The nature of the monetary and financial stability
Monetary policy is the process of arranging the money supply or the interest rate of money. Through monetary policy, such kinds of goals have been conducted, which are intended to provide sustainable economic growth and macroeconomic stability. During the last 40 years, the realization of the monetary policy has had many stages of development and now almost all countries, including those with a transition economy, have passed from the direct tools of the policy regulations – direct regulations of interest rate and monetary units to the indirect control system, through the interest rate regulations in the money market.
Generally, the monetary policy development process includes the following stages.
With the monetary policy tools at their disposal, Central Banks control the behavior of operational and intermediate goals of monetary policy, which are displayed in the ultimate goal of the Central Bank. In this chair of monetary policy implementation, the intermediate aim or “the nominal anchor” of the monetary policy is essential. At different periods of history, the Central Banks have chosen the exchange rate, the money units, started from the 1990s, also the projected level of inflation as the monetary policy’s “nominal anchor”, and, accordingly, the strategies of the monetary policy – the strategy of “the exchange rate objective”, “the money units objective” or “the inflation objective”.
The purpose of the monetary policy of the Central Banks of Armenia and many countries of the world is the insurance of price stability, and as the intermediate intent, it is the projected level of inflation, however, there are also other purposes, such as the economic stability, the full employment or the stability of the currency. For instance, the Reserve Bank of Australia aims a monetary policy to ensure currency stability, full employment, and economic well-being at the same time.
The importance of financial stability
The National/Central Banks of the countries are considered to be responsible for ensuring both monetary policy and financial stability. However, it should be mentioned that, unlike monetary stability with deeper roots, the importance of financial stability became relevant after the global financial crisis in 2007, when it was clear that the policy of countries aimed at the regulation and control of individual financial institutions is not enough for providing stability to the whole financial system.
According to the description of the World Bank, a stable financial system provides the effective distribution of resources, financial risk management, full employment preservation, or elimination of relative fluctuations in the prices of real or financial assets, which influences the level of monetary stability and employment.
The recent financial and economic crisis pointed out that only the main tool of the Central Banks, the interest rate, and the regulative and controlled opening regimes are “weak” to prevent or absorb systemic risks in the financial sector. Therefore, there was a need to create one more link, which could record and prevent systemic risk factors in time, with the help of more expended tools.
The indicators and the advantages of the financial stability in Armenia
The financial stability indicators are the wholeness of the statistics, which characterize the financial health and stability of a country’s financial system, its corporate sector, and households. Each country’s financial stability indicators are published on the website of the International Monetary Fund. There are seven indicators, which are mentioned by the Central Bank of Armenia and presented to the International Monetary Fund.
Table 1. The financial stability indicators in Armenia
|1||The ratio of the total nominative capital to risk-weighted assets.|
|2||The ratio of the fixed nominative capital to risk-weighted assets.|
|3||The ratio of the non-performing loan to total loans.|
|4||The profitability according to assets.|
|5||The profitability according to capital.|
|6||The ratio of the highly liquid assets to the total assets.|
|7||The ratio of the highly liquid assets to net demand liabilities.|
As we notice, in Armenia the indicators of the financial system stability only refer to the banking system. However, this can be substantiated by the fact that banks in Armenia make up 84.1% of the financial system, which means, considering only the behavior of the banking system, it will be possible to have a substantial idea also about the financial system of Armenia.
As we can see in diagram 1, these indicators do not fluctuate significantly in Armenia. Decision No. 39N of the Council of Central Bank of Armenia of February 9, 2007, established “Regulation of Banking Activities, Basic Economic Standards of Banking, Regulation 2”, by which the economic standards presented to banks are higher than the requirements of Basel 2nd and Basel 3th. In general, the Central Bank of Armenia carries out the regulation and the control of the financial system with rather “strict” standards, and this method has justified itself, as the financial and economic crisis in 2008-2009 and the currency crisis in 2014-2015 showed, that the banking and financial system in Armenia has a stable basis.
The COVID-19 started in May 2020 and the war in the republic – September 27, in the same year has also affected the economy, as well as the financial system. However, it should be mentioned during the period, followed by the situation, the central bank is actively using all tools that it has, to neutralize the possible risks and to activate economies.
The features of the monetary policy in Armenia
As we know, the stability of the Central Bank interest rate, the objective, and the prices of inflation are the bases of the transference mechanism of the current monetary policy of the Central Bank, that is: by changing short-term interest rates, the CB should affect on inflation and price stability.
This chain is often called the transference mechanism of monetary policy.
By saying short term interest rate, we should understand the interest rates of refinancing, involved resources, and Lombard repo. It should be mentioned that during the analysis, the attention is more often paid to the refinancing interest rate, as it is the “price” of money in that special country, that is the price by which the Central Bank provides resources to the banks and credit organisations.
The correlation of interest rate and inflation is called the monetary or Taylor’s theorem, which was suggested by the professor of Stanford University John Taylor in “Discretion versus policy rules in practice” in 1993. The meaning of the monetary and credit rule is that by managing short term interest rates, the Central Bank can reach its target inflation, therefore- price stability. Due to this inverse link, if the projected quarterly inflation exceeds the inflation target indicator, then the Central Bank can increase the interest rates to decrease the inflation and to reach the target level. But how does the change of interest rate influence inflation? As mentioned above, the commercial banks and credit organisations are the first to feel the change of interest rate should be through the change of lending volumes. It means, that the increase of interest rate should lead to the decrease of lending volumes, as “the price” of money increases, and vice versa, the decrease of interest rate should lead to the increase of lending volumes. However, in many countries this rule either does not work or has poor efficiency, depending on the country’s economic features.
It can be observed, that how does this mechanism work in Armenia.
The chart shows the volumes of loans provided by the Central Bank in 2004-2020 for a period of up to and more than 1 year in AMD (2020 includes data until September), and the changes of refinancing interest rate defined by the Central Bank, during the same year (2020) includes changes done until October.
Diagram 1. The dynamics of volumes of the refinancing interest rate and AMD landing (2004-2020)
The transference mechanism of monetary and credit policy also has some problems in Armenia. The periods in the circle shown in Diagram are those, during which the change of interest rate either has no significant adverse effect in lending volumes, or its influence takes place in different periods, which complicates the work of the Central Bank. It can also be seen from the diagram that we are now approaching the historically lowest level of refinancing rate – 3%.
In conclusion, we can say that the world has developed many risk mitigation mechanisms for monetary and financial stability, the localization of which has different levels of effectiveness in different countries.
Monetary policy and measures to stabilize the financial system have their peculiarities and complexities in Armenia, which are conditioned by the structural features of the country’s economy, such as the high level of dollarisation, the homogeneous structure of the financial system.
However, it should be mentioned that the financial system of Armenia went through various shocks, starting from 2008, but remained stable. The participants of the financial system felt these shocks as little as possible due to the competent interventions of the Central Bank of Armenia. Moreover, according to the International Monetary Fund 2008 research, the financial system of Armenia has been assessed as stable and reliable.
It should be mentioned that the mechanisms and tools, which are used by the National and Central Banks of countries, need refinement and new approaches, as, especially starting from the beginning of 2020 the epidemic situation shows that new challenges require new tools.
Author: Marine Avetisyan © All rights reserved․
Translator: Mery Hambardzumyan