## _cr10119

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### Capital flows, inflation targeting, and foreign-exchange strategy
- Findings:
  - Poland likely to attract renewed capital inflows after avoiding outright recession during the crisis.
  - Risks from rapid inflows: excessive exchange-rate appreciation undermining competitiveness; overheating with domestic credit booms and asset-price bubbles.
  - Foreign-exchange intervention can be prudent to resist appreciation when the REER rises beyond fundamentals and when authorities can build reserves.
- Trade-offs and costs:
  - Purchases of foreign exchange can complement interest-rate cuts when no inflationary pressures exist, but under a rising output gap and overheating:
    - Tighter domestic interest rates can induce further capital inflows and undermine intervention objectives.
    - Purchases of foreign exchange need to be fully sterilized to support tighter monetary conditions, which can be costly.
  - Benefits of reserve accumulation: precautionary balances against current and capital account shocks.
  - Costs of reserve accumulation: opportunity cost of foregone consumption and investment, proxied by the spread between interest paid on country debt and risk-free return of reserves.
- Practical guidance for Poland:
  - A flexible exchange-rate policy remains the main defense against a sustained surge in capital inflows.
  - Early, temporary, limited foreign-exchange intervention could be considered if transparent, well-communicated, and timed with the economic cycle.
  - Guidotti-Greenspan adequacy metric cited: “100 percent coverage of gross financing requirements (short-term debt at remaining maturity plus the current account balance)”; estimated additional FX reserves needed for Poland: $20-25 billion.
  - Access to the IMF’s Flexible Credit Line noted as a potential source of FX liquidity.

### Case studies: Israel and Colombia (lessons on timing, sterilization, credibility)
- Israel (March 2008 program):
  - BoI initiated a two-year $10 billion FX accumulation program; target range identified: $35-40 billion, later raised to $40-44 billion.
  - Implementation: pre-announced daily operations $25 million/day initially; by mid-2008 daily size increased to $100 million.
  - Outcomes and figures:
    - Revised target reached by early 2009 (one year earlier than planned); BoI maintained program until August (year not specified).
    - End-July (year not specified) FX reserves reached $52 billion; end-2009 reserves were $60.6 billion, reflecting SDR allocation of $1.2 billion.
    - Reserves coverage of imports rose from 4 ½ months to 12 months over the period.
    - Exchange-rate movements: December-2007 to July-2008 REER rose close to 20 percent; shekel appreciated about 25 percent vs US dollar and 12 percent vs euro; through end-2009 shekel depreciated about 15 percent vs US dollar and 10 percent vs euro.
  - Institutional note: IMF reclassified Israel’s exchange rate regime from "free floating" to "floating" after three consecutive discretionary FX purchases.
  - Lesson: transparent, credible, well-communicated intervention can be consistent with inflation targeting and reserve adequacy goals.
- Colombia (2004–2007 experience):
  - BdR used rule-based FX swap auctions and discretionary spot interventions under inflation targeting and flexible exchange rate.
  - Context: end-2003 to end-2004 peso appreciated close to 20 percent; inflation expectations fell well below target and competitiveness concerns rose.
  - Evidence:
    - Early, pre-determined auctions supported by policy rate reductions while economy below potential were effective.
    - Continued interventions while the economy overheated and monetary policy tightened sent conflicting signals; by mid-2007 interventions were ineffective.
  - Lesson: timing relative to cyclical position and credible, rule-based interventions matter; sterilization and intervention can be unsustainable when output gaps widen.

### Macro-prudential policy, liquidity, and FX exposures
- Objectives and design:
  - Primary objective: protect the banking system from reversals of boom-like conditions characterized by strong inflows, rapid credit growth, and asset-market bubbles.
  - A strong framework needs a range of interlocking measures; focusing on a single metric can encourage risk build-up and arbitrage.
  - Cross-country evidence: prudential measures, sometimes supported by monetary measures, have on average contributed to temporary containment of lending booms.
- Countercyclical buffers and provisioning:
  - Macro-prudential approach requires build-up of buffers in good times to draw upon in bad times.
  - EU framework likely to combine dynamic provisioning and time-varying capital buffers.
  - Example: Spain since 2000—dynamic provisioning requires banks to set aside general provisions through the cycle.
- Lending standards and FX mortgage risks:
  - Prudential measures recommended: prudent LTV ratios (example: Poland’s Recommendation T and Recommendation S/Recommendation S (II)), liquidity regimes ensuring long-term funding and hedging of FX mortgages, higher capital requirements for FX exposures.
  - Effects:
    - Higher capital requirements increase resilience but raise cost of offering FX mortgages and may cool capital inflows.
    - Coordination with home supervisors of parent banks improves effectiveness and reduces circumvention risk.
- Liquidity risk and funding structures:
  - Short-term foreign funding and domestic funding hedged via short-term swaps create roll-over, margin-call, and liquidity risks.
  - Box summary of funding models:
    - Long-term FX funding = less reversal-prone.
    - Short-term FX funding = vulnerable to sudden reversals.
    - Short-term domestic funding hedged via swaps = generates net short FX positions and hedge roll-over risks.
  - Crisis observation: private swap markets broke down from 2008Q4 across the region, forcing recourse to central bank currency swaps.

### Capital controls, instruments, legal constraints, and Croatia experience
- Instruments and trade-offs:
  - Unremunerated reserve requirements (URRs): mandatory non-remunerated deposit of a portion of short-term foreign currency debt; can alter inflow composition toward longer maturities; evidence on volume effects mixed; effective in protecting banking system in Colombia, Chile, and Croatia; constrained by EU Treaty and OECD rules; can push activity offshore or into non-bank sectors.
  - Taxes on capital inflows: can reduce attractiveness by lowering non-resident returns; limited impact when applied narrowly; broad taxes face administrative/enforcement costs and may conflict with EU Treaty if discriminatory.
  - URRs impose administrative burdens that increase with repeated scope/term changes.
- Croatia (Box 2) — combined monetary and prudential measures since 2004:
  - Outcomes:
    - Slowed bank credit growth and increased bank awareness of FX lending risks.
    - Funding composition shifted: foreign borrowing declined; banks sought domestic deposits.
    - Capital adequacy increased partly because foreign-owned banks raised capital from parents.
  - Negative implications:
    - Raised spreads and may have reduced SME credit access.
    - Regulatory arbitrage: direct cross-border borrowing for large corporates and growth in non-bank sectors.
    - Administrative costs increased due to successive adjustments.
  - Measures cited (selected):
    - Marginal reserve requirement (MRR) on new foreign borrowing: introduced mid-2004 at 24 percent, increased in steps to 55 percent.
    - Special reserve requirement (SRR) 2006 at 55 percent on liabilities from issued securities.
    - “12 percent rule” credit controls in 2007 requiring banks to purchase low-yielding CNB bills for 50 percent of excess credit growth relative to a ceiling consistent with 12 percent annual credit growth.
    - Prudential: “32 percent rule” foreign-currency liquid asset requirement (2003), provisions for general banking risks for high asset growth banks (2004, modified 2006), increased risk weights on unhedged FX loans (2006, raised late-2007).

### Legal and multilateral constraints
- EU Treaty provisions:
  - Article 56(1): prohibits “all restrictions on the movement of capital between Member States and between Member States and third countries.”
  - Article 58(1): allows measures “to prevent infringements of national laws and regulations... or to take measures which are justified on grounds of public policy or public security.”
  - Article 58(3): such measures cannot constitute “a means of arbitrary discrimination or a disguised restriction on the free movement of capital and payments.”
  - Compatibility of measures adjudicated by the Court of Justice of the European Communities.
- OECD and WTO:
  - OECD Codes prescribe liberalization with limited temporary reservations; new discriminatory restrictions allowed only under specified disturbances or balance-of-payments difficulties.
  - WTO (GATS) introduces jurisdiction over capital flows associated with banking services; prudential measures excluded but capital controls can be subject to dispute panels.
- Policy implication for Poland: design of URRs or capital-flow measures must respect EU and OECD constraints and is likely to face limits and potential circumvention.

### Comprehensive public sector balance sheet methodology and Poland results
- Purpose and construction:
  - Augments traditional backward-looking financial net worth (financial assets minus financial liabilities) with discounted future primary balances under current policy.
  - Two NPV measures: finite horizon (50 years) and infinite horizon.
  - Discounting uses nominal interest rate on debt; baseline medium-term (2009-15) corresponds to IMF outlook; long-run assumptions include GDP deflator converging to 2 percent, real interest rate stabilizing at 100 basis points above real growth, real GDP growth converging to EC estimate of 2.5 percent by 2025, and net aging-related expenditures from EC: -1.2 percent of GDP for 2010-60.
  - Medium-term projections assume consolidation package announced end-January 2010 will be implemented.
- Traditional balance sheet (end-2008):
  - Financial liabilities: 54 percent of GDP.
  - Financial assets: about 34 percent of GDP.
  - Traditional financial net worth: about -20 percent of GDP (negative net worth).
- Intertemporal net worth results (selected numbers preserved; percent of GDP):
  - Financial Assets: 33.7 (2009) and stable at 33.7 through 2014.
  - Financial Liabilities: 56.3 (2009); 60.3 (2010); 63.6 (2011); 65.8 (2012); 67.0 (2013); 67.6 (2014).
  - Current Financial Net Worth: -22.6 (2009); -26.6 (2010); -29.9 (2011); -32.1 (2012); -33.2 (2013); -33.8 (2014).
  - NPV (50 years): -51.0 (2009); -46.7 (2010); -42.8 (2011); -40.2 (2012); -38.5 (2013).
  - NPV (infinite): -122.5 (2009); -117.5 (2010); -112.9 (2011); -109.6 (2012); -107.2 (2013).
  - Intertemporal Net Worth (50 years): -73.6 (2009); -73.3 (2010); -72.7 (2011); -72.3 (2012); -71.7 (2013); -71.2 (2014).
  - Intertemporal Net Worth (infinite): -144.4 (2009); -144.5 (2010); -143.2 (2011); -142.1 (2012); -140.8 (2013); -139.7 (2014).
- Interpretation:
  - Intertemporal net worth is negative at about -74 and -145 percent of GDP (finite and infinite horizons) and only slowly improving under baseline assumptions.
  - Current policies, including announced consolidation, are not sufficient to satisfy Poland’s intertemporal budget constraint but are not worsening the long-run position.
- Sensitivity analysis (2010 percent deviation relative to baseline):
  - Long-run real interest rate differential relative to growth:
    - higher by 1/2 ppt: -4 / -24 (finite / infinite)
    - lower by 1/2 ppt: 4 / 72
  - Long-run aging costs:
    - higher by 1/2 ppt: 4 / 26
    - lower by 1/2 ppt: -7 / -33
  - Medium-run real growth rate:
    - higher by 1/2 ppt: -8 / -10
    - lower by 1/2 ppt: 7 / 11
  - Implication: finite-horizon measures fairly robust; infinite-horizon measures sensitive to interest-growth differential and aging costs.

### Fiscal position, required adjustment, and policy recommendations
- Fiscal context and headline figures:
  - Poland’s overall fiscal deficit increased to above 7 percent of GDP and gross public debt to about 50 percent of GDP in 2009.
  - European Commission long-term indicators imply an upfront adjustment of some 3 percent of GDP to maintain sustainability in 2009.
- Required fiscal adjustment and scenarios:
  - Baseline analysis suggests current policies need to adjust by about 1.5 percent of GDP to ensure a balanced net worth position.
  - A 1 percent of GDP permanent improvement in the primary balance implemented in 2010 yields about:
    - 50 percent of GDP in NPV terms if done for 50 years.
    - 125 percent of GDP in NPV terms if done forever.
  - Minimum upfront adjustment recommended: about 1.5 percent of GDP (in addition to measures announced in early 2010) to bring intertemporal net worth to zero; EDP requirement of about 3 percent of GDP upfront would be more than sufficient.
- Recommended policy mix:
  - Fiscal: focus on spending reforms (especially social expenditures where 3/4 of total spending is statutory), broad structural reforms, and a clear fiscal rule to limit spending and deficit.
  - Revenue: limited room to raise direct taxes given recent cuts; focus on broadening the tax base.
  - Structural: reforms to labor and product markets to raise potential GDP.
  - Pensions: further reforms (including uniformed personnel and farmers; equalizing retirement age) to yield long-run savings.
  - Prudential/financial: introduce countercyclical capital buffers and provisions; review and possibly strengthen liquidity standards; limit FX lending and ensure long-term funding/hedging of FX mortgages.
  - Communication: publish and update comprehensive net worth yearly to communicate fiscal sustainability and policy impact to the public.
- Caveats:
  - Point estimates depend on assumptions about long-run growth, interest rates, and aging costs; emphasis should be on sign, order of magnitude, and direction rather than precise point values.
  - Political-economy risks (pressure to increase pensions) could raise fiscal costs and worsen net worth.

*Prepared by Natan Epstein, Manuela Goretti, and Erlend Nier; April 16, 2010. Source: _cr10119_*

### 2010. The views expressed in this document are those of the staff team and do not necessarily reflect

### CHAPTER I. COPING WITH CAPITAL FLOWS UNDER AN INFLATION TARGETING REGIME: LESSONS FOR POLAND

### A. Introduction
- Poland as the only EU economy to avoid outright recession during the crisis is likely to attract renewed risk appetite and could become one of the main recipients of capital inflows.
- Risks from rapid capital inflows:
  - Excessive exchange-rate appreciation undermining competitiveness.
  - Overheating associated with domestic credit booms and asset-price bubbles.
- Policy responses can be multidimensional; conventional tools include fiscal tightening and exchange rate flexibility. Less-conventional responses discussed include foreign-exchange intervention and macro-prudential regulation.

### B. Stylized Facts on Capital Flows to Poland and Emerging Europe
- Capital flows to Poland were smaller and less volatile than in other Emerging European countries.
- In some Emerging Europe countries, inflows were excessive and concentrated in non-tradable sectors (real estate, banking, other services), contributing to absorption booms, external imbalances, and abrupt reversals.
- Poland’s relative resilience attributed in part to timely introduction, during the boom, of counter-cyclical macro-prudential measures—notably on FX mortgages.
- More recently, Poland outpaced the region in gross and net capital inflows due to renewed risk appetite for strong emerging markets.

### C. Policy Response to Capital Inflows — Foreign-Exchange Market Strategy
- Foreign-exchange intervention can be prudent to resist appreciation when the REER rises beyond what fundamentals justify and when authorities can build reserves.
- Purchases of foreign exchange can complement interest-rate cuts to stem capital inflows when there are no inflationary pressures; under a rising output gap and overheating, trade-offs emerge:
  - Tighter domestic interest rates can induce further capital inflows, undermining intervention objectives.
  - Purchases of foreign exchange would need to be fully sterilized to support tighter monetary conditions, which can be costly.
- Costs and benefits of reserve accumulation:
  - Benefits: precautionary balances against current and capital account shocks.
  - Costs: opportunity cost of foregone consumption and investment, proxied by spread between interest paid on country debt and risk-free return of reserves.

### D. The Israeli Experience (as an illustrative case)
- In March 2008, facing sustained capital inflows and upward pressure on the shekel, and relatively low FX reserves, the Bank of Israel (BoI) initiated a two-year $10 billion FX accumulation program.
- BoI identified a target range of $35-40 billion in FX reserves as appropriate for Israel’s needs.
- Purchase implementation:
  - Pre-announced daily operations at $25 million per day initially (average daily market volume at the time over $2 billion).
  - By mid-2008, daily intervention size increased to $100 million.
  - In late 2008, the BoI raised its targeted reserve range to $40-44 billion.
- Program outcomes and timeline:
  - The revised target was reached by early 2009, a year earlier than planned; BoI maintained program until August (year not specified).
  - BoI discontinued daily $100 million FX purchases thereafter but stated it would continue discretionary intervention in certain circumstances.
- Measured successes claimed by authorities:
  - Achieved FX reserves adequacy level (target exceeded substantially).
  - Implemented a transparent and credible strategy preserving inflation-targeting: long-term inflationary expectations remained anchored within the targeting range.
- Notable figures reported:
  - At end-July (year not specified), FX reserves reached $52 billion; at end-2009, reserves were $60.6 billion, reflecting SDR allocation of $1.2 billion.
  - Reserves coverage of imports rose from 4 ½ months to 12 months over this period.
- Exchange-rate effects:
  - Between December-2007 and July-2008, Israel’s REER rose by close to 20 percent.
  - Over the same short period, the shekel appreciated about 25 percent against the US dollar and 12 percent against the euro.
  - Through end-2009, the shekel depreciated by about 15 percent against the US dollar and 10 percent against the euro.
- Institutional note:
  - Following shifts to less-transparent discretionary intervention, the IMF reclassified Israel’s exchange rate regime from "free floating" to "floating" (reclassification triggered after three consecutive discretionary FX purchases).

### E. The Colombia Experience (timing and cyclical considerations)
- Between 2004 and 2007, Banco de la Republica (BdR) of Colombia used rule-based auctions of FX swaps and direct/discretionary spot interventions while operating under inflation targeting and a flexible exchange rate.
- Colombia’s FX strategy objectives: maintain adequate reserves, limit excessive short-horizon volatility, and moderate excessive exchange rate movements that endanger inflation targets and stability.
- Context and timing:
  - Between end-2003 and end-2004, the Colombian peso appreciated by close to 20 percent, leading to expectations of inflation falling well below target and adverse competitiveness effects.
- Evidence on effectiveness:
  - Empirical evidence suggests only the early intervention period was successful in stemming excessive appreciation.
  - Initial interventions were pre-determined auctions supported by policy rate reductions while the economy was below potential.
  - As the economy overheated, interventions continued in parallel with tightening monetary policy, sending conflicting signals: policy rate aimed at inflation, FX intervention aimed at exchange rate—by mid-2007 these signals were conflicting and ineffective.

### Key policy implications and considerations illustrated by the cases and analysis
- Foreign-exchange purchases can be effective tools to:
  - Dampen unwarranted exchange-rate appreciation.
  - Build precautionary reserves.
  - Be consistent with inflation targeting if implemented transparently and timed appropriately with the economic cycle.
- Risks and trade-offs:
  - Intervention requires careful assessment of sterilization costs and potential conflicts with monetary policy when inflationary pressures are present.
  - Credibility of the inflation-targeting framework depends on the transparency and predictability of intervention strategies.
  - Timing relative to the cyclical position is critical: interventions combined with tightening monetary policy in an overheating economy can send mixed signals and be ineffective.
- Macro-prudential measures (noted elsewhere in the chapter) can limit volatility of inflows and financial-sector vulnerabilities, especially for FX-denominated lending.

*Prepared by Natan Epstein, Manuela Goretti, and Erlend Nier; April 16, 2010.*

### 16.      Moreover, the pursuit of inconsistent policies and the commitment to the

### _cr10119 - 16.      Moreover, the pursuit of inconsistent policies and the commitment to the

### Inflation targeting, FX intervention, and financial derivatives
- The pursuit of inconsistent policies and the commitment to the inflation target gave rise to the build-up of offsetting financial derivatives positions as investors started betting on a peso appreciation.
- One-sided, protracted discretionary intervention by the central bank exposed the peso to speculative appreciation pressures as a consequence of leveraged one-way bets in the derivatives market by investors expecting BdR to remain committed to its price-stability objective.

### Role of country cyclical position and sterilization
- The Colombia experience exemplifies:
  - The need for a credible intervention strategy.
  - The risks to financial stability arising from conflicting goals.
- Sterilization of foreign reserve accumulation is unsustainable in the presence of rising output gaps.
- The country cyclical position is a key consideration in any FX strategy to ensure stable inflation and avoid external imbalances.

### Macro-prudential regulation: objectives and design
- Primary objective: protect the banking system from a reversal of boom-like macro-economic conditions characterized by strong capital inflows, rapid credit growth and credit–fuelled bubbles in asset markets.
- Prudential measures aim to increase banking system resilience and may indirectly:
  - Discourage overly rapid credit growth.
  - Reduce build-up of foreign exchange denominated exposures.
- A strong macro-prudential framework needs a range of interlocking measures; focusing on a single metric (e.g., Basel capital adequacy ratio) can encourage risk build-up and regulatory arbitrage.
- Cross-country evidence suggests the introduction of prudential measures, sometimes supported by monetary measures, has contributed, on average, to some, at least temporary, containment of lending booms, especially when the prudential approach relied on a range of measures.

### Liquidity risk monitoring and international standards
- Monitoring and control of liquidity risks is a key element of the macro-prudential approach due to overreliance on short-term funding markets.
- Short-term international wholesale funding and embedded currency mismatches have increased banks’ vulnerability.
- The Basel Committee issued a consultation paper envisaging an international requirement for banks to hold highly liquid assets against funding sources subject to roll-over risks and emphasized the need to contain currency mismatches in banks’ liquidity positions.

### Countercyclical buffers and provisioning
- A macro-prudential approach requires the build-up of buffers in good times to be drawn upon in bad times.
- The EU framework likely to be adopted combines dynamic provisioning and time-varying capital buffers.
- Dynamic provisioning (example: Spain since 2000):
  - Requires banks to set aside general provisions against loan losses expected over a full economic cycle.
  - When losses materialize, general provisions are released and replaced by specific provisions, avoiding cyclical provision patterns that can undermine capital in recessions.
- Authorities can promote build-up of capital buffers in good times; a countercyclical capital framework smooths impact of economic and financial shocks from volatile capital flows.
- Central bank imposed controls on credit growth (example: Croatia from 2007) are an alternative.

### Lending standards and targeted prudential rules
- Measures directed at banks’ balance sheets should be complemented by close supervision of lending standards.
- Example: Poland’s Recommendation T enhances consumer loan credit risk appraisal and introduces maximum loan-to-income (LTI) and loan-to-value (LTV) ratios.

### Risks from foreign-exchange denominated exposures
- Since the late 1990s in central and eastern Europe (CEE), a rising share of household loans, especially mortgages, was denominated in foreign currency, notably euro and swiss franc.
- Households often took on substantial unhedged FX liabilities, creating balance sheet vulnerabilities and complicating policy responses.
- Depreciation effects:
  - In flexible-rate countries, 2008–2009 depreciations increased debt servicing costs, depressing disposable income and consumption.
  - In fixed-rate countries, devaluation was feared to stress household balance sheets despite potential competitiveness benefits.
- Depreciation impacts on banking sector:
  - Raises probability of default (PD) as households’ ability to repay falls.
  - Erodes collateral value when collateral is priced in local currency, increasing loss given default (LGD).
  - Expands risk-weighted assets when loans are converted to local currency on banks’ balance sheets; unrealized capital gains are usually excluded from regulatory capital, pressuring capital ratios and potentially causing a capital crunch.

### Funding and hedging vulnerabilities
- Funding and hedging structures affect vulnerabilities:
  - Short-term foreign funding is exposed to sudden reversals and roll-over risks.
  - Funding raised domestically but hedged via short-term currency swaps creates vulnerabilities because depreciation increases rolling costs and in stressed conditions private swap markets may be unavailable, forcing recourse to central bank currency swaps.
- Box 1 highlights funding models and related risks:
  - Long-term foreign currency funding (e.g., long-term FX bond): creates foreign capital inflow and upward pressure on local currency but is less reversal-prone.
  - Short-term foreign currency funding (e.g., FX deposits or parent bank funds): creates inflow but is vulnerable to sudden reversals, posing acute banking system risk.
  - Short-term domestic currency funding hedged through short-term swaps: does not create a net capital inflow in itself, but the local bank’s sale of foreign currency under the swap generates a net short FX position and upward pressure on the exchange rate; the hedge roll-over creates liquidity and margin-call risks.
- Crisis experience: private swap markets broke down from 2008Q4 across the region, forcing recourse to central bank provided currency swaps.
- Depreciation tends to cause margin calls and increase cost of rolling over hedges in local currency terms, potentially squeezing local interbank liquidity.

### Prudential measures for FX mortgage risks
- Measures to address FX mortgage risks include:
  - Prudent loan–to-value (LTV) ratios (example: Poland) to limit household vulnerabilities.
  - Liquidity framework enhancements prescribing that long-term FX exposures be funded and hedged on a long-term basis.
  - Raising capital requirements to reflect increased credit and valuation risks associated with FX exposures.
- Higher capital requirements can increase resilience but also raise the cost of offering FX denominated mortgages and may cool capital inflows.
- Effectiveness of increased capital requirements improves if coordinated with home country supervisors of parent banks to avoid disintermediation where parent institutions directly provide FX mortgages.

### Institutional cooperation and multilateral action
- Effective macro-prudential frameworks require close cooperation between national authorities (central bank and supervisory authority) for analysis and coordination/timing of measures.
- Attention should be given to avoid pro-cyclicality and excessive rigidity that can harm banking system health and access to credit.
- National approaches to mitigate cross-border flows face limitations; the EU approach to capital inflows may benefit from multilateral action under new European authorities such as the European Banking Authority (EBA) and European Systemic Risk Board (ESRB).
- A recent European Commission proposal envisages higher capital requirements for foreign currency mortgages across the European Union.

### Capital controls, instruments, and trade-offs
- Capital controls can help counter strong temporary surges in capital inflows and reduce exchange rate pressure and macro-financial vulnerabilities; administration can be by government or central bank.
- Common instruments:
  - Unremunerated reserve requirements (URRs): mandatory deposit of a portion of short-term foreign currency debt for a period without remuneration; alter composition of inflows toward longer maturities; evidence on volume effects mixed; effective in protecting the banking system in cases like Columbia, Chile and Croatia; constrained by EU Treaty and regulations and can push activity offshore or into non-bank sectors.
  - Taxes on capital inflows: reduce attractiveness by lowering non-resident returns; limited impact when applied to specific transactions (example: Brazil); broad taxes face high administrative and enforcement costs and may conflict with EU Treaty if discriminatory between foreign and domestic residents.
- URRs impose administrative burdens, which increase with repeated changes in coverage and terms.

### Box 2 — Croatia experience: combined measures and outcomes
- Croatian National Bank (CNB) actions since 2004 combined monetary and prudential measures to reduce macro-financial vulnerabilities associated with strong inflows and rapid credit growth.
- Outcomes:
  - Slowed bank credit growth and increased bank awareness of FX lending risks.
  - Altered funding composition: foreign borrowing declined; banks sought domestic deposits.
  - Capital adequacy increased partly because foreign-owned banks raised capital from parents rather than rely on foreign borrowing subject to CNB measures.
- Undesirable implications:
  - Measures raised spreads and may have reduced credit access for small and medium-sized enterprises.
  - Foreign banks arranged direct cross-border borrowing for large corporates, leaving domestic banks with less-creditworthy customers.
  - Regulatory arbitrage led to expansion in non-bank financial sector (e.g., leasing companies).
  - Administrative costs for banks and the CNB increased due to successive adjustments in scope to close loopholes.
- Measures implemented to address credit growth:
  - Monetary measures:
    - Marginal reserve requirement (MRR) on new foreign borrowing: introduced mid-2004 at a rate of 24 percent, subsequently increased in steps to 55 percent; loopholes closed.
    - Special reserve requirement (SRR) (2006): set at 55 percent on liabilities from issued securities to close a loophole for the MRR; reserve base defined relative to January 2006 average.
    - Credit controls reintroduced in 2007 (last applied in 2003): banks required to purchase low-yielding CNB bills for 50 percent of the amount by which credit growth exceeded a ceiling consistent with 12 percent credit growth for the full year (“12 percent rule”); controls were modified over time with tightened conditions, closed loopholes and monthly sublimits.
  - Prudential measures:
    - Foreign-currency liquid asset requirement (the “32 percent rule”) (2003); base broadened in late 2006 to include indexed instruments.
    - Requirement to set aside provisions for general banking risks for banks with asset growth above specific threshold (2004, modified 2006).
    - Increased risk weights on unhedged FX loans (2006, raised further in late 2007).
    - Issuance of guidelines for banks on managing risks of FX/household loans (2006).
    - Minimum required capital linked to credit growth and funding sources (2007).
    - Intensified cross-border supervisory coordination.

*Source: _cr10119 - 16.      Moreover, the pursuit of inconsistent policies and the commitment to the*

### Box 3: EU and OECD Regulation on Capital Controls

### Box 3: EU and OECD Regulation on Capital Controls

### EU, OECD, and WTO rules on capital controls
- EU:
  - Article 56(1) of the EU Treaty: “all restrictions on the movement of capital between Member States and between Member States and third countries shall be prohibited.”
  - Article 58(1) allows members the right “to take all requisite measures to prevent infringements of national laws and regulations, in particular in the field of taxation and the prudential supervision of financial institutions, or to lay down procedures for the declaration of capital movements for purposes of administrative or statistical information, or to take measures which are justified on grounds of public policy or public security.”
  - Article 58(3): such measures and procedures cannot constitute “a means of arbitrary discrimination or a disguised restriction on the free movement of capital and payments.”
  - The Court of Justice of the European Communities adjudicates compatibility of measures with Treaty rules.
- OECD:
  - The OECD Code of Liberalization of Capital Movements and Code of Liberalization of Current Invisible Operations prescribe full liberalization of all current and capital transactions and the related payments and transfers.
  - Temporary reservations to liberalize specific transactions are accepted for sequencing.
  - New restrictions (defined as any discrimination in transactions between residents and non-residents) may be introduced only if:
    - (i) free capital flows have resulted in serious economic and financial disturbances, or
    - (ii) in the case of serious balance of payments difficulties for a limited time,
    - or if the latter does not apply for specific transactions (mainly short-term and real estate-related).
- WTO:
  - GATS provisions introduce WTO jurisdiction over capital flows associated with banking services for which the EU has accepted specific WTO commitments.
  - While prudential measures are excluded, capital controls are subject to a WTO dispute panel.

### Key findings and policy implications for Poland
- Mandate and instruments:
  - Poland’s Central Bank Act: key objective is to maintain price stability; the NBP mandate focuses on the inflation target and allows use of multiple instruments including foreign exchange intervention when exchange rate fluctuations “exert a considerable impact on macroeconomic and financial stability, which in turn endangers the attainment of the inflation target.”
- FX reserves management and intervention:
  - FX intervention can smooth excessive exchange rate appreciation and enable reserve build-up while remaining consistent with inflation targeting, provided timing aligns with the economic cycle.
  - For Poland, the strategy appears justified because “the economy [is] not expected to reach potential until 2011 and a stable inflationary environment.”
  - Measured against a Guidotti-Greenspan adequacy rule—“100 percent coverage of gross financing requirements (short-term debt at remaining maturity plus the current account balance)”—authorities would need to target $20-25 billion in additional FX reserves to satisfy this rule.
  - Access to the IMF’s Flexible Credit Line provides another potential source of FX liquidity to meet this target level or possible tail risks.
  - Limitation: reserves accumulation is a short-term solution; once the macroeconomic cycle calls for tightening monetary policy, intervention cannot address the inflationary impact of capital inflows because higher interest rates may trigger further inflows.
- Macro-prudential framework:
  - Existing measures helped mitigate surges during the boom:
    - 2006 introduction of Recommendation S by NBP’s Banking Supervision strengthened risk management in the mortgage sector and limited household vulnerabilities from foreign currency mortgages.
    - Authorities approved Recommendation T to strengthen lending standards for consumer loans, including new maximum debt to income ratios.
    - Following the merger of banking supervision into the Polish FSA (KNF), an enhanced Recommendation S (II) was introduced in 2008.
  - Further measures to consider:
    - Introduce countercyclical capital buffers and provisions.
    - Review and possibly strengthen existing liquidity standards in light of international proposals.
- FX mortgage–specific vulnerabilities:
  - Develop a liquidity regime ensuring FX mortgages are funded and hedged on a long-term basis.
  - Increase risk weights on foreign currency exposures to reflect greater credit and valuation risks; such measures could raise banks’ costs of offering foreign currency denominated mortgages and cool capital inflows associated with funding FX exposures.
  - Coordination with home authorities of parent banks is important to avoid circumvention by parent institutions providing FX mortgages.
- Monetary controls on inflows:
  - Monetary controls (e.g., URRs) can increase buffers and financial resilience even if their effect on flow volumes is limited.
  - Croatia’s experience with URRs on banks’ new foreign borrowing resulted in temporary reductions in such borrowing.
  - Monetary controls are most effective when combined with prudential measures.
  - Risks: discouraging financial intermediation and shifting activity offshore to circumvent domestic regulations.
  - Design constraint for Poland: URRs would be constrained by the EU Treaty and OECD regulations.

### Contextual statistics and fiscal context cited in the source
- Poland macro/fiscal context:
  - Poland’s overall fiscal deficit increased to above 7 percent of GDP and gross public debt to about 50 percent of GDP in 2009.
  - European Commission long-term indicators imply an upfront adjustment of some 3 percent of GDP to maintain sustainability in 2009, compared to no adjustment required three years earlier.
- Reserves adequacy metric cited:
  - Guidotti-Greenspan rule: “100 percent coverage of gross financing requirements (short-term debt at remaining maturity plus the current account balance).”
- Reserve target estimate:
  - $20-25 billion in additional FX reserves needed to satisfy the Guidotti-Greenspan adequacy rule for Poland.

### Conclusions and recommended policy mix
- Main defense:
  - A flexible exchange-rate policy remains the main defense against a sustained surge in capital inflows.
- Additional tools and timing:
  - Early intervention in the foreign exchange market and/or enhanced macro-prudential measures may be required to avoid overshoot and sharp reversal.
  - Temporary, limited foreign-exchange intervention could be considered under certain conditions, provided it is transparent and well-communicated so as not to undermine the inflation-targeting framework.
- Prudential measures:
  - Careful application of a strong macro-prudential framework can help stem flows and strengthen the financial sector.
  - Limitations on foreign-currency lending recommended for prudential reasons could also slow the resurgence in capital inflows.

*Source: Box 3: EU and OECD Regulation on Capital Controls, _cr10119 - Box 3: EU and OECD Regulation on Capital Controls_*

### 5.      Hence, an increasing awareness is slowly emerging to integrate more fully the

### _cr10119 - 5.      Hence, an increasing awareness is slowly emerging to integrate more fully the

### Overview
- The paper develops and applies a "comprehensive public sector balance sheet" to assess the public sector’s intertemporal net worth and provide policy recommendations for Poland.
- The tool complements the traditional accounting balance sheet with projected outcomes of current policies on future assets and liabilities, producing measures of intertemporal net worth over a finite (50-year) and an infinite horizon.

### Definition and advantages of the Comprehensive Public Sector Balance Sheet
- Purpose:
  - Measures consequences of current policies on fiscal accounts both at present and in the future.
  - Provides a direct snapshot of a government’s net worth at a given point in time, under current policies.
- Key features:
  - Complements backward-looking traditional accounting balance sheet by adding discounted future primary balances (net of interest) from current policy paths.
  - Mirrors EC forward-looking indicators but uses a somewhat more intuitive framework, potentially easier to present to the public.
  - Does not include liabilities of the financial system nor liabilities resulting from environmental factors.
- Uses:
  - Early warning of fiscal (un)sustainability when intertemporal net worth is negative.
  - Communication device: more intuitive to the general public because it is analogous to a balance sheet and financial net worth.

### Construction methodology (two steps)
- Step 1: Build traditional backward-looking accounting balance:
  - Compute difference between fiscal financial assets and financial liabilities at a point in time (financial net worth = assets minus liabilities).
- Step 2: Augment with projected outcomes of current policies:
  - Prepare a baseline macroeconomic and fiscal scenario under current structural and fiscal policies.
  - Project yearly future fiscal deficits net of interest payments based on current policies.
  - Discount the stream of future primary balances using the nominal interest rate on debt.
  - Add the net present value (NPV) of discounted future primary balances to current financial net worth to obtain intertemporal net worth.
- Two NPV measures constructed:
  - Finite horizon: 50 years.
  - Infinite horizon: perpetual horizon.

### Poland: Traditional public sector balance sheet at end-2008
- Financial liabilities amounted to 54 percent of GDP at end-2008.
- Financial assets were estimated at about 34 percent of GDP at end-2008.
- Traditional financial net worth (assets minus liabilities) equals about 20 percent of GDP (negative net worth of about 20 percent of GDP).
- Note: Net capital stock not included due to absence of data; financial net worth likely underestimates total net worth.

### Medium-term and long-run assumptions for Poland
- Medium-term (2009-15) macroeconomic and fiscal projections correspond to the latest IMF outlook for 2009-15.
- Long-run assumptions:
  - GDP deflator growth converges to the ECB’s target of 2 percent in the long run.
  - Real interest rate projected to stabilize at 100 basis points above real growth in the long run.
  - Real GDP growth assumed to converge to the EC’s estimated value by 2025 (2.5 percent of GDP) and follow the Commission’s path thereafter.
  - Net aging-related expenditures taken from the EC’s Sustainability Report: -1.2 percent of GDP for 2010-60 (Poland is the only EU27 country with negative aging costs).
- Medium-term fiscal projections assume the consolidation package announced at end-January 2010 will be implemented.
- From 2015 onward: all non-age, non-interest related fiscal revenues and expenditures, as well as financial assets and other financial liabilities except for public debt, assumed constant in percent of GDP.

### Key medium-term numerical projections (selected table figures preserved)
- Activity and prices (2008-15):
  - GDP (change in percent): 5.0, 1.7, 2.7, 3.2, 3.9, 4.0, 4.0, 4.0 (2008 to 2015).
  - Nominal GDP (zloty millions): 1,273; 1,342; 1,402; 1,481; 1,573; 1,676; 1,786; 1,904 (2008 to 2015).
  - Unemployment rate: 7.1; 8.0; 9.5; 10.8; 11.2; 11.7; 11.2; 10.8 (2008 to 2015).
- General government revenues and expenditures (2008-15, percent of GDP):
  - General government revenue: 39.6; 37.4; 39.4; 39.7; 40.2; 40.4; 40.5; 40.6 (2008 to 2015).
  - General government expenditure: 43.3; 44.6; 46.8; 46.6; 45.9; 45.4; 44.9; 44.4 (2008 to 2015).
  - General government balance: -3.7; -7.2; -7.5; -6.9; -5.8; -5.0; -4.4; -3.8 (2008 to 2015).
  - Public debt: 47.2; 51.0; 55.0; 58.3; 60.5; 61.6; 62.3; 62.2 (2008 to 2015).
- Notes: Projections include announced consolidation measures; do not include additional measures that would be triggered under the Public Finance Act if debt (national definition) exceeds the 55 percent-of-GDP threshold.

### Poland: Intertemporal net worth results (2009-14)
- Current financial assets and liabilities and financial net worth (selected series):
  - Financial Assets: 33.7 (2009) and stable at 33.7 through 2014 (percent of GDP).
  - Financial Liabilities: 56.3 (2009); 60.3 (2010); 63.6 (2011); 65.8 (2012); 67.0 (2013); 67.6 (2014) (percent of GDP).
  - Current Financial Net Worth: -22.6; -26.6; -29.9; -32.1; -33.2; -33.8 (2009-14, percent of GDP).
- Net present value (NPV) of primary balances:
  - NPV (50 years): -51.0; -46.7; -42.8; -40.2; -38.5 (2009-13, percent of GDP).
  - NPV (infinite): -122.5; -117.5; -112.9; -109.6; -107.2 (2009-13, percent of GDP).
- Intertemporal Net Worth:
  - Intertemporal Net Worth (50 years): -73.6; -73.3; -72.7; -72.3; -71.7; -71.2 (2009-14, percent of GDP).
  - Intertemporal Net Worth (Infinite): -144.4; -144.5; -143.2; -142.1; -140.8; -139.7 (2009-14, percent of GDP).
- Interpretation:
  - Measures are negative at about 74 and 145 percent of GDP and only slowly falling over time.
  - Current policies (including announced fiscal consolidation) are not sufficient to satisfy Poland’s intertemporal budget constraint, but they are not worsening the long-run fiscal position.

### Cross-country perspective and relative position
- Poland’s intertemporal net worth is relatively limited compared with other European countries:
  - Only a few European countries show a sustainable long-run fiscal position after the crisis and pension reforms.
  - Some countries have net worth in excess of negative 300 percent of GDP (finite horizon) and over 1,000 percent of GDP (infinite horizon).
  - EU-27 average: close to 200 percent of GDP (finite horizon) and close to 700 percent of GDP (infinite horizon).
  - Poland ranks well below the EU-27 average on both long-term measures, mainly because declining long-run aging costs partly compensate for higher medium-term deficits and debt.

### Sensitivity analysis (2010 intertemporal net worth, percent deviation relative to baseline)
- Finite horizon / Infinite horizon percent deviations:
  - Long-run real interest rate differential relative to growth:
    - higher by 1/2 ppt: -4 / -24
    - lower by 1/2 ppt: 4 / 72
  - Long-run real growth rate (keeping interest differential constant):
    - higher by 1/2 ppt: 0 / 0
    - lower by 1/2 ppt: 0 / 0
  - Long-run aging costs:
    - higher by 1/2 ppt: 4 / 26
    - lower by 1/2 ppt: -7 / -33
  - Medium-run real growth rate:
    - higher by 1/2 ppt: -8 / -10
    - lower by 1/2 ppt: 7 / 11
- Implications:
  - Finite-horizon measures are fairly robust to changing assumptions.
  - Infinite-horizon measures are sensitive to assumptions on the interest-growth differential and aging costs because the discount rate has a larger role over the infinite horizon.
  - Results should be interpreted with caution and updated when macroeconomic conditions change.

### Policy implications and concluding points
- The comprehensive balance sheet:
  - Offers a practical framework for integrating forward-looking considerations into fiscal policy analysis and communication.
  - Can serve as an early warning system if intertemporal net worth is negative even after accounting for long-run policy effects.
- For Poland:
  - Current policies, including the announced consolidation package, do not satisfy the intertemporal budget constraint.
  - Intertemporal net worth is negative and large in magnitude (about -73.6 percent of GDP finite-horizon, -144.4 percent of GDP infinite-horizon in 2009) and only slowly improving under current assumptions.
  - Negative aging costs (-1.2 percent of GDP for 2010-60) from past pension reform partly mitigate long-run fiscal pressures.
  - Policy attention is needed to bring total assets in line with total intertemporal liabilities to avoid eventual market-driven adjustments.
- Communication recommendation:
  - The intertemporal net worth concept may be easier to convey to the public and policymakers than some other long-run fiscal models or indicators.

*Source: IMF staff calculations.*

### 17.      Poland’s comprehensive balance sheet reveals an unsustainable long-run

### 17.      Poland’s comprehensive balance sheet reveals an unsustainable long-run position.

### Key findings
- Net debt represents only about 20 percent of GDP, while comprehensive net worth is at around 74-145 percent of GDP.
- The difference between net debt and comprehensive net worth indicates policies need to be strengthened to bring future liabilities in line with the government’s capacity to generate assets.
- The comprehensive balance sheet results are fairly robust to the macroeconomic assumptions used, as indicated by the sensitivity analysis, but point estimates depend on long-run growth, interest rate, and long-run cost assumptions.

### Required fiscal adjustment and scenarios
- The current baseline analysis suggests current policies need to adjust by about 1.5 percent of GDP to ensure a balanced net worth position.
- A 1 percent of GDP permanent improvement in the primary balance implemented in 2010 yields about:
  - 50 percent of GDP in NPV terms if done for 50 years.
  - 125 percent of GDP in NPV terms if done forever.
- Consequently, a minimum upfront adjustment of about 1.5 percent of GDP (in addition to measures announced in early 2010) would be needed to bring intertemporal net worth to zero.
- Such consolidation could be undertaken gradually over a few years, but this would likely imply a somewhat larger overall adjustment.
- The current requirement under the EDP—an upfront consolidation of about 3 percent of GDP to attain the Maastricht deficit threshold of 3 percent of GDP by 2012—would be more than sufficient to restore long-run fiscal sustainability.

### Policy recommendations
- Fiscal adjustment should focus on spending reforms and be complemented by broad structural reforms.
- Reforms are needed especially of social expenditures because ¾ of total spending is statutory, to ensure expenditures do not fall out of line with the country’s capacity to generate revenues.
- A clear fiscal rule that limits spending and the deficit could be helpful.
- On revenue: limited space to increase direct taxes due to recent cuts in personal income taxes and social security contribution rates; efforts should focus on broadening the tax base.
- Broad structural reforms to make labor and product markets more efficient are crucial to increase the level of potential GDP in the long-run, thus generating additional revenues and lowering the debt burden.
- Further pension reforms, including reforms for uniformed personnel and farmers and equalizing the retirement age, could yield additional long-run savings to reduce negative net worth.
- Definitional changes, or proposals to lower payments to private pension funds to lower short-run headline deficits, would not affect intertemporal net worth if long-run pension liabilities remain unchanged.

### Use of the comprehensive balance sheet and communication
- The comprehensive balance sheet can be used to assess policy plans and strengthen communication of policy messages to the public.
- Publishing and updating comprehensive net worth yearly, perhaps in the budget document, would show how net worth evolves over time and help present planned policy changes to voters.
- Example: The government’s proposed measures to broaden the tax base and limit discretionary expenditure growth, estimated to yield about ¼ percent of GDP permanent improvement in the primary balance, have already reduced the negative net worth of the public sector by more than 10 and 30 percent of GDP under the finite-horizon and the infinite-horizon measure, respectively.
- This indicates:
  - (1) a relatively small short-run, permanent adjustment can have significant long-run benefits; but
  - (2) the package needs to be complemented with other, more significant measures to ensure intertemporal solvency.

### Caveats and interpretation
- The comprehensive public sector balance sheet is based on assumptions about long-run growth, the interest rate, and long-run cost estimates that are subject to large uncertainty; net worth point estimates depend on these underlying assumptions.
- Emphasis should be on the sign, order of magnitude, and the direction of net worth over time, rather than the precise point value.
- Fiscal costs from population aging could be higher if political pressures arise to increase pensions and finance them from the budget, which could lead to larger negative net worth.
- Replacement rates are projected to decline from over 50 percent now to about 30 percent by 2060, while the number of elderly will exceed that of the working population by 2060; this raises political-economy questions about the sustainability of the sharp decline in replacement rates.

### Comparative indicator note
- Measures similar in spirit to the EC’s S1 and S2 indicators differ due to different underlying assumptions. In the case of Poland, the EC’s S1 and S2 are estimated at about -125 and -170 percent of GDP for the finite and infinite horizon measures, respectively, somewhat higher than the estimates in this analysis mainly due to the EC’s higher assumed medium- and long-term primary deficit, which does not include the recently announced measures.

### Appendix: intertemporal net worth definition (methodology highlights)
- The intertemporal budget constraint (solvency condition) requires the discounted sum of future primary surpluses to be equal to or larger than current net worth (NWt).
- The infinite-horizon intertemporal net worth (inw) is defined as the difference between the discounted sum of future primary surpluses under current policies and current net worth.
- A finite-horizon inw* (e.g., up to 2060) is defined as the discounted sum of future primary surpluses over that period minus current net worth; using a finite horizon can be easier for public communication and can avoid time-consistency problems associated with infinite-horizon measures.

*Source: _cr10119 - 17.      Poland’s comprehensive balance sheet reveals an unsustainable long-run position.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10119.pdf_