy to run ahigher rate of inflation than its main tradingpartners for a sustained period of time.The examples of Chile, Poland and Portugal,among others, demonstrated that the crawl-ing peg/band exchange rate regime fulfilledthese expectation. (See Figure 3)

The use of the exchange rate as thenominal anchor, the predictability of deval-uation coupled with stringent fiscal and in-come policies opened up the way to gradualdisinflation. Announcing the rate of devalu-ation in advance (first until the end of 1995)assisted in making expectations forward-looking, and the restrictive fiscal and in-come policies pursued guaranteed that thesurge in inflation induced by cost-side pres-sures created by the radical stabilisationmeasures remained temporary (and was notin excess of what cost side pressures war-ranted) and could be gradually reversedfollowing the shock.

This significantly contributed to solidi-fying the credibility of economic policy.Under the pre-1995 exchange rate regime,investors expected higher yields from forintdenominated financial assets owing to theuncertainties surrounding the date andmagnitude of prospective devaluations:forint yields contained a substantial pre-mium. This was particularly burdensome forthe budget, the state being Hungary’s larg-est debtor. The success of the stabilisationmeasures and the impeccable track recordof the exchange rate regime reduced thispremium for the risk of an unexpected ex-change rate realignment to a negligiblelevel.

The other component of exchangerate risk, the possible change of the ex-change rate within its fluctuation band, re-mained, but, until the end of 1997 it was notconsidered to be significant as the exchange



3 Or to a currency basket, but this does not alter the heartof the matter.

rate stayed almost permanently at thestrong edge of the band. The country’s for-eign exchange default risk also declinedrapidly after the introduction of the new re-gime. The reduction in the risk premiumand the concomitant decline in domesticinterest rates contributed to the accelerationof growth and helped reduce the fiscal defi-cit.

The Constraintsof a Monetary Policy in Pursuitof an Exchange Rate Target

A fixed exchange rate regime limits mone-tary policy’s ability to set interest rates andpursue domestic macroeconomic goals in-dependent of monetary conditions outside

the country. This also holds for a crawlingpeg regime.

A rise in domestic rates nudges the ex-cess return on the local currency over for-eign assets higher and leads to substantialcapital inflows and surplus liquidity, unlessthe devaluation rate is also increased simul-taneously.The monetary tightening imposed throughthe interest rates channel is then, however,offset by the loosening through the ex-change rate channel. (With a higher rateof devaluation the real exchange rate is alsotemporarily devalued due to the stickinessof prices.) In such a situation the burdenof monetary tightening falls on companieswhich are not exposed to competition inexternal markets and so are less sensitiveto changes in exchange rates (the



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RussianStock exchange crisisCzech crisis

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devaluation

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Band width+/- 0.5%

Asian crisis23 Oct. 1997

Russiandevaluation

The logarithm of the basket exchange rate (reversed scale)

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Jun

eJu

ly

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Figure 3 The Exchange Rate of the Hungarian Forint,January 1994–January 2000*

* Composition of the basket: August 1993-May 1994: 50% DEM+50%USD. May 1994–December 1996: 70% ECU+30%USD. January 1997–December 1998: 70% DEM + 30% USD. January 1999–December 1999: 70% EUR+30% USD. SinceJanuary 2000: 100% EUR

non-tradable sector), because for compa-nies that sell to export markets (the trad-able sector) the devaluation of the ex-change rate neutralises the restrictive im-pact of higher real interest rates on mone-tary conditions. This also means that shouldother elements of economic policy generateinflation expectations that are not consis-tent with the announced rate of devaluation,monetary policy, under the current ex-change rate regime, could not in itself coun-ter these inflationary tendencies. But evenunder a more flexible exchange rate regimemonetary policy cannot suppress inflation-ary pressures, if all other components ofeconomic policy work in the opposite direc-tion. Thus the consistency of economic pol-icy, particularly of monetary and fiscalpolicy is of paramount importance for Hun-gary.

Another problem with the fixed-typeexchange rate regime is that shocks that im-pinge on the economy of the anchor cur-rency are directly transmitted to the countrypursuing the exchange rate target, becausedomestic interest rates must remain alignedwith foreign rates.

The ERM was plagued by exactly this phe-nomenon in the wake of Germany’s sustainedmonetary tightening which attempted tocounter the impact of the expansionary fiscalpolicy which reunification necessitated and ofthe erroneous conversion rate applied to theEast German Mark. Other countries in theERM were also pressured to raise interestrates and pursue a monetary policy whichwas more stringent than what domestic pro-cesses would have warranted. The ERM crisisoccurred because some of the countries wereunwilling to further increase domestic interestrates and bear its economic costs.

An improvement in debt indicators,the growth in foreign exchange reserves andthe economic stability of a country are notalways sufficient safeguards against capitalflight and speculation against the exchangerate. The central bank at such times candemonstrate its commitments to the fixedexchange rate by raising interest rates,thereby stating that it is not deterred by the

economic costs of defending the exchangerate regime. The possibility of raising inter-est rates notwithstanding, the central bankneeds to maintain a level of foreign ex-change reserves deemed sufficient to wardoff unfavourable external shocks. What levelis considered sufficient is determined by thecurrent account position, the intensity andcontinuity of capital inflow, and the stock ofstate debt to foreigners.

A fixed exchange rate poses additionalthreats to countries with high foreign ex-change debt and to ones that are importersof capital. Through its promise to maintainthe exchange rate regime, the central bankprovides insurance against exchange raterisks to the economy. When economic pros-pects are uncertain and longer maturity in-struments are not available in the domesticcurrency, companies, banks and even thestate find it easier and cheaper to borrow inforeign markets, which may lead to a sub-stantial build-up in foreign currency openpositions. In a situation like this the econ-omy could incur tremendous losses onthese open positions should a devaluationoccur, leading to a financial crisis and reces-sion. From this point of view, the increasedvolatility of the forint during the Asianand Russian crises was beneficial for Hun-gary’s financial markets, because theyprompted economic agents to assess risksmore thoroughly and to hedge them moreprudently.

The Lower Levelof the Setof Objectives

In addition to the intermediate targets, themajority of central banks also use operat-

ing target variables. Most of the time this roleis played by short-term money market rates.There are two fundamental differences be-tween the operating target and the interme-diate target. On the one hand, the operatingtarget has, generally, a direct relationship



with the available instruments of the centralbank, so monetary policy steps are immedi-ately reflected in the values of the operatingtarget variables, while in the case of interme-diate targets this usually takes some time.On the other hand, in most cases the operat-ing target is unable to fill the role of thenomi-nal anchor.

Short-term interest rates are suitable asoperating targets because they play a prior-ity role in the impact mechanism of mone-tary policy. Most corporate credits bearingvariable interest are linked to someshort-term rate, thus the central bank is ableto directly influence the liability costs ofcompanies and consequently the demandfor investment goods by influencing thelevel of these interest rates. In addition, therates on household deposits also tend to fol-low changes in short-term rates. By control-ling household rates, the central bank influ-ences the public’s decisions on saving andconsumption. Therefore, by influencing in-terest rates, the central bank is able to influ-ence the aggregate demand for investmentand consumer goods throughout the econ-omy. The level of short-term rates (or to bemore precise, the real yield that may beachieved on short-term rates) provides in-formation concerning the restrictive or ex-pansive nature of monetary policy.

In countries employing a floating ex-change rate regime, monetary policy deci-sions affect aggregate demand not onlythrough interest rate movements but alsothrough shifts in the exchange rate. In small,open economies where the weight of foreigntrade in the national economy is very highand the effect through the exchange rate isconsiderable, the level of short-term ratesdoes not characterise the restrictive or ex-pansive nature of monetary policy to an ad-equate extent. In some countries, therefore,the weighted average of short-term ratesand the exchange rate are used as an oper-ating target. This is referred to as the Mone-tary Conditions Index (MCI).

Indicators are macroeconomic vari-ables which provide a signal concerning theexpected development of the ultimate goal

variable; at the same time, it is not a directand declared objective of monetary policyto influence them. Such a variable can bethe difference between long-term andshort-term rates, changes in industrial out-put, or the agricultural price index, etc. Theindicators, however, assist in the choice ofthe central bank’s steps by enabling thecentral bank to take the measures that bestserve the different purposes; at the sametime, the central bank’s policy has no inten-tion to directly adjust the values of the indi-cators.

With the help of the central bank’smonetary policy instruments, the monetaryauthority is able to directly influence theamount and/or cost of bank money avail-able to commercial banks. Through theseinstruments, the central bank is at the sametime able to exert an indirect influence onthe other elements of the set of objectives:the operating and intermediate targets andthe ultimate goal. A detailed description ofthe central bank instruments is presentedin the last chapter.

The Operating Targetof the NBH

The interest rate moves of the NBH, whichtend to track changes in market yields, at-tempt to meet the dual objective of main-taining domestic real interest rates at a levelhigh enough to keep savings at the levelconsistent with external equilibrium and dis-inflation, and of keeping returns on Hungar-ian securities for foreign investors alignedwith the expected returns in that asset class.The latter means that domestic interestrates adjusted for the announced devalua-tion rate contain a sufficiently high premiumover foreign interest rates to keep the ex-change rate of the forint within its band.

The NBH uses the rate on its two-week(earlier one-month) deposit facility to steermarket yields, especially the 3–6-month in-terbank and government security marketyields, which it views as the most importantdeterminants of both domestic savings andof the volume of interest rate sensitive capi-



tal flows, which strongly influence the ex-change rate.

With the liberalisation of money andcapital markets the relationship betweendomestic and foreign interest rates becametighter through unhedged interest rate par-ity, reducing the NBH’s room for manoeuv-ring in setting interest rates. Under thecrawling peg regime the central bank’s in-dependence in setting interest rates is deter-mined by the exchange rate and the countryrisk that investors perceive and the width ofthe exchange rate’s fluctuation band. Wheninterest rates fail to coincide with the yieldsexpected by foreign investors – for instance,because of changes in the risk premium –the forint moves within the exchange rateband and eventually, in case of a significant

misalignment, foreign exchange interven-tion evolves at the edges of the fluctuationband.

The NBH sterilises the liquidity effectsof its foreign exchange market interven-tions through its deposit facilities, bondsand open-market operations performedwith government papers. Sterilised inter-vention stabilises the monetary base in pe-riods of substantial capital flows and givessome latitude to the NBH to set interest rateswith a focus on developments in the domes-tic economy. Since the spring of 1998, theNBH has allowed longer term yields to bedetermined by market forces and fixed theinterest rate only on its short term sterilisa-tion instruments. Longer maturity NBHbonds have been offered in free tenders.



Monetary Aggregates

Excessive money supply may increaseinflation and deteriorate the current ac-

count. Consequently, monetary policy al-ways, even when it does not specify a moneysupply target, attempts to prevent excessiveexpansion of monetary aggregates. How-ever, the exchange rate regime significantlyinfluences the autonomy of monetary policyand the role of the monetary aggregates inpolicy formation.The exchange rate of theforint plays the role of an intermediate targetin the current Hungarian system. The ex-change rate system is a crawling peg, andthe NBH has no explicit money supply tar-gets. Nevertheless, in examining the net fi-nancing requirements of the corporate andthe households sectors, the central bankpays particular attention to the analysis ofclaims belonging to different money catego-ries.

Various components of money, suchas banknotes and coins, cheques, foreignexchange, current account, time deposit,certificate of deposit or bank bond, etc., ap-pear on the liability side of a bank’s balancesheet. The monetary aggregate, containingthe liability-side items of the central bank’sbalance sheet, represents the monetarybase, while the liabilities of the consolidatedbalance sheet of the banking sector lead to awider definition of the money supply. Themoney supply taken in the broadest sense,points beyond even the banks’ balancesheets, is also used.

The monetary base is an important in-dicator for monetary policy because this isthe only monetary aggregate which is di-rectly controlled by the central bank and,at the same time, this is the category which,through the money multiplier, constraintsthe money supply in the economy. Conse-quently, changes in the monetary base indi-rectly influence economic activity; it influ-ences inflation, the interest rates and thecurrent account. The monetary basemarked as M0 consists of cash outside thecentral bank and banks reserves held at thecentral bank.

Funds of credit institutions placed atthe central bank are usually regarded aspart of the monetary base depending onwhether or not they constitute a basis formoney multiplication. The central bankmay control the impact of foreign capital in-flow on the money supply by using variousinstruments of sterilisation. Sterilisation in-struments and the commercial banks’ for-eign exchange deposits kept at the centralbank, although they are liabilities of thecentral bank’s balance sheet (see Figure 4)as they do not participate in money multipli-cation, they are not considered to be com-ponents of the monetary base.

The averaging period for commercialbanks required reserves is one-month. Ac-cordingly when calculating the monthlymonetary base, as currently published bythe NBH, the end-month stock of cash in cir-culation is added not to the end-monthstock of reserves and other forint accountsof the credit institutions held at the central


INDICATORS

bank, but to the average of the reserve pe-riod.

The relationship between the liabilityside of the central bank’s balance sheet andthe liability side of the consolidated balancesheet of the banking sector represents theimpact of monetary policy on money sup-ply. This relationship is described by themoney multiplier. Changes in the moneymultiplier can be traced back to changes inthe share of cash (cash related to the banks’liabilities) and the reserves ratio (the re-serves relative to the banks’ liabilities).

Money multiplier = Broad money /Monetary base = M3 / M0

where the money in circulation can beexpressed as the sum of cash and otherbank liabilities. When both the numeratorand the denominator are divided by theamount of banks’ liabilities, then

Money multiplier = (KP + BF) / (KP +TR) = KP/BF + 1) / (KP/BF + TR/BF),

where KP = cash,TR = required reserves at the central

bank, andBF = commertial bank liabilities.The formula above shows that money

multiplier increases with the decline of thereserve requirement (TR/BF), hence the re-serve requirement ratio limits the moneycreation. Money multiplier also moves in an

inverse proportion with changes in the shareof cash (KP/BF): the money multiplier de-clines when the share of cash in the banks’liabilities increases.

Broader monetary aggregates can beconstructed using items on the liabilityside of the consolidated balance sheet ofthe banking system. When consolidatingthe balance sheets of the central bank andthe commercial banks, the money opera-tions of the central bank and the commer-cial banks with one another are netted out,thus the central bank’s refinancing creditallocated to commercial banks is no longerincluded in the consolidated balance sheetof the banking sector. Similarly vaultcash, banks’ reserves and the sterilisationinstruments kept at the central bank can-cel each other on the commercial banksand central bank balance sheets (seeFigure 5).

The various monetary aggregates canbe defined according to the degree of li-quidity of assets. The supply of M1 in-cludes the perfectly liquid means of pay-ment, that is, those forms of money whichmeet the payment function without anylimitation. M1 includes cash in circulationand household, corporate or municipal cur-rent accounts, transfer accounts andchecking accounts.



Figure 4 The Balance Sheet of the NBH(30 November 1999)

Forint billion

E.1. Refinancing credits 130 Monetary base (M0), (F.1 + F.2) 1,323

F.1. Cash 833E.2. Net lending to governent 1873 F.1.1.Vault cash 73

F.1.2.Cash outside the bankingsystem

760

E.3. Net foreign assets 915 F.2. Banks’ reserves 490

F.2.1. Required reserves 485

E.4. Net other items –458 F.2.2. Free reserves 5F.3. Foreign exchange deposits

of banks kept with the NBH619

F.4. Sterilisation instruments 518

M3 or broad money in addition toM1also covers the items that directly fulfilthe function of money and can be turnedinto cash relatively easy. These additionalitems include fixed forint deposits and for-eign exchange deposits, which are theso-called quasi money. In addition to all ofthis, M3 also contains those financial assets,which, with respect to their form, are not

bank accounts but represent other bank se-curities, certificates of deposits, letters ofsavings or bank bonds.

Hungarian monetary statistics do notcalculate M2, the monetary aggregate gen-erated as the sum of narrow money (M1)and quasi money (that is the category simi-lar to M3, but from which bank securities areexcluded). The reason for this is that several



Figure 5 The Balance Sheet of Commercial Banks(30 November 1999)

Forint billion

E.1. Credits 3,847 F.1. Forint deposits 3,378

E.1.1. Credit to households 461 F.1.1. Sight deposits 1,179

E.1.2. Credit to corporations 2,323 F.1.2.Time deposits 2,200

E.1.3. Credit to municipalities 48

E.1.4. Net credit to general government 1,015 F.2. Foreign exchange deposits 904

E.2. Vault cash 73 F.3. Bank securities 51

E.3. Banks’ reserves at the central bank 490

E.4.Banks’ foreign exchange depositsplaced at the NBH

619 F.4. Refinancing credits 130

E.5. Sterilisation instruments 518

Figure 6 Consolidated Balance Sheet of the Banking System(30 November 1999)

Forint billion

E.1. Credits5,720

Broad money (M3 (F.1.+F.2.+F.3.) 5,094

E.1.1. Credit to households 461 F.1. Narrow money (M1) 1,939

E.1.2. Credit to corporations2,323

F.1.1.Cash outside the bankingsystem

760

E.1.3. Net credit to generalgovernment 2,935

F.1.2.Sight forint deposits 1,179

F.2. Quasi money 3,103

E.2. Net foreign assets –125 F.2.1.Term forint deposits 2,200

F.2.2. Foreign exchange deposits 904

E.3. Other assets –501 F.3. Bank securities 51

bank securities do not differ from term de-posits in terms of maturity or liquidity. So byfunction they are not real securities, but theyare rather similar to deposits. The difficultiesinvolved in separation of these makes thecalculation of M2 less meaningful, conse-quently only M3 is published in the Hungar-ian practice.

An even wider money category, M4,goes beyond the consolidated balance sheetof the banking system and in addition to M3it also includes non-bank instruments likethe stock of government papers and thebonds issued by the NBH and held by agentsoutside the banking system.

Although bonds issued by the NBHcould be included as part of M3 as bonds offinancial institutions, they are, nevertheless,presented under the broader money cate-gory M4 reflecting the fact that the centralbank bonds are largely substitutes for gov-ernment papers of the same maturity bear-ing the same risk (in the final analysis, theultimate debtor is the state as the share-holder of the central bank).

As M4 covers all forms of savings, it isnot sensitive to portfolio rearrangements,consequently it is the most stable monetaryaggregate (see Figure 7).

Credit Aggregatesand the Net FinancingCapacity

Similarly to monetary aggregates, NBHhas no target concerning the stock of

credit under the current framework of themonetary policy. Yet changes in the stock ofcredit may signal important information onthe changes in the environment of monetarypolicy. Normally, the central bank does notconcentrate solely on credit when analysingthe effects of credit on the money supplyand on the balance of investments and sav-ings. Analysis of changes in the credit port-folio is linked to the examination of theconsolidated balance sheet of the bankingsector and the net financing capacity ofmajor sectors.

Net financing capacity of a given sec-tor means the balance of transactions re-lated to the claims and liabilities of the sec-tor. The balance of transactions corre-sponds to the increment in the stock ofclaims and liabilities net of the exchangerate and other volume changes.

The balance of transactions linked tothe claims of households normally exceedsthat of transactions linked to the creditsof the sector, hence the households sector,is net lending. In the case of the corporatesector, however, the situation is exactlythe reverse: owing to the net inflow of exter-nal funds to finance investments of thesector, so the corporate sector is net borrow-ing.

The net lending/borrowing balance ofthe domestic sectors is equal to the foreignfinancing requirement, which correspondsto the deficit in the current account. Accord-ingly, the changes in the current accountdeficit may be broken down to the changesin the net lending/borrowing position of thevarious domestic sectors.

Under the current exchange rate sys-tem the central bank monitors the credit al-location to corporate and households sec-tors because it influences the financing ca-pacity at these sectors as well as the current



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Figure 7 Growth Ratesof the Monetary Aggregates Relative

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account. Faster credit growth also influ-ences inflation through investment and con-sumption demand, but at a quasi fixed ex-change rate a substantial portion of the in-flationary impact finds it way only after theunavoidable devaluation, a result of the de-teriorating current account deficit caused bythe credit expansion.

The Information Contentof the Yield Curvefor Monetary Policy

The term “yield curve” (or “term structureof interest rates”) refers to the relation-

ship between interest rates of different matu-rities. In most cases, when yields of differentmaturities are compared, investments withthe same risk level4 are considered. Theanalysis of the yield curve provides impor-tant information in relation to expectationsconcerning the future evolution of inflation,real interest rates and growth. In addition,the yield curve is a useful signal for the cen-tral bank concerning the effectivenessand credibility of the monetary policy it pur-sues.

In properly functioning money andcredit markets, monetary policy with thehelp of an appropriately designed set ofmonetary policy instruments has a signifi-cant impact on the shorter maturities of theyield curve in the case of both structural li-quidity surplus and shortage.5 Short-term isgenerally interpreted as up to one year. (SeeFigure 8)

Yields on longer maturities, however,are strongly dependent on expectations con-cerning future interest rates. In countrieswith developed financial markets, thecentral bank, although able to influencethe yield curve, is unable to keep it fullyunder control: on maturities longer than3–6 months, the central bank is unableto maintain interest rates different from

market expectations in a sustained man-ner.

Longer maturities are not influenceddirectly through the control implementedthrough the set of instruments but throughthe signals concerning the (future) conductof monetary policy. By “signals”, we meanchanges in the policy, i.e., very short-terminterest rate.

The interpretation of the interest ratemeasure and its reasoning provides infor-mation to economic agents concerning theposition taken by monetary policy, who willdevelop their expectations concerningfuture inflation, nominal and real interestrates on that basis. That is to say, changein longer-term rates is a function muchmore of the expectations of economic



4 Market agents and the central bank generally examinethe structure of the yield curve obtained from the risk-freegovernment paper market yields because high-frequencyprice information observed easily and accurately can beprovided best by the government paper market.

5 According to the Hungarian terminology, we speakabout an active-side regulation when, characteristically,the banking sector struggles with a structural liquidityshortage for administering payments and in obtainingcentral bank money required for meeting the reserve re-quirement (wherever it exists). Then the central bank ef -fects liquidity and short-term yields using its credit-sideinstruments. In the opposite case, when (“passive-sideregulation”), the banking sector is in structural liquiditysurplus on central bank money and the central bank with-draws the excess liquidity through its facilities of depositacceptance in the course of which it also determinesshort-term yields.

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Figure 8 Zero-Coupon Yield Curvesin Hungary at Various Points in Time

agents thanof theshort-term rates of centralbanks.

Yield Curve Theories

The interpretation of the shape (slope) ofthe yield curve is not unambiguous, basi-cally it depends on economic theory.Testing of the theories has revealed that noteven the most widely accepted theories holdtrue in all markets and at all times, neverthe-less, they provide some kind of a basis forinterpretation. In the course of the compari-son of rates on various maturities, that is,the interpretation of the shape of the yieldcurve, most frequently three theories arementioned.

According to the expectations hypoth-esis, the yield curve reflects the expectationsof market agents concerning future inflation.Nominal yields are usually observed also asindicators of economic activity becausepresent yields of vigorously positive slopecan be interpreted as harbingers of highereconomic growth and higher inflation. Thecurrent Hungarian situation (i.e. a yield curvewith a negative slope) does not mean, how-ever, that economic agents anticipate a re-cession. What stands behind the phenome-non is that the continuous decline in inflationover the past few years contributes to the re-duction of inflation and interest rates ex-pected in the future, which is stronger thanthe impact of economic growth on the yieldcurve.

By comparing rates on various maturi-ties, rates expected in the future (implicit for-

ward rates) can be calculated from the spotyields (from the shape of the yield curve). Aspot yield curve of negative slope renders afuture decline in short-term rates probable.Naturally, there is nothing to guarantee thatwe shall be able to actually observe theserates in the future but, according to this hy-pothesis, this is the best estimate that we canmake based on information available in thepresent.

According to the liquidity preferencetheory, investors are willing to accept loweryields on short term investments becausethey regard shorter-term securities as lessrisky (as compared to longer term invest-ments). Shorter-term investments can be ad-vantageous for two reasons: first, they offergreater liquidity, second, their price is lesssensitive to interest rate fluctuations. Ac-

cording to this theory, these two effects over-compensate for the disadvantage that, bypurchasing shorter-term papers, by the morefrequent roll-over of investments, it is neces-sary to assume the risk of renewal: we under-take uncertainties in relation to the yield ofinvestments to be made in the future. Inves-tors therefore invest for the longer term onlywhen they can achieve a higher yield. There-fore, the theory makes a yield curve of a pos-itive slope probable.

The third theory is referred as the mar-ket segmentation theory. It presupposesthat various maturities have their own sepa-rate markets and the yields on individualmaturities evolve as a result of equilibriaevolving independently of one another. Inother words, the slope of the yield curve isdetermined by the investors’ term prefer-ences.

This approach is criticised largely be-cause of its excessive discretion in distin-guishing individual maturities. If we acceptthe probable assumption that individual in-vestors are willing to deviate from the invest-ment period they would otherwise preferagainst an adequate consideration, i.e. yieldpremium, then we arrive at the theory of pre-ferred habitats. The theory of preferred habi-tats says that yields on individual maturitiesevolve subject to what maturities investorsprefer the most and for what premium theyare willing to deviate from that preference in aspecific direction.

From the viewpoint of monetary pol-icy, knowing the inflation expectations ofmarket agents is useful for several reasons.First, this provides additional informationconcerning the expected real economic ef-fects of monetary policy steps because, forinstance, unexpected price changes have amuch greater real impact. Thus, to be ableto forecast the expected real effects ofanti-inflationary policy, we must have reli-able estimates about the inflation expecta-tion of market agents. Second, these ex-pectations play an important role in the as-sessment of the credibility and effective-ness of monetary policy. When ananti-inflationary policy is successful, long-term expectations of inflation and nominalrates are low.



A common method of analysing ex-pectations is the analysis of implicit for-ward yields. Forward yields can be calcu-lated by comparing the rates on various ma-turities, which are normally broken downinto expected inflation, real interest ratesand premium6 for the purposes of the analy-sis.

A decline in long-term rates indicatesthe credibility of the anti-inflationary policyand expectations of low inflation and inter-est rates, while their rise points towards anincrease in inflation (and interest rates)expected in the future (see Figure 9).

One can draw conclusions concerninginflation expectations and real interest rateswhen assumptions are made concerning thedevelopment of the other two factors.According to international experience, wecan draw conclusions from the term struc-ture of shorter rates concerning the develop-ment of future real interest rates and the realgrowth, while medium and long-term ratescontain information about inflation expecta-tions and, consequently, future inflation.

There is no single preferred method forthe calculation of the yield curve. The nec-essary calculations can be performedin several ways; the purpose of applicationshould determine the procedure chosen.Most of the time, there is a trade-off betweenthe accuracy, stability and reliability of indi-vidual methods (one criterion can be en-forced only to the debit of another) and sig-nificant differences can be observed with re-spect to the technical apparatus required aswell as complexity.

The yield curves used in economicanalyses can generally be grouped into twotypes. The first type is the internal rate ofreturn (IRR) yield curve, which comparesyields calculated until maturity. This typecan be calculated the most easily (all that isneeded is the internal rates of return of indi-vidual bonds).7

Nevertheless, this is the type that is theleast suitable for purposes of analysis be-cause of its numerous theoretical and prac-tical disadvantages. The most significantdisadvantages include that it is not continu-

ous, furthermore, that the internal rate of re-turn – owing to its definition and method ofcalculation – does not enable the calculationof forward yields, or the monitoring of ex-pectations.

The other group of yield curves con-sists of the zero-coupon type curves.8

They are characteristically continuous(can be interpreted for any maturity) andwhat is a truly useful feature of these typesis that they are suitable for extracting in-formation about market expectations con-cerning the development of future interestrates and inflation. They can be used moreextensively because in contrast to the typereferred to above, these methods arebased on much more sophisticated esti-mating procedures (which are also more



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Figure 9 The Policy Rateof the NBH and Its Future Course

Derived from the Yield Curve

6 Most frequently, “term premium” and “liquidity pre-mium” are distinguished. The term premium means thatthe investment risk is higher in the case of longer-term in-vestments (the price volatility of bonds is more signifi -cant than that of shorter-term papers). The liquiditypremium compensates the investor against fixing anamount for a longer term (in general, economic agentscharacteristically prefer to borrow for a term longer thanothers wish to fix their deposits for, thus generally, arelative shortage evolves in funds fixed for longer peri-ods).

7 The internal rate of return of a bond means the yield atwhich its present value (thus also market price) is equal to itsface value.

8 The description originates from the estimation proce-dure, which simulates bonds not having coupons (of the typeof the discount treasury bill) out of interest bearing bondsand makes calculations on these.

complicated and require greater atten-tion). Typically, central banks prefer sta-ble estimates that lend themselves to eco-nomic interpretation, therefore, character-istically they use the zero-coupon yieldcurves.9

The National Bank of Hungary appliesthe Svensson method – first published byLars Svensson – which is considered as oneof the most widespread procedures amongcentral banks. The zero-coupon yield curveestimated according to the Svenssonmethod is suitable for the analysis of expec-tations of interest rates and inflation, moni-toring the changes therein, i.e. all the factorswhich a central bank needs in order to beable to evaluate the economy in generalterms and to consider the effectivenessand credibility of monetary policy (seeFigure 10).

In Hungary, the rate of the two-weekdeposit facility can be regarded as the pol-icy rate of the central bank.

The NBH exerts significant influenceon short-term yields through its deposit rate.The rates on 3–6-month government pa-pers, which have an outstanding role to playin pricing credits and deposits, generally

fluctuate around the policy rate as thebenchmark interest rate. With this, shapingshort-term interest rates provides the cen-tral bank with an instrument through whichit can influence consumption and invest-ment decisions as well as inflation and theexternal equilibrium of the economy. In con-trast, yields on maturities of over a year aredetermined not by monetary policy but bythe expectations of market participants con-cerning the future conduct of monetary pol-icy and interest rates. This provides an op-portunity for the central bank to obtain im-portant information from the yield curveconcerning the expected inflation and nomi-nal interest rates.

In Hungary’s case, of the three factors(inflation, real interest rates and liquiditypremium) the volatility of expected inflationwas much greater than that of the other twofactors in the 1990s. Hence the assumptionthat could be regarded as the mostwell-founded one was that the expected realinterest rate and the liquidity premium wererelatively stable. Under these assumptions,information could be obtained concerningthe development of expected inflation byanalysing money and capital market yieldsand comparing short-term and long-termrates.

Conclusions concerning the relation-ship between expectations of inflation in thefuture and current inflation could be drawnwithout any particular calculation, simplyfrom the slope of the yield curve (see theexpectations hypothesis under the presen-tation of yield curve theories).

A yield curve with a positive slopedoes not necessarily mean expectations ofrising inflation but a curve of a negativeslope can, with a high degree of probability,be interpreted as a signal of belief in declin-ing inflation.

By the beginning of 1999 inflation inHungary had dropped to a single-digit rateand, in parallel, the fluctuation of expecta-tions of inflation subsided considerably (afew years earlier, at the time of the thencharacteristic 20–30 per cent inflation, un-certainty concerning the inflation of the



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Figure 10 Historical Developmentof Forward Zero-Coupon Yields

in Hungary

9 For greater detail on estimating procedures, see AttilaCsajbók: Zero-coupon Yield Curve Estimation from a Cen-tral Bank Perspective, NBH Working Papers, 1998/2

coming period was measured in percentagepoints; at present, this has declined sub-stantially and can now be measured only intenths of percentages). Thanks to the morefavourable inflationary environment and thedevelopment of the domestic capital mar-

ket, increasingly more reliable informationcan be extracted from the changes in theyield curve with respect to the expectationsof market agents concerning the evolutionof real interest rates, inflation and economicgrowth.



The Channelsof Monetary Transmission

One of the key issues in the operationof the instruments of monetary policy

is monetary transmission. The term ‘mone-tary transmission’ indicates the mecha-nism whereby the quantitative and interestrate decisions brought by monetary policyinfluence macro demand and inflation in theeconomy through various transmissions.

In the short term economic policy in-fluences economic growth and inflation fun-damentally through the development ofmacro demand. In general it can be said thatdue to an increasingly more restrictivemonetary policy, higher interest rates de-crease the consumption and investment de-mand of the private economy which, re-garding the supply side of the economy asgranted, mitigates both economic growthand inflation.

Over the long term, however, the nom-inal value of products and services (theprice level) and their changes (inflation) arepurely monetary phenomena and monetarypolicy has the important role in their formu-lation. In contrast, economic growth is de-termined by the supply side of the economy;of necessity, the central bank can exert onlyindirect influence on it. A central bank maypositively influence the long-term growthcourse of an economy by reducing inflationand thereby the loss of efficiency caused byinflation.

Monetary transmission exerts its effectthough five channels:

• With increased government papermarket and deposit rates, the yieldon postponed consumption (sav-ings) increases. This promptshouseholds to reduce present con-sumption whereby they are able toincrease the present value of theirtotal current and future consump-

tion (intertemporal optimisation ofconsumption).

• A rise in credit rates reduces largelyhousing construction and the pur-chase of consumer durables fi-nanced by consumer credits in thecase of households, while in thecase of companies, as a result ofshort-term working-capital loansbecoming more expensive, it di-rectly puts the brakes on expansionin the business sector (income ef -fect).

• With the increase in interest rates,the present value (price) of the fi-nancial assets of households de-creases, which can be replenishedonly with a consumption courselower than planned (wealth effect).

• The rise in the rates on investmentcredits prompts companies to miti-gate their fixed asset accumulationprimarily because of the decrease inthe net present value of plannedprojects (discount factor effect).


MONETARYTRANSMISSION

• Finally, increased domestic ratesalso have an impact on the ex-change rate. The appreciation of thelocal currency alters the relativeprices of domestic and foreign prod-ucts and services which, on the onehand, reduces demand for the for-mer and, on the other, directly re-duces the prices of tradable prod-ucts (real exchange rate effect).

To this point, we have not distin-guished real and nominal rates. In relation tothe income effect, however, a subcase couldbe distinguished when a higher nominal raterestraints the borrower even under a givenreal interest rate owing to his liquidity con-straint. For instance, when inflation is at15–20 per cent, a housing constructioncredit means a great burden for an individ-ual even if the real interest rate is low. Theprice of the house will rise in proportion toinflation in vain because he has little oppor-tunity to realise that gain from time totime,10 while he has to continuously financethe nominal interest, kept high because of

inflation, out of his current income. There-fore, this does not mean classical insol-vency – it merely means that his nominal in-terest expenditures clash into the cash-flowconstraint.

In addition to the direct effects referredto, expectations and the credibility of eco-nomic policy have a paramount andever-increasing role to play in the assertionof the transmission mechanism. The theo-retically expected effects (as detailedabove) of an interest rate measure by thecentral bank may be significantly modified,in an unfavourable case, decreased or evenreversed by the changes taking place in theexpectations concerning future interest ratedecisions or the development of economicprocesses. In the event of vigorous expecta-tions of devaluation, for instance, an interestrate increase introduced to protect a fixedexchange rate may increase the costs ofmaintaining the exchange rate to the extentthat will only reinforce market agents in theirexpectations of pending imminent devalua-tion and consequently rising inflation. (SeeFigure 11)



Central bankrate

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Figure 11 The Impact Mechanism of Monetary Transmission

10 In principle, he could do so not only by renting aroom or two in the house from time to time, but also bytaking out new credits from time to time to debit his real

property, whose value is nominally increasing. In prac-tice, however, banks shy away from this type of lendingpractice.

Taking explicit account of the inflationexpectation of economic agents is particu-larly important in an economy where dou-ble-digit inflation has a fairly long historyand the credibility of economic policy is notyet fully established.

What counts in making decisionsabout savings and lending is the real inter-est rate expected by economic agents.When the credibility of economic policy islow, the inflation incorporated in the expec-tations of market participants may be sub-stantially higher than that announced in themonetary programme.

The real interest rate content of thenominal rate, assumed by market agents,consistent with the inflation target of thecentral bank will, of necessity, be lower thanwhat would match the saving and borrowingbehaviour intended by economic policy.Higher macro demand, arising as a conse-quence, presents economic policy deci-sion-makers with a choice of alternatives. Incase of an unchanged interest rate policy,inflation expected by market agents, higherthan the inflation target of the monetary au-thority, evolves as a self-fulfilling prophecy.With nominal – and ultimate real – rateshigher than otherwise necessary, thegrowth-restraining impact of the planned in-flation reduction will be stronger.

Therefore, the resolve of economicpolicy and consistency in its objectives arerequired for substantially reducing the ef-fects of the disinflationary policy expressedin a short-term slowdown in economicgrowth in an economy with a long history ofinflation, so that adjustment to the lower in-flation course should take place more rap-idly and less painfully through expectations.

Communication by the central bankhas a major role to play in shaping expecta-tions.

The central bank must establish itsanti-inflationary credibility in which theoutward communication of the bank has apivotal role to play. In its publications andanalyses, it declares its goals and commit-ment, presents macroeconomic money and

capital market processes and the monetarypolicy instruments, with which it influencesprocesses in the desired direction. In mostcountries, central banks have publicationswhich present their declared main objec-tives in reducing inflation, describe the rele-vant instruments and publish their analysesand forecasts regularly, all of which is donein the light of the ultimate goal.

Such a publication of the NBH is its“Monetary Policy Guidelines”, which de-scribes the economic environment in whichmonetary policy must operate and providesinformation about the objectives and instru-ments of monetary policy. The Guidelinesare published once a year. The “QuarterlyReport on Inflation” is a quarterly publica-tion of the NBH providing an overview ofchanges in inflation to date and as expected,and on how the NBH evaluates the macro-economic processes which determine infla-tion.

When assessing the effectiveness ofmonetary transmission, the issue of thetransmission lag cannot be avoided.Money market and government paper mar-ket yields tend to follow the interest mea-sures of the central bank immediately orwith a slight time lag; adjustment in the caseof corporate and retail lending and depositrates may, however, take several months.

A change in interest rate policy exertsits full impact on growth and inflation only in1.5–2 years according to the empirical stud-ies of a number of countries. This is pre-cisely why monetary policy must, as far aspossible, be forward-looking in the course ofits operation.

The appropriate steps will have to betaken at the time when an unfavourable in-flationary process has not even genuinelyunfolded, and only the signs foreshadowingit can be perceived.

The leading indicators discussed in theprevious chapter provide a great deal ofhelp in this; their changes tend to manifestthemselves before the inflationary processand the change in macro demand condi-tions defining it appear. There is a wealth of



indicators of this kind, their choice and spe-cific application greatly depend on the giveneconomic environment.

In addition to the monetary aggregates(some kind of money or credit aggregate),detailed in the previous chapter, and infor-mation derived from financial products(changes in the yield curve, the forwardcurve, etc.), data forecasting changes in anelement of macro demand (for instance, or-ders from the viewpoint of industrial outputor the number of building permits from theviewpoint of household investments) mayalso serve as indicators.

Coincident indicators have a peculiarrole to play: they do not precede the processintended to be forecast but move along withthem and the relevant data are availableearlier (VAT receipts or statistics on carsales in respect of changes in householdconsumption).

In spite of this, those in charge of for-mulating monetary policy are frequentlyforced to take interest rate or money supplydecisions when the actual processes can beforecast only with a substantial margin of er-ror. It is therefore no surprise that, as a gen-eral characteristic, interest rate measurestaken by the central bank are frequently fol-lowed by additional ones, that is, a changeintended in the monetary conditions is ef-fected not at once but in a series of subse-quent small steps.

Interest RateTransmission

The Effectivenessof Transmission

In a country with an advanced system of fi-nancial intermediation, monetary policy

is able to influence (bank deposit, creditand government paper) yields only indi-rectly. As we have seen, central banks re-gard the shaping of 3–6-month interbank orgovernment paper yields as their direct tar-

get. The yields evolving in the money mar-ket then ripple on to create changes in thedeposit and lending rates of commercialbanks with more or less of a time lag. Thispriority area of monetary transmission isreferred to as the mechanism of interest ratetransmission.

There are several factors which influ-ence the effectiveness of interest rate trans-mission, i.e. the simultaneous and propor-tionate movement of money market yields,influenced directly by the central bank, andthe banks’ deposit and lending rates:

• the degree of competition in the sys-tem of financial intermediation,

• the re-pricing period (duration) ofbank products, and

• the volatility of the lending risk pre-mium.

A segmented system of financial inter-mediation with a high degree of monopoly isunable to effectively mediate the impulses ofthe central bank towards ultimate saversand borrowers.

Without the driving force of competi-tion, the monopolist can easily “swallow”the interest rate reduction by the centralbank, increasing his profits. In developedcountries, however, not only the bankscompete against one another, the possibilityof direct financial investments and fund-raising, which bypasses the banking sys-tem, also forces them to pursue an inten-sively compliant behaviour when pricingtheir products.

The time central bank measures taketo ripple on (the lags in transmission) is fun-damentally influenced by the average matu-rity and structure of the banks’ assets and li-abilities.

The shorter the duration of assets andliabilities, the higher the share of variable in-terest bearing instruments and the greaterthe frequency of interest review dates, theshorter the lags may be expected to be ingeneral.



The final price of a credit is determinedas the sum of the bank’s liability costs (in-cluding the cost of intermediation andprofit) and the lending risk premium. Thelatter depends on the risk of the debtor, hiscapability to repay the credit. When the pre-mium changes frequently and with greatvolatility for a major part of debtors, thelending rate intended to be influenced willmove together with the liability costs thatcan be influenced by the central bank onlypartially, resulting in a low effectiveness ofinterest rate transmission.

The effectiveness of transmission alsodeteriorates when dynamic banks intentupon market acquisition can be found in abanking system with a large weight, as theyaim at implementing their longer-term stra-tegic objectives instead of maximising theircurrent profits when pricing their depositsand credits.

The Effectivenessof Interest Rate Transmissionin Hungary

The risk premium on lending rates relativeto the yield on government papers hasfluctuated substantially over the past fewyears.

The difference in yields on corporatecredits maturing in less than a year andthree-month discount treasury bills roseabove +5 per cent from the earlier negativefigure in 1995, then declined gradually untilearly 1998 to +1 per cent. As corporatelending rates followed government paperyields only in part at the time of the 1998Russian crisis, the spread declined again inOctober, then jumped back to the figurecharacterising the preceding period in ashort while. (See Figure 12)

It is a natural consequence of Hun-gary’s high and volatile inflation that theshare of facilities maturing within a yearbearing variable interest is high on both thecredit and the deposit side. Owing to this,the duration of the banks’ assets and liabili-

ties is short, which naturally reduces the lagin the transmission mechanism.

In the context of the effectiveness ofthe transmission mechanism, it is necessaryto mention a specific feature in the liquidityposition of the Hungarian banking sectornoted since the autumn of 1995 in compari-son with the advanced economies. Since theautumn of 1995, as a result of substantial in-terventions by the central bank, the Hungar-ian banking sector has had surplus liquiditywhich is withdrawn by the central bankfrom the banking sector through its pas-sive-side instruments (reverse repo, de-posit, bond). (See the section on the instru-ments of sterilisation.)

Consequently, commercial banks arein a net lender position vis-à-vis the cen-tral bank in contrast to the net borrowerposition, which can be regarded as generalinternationally. In principle, this need notgive rise to any difference in the effective-ness of transmission, as banks interestedin increasing their profits should react thesame way to interest rate measures takenby the central bank affecting their costs offinancing through shaping the price of li-quidity still necessary, as in the event of



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Figure 12 The Spread betweenCorporate Lending Rates

on Loans Maturingin Less than a Year

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offering alternative investment opportuni-ties to them through the yield on the place-ment of their surplus liquidity. Neverthe-less, experience shows that banks tend toreact to changes in the effective cost offinancing more sensitively in the courseof their everyday operations than tochanges in their profits lagging behindtheir potential.

The Interest Rate Policyof the NBH

In developing its interest rate policy, the Na-tional Bank of Hungary pursues a dual inter-est rate objective. Under the crawling pegexchange rate regime, it aims at shapingmoney market yields through its policyrates, which, together with the premium ex-pected by investors, guarantee a yield ad-vantage for the forint against the dollar andthe euro. On the other hand, however, by in-fluencing money market yields the NBH in-tends to guarantee a real interest rate levelfor banking rates that favours householdsavings and does not lead to a credit expan-sion, which could endanger the inflation tar-get and the external equilibrium.

The exchange rate target is the ex-change rate course of the central rate of theforint relative to the currency basket impliedby the rate of devaluation announced in ad-vance. Together with the government, theNBH adjusts the announced monthly rate ofdevaluation to changes in expected infla-tion. This allowed for a tenth of a percentagedecrease annually on two-three occasionson average in recent years. With the in-crease in the credibility of the exchange rateregime over the past few years, the pricingbehaviour of market agents was aligned in-creasingly to the pace of devaluation:changes in the nominal exchange rate in-dex, which characterise competitiveness,arising from the shifts of the exchange ratewithin the band, and changes in the dol-lar-deutschmark cross rates did not appearin the development of inflation.

Comparing the exchange rate courseannounced in advance with the appropri-ately weighted foreign interest rates of thecurrency basket of the forint and the ex-pected interest premium (for its factors, seethe next paragraph) in accordance with thelogic of interest rate parity, the exchangerate course determines the desired extent ofshort-term (3 or 6-month) forint rates.When monetary policy, focusing on domes-tic processes, deviates from this, then:

• the forint shifts within the band,and/or

• either the central bank intervenes atthe edge of the exchange rate bandor the extent of intervention em-ployed until then changes.

The expected interest premium isshaped by the exchange rate risk premiumgiven by the risk of an extraordinary devalu-ation or shifts within the exchange rate bandor the premium on the risk of solvency of agiven country interpreted by foreign inves-tors in terms of foreign exchange. Followingthe introduction of the exchange rate re-gime, the magnitude of the risks and conse-



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Figure 13 The Trend of Core Inflation*and the Rate of Devaluation

* The methodological description of core inflation as cal-culated by the NBH can be found in the September andDecember 1999 issues of its publication “Quarterly Re-port on Inflation”.

quently the extent of the premium chargedby investors decreased radically. The cen-tral bank increased the elbowroom of its in-terest rate policy by loosening the “an-nounced in advance” character of the ex-change rate regime from early 1996: fromthen on, neither the period for the an-nounced extent of the rate of devaluation,nor the date of the next modification havebeen declared. This increased the exchangerate risk in a characteristically asymmetricmanner, as an increase in the rate of devalu-ation was outside the intentions of the mon-etary authority, but it could “surprise” mar-ket agents by reducing the pace at any time.(See Figure 14)

The 1998 international exchange ratecrisis in general and the August Russian ex-change rate crisis in particular constituted arelatively novel situation as it reduced glob-ally the willingness of investors to assumerisk, which led to an increase in the extentand volatility of the expected premium alsoin Hungary’s case.

The exchange rate of the forint is al-lowed to fluctuate in a band of ±2.25 percent around the centre rate; in the past, theNBH had no intention to influence the ex-change rate of the forint by interveningwithin the band. The advantage of the vola-tility thus arising is that the fluctuating pre-mium expected by foreign investors against

the forint – particularly at times of interna-tional turmoil – does not require the immedi-ate adjustment of interest rates; the ex-pected and the factual premium arrive at anequilibrium through shifts within the ex-change rate band.

Should the exchange rate of the forintreach the edge of the fluctuation bands, thecentral bank intervenes at the strong(weak) edge of the band by purchasing(selling) foreign exchange in order to stabi-lise the exchange rate.

Until the summer of 1998, substantialstrong-edge interventions took place incertain periods, in the course of which theforint liquidity flowing out was tied down bythe central bank using its sterilisationinstruments (reverse repo, deposits, NBHbonds).

This practice of sterilised interven-tion enabled the maintenance of forint rateshigher than those called for by foreign pro-cesses, thereby facilitating a reduction in in-flation.

Relative to the exchange rate regime in placebefore March 1995 (fixed exchange rate withunexpected devaluations at variable rates),the nature of the crawling peg exchange rateregime in Hungary and the reduction of themonthly rate of devaluation by small stepsprovides opportunities for forint and foreignexchange market speculation that are smallerby orders of magnitude. Over the past fewyears, when the forint stuck to the strong edgeof the band in the long term, one could still ob-serve a more sophisticated version of specu-lation linked to expectations concerning inter-est rates and devaluation.

Two different circles aimed at speculationin two different ways. Approaching the ex-pected date of interest rate reduction, thebanks placed increasingly large amountsinto the fixed central bank deposit facility,which at the time matured in four weeks, fi-nanced partly by acquiring funds fromabroad, trusting in the stable position of theforint within the band. Hungarian regulations,however, strongly limit the open foreign ex-change position which the banks may under-take, so they hedged against their open for-eign exchange positions according to theirbalance sheets in the OTC market or in theforward foreign exchange markets of the Bu-



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Figure 14 Changes in the InterestPremium on the 3-month Discount

Treasury Bill

dapest Commodity Exchange or the Buda-pest Stock Exchange. The other circle ormarket agents undertook to sell foreign ex-change forward to the banks.

As the period of validity of the current rateof devaluation is not declared according toHungarian practice, when quoting dollar anddeutschmark rates for the various maturitiesin the forward foreign exchange market, theforint yields of similar maturities proved to begoverning. Because of this, when the centralbank reduced its rates and consequentlygovernment paper yields declined – similarlyto the announcement of reducing the rate ofdevaluation – the forward rate of the forintstrengthened relative to the currencies in thecurrency basket. Making use of this interrela-tion, those trading in the forward marketcould make significant profits by forwardselling dollar and deutschmark in proportionto the currency basket – exploiting the lever-age increasing effect of the forward market –even at times of expectations of minor reduc-tions in the interest rate or the rate of devalu-ation.

When the interest rate reduction hit themark, the banks naturally won in the spot

market (conversion of foreign exchange andplacement of the proceeds at the still higherforint rate), while they lost against the specu-lators in the forward market owing to thestrengthening of the forint. We could say thatthe banks were willing to cede a part of theirprofits to the market agents trusting in thestrengthening of the forint in the forward for-eign exchange market in order to expand theamount of funds available for the deposit fa-cility prior to the reduction of the interestrate. Naturally, the process could be initiatedboth by the banks (conversion, depositplacement, forward purchase of foreign ex-change) and the speculators in the forwardmarket (forward sale of foreign exchange,11

conversion, deposit placement), though theend result was always the same. When an in-terest rate reduction was expected, the openforeign exchange position of the banks ac-cording to their balance sheets increased andthe sale of foreign exchange against the cen-tral bank strengthened and the short-term

sterilisation stock increased suddenly. Whenthe central bank warded off the surplus steri-lisation burden caused by higher conversionby reducing its policy rates (as happened onseveral occasions), the expected declinein yields was realised and the market in-duced expectation became a self-fulfillingprophecy.

Transmission Alongthe Yield Curve

It is general practice among today’s centralbanks that a central bank will intervene onlyat the very short end of the yield curve goingup to a maximum of a month, quoting inter-est rates. This has a two-fold reason: first,this is where the central bank is strongestagainst other market agents (because theshorter period means a lower profit by spec-ulation for market agents when they “hit”the central bank’s interest rate measures; inthis way, there is no need to calculate withunmanageable outflows of credit or place-ment of deposits due to speculation); sec-ond, this enables the part of the yield curvelonger than a year to purely reflect the ex-

pectations of market agents concerning in-

flation, which is a source of information ofparamount importance for any centralbank. (See Figure 15)



11 As banks quote prices in this forward market, in thecase of major sales investors ultimately conclude transac-tions on a massive scale with them. On the other hand, thebanks sell foreign exchange in the spot market in proportionto the increase in their forward position to hedge their openforeign exchange positions.

Figure 15 The Period of the PolicyRate Applied by Individual Central

Banks

Period (day)

EMU 14

Germany* 14

France* 7

Italy* <30

United Kingdom 1–33

USA 1

Japan 1

Canada 1

* Prior to 1 January 1999.

Partly for similar considerations, inMarch 1999 the NBH shortened the periodof its policy instrument in the course of thelast few years to two weeks, similarly to thatof the European Central Bank. With the ratequoted for this period, the central bank isable to effectively influence the 3–6-monthinterbank and secondary government papermarket yields, of outstanding importance inHungary from the viewpoint of interest ratetransmission under balanced market condi-tions.

The 3–6-month period (benchmark orBUBOR) has an outstanding role in pricingbank credits with respect to both workingcapital finance maturing in less than a yearand development credits maturing over ayear, as the vast majority of these creditsbear variable interest. A pricing practice ofwithin a year also characterises householddeposits even though more than half thestock is fixed for a period of more than half ayear (between 6 and 12 months). Here, pol-icy rates have a less significant role to play

than in the case of credits, as a great manyHungarian banks also follow strategic ob-jectives (market acquisition, enforcing ofmonopoly prices) in the field of collectinghousehold funds.

Owing to the substantial part playedby discount treasury bills in household sav-ings, it may, however, be assumed thatchanges in the yields of government papersmaturing in less than a year governhousehold deposit collection as well, eventhough it is relatively less exposed to com-petition.

The shortest-term, and therefore mostsensitive, rate in the money market is theovernight (O/N) rate evolving in the inter-bank market.

Central banks, whose policy rate is theovernight rate, obviously intend to tolerateonly the least possible volatility in the O/Ninterbank market. (See Figure 16)

For central banks whose governing ar-rangement is for a longer term (two weeks),like the NBH, the O/N interbank yield is im-

portant from the viewpointof the transmission mecha-nism to the extent that it isable to shift the longer-termmarket yields on arrange-ments maturing in less thana year in some direction.Because of this, the NBHmaintains an interest ratecorridor symmetric to thetwo-week governing yieldon the O/N maturitythrough its repo and depositarrangements. This iscalled to ensure that theO/N interbank rates remainwithin the relatively narrowband determined aroundthe two-week deposit rate,apart from cases of extremeliquidity shortage.12 In prin-ciple, however, the O/Nyields may give rise to un-



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Corridor of the Central Bank

12 As against the deposit arrangement, there is a credit line broken down for banks, attached to the repo facility, hence it ispossible that in case of a substantial liquidity shortage, the interbank rate may shoot out from the corridor upwards.

desirable effects spilling over to the longerterms, when, during the reserve period, theystick to one half of the band in a sustainedmanner and, because of this, the rolloveryield on O/N credits or deposits differs fromthe effective central bank rate. To managesuch exceptional situations, the NBH has ashort, but variable term, quick tender that iscapable of managing liquidity situations,which differ vastly from that expected by thebanks within the reserve period (for greaterdetail see the chapter on the set of instru-ments).

Ultimately, the central bank is able toexert an impact on longer-term yieldsthrough the short rates using the forward in-terest parity.

Accordingly, the three-month yieldlevel settles at a level so that the yield on3-month investments should correspond tothe expected yield of rolling a two-week in-vestment through three months. When forinstance the market expects stable two-weekly central bank rates, the 3-monthnominal yield must exceed that of thetwo-week, as the rollover investment meansthat a compound interest is mopped up.When the market expects a general trend ofinterest rate reduction, the yield curve willnaturally be inverted because, in the courseof rolling the two-week investment, rein-vestment will be possible only at increas-ingly lower rates.

When the market expects an interestrate reduction with a high degree of proba-bility, the yield curve will pivot around thepolicy rate of the central bank.

The explanation of this phenomenonis that market agents would like to makethe largest possible profit from there-pricing expected because of the interestrate reduction. When the yield curve is ex-pected to shift downwards in a parallelfashion as a result of an interest rate reduc-tion, the price of financial assets with a highduration will increase substantially.Knowing this, market agents attempt topurchase securities with the longest possi-ble term, bearing fixed interest, at times ofexpectation of interest rate reduction,

which drives (pushes) the price (yield) ofthese papers upwards (downwards) evenbefore the interest rate reduction. The effi-ciency of this speculation strategy can beimproved when the investor usesshort-term – for instance, interbank – loansto purchase longer-term papers in theknowledge that, after the interest rate re-duction, the yield level will also decline onthe shorter maturities, so later he will beable to finance the longer-term investmentwith cheaper, short-term funds.

When an interest rate reduction is ex-pected, the growing demand for short-termfunds triggers an increase in very short-termyields.

All in all, therefore, the yield curve piv-ots as a result of the expectations of interestrate reduction and the shift in the yield curveon longer maturities precedes the expectedchange in interest rates. Because of this,when the central bank does not alter interestrates, the expectations of interest rate re-duction will grow stronger again and again,and the volatility of longer-term yields in-creases even when the central bank rate isstable. (See Figure 17)

The fluctuation in interest rates causedby pivoting is not necessarily bad because itcontains information for the central bank



Interest rate

Maturity3 6 9 12 month

Figure 17 Pivoting of the Yield Curvein Case of Expectations of Changes

in the Interest Rate by the Central Bank

with respect to expectations concerning theinterest rate level. If in such a case the cen-tral bank intends to blunt the shift in over-night yields with the “traditional” instru-ments – narrow interest rate corridor or

pumping additional liquidity into the sys-tem – it will only increase the speculationopportunities for money market agents,who will be able to obtain short-term fundsmore cheaply.





III. THE INSTRUMENTSOF MONETARY POLICY

During the history of the one-tier bankingsystem, the main instrument of mone-

tary policy was the system of credit quotas:in the course of economy planning, creditlines were specified to finance state invest-ment programmes, private housing con-struction and other preferred investments,such as export development, import substi-tution, etc. The preferred objectives weresupported by interest rate subsidy or subse-quent interest reimbursement by the budget.Credit quotas were also applied in work-ing-capital loans , which, however, fell withinthe competence of the NBH in contrast to theplan reconciliation procedure of long-termlending.

From 1 January 1987, the organisa-tional separation of the banking systemwas in place but actual competition amongcommercial banks evolved only gradually.

The Use of Direct MonetaryInstruments

The instruments of monetary policy can beclassified in several ways (described ingreater detail in the next chapter), but inHungary’s case from the viewpoint of thedevelopment of the instruments it is relevantto draw a distinction between direct and in-direct instruments. During the initial periodthe use of direct instruments was typical,the essence of which was that the centralbank, as the monetary authority, was enti-tled to issue binding rules for the commer-cial banks and thereby it directly delineated

the magnitudes of the variables it intendedto regulate. The most frequently used directinstruments were direct interest rate regula-tion, setting interest rate ceilings (or eventu-ally interest rate floors, interest margins)and lending ceilings (credit quotas).

The indirect instruments attempt toexert an effect on the money supply throughinfluencing the supply components of themonetary base and the multiplier, i.e. theiruse is based on the central bank’s ability toinfluence money market conditions. Indirectinstruments include the various types ofopen-market operations, credit auctionsand deposit tenders. The use of direct in-struments was inevitable in the conduct ofmonetary policy when it was not possibleto deploy indirect instruments in the finan-cial system due to the underdeveloped na-ture of the markets. Nevertheless, coun-tries with an developed financial systemalso apply them frequently, for instance inthe event of a vigorous credit expansion.Yet, they have lost significance every-where for several reasons: for instance, di-rect limits deprive banks of the incentiveto collect deposits once the credit ceilingwas reached; they reduce competitionamong the banks; the banks develop inno-vations tailored to local conditions andconstraints, with which they are able to getaround regulations; and they act as incen-tives for the establishment of a system offinancial intermediation outside the banks.


A HISTORICAL OVERVIEWOF THE DEVELOPMENT OF THE

INSTRUMENTS1

1 An accurate description of the monetary policy instru-ments mentioned in this chapter can be found in the nextchapter, which addresses the concepts of the instrumentsand its current operation.

Together with the appearance of foreign in-stitutions in an economy with increasingopenness, new techniques and innovationsevolved; as a result of deregulation in the fi-nancial system, new institutions being notsubject to direct regulation could be estab-lished; and the banking sector subject to di-rect control also became capable to inno-vate, evading the restraining instruments,or, if viewed from a different angle, theywere forced to act this way as otherwisethey would have been driven out of themarket. Until the early 1990s, the centralbank was strongly restricted in developingits monetary policy instruments, partly be-cause of the absence of a money marketand partly because of the limited nature ofcompetition among the banks.

A decisive constraint was that com-mercial banks were not permitted to engagein retail banking in the first two years of theiroperation, they were licensed to collect de-posits only from the corporate sector and tolend only to them. Until the spring of 1989,commercial banks had no license to admin-ister foreign exchange operations or to col-lect foreign exchange funds. Hungary had asubstantial net foreign debt and this stockappeared in the balance sheet of the NBH atthe time when the banking sector was trans-formed into a two-tier one. With the separa-tion of the commercial banks, the NBHstock of claims against companies wastaken over by the banks, but the net foreigndebt, which represented the source of fi-nancing for a considerable part of corporateloans, remained in the balance sheet of theNBH.

Under such conditions of strongly re-strained competition and a macroeconomicsituation characterised by significant cur-rent account deficit, sustained double-digitinflation and frequent and major devalua-tions, commercial banks had to rely on thecentral bank to provide them with fundingand this channel of refinancing was the fun-damental instrument of central bank regula-tion until 1991.

From the demand side, demand forcentral bank refinancing was virtually un-

limited, as the “soft budget constraint” incorporate financial management was stillupheld (the bankruptcy and liquidationrules already in force were not yet effec-tively enforced). In contrast, the pruden-tial rules, regulations concerning debtorrating and provisioning, which would haveminimised the losses of the banks, werenot yet in place. Owing to the unlimited de-mand for credit and the flow of all the freefunds to lending, the central bank hadto sterilise free liquidity in order to achievethe macroeconomic objectives. As de-mand was interest rate insensitive, interestrate policy was not a suitable instrument.As the banking sector was still stronglydependent on central bank funding, theregulation of liquidity by direct instru-ments was evident through the reductionof the normative short-term refinancingcredit lines of the banks and raising the re-serve requirement.

In the initial years, when the centralbank was able to use genuinely indirect in-struments only in a very limited way be-cause of the underdeveloped markets, theinstrument of the reserve requirement or,to be more accurate, liquidity managementachieved through altering the reserve ratethrough the impact on money multiplicationwithin the functions of the reserve system,gained a role greater than at present.(The instrument of the reserve requirementcan be grouped under both direct and indi-rect instruments as in the course of its appli-cation the central bank, in its capacity asmonetary authority, provides for the obliga-tion of setting aside reserves while it influ-ences money in circulation indirectlythrough the money multiplier.)

To offset the acceleration of multipli-cation and to absorb liquidity, the centralbank raised the reserve rate both in 1989and 1991. The central bank has paid com-pensation on the reserve stock depositedby commercial banks since September1990. This was called to partially offset theloss of income owing to the reserve rate re-garded as high in an international compari-son.



Money Market Development –Use of Indirect Instruments

Changes in macroeconomics, institutionsand regulation, launched in the first fewyears of the operation of the two-tier bank-ing system, provided an opportunity andcalled for the development of monetary pol-icy instruments in the early 1990s.

Although the distinction betweencorporate and retail banking operationsceased as from 1 January 1989, for sometime integration was made more difficultby the fact that special reserve require-ment provided protection to the depositportfolio of OTP, i.e. to the financialsources of households, primarily housingconstruction credits. This regulation was,however, not extended to certificates ofdeposit, hence this opened the floor for theevolution of competition for the incrementin household savings. Corporate depositand lending rates were liberalised as earlyas 1987, retail rates were liberalised onlyafter the integration of bank operationsbut, until 1991, the central bank used theinstrument of an interest rate ceiling onhousehold deposit and lending rates, andcertificates of deposit.

The decentralisation of foreign ex-change operations of commercial bankswas a process that took several years, be-ginning in 1989 with the step of permittingthe banks to collect foreign exchange de-posits, which entitled the banks to use for-eign exchange credits in a limited range,and swap operations. In the first half of1990, banks properly prepared to performforeign exchange operations were licensedto administer trade-related foreign ex-change transactions administered in con-vertible currencies. In 1991–92 restrictionson foreign exchange operations were fur-ther softened and, in fact, both the place-ment and collection of foreign exchangefunds became unrestricted. Until then, for-eign exchange over and above that in-tended for permitted placement and limiteduse had to be sold to the NBH. From thenon, however, banks were permitted to

freely buy and sell foreign exchange fromone another. The then limited interbank for-eign exchange market began to operate inJuly 1992, where the exchange rate of theforint developed in response to demand andsupply. This meant that monetary policycould use the instrument of conversion.Once this was in place, the central bank lim-ited the risks arising from the banks’ foreignexchange positions not directly, but throughthe banks’ open foreign exchange posi-tions.2

Certain forms of the money market ap-peared as early as the beginning of the1980s, with the licensing of intercompanylending (the interest rate and other condi-tions of intercompany lending, however, re-mained largely hidden to monetary policy)and the institution of the bill of exchange.With the establishment of a two-tier bankingsystem and the liberalisation of domestic in-terest rates, the floor was opened for the de-velopment of money markets. This, how-ever, did not begin because of the liquidityshortage, the lack of confidence and theproblems in liquidity management and re-demption risks. Consequently no character-istic short-term market rate could evolve.In order to create a properly functioningmoney market, the National Bank ofHungary, by virtue of its central role, beganto organise the auction market of treasurybills and a centralised interbank moneymarket.

In the centralised interbank market,market agents stood in a contractual rela-tionship not with one another but with thecentral bank, which meant that the NBHpaid whenever a borrower bank was unableto pay on time (at the same time, the centralbank could exclude banks in default fromthis market). This was an off-balance sheetactivity for the central bank. It acted as anagent driven exclusively by the desire tobuild the market.

The National Bank of Hungary oper-ated the auction market for discount trea-sury bills from December 1988. As the



2 The total open position of a credit institution may not ex-ceed 30 per cent of its guarantee funds.

yields evolving in the auctions could notbreak away from deposit rates (particu-larly corporate deposit rates), the yieldsevolving in the auctions had an impact onthe general interest rate. The still accept-able yield maximum (i.e. the minimumprice that could be accepted at the auc-tion) was determined by the Ministry of Fi-nance; the main criterion in making thisdecision was the development of the gen-eral financing requirement. It is importantto emphasise this because during this pe-riod, when the market was characterisedby ample liquidity and the central bankhad no other instrument to tie down excessliquidity (1992), the sale of the discounttreasury bills in the primary market playedthe role of sterilisation. The impressionthat the discount treasury bill auctionswere part of the central bank’s set of in-struments was reinforced by the coinci-dence of the endeavour by monetary pol-icy to generally reduce lending rates andthe natural need of the budget to reducethe costs of financing. (This impressionwas further reinforced by the fact that thediscount T-bill auctions were organisedand administered by the central bank.) Is-sue, however, was determined not bymonetary criteria but the financing re-quirement of the budget, which did notnecessarily coincide with the requirementsof monetary policy. (This became evidentin the following year, when the centralbank decided to raise interest rates owingto the deteriorating macroeconomic pro-cesses, but the budget continued toendeavour to finance the budget deficit ascheaply as possible.)

The large-scale issue of treasurybills, which had a history of several yearsby then, the appearance of commercialbills, and early in the 1990s that of com-mercial bonds and the substantial quantityof government bonds issued for the pur-poses of bank consolidation all representeda stock of securities of a volume and qual-ity that provided an adequate base for per-forming open-market operations. In addi-tion, organising the issue of, and trading in,

these securities established the technicaland professional background required forusing similar money market instruments atboth the central bank and the commercialbanks. From 1993 the NBH introducedcentral bank quotations for repurchaseagreements (repo) and reverse repurchaseagreement (reverse repo) with respect togovernment papers. This indirect instru-ment was aligned to the process of financialliberalisation and deregulation, and it con-stituted a more sophisticated tool of regula-tion than the opportunities provided by al-tering refinancing credit lines.

From 1993 the central bank satisfiedthe short-term liquidity needs of financial in-stitutions, i.e. short-term refinancing (or tieddown excess liquidity) in the form of repotransactions. The central bank, however,developed their conditions so that the banksshould find it more worthwhile to turn to theinterbank market in the event of a liquidityshortage.

The portfolio of medium and long-term refinancing continued to represent asubstantial share in the central bank’s as-sets. The NBH played only an intermediaryrole in distributing these credits. Thesewere largely foreign credits (i.e. foreign ex-change funds), which the commercialbanks were unable to raise directly (for along time, only the National Bank of Hun-gary had connections with foreign lendersbecause building up confidence, a nameand network of connections takes a longtime, particularly for an economy in transi-tion). Hence the NBH channelled thesecredits to the commercial banks. Thesemainly medium and, less frequently,long-term credits did not constitute partof the monetary instruments as the centralbank undertook only an intermediary rolefor historical and institutional reasons.The greater part of these credits servedproject financing or some kind of a selec-tive purpose (export promotion, moderni-sation, acceleration of the establishmentof modern forms of ownership, etc.). (SeeFigure 18)



To expand their forint liquidity, com-mercial banks could also use the foreign ex-change deposits placed with them. Whenthe central bank expands the range of trans-actions covered by foreign exchange – thatis, renders its conditions more favourable –it facilitates the expansion of liquidity in thebanking sector. This is also an incentive forcommercial banks to raise funds abroad.The purpose of the foreign exchange de-posit swap was to transform long-term for-eign credits and short-term foreign ex-

change funds to long-term Forint-denomi-nated credits. The essence of the arrange-ment was that the NBH extended me-dium-term or long-term forint refinancingcredits against foreign exchange depositskept with the central bank to an amount cal-culated with the exchange rate quoted onthe day of their placement, in a period whenlong-term funds had not yet been generateddomestically. This arrangement also didaway with the exchange rate risk, arisingupon the onlending of the foreign and do-



Figure 18 Changes in the Medium and Long-Term Refinancing Portfolio, 1991–98(Data as at 31 December)

Ft billion1991 1992 1993 1994 1995 1996 1997 1998

Investment and other

refinancing credits* 145.3 138.9 91.2 74.1 58.8 8.9 5.7 2.8

Arrangements assisting

companies 17.5 27.1 104.7 134.4 137.9 127.6 110.4 91.1

– Refinancing creditsof international financialinstitutions 0.0 0.0 7.4 6.5 11.9 10.4 7.8 4.1

– World Bank refinancingcredits 0.0 0.0 40.4 32.8 29.7 20.9 16.2 12.7

– Development purposerefinancing creditsfor small businesses 3,0 3,2 1,3 0,9 0,5 0,4 0,4 0,4

– Start up Refinancingcredits 10.5 7.0 3.6 1.4 0.9 0.5 0.3 0.1

– START refinancingcredits 3.0 7.6 8.7 8.8 7.3 6.4 6.8 8.9

– Refinancing creditslinked to reorganisationand privatisation 1.0 9.4 32.2 60.4 60.6 54.8 46.1 36.7

– Japanese refinancingcredits 0.0 0.0 11.2 23.7 26.9 34.4 32.9 28.1

Refinancing credits

extended in foreign

currency** 24.3 33.2 24.3 19.1 15.7 11.7 12.6 11.5

Refinancing credits

extended against foreign

exchange deposits 10.6 7.2 21.1 130.3 79.7 77.5 49.0 50.6

Total 197.7 206.3 241.3 357.8 292.1 225.7 177.7 156.0

NBH balance sheet total 2,553.1 2,688.9 3,468.8 4,024.2 5,420.4 5,119.3 5,338.1 5,930.5Share of refinancing credits in

the balance sheet of the NBH

(%) 7.7 7.7 7.0 8.9 5.4 4.4 3.3 2.6

* Largely pre-1987 investment and shorter-term credits linked to the initial period of the two-tier banking system.** Fixed-purpose financing credits extended by foreign governments and banks generally for the purchase of capitalgoods from the lender countries.

mestic foreign exchange funds in forintterms, which would have been substantialunder the given conditions of economic pol-icy and the absence of instruments suitablefor the management of long-term exchangerate risk. The development of the interbankforeign exchange market and the wideningof possibilities for placing foreign exchangeabroad enabled the central bank to gradu-ally subdue this channel of refinancing (firstwith respect to shorter maturities, terminat-ing the arrangement in 1993 and then alsoon medium maturities), closing it altogetherin 1995.

Futures and Forward markets provide an op-portunity for hedging against exchange raterisk. Their limited nature, particularly with re-spect to maturity and the shortage of long-term funds, called for a foreign exchange de-

posit swap arrangement in force from 1995 to1998. This arrangement could then be usedexclusively for project financing understrongly delineated conditions. As seen fromthe preceding paragraph, this arrangementcould not be regarded as part of the monetarypolicy instruments.

Short-term foreign exchange swap ar-rangements3 did in turn constitute part of theinstruments. From 1993 foreign exchangeswap transactions had a role identical withthat of repo transactions in monetary policy;their conditions were adjusted to those ofthe repo transactions.

With the Hungarian banking systemgaining muscle, the conditions for thebanks’ direct entry to foreign markets weregradually put in place. The NBH ende-avoured to dismantle the above activities– re-channelling of foreign government andbank credits, transformation of foreign ex-change deposits into long-term forint credits– which could not be reconciled with its cen-tral banking functions and to entrust them tothe market, purging them from its balancesheet.

Although the instruments with whichthe central bank could regulate the demandfor money by the banks in a more differenti-

ated manner gradually came into existence,the instrument of the reserve requirementcontinued to be used by the central bank toadjust liquidity in the banking sector owingto the relative underdevelopment of themoney markets. The impact of changing thereserve rate is immediate and “vigorous”,hence the central bank made use of the pos-sibility of raising the reserve rate in the initialperiod of capital inflow.

In the longer term, however, the objective is tosignificantly reduce the reserve rate, which willdecrease the loss of income arising from set-ting aside the reserve and thereby improve thecompetitiveness of domestic banks. In 1996,the NBH created a reserve requirement sys-tem, where the expansion of the range of liabil-ities subject to the reserve requirement madeavoidance of setting aside the reserve moredifficult, and terminated the preference of cer-tain groups of liabilities, which enabled a re-duction in the ratio (to 12 per cent) without re-ducing the effective placement of reserves.The chapter on the set of instruments dis-cusses in greater detail the new reserve re-quirement system developed in 2000, to be in-troduced gradually by the summer of 2001.

Over the past ten years, the instru-ments of monetary policy in Hungary haveundergone rapid developments. Starting outfrom the initial distribution of credit lines,the central bank deliberately aimed at ap-plying market methods. The applicable in-struments, however, are greatly dependenton the macroeconomic and institutionalconditions. The need to develop the instru-ments frequently preceded the developmentof the institutional system and interventionsin conformity with market principles experi-enced significant constraints. The budget,or rather its financing, frequently influencedprocesses in a decisive manner.

In 1991–92 the neutralisation of theexcess liquidity caused by the budget defi-cit and capital inflows created problems forthe central bank as its instruments em-ployed until then were fundamentally de-signed for liquidity expansion. Based onthese experiences, the central bank, givingup quantitative regulation, gradually movedtowards interest-rate-driven monetary con-trol.



3 For more detail on the instrument of the swap see thesection on “The Basic Instruments of the Current CentralBank” in the chapter “The Set of Instruments”.

Although the term ‘central bank mone-tary policy instruments’ can be read

and heard frequently, it is not always clearwhat the users of this expression mean. Oneof the main reasons for this could be that theinstruments of monetary policy are stronglyspecific to the central bank in question, ad-justed to the targets marked in the hierarchyof objectives in the monetary policy of thegiven bank. Hereafter, there is a descriptionof the instruments, based on the practice ofthe NBH, using categories based on the op-erating target to be achieved by the instru-ment, proceeding from general aspects toactual practice.

In a primary breakdown, we can distin-guish the instruments directly linked tothe maintenance of the exchange rateregime (foreign exchange market interven-

tion) from the forint money market and reg-ulatory instruments in the practice of theNBH.

Foreign Exchange MarketIntervention

To maintain the given exchange rate re-gime, whenever there is a danger that the

currency of a country becomes overvalued,the central bank buys foreign exchangein the foreign exchange market, i.e. it inter-venes in the course of which it increasesthe amount of the local currency in circula-tion. It intervenes in the opposite directionwhen the local currency may become un-

dervalued in the foreign exchange market.The point of reference relative to which thelocal currency may become either under orover is determined by the exchange rate re-gime.

Until the end of 1999, the exchangerate of the forint was pegged to a currencybasket, which, in 1999, consisted of70 per cent euro and 30 per cent US dollar.From 2000 the forint has been fullypegged to the euro. Under this regime,since March 1995, the NBH has been exe-cuting crawling exchange rate devalua-tions announced in advance, applying afluctuation bands of ±2.25 per cent. Deval-uation is effected daily, based on thecrawl, determined for a month in advancebut announced months before. This meansthat the exchange rate, pegged to the cur-rency basket till the end of 1999 and thenon the euro, is devalued daily by a specificrate; the market exchange rate of the forintmay be 2.25 per cent weaker or strongerthan this centre rate, i.e. the market rate ofthe forint may fluctuate within a band of4.5 per cent.

At the two edges of the band of devalu-ation the NBH is at the banks’ disposal. Atthe strong edge, it automatically offers topurchase foreign currency, while at theweak edge, it offers to sell foreign currencywith no ceiling on amounts. In these casesthe lowest transaction amount is USD4 mil-lion or EUR3.5 million which may be raisedby steps of 0.1 million. Consequently, it isalso possible for transactions to be con-cluded in the event of trading in substan-


THE OPERATIONOF THE INSTRUMENTS

TODAY

tially lower amounts outside the exchangerate band to a minimal extent.

The central bank is available to tradersat the edges of exchange rate band from9.00 to 12.00 hours and again from 13.00 to15.00 hours.4 Settlement (debiting andcrediting the forint and foreign exchange ac-counts of the commercial banks) is effectedon the second workday after the day of thetransaction.

To protect the value of the currency,the NBH also has an opportunity to tradewithin the band. Examples of this have beenexceedingly rare and they occurred only inthe form of selling foreign exchange: up to1999 it happened only as a result of the Rus-sian crisis.

The Operation of the ForintInstrumentarium

The potential (possible maximum) cen-tral bank instruments represents the

set of monetary policy instruments, the es-

tablishment and use of which isprovided for in the Act on theCentral Bank.

The set of business instru-ments is narrower than the po-tential set of central bank in-struments, as it refers to all theinstruments for which the cen-tral bank has developed itsbusiness conditions in force orthere is a central bank (NBH)regulation in place, regardlessof whether or not the centralbank uses the given instrument.These are the instruments,which the monetary decision-making body uses, or may use,at any time as their frameworkconditions are continuously inforce.

When thinking of the in-struments, we most frequently

mean the business instruments. The appliedinstruments constitute that part of the busi-ness instruments which contain elementscontinuously applied by the central bank.This includes those tenders, which need tobe separately and individually announced(which is part of their application); but thearrangement is continuously available, sothere is no need to separately announce thearrangement itself.

The elements of the set of instrumentscan be grouped using a number of criteria:



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Intervention (weekly data,right-side scale)Deviation of the exchange ratefrom the centre of the band(left-side scale)

19981997 1999 2000

Figure 19 Changes in the Exchange Rateof the Forint and Foreign Exchange Market

Potential Instruments

Business instruments

Applied instruments

Interest rate ceiling

NBH bond

Interest rate floor

Deposit Repo

Reverse repo

Delivery repo

Reserve rate

Lombard loanRefinancing facility

Purchase and saleof government papers

NBH bond

Credit withoutcollateral

Figure 20 The Structure of the ForintInstruments of the NBH early in 2000

4 The table showing the hours of business of the NBH ispresented in the Annex.

they can be distinguished by maturity;by their objective or role; by their form ofsale or introduction to the market; and bytheir availability or the eligibility of thecounterparties. The instrumentarium is fre-quently broken down into direct and indirectinstruments based on their impact mecha-nism. Direct instruments include the highestlending rate or the lowest/highest depositrate which commercial banks may apply,the use of credit or deposit quotas appearingat the regulatory level, with the regulation ofthe reserve rate frequently put in this cate-gory as well.

The indirect instruments includeopen-market operations with the standingfacility lumped together with them, or putinto a category of its own under indirect in-struments. Classic open-market operationsare the outright sale or purchase of securi-ties, tendering (repo, reverse repo or deposittenders) and the issue of bonds.

Below, the instruments will be pre-sented primarily in a breakdown by objec-tives.

By their functions and objectives, wemay distinguish:

• the reserve rate,and the groups of instruments playing a di-rect role in the development of interest ratepolicy, such as

• the instruments used to maintain theinterest rate corridor,

• the instruments used as key instru-ments,

• the instruments used for sterilisationpurposes, and

• the elements used for adjusting li-quidity.

Reserve RequirementSystem

When employing the reserve requirementregulation, financial institutions subject tothe regulation must place a specific portionof their liabilities in central bank money onthe account kept at the central bank.

Functions of the Reserve requirement

The original function of the reserve re-

quirement can be traced back to pruden-tial factors. Upon its appearance it consti-tuted a reserve against deposit withdraw-als. The purpose of its use has, however,changed and the area of its application ex-panded. The tasks of reserve requirementare multifarious, changing from country tocountry, depending on which function ispreferred by the central bank. Reserve re-quirement regulation may have the follow-ing functions:

• As the reserve requirement meansstable demand for central bankmoney, it withdraws a certainamount of money from circulation,thereby directly reducing liquidityin the banking sector. The reserverequirement, when it creates a li-quidity shortage in the banking sec-tor, prompts banks to turn to thecentral bank for funding. The centralbank uses the demand for centralbank money to effectively influencethe rates applied by the banksthrough its interest rate policy – thatis to say, it improves the effective-ness of the transmission mecha-

nism. When the banking sector of acountry has a sustained liquiditysurplus in a given period – forinstance, in the event of majorcapital inflows – the reserve require-ment assists in absorbing excess li-quidity.

• The reserve requirement can assistin the banks’ liquidity manage-

ment. When the reserve require-ment must be met at an average ofthe reserve period, this mechanismprovides an opportunity for thebanks to hold, for a transitory periodof a few days, reserves lower orhigher than the reserve requirementlevel in the given reserve period.Consequently, the reserve require-ment as a buffer reduces the volatil-ity of interbank rates.



• It may serve as collateral in theevent of a decrease in liabilities.

• It may be used as an indirect tax inthe event of the payment of interestbelow the market rate or the non-payment of interest.

• It provides information on changesin the liabilities of the banks.

Elements of the Reserve System

The Reserve requirement system has sev-eral features, which may differ from countryto country. The most important elementsof the reserve system are the reserve rate,the reserve bases, the objective form of theplacement of the reserve, the entities sub-ject to regulation, the interest paid onthe reserve, the form of meeting the require-ment or the relationship between the periodof calculation and the period of place-ment.

As to the form of placing the reserve,the reserve may be placed in local currency,foreign currency or different currencies byliability in accordance with the regulationsprevailing in the given country. The place-ment may include vault cash or only theamount kept with the central bank maybe regarded as eligible for meeting the re-serve requirement. A solution whereby theamount corresponding to the amount of thereserve requirement must be transferred toa separate account for placing the reserve isalso possible. However, in most countries,the settlement deposit account fulfils thisfunction.

The rate of reserve (the reserve rate)is a percentage of the external liabilities heldby the entities subject to the reserve require-ment as specified by the central bank, whichdetermines the amount of the reserveto be placed by the given institution for agiven period. The rate and the base ofthe reserve – or rather the amount of thereserve determined by them – are importantfrom the viewpoint of the withdrawal ofliquidity.

The entities subject to the reserve re-quirement are the members of the financialsystem, most frequently the banks only, and

other financial institutions operating as abank.

The base of the reserve is generally theamount of external liabilities, which maychange according to the national prefer-ences of individual countries (exemptionfrom the reserve requirement for external li-abilities originating from abroad or foreignexchange funds).

To measure the base of the reserve,the stock of liabilities subject to the reserverequirement in one or more selected days ofa given period may be designated; most fre-quently, however, every day of a given pe-riod is considered and an average of thestock of liabilities subject to the reserve re-quirement is calculated (this period is theperiod of calculation). The reserve calcu-lated in this manner must be placed for agiven period in central bank money (the pe-riod of placement). Most frequently, the pe-riods of calculation and placement are equalin length, but they do not necessarily coin-cide. The periods may be successive, stag-gered (not overlapping), semi-overlappingor overlapping periods.

The advantage of overlapping periodsis that the reserve must be deposited on thecurrent stock of external liabilities. As,however, it is difficult to ensure accuratemeeting of the requirement at the end of theperiod, the semi-overlapping period is ap-plied, which provides an opportunity for ac-curately meeting the average requirementthat cannot be foreseen at the beginning ofthe period of placement. The successiveperiod is better than the semi-overlappingperiod in the sense that the periods of cal-culation and placement are separated.However, frequently, at the beginning ofthe period, it is unknown on what amount ofaverage liabilities must the required sum beplaced. This can be particularly problem-atic when banks must meet a part or all ofthe reserve requirement daily. That is whythe non-overlapping period is also applied,when the extent of the reserve requirementis known at the beginning of the period ofplacement. The disadvantage of thismethod is that–in a comparison of the four



methods–the period of calculation is fur-thest away in time from the period of place-ment. (See Figure 21)

The Flexibility of Reserve Regulation

The reserve requirement ratio regulationfundamentally determines the centralbank’s instruments. The other elements ofthe instruments will have to be structureddifferently depending on whether

• there is no reserve requirement reg-ulation,

• reserve regulation exists, but it is in-flexible, or

• it exists and it is flexible.When there is no reserve requirement

regulation, the central bank has to facilitatestable demand for central bank money andthe smooth operation of the banks’ liquiditymanagement with other instruments.

Reserve regulation is said to be inflexi-ble when the requirement must be met in fullevery day. In this case the monetary role ofthe reserve is to reduce market liquiditypermanently. The reserve requirement maycreate sustained demand for central bankmoney or, in a period of sterilisation, may

contribute to safely tying down a part of ex-cess liquidity.

When reserve regulation exists and it isalso flexible, then its task, in addition to theformer function, is to provide some elbow-room to the banks’ liquidity management.At such times the reserve requirement neednot be met daily, only in the average of theperiod. With this, the banks’ treasuries mayhandle the balance of their reserve accountkept with the central bank as a buffer andmay replenish the reserve or draw fundsfrom it above or below the average withinthe period of placement. It may well be en-visaged at system level that the banks mayhave problems in replenishing the reserve orin tying down liquidity released by the with-drawal of the excess reserve at the end ofthe period. The central bank attempts to re-solve such problems either on a continuousor on an ad hoc basis.5

A reserve system with limited flexibilityis built up of the elements of the fully flexible



Figure 21 The Relationship of the Periods of Calculation and Placementto One Another

Overlapping Semi-overlapping

Periodof calculation

Periodof placement

Successive Non-overlapping

Periodof calculation

Periodof placement

5 Carrying over the surplus (or deficit) accumulated by theend of one period to the next or inviting (quick) tenders in theappropriate direction and amount and, as a final resort, theO/N instruments of the central bank interest rate corridormay be used as possible solutions.

and inflexible reserve regulation. Under suchregime the central bank provides for the av-eraging method, while specifying a dailyminimum to be met in a given percentage ofthe reserve. When there is no such manda-tory daily minimum requirement, the banks’internal regulations frequently prohibit themfrom going below a certain part of the pre-scribed reserve requirement on a daily basiseven if it means failure to exploit the opportu-nities given by the current money market sit-uation for reasons of risk management.When the averaging method is used, it is fre-quently provided that the balance of the re-serve account cannot be in the red, whichmay also be interpreted as the zero balancebeing the daily minimum. The surplus or def-icit generated in the reserve period and keptwith the central bank may be carried forwardto the next period in some countries, pro-vided certain conditions are met.

According to one regulation, the reserve re-quirement ratio is zero but this requirementmust be met in average within the period,which means that the balance of the account ofthe financial institutions kept with the centralbank may also be negative (zero averaging).

The Current Practiceof the NBH

In Hungary, the Act on the Central Bank pro-vides an opportunity for the NBH to imposethe reserve requirement on investment busi-nesses in addition to credit institutions. Nev-ertheless, NBH Ordinance 1/1996/PK.1 onthe reserve requirement extends only tocredit institutions including the Hungarianbranches of credit institutions with theirheadquarters abroad.

The nominal reserve requirement ratio de-clined gradually from 17% to 12% in 1996. Thiswas concomitant with widening the reservebase so that the effective reserve requirementratio did not change. With the last change im-plemented in 1996 every liability item, withinthe M3 monetary aggregate and those close toit, came to be included in the base of the re-serve. Asset side items ceased to be deduct-ible. Thus, with the exception of internal liabili-ties, interbank liabilities and liabilities originat-ing from abroad, reserves must be set aside

practically on every bank liability. Now, underthe system, which in the meantime underwentminor modifications only, even forint vaultcash is included in meeting the reserve re-quirement. Reserves by certain credit institu-tions and on certain liabilities had to be setaside at different ratios. In view of their funda-mentally different activities (drawing inlong-term funds), housing saving funds andthe Hungarian Development Bank set aside re-serves at 4%. The ratio for at least 3-year secu-rities, publicly issued by credit institutions, wasalso 4%. The reserve requirement need not beset aside on interbank liabilities, foreign ex-change liabilities maturing in more than a year,originating from abroad, and liabilities col-lected by way of letters of mortgage, issued forat least 5 years. (See figure 22)

Gradually, the NBH will introduce anew reserve requirement system from July2000. The purpose of changing the reserverequirement system is to create regulationswhich improve the competitiveness of thebanks. The objective is that the reserve reg-ulation should approximate the reserve re-quirement system applied by the EuropeanCentral Bank (ECB), thereby easing theshift later. With this the costs of harmonisa-tion will not arise all at once.

The new regulation will do away withthe structural disparity arising from differentreserve requirement ratios set for foreignand domestic liabilities; the criterion for ex-emption from the reserve requirement willno longer be the origin of the liabilities, buttheir maturity. That is, liabilities shorter than



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19981997 1999 200019961995

Per cent

Figure 22 Changes in the ReserveRequirement Ratio in Hungary

2 years would be subject to the reserve re-quirement and those longer than two yearswill be exempt (in accordance with ECBpractice). This will abolish the preferentialratios for the Hungarian Development Bankand the housing savings banks as institu-tions, but as they basically collect long-termfunds by far the greater part of their liabili-ties will be exempt from the reserve require-ment.

Gradual introduction means that from1 July 2000, 50% of the funds originatingfrom abroad and maturing within a year willbe subject to the reserve requirement; and50% of the forint vault cash may be takeninto consideration for meeting the reserverequirement; the nominal ratio will be re-duced from 12% to 11%. From 1 July 2001all foreign exchange funds maturing withintwo years and originating from abroad willbe subject to the reserve requirement, andforint vault cash will no longer be an accept-able asset in which to meet the reserve re-quirement. The level of the nominal ratio tobe in force from 1 July 2001 will be deter-mined by 1 June 2001.

The NBH pays interest on the reserverequirement placed with it. Although its rateis lower than the market rate, the income ef-fect (indirect tax) of having to set aside a re-serve is no higher than 0.8% even with thehigh nominal ratio. To offset the additionalcosts caused by the reserve requirement,commercial banks increased the margin be-tween their deposit and lending rates, i.e.banks ultimately shift the losses suffered inthe course of setting aside the reserve totheir clients.

By subjecting the full range of short-term foreign exchange funds to the reserverequirement, these liabilities will also beburdened by income withdrawal. Thismark-up will have a more vigorous effect inforeign exchange markets because they arecharacterised by a lower nominal interestrate and a narrower margin. It is not an ob-jective of the NBH to make short-term for-eign exchange funds more expensiveand thereby to encourage the creditworthyclients of the banks to raise credit abroad.

To that end, the NBH would set the extent ofthe compensation paid on the reserves, setaside on foreign exchange funds (whetherobtained from residents or non-residents),gradually so as to pay 1.5 percentage pointhigher interest by the end of the transitionprocess. In the first phase and the secondphase, the NBH would pay 0.5 and 1.5 percent higher interest, respectively, on re-serves set aside on foreign exchange fundsthan on reserves on forint funds.

Under the Hungarian reserve regime,the reserve period is one calendar month,which follows the month of the period of cal-culation (successive period). Every day ofthe month of the calculation period must betaken into account for determining the baseof the reserve. The one-month reserve pe-riod was introduced in September 1998 toreplace the former two-week period. In addi-tion to providing a higher degree of freedomfor banks, the shift was justified by the factthat the one-month period coincided withthe frequency of tax and contribution pay-ments. Thus the banking sector must adoptsimilar scheduling to manage the approxi-mately similar waves of liquidity within themonth.

Under the former regime, comprising two pe-riods in one month, it was observed that in thesecond placement period of the month therewas a higher degree of uncertainty in liquiditymanagement (owing to tax payments due onthe 20th day of the month), reflected also inthe changes of the interbank O/N rates. Be-cause of this, one could envisage a reserveperiod beginning on the 15th day of the calen-dar month, covering a whole month, whichwould provide a longer period for the banks toovercome the shock arising at the beginningof the period.

Within the period, a bank may freelyalter the balance of the settlement accountas it needs to meet the requirement only inan average of the month, but the balance ofthe account may never be negative. Thisrule and the high level of the reserve, takentogether, provide a flexible liquidity man-agement possibility for the banks.

The series of the NBH data publishedin Reuters, which contains the reserve re-



quirement of the banking sector and thestocks placed up to the given date in a timeseries, also promotes the accuracy of thebanks’ liquidity management. With this, thebanks’ treasuries obtain important assis-tance to estimate the liquidity position of thebanking sector expected by the end of thereserve period and, in the light of this, toprepare for making up the deficit or placingthe surplus.

The Basic Set of Current CentralBank Instruments

Before discussing the specific money mar-ket instruments the NBH employs, we shalldescribe the basic types of instruments andtheir defining features.

Open-Market Operations:

Outright and Repo Transactions

Under the outright purchase and sale of gov-ernment papers (outright operations), whichcount as classical open-market operations,the central bank trades in securities, primarilygovernment papers with a view to regulatingmoney in circulation.

Over the past decade, open-marketoperations have gained in importance in theconduct of monetary policy. This is due to thefact that they have several advantages overother instruments such as refinancing,rediscounting operations, or the adjustmentof reserve requirement. They can be flexiblyapplied for implementing even daily mone-tary control tasks; they do not have an “an-nouncement” impact (as have, for instance,interest rate decisions). Outright operationsare initiated by the central banks; they do not,however, put pressure on the market becausethey are realised through decisions guided byyields. Their precondition is, however, the ex-istence of an adequate amount of securities,i.e. the existence of an advanced liquid pri-mary and secondary securities market in thegiven country. In the absence of this condi-tion, classical outright operations became im-portant instruments within the monetary poli-cies of relatively few countries (United States,United Kingdom). With the development ofthe securities market, however, innovationsand methods came into being which did notrequire similarly high volumes of free liquidityand securities stock as did outright opera-tions; yet they proved to be successful in the

fine-tuning of monetary regulation, the regu-lation of liquidity in the banking sector. Such atypical instrument is the repurchase of securi-ties or the repo transaction (see, in greater de-tail, under the heading “Repo”). In most coun-tries central banks create the necessary stockof securities by organising the primary gov-ernment paper market or by issuing their ownsecurities.

At the end of the 1980s the conditionsin Hungary for performing open-market oper-ations did not yet obtain. The regular Treasurybill auctions (from 1989) and the introductionof the central bank securities account (1992)enabled the central bank to launch repo quo-tations. Over the years the conditions alsomatured for performing outright operationsand the NBH made active use of this instru-ment for a longer period. Nevertheless, itnever became important in its monetary pol-icy. This is attributable partly to the fact that,by the time the central bank was able to ac-tively use the instrument of selling and buyingsecurities, the repo was already in place,which proved to be an efficient instrument forregulating the money supply. (Repo transac-tions are not restricted by the maturity of theavailable securities and, through them, it ispossible to efficiently influence the centralbank’s operating interest rate target evenlyand constantly over the short term; with therepo, the central bank can be available di-rectly at the announced interest rate or it canissue an interest rate tender). The environ-ment of monetary policy has also changedover time: in the wake of the sustained liquid-ity surplus and the necessary sterilisation bythe central bank, the government paper port-folio of the central bank decreased vigorously,thereby limiting the possibility of using theoutright (and repo) instruments. The limita-tions were reinforced by the Act on the CentralBank, according to which the central bankmay not buy government papers in the pri-mary market. This provision was introducedto adjust to the criteria of the European Unionand to keep central bank lending to thebudget outside the money market under con-trol.

Repo

The term is an abbreviation for the “sale andrepurchase agreement”. A repo transactionis, in actual fact, the result of two transactionswhereby the counterparties handle the trans-actions as a single package. The first leg ofthe transaction is the prompt sale or purchase



of a given security (most of the time somegovernment paper), followed by the reverse ofthe prompt transaction after the lapse of aspecific period of time.

In a repo transaction, the promptmoney and securities movements are re-peated in the opposite direction at a subse-quent date specified in advance, hence thetransaction could be interpreted as the resultof a securities loan and a money loan in re-verse. In general, under repo contracts, therights linked to the lent security (price and in-terest income) are due to the original holder.Repo transactions are always motivated bytaking out or extending a money loan (underthe collateral of adequate securities) or theborrowing of specific securities. The counter-parties agree on the original sales and forwardrepurchase prices at the very beginning of thetransaction. The two prices are set so thattheir difference coincides (conceptually) withthe rate on a loan secured by collateral, whichis referred to as the repo rate.

The two counterparties to a classicalrepo transaction are the seller (or lender) whosells his security at the initial date and then re-purchases it at a later date and a buyer (orborrower or investor) who practically extendsa money loan under the collateral of securi-ties. It is important to note that the above de-scriptions follow the terminology of the bondmarket and not that of the money market. Ac-cording to the terminology of the money mar-ket, the lender of the money, i.e. the borrowerof the security, is referred to as the lender.

Repo appears in the Terms and Condi-tions of Business of the NBH in several forms.The central bank’s repo terminology distin-guishes the repo and the reverse repo. Repo

is a transaction (in which the counterparty ofthe central bank is the active party) underwhich the central bank finances the givencounterparty with the backing of governmentpapers. The reverse repo is the reverse of theformer when the central bank performs a repotransaction with an eligible counterparty inthe course of which the central bank extendsgovernment paper collateral against liquiditytied down with it for a specific period of time.

The NBH may perform repo transac-tions employing four forms of sale (see thedetails below):

• continuously available standing facility• intermittently available standing facility,• tender, and• quick tender.

As far as title to the security used as col-lateral is concerned, we may distinguish thedelivery repo and hold-in-custody repo. In thecase of delivery repo, title is transferred for theperiod of the transaction by the seller to thebuyer, who may have free disposal over the se-curity during this period. At the time of the for-ward repurchase, the buyer has to return theoriginal papers or – depending on the agree-ment – papers with corresponding conditionsto the seller. In the case of hold-in-custodyrepo, title is retained by the seller, but the sellerplaces the securities in a separate deposit ac-count for the buyer (i.e. blocks them). Shouldthe seller be unable to honour the payment ob-ligations at the date of the repurchase, title tothe securities is transferred to the buyer.

Repo transactions have been used bycentral banks as part of their monetary policyinstruments, but their application has alsoquickly spread to the business sector. Deliv-ery type repo transactions are more wide-spread in commercial life, because this formprovides an opportunity for a multifarious ex-ploitation of the transactions: in the event ofdelivery-type transactions, money marketagents can obtain possession of the paperused as collateral, they may sell them, per-form additional repo transactions with them,lend them and put them up as collateral.

In Hungary, the use of repo transactionshas been relatively limited in the money mar-kets, although they play a central role in theNBH instruments. The NBH uses the pledge-type repo. From the viewpoint of the centralbank, there is no difference of substance be-tween the delivery repo or the hold-in-custodyrepo on the active side because the centralbank does not use the security used as collat-eral during the period of the transaction, thus ithas no significance whether it possesses thepaper during that period or not. Depositing thepledge-type securities is the simpler solution.The delivery-type reverse repo of the centralbank would have the advantages listed abovefor the counterparties of the central bank. Itsapplication is, however, impeded by the lim-ited stock of securities that may be used asrepo collateral (and another problem may bewhen the existing stock is not homogeneous),i.e. by the constraints, which, inter alia, led tothe replacement of the reverse repo with thecentral bank deposit.

The value of the securities put up ascollateral in the course of repo transactionsmay change during the period of the transac-tion with the movement in prices. To offsetthis, it may be useful to review the value of



collateral (collateral assessment) to checkwhether the value of the collateral correspondsto the amount of the loan. In the event that theloan is not covered, the seller of the securitymust effect additional payment which, subjectto agreement, may be made by paying cash orblocking government papers. In the oppositeevent, i.e. when the price of the security rises,the lender of the security may claim reim-bursement or request that a part of the blockedamount be released. Collateral reassessmentis generally performed daily although, if the se-curity margin (haircut or initial margin) ap-plied initially is sufficiently wide, it is not cer-tain whether daily re-assessment is necessary.The disadvantage of a sizable haircut primarilyeffects the borrower of the money who can ob-tain a lower amount of cash against the samesecurity than what he could have obtained hadthere been daily assessment. The use and sizeof the haircut depends on the system of collat-eral assessment and the creditworthiness ofthe counterparties.

The NBH introduced the so-called nor-mative collateral assessment system in Febru-ary 1999, whereby the NBH assesses the valueof securities accepted as collateral based on auniform method in the case of its active-sidelending transactions. The discount applied incollateral assessment was set broken downinto two parts depending on the period of thetransaction for O/N and longer maturities.

The central bank set the objective of mi-grating to daily collateral assessment in themedium term. A daily collateral assessmentregime is highly efficient and up-to-date andguarantees the daily automatic review of thevalue of the collateral, its adjustment in case ofany deviation, also providing an opportunityfor security substitution, which practice iswidespread abroad in the case of repo transac-tions. It is hoped that the NBH collateral as-sessment system will also serve as a model forrepo transactions concluded by and betweenmarket agents because of the daily reassess-ment of collateral facilitates and the use ofgenuinely low initial discounts (i.e. less gov-ernment paper collateral for the same transac-tion). In addition, this implies the lowest riskamong all collateral assessment systems.

Swap Transactions6

The foreign exchange-forint swap transactionis a transaction in the course of which one of

the counterparties swaps his assets, denomi-nated in forints, with the other against assetsdenominated in some other currency. Gen-erally, this is a forint initiated transaction asmost frequently the counterparty borrowingforints uses the foreign exchange as collateraland pays interest on the forint credit. Cur-rently, swaps are available only on the over-night maturity with the same conditions as theO/N repo. In this way the counterparties of thecentral bank may consider whether they preferto put up foreign exchange or government pa-per collateral for the overnight credit taken outfrom the central bank. Swap transactions repre-sent a negligible volume within the NBH instru-ments.

The Central Bank Deposit in Hungary

As a result of the current structural liquiditysurplus, this instrument – with a maturity oftwo weeks – is the policy instrument of thecentral bank. Central bank deposit meansthat a counterparty of the central bank placesa certain amount with the central bank underspecified or evolving conditions (term, inter-est rate). As against the reverse repo, the cen-tral bank does not provide any collateralwhatsoever as backing for the amount placed.

The types of deposits sold include thecontinuously available standing facility, theintermittently available standing facility, thetender and the quick tender. Similarly to repotransactions, there are quantitative and inter-est rate tenders, interest rate tenders with aquantitative limit, and free forms of tenderingamong tenders and quick tenders.

In 1997, the NBH deposit was availablefirst for terms of six months, then for twelvemonths. At the time, its role was to influenceinterest rates and to reinforce sterilisation.With the introduction of the NBH bond – as itsrole was completely taken over – the rela-tively longer-term deposit arrangement wasterminated.

In the autumn of 1997 the suspensionof reverse repo transaction was necessitated,on the one hand by the fact that the stock ofgovernment papers available within the cen-tral bank decreased greatly because of thesterilisation of the liquidity surplus evolvingas a result of the inflow of capital (reverserepo and government paper sales), and therewas a danger that homogeneous governmentpaper collateral could not be put up to backsome major transactions which, in a technicalsense, made the administration of the trans-actions more difficult. On the other hand,there was no reason why the NBH – as a



6 In theory and strictly speaking, swap transactions do notconstitute part of the forint instruments. Nevertheless, theyare discussed here because they constitute part of the inter-est rate corridor and are fitted into the framework conditionsof the repo.

debtor that will certainly pay – should providecollateral for the amounts kept with it. Therole of the reverse repo could be fully substi-tuted with the deposit facilities, offering simi-lar terms and conditions, while the technicaladministration of these transactions wasmuch simpler. From that date, the 28-daymoney market NBH deposit became the pol-icy instrument of the central bank. The firstsignificant change in the instrument was theshift from continuous availability to intermit-tent availability. The second change tookplace in March 1999 when, in order to ease li-quidity management by the banks, the centralbank shifted from a 28-day deposit to a termof 14 days. Transactions may be concluded atthe central bank at a fixed interest rate on thegiven dates from 10.00 to 12.00 hours.

The interest rate on the central bank O/Ndeposit facility serves as the floor of the interestrate corridor. This is the O/N fixed-interest NBHdeposit facility, which is continuously available.Transaction times range from 8.30 to 10.00 onevery day of business.

Forms of Sale

The NBH may invite tenders or quick tendersfor deposit facilities at any time, for any of theforms (described above) for the purposes ofsterilisation, interest rate adjustment orfine-tuning.

Until 1999 the central bank did not usetenders in the case of shorter-term governingand sterilisation instruments, although it hadthe opportunity to introduce them at any time.Pursuant to the Terms and Conditions of Busi-ness of the NBH, there may be several typesof tender. They include the interest rate ten-der, the variable rate tender, the interest ratetender subject to quantitative limits and thefree tender. The central bank may use theseforms of tendering at its own discretion onboth the deposit and the lending sides.

A fixed rate (volume) tender meansthat the issuer sets the interest rate in advanceand accepts bids at this rate for the specifiedamount during a given period. In terms of eco-nomic content, this in itself does not differgreatly from the intermittently availablestanding facility but, owing to a few technicaldeviations, the difference is indeed signifi-cant. One such difference is that there is anannouncement of the outcome in the case ofthe tender from which it follows that the tendermay be declared unsuccessful and all the ac-cepted amounts are disclosed to the public.Tenders must be invited separately (that is,at discretionary dates), while the intermit-

tently available standing facility means avail-ability on automatically determined days.Terms may change even on every occasion inthe case of tenders, while this is only a theo-retical possibility in the case of the intermit-tently available standing facility.

The essence of a variable rate (interestrate) tender is that the issuer announces theamount intended to be sold and bids mustcontain, in addition to the amount, the offered(or rather the expected) yield. In the course ofbid evaluation, bids are ranked according tohow favourable they are for the issuer, movingfrom the most favourable towards the least fa-vourable. Bids are accepted in this order butthe amount indicated in the invitation to ten-der constitutes a top limit. The NBH invitestenders on the preceding day, administers thetender on the day in question and perfor-mance is effected on the day following.The central bank handles this instrumentas a bid price (Dutch type) tender, i.e. thecounterparties of the central bank get (pay)the interest rate offered in their bid on theamount won in the course of the tender. Thecentral bank always has the right to deviatefrom the amount announced.

In the case of a fixed rate tender withlimited volumes, the issuer, in addition to theconditions announced for the ordinary inter-est rate tender, specifies the amount it intendsto accept. This means that when the amountof the bids submitted is higher than theamount indicated, the amount is distributedpro rata to all the bids.

When free tenders are invited, the is-suer does not announce either a limit amountor an interest rate. This means that the issuerdecides on the accepted bids enforcing inter-est rate or quantitative preferences (or somecombination of these according to some crite-ria) with respect to the bids ranked in accor-dance with the allocation procedure de-scribed under the variable rate tender. Thefree tender is administered in the bid priceform.

Many central banks apply interest ratetenders regularly in pure or quantitative limitforms because through them they can influenceinterest rates in a more transparent manner.

Interest rate corridor

The purpose of the central banks’ interestrate corridor is to prevent wide fluctuationsin the interbank interest rate level. The top



of the interest rate corridor (the interest rateceiling) means, in this context, that the bankdetermines the lending rate at which it ex-tends credits to eligible counterparties for aterm of one day without limitation. Whenbanks have an extraordinary need ofshort-term liquidity but, for some reason,have no opportunity to obtain it from thebanking sector, interest rates in the inter-bank money market cannot go up to ex-treme heights, because the central bank sat-isfies all demand at a relatively high interestrate level. This means that the interbankO/N rate cannot be higher than the interestrate ceiling.

Similarly, the rate indicated by thecentral bank at eligible counterparties areentitled to perform overnight deposit or de-posit-type transactions with the centralbank is referred to as the bottom of the inter-est rate corridor (interest rate floor). Attimes, the interest rate declines in the O/Ninterbank market when liquidity, which canbe tied down only with difficulty, is availableto the money market for a transitory period.The purpose of the interest rate floor is tohalt the decline in the interest rate at a rela-tively low point. At this rate, credit institu-tions may place their superfluous fundsovernight with the central bank without limi-tation, thus banks have no interest in con-cluding overnight interbank transactions ata rate lower than the bottom of the interestrate corridor. (See Figure 16 for changes inthe interest rate corridor.)

The instruments of the interest ratecorridor apply virtually without exception toactive or passive overnight operations,whereby extreme interbank interest rate vol-atility can be contained.

It happened – inter alia, in Hungary from themiddle of the 1990s until September 1998 –that the interest rate corridor could be inter-preted for longer than overnight maturities

(for instance, one-week active and reverserepo).

Generally, the most frequent transac-tions at the top of the interest rate corridor areO/N repo, lombard loan, overdraft or swap.Of the instruments on the passive side, theO/N reverse repo or the deposit are typical. Inall these cases, the transaction is concludedat a predetermined rate upon the initiative ofthe eligible counterparties (generally, creditinstitutions).


In Hungary the interest rate corridor as it isunderstood today, i.e. an instrument whichinvolves the top and bottom limit for inter-bank rates, has been in existence since1993. Although the band was, at times,rather wide, it operated with instruments ofvarious maturities, so it did not always con-stitute an effective constraint for O/Nmoney market rates.

At present the ceiling of the interestrate corridor is the O/N repo (swap) rate,while the floor is the O/N deposit rate. Theceiling is atypical in international practice inthe sense that even though the instrumentbehind it is a standing facility, its use is sub-ject to a quantitative limits. Under the cur-rent system this means that every credit in-stitution is allocated a repo and swap linebased on its balance sheet total and theymay make use of repo borrowing at thegiven interest rate up to that amount.7

Should that be insufficient, the counterpartymay resort to additional repo beyond therepo line allocated to it, relying on the freelydisposable government paper stock of thecentral bank. This, however, is available at asubstantially higher interest rate. Anotherimportant point to note is that transactionsconcluded for such instruments are settledon the day of the transaction.

The rate on the overnight deposit ofthe central bank constitutes the floor forovernight interbank rates. With this, theNBH is available to the banks without limita-tion (continuously available standing facil-ity). Fluctuation in interbank rates is also re-



7 Repo lines are determined automatically once everyquarter. The base of the repo line calculation is the lower ofthe balance sheet totals of the last two balance sheets sub-mitted to the Supervision in every quarter. The bank’s repoline increases with Ft200 million for every Ft10 billion of thebalance sheet total, although it may never exceed Ft30 bil-lion. Having set the new repo line, it enters into force on the10th day of the second month following the quarter.

duced by the gradual approximation of theO/N central bank deposit rate and the levelof the repo rates. Owing to this, the NBHgradually reduced the width of the effectiveinterest rate corridor from the second half of1998.

The purpose of narrowing the interestrate corridor is to decrease the overnight in-terest rate volatility of the Hungarian moneymarket, as is done in the advanced coun-tries. (See Figure 23)

Earlier, the central bank used to offer the con-tinuously available standing facilities at sev-eral maturities. Currently, in its pure form, itexists only in the case of overnight deposits.The O/N repo facility at a standard interestrate was available to counterparties up to therepo limit, above which they could use sup-plementary repo. In the case of supplemen-tary repo facility, the top limit for transactionsis the freely disposable government paperstock held by the central bank. In terms of thesales channel, O/N swap transactions, whichconstitute part of the repo line, are treated thesame way as the repo. There have been ex-amples when the central bank sold NBHbonds or other government papers as a stand-ing facility at dictated yields; this deviatesfrom the pure form in that the depletion of thestocks may disrupt continuous availability (ashappened in relation to the prompt securitysale and purchase transactions of the centralbank).

For a long time the Hungarian inter-bank interest rate corridor was extraordi-narily wide by international standards (awidth of 8–12 percentage points was alsonoted). One of the underlying reasons wasthat from the summer of 1995 active-siderates were not genuinely effective owing totheir relatively high level, i.e. practicallyneither of the instruments played the role ofan interest rate ceiling. So, the active O/Nrates did no more than follow the frequentre-pricing of the main (governing) instru-ment or that of the passive-side O/N instru-ment in steps of adjustment. (Keeping ac-tive-side rates at an artificially high levelwas warranted by the need for sterilisa-tion.)

The central bank endeavours not onlyto reduce the width of the interest rate corri-dor to the optimal level but also to keep therate on the policy instrument in its centre, sothat the rates on the two O/N instruments,working in opposite directions be locatedsymmetrically around it.

The Policy Instrument

In the case of countries pursuing a monetarypolicy with the interest rate as their operat-

ing target, the policy instrument is the onewhose purpose is to assert the interest ratewhich the central bank regards as optimal,and which it also intends to mediate in themarket at the maturity that is most impor-tant from the viewpoint of transmission, tak-ing into account the effectiveness of centralbank intervention, without eroding it. This ismost frequently done with a posted interestrate when the central bank determines therate on the given instrument.

When there are no extraordinaryevents to disturb the money market, i.e. a



Figure 23 Elements of the O/NInterest Rate Corridor in Hungary*

Name of in-strument

Directionof operation

Formavailavle

on the mar-ket

Frequencyof applica-

tion

O/N

(active)

repo

and swap

active side standingfacilityup to theamountof the repoline

ad hocin the eventof liquidityshortage

Repo sup-

plementing

the (active)

reo line

active side standingfacility

not usedsince 1995

O/N de-

posit

passiveside

standingfacility

ad hocin periodsof abountliquidity

* Until 1997 the central bank offered pledge-type re-verse repo facilities on a continous basis atthe bottom ofthe interest rate corridor.

condition of peace prevails, a portion oftransactions come into being between thecentral bank and its counterparties at thepolicy rate, through which the monetary au-thority is able to exert a direct and highly ef-fective influence on the money market.

Similarly, the signalling role of the in-terest rate (change in the interest rate) of thepolicy instrument is also important. Fre-quently, expectations concerning changesin the key interest rate have an impact onthe interest rates in themselves. When thecentral bank’s policy coincides with the ex-pectations of the market, another signal isemitted indicating that the assessment ofthe financial and economic processes by themarket and the central bank is similar. Thesignal is more spectacular when the centralbank takes an interest rate step that devi-ates from market expectations (or when itdoes not take the decision expected by themarket). At such times market agents, inaddition to having access to central bank in-struments at terms and conditions differentfrom their expectations, experience that thecentral bank evaluates macroeconomicprocesses differently, which motivates themto re-evaluate their own interest rate poli-cies. Thus, the central bank is able to gener-ate changes going significantly beyond thedirect market impact of the interest ratechange in the money market.

Internationally it is not typical for thepolicy instrument to have no predeterminedinterest rate, being left to evolve in the mar-ket (e.g. in the course of auction sales).However, we can find examples of no beinglinked to the policy rate, which is publishedby the central bank as the one deemed de-sirable by it over the short-term and whichthe market takes into account.

The particular form (especially thelags) of the transmission mechanism has afundamental significance in determining thematurity of the policy instrument. This

means that the maturity of the central bankfacility, which is closest to the period overwhich banks re-price their variable long-term rate loans, can have the most directimpact on the real economy. At the sametime, it should also be taken into accountthat central bank transactions become lesseffective and highly costly for longer maturi-ties whenever the expectations of the mar-ket differ from those of the central bank.Therefore an equilibrium maturity must befound, with which the central bank is able toinfluence changes in market yields with ad-equate effectiveness.


The maturity of the deposit instrument re-garded as governing in Hungary is twoweeks with settlement and payment on theday following the conclusion of the transac-tion. The NBH chose the two-week facilityas its policy instrument because this is theoptimal maturity for the central bank for thefollowing reasons:

• it enables the central bank to exert astill adequate impact on the3-month maturity, which is of out-standing importance for transmis-sion (see the discussion under theTransmission Mechanism),

• it should not be so long as to forcethe central bank to move in a direc-tion corresponding to expectationsbecause of the strong effect of ex-cessively large or low deposit place-ments based on excessive expecta-tions concerning the interest ratemeasures of monetary policy (spec-ulation), and

• it should provide adequate assis-tance to banks in liquidity manage-ment; as the reserve period is onecalendar month, the two-weekly in-strument is expedient for tying downliquidity in an adequately safe man-ner.8 Using the two-week instru-ment, the central bank may effec-



8 Until the autumn of 1998, the policy instrument and theinstrument used for liquidity management within the reserveperiod were separate. Until then the reserve period lasted twoweeks (or to be more accurate, there were two reserve peri-ods every month), during which banks could bridge liquidityproblems using the one-week deposit (or repo). The policyinstrument was the 28-day deposit.

tively influence the 3-month marketyield and the pricing behaviour ofbanks.

The central bank was available withthe policy instrument twice a week in 1999and once a week from March 2000, whenthe 3-month NBH bond was introduced (in-termittently available standing facility). Eli-gible counterparties could conclude trans-actions with the NBH between 10.00 and12.00 hours at the interest rate announcedin advance. The financial settlement of thetransactions was effected on the followingday.

The intermittently available standing facilitymeans that the central bank is available dur-ing the day, similarly to the continuouslyavailable standing facility, but only on prede-termined days (e.g. on Tuesdays and Thurs-days). The advantage of the intermittentlyavailable standing facility over the continu-ously available one is that the direct settingof interest rates becomes more moderateowing to the less frequent possibility of exe-cuting transactions. Also, it encouragesbanks to be more active in their liquiditymanagement, i.e. to assess their liquidity po-sitions in advance and develop their expecta-tions accurately, which improves the effec-tiveness of the transmission mechanism. TheNBH makes its governing two-week deposit

facility available intermittently. Thus, apartfrom extraordinary cases, the central bankassists credit institutions in balancing their li-quidity positions only at the edges of the in-terest rate corridor, on three out of five work-ing days a week, and on four days a week asof March 2000.

The Instruments of Sterilisation

Generally, sterilisation is effected in coun-tries where capital inflow through foreignexchange market intervention leads tosuch an expansion in the money supplythat, without its neutralisation, it would havean inflationary impact. Neutralisation (steri-lisation) of excess liquidity arising from theconversion of foreign exchange flowing infrom abroad by central banks has been par-ticularly characteristic in the countries ofcentral and eastern Europe in the transitionperiod. The reason for this includes the factthat the countries of the region have usedthe exchange rate as the nominal anchor inmost periods; consequently, they wereforced to effect foreign exchange market in-

terventions from time to time. Also, to curbinflation and to maintain the external equi-librium at the desirable level, central banksattempted to dampen the pace of interest



Figure 24 Instruments Determining the Policy Rate Usedin Hungary from 1993

Name of instrumentDirection

of operationForm availableon the market Term

Frequencyof application

Repo* active side standing facility 1 week, or 28 days 1994-middleof 1995

Reverse repo passive side standing facility 28 days from mid-1995to October 1997

28-day deposit

(1 month)

passive side standing facility 28 days from October 1997to 1 March 1999

14-day deposit

(2 weeks)

passive side intermittentlyavailable standingfacility

14 days from 1 March 1999

* In the course of 1994 and 1995, first the 1-week then the 28-day repo dominated the transactions of the NBH. This,however, cannot be unambiguously attributed to its function as policy instrument but to the secure income which can beachieved by buying government papers, and the financing needs of the banks with liquidity shortage.

rate decreases, hence the so-called sterili-sation instruments offered attractive rates.

In the course of sterilisation, the cen-tral bank must take safety and cost consid-erations into account. With a view to thesafety of the exchange rate regime, the cen-tral bank, in the course of sterilisation, at-tempts to tie down excess liquidity in thebanking sector on longer maturities so that,in the event of the withdrawal of foreign ex-change not justified by the main macroeco-nomic indicators, the position against thecentral bank should not be suddenly dis-mantled, and foreign exchange movementsnot supported by the macro indicatorsshould take place more slowly. In addition,the central bank, besides considerations ofinflation and the balance of payment, hasalso to bear in mind the costs of sterilisation.By keeping the costs of sterilisation at aslow a level as possible (taking into accountfrom another aspect that there must be anadequate real interest rate as well), thecentral bank’s aim is that the spread be-tween the yield on risk-free papers denomi-nated in the local and foreign currenciesshould not generate capital inflow for specu-lative purposes, which should later be steri-lised.


The operation of the crawling exchangerate of the forint within a band of interven-tion means that the NBH has an automaticobligation to buy or sell (to intervene) atthe edges of the band. This also means thatincoming foreign capital appears at thecentral bank, increasing foreign exchangereserves. A sudden reduction in the foreignexchange reserves of the NBH, caused byany external or domestic shock, consti-tutes a risk. (The weakening of the ex-change rate may induce the sale of foreignexchange for some period of time at the

lower point of intervention through thestanding facility and, in the course of thesale, the Bank must also be available at theedge of the band.) Therefore, in order thatthe foreign exchange reserve should not bedepleted quickly, the NBH attempted tolengthen the duration of the sterilisationstock using various instruments (6-monthand 12-month deposit and the NBH bond).9

These efforts of the central bank went handin hand with a rearrangement in the struc-ture of the sterilised stock by maturity. (SeeFigure 25)

The NBH Bond

The NBH bond is a debt security issued by thecentral bank which, pursuant to the ordinancedetermining the range of securities accept-able as for repo transactions, may be used byits owner for repo transactions with the centralbank. (Ultimately, NBH papers are just asrisk-free as government papers as the ownerof the central bank is the state, the NBH paysits profits to the budget and the budget coversits eventual losses.) The NBH bond was firstissued in June 1997, in addition to meetingthe sterilisation need also with a view to en-suring sterilisation on longer maturities. Thenthe central bank was continuously availablewith the bond, limited only by the amount is-sued for the given period. The NBH chose theissuing technique according to which itplaced the bonds in its own account and soldthem from there for a month. At the end of thegiven month, the bonds remaining in its ownportfolio were annihilated and a new serieswas issued. In this way intervention at a fixedrate was effected practically at an interval ofbetween 11 and 12 months.

By April 1998, it was no longer neces-sary for the central bank to directly set rateson the maturity of between 11 and 12 months,although excess liquidity still had to be tieddown permanently. Thus, the new series ofNBH bond were placed on the market usingauction sales. Auctions were held every twoweeks and the central bank again offered thebond from its own account until the stock wasdepleted or the period to maturity reached10 months. At the auction the central bankannounced the amount intended to be sold,and the banks could submit their bids be-tween 9.00 and 11.00 hours. Once the bidswere submitted the Auction Committee ex-amined whether it was necessary to alter theamount by a maximum of ±25 per cent rela-



9 In the case of the government paper outright transac-tions applied in 1997 for the last time; government paperswith a period to maturity of 9 to 15 months bearing fixed in-terests were sold.

tive to the amount offered or whether the auc-tion should be declared unsuccessful in theevent where bids were found to be extremelydifferent from market conditions. The NBH

bond is financially settled onthe second day following thetransaction.

In the potential instru-ments of the NBH there arethree types of instruments suit-able for sterilisation. These in-clude the reverse repo, thestanding deposit and the NBHbond. Their method of issueand period differ substantially.Since one-year NBH bond auc-tions were terminated in Octo-ber 1998 and they maturedone year later, the sterilisationinstrument within the NBH in-struments was the 1-monthand, subsequently, the 14-daydeposit, which also played therole of the policy instrument.

The reverse repo is notamong the instruments ap-

plied for reasons already discussed (thelimited government paper stock of theNBH). In addition to the 2-week deposit,the 3-month NBH bond has assisted sterili-

sation since March2000. When issuingthe bond the centralbank invites free ten-ders to tie down liquid-ity (without determin-ing either the amountor the interest rate),i.e. it applies an auc-tion techniquewhereby it affects in-terest rates only indi-rectly. (See Figure 26.)As far as the elementsof the instrumentsused for sterilisationare concerned, the pe-riod of the instrumentsand the method of set-ting the interest rateare important. In thecase of dictated (fixed)interest rates, the



-1200

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Repo/deposit stock

NBH bond

Forint billion

19981997 1999 200019961995

Figure 25 Changes in the Sterilisation Stock in Hungary

Figure 26 Potential Instruments of Sterilisation

Nameof instrument

Form availableon the market

Maturity Characteristicperiod

28-day reverse

repo

standing facil-ity

28 days from March1995 to Sep-tember 1997

28-day and

14-day

deposit

(the policy

instrument)

first standingfacility, thenintermittentlyavailablestanding facil-ity

28 days, thenfrom 1 March1999, 14 days

from Septem-ber 1997

6-month

and 12-month

deposit

standing facil-ity

6 and12 months

from Janu-ary–June 1997

NBH bond availability,then auctionauction

between 12and 11 months,then 12 and10 month,3 months

from July 1997to October1998from March2000

monetary decision-making body mustcontinuously review the interest rate andintroduce changes from time to time in ac-cordance with expectations concerningthe real interest rate and the spread. In thecase of the sterilisation instrument sold in-directly – largely by way of quantitativeauctions – the interest rate evolves at theauction (in the case of deposits, at the ten-der). The NBH makes sure that, if possi-ble, nobody should obtain the bond at alevel above the equitable yield. To thatend, the central bank is entitled to deter-mine the amount issued in 75–125 percent of the amount offered. By using thefree tender, the central bank, while main-taining its intention to effect sterilisation,refrains from directly influencing the yieldcurve.

As already mentioned in the chapteron transmission, the extent to which thecentral bank ties down free liquidity in thebanking sector may have significance forthe effectiveness of regulation. Active-sideoperations may be more effective from theviewpoint of the central bank in influencinginterest rates because they force credit insti-tutions more strongly to apply the rates dic-tated by the NBH: their liquidity positiondoes not enable them to make up for thestructural deficit from other sources in thebanking sector. From the viewpoint of thetransmission, the rippling on of lending ratesto the real sector presumably takes placemore rapidly in the event of active regula-tion. When the liability costs of the banksare raised (for instance, because of an in-crease in the rate on the active central bankinstruments), the bank suffers an effectiveloss unless it raises the price of financing. Inthe event of passive-side operations, how-ever, the banks, when they do not follow theinterest rate measures of the central bank,“only” lose a surplus revenue when they failto place their excess liquidity using the opti-mal facilities. It should, however, be notedthat in the case of cost-sensitive bankscompeting against one another the two li-quidity situations should not result in differ-

ences in the banks’ reactions to the steps ofthe central bank (transmission).

When commercial banks can meet their re-serve obligations or have the settlement de-posit stock required for the safe administra-tion of business through short-term credits(shorter than the reserve period) (for in-stance, repo), we may speak about a situationof liquidity shortage. In most countries wherethere is no considerable foreign exchangemarket intervention, central banks attempt tocreate such situations of liquidity shortage.The Bank of England, for instance, ensures li-quidity shortage in the very short term by is-suing 3-month securities, thereby guarantee-ing the effectiveness of short-term active in-struments.

In contrast, in countries – includingHungary – where there is significant foreignexchange market intervention, the interbankmarket is characterised by ample liquidity.This means that commercial banks are ableto meet the reserve requirement without bor-rowing from the central bank, i.e. they areable to have the required settlement depositstock. In this case commercial banks placetheir free reserves in the form of assets bear-ing market interest (sterilisation instrument)outstanding against the central bank.

The size of the sterilised stock at theNBH is so large that the creation of a struc-tural liquidity shortage is not on the agenda in2000. In the event of a lower stock, when itwill be possible to transform the sterilisedstock kept with the NBH into longer-term in-struments at relatively low cost, a sustained li-quidity shortage can be created, leading tothe policy instrument of the NBH operatingagain on the active side.

Liquidity Planningand Fine-Tuning(Quick Tender)

The Role of Liquiditymanagement

As discussed in the chapter concerning theirobjectives, in order to implement their ulti-mate goals central banks follow operatingtargets in their day-to-day operation. Theircontinuous market presence is called to fa-



cilitate the realisation of these targets.Pursuing an operating target, whether it isthe interest rate of a preferred maturity(characteristically from 3 months to 6months) or influencing the growth rate of themonetary base, they exert their influencethrough the transmission mechanism on thevariables relevant with respect to the inter-mediate targets and the ultimate goal. Thecounterparties of central banks are the com-mercial banks, hence it is obvious that theoperating target is formulated in terms of theachievement of a level of a quantitative oryield variable, regarded as optimal, which isof crucial importance for the banks. Con-cretely, the operating target of the centralbank is to influence the amount or cost of thereserve money (central bank money) avail-able to the commercial banks.

As mentioned when discussing thebanker of banks function, the demand of thebanks for reserve money stems from threesources. First, banks need vault cash to sat-isfy the cash needs of their clients. Second,administration of day-to-day transactionsnecessitates that the banks have claimsagainst the central bank, which can bepromptly exchanged for cash. Third, thebanks must meet the reserve requirementprescribed by the central bank. The reserverequirement sets the level of the stock ofbank money at a higher level than whatwould evolve without it.

Through its open-market operations,the purchase and sale of government pa-pers and its own instruments, the centralbank provides or withdraws bank moneyfrom the interbank market. The objective ofthese measures is that, through modifyingthe demand and supply conditions in thereserve money market, the central bank di-rectly or indirectly influences the fundingcosts of the commercial banks or the yieldof the assets of the banks placed with thecentral bank. With this, the central bankprompts banks to restructure their balancesheets or, on the contrary, prevents a bal-ance sheet restructuring regarded as unde-sirable from the viewpoint of monetarypolicy.

These transactions are the first steps inthe transmission mechanism. The perma-nent alteration of the liability costs of com-mercial banks or of the yield of the centralbank instruments available to them in-duces different stock and yield changes,which ultimately result in a modification ofthe course of the real economic variables.With some simplification it may be statedthat the central bank reaches its ultimategoals by influencing the yields evolving inthe interbank market. Liquidity manage-ment can therefore be regarded as the low-est level of monetary policy, which is an in-dispensable condition of the implementa-tion of the ultimate goal.

Liquidity management may be dis-cretionary or accomodative. When discre-tionary regulation is applied, the centralbank decides in what amount it accepts de-posits (or sells government papers)from/to the banking sector or offers creditsto them under various facilities (or buysgovernment papers). In short, it is the deci-sion of the central bank and not that of thecommercial banks that determines the li-quidity of the banking sector.

The objective of the accomodativeregulation is also to influence the liquidity ofthe banking sector. In this case, however,the central bank operates with standing fa-cilities.

This means that the central bank offersfunds and accepts deposits at pre-determined interest rates, but the banks canmake use of these according to their needs.In this way liquidity management is in thehands of the banking sector and we cannotspeak about active liquidity managementby the central bank.

The two regimes, although they funda-mentally differ in their operating mecha-nisms, serve the same purpose, namely toreach a level of interbank rates which is inline with the central bank’s targets. With dis-cretionary regulation, the central bank influ-ences indirectly through volumes; under theaccomodative regulation it influences themdirectly.



The precondition of discretionary li-quidity management is liquidity planning bythe central bank. In the case ofaccomodative regulation, what the centralbank does is more in the nature of liquiditymonitoring, an examination of the self-regulatory behaviour of commercial bankswithin the framework conditions created bythe central bank’s rules and instruments.

When liquidity forecasts are of appro-priate quality, the central bank may supple-ment the interest rate corridor and the keypolicy instrument with the quick tenderused for the fine-tuning of liquidity. Quicktenders are generally applied in two cases.If, at the end of the reserve maintenance pe-riod, the banks would not be able to meetthe reserve requirement owing to some li-quidity cutting shock (or because they sim-ply have miscalculated) the interbank de-mand for free liquidity in the banking sectormay rise and this may, for a transitory pe-riod, induce exceedingly high interest rates(generating volatility). Then a situation of li-quidity shortage may arise, which may beremedied by an money providing quick ten-der. The other case may arise owing to un-expected, significant capital movementsabroad. In such cases, in the event of majorcapital inflows over a short period of time,an additional sterilisation pressure, difficultto plan for in advance, would be exerted onthe central bank, which may induce thebank to apply a quick tender for deposits.

Central banks must be highly circum-spect with the regular use of the quick ten-der because when it is frequently invited akind of moral hazard may arise; the bankswill make less of an effort to manage their li-quidity position perfectly during the period,as they can be sure that they can rely on thecentral bank.

In countries where they have intro-duced the quick tender and the centralbanks’ liquidity management functions ef-fectively, the decision on inviting quick ten-ders can be made on the basis of veryshort-term liquidity forecasts, even over anhour.

The method of administering quicktenders – generally with a different eligibilitycriteria for counterparties and dates – is sim-ilar to that of the ordinary tender.


The monetary policy instruments of theNBH – with one exception – operate in theform of standing facilities: the central bankaccepts overnight or two-week deposits (onthis maturity, availability is intermittent) orgrants overnight credits at a given rate in ac-cordance with the needs of the banks. Thelatter facility is available to the banks onlywithin the limit specified in proportion totheir balance sheet total (repo line) but,within this limit, they are free to decide onthe amount.

When, as a result of unforeseeableevents, the supply of central bank moneysignificantly decreases, the reserve stocksof a few banks may sink so low that they areunable to meet their reserve requirementwithout getting founds through repo. Thenegative impact of the factors influencing li-quidity may be so great that commercialbanks are unable to raise their reservestocks to a level corresponding to the re-serve requirement even by exhausting theirrepo line in the remaining part of the reserveperiod. In such a situation interbank ratesmay rise above the overnight repo rate (thatis, outside the interest rate corridor).

The January 1999 introduction of thequick tender aimed to eliminate such situa-tions of temporary liquidity shortage. TheNBH, depending on whether or not it re-gards a rise in interbank rates desirable,may decide whether or not to provide liquid-ity to the banking sector in the form of aquick tender. The quick tender is the onlytypical discretionary element of the centralbank’s instruments, which also provides anopportunity for active liquidity manage-ment. In addition, the business conditions ofmoney market operations enable the NBHto offer the two-week deposit, which is itspolicy instrument, not at a given interest



rate but by announcing its amount to thebanks. In Hungary there were fundamentallytwo reasons for including the quick tender inthe set of instruments. On the one hand, itwas introduced to reduce the impact of un-expected, significant money movementsjustified by international events but not sup-ported by changes in macroeconomic pa-rameters. The other reason was to facilitateliquidity management, particularly with re-spect to the last days of the reserve period,which are difficult to plan for.

All the types listed under tenders also exist forquick tenders on both the active and the pas-sive sides. The advantage of the quick tenderis that it can be administered even in a singleday as it is announced before 8.00 a.m. andresults are declared as early as 9.00 a.m. Fi-nancial settlement is effected the very sameday. Bids to the quick tender can be submit-ted only through Reuters; any one counter-party (which must be a bank) can submit onlyone bid and the bid must be fully divisible byFt500 million.

The series of international events in1997–98, which resulted in a decline in in-ternational confidence in the region and in-vestors having a propensity to overreact tothe effects of the crisis and to assess the sta-bility of the countries of the region not on thebasis of real threats or the fundamentals, fa-cilitated the introduction of the quick tenderin Hungary.

At such times, the central bank may,with a view to protecting the interest rateand the exchange rate, perform rapid andtransitory intervention.

The central bank may intervene in theforeign exchange market, may reduce theextent of intervention or may even substi-tute intervention by inviting quick tenders inthe forint market. Then the quick tendermust be of a rate taker type, that is, onlyquantitative and free tenders can be consid-ered.

When the central bank is able to prop-erly quantify the expected outflow of foreignexchange in a situation near to crisis, then itis worthwhile to tie this (or a part of it) downin the forint market through a variable ratetender. When, however, the forecast is not

sufficiently reliable, the use of a free tenderis more expedient.

Approaching the end of the reserveperiod, it happened that banks tried to findthe missing reserve amounts and placethem “fighting the fires”. In the event of lowsystem liquidity, they could obtain theseamounts only at high interbank or repo rates(at the level of the interest rate ceiling),which introduced considerable volatility tointerest rates and substantially diverted theinterbank money market. At other timesbanks set aside excessively large amountsearly in the period in the belief that theywould be able to place their excess liquidityprofitably by the end of the period. Thesesituations can best be remedied by an inter-est rate tender subject to quantitative limitas the liquidity shortage or surplus can bequantified at the level of the system. Thecentral bank can determine the interest rateand can force the banks to accept it. Thequantitative limit serves the purpose of pre-venting tensions in the system caused bythe liquidity deviation appearing at the levelof the banking sector, and the deviation ofthe accumulated liquidity shortage or sur-plus of individual banks. The first two repoquick tenders invited at the end of January1999 in Hungary were also implemented inthe form of interest rate tenders subject toquantitative limits.

Fine-tuning requires proper liquiditymonitoring and forecasting at the level ofthe banking sector. Proper information flowbetween the central bank and the budget isimportant for this.

The NBH daily monitors changes inthe banks’ payments and their tied-down li-quidity and continuously updates the liquid-ity forecasts for the immediate future.Whenever the banking sector lands in a situ-ation of transitory liquidity disturbance (lowor abound liquidity), the central bank mayconsider whether it will leave interbank ratesto significantly shift within the boundaries ofthe interest rate corridor, or to let changes inthe forint money supply be dealt withthrough foreign exchange market interven-tion, or to prevent transitory interest rate



volatility (which may have a disturbing ef-fect and may be unjustified) by way of aquick tender.

Liquidity Planning

Owing to the largely adjusting nature of itsinstruments, the significance of liquidityplanning pursued at the NBH is substantiallyless than in the case of central banks pursu-ing discretionary regulation. At the sametime, the continuous monitoring of the li-quidity and behaviour of the banking sectorprovides valuable information concerningthe expectations of the market and theeventual need to modify the instruments orthe framework conditions of the interbankmarket.

Liquidity planning at the central bankfulfils its classical function not in ordinarysituations but when quick tenders are an-nounced. The decision on the amount ofcredit offered through the tender may bemade after assessment of the factors influ-encing the reserve stocks of the commercialbanks in the remaining part of the reserveperiod.

Liquidity planning involves the sys-tematic ordering of the factors which are ex-pected to shape demand for and supply ofcentral bank money, i.e. taking stock of theasset and liability side items of the centralbank balance sheet. Figure 27 presents theschematic central bank balance sheet whichthe NBH uses for liquidity forecasting.

From the viewpoint of liquidity plan-ning, the banks’ reserve stock is of interestbecause that determines the demand of thewhole banking sector for bank money. In thecourse of liquidity management and moni-toring the liquidity position, the central bankexamines every factor from the viewpoint ofhow a change in the given item of the centralbank balance sheet affects the banks’ re-serve stocks.

Changes in some of the balance sheetitems do not influence the account balanceof the commercial banks. The most impor-tant of these items are the transactions be-tween the budget and the central bank.When for instance, the Treasury repays aloan to the NBH, this reduces the balanceof credits to the budget (asset side) andthe balance of the Unified Treasury Account



Figure 27 The Simplified Balance Sheet of the NBH

Assets Liabilities

Claims on general government General government deposits

Forint credits Treasury Unified Account*

Foreign exchangre credits

Claims on banks Bank deposits

Refinancing credits Settlement deposit account (reserve account)

Repo Vault cash

Claims on non-residents (foreign exchangereserve)*

Two-week deposit

Other Overnight deposit

NBH bond

Banknotes and coins outside the banking sector

Foreign debt

Other

Equity

* Together with the deposit of ÁPV Rt.

(liability side). Net interest payments be-tween the central bank and the budget altertwo liability-side items which do not affectcommercial banks: the balance of theUnified Treasury Account and the centralbank’s profit. When the foreign exchangeposition of the central bank changes, againonly the transactions vis-à-vis commercialbanks are of interest (foreign exchangemarket intervention), as the transactions ofthe central bank and the budget in relationto the foreign exchange debt have no liquid-ity impact, i.e. they do not influence the re-serve position of the commercial banks.

To predict the bank money stock ofcommercial banks a forecast must be pre-pared for each of the above-mentioned vari-ables. With the forecast it is possible to cal-culate the monthly average expected bal-ance of the reserve accounts without place-ment of deposits and borrowing by com-mercial banks. Then this stock can be com-pared to the reserve requirement to be metby the commercial banks in the remainingpart of the month.

The difference between the two figuresis the free liquidity in the banking sector,that is the amount which the banking sectormust place at the central bank until the endof the reserve period. When the monthly ex-pected reserve stock is short of the reserverequirement to be met, a liquidity shortagehas arisen. Then commercial banks mustborrow from the NBH in the form of a repoin order to be able to meet the reserve re-quirement.

Liquidity Surplusand O/N Rates

As a result of the capital inflow of the pastfew years, the Hungarian banking sector hasbeen characterised by a substantial liquid-ity surplus, that is, banks have more centralbank money than would be necessary tomeet the reserve requirement. In this way,free liquidity is largely positive, the bankingsector has superfluous reserves. Individualbanks may reduce their surplus reserves byoffering interbank credits, the entire bank-

ing sector can, however, do so only by plac-ing deposits with the central bank. Thetwo-week deposits account for by far themajority of placements, because their rate issubstantially higher than that of the over-night instrument.

The banks’ objective is to gradually di-vest themselves of their surplus liquidity toachieve the highest possible interest in -come. By the last day of the month, theymust reduce their free liquidity to a minimallevel, because the NBH does not pay an in-terest on the average account balance overand above the reserve requirement.

The free liquidity of the banks is theamount which, according to the current ex-pectations concerning changes in the fac-tors forming liquidity, is not needed formeeting the reserve requirement. Changesin the factors influencing liquidity cannotbe forecasted with absolute certainty,hence free liquidity can also not be accu-rately determined. Banks are well aware ofthe fact that a number of unpredictable fac-tors influence liquidity until the end ofthe reserve period, which may divert freeliquidity from its value expected at themoment.

The real problem for the banking sec-tor arises when their free reserves at the endof the month are in the red, i.e. they need totake out expensive central bank credit tomeet the reserve requirement level. Toavoid this, banks attempt to keep the levelof their free reserves at a positive levelthroughout, that is, they build up a securitystock capable of absorbing negative effectsaffecting the reserve account (such as theimpact of tax payments substantially higherthan expected).

With the progress of the reserve pe-riod, the uncertainty around the end of themonth reserve position declines, thus even alower free liquidity stock will provide a suffi-cient margin of safety.

The level of free liquidity in the bank-ing sector has a close inverse relation to in-terbank rates. When banks have ample freereserves, they place their money in central



bank deposits and its yield will govern inter-bank rates.

When, however, the majority of banksare dissatisfied with their own reserve posi-tions, i.e. they assess their free liquidity asinsufficient, their growing demand for re-serves will drive interbank rates above thelevel of the central bank deposit rate.

The equalising mechanisms of the in-terbank market guarantee that the global li-quidity surplus of the banking sector will ap-proximate to the positions of individualbanks.

Accordingly, the NBH is able to fore-cast the movement of interbank rates with-out examining the positions of individualbanks, merely on the basis of the forecast ofglobal liquidity.

The NBH discloses the reserve stockof the commercial banks via Reuters. Sup-plementing the public information disclosedby the NBH with individual informationabout liquidity among their own clientele,banks are able to draw conclusions con-cerning the liquidity position of the bankingsector and also the expected movements inO/N rates. (See Figure 28)



Figure 28 Individual Functions and the Basic Forms of the Assigned Instruments

Interest rate corridor Policy instrument Sterilisation Fine-tuning

Repo O/N repo 7-day maturity untilthe summer of 1995

quick repo tenders

Reverse repo O/N reverse repountil October 1997

from the summerof 1995 to October1997 with 7,then 28 daymaturity

until October 1997,maturity of 28 days

possibility of invit-ing quick reverserepo tenders

Swap O/N swap

Deposit O/N deposit fromOctober 1997

28-day maturityfrom October 1997,14-day from March1999

28-day from Octo-ber 1997, 14-dayfrom March 1999

possibility of quickdeposit tenders

Sale of government

papers

in 1997 for the lasttime

can be announcedwhen needed

Purchase

of government

papers

can be announcedwhen needed

NBH bond standing facilitywith a maturity ofone year from July1997 to April 1998,then auction saleuntil October 1998.From March 2000,free tender with amaturity of threemonths

Individual Elementsin Operating the Instruments

Eligible Counterpartiesfor the NBH

The counterparties of the NBH eligible formonetary transactions generally include alllegal entities that are or may be in somekind of a business relationship with the cen-tral bank while it performs its monetaryfunctions. This exceedingly broad interpre-tation covers not only the multitude ofcounterparties who enter into contact withthe central bank in relation to implementingthe objectives of monetary policy, but alsothose whose accounts are managed by theNBH.

The central bank is able to determinethe group of eligible counterparties for agiven type of transaction in order toachieve its monetary policy objectives.First, it can directly determine this circleand second it may include conditionsamong the Terms and Conditions of Busi-ness for the given instrument, which eitherbar certain institutions, otherwise eligible,from entering into the given transaction orrender it very difficult for them to deal withthe central bank.

The NBH separately specifies its eligi-ble counterparties for every one of its mone-tary policy instruments. (See Figure 29) Thefull group of eligible counterparties, whichcovers every institution that enters intosome kind of a business relationship withthe NBH in relation to the central bank’smonetary policy transactions, includes thebanks, the specialised credit institutions(Hungarian Development Bank, Eximbank,Mortgage Bank, housing savings funds), theprimary government paper dealers, savingsbanks and saving co-operatives, andKELER Rt.

Certain conditions of the given facilitymay, however, restrict individual counter-parties in concluding transactions with thecentral bank.

For instance, the minimum transac-tion amount or an increase in the transac-tion amount or its “tick” may also act as de-terrents. Strikingly high requirements ap-pear in the case of quick tenders, when abank needs to be able not only to make adecision on whether or not to participate inthe auction and under what conditionswithin 30 minutes following the invitation totender by the NBH, but it must also have ad-equately rapid data transmission channelsand at least Ft500 million per bid.



Figure 29 The Eligibility of Individual Groups of NBH Counterparties to Enterinto Business

Reserverequirement

O/N depositand deposit

tender

O/N repo andrepo tender

Purchaseand sale of NBHbond, government

papers

Deposit and repoquick tenders

Banks X X X X X

HDB, Exim,Mortgage Bank X X X

Housing savingsbanks X X X

Savingsco-operatives,saving banks, X

Primary dealers X

NBH Channelsof Communication

The central bank notifies its counterpartiesof its decisions through various channels: bymail, facsimile, dailies and Reuters. Theprinciple is that new information shouldreach those most concerned as quickly aspossible.

The central bank notifies those con-cerned of any changes in its Terms and Con-ditions of Business by fax or mail.Counterparties are required to confirm theamended conditions and it is only thereafterthat they may deal with the NBH pursuant tothe amended conditions. When a counter-

party fails to sign the contract, it thereby de-prives itself of eligibility.

Banks and other concerned credit in-stitutions are notified of changes in interestconditions by way of a faxed circular. Notifi-cation concerning changes in business ratesis sent to the banks’ treasuries, that onchanges in the base rate to the CEOs of thebanks.

Changes in interest rates, invitations totender, to buy or sell government papersand the results of tenders and auctions arepublished in the Reuters pages of the centralbank (NBHJ, NBHK) and in daily newspa-pers. Thus information reaches those di-rectly concerned and financial experts in themost rapid way and at the very same time.



A Magyar Nemzeti Bank 70. éves évfordulóskiadványa (The 70-year AnniversaryPublication of the National Bank of Hun-gary), Budapest, 1994

A Magyar Nemzeti Bank története I (History ofthe National Bank of Hungary I), KJK,Budapest, 1993

The Statutes of the National Bank of Hungaryas of 13 March 1999

A monetáris politika céljai és eszközei (Objec-tives and Instruments of Monetary Pol-icy) by members of the Department ofMonetary Analyses of the NBH,Bankszemle, 36, 1992

Alberto Alesina, Lawrence H. Summers: Cen-tral Bank Independence and Macroeco-nomic Performance – Some Compara-tive Evidence. Journal of Money, Creditand Banking, May 1993, pp 151–152

Zsófia Árvai: A piaci és a kereskedelmi bankikamatok közötti transzmisszió 1992 és1998 között (Transmission betweenMarket Rates and Commercial BankRates between 1992 and 1998), NBHFüzetek, 1998/10

Banaian, King, Leory O’Laney, Thomas D.Willett: Central Bank Independence, AnInternational Comparison–Federal Re-serve Bank of Dallas Economic Review –March 1983, pp 1-13

Borio, Claudio E.V: The Implementation ofMonetary Policy in Industrial Countries:A Survey, BIS Economic Papers

Burda, M. and C. Wyplosz: Macroeconomics:A European Text, Oxford, Oxford Uni-versity Press, 1993

Crockett, Andrew, “Rules versus Discretion inMonetary Policy”, in J. Onno de Beau-fort Wijnholds, S. C. W. Eijffinger and L.H. Hoogduin (eds.): A Framework forMonetary Stability, Dordrecht andBoston, Kluwer Academic Publishers,1994

Cukierman Alex, Steven Webb, Bilin Neyapi:The measurement of central bank inde-pendence and its effects on policy out-comes. The World Bank Review, 6,1992, pp 353–398 3.3.3, 4.2.6

Attila Csajbók: Zéró-kupon hozamgörbebecslés jegybanki szemszögbõl (Esti-mating the Zero Coupon Yield Curvefrom the Viewpoint of a Central Bank),NBH Füzetek, 1998/2

Dale, Spencer: The effect of official interestrate changes on market rates since 1987

David W. Pearce (ed.): A modern közgaz-daságtan ismerettára, McMillan Dictio-nary of Modern Economics, KJK, Buda-pest, 1993

Ederington, Louis-Goh, Jeremy: A VarianceDecomposition Analysis of the Informa-tion in the Term Structure, Journal ofFinancial Research, vol. 20 (1), Spring1997, pp 71–91

Estrella, Arturo- Mishkin, Frederic: The Pre-dictive Power of the Term Structure of In-terest Rates in Europe and the UnitedStates: Implications for the EuropeanCentral Bank, European Economic Re-view, 1997, vol. 41, pp 1375–1404

Fischer, Stanley: Modern Central Bank-ing–Prepared for the Tercentenary of the


BIBLIOGRAPHY

Bank of England Central Banking Sym-posium, 1994

Freedman, Charles: “The Use of Indicators andof the Monetary Conditions Index in Can-ada”, in Balino and Cottarelli (eds.):Frameworks for Monetary Stability: Pol-icy Issues and Country Experiences, In-ternational Monetary Fund, WashingtonD.C., 1994

Gerlach, Stefan: The Information Content ofthe Term Structure: Evidence for Ger-many, Empirical Economics, 1997, vol22 (2), pp 161–179

Magyar Nemzeti Bank Általános Tájékoztató(National Bank of Hungary General In-formation), Budapest December 1998

McCallum, Bennett T., Monetary Economics:Theory and Policy, New York, MacmillanPublishing Company, 1989

Mishkin, Frederic S.: The Economics ofMoney, Banking and Financial Markets,Third Edition

Pénzügytan (Finances) – university notes,BKE, Saldo, 1992

Robert L. Hetzel: Central Banks’ Independencein Historic Perspective – a Review Essay

– Journal of Monetary Economics, 25,1990, pp. 166-176

Mrs. József Romhányi: A Magyar NemzetiBank történetének kronológiája (Chro-nological History of the National Bank ofHungary), NBH, Budapest, June 1999

Svensson, Lars E.O.: Estimating and Inter-preting Forward Interest Rates: Sweden,1992-1994, International MonetaryFund Working Paper No. 114, Septem-ber 1994

István Szalkai: A monetáris irányítás(Bevezetés a monetáris közgazdaság-tanba) (Monetary Control – Introductionto Monetary Economics), Second re-vised, expanded edition, 1995

Imre Tarafás: Monetáris Politika – eszközök ésfeltételek (Monetary Policy – Instru-ments and Conditions), KözgazdaságiSzemle, 1995, No. 11, pp 1024-1043

The Federal Reserve System – Purposes andFunctions, Washington D.C., 1994

The Monetary Policy of the Bundesbank, Deut-sche Bundesbank, Frankfurt am Main,October 1995

The Transmission Mechanism of MonetaryPolicy, Bank of England, May 1999.




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GLOSSARY

GLOSSARY


GLOSSARY

aggregate demand: the sum ofplanned consumption, investment and gov-ernment purchases of goods and servicesand the net export of goods and services(the difference between export and import);

aggregate supply: the total volume ofgoods and services intended to be sold byproducers at a given price level;

balance of payments: the total volumeof real and financial transactions of a coun-try vis-à-vis the rest of the world. Its mostimportant components are the current ac-count, the capital account and the financialaccount;

banknote tax: a statutory provision tocontrol the money supply. The financial in-stitution authorised to issue money (thebank of issue) had to pay a tax to the state inproportion to the money supply when themoney in circulation exceeded the coveragedefined by the regulation plus a certaintax-free amount;

business cycle: subsequent periods ofeconomic boom and recession (or slow-down in growth) in the course of which thegrowth rate fluctuates around its long-termtrend;

capital operations: transactions affect-ing the capital account of the balance ofpayments (foreign direct investment, port-folio and other capital flows);

central bank independence: the cen-tral bank as the organisation responsible formonetary policy must have adequate free-dom and independence from personal, fi-nancial and professional aspects in takingmonetary policy decisions. In most ad-vanced countries legal independence is es-tablished by law or statute;

central bank instruments: the range ofinstruments available to a central bank toachieve its objectives. The central bank caninfluence the level of interbank rates and theamount of the central bank money circulat-ing in the interbank market directly with itsinstruments. The most important instru-ments are the open-market (forint and for-eign exchange) operations and the reserverequirement;

conversion on demand: in the case ofmonetary systems based on precious metal,the obligation of the central bank to ex-change the money substitutes in circulationinto monetary precious metal on demand.Although the precious metal does not par-ticipate in circulation or only to a limited ex-tent, the characteristics of a classicalgold-based monetary system prevailthrough payment on demand (see goldstandard);

conversion: conversion of forint to for-eign exchange (or the other way round).Conversion by the central bank includes, inaddition to foreign exchange market inter-vention, the foreign exchange-forint conver-sion related to the foreign exchange opera-tions of the state (debt service, borrowing,privatisation);

core inflation: a special inflation indi-cator which shows changes in inflation netof the impact of the most volatile factors,which are independent of monetary policy(seasonal foodstuff, fuel, pharmaceuticalprices);

coverage system, banknote coverage,currency-banking debate: in the era whencurrencies were convertible into preciousmetals, the amount of banknotes and coinsissued was restricted on the basis of thequantity of precious metals held by the bankof issue. Full coverage could not (in gen-eral) be implemented, but a specified shareof banknotes and coins in circulation had tohave adequate precious metal coverageheld by the central bank. The central bankcould issue money only when it was alreadyin possession of the precious metal cover-age. The coverage of additional cash inmoney circulation was ‘bank-type cover-age’, generally the discounting of good-quality commercial bonds;

credibility: the extent to which marketagents trust that economic policy deci-sion-makers will react to various economicevents in accordance with their declaredprinciples. For instance, a credible centralbank which sets price stability as its goal,should respond with more restrictive mone-tary policy to signs of growing inflation;


GLOSSARY

currency basket: in a fixed exchangerate regimes the domestic currency is fixedagainst either a single currency or a com-posite of currencies. In the latter case, thecentral bank keeps the weighted averageexchange rate of the domestic currency rel-ative to several different currencies at a des-ignated level. The set of these currenciesand the corresponding weights make up thecurrency basket;

current account, deficit: the balance oftrade in goods and services (exports minusimports), current transfers and incometransfers vis-à-vis non-residents;

current payment operations: transac-tions affecting the current account (tradetransfers, income transfers vis-à-vis non-residents, transfers);

denomination: the currency of finan-cial claims and debts. Settlement is to be ef-fected in the currency of the denominationupon the due date;

deposit insurance fund: the fund pro-vides security to deposit holders in the eventof the insolvency of a bank. Compensationis available on registered deposits up to theinsured amount (according to current Hun-garian regulation up to Ft 1 million);

discount factor: a conversion ratio atwhich cash-flow items at different points oftime exchange hands;

discount rate: the interest rate used inthe calculation of the discount factor;

discount treasury bill: a debt security.A special form of government paper gener-ally of a maturity of less than one year,which does not pay interest. It is sold at aprice below its face value and repaysthe face value upon maturity. It is issuedby the Treasury with maturities of 3, 6 and12 months;

disinflation: reduction or decline of in-flation;

duration: the average maturity of acash-flow stream (for instance, interest pay-ments and redemption of a bond) weightedwith the present value of the cash-flowitems. Its magnitude reflects the sensitivityof the price of the given financial asset tochanges in market yields. The higher the

duration of a financial asset, the more sensi-tive its price to shifts in the yield level;

exchange rate risk: the risk on foreignexchange denominated financial assetsarising from the fact that the value of the as-set expressed in terms of domestic currencychanges with a shift in the exchange rate;

expansionary monetary policy: amonetary policy resulting in the expansionof aggregate demand (faster growth in themoney supply, lower real interest rates ordepreciating exchange rate);

fixed or floating exchange rate regime:in a fixed exchange rate regime, the centralbank undertakes the obligation to keep theexchange rate of the domestic currency rel-ative to a given currency or currency basketon a predetermined path with the help of for-eign exchange market interventions. In thecase of a floating exchange rate regime, thecentral bank has no target with respect tothe level of the exchange rate, which thusmay freely move depending on the demandand supply conditions of the market. Thetype of the exchange rate regime funda-mentally determines the way monetary pol-icy can be conducted;

foreign exchange deposit swap: a cen-tral bank instrument, which provideslong-term forint financing to commercialbanks against the placement of a foreign ex-change deposit with the central bank. TheNBH terminated its use in March 1998;

foreign exchange market intervention:see ‘intervention’

forward interest parity: a function de-scribing the relationship between spot andforward rates: it expresses that the totalyield on subsequent short-term forward in-vestments (to be launched in the future)must equal the yield on a spot long-term in-vestment of corresponding maturity;

forward rate: the interest rate on in-vestments starting at a future date. For in-stance, the 6-month forward rate beginningin one year’s time is the expected interestrate on a 6-month investment starting afterone year. In other words, the forward rate isthe interest rate for a future period of time(in the previous example, for the period of


GLOSSARY

starting at one year’s time and ending in oneand half year’s of time from now on). Theforward interest parity establishes the rela-tionship between spot and forward yields;

forward transaction: a transactionwhere the purchase or sale is carried out at apredetermined price at a specified futuredate (see prompt transaction);

founders’ resolution: its scope may ex-tend to the election and recall of the electedmembers of the Board of Directors, deter-mining the remuneration of the President,the Vice President and the members of theCentral Bank Council, the Board of Direc-tors and the Supervisory Board; and to thealienation of a stake in a business organisa-tion to be regarded as non-resident accord-ing to foreign exchange regulations. In addi-tion, the General Meeting determines andamends the Articles of Association, deter-mines the equity and reserve capital, thebalance sheet, the statement of net assets,the income statement and the distribution ofprofits. The General Meeting also approvesthe statutes of the Supervisory Board;

gearing ratio: the ratio of the internaland external liabilities of a business;

gold standard: a monetary system inwhich the value of the currency of a countryis equal to a fixed quantity of gold deter-mined by law and the domestic currency ap-pears in the form of banknotes which can beconverted into gold at a specified rate. Thissystem provides that the exchange rate re-mains fixed within narrow limits againstother gold-based currencies;

hyperinflation: extremely high infla-tion. Generally, the term is used to charac-terise a rise in the price level in excess of50% a month. Money does not fulfil or onlypartially fulfils its traditional functions (legaltender, form of savings);

implied forward yields: (implied) for-ward yields calculated from the spot yieldcurve according to the forward interest rateparity;

indexation: linking the value of finan-cial claims, prices or wages to some domes-tic price index or exchange rate;

indicators: economic and financialvariables, which provide preliminary infor-mation on the state of the economy and theevolution of fundamental variables;

inflation expectation: inflation ex-pected for a future point in time or period;

inflation targeting: a monetary policyframework in which the central bank explic-itly declares its targets concerning the evo-lution of inflation in the future and under-takes an obligation to meet those targets;

inflation: continuous and sustainedrise in the general price level of goods andservices;

interbank market: a segment of themoney market; the market of central bankfunds, where banks are the participants.Transactions concluded in the interbankmarket are usually very short-term; the vastmajority of transactions are o/n transac-tions;

interest rate corridor: the corridormarked by the central bank’s O/N (over-night, one-day) repo and/or deposit rates;restrains movements of overnight interbankrates. Central banks use it in order to bluntthe undesirably large fluctuation of short-term rates;

interest rate premium: the part of theyield on domestic currency denominated in-vestments in excess of the foreign yield andthe expected devaluation in the exchangerate. Investors demand higher yield when in-vesting into forint assets compared to dollaror euro investments to compensate for thehigher risk involved. This difference in de-manded nominal yields corresponds to theinterest premium;

interest transmission: see: ‘monetarytransmission mechanism’;

intermediate target: a variable whichhas a clear-cut influence on the ultimategoal of monetary policy, and at the sametime which is under the control of the centralbank. Intermediate target may be a mone-tary aggregate (money or credit), nominalexchange rate or even the central bank’s in-flation forecast;


GLOSSARY

internal rate of return (IRR): the rate atwhich the present value of an investment isequal with its market value (its price);

intervention: central bank interventionon the foreign exchange market. The centralbank influences the exchange rate of the do-mestic currency by buying or selling foreignexchange on the market. As a result of theintervention, the amount of central bankmoney in the economy changes (decliningwith the sale of foreign exchange and grow-ing with its purchase); the effect of that canbe offset by sterilised intervention (see‘sterilised intervention’);

issue: issuance of money (banknotesand coins);

lender of last resort: the central bank.To safeguard the stability of the financialsector (in particular the banking sector), thecentral bank undertakes an implicit obliga-tion to protect bank clients and providesbanks in difficulties with sufficient liquidity(central bank money) in order to avoid thebank’s collapse. When this obligation is ob-vious, a moral hazard situation may arise;

limping gold standard: in the case ofthe Hungarian aranykorona (gold crown)introduced in 1892 some of the specific fea-tures of the classical gold standard weremissing, therefore, it was referred to as thelimping gold standard. Monometallism wasnot enforced, which means that, apart fromgold, the silver coins minted earlier werealso accepted as legal tender and the stockof silver was also included in the coverage.Payment on demand, that is, the mandatoryconversion of banknotes into gold, was alsonot implemented and government paperslacking coverage also remained in circula-tion;

liquid asset: an asset which can beconverted into cash quickly and at low cost(including exchange rate loss);

liquidity constraint: the maximumamount of domestic and external liabilitiesthat may be used by an economic agent.For instance, we speak about a householdunder liquidity constraint when, in the ab-sence of the possibility of borrowing, itsconsumption or investment decisions are

determined by its current income positionand not its income flow expected over a lon-ger time horizon;

liquidity management: in a broadersense, the activity of financial andnon-financial enterprises in the course ofwhich they ensure the liquid assets requiredfor administering their business at the leastpossible cost. In a stricter sense, the activityof the commercial banks in the course ofwhich they provide the liquid assets re-quired for the transactions of their clientsand the reserve requirement regulated bythe central bank at the least possible cost;

liquidity situation, liquidity manage-ment of the central bank: the relationshipbetween the actual and desirable level ofbank reserves. There is a liquidity shortagewhen the desired level is higher than the ac-tual and the banks have to turn to the centralbank for credit. Liquidity management is themoney market activity of the central bank; itshapes the demand for or supply of centralbank money so as to align them with thecentral bank’s operating target, be that aquantitative or an interest rate target;

monetary authority: the institutionhaving a monopoly in issuing money (bank-notes and coins), characteristically the bankof issue or the central bank;

monetary base (M0): the narrowestmonetary aggregate, which contains cashand the commercial banks’ balance of theforint accounts at the central bank. The cen-tral bank has a direct influence on the vol-ume of the monetary base. The monetarybase is also referred to as central bankmoney, base money or high-poweredmoney;

monetary conditions: variables de-scribing the stance (expansionary, restric-tive) of monetary policy; generally the realinterest rate and the real exchange rate;

monetary transmission mechanism:the chain of effects in the course of whichchanges in central bank instruments (policyrate) influence the consumption and invest-ment decisions of the private sector, andthereby ultimately the central bank’s maingoal (inflation);


GLOSSARY

money illusion: this term is used to de-scribe the phenomenon when economicagents are unable to distinguish nominaland real changes. Owing to the money illu-sion, an increase in the money supply can,for a transitory period, increase aggregatedemand; in the longer term, however,money illusion fades out and growth in themoney supply results in inflation;

money multiplier, money multiplica-tion: the money multiplier is the quotient ofa monetary aggregate (M1 or M3) and themonetary base (otherwise central bankmoney). Money multiplication is the pro-cess in the course of which a unit expansionin the monetary base increases the broadermonetary aggregate by a multiple—pre-cisely the value of the money multiplier—asa result of the lending and money creatingactivities of commercial banks;

moral hazard: arises when certainagents of the economy can fully retain theprofits of their activities, and at the sametime are able to shift their potential lossesonto others at least in part. Such situationsgenerally lead to excessive risk-taking. Inrelation to the banking sector, it arises whenbanks can be certain that the government orthe central bank would bail them out in aneventual crisis, therefore motivated by po-tentially large profits, pursue a lending prac-tice which involves risks higher than theprudential level;

moral suasion: using its authority, thecentral bank may persuade banks to altertheir behaviour informally (through bilateraldiscussions, written warnings, etc.);

net financing capacity: the final bal-ance of transactions in a given period linkedto the claims and debts of a given sector.For instance, the net financing capacity of ahousehold is that part of its income which isnot spent on consumption and investment,and thus is available to finance other sectorsof the economy;

net present value: the difference be-tween the present value and the currentmarket price. An investment is worth imple-menting when its net present value is posi-tive, that is, if it can be bought or imple-

mented at a market price lower than itspresent value;

nominal anchor: nominal macroeco-nomic variables (e.g. exchange rate, wages,money supply) directly targeted by an eco-nomic policy, which aims at stabilisation,the planned development of which serves asguidance or reference for setting other nom-inal prices. Through this it helps in ‘anchor-ing’ inflation and inflation expectations. Thenominal anchor generally coincides with theintermediate target variable of monetarypolicy;

nominal variables: variables, which re-flect changes in both prices (inflation) andvolume;

one-tier banking system: the centralbank responsible for monetary policy has adirect lending relationship with companiesand a wide range of the public;

open foreign exchange position: a for-eign exchange position is open when thesum of the foreign exchange assets and for-ward foreign exchange claims of a credit in-stitution in a currency does not correspondto the sum of its foreign exchange liabilitiesand forward foreign exchange debts. The to-tal open position of a credit institution is thesum total of its (long and short) positionsoutstanding in the various foreign curren-cies expressed in domestic currency terms.The open position according to the balancesheet is the sum of the net open positionscalculated on the basis of the foreign ex-change assets and liabilities presented inthe balance sheet of a credit institution;

open-market operations: the activity ofthe central bank in the course of which itsells or buys securities (primarily govern-ment bonds) in order to influence theamount of central bank money or the inter-est rate level;

operating target: a variable on whichthe central bank is able to exert an effect di-rectly and immediately and whose changeinfluences the intermediate target of mone-tary policy. Most frequently it is some kindof short-term money market yield;

outright operation: a transaction ofpurchase and sale where the asset constitut-


GLOSSARY

ing the subject of the purchase and sale (se-curity, foreign exchange) changes hands forgood (see repo);

overnight (O/N rate): the rate on(characteristically interbank) placements orcredits maturing in one day, that is, startingtoday and maturing tomorrow;

payment and clearing system: the setof instruments, agreements, organisationsand institutions engaged in the intermedia-tion and settlement of payments; it enablesthe administration of payments and the ex-change of the various assets in the financialmarkets (securities and foreign exchangetransactions);

policy instrument: the instrument ap-plied by the central bank to set the interestrate deemed to be optimal for the state ofthe economy. Using it, the central bank in-tends to exert a direct and effective impacton the money market yields and subse-quently on the interest rates charged bybanks to their customers;

policy rate: the interest rate which bestreflects the stance of monetary policy. Thisis usually the interest rate set on the centralbank’s main policy instrument;

premium (lending risk, liquidity pre-mium): the surplus yield on a given assetrelative to the yield on a risk-free asset,which investors expect to compensate themfor the various (political, counterparty, li-quidity, etc.) risks of the given asset. Theexpected (ex ante) and actually realised (expost) yield may differ;

present value: the value of futurecash-flows today;

price stability: an economic environ-ment characterised by a stable price level orvery low (0-2 per cent) inflation, so that in-flation is not a factor in the consumption andinvestment decisions of economic agents;

primary market: the market for issuingsecurities for the first time;

prompt transaction: a foreign ex-change or security transaction where settle-ment is simultaneous with the conclusion ofthe contract (see also ‘forward transaction’);

prudential regulation: regulation bythe supervisory authority which curtails the

assumption of excessive risk by credit insti-tutions (for instance, the limits on capitaladequacy and large credits). By complyingwith prudential rules, the credit institutionmust maintain its immediate and continu-ous creditworthiness (that is, its liquidityand solvency);

real exchange rate: the quotient of theexchange rate and the ratio of the domesticprice level to the foreign price level. This isan indicator of the competitiveness of aneconomy as it presents the value of foreigngoods expressed in terms of domesticgoods. An appreciation of the real exchangerate implies monetary conditions becomingmore stringent, a deterioration in competi-tiveness and a reduction in aggregate de-mand and inflation, while devaluationmeans easing of monetary conditions,which generally has the effect of improvingcompetitiveness but also of raising the pricelevel. Monetary policy is able to influencethe development of the real exchange rateonly in the short term;

real interest rate: the part of nominalrates in excess of expected inflation. Thelevel of the real interest rate has an impacton consumption, savings and investmentdecisions and thereby on aggregate de-mand and inflation. By influencing the levelof the real interest rate in the economy themonetary policy aims to influence its inter-mediate targets.

real variables: variables net of pricechanges reflecting the volume effect only;

real-time gross settlement system: agross payment system (which performsclearing and settlement at the same time) inwhich the processing of payment orders andtheir final settlement take place continu-ously with the immediate notification of theconcerned participants in contrast to the netsystem (where the moment of settlementand of clearing are separated in time) or thegross systems with delayed settlement(such is, for instance, the interbank clearingsystem earlier referred to as the giro);

redemption yield: see ‘internal rate ofreturn’;


GLOSSARY

refinancing credit: forint credit ex-tended by the central bank to commercialbanks in order that they onlend them tobusiness organisations (under specifiedprogrammes);

repo transaction: security repurchaseagreement. A combination of two purchaseand sale transactions of opposite directions,where an asset (generally a government pa-per) exchanges hands in the present and atthe same time a reverse future transaction isalso concluded for a pre-specified date andprice. Its purpose is to extend a short-termcredit or to place a short-term deposit;

repo: security repurchase agreementwhere one party (e.g. the central bank) buyssecurities (generally government papers)and sells them forward to the other party (abank) from whom it had bought them at adate and price specified upon conclusion ofthe transaction. The repo may be inter-preted as lending against collateral of secu-rities (see also reverse repo; repo transac-tion);

reserve requirement (ratio): commer-cial banks must hold a portion of their de-posits and other liabilities as reserves at thecentral bank, the portion is determined bythe reserve ratio. Raising the reserve ratiodecreases, reducing it increases the moneysupply in the economy;

restrictive monetary policy: a mone-tary policy which results in a decline in ag-gregate demand (slower increase in themoney supply, higher real interest rates ormore appreciated exchange rate);

reverse repo: a security repurchaseagreement, where one party (e.g. the cen-tral bank) sells securities (generally govern-ment papers) and repurchases them at a fu-ture date and price specified upon conclud-ing the transaction. A reverse repo con-ducted by the central bank can be inter-preted as an acceptance of a deposit, in thecourse of which the central bank withdrawsliquidity from the banking sector (see alsorepo);

secondary market: the market for thepurchase and sale of securities issued ear-lier;

shock: an external effect reaching theeconomy, which displaces macroeconomicvariables from the equilibrium courses;

short- or long-term: relative terms. In fi-nancial terminology, short-term is shorterthan one year, long-term is longer than oneyear. In economics, short-term refers to atime interval within which the supply side ofthe economy is able to respond to demandeffects only partially, because a part of thefactors of production are given, while in thelong term, all production factors may adjust;

small, open economy: economic the-ory regards a country small when it is in aprice taker position in its export and importmarkets. The measure of openness is theextent of the country’s economic relationswith non-residents, i.e. its foreign trade;characteristically, it is defined by the shareof the sum of export and import in GDP;

spot transaction: see ‘prompt transac-tion’

sterilisation: all the central bank oper-ations, the purpose of which is to offset theeffect of foreign exchange market interven-tion on the domestic money supply. For in-stance, by increasing the central bank stockof deposits or bonds to an extent identicalwith that of the foreign exchange market in-tervention;

sterilised intervention: a harmonisedseries of central bank operations, in thecourse of which the central bank intervenesin the foreign exchange market to maintainthe exchange rate target and at the sametime offsets the liquidity impact of interven-tion with open-market or other operations;

supervision by the central bank: su-pervision of compliance with reporting obli-gations and provisions of certain legal regu-lations (for instance, central bank ordi-nances);

sustainable inflation reduction: a termused by the NBH to describe its objectivefunction. The ultimate goal of reducing infla-tion is constrained by the need to maintainexternal equilibrium;

swap transaction: a purchase and saleagreement, pursuant to which the contract-ing parties swap future cash-flows under


GLOSSARY

conditions specified in advance. In a foreignexchange swap transaction, the contractingparties contract to exchange cash-flowsspecified in different currencies. Swaptransactions (beside futures and options)are the fundamental instruments of riskmanagement;

time inconsistency: a term used to de-scribe all or certain parts of economic pol-icy. Time inconsistency is mentioned whenan economic policy, which is optimal atpresent, is expected to be sub-optimal in thefuture and thereby the government feelstempted to deviate from its declared poli-cies. The most characteristic example iswhen following wage negotiations the gov-ernment, which aims at curbing inflation,makes measures that lead to higher than ex-pected inflation with a goal to achievehigher growth or better external equilibrium;

tradable goods: goods and servicesactually or potentially participating in for-eign trade;

transmission lag: the time necessaryfor a monetary policy measure to reach itsfull impact;

transparency: transparency of the op-eration of the central bank as perceived by

the agents of the economy. Transparent op-eration contributes to the establishment andmaintenance of a credible monetary policy;

two-tier banking system: the bank ofissue responsible for monetary policy is indirect relationship only with banks and otherfinancial firms (eligible counter-parties).These counter-parties mediate the mone-tary policy measures to the companies anda wide range of the public;

yield curve: yields (interest rates) plot-ted against maturity; yields represented as afunction of maturity. Central banks mostfrequently calculate the yield curve fromgovernment securities market data;

zero-coupon yield: the yield (discountrate) at which a zero-coupon security can beissued under the given market conditions.Zero-coupon assets repay their face value ina single amount at maturity. Zero-couponyields can also be calculated from financialassets, which pay interest and principal sep-arately. When the cash-flow stream from afinancial asset is discounted with the corre-sponding zero-coupon yield, the sum of thepresent value of the cash-flow items (that isthe present value of the asset) will be equalto the market price of the asset.


GLOSSARY

A

accomodative regulation 105Act LX of 1991 on the Central Bank 16Asset and Liability Committee (ALCO) 38Austro-Hungarian Bank 10averaging method 92

B

bank failure 22Bank of International Payments (BIS) 12bank of the banks 15bank supervision 29Banking Committee 38banknote issue 18, 19board of directors 36broad money (M3) 61Budapest Commodity Exchange (BCE ) 32Budapest Stock Exchange (BSE) 31

C

Central Bank Council 35, 40, 41central bank independence 12, 39, 41central bank instruments 53, 57, 88, 94, 100central bank money 20, 89, 90, 91, 108Central Depository and Clearing House

(Budapest) Co. Ltd. (KELER) 31Central Statistics Office 34centralised interbank money market 83change in interest rates 100coincident indicators 71collateral assessment 96communication by the central bank 70compensation paid on the reserves 93

competitiveness 50consolidated balance sheet of the banking

sector 62continuously available standing facility 98convertibility 28correspondent members 32crawling exchange rate 102crawling peg exchange rate regime 50, 73,

74credibility of economic policy 54, 69credit crunch 48credit quota 81currency basket 54, 87current account 62

D

daily coverage assessment 96data collection and reporting 19debt crisis 14de facto independence 39default risk 55delivery-type repo 95deposit insurance fund 22direct instruments 81, 89discount factor effect 68discount Treasury bill auctions 84discretionary regulation 105disinflation 47duration 72DVP (Delivery Versus Payment) 32

E

ECB (European Central Bank) 92economic costs of inflation 47


INDEX

eligible counterparties 111exchange controls 12exchange rate 53exchange rate course 73exchange rate risk 73exchange rate risk premium 74exchange rate target 53exemption from the reserve requirement 92expected interest premium 73external equilibrium 50

F

financing the central budget 24fixed exchange rate regime 51forecast 109foreign exchange centre 11, 12foreign exchange debt 51foreign exchange deposit swap facility 85foreign exchange licensing authority 27foreign exchange reserve 18, 25, 102foreign exchange structure of reserves 26foreign exchange swap 86forward foreign exchange market 75forward interest parity 77free liquidity 109, 110free tender 97

G

general meeting 35giro (Interbank Clearing System–BKR) 32Giro Payments Co. Ltd 31gold standard 10government paper market outside the stock

exchange (OTC) 32government’s banker 23

H

haircut 96hold-in-custody repo 95hyperinflation 13

I

implied forward yields 65income effect 68indexing of tax systems 48indicators 57indirect instruments 81, 89inflation expectation 66

inflation targeting 53Interbank Clearing System 32interbank payments 30interest rate ceiling 98, 107interest rate corridor 76, 97interest rate floor 98interest rate tender 97interest rate transmission 71intermediate target 52intermittently available standing facility 101internal rate of return (IRR) 65International Monetary Fund 15, 28intertemporal optimisation of consumption

68intervention 72, 74, 87, 101, 107, 109issue 18issue of coins 19

K

KELER Rt., Central Depository and ClearingHouse (Budapest) Co. Ltd. 31, 111

KESZ, Unified Treasury Account 24, 109Keynesian school 45

L

law harmonisation 42leading indicators 70legal (de jure) independence 39legislative function 27lender of the last resort 17, 21lending risk premium 72licensing 27liquidity management 93liquidity management at a bank 91liquidity planning by the central bank 106,

108liquidity shortage 21

M

monetarist school 45monetary aggregates 59monetary base 59Monetary Committee 38Monetary Conditions Index (MCI) 57Monetary Policy Guidelines 70monetary transmission 68money in circulation 60money market crises 22money multiplier 60


INDEX

money supply 21monopoly of issuing 17Monthly Report 35moral hazard 106

N

narrow money (M1) 61NBH bond 58, 74, 96, 102, 103new-classical macroeconomics 46net financing capacity and requirement 62New Economic Mechanism 14nominal anchor 52non-tradable sector 56

O

OECD membership 28one-tier banking system 13open foreign exchange position 74, 75, 83open-market operation 89, 94, 105operating target 52, 56, 57, 104operational independence 40outright operations 94overdraft 98

P

period of placement 90personal independence 39Phillips curve 45pivoting 77policy instrument 76, 96, 99, 103Post Office 34president 37price stability 18, 46

Q

Ouarterly Report on inflation 70quick tender 77, 91, 95, 96, 97, 104, 106,

107, 111

R

rate of devaluation 50, 54, 56rational expectations 46real exchange rate effect 69real-time gross settlement system (VIBER)

33

reducing the rate of devaluation 75refinancing channel 82repo 84, 94,109repo line 106Report on Changes in Inflation 70reserve base 90reserve period 93, 100, 107reserve requirement 21, 23, 82, 86, 89, 109reserve requirement ratio 91, 92reverse repo 84, 95Royal Hungarian Note Issuing Institute 11Russian exchange rate crisis 74

S

S.W.I.F.T. Society for Worldwide InterbankFinancial Telecommunications 33

secondary securities market 94settlement account 20, 30short-term costs of disinflation 48signalling 100small, open economy 50social costs of inflation 47soft budget constraint 82speculation 74, 100speculation against the exchange rate 56State Money and Capital Market Supervision

(SMCS) 27, 29, 30statistical service 34sterilisation 94, 96, 101, 103sterilisation costs 102sterilisation instruments 58sterilised intervention 58, 74supervision by the central bank 29supervisory board 36surplus cost caused by the reserve require-

ment 93surplus liquidity 72, 73sustainable reduction of inflation 49swap 96

T

TARGET 33target value 52tender 95, 96, 97Terms and Conditions Of Business 97tradable sector 56transmission mechanism 46, 52, 69, 72,

100, 101, 105


INDEX

transparency 42treasury 108treasury bill 83treasury bill auction 94two-tier banking system 15

U

ultimate goal 41, 45

V

variable rate tender 97, 107vice president 36volatility 106

W

wealth effect 68World Bank 26

Y

yield curve 63, 65yield curve theories 64

Z

zero averaging 92zero-coupon yield curve 66zero-coupon yield curve estimated

by the Svensson method 66


INDEX

MONETARY POLICY IN HUNGARY - MNBThe publication presents an overview of the monetary policy of the...

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