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Business Expert Magazine: Interview with Johan Mathisen, IMF Resident Representative in Moldova

Johan Mathisen: It is our opinion that any increase of reserves contributes to taming the inflation

The administrative council of the National Bank of Moldova decided to gradually increase the rate of required reserves maintained by the banks up to 22 %. Do you think that the increase by six percentage points is sufficient to tame the explosive growth of inflation that has already reached 16.2%?

It is our opinion that any increase of required reserves maintained by the banks contributes to taming the inflation. But talking about such specific administrative measure one needs to see the whole picture in ensemble. One of the big problems encountered by the Republic of Moldova in general and by the monetary authorities in particular is lack of sufficiently strong link between the interest rate and inflation, i.e. the so-called transmission mechanism. These transmission mechanisms are extremely weak. One of the main reasons explaining weakness of these links lies with excess liquidity in the national economy.

Hence, the question on how much should the required reserves be increased in order to stop the inflation is an empirical one as the excess liquidity should be analyzed at any level and compared to the level of required reserves. In order to improve this mechanism of transmission and to make it more efficient in contending the inflation it is necessary to mop up the excess liquidity. Increasing the norm of required reserves is one of the instruments capable of moping up the excess liquidity.

Yet another measure is the one realized by the Government last year and that is transfer of treasury accounts to the National Bank.

All these measures are targeted towards improvement of the transmission mechanism so that the National Bank is better equipped to contend with inflation. The problem is that increase of required reserves will affect to a certain extent certain banks. Some of the banks have more liquidity as compared to others, which means that in case of higher rate of required reserves these will encounter certain problems. Other banks will have to either increase interest rates on deposits or search for other options for attracting resources. Probably, the key mechanism used for the purpose will be transactions in non-banking market. So far there is not too much activity in the interbanking market.

Comparison with the states that have recently became members of the European Union shows that the situation in Moldova differs in the most serious way. As I have already mentioned, one of the key problems is the excess of liquidity in the banking system and Moldova is not the only country facing this problem. For example, in Romania the norm of required reserves maintained in Romanian lei is 20 %, while for the foreign currency reserve is amounts to 40 %. For a number of years they had to fight with the same problem that we are facing at the moment while making attempts to resolve it through an increase of required reserves. Analysis of what has happened shows that this was a rather useful mechanism in moping up excess liquidity in the market and by so doing they improved the transmission mechanism, which in its turn was used in fighting with inflation. As a result, the inflation dropped down considerably in a very short term.

Increase of required reserves is a monetary instrument. In the following months there will be strong inflationary pressure generated by further raise of prices on natural gas, electricity and food. Given these conditions, to what extent increase of required reserves could be considered as efficient measure?

The practice shows that the best way of countering inflation is through application of monetary instruments, especially in situation in which the Republic of Moldova finds itself at the moment when there is an increase of prices on certain components of the consumer basket.

Let us imagine a consumer basket with certain set of products and, for example, price on fuel, which went up considerably as compared to other prices. If nothing happens then these increases of price are compensated through excess liquidity. Yet another approach to analyzing the problem is to assume that when the price on one of the components of the consumer basket goes up considerably it is necessary to take measures to make prices on other components raise so as to allow for fighting with inflation. This means that in conditions of a shock bound to increase of prices, both fiscal and monetary policies shall be more austere so as to contribute to taming the inflation and preventing it from rapid growth, thus avoiding strong shock onto the population as well as on the business community.

If, for example, prices on fuel went up by 20 % while prices on other products increased on the average by 5 % then the inflation will increase from 5 up depending on the share of product holding the higher price. But when measures are attempted to mop up excess liquidity the scope pursued is to compensate strong growth of price on one product by halting growth of prices on other products.

Hence, we proceed to increase the norm of required reserves. Part of money gets tied up with reserves and thus become more expensive. One could expect an increase of interest rates on bank loans. We hear talks about actually raising it up to 30 %. The ones willing to borrow will have no incentive to do so. And then a question arises on how this measure of increasing required reserves could cope with the intention to prop up economic growth?

Comparing March of the current year with the similar period of last year shows that money supply increased by about 42 percent. Since 2000 up to now registered was an all-time-high lending to economy. At the end of 2007 the volume of growth of lending was 52 percent while at the end of March the growth was already 53 percent, which means that during the last months the banks were lending at highest level ever. Accordingly, if the scope pursued is to tame the inflation it is necessary to reduce the pace of lending growth.
In fact, in a situation when there is excess lending growth, its volume is exceeding the one characteristic of healthy economy.

The economic growth outlook for this year is fairly good. We project 6 to 7 percent growth for 2008 but in care of high-yielding crop and resumed pace of production at the expense of export of vine and wine products then we can aspire for even bigger progress.

But, clearly, for this to happen, the pace of lending to economy needs to go down along with taking serious measures in order to reduce the inflation.

The Republic of Moldova faced similar situation with raising inflation back in 2000. The interest rate on government securities was about 23 percent while the interest rates in banking system were about 32 percent. And here is what is happening we are going back to the same high level of inflation. In order to reduce the inflation is necessary to tighten fiscal and monetary policies. If we look back at past experience we can see that application of adequate monetary and fiscal policies gives rather rapid response. In just few months the inflation decreased from 17 % to below 5 %. Rather rapid decrease was marked in the interest rates on T-bills as well. It means that in case when rigorous measures are taken, fighting with inflation could gain a success in just few months. Taken as an example could be the case of Poland that got in the same situation and used same measures.