## 1. Estimates of the Demand of Banknotes (wp1855)

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---

### Context and motivation
- BoA pursued expansionary monetary policy under inflation targeting and a flexible exchange rate to counteract subdued growth and below-target inflation.
- Reacting to disinflation in Q1 2016, BoA cut policy rates to:
  - policy rate: 1.25 percent (May 2016)
  - deposit facility rate: 0.25 percent
  - marginal lending facility rate: 2.25 percent
- Key policy question: how far could policy rates be further lowered as the policy rate reached its lowest level in Albania?
- Global backdrop:
  - World real interest rates have been in secular decline over the past 30 years.
  - Since the global financial crisis, interest rates have fallen further toward zero.
  - A two percent inflation target would now put nominal interest rates at two percent on average over the cycle.

### Methodology and provenance
- Framework introduced to empirically assess the lower bound for the policy rate in small, open, and euroized economies with strong links to the euro area.
- Methodology developed in the context of IMF technical assistance to Albania financed by the Swiss Government.
- Section I of the paper estimates impact of the lower deposit rate on demand for banknotes in Albania, including demand for large denominations.

### Key concepts and definitions
- Technical Lower Bound (TLB):
  - The nominal interest rate at which the transmission mechanism breaks down completely due to a wide-scale shift into cash.
- Effective Lower Bound (ELB):
  - The point at which either (1) conventional policy rate becomes ineffective; or (2) unintended and adverse consequences from policy rate cuts imply a negative risk-reward profile for policymakers.
  - ELB may coincide with TLB or be equal to or higher than TLB; ELB encapsulates TLB.

### Stylized facts on Albania’s cash use and financial structure
- Currency in circulation as a percentage of GDP and M3 is higher in Albania than regional peers.
- Broad money to GDP is higher in Albania than peer countries; banking sector size increased by remittance accounts.
- Factors reinforcing cash preference:
  - Banking crisis in late 1990’s reduced trust in banks.
  - Hysteresis: fixed costs of cash handling and habit persistence.
  - Low penetration of banking services in rural areas and underdeveloped payment infrastructure.
  - A large informal economy estimated at 40 percent of GDP.
- Historical trend:
  - Cash-to-M3 and cash-to-GDP ratios declined secularly but trend stopped and slightly reversed since domestic-currency deposit interest rates reached historically low levels in 2014.

### Econometric framework
- Panel estimator (Equation 1): regress local currency in circulation to GDP on log(GDP per capita), local currency deposit to GDP, foreign currency deposit to GDP, local currency deposit rate, country and year fixed effects.
- Albania VECM (Equation 2): 5×1 vector of local currency to GDP, log GDP per capita, local currency deposit to GDP, foreign currency deposit to GDP, local currency deposit rate; captures long-run relation and short-term dynamics.

### Key empirical findings (panel and Albania VECM)
- Panel estimates (Observations: 1,503 and 1,349; Time period: 2006-2015; Number of countries: 154):
  - Log GDP per capita coefficient: -1.484*** and -1.247***.
  - Local currency deposit to GDP: 0.0142*** and 0.0123**.
  - Foreign currency deposit to GDP: -0.0402*** and -0.00614.
  - Local currency deposit rate: -0.0385* and -0.0422**.
  - Albania fixed effect: 4.862***.
- Albania VECM estimates (Observations: 57; Time period: 2002 Q2 - 2016 Q2):
  - Co-integrating equation (selected): Log GDP per capita -1.180*; Local currency deposit to GDP -0.122***; Foreign currency deposit to GDP -0.019***; Local currency deposit rate -0.314***.
  - Error correction (selected short-run): Log GDP per capita -3.637***; Local currency deposit to GDP -0.0549***; Foreign currency deposit to GDP -0.163; Local currency deposit rate -0.389**.
- Interpretation:
  - Low deposit rates boost demand for banknotes in most countries; negative correlation between deposit rates and banknote demand corroborated.
  - Albania shows a stronger negative correlation between deposit rates and banknote demand than in the panel.
  - In Albania, financial depth shows negative correlation with banknote demand in time series (interpreted as ongoing financial inclusion).

### Demand for large-denomination banknotes
- Empirical facts:
  - Share of the two largest denominations (equivalent of $60 and $25) increased from less than 10 percent to more than 30 percent during the last 10 years.
  - Share of smaller banknotes declined; medium-sized denominations remained stable.
- Model (Equation 3) regressors: log(real GDP per capita), log(CPI), lek deposit rate, euro deposit rate, and quarter dummies.
- Key regression coefficients and statistics (time periods and observations preserved):
  - Shr5000 (largest denomination; Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.969):
    - Log(real GDP per capita): 9.947**.
    - Log(CPI): 24.11***.
    - Lek deposit rate: -0.518***.
    - Euro deposit rate: -0.938***.
  - Shr2000 (Time period: 2009Q1 - 2016Q2; Observations: 30; R-squared: 0.986):
    - Log(real GDP per capita): 2.168.
    - Log(CPI): 67.24***.
    - Lek deposit rate: -0.887*.
    - Euro deposit rate: -0.972.
  - Shr1000 (Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.710):
    - Log(real GDP per capita): 22.60*.
    - Log(CPI): -26.35.
    - Lek deposit rate: 0.939**.
    - Euro deposit rate: 2.283***.
  - Shr500 (Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.960):
    - Log(real GDP per capita): 10.94.
    - Log(CPI): -88.43***.
    - Lek deposit rate: 0.225.
    - Euro deposit rate: 1.428***.
  - Shr200 (Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.540):
    - Log(real GDP per capita: -3.279.
    - Log(CPI): -2.978.
    - Lek deposit rate: -0.139.
    - Euro deposit rate: -0.284.
  - Shr100 (Time period: 2003Q2 - 2016Q2; Observations: 29; R-squared: 0.959):
    - Log(real GDP per capita: -9.781*.
    - Log(CPI): 20.93**.
    - Lek deposit rate: 0.669***.
    - Euro deposit rate: -2.507***.
- Interpretation:
  - Lower lek deposit rates significantly increase demand for large-denomination banknotes (negative lek deposit rate coefficients for largest denominations).
  - Euro deposit remuneration also matters: demand for large lek denominations is negatively and significantly correlated with euro deposit rates, highlighting importance of lek-euro interest rate spread.

### Conclusion on TLB
- Strong and negative correlation between interest rates and demand for cash, especially large denominations.
- Low interest rates slowed financial deepening historically.
- TLB has not been reached yet: increased banknote demand does not yet indicate a large-scale shift into cash that would seriously impair transmission.
- Cautionary notes:
  - Relationship may present nonlinearities (negative correlation could surge below a certain interest rate).
  - Investors may develop alternative strategies if returns remain below minimum acceptable for long.

### Determinants of the Effective Lower Bound (ELB)
- ELB reflects likelihood that unintended/adverse consequences of very low policy rates will materialize.
- Two broad categories of unintended consequences:
  1. Those affecting functioning/efficiency of the transmission mechanism.
  2. Those affecting financial stability.
- Identification of unintended consequences does not automatically imply ELB is reached because:
  - Consequences may be mitigated by changes in the monetary policy framework.
  - Consequences may develop over time; central banks can cut further and monitor.
  - Policymakers must weigh trade-offs between unintended consequences and cost of keeping rates higher than needed for price stability.
- ELB can change over time due to evolving factors, agents’ adaptation, and sequencing of policy actions.
- Non-conventional tools may be preferred once ELB assessment suggests diminishing returns from further policy-rate cuts.

### Impairment in the transmission mechanism
- Two phenomena impair transmission beyond cash hoarding:
  1. Rigidities and nonlinearities of the transmission mechanism.
  2. Euroization impacts on the credit channel.
- Rigidities and nonlinearities:
  - Banks may not lower deposit rates sufficiently at low policy rates due to deposit outflow risk and margin maintenance.
  - Transmission of negative policy rates to retail deposit rates internationally has been weak.
  - Regulation in small, open, and euroized economies often prevents remuneration of customer funding at negative rates, reinforcing nominal rigidity.
  - In Albania:
    - Monetary policy pass-through has not declined as policy rate moved toward 1 percent: changes passed through to interest rates of new deposits and new credits.
    - Policy-rate changes transmitted to the risk-free yield curve with tendency to flatten at low rates.
- Euroization and exchange rate channel:
  - In heavily euroized economies, low domestic–foreign interest rate differential can trigger depreciation that:
    - Raises debt-servicing costs on foreign-currency loans, increasing NPLs and reducing bank profitability (BoA stress test: a 10 percent depreciation adds 3.1 percentage points to NPL ratios for foreign-currency loans in the first year and 2.1 percentage points in two years).
    - Encourages further financial euroization, reducing monetary policy scope because foreign-currency asset yields in the domestic system are unlikely to fall below zero.
  - BoA/central bank implications:
    - May need to maintain a minimum interest rate differential relative to foreign-currency substitute assets to prevent currency reallocation.
    - Minimum must account for nominal rigidities preventing negative remuneration on foreign-currency deposits and depreciation expectations.
    - Alternative domestic measures (higher reserve requirements, lower reserve requirement remuneration, stricter HQLA requirements) could reduce attractiveness of foreign-currency deposits, but domestic investment opportunities are limited.

### Financial stability channels (four channels)
- 1. Euroization with large unhedged exchange-rate exposures.
  - Euro deposit share increased from 40 percent to 50 percent of total deposits from 2006 to 2016.
  - IMF estimates: an increase of 1 percentage point in the spread between BoA and ECB monetary policy rates reduces the share of foreign currency deposits between 0.8 and 0.9 percentage points during 2007–16.
- 2. Banks’ profitability erosion.
  - Literature: positive relationship between short-term rates and bank profitability and between yield-curve slope and profitability.
  - In Albania:
    - Net interest margin: 3.9 percent in 2017 from 4.2 percent at end-2016; long-term average: 4.1 percent.
    - Net interest income constitutes around 81 percent of banking sector income.
- 3. Banks’ funding-structure shifts.
  - “Thinning of the middle”: decline in 1–12 month savings deposits as savers shift to demand/current accounts or longer-dated deposits.
  - No corresponding move to more marketable assets on banking system asset side observed.
- 4. Asset bubbles and capital misallocation.
  - Prolonged low rates can induce “search for yield,” pushing asset prices beyond fundamentals or increasing leverage.
  - In Albania risks appear low: credit growth moderate due to stricter lending standards; property prices sluggish with large stock of unsold and unfinished projects.

### Proposal: Systematic monitoring framework (ELB Barometer)
- Purpose:
  - Identify early-warning signals that unintended consequences of low rates are materializing and may outweigh benefits, signaling the ELB.
  - Guide policy-rate decisions to anticipate transmission weakening and financial-stability effects.
- Six monitoring dimensions used by BoA:
  1. Financial euroization.
  2. Exchange rate developments and trends.
  3. Banks’ profitability.
  4. Financial intermediation and disintermediation.
  5. Average maturity of banks’ deposits.
  6. Saving rates.
- Operationalization:
  - Compare each indicator’s current value against benchmark measured as average level and/or standard deviation over past two years.
  - Normalize each indicator on a 0–1 scale where 0 = lowest value over past two years and 1 = highest value over past two years; mean indicates midpoint.
  - Values approaching upper limit (1) signal worsening; lower limit (0) signal improvement.
  - Visual bands: green = safe; red = warning.
- Use:
  - Provide systematic, timely signals to complement economic judgment on whether ELB is approaching or reached.

### Box 1 — The 12 barometer variables (definitions and monitoring rules)
- 1. Volume of interbank lending as a ratio to the reserve requirement (daily data averaged for last month; compared to average of last two years).
- 2. CiC as percent of total financial assets in lek (includes deposits in lek and government securities in lek held by households).
- 3. Volatility of CiC/total financial assets in lek measured as standard deviation of monthly changes.
- 4. Spread of currency deposit interest rate between lek and euro (monthly, time deposit interest rates).
- 5. Euro/lek exchange rate (monthly) compared to average of last two years.
- 6. Volatility of euro/lek exchange rate measured as standard deviation of monthly changes.
- 7. Liquid deposit in lek as percent of total deposit in lek for households (monthly).
- 8. Volatility of ratio of liquid deposits to total deposits in lek of households measured as standard deviation of monthly changes.
- 9. Banking system return on equity (monthly); should exclude one-off provisioning changes.
- 10. Banking system net interest income-to-risk-weighted-assets ratio (monthly; includes lek and foreign currency assets).
- 11. Euro deposits as percent of total financial assets (monthly; includes all deposits and government securities held by households).
- 12. Interest rate spread between lending rate in lek and policy rate (monthly).

### Use, recent assessment, and interpretation of the barometer
- The barometer signals extent in which undesirable effects of low rates are materializing and their relative strength; it complements but does not replace policy judgment.
- ELB barometer was widely used in Albania throughout 2016 and again in 2017.
- Mid-2017 reading (Figure 10 summary):
  - Of the 12 risk variables, nine are above historical values; of those nine, four at or close to historical records.
  - Nuances:
    - Interest rate differential at historical lows did not induce abnormal exchange rate depreciation or volatility.
    - Trend toward higher euroization detectable, but financial disintermediation not a major concern (cash-to-lek financial assets ratio).
    - Deterioration in return on equity largely due to spike in provisioning; risk-adjusted returns close to historical lows.
    - Despite trend toward lower maturities on liabilities, transmission mechanism not impaired (spread between loan and policy rates and interbank market activity).

### Policy implications and recommendations
- Medium-term:
  - Reduce public’s preference for cash and for saving in euro via development of a credible track record of low and stable inflation and financial sector stability.
- Short-term measures to enhance pass-through of negative euro area interest rates to domestic financial sector:
  - (i) Align remuneration rate of foreign currency–denominated reserve requirements to the same rate applied by the ECB on its deposit facility (i.e. -40 basis point).
  - (ii) Allow banks, according to their own business decisions and assessment, to charge negative interest rates on euro-denominated deposits.
- Contextual assessment:
  - With Albanian inflation underpinned by a narrowing output gap, steady growth rates, and lower disinflationary forces from the euro area, the ELB has become somewhat less topical.
  - The ELB barometer can be used by other countries facing similar policy challenges; BoA has a more robust monitoring framework and ELB assessment may become topical again in future easing cycles or if downside risks to price stability materialize.

*Source: wp1855*

### 1. Estimates of the Demand of Banknotes ................................................................................

### 1. Estimates of the Demand of Banknotes

### Context and motivation
- Bank of Albania (BoA) pursued an expansionary monetary policy in the context of inflation targeting and a flexible exchange rate to counteract subdued economic growth and below-target inflation.
- Reacting to disinflation in Q1 2016, the BoA cut policy rates to:
  - policy rate: 1.25 percent (May 2016)
  - deposit facility rate: 0.25 percent
  - marginal lending facility rate: 2.25 percent
- The key policy question: how far could policy rates be further lowered as the policy rate reached its lowest level in Albania?
- Global backdrop:
  - Over the past 30 years, world real interest rates have been in secular decline.
  - Since the global financial crisis, interest rates have fallen further toward zero.
  - A two percent inflation target would now put nominal interest rates at two percent on average over the cycle, reducing the room above zero for monetary policy.

### Methodology and provenance
- The paper introduces a framework to empirically assess the lower bound for the policy rate in small, open, and euroized economies with strong links to the euro area.
- The methodology was developed in the context of IMF technical assistance to Albania financed by the Swiss Government.
- Section I of the paper estimates the impact of the lower deposit rate on the demand for banknotes in Albania, including demand for large denomination banknotes.

### Key concepts and definitions
- Technical Lower Bound (TLB):
  - The nominal interest rate at which the transmission mechanism (mostly via the interest rate channel) breaks down completely.
  - Occurs at an interest level below which a wide-scale shift of financial assets into cash would occur, depriving monetary policy of leverage on economic and financial agents.
- Effective Lower Bound (ELB):
  - The point at which either:
    1. monetary policy, conducted through the conventional policy rate lever, becomes ineffective; or
    2. unintended and adverse consequences from policy rate cuts imply a negative risk-reward profile for policymakers.
  - At the ELB, policymakers should consider employing additional policy tools, either as a substitute or complement to further policy rate cuts.
  - The ELB may coincide with the TLB if lower policy rates bring minor adverse consequences; otherwise the ELB will be equal to or higher than the TLB.
  - The ELB concept encapsulates the TLB concept.

### Policy relevance and implications for Albania
- The lower policy rate bound question is especially pertinent given:
  - Albania’s historical low policy rate levels reached in 2016.
  - Risks of further downside shocks to inflation and possible dis-anchoring of inflation expectations.
  - The structural context of low global interest rates and a low-inflation environment that compresses nominal interest rate space.
- The paper aims to quantify how reductions in deposit rates affect banknote demand—information critical to assessing when the TLB or ELB might bind and when alternative policy tools should be considered.

*Source: wp1855 - 1. Estimates of the Demand of Banknotes*

### Section II analyzes the determinants of the ELB. Section III proposes a framework to monitor

### wp1855 - Section II analyzes the determinants of the ELB. Section III proposes a framework to monitor

### Determinants of the Technical Lower Bound (TLB)
- The TLB depends on the sensitivity of the demand for banknotes to the interest rate paid on banks’ deposits.
- Public demand for banknotes is driven mainly by transactions (GDP and prices), portfolio decisions, and payment-method innovations.
- The opportunity cost of holding zero-yielding banknotes is the deposit interest rate; the influence of interest rates on banknote demand is the focus.

### The Demand for Banknotes in Albania
- Stylized observations:
  - Currency in circulation as a percentage of GDP and M3 is higher in Albania than regional peers.
  - Broad money to GDP is higher in Albania than peer countries; banking sector size is increased by remittance accounts.
  - Factors reinforcing cash preference in Albania:
    - Banking crisis in late 1990’s reduced trust in banks.
    - Hysteresis: fixed costs of cash handling and habit persistence.
    - Low penetration of banking services in rural areas and underdeveloped payment infrastructure.
    - A large informal economy estimated at 40 percent of GDP.
- Historical trend:
  - Cash-to-M3 and cash-to-GDP ratios were on a secular decline reflecting formalization and payment system development, but the trend stopped and slightly reversed since domestic-currency deposit interest rates reached historically low levels in 2014.
- Econometric framework (panel and Albania-specific):
  - Panel estimator (Equation 1) regresses local currency in circulation to GDP on:
    - log(GDP per capita), local currency deposit to GDP, foreign currency deposit to GDP, local currency deposit rate, country and year fixed effects.
  - Albania VECM (Equation 2) includes a 5×1 vector: local currency to GDP, log GDP per capita, local currency deposit to GDP, foreign currency deposit to GDP, and local currency deposit rate; model captures long-run relation and short-term dynamics.
- Key empirical findings (Table 1, panel and Albania VECM):
  - Panel estimates:
    - Log GDP per capita coefficient: -1.484*** (Local CIC to GDP) and -1.247*** (Local CIC to GDP, differenced specification).
    - Local currency deposit to GDP: 0.0142*** and 0.0123**.
    - Foreign currency deposit to GDP: -0.0402*** and -0.00614.
    - Local currency deposit rate: -0.0385* and -0.0422**.
    - Albania fixed effect: 4.862*** (positive and significant).
    - Observations: 1,503 and 1,349; Time period: 2006-2015; Number of countries: 154.
  - Albania VECM estimates:
    - Co-integrating equation (selected coefficients): Log GDP per capita -1.180*; Local currency deposit to GDP -0.122***; Foreign currency deposit to GDP -0.019***; Local currency deposit rate -0.314***.
    - Error correction equation (selected short-run coefficients): Log GDP per capita -3.637***; Local currency deposit to GDP -0.0549***; Foreign currency deposit to GDP -0.163; Local currency deposit rate -0.389**.
    - Observations: 57; Time period: 2002 Q2 - 2016 Q2.
  - Interpretation:
    - Low deposit rates boost demand for banknotes in most countries; the negative correlation between deposit rates and banknote demand is corroborated.
    - Albania exhibits a stronger negative correlation between deposit rates and banknote demand than in the panel.
    - In Albania, financial depth shows a negative correlation with banknote demand in time series (interpreted as ongoing financial inclusion).

### Demand of Large-Denomination Banknotes
- Empirical facts:
  - The share of the two largest denominations (equivalent of $60 and $25) increased from less than 10 percent to more than 30 percent during the last 10 years.
  - Share of smaller banknotes declined; medium-sized denominations remained stable.
- Model (Equation 3) for share of each banknote:
  - Regressors: log(real GDP per capita), log(CPI), local currency deposit rate (lek deposit rate), foreign currency (euro) deposit rate, and quarter dummies.
- Key empirical results (Table 2, coefficients preserved):
  - Shr5000 (share of largest denomination):
    - Log(real GDP per capita): 9.947**.
    - Log(CPI): 24.11***.
    - Lek deposit rate: -0.518***.
    - Euro deposit rate: -0.938***.
    - Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.969.
  - Shr2000:
    - Log(real GDP per capita): 2.168.
    - Log(CPI): 67.24***.
    - Lek deposit rate: -0.887*.
    - Euro deposit rate: -0.972.
    - Time period: 2009Q1 - 2016Q2; Observations: 30; R-squared: 0.986.
  - Shr1000:
    - Log(real GDP per capita): 22.60*.
    - Log(CPI): -26.35.
    - Lek deposit rate: 0.939**.
    - Euro deposit rate: 2.283***.
    - Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.710.
  - Shr500:
    - Log(real GDP per capita): 10.94.
    - Log(CPI): -88.43***.
    - Lek deposit rate: 0.225.
    - Euro deposit rate: 1.428***.
    - Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.960.
  - Shr200:
    - Log(real GDP per capita): -3.279.
    - Log(CPI): -2.978.
    - Lek deposit rate: -0.139.
    - Euro deposit rate: -0.284.
    - Time period: 2003Q2 - 2016Q2; Observations: 53; R-squared: 0.540.
  - Shr100:
    - Log(real GDP per capita): -9.781*.
    - Log(CPI): 20.93**.
    - Lek deposit rate: 0.669***.
    - Euro deposit rate: -2.507***.
    - Time period: 2003Q2 - 2016Q2; Observations: 29; R-squared: 0.959.
- Interpretation:
  - Lower lek deposit rates significantly increase the demand for large-denomination banknotes (negative coefficient on lek deposit rate for largest denominations).
  - Euro deposit remuneration also matters: demand for large lek denominations is negatively and significantly correlated with euro deposit rates, highlighting the lek-euro interest rate spread importance.
- Conclusion on TLB:
  - Strong and negative correlation between interest rates and demand for cash, especially large denominations.
  - Low interest rates slowed financial deepening historically.
  - The TLB has not been reached yet: increased banknote demand does not yet indicate a large-scale shift into cash that would seriously impair transmission.
  - Cautionary notes:
    - Relationship may present nonlinearities (negative correlation could surge below a certain interest rate).
    - Investors may develop alternative strategies if returns remain below minimum acceptable for long.

### Determinants of the Effective Lower Bound (ELB)
- ELB reflects the likelihood that unintended/adverse consequences of very low policy rates will materialize.
- Two broad categories of unintended consequences:
  1. Those affecting functioning/efficiency of the transmission mechanism.
  2. Those affecting financial stability.
- Identification of unintended consequences does not automatically imply the ELB is reached because:
  - Consequences may be mitigated by changes in monetary policy framework.
  - Consequences may develop over time; central banks can cut further and monitor.
  - Policymakers must weigh trade-offs between unintended consequences and the cost of keeping rates higher than needed for price stability.
- The estimated ELB can change over time due to evolving factors, central bank reassessments, agents’ adaptation, and sequencing of policy actions.
- Non-conventional tools may be preferred once the ELB assessment suggests diminishing returns from further policy-rate cuts.

### Impairment in the Transmission Mechanism
- Two phenomena that can impair transmission beyond cash hoarding:
  1. Rigidities and nonlinearities of the transmission mechanism.
  2. Euroization impacts on the credit channel.

- Rigidities and nonlinearities:
  - Banks may not lower deposit rates sufficiently at low policy rates due to deposit outflow risk; they may maintain interest rate margins.
  - Transmission of negative policy rates to retail deposit rates internationally has been weak; overall transmission to funding costs depends on share of wholesale funding and elasticity of deposit supply.
  - Regulation in small, open, and euroized economies often prevents remuneration of customer funding at negative rates, reinforcing nominal rigidity.
  - In Albania:
    - Monetary policy pass-through has not declined as policy rate moved toward 1 percent: changes in policy rate passed through to interest rates of new deposits and new credits.
    - Policy-rate changes transmitted to the risk-free yield curve with tendency to flatten at low rates.

- Euroization and exchange rate channel:
  - Exchange rate depreciation is a key transmission mechanism in small, open economies.
  - In heavily euroized economies, a low domestic–foreign interest rate differential can trigger depreciation that:
    - Raises debt-servicing costs on foreign-currency loans, increasing NPLs, provisions, and reducing bank profitability—banks may raise lending rates, offsetting easing (BoA econometric evidence: credit risk premia on new loans strongly correlated with past exchange rate developments).
    - Encourages further financial euroization, reducing monetary policy scope because foreign-currency asset yields in the domestic system are unlikely to fall below zero.
  - Central bank implications:
    - May need to maintain a minimum interest rate differential relative to foreign-currency substitute assets to prevent currency reallocation.
    - This minimum must account for nominal rigidities that prevent negative remuneration on foreign-currency deposits and exchange rate depreciation expectations.
    - Alternative domestic policy measures (higher reserve requirements, lower reserve requirement remuneration, stricter HQLA requirements) could reduce attractiveness of foreign-currency deposits, but domestic investment opportunities are limited.

### Financial Stability Channels
- Four channels through which low policy rates could harm financial stability in Albania:
  1. Euroization with large unhedged exchange-rate exposures.
  2. Banks’ profitability erosion.
  3. Banks’ funding-structure shifts.
  4. Asset bubbles and capital misallocation.

- Euroization:
  - Lek depreciation after the crisis increased NPLs on foreign-currency-denominated loans.
  - BoA stress test: a 10 percent depreciation adds 3.1 percentage points to NPL ratios for foreign-currency loans in the first year and 2.1 percentage points in two years.
  - Euro deposit share increased from 40 percent to 50 percent of total deposits from 2006 to 2016.
  - An increase of 1 percentage point in the spread between BoA and ECB monetary policy rates reduces the share of foreign currency deposits between 0.8 and 0.9 percentage points during 2007–16 (IMF estimates).

- Banks’ profitability:
  - Literature (Borio and others 2015) shows positive relationship between short-term rates and bank profitability and between yield-curve slope and profitability.
  - Unusually low rates and flat term structure tend to erode net interest income more than they reduce loan loss provisions or increase non-interest income.
  - In Albania:
    - Net interest margin: 3.9 percent in 2017 from 4.2 percent at end-2016; long-term average: 4.1 percent.
    - Net interest income constitutes around 81 percent of banking sector income.

- Funding structure effects:
  - “Thinning of the middle”: decline in 1–12 month savings deposits as savers shift to demand/current accounts (liquidity) or longer-dated deposits (yield).
  - This shift has not produced a move to more marketable assets on banking system asset side, nor a shift into shorter-term government paper or shorter-duration credit.

- Asset bubbles and misallocation:
  - Prolonged low rates can induce “search for yield,” pushing asset prices beyond fundamentals or increasing leverage.
  - These risks can be mitigated by targeted micro- and macroprudential policies, but timely identification is challenging.
  - In Albania risks appear low: credit growth moderate due to stricter lending standards; property prices sluggish with large stock of unsold and unfinished projects.

### Proposal for a Systematic Monitoring Framework (Barometer)
- Purpose:
  - Identify early-warning signals indicating that unintended consequences of low rates are materializing and may outweigh benefits, signaling the ELB.
  - Guide policy-rate decisions to anticipate transmission weakening and financial-stability effects.
- Six monitoring dimensions used in BoA framework:
  1. Financial euroization.
  2. Exchange rate developments and trends.
  3. Banks’ profitability.
  4. Financial intermediation and disintermediation.
  5. Average maturity of banks’ deposits.
  6. Saving rates.
- Operationalization (barometer approach):
  - Compare each indicator’s current value against benchmark measured as average level and/or standard deviation over past two years.
  - Normalize each indicator on a 0–1 scale where 0 = lowest value over past two years and 1 = highest value over past two years; the mean indicates the midpoint.
  - Values approaching upper limit (1) signal worsening; lower limit (0) signal improvement.
  - Visual bands: green = safe; red = warning.
- Use of the tool:
  - Provide systematic, timely signals to complement economic judgment on whether ELB is approaching or reached.
  - Box 1 in the source provides descriptions of variables used in the barometer.

*Source: IMF staff analysis presented in the provided content unit.*

### Box 1. The Variables of the Barometer

### Box 1. The Variables of the Barometer

### Definitions and monitoring rules for the 12 variables
- 1. The volume of interbank lending as a ratio to the reserve requirement.  
  - Further lowering of policy rate and the narrowing of the corridor might lower incentives for interbank trading.  
  - Considering frictions in the market, it is important to monitor the volume of interbank transactions in relation to reserve requirement needs, so that monetary policy does not endanger activity in this market.  
  - The data are daily, averaged for the last month and compared to the average of the last two years.

- 2. The CiC as a percent of total financial assets in lek. The latter includes deposits in lek as well as government securities in lek held by households.  
  - Currently, this ratio stands above its average of the last two years. As the interest rate approaches the lower bound, the tendency to keep cash increases considering the opportunity cost. Although it is very difficult to measure the cost of keeping cash, which would ideally be the lower bound of interest rates, monitoring the increase of cash outside banks should give a signal for being close to that bound.

- 3. The volatility of CiC/total financial assets in lek measured as the standard deviation of monthly changes.  
  - This measure captures the speed of a growing preference for keeping cash. As this preference increases, it should give some signal that monetary policy is having adverse effects.

- 4. The spread of currency deposit interest rate between lek and euro (monthly, time deposit interest rates).  
  - The spread between time deposit interest rate in euro and that in lek incentivizes the holding of one currency or the other. As the spread minimizes, the incentive to hold hard currency increases, spurring implications for the exchange rate, which in turn endangers financial stability given the considerable share of unhedged loans in euro.  
  - Currently, this spread is at the minimum of its historical values of last two years, but with no visible effect on the exchange rate.

- 5. The euro/lek exchange rate (monthly).  
  - The level of exchange rate is compared to an average of last two years, in relation to the considerations mentioned above.

- 6. The volatility of euro/lek exchange rate measured as standard deviation of monthly changes.  
  - The measure captures the magnitude of depreciation of the euro/lek exchange rate compared to its historical development.

- 7. Liquid deposit in lek in percent to total deposit in lek for households (monthly).  
  - Comparable to the meaning of indicator #2, this indicator gives a signal for savers switching to liquid assets as time deposits start to yield low returns. Currently, this ratio is at the maximum of its last two years.

- 8. The volatility of the ratio of liquid deposits to total deposits in lek of households measured as a standard deviation of monthly changes.  
  - This measure captures the magnitude of change of the ratio relative to its average of last year. As the ratio increases, the households’ preference to shift to liquid assets is growing faster.

- 9. Banking system return on equity (monthly).  
  - This indicator suggests the impact of low interest rates on banks’ profitability. As the interest rates for deposit is reaching a low bound (zero), the transmission of monetary policy is expected to affect only the lending rates reducing the interest rate margin, which accounts for a considerable part of income. The measure should exclude eventual one-off changes in provisioning rules.

- 10. Banking system net interest income-to-risk-weighted-assets ratio (monthly).  
  - This is a more straightforward indicator that captures the return on banks’ policies to invest and to take risk. It also includes investments in securities, but the bulk of risk-weighted assets is composed of lending. The lower the return, the less willing are banks to take risk. Currently this indicator is close to its minimum of the last two years. The data are monthly and include lek and foreign currency assets.

- 11. Euro deposits as a percent of total financial assets. The latter includes all deposits, as well as government securities held by households (monthly).  
  - This indicator compares to indicators #4 and #5, and tries to capture the tendency for increasing euroized assets as the return of lek assets diminishes. Increasing euroization is an adverse impact of further easing of monetary policy. Currently, this ratio is slightly below its maximum level over the last two years.

- 12. Interest rate spread between lending rate in lek and policy rate (monthly).  
  - While this is a very volatile indicator, the correlation between lending rate and policy rate appears to have strengthened in the last two years. Hence the lending rate will follow the movements in policy rate, albeit with some lags. Once this correlation weakens, it warns of fading transmission of policy rates through the lending channel. In tandem, we look at the credit conditions (not included in the barometer). Currently, the spread of lending rate and policy rate is at its minimum over the last two years, while credit conditions are easing gradually.

### Use, recent assessment, and interpretation
- The barometer is an effective tool to monitor the different relevant indicators of the effective lower bound. It signals the extent in which undesirable effects are materializing and the relative strength of these effects. It facilitates policy decision, but it does not replace policy judgment on issues such as the trade-off between the costs and the benefits of lower policy rates relative to alternative policies. The indicators to use in the barometer, their relative importance, their number, and the scale to use for each indicator can obviously be adjusted.
- The ELB barometer was widely used as a monitoring tool in Albania throughout 2016 and again in 2017. Given the uncertainty over the possibility of a further downward drift of inflation expectations, the need for additional monetary stimulus could not be ruled out. The ELB barometer has continuously been a key instrument used to assess the room for further policy rate cuts and to inform the BoA of the impact of the low interest rate environment on the key identified risk dimensions.
- A reading of the barometer as of mid-2017 is depicted in Figure 10. The low policy rate environment was assessed to cause some stress in the identified risk dimensions. The stress was not spread equally across all dimensions:
  - Of the 12 identified risk variables, nine are above historical values. Of those nine, four are at or close to historical records.
  - Nuanced observations:
    - While the interest rate differential was at historical lows, it was not inducing any abnormal exchange rate depreciation or exchange rate volatility.
    - While a certain trend towards higher euroization levels can be detected, financial disintermediation does not appear to be much of a concern, as evidenced by the cash-to-lek financial assets ratio.
    - An external analysis indicates the deterioration in the return on equity is largely due to a spike in provisioning, though risk-adjusted returns in the banking system are close to historical lows.
    - Despite a trend towards lower maturities in the liabilities side of the banking system balance sheet, the transmission mechanism appears to be not impaired, as evidenced by the reading on spread between loan and policy rates and by the interbank market activity.

### Policy implications and recommendations
- Medium-term policy actions to attenuate ELB constraints:
  - Reduce the public’s preference for cash and for saving in euro through development of a credible track record of low and stable inflation as well as financial sector stability. This is a medium to long-term endeavor.
- Short-term measures to enhance pass-through of negative euro area interest rates to the domestic financial sector:
  - (i) Align the remuneration rate of foreign currency–denominated reserve requirements to the same rate applied by the ECB on its deposit facility (i.e. -40 basis point).
  - (ii) Allow banks, according to their own business decisions and assessment, to charge negative interest rates on euro-denominated deposits.
- Contextual assessment:
  - With the Albanian inflation rate underpinned by a narrowing output gap, steady economic growth rates, and lower disinflationary forces from the euro area, the ELB has become somewhat less topical. These factors, although slowly and with a considerable lag, should contribute to return of inflation to target.
  - The approach and instrument could be used by other countries facing similar policy challenges; the BoA now has a more robust and comprehensive monitoring framework; and the assessment of the ELB may become topical again at the time of any future easing cycle or if further downside risks to price stability materialize, especially if equilibrium real interest rates remain low in the future.

*Source: authors*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1855.pdf_