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Inflation Targeting in Albania
Mimi KODHELI
[email protected]
“Pushing inflation too low-say, below to 5 percent- may entail a loss of
output and seigniorage revenue, suggesting a need for caution in setting
very low inflation targets in low-income countries. These countries tend to
be subject to larger output volatility and more pronounced price shocks,
and program design should take these attributes properly into account. In
particular, inflation targets should be set so as to help avoid risks of an
unintended concretionary policy stance.”
IMF (2006), pg 17
Economics Department - University of Verona
Polo Didattico Giorgio Zanotto
Viale dell'Università, 4
37129 - Verona - Italy
1. Albanian macroeconomic environment, features and
indicators
Albania has made substation progress since the beginning of the
transition in 1991. Unlike some former Soviet Union and CEE
countries that started the liberalization of the economy in the ‘80s
(like Hungary e.g.), Albania did not undertake any pre-transition
reform before 1991.
During 1991-1992 the economy experienced sharp decline in output
and high levels of unemployment and inflation. The economic
situation led to a mass migration of the world abroad, especially to
Italy and Greece.
Recovering from the pyramid schemes crises of 1997, Albanian
economy continued to experience high positive growth rates. Between
1998 and 2006 real GDP has averaged almost 6 percent annually
(Fig.1).
Inflation record has also been impressive, varying not far from 3
percent target of the central bank in more than 8 years now (Fig. 2).
The vigorous growth led to an estimated GDP/capita of almost US
3,000 in 2006 upgrading Albania to the group of middle income
countries (Fig.3).
Fig.1 Real GDP growth 1996-’06 (in %)- Source: INSTAT (Albanian Institute of Statistic)
Inflation rate 2000 - 2007
in %
4
3.5
3
2.5
3.3
3.5
2
1.5
1
2.5
3.01
2006
2007
2
2.2
1.7
0.5
0
2001
2002
2003
2004
2005
Year
Fig. 2 Inflation-annual average 2001-‘07 (in %)-Source: INSTAT
Fig.3 GDP/capita in USD-Source: INSTAT
The initial rapid speed of growth was mainly observed in those
sectors of the economy where market liberalization proceeded quickly
like services and agriculture. Despite the initial revitalization of
agriculture, lack of investments, land fragmentation and absence of
proper land market, land property problems, poor infrastructure
reduction market access, and weak food processing capacity, led to a
slowdown in agriculture growth to around 3 percent per annum. As a
result its share to GDP narrowed to 21 percent from its high 35
percent in 1996 (Fig.4). However, it still remains the main source of
income for nearly 40 percent of the population.
Fig.4 Contribution to GDP by sectors 1996-2005 -Source: INSTAT
In the last ten years sectors like construction and services have been
the major contributors to Albanian growth. Services sector is one of
the most dynamic sectors of the Albanian economy, constantly
providing a high contribution to the economic activity and growth of
the country. The weight of this sector to the economy has been
increasing, recording a trend expected to continue even in the future.
The assessment of performance of this sector is based on the sales
index of economic enterprises by services items in wholesale and
retail market, hotel and restaurant services, telecommunication and
other services. Revenues generated from sales of these services have
increased constantly during latest years and currently constitute
about 60 percent of overall revenues of economic enterprises.
Construction emerged as key sector in sustaining growth,
compensating for the agriculture and industry oscillation. During
latest years construction has turned out to be one of the main pillars
of the Albanian economy, because of its weight in the overall
production and the high growth rates evidenced in this sector. Since
some years earlier, the annual growth of this sector has fluctuated
around 10-15 percent, making this sector be the first in the list of
economy sectors for development.
Nonetheless, direct and indirect indexes of this sector’s output
indicate that further progress requires a broader attention,
particularly to a better allocation of financial, private or public
resources. Construction developments in recent years, particularly
their extreme concentration on certain territories, prove the lack of
efficiency of urban development vision, not guaranteeing long-term
sustainability of the branch. Furthermore, construction is still
dominated by housing building, lagging behind all other strategic
items, such as investments in road infrastructure, and other
investments directly related to the standard of living of small urban
and rural communities.
Box 1. Opinions on housing prices in Tirana
Nowadays there is accepted the negative impact, which has a bubble effect, of real
estate prices on the economic growth. The rapid price rise of houses, not justified
by basic economic factors, may lead to inappropriate investments, which will
reduce the economy efficiency. The house price, likewise the price of any other
asset, influences significantly on the production and inflation in the economy,
because when the house price go up, the expectations on their future
performance are positive. Such a fact will encourage the increased demand. Also,
a higher house price increases the wealth of the individuals, encouraging
consumption rise and in consequence, even the aggregate demand.
Recently, in Albania, more and more discussions are taking place on rapid price
rise of apartments. To study the developments in real estate market and
particularly, taking into account the lack of official statistics on this performance,
in mid 2006 the BoA carried out a survey on price performance in Tirana house
market. 16 real estate agencies, 12 construction firms and 17 commercial banks
participated in this survey. The following came out:
In the real estate market, the main factor having caused the price rise on the
supply side is the reduction of building areas and the land price are of an aboveaverage, having influenced the price rise on the supply side. Essential factors that
encourage the demand for living apartments are the increasing demand for
house, driven also by demographic movements, the increased preference to
invest in long-term periods and increased household incomes (particularly those
of emigrants).
Most of current transactions for house purchase are based on individual savings.
Also the emigrants’ remittances contribute on average by 30 percent to financing
the house purchases. Most of sale transactions are carried out in euro, above 90
percent of the cases. Even when payment is made in Lek, the value of house is
quoted in euro. Concerning the way the payment is done, the agencies underline
that paying by installments represent about 53 percent of the cases, while the rest
is made in the form of a down payment.
Now days, a considerable part of real estate purchases is financed by the banking
system. Most of market stakeholders are of the opinion that bank loans increased
in last 2-3 years. Real estate loans extended by the banking system usually
constitute 80 percent of the collateral value. All the banks of the system use the
market value approach for evaluating the collateral. Also banks apply fixed and
variable interest rates for mortgage loans.
Together services and contraction count for more than 2/3 of the
GDP.
Strong domestic demand supported by total factor productivity
improvements and remittances has sustained high growth rates
during the whole transition period. According to Country Economic
Memorandum (WB, 2005) growth accounting analysis in the period
1993-2003 TFP1) growth was mainly the result of resource
reallocation from low productivity sectors (agriculture, industry) to
high productivity ones (services, construction). However, according
to the same report Albania needs to identify other sources of growth
to sustain the high rates of growth experienced thus far, such as
enhancing capital accumulation and increasing exports.
***
The fiscal posture has improved continuously. The size of budget
deficit (including grants) was reduced from 10 percent to GDP before
1999 to 3.2 percent in 2006. An ongoing reform to reduce the size of
informal economy, which is estimated to be one of the biggest in the
region, is expected to increase tax revenues further.
The efforts have also reduced debt-to-GDP ratios to just below 55
percent of GDP (Fig.5). But the debt, which is largely domestic, has a
short maturity profile and a narrow investor hold base, creating
rollover risks.
______
1) Total Factor Productivity (TPF) growth is measured as a residual, total output growth less the weighted
sum of input growth, known as “Solon residual”.
Fig.5 Public Debt as a % of GDP Source: BoA
Albania has been characterized by large current account deficit
throughout the transition period (Fig. 6). Imports have steadily
grown reaching 47 percent of GDP in 2007 with exports covering
behind at 23 percent of GDP, leaving Albania with a trade deficit of 24
percent.
Albania’s receipts from migrant remittances are, relative to GDP,
among the highest in the world. Remittances are considerably larger
than exports (1.2 times – Sep.07) and represent 14 percent of GDP.
Although the volumes of remittances are still sent through informal
channels, the importance of the formal channel has increased in
recent years (Fig.7).
Fig.6 Current Account Balance, 1996-’06 (% of GDP) Source: BoA
Fig.7 Distribution of Remittances 1994-’04
Source: IOM (International Organization of Migration)
Foreign Direct Investments (FDI) remain low at 3-4 percent of GDP
to fill the remaining current account gap which so far has been largely
covered with grant and soft loans. While, long run sustainability
issues of current accounts may occur, if certain measures that make
better the competitiveness of Albanian exports and attract more FDI,
are not undertaken.
2. Reasons that pushed Albania to Inflation targeting
After bringing inflation down from 237 percent in 1992 to just 6
percent in 1996, inflation has fluctuated around 3-4 percent (with the
exception of the limited period after the collapse of pyramid
schemes). McNeilly, et al. (1998) attributes the success of Albania in
achieving low inflation to the early price liberalization …and an early
aggregate supply increase in goods and services alongside a restrictive
monetary policy implemented by the Bank of Albania (BoA).
As far as monetary aggregates do not contain all the
necessary information to predict future inflation, relying on
a monetary targeting regime could be suboptimal. (?)
Albania has been one of the few countries to have endorsed a
monetary targeting regime.
Such a regime was appropriate for the framework of Financial
Programming upon which the IMF technical assistance programs
were based. The monetary targeting aimed to control the money offer
in the economy by monitoring M3 as an intermediate target.
In compliance with the formal framework of programs supported by
the IMF, the monetary targeting was accompanied by quantitative
objectives (minimum) of the net international reserve, of net internal
means of BoA (maximum) and of the total funding of the budget
deficit (ceiling). Such limitations, in addition to being part of the
limitations of the IMF programs became operational objectives of
BoA through which it would be aimed to achieve control of the
monetary supply.
Initially, the central bank relied on direct instruments in conducting
monetary policy. The supply of broad money (M3) was controlled by
ceilings imposed on the level of credit extended by commercial banks.
Later on in 1995, the interest rates of State Owned Banks’ deposits
(SOBs) were also managed in a first move to switch to indirect
instruments. In 1999 credit ceilings were removed, and from 2000
the central bank (BoA ) tries to influence interest rates only through
open market operations in T-bills (Repos).
Although the regime has been rather successful in terms of price
stability, it would not be entirely correct to attribute the success only
to this regime. According to Estella and Mishkin (1997), as inflation
is brought under control the informative role of monetary
aggregates diminishes because the velocity shocks’ relative noise
increases. This, according to them, could be an important reason
why industrial countries and many emerging market economies do
not rely on monetary targeting in the era of price stability.
The velocity shocks could be attributed to the instability of money
demand which increases as structural changes of the financial system
advance.
Albania does not make an exception from the rule. Table 1) shows the
targeted and actual growth rates of the broad money (M3) and
inflation.
It is evident that the actual growth rates of M3 until 2000 have
diverged widely from the targets. On the contrary, inflation objective
during the same period has been most of the time undershot. Even
after the year 2000 when M3 growth rates have been fairly close to
the targets, they have varied widely, from 5 to 13 percent, compared
to the relatively stable inflation rates.
This raises doubts about the relative significance of the nominal
anchor used in achieving low levels of inflation and makes it very
difficult to clearly transmit the intentions of the central bank by
simply announcing M3 growth targets.
Furthermore, the velocity of M3 has demonstrated a relatively high
fluctuation that makes M3 an unpractical indicator in the
implementation of the monetary policy. Although the annual growth
of the M3 may retain the forecasting capacity, in long term periods of
time it is not sufficient to serve on due time to the decision – making
relevant to the monetary policy.
Consequently, BoA has to look at other possibilities and alternatives
of using the information that may serve to implement on due time the
monetary policy.
The central bank has been aware of this divergence and in practice
decisions on changing the monetary policy have been taken based on
a wider range of information besides the M3 growth, such as:
inflationary pressures coming from exchange rates movements, price
changes in different markets, including foreign markets, supply
shocks, etc.
The experience of transition countries does not provide a clear answer
on the choice of an optimal regime of the monetary policy. The best
possible conclusion is that the choice should be based on a careful
assessment of the specific conditions of the economy and that this
choice should be combined with other macroeconomic policies.
Sustainability of the overall price level in the recent years gives to BoA
the alternative to follow a monetary policy in the form of monetary
targeting. While the implementation of the monetary policy is
oriented towards targeting of the liquidity level in the market and
towards the policy of interest rates in function of keeping inflation
low, BoA has maintained flexibility of the response on time towards
internal macroeconomic shocks, an example of which was the
massive withdrawal of deposits in 2002 (see annual report of BoA,
2002)
This way of running monetary policy to some level resembles that of
inflation targeting. BoA makes public at the end of each year level of
inflation aimed, which led Stone (2003) to classify Albania as an
inflation targeting lite country as compared to a full fledged IT
country (see Table 2).
However, there are two important elements that distinguished
Albania from trained and experienced Inflation Targeting regimes:
These are the communication of monetary policy strategy including
the publication and explanation of its inflation forecast and a formal
mechanism that makes BoA accountable to the announced inflation
target.
Table 2 Inflation targeting Lite
Box. 2- Alternative regimes
The other alternatives to inflation and monetary targeting are exchange rate
pegging and the so called “just do it” policy applied by FED (Mishkin, 2002).
Exchange rate pass-through in Albania is thought to be high, though asymmetric,
given the large proportion of imported goods in consumer basket (approx. 70
percent). This would make this regime an effective way of conducting monetary
policy.
The relation of prices to the exchange rate was studied with interest during ’60’70-s. Initially models were established that based on the theory “Law of one
price” presumed the existence of a unitarian connection between them. Later on
there were developed models of the Parity of Buying Power (absolute and
relative) that were used to identify variations in exchange rates. However,
numerous empirical tests did not support these suppositions, bringing about the
idea that fluctuations in exchange rate are not completely reflected in the level of
prices of a country (incomplete pass-through of the exchange rate). Now there are
many models/theories that explain why this conduction/conveying) is
incomplete. Recently, many empirical studies have testified that in addition to
being incomplete, this transmission is also in decline.
In literature we meet “first level” pass–through that refers to the sensitivity of
import prices in a country towards the variations in the exchange rate of the
currency of that country and “second level” pass–through that refers to the
sensitivity of consumer prices towards variations in the import prices
Nevertheless, many studies do not distinguish between these two stages,
including the definition of the effect of the exchange rate fluctuations both the
effect in the import prices and in the CPI.
Literature on monetary policy in Albania has often considered the channel of
exchange rate as the most important one for explaining inflation developments in
Albania (Muço et al, 2004). Considering the importance of the exchange rate in a
small and open economy as is the Albanian economy, the central bank did neglect
the developments in the exchange rate of lek.
Such literature has observed that the change in the relation between the exchange
rate and inflation after 2000 (Peeters, 2005) where pass–through of the
exchange rate with the consume prices in Albania are shown to be in decline.
Most of exchange rate discussions, however, refer to scenarios of controlling
depreciation to curb higher inflation. From some time, Albania like several other
transition countries has experienced appreciation of its currency instead. This
has helped easing inflationary pressures. This has pushed BoA to occasionally
intervene in the market and to reduce the local currency interest rates against the
euro. However, it remains unclear whether this appreciation is a return to some
kind of long term equilibrium supported by fundamental changes. This shows
that exchange rate developments cannot be ignored that easily in monetary policy
decision even if committed to the free floating regime.
3. The transition experience to inflation targeting.
Despite of the stable pace of main indicators, the macroeconomic
stability is not consolidated yet and it may not be considered that the
success of monetary policy has been achieved. The pace of some of the
financial market indicators proves that there is still much to do in
order to achieve a strong foundation of the Albanian public trust in
the national currency. Bolle and Meyers (2005) argue that the
inflation prime shown in the yield curve of securities and the high
level of dollarisation show that inflationary expectations have not
reached yet the level representing BoA objectives.
Masson (1997) and Stone (2003) have pointed out the importance of
fiscal discipline of the success of the inflation targeting regime.
Although the fiscal discipline has been a crucial factor in bringing
inflation down in Albania, several events, especially certain structural
reforms, have forced the government to slow down its discipline.
Among these events an important one is that the government is
covering most of the compensation expenses through its budget, and
this really put a lot of pressures on inflation.
Box. 3 Electricity sector
One of the main budget costs for compensation in 2007 is those concerning
electricity that amount to 17 -20 million Euros.
Unpaid electricity use to be and still is another core problem. The declined
pointed in January 2006, when payment was received on only a third of
electricity supplied, compared to some 75 percent in the region (IMF country
report 2008).
Electric power is the main source of energy in the country used by industrial,
services and household consumers. Lack of productive capacities, high technical
losses, unfavorable weather conditions, and irregularities in bill payments have
generated a number of problems accumulated over years. Restrictions in
electricity production against the increasing demand have led to re-occurrence of
energy crises during 2006-2007, implementing the economic activity in many
enterprises.
Total electricity production in 2007 declined considerably by 46.9 per cent in
comparison to 2006. The total produced quantity was represented 50.1 per cent
of the total electricity sources.
Electricity import experienced a substantial growth of 136.2 per cent compared to
2006 and represented 49.9 per cent of the total sources in 2007, whereas in 2006
it had represented 18.3 per cent. In 2007 the electricity price in markets grew
considerably thus causing the electricity import price to grow over 50 per cent.
(Fig. 8)
At the same time, power imports jumped three fold to balance the drop in
domestic production and poor water reserve management in 2006. Altogether
electricity import costs increased by 2 percent of GDP in 2007.
Fig. 8 Source: IMF
Transition countries have faced difficult alternatives in drafting
stabilizing policies. Drop of internal production in the first years
following the changes in the political system brought about decline of
fiscal income and a rise in the unemployment level and the latter one
was also accompanied by increased costs in the form of economic
support. Lack of the development of a financial market made the
funding of budget deficit the only funding alternative. Amidst natural
changes of relative prices during the transition period in a market
economy, high deficits contributed directly in high inflation rates. At
the same time, the first years were accompanied by a tangible
deterioration of the current account. In such circumstance, the
economic policy faced parallel challenges of the need to take strict
measures aiming to achieve macroeconomic stabilization and of the
need to encourage the economy, aiming to reduce unemployment and
social tensions. Solving this dilemma was the essence of the pace and
dynamics of deflationist policies.
The coordination between monetary and fiscal policy in Albania
during the transition period has been satisfactory with the
international factor playing a critical supportive role in the regard.
Since 1992 Albania has gone under several IMF supported programs.
The Memorandum of Economic and Financial Policies (MEFP) signed
in the course of these programs has been an effective machine to seer
both fiscal and monetary policies in a consistent way with the
objective of a sustainable growth at low rates of inflation.
Modeling and Forecasting
Achieving a reasonable accuracy of the inflation forecast, which
serves as an intermediate target, is crucial for the successful
implementation of the inflation targeting regime.
Box4. Pre- conditions of inflation targeting.
Literature on inflation targeting recommends a series of pre-conditions that must
be met in order before implementing this regime. Eichengreen et al. (1999) sees
lack of the technical capacities of central banks as a fundamental obstacle for the
implementation of inflation targeting. Other scholars have maintained a balance
in this direction. While listing a number of pre-conditions that must be met,
Carareet al. (2000) remains faithful to the idea that such “pre-conditions” must
not be considered as “strict pre-conditions” for starting to implement the
inflation targeting.
This means that a central bank may proceed with its implementation even if
some of these pre-conditions have yet to be fulfilled. Nevertheless, they reiterate
the need for required policies aiming to satisfy these pre-conditions in the future.
Jonas and Mishkin (2000) share a similar view. IMF (2005) highlights that none
of the transition countries met all pre-conditions before proceeding with the
implementation of the inflation targeting.
In World Economic Outlook, September, 2005 IMF divides the pre-conditions in
four categories:
• Institutional independence.
• Developed technical infrastructure.
• Economic structure.
• Sound financial system.
With exception of the direct funding of the budget deficit, Bank of Albania
envisages that it will meet the pre-conditions in the end of 2008. The issue of
debt funding requires an amendment of the legal framework, i.e. of the law “On
Bank of Albania” Which in compliance with the National Plan for implementing
the Stabilization Association Agreement is expected to be approved no later than
end of 2009. The new law must be completely in line with EU acquis
communitaire, thus making compulsory the requirement to prohibit deficit
funding from the central bank. This moment will mark the official transfer to a
complete inflation targeting regime in Albania.
The central bank has compiled during all these years, a list of
technical problems that need to be tackled, aiming at improving not
only the understanding of inflation sources but also the monetary
policy transmission mechanism and of functioning of the Albanian
economy as a whole in order to come up with appropriate responses
to different shocks that might hit the economy and prices.
This list consists in: (i) building up forecasting models for inflation;
(ii) evaluation and developing the inflation forecasts models; (iii)
initiating a macro-economic model for Albania, more simple modes
of inflation that could be used alternatively or complementary to
forecast inflation, like VAR et.; (iv) improving the statistical
framework, especially the short term real sector data.
After 2005, BoA changed the objective form from the interval form of
the objective of 2-4 per cent to an objective of 3 per cent in a tolerance
margin of +/-1 per cent. Furthermore, BoA reviewed the time span of
the inflation objective from a one - year framework fixed at the end of
the year to a continual horizon. Such a change was made public and
explained in the Monetary Policy Paper of 2006 and was extended to
a three - year period of time in the “Development of BoA during 2006
– 2008”.
The new form of the objective aimed to enable the focus of
inflationary expectations and their anchorage to a single value of 3
per cent. This supposition stemmed from belief that in the interval
form of the objective, inflationary expectations are generally oriented
towards the upper limit of the target interval.
Currently BoA is using a portfolio of the models for inflation
forecasting. BoA personnel and the decision – making body
(Supervisory Council) are aware of these models’ limitations that
originate from problems related to data, short experience in the
modeling process and difficulties in assessing expected developments
of exogenous variables. This is the reason why current efforts are
focused in two directions:
(1) Priority is given to the improvement of existing instruments for
forecasting. All the six models are improved and updated continually
with new indicators that show a better continuity of the explanation
and forecasting of inflation. Currently, the forecasts provided by the
models over the past 18 months are being re-assessed (Kota et al.
2006). In 2007, the continuity of each model was assessed formally
and inflation forecasts were selected. The results showed that
quarterly models of forecasting provided better results than the
monthly models, while the quarterly database is more complete and
more reliable (Kota et al. 2006). BoA maintains that in the near
future the monthly models will be replaced by the quarterly models
considering that the focus of the monetary policy of B0A will move on
to three months timeframes.
(2) The second focus of efforts is the development of a
macroeconomic model for Albania (meam). Dushku (et al. 2006)
makes a technical description of the model. Although progress is
observed in this direction, ‘meam” is a continual process that consists
in the upgrade of statistical data base, in developing equations and in
strengthening relations between the structure of the model and the
monetary policy. Results of “meam” are intended to be used for
providing reliable macroeconomic forecasts in 2008, in the earliest
variant possible for retrieving reliable results. During the period prior
to retrieving such results, “meam” will be used for simulating
macroeconomic shocks, and this will be of assistance to the decision
making of BoA with regard to the monetary policy.
Policy Implementation
Positive macroeconomic environment and low and stable inflation
rate enabled to BoA to gradually reduce the monetary conditions in
the economy starting from 2000. Such a policy relieved overappreciating pressures towards the exchange rate and made room for
extending financial mediation. Nevertheless, loans mediations occurs
mainly for loans in foreign currency and the low interest rate in
international markets encourages this phenomenon. With exception
of the banking sector, the financial sector remains still undeveloped
and includes only some small institutions involving insurance and
pensions but lacks of stock market.
Having a clear understanding of transmission of monetary policy it is
not an easy task for an emerging market economy characterized by
low financial markets and subjects to frequent structural shocks.
Investigating all the possible channels through which monetary
policy could affect inflation:

interest rates channel- money view;

exchange rate channel;

bank lending channel- credit view;

inflation expectations channel;
proved a very useful exercise to get some good indications on what
are the most appropriate instruments to achieve the inflation
targeting in Albania:

money supply,

short – term interest rates,

exchange rate etc.,
or all combination of them.
Inflation Targeting (IT) and exchange rate
Choosing a monetary regime based on a strict regime of the exchange
rate would require appreciation of the real exchange rate. In such a
situation, the economic competition with foreigners would be
weakened and trust of the central bank would be damaged for
fulfilling the objective if the effect would be reduced through a
nominal depreciation of the exchange rate. Furthermore, such a
regime made it difficult to reduce specific challenges of the transition
countries such as the high capital flow in the form of foreign currency
remittances. Underlining these issues, IMF (1997) suggested to the
transition countries with a regime of fixed exchange rate to transfer to
a regime of floating exchange rate after reaching a low inflation rate.
Now days, in terms of exchange rate policy, Albania could be better
defined under floating regime with occasional interventions in the
forex market to maintain a certain level of international reserves.
Although the Exchange rate pass-through is quite high especially
during depreciation periods, BoA so far has been unwilling to rely on
direct forex interventions to meet its inflation targets.
This is partly because of changes in fundamentals in periods of strong
depreciations (like 1997) and the insufficient level of international
reserves (the level of it is fixed on an annual basis, in cooperation
with WB and IMF, and nowadays the floor is under the value of 4
months imports- actually at EUR 1.5 billion). From 2001 Exchange
Rate has shown noticeable stability (Fig.9). The ER pass-through
effects have also dropped (Fig.10).
Fig.9 NEER & REER2) of Lek vs.80% Euro and
Fig.10 % of ER fluctuations of less than 1%
20% USD in Albania
within 2 year period
Running a flexible monetary policy like Monetary Target and
Inflation Target does not mean that monetary policy has to disregards
the exchange rate. Monetary policy under Inflation Target regime
affects exchange rate channels in several ways. There are two main
reasons, I think, why exchange rate channel should be closely
watched.
(1) Fear of pass- through: while direct interventions have been
avoided so far, monetary policy has been particularity attentive to
interest rate differentials between Lek and Euro/USD to avoid
currency (deposit) substitution which is turn could trigger an
inflation-depreciation spiral (97’ shock: BoA increased interest
rates by more then 10 percentage points). One issue which
requires further attention is interest rate misalignments – can
___________________
2) NEER is the weighted average of bilateral nominal exchange rates of the home currency in
terms of foreign currencies. The REER, defined as a weighted average of nominal exchange rates
adjusted for relative price differential between the domestic and foreign countries
monetary policy keep its interest rate over the “natural rate of
interest” for unlimited time.
(2) Fear of floating: although euroisation in Albania can be classified
as moderate compared to other countries in region (like Croatia),
it still remains significant enough to be disregarded for its
inherent risks and implications on economy. In this environment
central bank becomes rather sensitive to exchange rate volatility
even under a free float.
A high degree of foreign currency substitution (euroisation,
dollarisation) can cause serious problems for Inflation Targeting
(Mishkin, 2000). Partial euro/dollarisation has the potential to make
inflation targeting regime, which requires some degree of exchange
rate flexibility, vulnerable to financial instability (Mishkin and
Sevastano, 2002).
In Albania the level of euro/dollarisation in terms of foreign deposits
to total baking assets is around 20-36 percent. The problems related
to euro/dollarisation need to be treated with caution in the prospect
of the declining foreign remittances that so far has reduced the
impact of drop of current account deficit and have ensured a
relatively stable exchange rate.
Unilateral euro/dollarisation in countries like Albania is already
taking place not simply because of monetary policy (or several others)
differences as much as due to the tight links these countries have with
EU (70+ percent of Albanian import/export with Italy and Greece, 30
percent of labor force is established to be working abroad, mainly in
these countries). To ensure some flexibility these countries have let
open the option of euroisation (holding fx deposits/loans, and
carrying out transition in euros). Therefore a partial euroisation unintentionally is already taking place. In Albania e.g. quite 80% of
housing transactions are done in euro. Measures to “stop” euroisation
may not be that different from measures to reduce cash economy.
Here we could mention the enforcement of transactions in domestic
currency especially of durable goods and long term contracts and of
loans. Still the question remains: how promising is this and is it worth
pursuing?
If yes, question rise: could exchange rate serve as an extra instrument
to central banks beside interest rates particularly concerning for
forthcoming capital inflows?
The uncertainties about monetary policy transmission mechanism
make it difficult to foresee the long indirect effect of interest rates and
exchange rates on inflation (Orr et al.98). While exchange rates and
interest rates could be complementary tools in short run it is less
likely so in the long run, especially when the relative importance of
real shocks is greater.
IT and Interest and Banking Channels
A sound financial system is important to the success of IT for several
reasons. A financial system could better sustain the negative impact
of eventual exchange rate volatility related to the high dollarisation.
Also, considering the several objectives BoA is following, it might be
important to examine whether Albania has missed or could miss the
inflation target if it conflicts with reaching other objectives such as
financial stability. A sound financial system would put BoA under less
pressure to trade off between objectives.
The development of the financial system is an important factor also
for the conduct of monetary policy. The actual level of financial
development in Albania is far from being adequate for an effective
monetary policy. The level of competition among banks at the
moment is still low while the money and stock markets are virtually
non existent.
As mentioned in the fist part of the draft, a turning point was marked
by the successful privatization of the Savings Bank of Albania (now
Reiffaisen Bank), by far the largest bank of the system, which until
the end of 2003 was state-owned (Box.3). This privatization sparked
a series of positive changes in the banking system such as strong
credit growth for example. In 2005 the growth of credit reached an
extraordinary velocity of almost 82 percent, though from a low base.
Box. 4 Albanian Banking System-Main features
Today, in Albania act 14 foreign – owned banks, out of 17. Some big international
names entered Albanian banking system in 2007:

Intesa SanPaolo IMI bought American Bank of Albania and Italian-Albanian
Bank (both banks were merged and by first of January 2008, operate under
American Bank of Albania trademark);

Société Générale bought 75.01% of Albanian Popular Bank.
A highly concentrated banking system emerges from statistics, where top four
banks have a share of ~ 73 percent of total assets. There is no public (stateowned) bank in Albania any more; The Albanian Government owns only a 40%
equity stake at United Bank of Albania (~EUR 3.7 mio).
Credit of householders has grown proportionally with total credit
growth with small advances against credit to business (Fig.11).
But credits to business constitute the lion share of total credit. A
considerable share of credit is extended in foreign currency. Credit in
Lek (local currency) has gained some grounds recently, mainly due to
the fatigue of funds (deposits) in foreign currency, but the preferences
of banks and businesses remain influenced toward foreign exchange
credit.
Fig.11 Household credit against total volume of credit (in mln of lek)
The long period of macroeconomic stability has created kindly
monetary conditions, reflected in low or declining interest rates and a
stable or appreciating exchange rate, even the credit ratios still low
compared to EU and SEE standards (Fig.12).
However, monetary policy transmission mechanism becomes more
uncertain as financial markets get deeper. The main concern relates
to the interest rate channel effectiveness. Previously this channel has
been adequate to influence the exchange rate by affecting prices of
traded goods. However, as price pressures from the rapid credit
6000
50
5000
40
4000
30
in %
in mln EUR
Credit/Deposit ratio 2001 - 2007
3000
20
2000
10
1000
0
2001
2002
2003
Credit to Economy (mln EUR)
0
2004
2005
Deposits
2006
2007
Credit/deposit ratio
Fig.12 Credit/Deposit ratio 2001-‘07
growth increase, interest rates channel becomes weaker. The growth
rate of credit is relatively unresponsive to interest rate changes, given
the fact that loans are largely extended in foreign currency.
Tightening of monetary policy would simply lead to appreciation with
little impact on credit volume. Forex intervention to avoid excessive
appreciation needs sterilization to maintain monetary policy
tightness.
The recent experience though, has shown that credit channel may not
be completely lost. Although, local interest rates play little role in
influencing the demand of foreign currency loans it may restrict their
supply through deposits’ rates differentials. If central banks increase
local interest rates, besides restricting demand for domestic currency
loans, reduces also the incentives of savers (investors) to put their
money in foreign exchange deposits which should reduce banks’
funds for extending foreign currency loans.
There are two “get-outs” with the above transmission channels:
First, foreign banks may force their own interest rate differential that
would dominate central bank interest rate policy;
Second, even if private banks follow central bank interests they may
borrow some foreign exchange resources from abroad, which would
be a typical case of credit boom.
If the above transmission channel fails, then central bank is left with
direct instruments such as credit ceiling. However, some other
supervisory measures have been introduced as an alternative to slow
down growth before recurring to credit ceilings, which at the same
time will aim to contain weakening of banks’ loan portfolio. Some of
these measures are: increasing reserve requirements on foreign
currency deposits above 10 percent; capital adequacy will be amended
to allow risk weights up to 150 percent to apply to high risk loans or
portions of loans; impose higher then 12 percent minimum capital
adequacy requirements on individual, relatively high-risk, banks; and
introducing stricter requirements for collateral/loan value ratios.
The importance of defining the target
From the start of the transition process the Bank of Albania was given
the task of reducing and keeping inflation at low levels. However, as
in many other independent central banks’ laws, the Bank of Albania
Law does not specify precisely what low inflation is. Even if the
ongoing debate on the right degree of flexibility in defining the exact
level of the target, a consensus has been emerging among academics
and central bankers that low inflation should be close to zero but
positive3). Some central banks in particular those applying inflation
______________________
3) Inflation rates slightly higher then zero are usually sustained on the bases of: first, once
inflation gets negative, which is very likely in a strict zero target, it may be very difficult to get out
of deflationary cycle; second, at inflation rates close to zero, rigidities could make it costly to
sustain further inflation reductions; third, possible measurement biases in CPI asks for some
allowances when targeting zero inflation
targeting like European Central Bank (ECB), have defined the
inflation level they target, while others like FED have been more
reluctant to make public a precise number.
While this regime does not necessarily require announcing an explicit
inflation target, in the case of Albania there has been a visible
objective for inflation too.
Thus, from the first Enhance Structural Adjustment Facility (ESAF)
Program signed with IMF in 1993 it was clearly stated: Following the
near-slide into hyperinflation in 1991-92, the reduction of inflation to
about 15 percent by 1996 is a key program objective: (IMF, 1993para.12).
Inflation objectives were revised each year and were regularly
mentioned in Bank of Albania annual Reports, alongside monetary
targets, which has not been a common practice in a pure monetary
targeting regime (e.g. Bundesbank).
The way inflation objective is announced or defined has been
adjusted to take into account the above problem. The definition of
meeting end-year inflation (Dec. to Dec) of 2-4 percent has been
replaced in bank’s reports with meeting annual inflation of 2-4
percent in mid-term. Mid-term horizon at the moment is defined at
around one year. The exact length of the horizon could be extended
depending on many factors which are being analyzed continuously
ranging from monetary policy transmission mechanism time length
to the confidence with which BoA assesses future inflationary
pressures.
For purely transparency reasons inflation definition has remained
headline inflation despite the recent decision to introduce a core
inflation definition by INSTAT. Switching to core inflation which
excludes food and energy items- subject to strong seasonal and
weather changes largely beyond monetary policy range of influence –
would simply disconnect the bank from public.
To that level achieving and maintaining a target of 2 to 4 percent for
mid - term period is still an appropriate objective for Albania for
several reasons:
(1) Large share of food in the consumer basket;
(2) Historical reasons;
(3) Balassa-Samuelson effects;
(4) Imported Inflation.
(1) Large food weight
As mentioned above the large weight food consumption in Albania
increases the volatility of prices. One way of getting rid of seasonal
volatility is to target average inflation. Other types of non – seasonal
volatilities should be addressed by widening the band. The 2 to 4
band in the last 5 years have proved to be reasonably appropriate to
account price volatility in spite of the changeable weather during this
period. This brings us to the historical reasons.
(2) Historical reasons
Albania has shown remarkable results in term of price stability.
Inflation has been distinguished generally by lower rates relative to
other transition economies and not far from inflation seen across EU
countries. After the initial period of transition 1991-1992 that saw
inflation levels as high as 200 percent, single digit inflation rates
prevailed until second half of 1996 when it started picking up over
20percent, largely due to fiscal dominance that characterized that
year.
In 1997 the pyramidal schemes events triggered an economic and
social chaos bringing the economy to a standstill and boosting
inflation up to 50 percent. After the turmoil of 1997, inflation has
been brought again under control to about 2-4 percent 1999, where it
has stabilized ever since. Both disinflation periods at the beginning of
transition and after 1997 have been short, without any obvious real
production and employment costs.
The actual band of 2 to 4 where inflation seems to stabilize when the
economy is not subject of major shocks could be interpreted as
equilibrium that for a mid-term period appears to be sustainable.
Nevertheless, this is a dynamic and fragile equilibrium. The catching
up process of the economy may have several implementations for
inflation. An often mention implication takes place through Balassa –
Samuelson (BS) effect.
(3) Balassa – Samuelson effect
Productivity convergence constitutes important adjustment that may
have significant implications for inflation in emerging markets. So far
BS effect does not appear to have been a significant inflationary
source in Albania. However, possible effects of BS on the exchege rate
have to be taken into consideration. Olters (2005) offered empiric
evidences which have shown that the presence of this effect has an
important significance.
Whether this will change in the future will very much depend on the
intensity of the forthcoming structural change the economy will
undergo. If any of these developments occurs, most probably it will
require upward revisions of the band to accommodate for these
necessary real adjustments.
(4)Imported Inflation
Inflation can be divided into two components, one that reflects
domestically generated inflation and one that reflects imported
inflation:
Total inflation = weight x domestic inflation + (1-weight) x imported inflation
Where: weight is domestic inflation’s share of total inflation and in
Albania is estimated to be 56 percent, which means that the weight of
imported inflation component is 44 percent (source: INSTAT).
The above three points were mostly related to domestic inflation. But,
Albania is a small and open economy with a large share of imports 42
percent of GDP). This means that imported inflation could be quite
significant. Unlike previous factors imported inflation is a component
that most likely pushes inflation down toward 2 percent level bearing
in mind that Albania’s two main trade partners are Italy (with 32
percent of total imports) and Greece (16 percent) both Eurozone
members that targets below 2 percent inflation rate.
A final argument, which is more, comforting that convincing, is the
experience of other countries in targeting inflation. As table below
shows inflation targets across these countries vary from 1 to 6
percent, with point targets on average 2 percent for industrial
countries and about 3 percent for emerging countries. The target
range is set about 1.0 to 1 .5 percentage points around the point target
for most Inflation Targeters.
Apart from the countries that at the time of Inflation Targeting
implementation have had high inflation, the range of the inflation
target is on average 2 percentage points. Many of countries that apply
wider bands tend to narrow them as inflation gets closer to their long
– term inflation objectives (Tab.3).
Table 3 Source IMF
Emerging Markets
Target
Israel
2.0
Czech Rep
3.0
Korea
3.0
Poland
2.5
Brazil
4.5
Chile
3.0
Colombia
5.0
S. Africa
4.5
Thailand
1.7
Mexico
3.0
Hungary
3.5
Peru
2.5
Philippines 4.5
Band
1-3
±1.0
2.5-3.5
±1.0
±2.5
1-4
±0.5
3-6
0-3.5
±1.0
±1.0
±1.0
3-6
Industrial Countries
Target
N. Zealand 2.0
Canada
2.0
UK
2.0
Australia
2.5
Sweden
2.0
Switzerland 2.0
Iceland
2.5
Norway
2.5
Band
1-3
1-3
2-3
±1.0
<2.0
A final point should be 3 ±1% or simply a range of 2 to 4 percent.
Again this depends very much on the confidence with which BoA
controls inflation. The former type of definition helps anchoring
inflation expectations better. However, it may also put more pressure
on central bank to explain inflation being below or above the centre
target even if it is within the ±1% range. In other words it may behave
and have the same implications as a point target. As I mentioned
above, BoA from 2001 has been announcing the 3 ±1% type of
objective rather than 2 to 4 range.
So far, it seems it has been a rewarding asymmetrically, especially
from above, in case real economic adjustments will require higher
inflation rates.
******
BoA aims to implement the inflation targeting as an efficient regime
for the implementation of the monetary policy. The implementation
of such regime is motivated by a number of reasons. Inflation
targeting encourages a higher level of transparency for the monetary
policy and as such, this regime provides the central bank with a
unique means for communicating the monetary policy to the public.
This peculiarity allows a more effective administration of the inflation
expectations, reduction of the risk prime as well as a better continuity
for the fulfillment of this objective. Furthermore, the implementation
of the monetary policy under inflation targeting is established on a
wide base of information, thus giving to BoA the opportunity to
include in the decision-making structure the increasing complexity of
the Albanian economy.
This allows to the central bank the required flexibility towards
possible macroeconomic shocks. Inflation targeting, defined as a
regime of “limited freedom” is expected to make possible a better
balance regarding the monetary policies: determining the necessary
limitations in order to avoid time discrepancy of the monetary policy
– represented by increased reliability – as well as the flexibility
required for administrating specific shock factors of the economy.
Considering that inflation targeting is accompanied with a regime of
fluctuating
exchange
rate,
it
provides
room
for
efficient
administration of external shock factors.
Lastly, benefits that BoA will derive from capacity building for the
implementation of inflation targeting should not be considered as
short - term benefits.
In the long term, the way of monetary policy is entertained with the
adaptation of the Euro, a long process if considered from the number
of years that it would take for this process to be concluded.
Conclusions
The nominal anchor used by the Bank of Albania in the last decade to
control inflation has been money supply. Although not regarded as an
orthodox regime nowadays as it used to be some twenty years ago,
monetary targeting has served Albania well judging from the low
inflation record. But the instability of money demand increases as
advances and structural changes of the financial systems take place.
The recent wake up of banking sector in Albania has urged BoA to
reconsider the actual regime, as it may become inappropriate in
attaching inflation expectations effectively in the future.
Inflation Targeting was considered as the most appropriate
alternative. Although some doubts have been raised about its
applicability in developing countries it is a good framework for at
least making clearer Central Bank’s intentions to maintain low
inflation, while allowing for some flexibility to real shocks (a major
advantage over exchange rate regimes). Several prerequisites of
inflation targeting are already present in Albania: (a) independent
central bank targeting inflation, (b) instrument independence, (c) free
floating exchange rate.
Explicit inflation targets have been announced since 1993 besides the
monetary targets. Some other elements are been developed further:
(i) forecast models, (ii) monetary policy (inflation) report.
However, other preconditions like well understood and effective
interest rate transmission mechanism, fiscal dominance (potentially)
prove to be more challenging to deal with. Most of these inflation
targeting preconditions however are indispensable for the success of
any other regime too, including the actual money targeting (MT).
Therefore, inflation targeting adoption cannot be simply judged based
on a standard compliance to these criteria.
***
Recommendations
Two critical problems need to be tackled for accelerating the progress:
(1) the inadequate technical expertise to build up the necessary tools
of inflation targeting implementation, and (2) the poor state of
economic data. The former has been addressed through technical
expertise from international institution like IMF. But, to make
technical progress sustainable over time, a strategy for developing inhouse human capital need also to be developed further.
Statistical issues represent one of the most challenging areas for
starting to implement inflation targeting. Regarding statistical data
drawbacks, several steps need to be taken to improve data sources
such as:
(a) carrying out surveys, interviews,
(b) assisting INSTAT to improve national account statistics frequency
and quality, and out of government politics as well.
(c) determining new indicators for prices of immovable assets, annual
index of industrial production and foreign debt on a quarterly basis,
surveys on foreign direct investments and measuring remittances
(d) reducing time for collecting and processing monetary data.
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