CENTRAL BANK INDEPENDENCE

THE THEORY AND PRACTICE IN THE CZECH REPUBLIC

Paper prepared for the conference "Central Banks in Eastern Europe"

Chicago, Illinois, April 21- 23, 1994

1. Introduction to the Economics of transformation ..................... 3
1.1 The scope and scale of the transformation process ..................3
1.2 Reform versus transformation..................5
1.3 Reforms in the West versus transformation in the East...............5

2. Theory and practice of transformation..............6
2.1 Mutual dependence of the central bank and the government ...6
2.2 The initial stage and alternative reform strategies .......7
2.3 Micro-economic functions of the SBCS.................................. 10
2.4 Macro-economic objective of the SBCS ................................ 12

3 . Central Bank as a ministry of banking ...............13
3.1 Licensing and supervision of banks...........14
3.2 Assistance to re negotiations with clients..........................14
3.3 Access to credits...................................................17
3.4 Non performing loans..................18
3.5 Sequence of the operations of the Central Bank.....................19

4. Formal organization.................20
4.1 Formal macro-economic functions..........20
4.2 Formal guarantees for independence...........21
4.3 Formal measures of the monetary policy ..............21
4.4 Formal micro-economic functions .....................22
4.5 Informal setting.............22

References ...................23

1. INTRODUCTION TO THE ECONOMICS OF TRANSFORMATION

As a rule, disputes are often based upon misunderstandings. The process as complex as a transformation of the formally socialist (post-socialist) country is certainly of no exception. The same thing may be labeled differently in different countries and/or social circles, while things of an entirely different nature may be referred to by the same terms.

In the Czech Republic it is believed that the success of its transformation programme depends on a clear understanding of its nature, goals and strategies within the very concrete environment of a transforming country. The same applies to the concept of the central bank independence. To begin with, a few comments towards what in the future may be referred to as "economics of transformation" may be of value.

1.1 The scope and scale of the transformation process

External observers rarely understand the genuine nature of the damage brought about, not so long ago, by the aggressive act of a so-called socialist revolution. Therefore, very few of them are fully aware of the fact that the prime target and victim of communism was the system of provision of the most fundamental public goods (and services) which are normally provided by a properly functioning democratic country. This destruction pervaded politics, administration, and the economy.

Politically, the major public good destroyed was an efficient and stable system of political

Administratively, the principal public good rests in a well-defined legal framework, and a structured system of government agencies and other institutions enforcing law and order.

Economically, an unquestionable and guaranteed system of property rights, particularly with respect to the means of production, forms the basis for the efficient performance of economic agents. Where they exist, the seemingly natural character of the above items, their routine and everyday presence, can lead their beneficiaries to forget that it has taken centuries of evolutionary development for systems to emerge to supply public goods and services to the country with some degree of efficiency.
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1 For more comprehensive analysis see Vaclav Klaus: Privatization Experience: The Czech Case (Speech at the International Chamber of Commerce Meeting, Cancun, Mexico, October 21, 1993.)
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Because the "public goods industries" in socialist countries were destroyed, many students and analysts fear the damage may be irreversible, as when one makes a fish soup from an aquarium. In the formerly socialist countries, the totalitarian government, state ownership and central planning have, in fact, made fish soup out of the traditional political legal and economic institutional framework.

Unlike many outside observers, the Czechoslovak (and later on the Czech) government has constantly stressed its awareness of the institutional core of the transformation problem and its political, legislative and economic aspects.

In the Czech Republic, the early emergence of relatively stable and ideologically well defined political parties (however fragile their existing relationships may be) is believed to be the most fundamental achievement of the overall transformation process. With respect to the administrative and legal aspects of transformation, the creation of a corresponding system of law and law-enforcing agencies was completed in a record time. Of course, what remains to be added are the appropriate personnel, standards and routines, which may take a generation.

In the economic sense, the transformation amounts to nothing more or less than "converting central planning into a market economy".

From the whole spectrum of the above mentioned aspects of the transformation we shall emphasize the economic ones. However, as it is the Central Bank that constitutes our major theme, the attention will be confined mainly to the relationships between some relevant elements of the administrative restructuring and their economic implications.

1.2 Reform versus transformation

Bearing in mind the above institutional concept, it must be stressed, in the first place, that it is the society and economy as a whole, not a particular government agency or enterprise that calls for transformation. In other words, however disabled individual parts of the society may appear, it is not they, but the overall society, which requires therapy.

Secondly, the formally socialist society, government and economy cannot be cured, transformed, or restructured without comprehensive "property reform". Without a radical shake-up in the realm of property rights it is unrealistic to expect a positive change in the economy's performance: it can never happen. The perestroika style of economic thinking suggests that the shift from a soft budget constraint to a hard one can be achieved and that economic behavior can be changed solely by macro-economic measures. This is wrong and misleading. Rational macro-economic policy represents a necessary but not a sufficient condition for the desired change.

There is no doubt that it is privatization that distinguishes a genuine, systemic change from perestroika, or "reform". The Czech government never wanted to reform the unreformable. Its target has always been to establish an entirely new institutional set up

1.3 Reforms in the West versus transformation in the East

Capitalist countries have also embarked on some type of a reform and transformation. Perhaps the best publicized of these efforts is the Thatcherite privatization of Great Britain in the late seventies and early eighties.

Unfortunately, these western-style reforms have almost nothing in common with the transformation of the formerly socialist countries. As a matter of fact, the very terms and concepts used within the reform schemes in the West may be misleading when used in the context of transformation in Central and Eastern Europe. No wonder that the very term has confused both analysts and many politicians. Unlike in the west, eastern transformation amounts to the very establishment of a heretofore non-existent institutions and-or their functions. In the East, the implementation of the changes into society, politics and economy must fulfill the most fundamental transformation objectives..2
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2 As the most aggressive act against the inherited frame of economic and pseudo-economic institutions the Czech government launched its first and second wave of voucher privatization. The major characteristics of the voucher scheme are summarized in, e. g., Dusan Triska: Political, Organizational, and Legislative Aspects of Mass Privatization - Czechoslovakia. (Marko Simoneti and Andreja Bohm (eds.): Privatization in Central and Eastern Europe 1991, Proceeding of the Second Annual Conference of the CEEPN.)
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2. THEORY AND PRACTICE OF TRANSFORMATION

Two observations may be of value in order to understand the logistics and mechanics of the transformation processes in a post-socialist country like ours:

First is almost anecdotal. It states that in a post-socialist country the economic transformation program is being designed and implemented by an extremely small group of agents. The core of the group would typically consist of no more than five economists and five lawyers.

Second observation is that the general stereotypes of an economic theory have to be taken absolutely seriously as an unavoidable rhetoric of the political struggle. The same theses must be, however, applied with a large degree of flexibility once the political battles are won.3

For reasons which will be treated in depth further, these two observations by themselves justify the emergence of the above mentioned new branch of the economic theory. By definition, the economics of transformation would qualify the standard notions and laws of the text-book economics.4

2.1 Mutual dependence of the central bank and the government

As our major topic is of an institutional nature, it should be noted that the extremely limited supply of human resources, especially in the very beginning of the transformation process, strongly modifies the standardized concepts of the division of labor amongst different agencies and institutions. Still more importantly, the informal links between the few "advocates of change" are very strong and consequently the formal relationships (however conform or non-conform to the theoretical designs they may be) often mean very little to the actual performances of the agencies under study.

The extremely strong effect of formal-versus-informal behavior is further multiplied by the effect of hidden-versus-transparent performances. This can be, perhaps, best exemplified on a substantially different issue of the price liberalization. Just like elsewhere in the post-socialist
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3 The Czech Prime Minister Vaclav Klaus in several recent interviews stressed the difference between what he calls "revolutionary dogmatism" and "every-day pragmatism".
4 By no means it is suggested that the standard neo-classical theory should be abandoned. I has been shown elsewhere that even within extremely distorted environments the standard theory holds given that the appropriate concept of "costs" and "revenues" is applied. The author himself contributed to the discussion in, e.g., Vaclav Klaus and Dusan Triska: Ekonomie Nicholase Kaldora - nova ekonomie, nebo jine ambice? ("Economics of Nicholas Kaldor - new economics or other aspirations"), Politicka ekonomie, Praha 1987.
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region it became an imperative to the Czech "transformers" to liberalize prices right from the very beginning in 1990. At that time, it was politically unthinkable to publicly admit that even the radical transformation policy contained a decent portion of a price regulation. Only today it can be admitted in the Czech Republic that no-one in the team took his/her highly dogmatic statements of that time seriously. Just the contrary, in our offices we devoted 90 % of our time to designing alternative price regulation schemes. Unlike for the external observers and advisors, the genuine practical problem for the team rested in regulation not the liberalization. The latter is easy, the difficult part of it is identification of what prices should be regulated, in what form and within what time-table ? At that time we did not need the advises - sometimes delivered to the country by the most distinguished economists - of the sort that "the market prices are much more efficient than the administratively set prices". What we needed and what we never got was a comprehensive concept of the, e.g., wage regulation, rent control, quotas and tariffs, monopolistic pricing etc. At that time we did not need "just economics". Now we understand that we expected something that did not exist at that time - the assumptions and observations of only now emerging field of economics.

Returning the topic of this conference one should avoid the same misconception of confusing the initial stage ("inherited economy"), the transition period ("transforming economy") and the "ideal world of a democratic capitalism". The present paper is, of course, incapable of offering comprehensive theory of a transforming economy. It may take a generation to elaborate a model of the transition period based upon the standard assumptions of a ("generalized") neo-classical economics. Here, we can only pin point in mostly casuistic way the historical context of separating the private sector from the public one and, in particular, the sequence of events associated with constituting central bank functions in the Czech Republic.

Due to all this, a warning is in order. Should there be no political concerns of the author, the title of his paper would have been: The necessary mutual dependence of and cooperation between the Government and the Central bank in a transforming economy.

2.2 The initial stage and alternative reform strategies

It is typical for socialist economies that macro-economic and micro-economic functions of the state are being confused and organizationally mixed up. In a socialist economy the whole economy7 according to the formal division of labor, appears to be governed by a body usually called as Central Planning Commission (CPC). All other government and non-government agencies (branch ministries, central bank) seem to degenerate to simple operations such as breaking-down the planning targets set by the CPC.

The loans are in a socialist economy treated as any other planning targets. They appear to be merely technical devises of financing the centrally planned goods and services flows. to the degree to which the goods and services were planned, the loans were planned, distributed and rationed as well.

As a consequence for many analysts the socialist economy had just one economic centre- the CPC. The economic analysis of the economy had thus two types of outcomes: The micro models describing the interactions between the CPC and state-owned enterprises5 and the so-called macro-models confining to the national economic aggregates, totals for outputs of the enterprises, their associations and-or all industries. Officially and often even within informally organized researchers it was believed that a true socialist economy there was no need for a genuine monetary centre that would take care of the macro-economic functions of a state.6

Institutionally this situation was formally expressed by the fact that the monetary policy in the socialist Czechoslovakia was implemented by the same institution which issued (distributed, rationed) loans, i.e. by the so-called mono-bank. In Czechoslovakia its role was played by " Statni banka Ceskoslovenska", or SBCS .7

It was not therefore an accident that the very first step of the transformation programme of the newly appointed democratic government consisted in establishing the true macroeconomic (monetary) centre. This was done even before the CPC was liquidated and institutionally it meant establishing the so-called two-tier banking system. As early as in January 1990 the SBCS was broken down into the Central Bank on the one hand and several commercial banks on the other.
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5 According to the "taste" of the author and-or his/her position in the official strata of economists the micro-models were either about "optimal planning" or about "bargaining". See, e.g., Dusan Triska: Bargaining and Search in Imperfect Markets: A Centrally Planned Economy. (R.E.Quandt, D.Triska (eds.): Optimal Decisions in Markets and Planned Economies. Westview Press, London 1990.)
6 One of the greatest mistakes is being made already in defying the initial stage, i. e. of the so-called centrally planned economy. The architects of the transformation in the Czech Republic, unlike most of the external analysts, always conceived of the post-socially economy as "any other economy", i.e. as an economy defined by a specific set of market imperfections. A broad base analysis of this situation can be found in V~ Klaus and D. Triska: The Economic Centre: The Restructuring and Equilibrium. (Czechoslovak economic digest, 1/1989, Prague, Czechoslovakia.)
7 In addition to the mono-bank there existed in that time four other state-owned relatively small "commercial banks". (The largest of them, the Saving Bank, focused on dealing with the house-holds deposits.)
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Two comments are in order here. First is that it is only fair to say that this measure was largely prepared already before the revolution by the socialist government, as this dismantling of a mono-bank system was by then even in Czechoslovakia supposed to be an acceptable part of the perestroika reform package.

Our second comment refers to those analysts who long before the November 1989 "Revolution" stressed that neither the planning targets were extremely "taught", nor was it true in the 70s through 80s that there was no monetary centre whatsoever.8 It was the thesis of the architects of the transformation that even in the socialist Czechoslovakia the economic centre was heterogeneous and consisted in both the planning (micro-economic) sub-centre and the monetary (macroeconomic) sub-centre. Their existence and mutual relationship was however institutionalized formally and therefore remained to a large degree hidden and unrecognized.

Nevertheless, it was admitted by the new (post-socialist) government, that in the socialist Czechoslovakia, the macro-economic functions of the state, i.e., the pursuance of the macro-economic equilibrium, were executed with a remarkable comprehensives. Put otherwise the monetary centre, however informal was its existence, relatively successfully disregarded the concrete microeconomic (politically motivated) requirements of the CPC and relatively efficiently succeeded in refusing the enterprise-efficiency-based problems of the "micro sphere".

It is of a degree of irony of the development in the Czech Republic that the genuine danger to the macro-economic stability came with establishing democracy. It was the newly appointed democratic government who could have easily destroy the unique macro-equilibrium of the country. The roots of this danger can be traced back to the variety of "reform strategies" discussed in Czechoslovakia already in the 1960s. These strategies could be classified into the following three categories:9 reforms in the economic mechanism, restructuring of the economy, enforcement of the macro-economic equilibrium.

The first strategy was advocated by so-called "traditional reformers", the second by "structuralists", the third strategy was spelled out by "macro-economists". In the early days of 1990 the political battle in Czechoslovakia was mostly amongst the three groups of economists. The reformers were largest in their number a recruited themselves mainly from the unsuccessful teams of political economists associated with the unsuccessful attempt to liberalize
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8 See V. Klaus and D.Triska (op. cit.).
9 See V. Klaus and D.Triska (op. cit.).
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socialism in the 60s. The camp of structuralists consisted from the rather cynical pragmatists produced by the "normalization" era of the 70s and 80s. The team of macro-economics was represented by no more than two or three people and in the late 80s had absolutely no political influence. 10

2.3 Micro-economic functions of the SBCS

Technically speaking, the process if dismantling the mono-bank consisted in dividing the balance sheet of the mono-bank amongst three ensuing commercial banks ("Investicni banka", "Komercni banka" and "Vseobecna uverova banka"). While the former bank was taken as a federal one, the latter two were conceived of as Czech and Slovak respectively. The introduction of the standard type two-tier system opened space for establishing the true Central Bank fulfilling its standard functions and at the same time opened way the follow-up financial and organizational restructuring of the commercial banking sector.

The historical relationships between the SBCS and the "artificially" created banks have played formally and informally important role in the future development of the economy. As the banks were confronted with problems which they believed were beyond their capacity to solve, the Central Bank spontaneously (formally and informally) became their "advocate" in their bargaining with the Government. l1

Historically, therefore, the situation evolved in such a fashion that on the one side the government and its branch ministries represented the clients of the banks (the enterprises) and on the other side there was the Central Bank who was to play a role of a "ministry of banking". From this historical perspective it was difficult for the Central Bank to clearly confine to its macro-economic function and keep its hands off the microeconomics problems. At the same time it was hard and impossible for the Government not to interfere with the affairs theoretically assigned only to the monetary centre. The transformation duties were, as already noted, at that time executed by only a few economists randomly located in the Government, Central Bank and enterprises.

As an illustration of the complexity of the bank-enterprise relationships it should be stressed that the most heavily indebted clients of the banks were typically those who suffered
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10. The team became more influential only after it had incorporated the micro-economic strategy to its programme, later resulting into the mass privatization plan.
ll. As an example of issues doubtlessly beyond the power of a commercial bank can be mentioned the problem of disintegration of Czechoslovakia, which started by gradual division of the "federal" institutions (including banks) into their Czech and Slovak part.
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from the disappearance of the traditional markets in the USSR, former GDR and Yugoslavia. The very same group of large enterprises faced the sharpest decline in domestic demand. Still worse some for these clients of the banks, they were almost immediately subjected to a genuine competition from the sharply growing imports. 12

All these unprecedentedly complex problems had to be solved in an enormously unstable internal situation in every bank. Each of them - just like any other agent in the economy - had to fulfill its own transformation, i. e. transform its own systems of management and mainly the managerial staff.

As already stressed, from the very beginning in February 1990 and consecutively ever since the economic policy of the government strongly relied on the concept of a private initiative. The government strongly articulated that the looked-for prosperity of the country mainly depends on the capacity of newly emerging economic agents and that these can be best helped by two policies - rapid privatization of the existing state-owned enterprises and keeping the macro-economic environment as stable as possible. According to the government the economy should extensively liberal and all economic agents (domestic and foreign, stateowned and private, newly established and privatized) should be given the same treatment, i.e. should be exposed to the so-called hard budget constraint.

It is relatively easy to understand that this type of a government policy could hardly be a good news for any of the seven commercial banks. They all were ready to ask the government for some type of help, for exemptions from the generally ruthless lines of the transformation policy. The banks were stressing "specific features" of their position in the economy and of their economic situation. They resisted their own privatization. They asked for "subsidies", or for assistance in writing down the non-performing loans. The macro-economic almost orthodox monetarist policy was, according the banks, too straightforward and could lead to a the "domino effect" of bankruptcies and ultimately also the collapse of the banking industry. The banks directly or indirectly lobbied for a "sound industrial policy" and the government s involvement in financial restructuring of their most difficult clients.

Paradoxically the monetary policy was in the hands of the Central Bank which - at the same time - sometimes involuntarily - became the speaker of the banks requirements. The Central Bank often explained that it would be a mistake to treat a commercial bank just like any other enterprise. It opposed the statement that "we all are in an evenly bad situation", that the banking sectors is in no worse or better situation than any other post-socialist company.
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12 In January 1991 the internal convertibility of the domestic currency was introduced and as a result the import to the country was liberalized.
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The government, its Ministry of Finance, demanded that it cannot be the state budget but the banks management who must mobilize their own resources. It was the thesis of the Ministry that just like in any other branch of the economy the only sensible therapy for the gigantic problems of the banking sector is its immediate privatization. As a part of the philosophy - the new owners of the banks not the government should solve the banks problems. It was the Central Bank who negotiated the compromise: the banks were privatized but the state kept substantial (40 - 50 %) of the stake in its hands.

The central bank thus played an important role in the micro-economic debate, especially as to the restructuring and privatization of commercial banks. Its micro-approach was often contradictory to its macro-functions. And it could not be otherwise.

2.4 Macro-economic objective of the SBCS

It is too trivial to merely state that the fundamental objective of the monetary policy of the Central Bank was and still is the macro-economic stability. The Central Bank was established as a body which were there to prevent the inflationary spiral so typical for post socialist countries.

In the real life of a transforming economy, there are at least three resources of an inflation:

- initial devaluation of the domestic currency and further devaluations associated with the internal convertibility,

- price liberalization,

- tax reform, in particular introduction of a value-added to the tax system.

Each of these inflationary time-bombs is by itself capable of launching hyper inflation. For being able to complete the above stabilization goal, the Central Bank cannot prepare its comprehensive plan independently from the Government. Still worse for the "theory of independence", the implementation of the policy of the Central Bank has to be closely coordinated with the Ministry of Finance and other government agencies. The reasons are both macro- and micro-economic.

The results of the mutual policy of the Government and the Central Bank are relatively good in the Czech Republic. The inflation is relatively under control - 10 % in 1990, 53,6 %1991 (the once-and-for-all impact of the price liberalization) and 11,5 % in 1992 (all consumer prices), 20 % in 1993 (due to the introduction of the value-added tax).

The Central Bank implemented its monetary policy by utilizing mainly direct instruments (ceilings on interest rates and credit volume). These instruments were removed in 1992 after the opening of a clearing centre for all inter-bank payment transactions and settling these transactions on the books of the central bank. This was one of the important measures that have given the central bank the opportunity to start to manage the money supply by using refinancing auctions and other operations on the open market.

However the Central Bank in the Czech Republic could not focus on the monetary policy only. It had to play a very important role also in implementing the overall transformation strategy. It was very active in designing the initial devaluations of the currency thus opening way for internal convertibility. It co-operated in drafting essential legislation associated with the currency and financial sector regulation. It had to organize the ungrateful task of the mutual separation of the Czech and Slovak currencies shortly after the Czechoslovakia was divided into the Czech Republic and the Slovak Republic. It has played the interventionists role in the policy of the fixed exchange-rate thus making the rate the anchor of the transformation policy.

All these functions together with the uniqueness of the evolution of the banking sector in the Czech Republic makes the theoretical concept of the monetary policy independence a little more complex than the economic text-books sometimes indicate.

3. CENTRAL BANK AS A MINISTRY OF BANKING

It has been stressed already that the theoretical independence of the Central Bank in formulating its macro-economic policy will always be in practice strongly affected by many factors. In the Czech Republic it was important that the Central Bank started to play a role of a regulator in the micro-economic world of commercial banking. The above discussed transformation of the banking industry had its legal foundations in the Law about the Central Bank and the Law about the Banks and Savings Banks accepted by the Federal Parliament in 1989.

In 1990 the seven commercial banks in fact represented the entire financial sector of the country. They started as state-owned enterprises, were later transformed into joint-stock companies and most of them were included into the voucher privatization scheme.13 The seven banks were gradually subjected to competition firstly from the newly established banks and later from the entirely new industry of investment companies and funds. 14 The financial sector in the Czechoslovakia now also includes two securities exchanges and a growing number of dealer/broker firms.
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13 For more detail about the demand and supply side of the voucher privatization see, e.g., Jan Mladek : Voucher Privatization in Czechia and Slovakia. The Fifth Meeting of the ADP, O.E.C.D. Paris, France, March 2-4,1994.
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3.1 Licensing and supervision of banks

In the beginning of the transformation process, i. e. in 1990 - 1991, the architects of the economic policy had no other way how to organize regulation of the commercial banking but:

- appoint the Central Bank as a regulator,
- agree to the overall liberal approach of the regulation.

Altogether seven new banks were granted their licenses in 1990 and further 25 new banks were established in 1991. The emergence of new banks had many positive effects as it generated first signals of competition and opened gates to the foreign expertise.

On the other hand, some of the newly created banks has problems to hire adequate human resources as the supply of skilled people was very limited.

The Central Bank has made visible progress in licensing and supervising banks. Most of the basic prudential rules for the banks have been introduced with a grace period for the banks adjustment. Issued prudential rules together with an implemented system of reporting and supervising have had significant positive effects on the decision-making process within the commercial banks. For instance, an audit based on international standards required by the banking supervision for all banks has stimulated the banks into improving their accounting, internal auditing and credit management.

3.2 Assistance to re negotiations with clients

Another area where the Central Bank had to play a micro-economic role of a commercial banks representative was the re negotiation of old credit contracts. This process started early in1990 when it was obvious that the old system of fixed interest rates was over. The banks faced a strong resistance of enterprises which were trying to keep their credit contracts unchanged and maintain the interest rates at the original level, in the range of 2 to 6 %. In many cases the banks took the restructuring of old companies into new ones as a pretext for the re negotiations of the old credit agreements. This policy of the commercial banks was accompanied during the second half of 1990 by the suspension of loans on permanently revolving inventories, as we shall discuss further below.
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14 See the analysis of Robert E. Anderson: Voucher Funds in the Transition Economies: The Czech and Slovak Examples. The World Bank, Technical Department ECA/MNA Regions.
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During 1990 and 1991 the banks re negotiated most of the old contracts and secured their loans with fixed assets, real estates and other kinds of property. Practically every new application for credit has been accepted only when secured by the property of debtors or by the guarantee of a third party. The sound securitization has certainly assisted in an improving the quality of banks loan portfolios. However, the policy has appeared to be a difficult barrier for many starting private entrepreneurs to get credit from banks.

After the period of development the banks were ready supported the government's efforts and the expectations of the public to give the priority for the development of the private sector7 but of course, not fully. The banks were not able to satisfy all loan applications and many proposals were turned down. The analysis of Kerous15 made in the autumn of 1992 showed that there was one approved proposal for approximately every five applications in the case of domestic banks and about ten applications in the case of foreign banks, which are more cautious than domestic banks. Notwithstanding the rapid growth of loans to the private sector, the banks credit policy has been criticized from time to time by the public and by the government for their policy of collateralisation .

The fast growing portion of credit to the private sector does not entirely diminish the importance of credit extended to state enterprises, which still represents more than one half of the banks total outstanding loans. Relations between state enterprises and the banks have undergone substantial changes. Enterprise debt owed to the banks has been secured as much as possible by mortgages, liens, stocks or in equity. The management of enterprises has lost the avenue of political pressure for receiving new credit - the most powerful method of credit rationing in the former regime - since banks significantly increased their negotiating strength in comparison with the past.

Nevertheless, the heritage from the former economic regime is still very powerful and the banks are, particularly in their relations with enterprises, in a position of captives of their debtors. They hold totally or partially secured debts and in theory they could take over the property or, in many cases, the whole enterprises. However, they do not have the staff and skills to take over the management of enterprises. This has been the main reason for the very cautious approach by banks in resolving the issue of non-performing loans to state enterprises.

The Central Bank, therefore, has to intervene in the formulation of the general policy concerning bankruptcies. The Law about bankruptcy was accepted in September 1991, but its effectiveness was later twice postponed. Under the limited power of that law it was impossible to declare bankruptcy if the form was insolvent, so that many state enterprises that were technically bankrupt did not close down but continued to survive.
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15 Miroslav Kerous: Czech and Slovak banking in transition period. Forthcoming, paper prepared for The Institute of Development Studies at the University of Sussex.
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One of the results of the credit contracts re-negotiations and the newly implemented credit policy has been the radical change in the loan structure in favor of short ( up to 1 year or medium term (up to 4 years) loans.

To support greater access to loans for those debtors with insufficient collateral, the governments has initiated the establishment of loan guarantee institutions. The Czech government together with several of the biggest banks founded The Czech Guarantee and Development Bank in January 1992 with the main goal to issue guarantees for privately owned companies. This guarantee bank with a capital of 1.1 billion CZK and total assets of 3.3 billion CZK, initiated several guarantee and support programs for small and medium entrepreneurs. In 1992 the bank provided more than 500 credit guarantees with a volume of 1.5 billion CZK and about 950 cases of interest rate subsidies (from 4 to 7 per cent items) with a volume of 0.6 billion CZK. A similar institution, The Slovak Guarantee Bank, has been developing its activities in the Slovak Republic since 1991.

The obstacles to a broader influence for these institutions are the relatively small guarantee capital and the slow and complicated administration process.

A third guarantee institution, The Export Guarantee and Insurance Company (EGAP), was set up for securing and insuring export claims. At the end of 1992 it began to insure short, medium and long term export contracts commercial and political risks. Nevertheless, already in the first half of 1993 it has been shown that the broadly oriented and more powerful institution for export financing in needed. Now the Czech authorities discuss different possibilities of establishing the Export-Import Bank, either through the expansion of the EGAP or through the creation a new specialized bank which assumed be initially closely connected with the ventral bank.

The last indirect government influence in the banks credit policy worth noting, is its relation to banking reserves. In spite of the verbal support for improving balance sheets of the banks, the government has been keeping a careful eye on the balance of its budget to which it gives the highest priority. The Ministry of Finance even blamed several banks for creating too high reserves in 1991 and in 1992 and thus avoiding payment of taxes and required the banks to refund the excess back to the state budget. These requests, in the amount of several billions CZK (5 billion in 1991, 6 billion in 1992), have been made in a highly arbitrary fashion with the goal of obtaining additional funds for the state budget. The reactions of the banks in question differed in dependency on their ownership structure and on the progress in the privatization process. While in 1991 several banks agreed to pay the additional taxes, in 1993 the two newly privatized commercial banks successfully refused to meet any additional payment requirements of the ministry.

3.3 Access to credits

The core of the trends discussed above reflects the changes in the loan portfolios of the traditional banks. Many of those trends are relevant for new banks as well, particularly the structure of credit preferring short or medium term maturates and the concentration on private forms, of course. Nevertheless, the situation of new established banks is rather different in comparison with the traditional banks.

The important difference is mainly the difficult access of new banks to the primary deposits, particularly to the long term ones. The new banks have been entering the market, which consists of two dominant collectors of savings from the public (Czech and Slovak Savings Banks) and several large-sized credit banks with long term banking relations to both collectors and distributors of savings. It is apparent that the traditional banks and the savings banks have been definitely holding in that respect a strong competitive advantage. The savings banks in each republic have felt a certain responsibility concerning with their dominant market position and have been providing funds to the new banks. However, the amount of deposit that the savings banks could make available to the new banks was limited. This was partly due the fact the savings banks launched very ambitious credit programs of their own with the goal of becoming competitive with the traditional credit banks. In addition, they could deposit only limited amounts of their resources in each of the new banks on prudential grounds.

With the aim of increasing their share in primary savings most of the new banks began to offer new banking products such as savings book, certificates of deposit and banking bonds. This strategy has a limited success because the traditional banks offered similar products but were able to use the larger branch networks.

The Central Bank was aware of the problem and it tried to support the new banks trough its refinancing facilities. This liberal refinancing policy of the central bank made available additional funds for new banks but the price of those funds was very high. Following its tight monetary policy the central bank could offer only limited volume of refinancing funds whose prices were fixed in regular auctions. Since 1993 the rules for the auctions have been changed when the central bank discovered that several small banks were becoming increasingly dependent on central bank refinancing. At present, any bank can borrow at most the 50% of offered auction funds, the refinancing credit shall be less than 20% of bank's credits to non banking clients and less than three-fold of paid-in capital of the bank.

The above discussion describes three ways of raising credit funds and it shows how the system could deliver more expensive money to small new banks while the savings banks and traditional credit banks had access to cheaper resources (deposits). This was a force which pushed the interest rate level of new bank's credits upwards and make the loan portfolios of these banks more vulnerable.

3.4 Non performing loans

The problem of non performing loans was not mentioned at the time when the banks were established in 1990. The first discussions, however, emerged immediately after the transformation of the mono-bank was completed. The Government succeeded in resisting the debates over "cleaning up the balance sheets of the banks" all through the year 1990. However, under the pressure from the Central Bank, the Government was forced to consider the problem in 1991, after price liberalization, when the inflation and interest rates went up and the debtors - the state enterprises and co-operatives - signaled that they were unable to service their debt.

Since that time several attempts have been made to estimate the magnitude of the non performing loans in the balance sheets of the banks. The estimates strongly varied from about 2/3 of the banks loan portfolios to some 1/3 of the total loans (World Bank 1991l6). The higher estimations were produced largely by the banks themselves and they of course suffered from a strong bias.

The Government reacted to the claims of the banks in its standard way - it refused all of them as unjustified. The Central Bank made this approach of the Government no longer acceptable by issuing a decree in which it differentiated between "standard" and "classified" assets of banks. The Government felt betrayed by the Central Bank as it presented a document which seemed to be - to a broader public - as an objective evaluation of the problem. The standard assets of banks were in this "objective" manner defined by the Central Bank as those in which the interest and principal are normally paid and the creditor has no doubts about the debtors satisfactory financial situation and/or the debt is sufficiently secured.

On the other hand, classified assets were defined as to consist in:

- non-standard assets, that have well defined "negatives parameters"; for instance loans that have not been repaid minimally 30 days after the maturity,

- doubtful assets, that are not reliably secured, for instance loans that have not been repaid minimally 90 days after the maturity or claims in clients who have fallen into bankruptcy, loss assets, whose repayment is unlikely and insufficiently secured, repayment has been over due for more than 360 days.
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16 CSFR Financial Sector Review. World Bank. Memo. March 31, 1991.
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3.5 Sequence of the operations of the Central Bank

In order to illustrate the scope of the micro-economic activity of the Central Bank we can show its most important measures. None of them was implemented without criticism from the Ministry of Finance. The most important measurers were the following:

a) The conversion of administratively defined loans to commercial loans

In the autumn of 1990 the government canceled the legal background for obligatory title of credit on "permanently revolving inventories" (PRI). This decision was made to make it possible for the banks to adjust the administratively prescribed interest rate of 6% to the market level. On January 1 1991, the central bank set the discount rate at 10% and the ceiling on the credit interest rates of commercial banks at 24%. The increase in interest rates from 6% to 18% or 24% threw many enterprises into difficulties, inter - enterprise debt went up very quickly and the government was exposed to strong pressure from business managers and the political opposition.

b) The Consolidation Bank

In March 1991 the government established a special agency into which about 50% of credits for PRI of co-operative firms and 80% of the credits for PRI from the state firms was transferred. The Consolidation Bank took over CZK 110 billion of these loans from the banks and obtained the resources to cover these loans mostly from long-term refinancing facilities of the savings banks and from the central bank. As for these enterprises, their former debt at 6% interest rate and an uncertain maturity has been changed into liabilities with a 13% interest rate and an 8 year maturity. Since that time, the Consolidation Bank has taken care of its ordinary debt service. The debt is slowly being repaid and at the end of 1992, the Consolidation Bank held 92 billion CZK of these loans on its balance sheet.

c) The supporting activities of the state budget

Because of its cautious budgetary policy, the government has not been sympathetic to the idea of large budgetary spending to finance the writing off of the non performing loans. The government initiative has been highly limited in this respect. It spent:

- 2.6 billion CZK for the reconstruction and liquidation of the inventories of the military industries,

- 1.5 billion CZK for covering the losses of enterprises with frozen foreign assets in countries under international embargoes

- about 10 billion CZK which the government promised for covering the losses and debts that have emerged due to the devaluation of the domestic currency at the end of l 990.

d) National Property Fund bonds

The National Property Fund (NPF) was established in 1991 as specialized financial institution responsible for some administrative tasks associated with privatisation.l7 Later, the Central Bank suggested that part of the NPF s property be used for strengthening the asset side of the balance sheets of the banks. According to the plan the NPF issued five-year convertible bonds in the overall value of 50 billion CZK and transferred them to the portfolios of the respective banks. In five years the bonds will be converted into shares of privatized companies. The banks were allowed to use this "capital injection" to write down some of their claims towards some of their clients.

It was the Central Bank who argued that it will be the commercial banks who will select which non-performing loans will be written off. Put otherwise, the Central Bank argued that the commercial banks have the capacity to distinguish future profit-makers from loss-makers and - still more importantly - should objectively identify which of their clients (enterprises) deserved the assistance. This method enabled to write off about 35 billion CZK of the "non performing" loans.

4. FORMAL ORGANIZATION

As already indicated the real life would sharply differ from the theory, in the Czech Republic formally incorporated in a special law about the Czech National Bank.

4.1 Formal macro-economic functions

According to the law the major objective of the Bank rests in "en suing the stability of the Czech national currency. With this in view the Bank (its Board18) is entitled to set monetary policy, issue bank notes and coins, control the circulation of currency, co-ordinate the payments and settlement of accounts between banks, and ensure their smooth and efficient operation.
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17. For simplicity we do not speak about the whole triad of NPFs, the federal, Czech and Slovak.
18. The Board is constituted as the "supreme managing body of the Bank". It consists of the following seven members: the Governor, two Vice-Governors and four other senior officers.
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4.2 Formal guarantees for independence

Theoretically, the independence of the Central Bank from the Government is beyond any doubt and has been stress, e.g., by both the key-note speech at the Conference l9 and the paper of the Governor of the Czech National Bank20.

Formally, this is guaranteed by the above mentioned law, which includes special set of regulations covering the Bank s relationship to the Government.2l According to it, the Government has no right to submit instructions and orders to the Bank. Whereas the Government has the right to appoint its representative to the meetings of the Bank s Board, the representative has no voting rights in the Board.

The Bank has the right to express its position towards any proposal submitted to the Government should the proposal align with the Bank s formal competencies. For that purpose the Governor of the Bank has the right to attend any meeting of the Government and speak at the meetings in his/her advisory capacity.

The Governor Vice-Governors and other members of the Board are appointed by the President. The term of appointment is here six years, while in the case of the Government its functions depend on the four-year parliamentary elections period. a it is accountable to the Parliament. Formally, the Bank submits to the Parliament a report on the monetary development of the economy. This report has to be submitted at least twice a year.

Unlike in the case of a minister (as a member of the Government), the member of the Board must not be a member of Parliament. In addition to this the Board member must not occupy any position with the (government and any position in commercially operating Units

4.3 Formal measures of the monetary policy

The Bank is entitled to set forth interest rates, structures and terms of payment.
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l9. See Michael Burn: Political Autonomy of Central Banks: Theory and Practice.
20. See Josef Tosovsky: The Role of the Central Bank in Transition to a Market Economy.
21. See articles 9 - 11 of the law.
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The Bank may set the minimum rates of interest on the deposits accepted by banks and branch offices of foreign banks, and the maximum rates of interest on the credits provided by the banks.

The Bank may stipulate the maximum volume of credits to be provided by banks.

The Bank sets the minimum reserves requirements. According to this, the Bank may demand that each bank will deposit an ex ante defined part of its resources on a special account in the Bank. For the volume of the reserves the law states a ceiling of 30 % of each bank s liability. However, the ceiling may be increased whenever the Bank believes that in the market emerge excessive liquidity and consequently inflationary pressures.

According to the law it is the Bank who proclaims the exchange rate of the Czech currency vis-a-vis foreign currencies. However, in the field of the legislation the Bank submits its proposals to the Government. In the case of the foreign exchange laws their drafts have to be submitted to the Government in co-operation with the Ministry of Finance.

4.4 Formal micro-economic functions

According to the law the Bank kept its position as the supervisory body over commercial banks. This, in fact means that the Bank remains the Ministry of Banking and as such has to combine its micro- and macro-economic functions.

Formally speaking the Bank s supervisory role includes licensing of newly established commercial banks and-or execution of these banks regulation. Thus the Bank is, among other things, entitle to issue sanctions against commercial banks.

4.5 Informal setting

Several times in the short history of the transformation of the Czech economy the advantages of the mutual independence of the Bank and Government could be subjected to reasonable questions. Even if it was regarded as positive that the Governor is not subordinated to the Prime Minister the trade-off is that the same Governor has had no voting right in the throughout the transition period and thus could never formally express his/her support to this or that proposal of the Ministry of Finance.

Bearing this in mind the theoretically obvious independence of the Central Bank could be in the Czech Republic, in sum, even viewed as a disadvantage. As an example can be given the historical meeting of the (then Federal) Government in April 1990 in which the first attempt to present the transformation package was refused just because some of the present economists had not the right to vote.22

On the other hand, the author could hardly find but one case when the Central Bank independence was a real contribution the transformation policy.

REFERENCES

Anderson Robert E.: Voucher Funds in the Transition Economies: The Czech and Slovak Examples. The World Bank, Technical Department ECA/MNA Regions.

Bruno Michael: Political Autonomy of Central Banks: Theory and Practice. This volume.

Kerous Miroslav: Czech and Slovak banking in transition period. Forthcoming, paper prepared for The Institute of Development Studies at the University of Sussex.

Klaus Vaclav: Privatization Experience: The Czech Case. Speech at the International Chamber of Commerce Meeting, Cancun, Mexico, October 21, 1993.

Klaus Vaclav and Triska Dusan: Ekonomie Nicholase Kaldora - nova ekonomie, nebojine ambice? ("Economics of Nicholas Kaldor - new economics or other aspirations"), Politicka ekonomie, Praha 1987.

Klaus Vaclav and Triska Dusan: The Economic Centre: The Restructuring and Equilibrium. (Czechoslovak economic digest, 1/1989, Prague, Czechoslovakia.)

Mladek Jan: Voucher Privatization in Czechia and Slovakia. The Fifth Meeting of the ADP, O.E.C.D. Paris, France, March 2 - 4, 1994.

Tosovsky Josef: The Role of the Central Bank in Transition to a Market Economy. This volume.

Triska Dusan: Bargaining and Search in Imperfect Markets: A Centrally Planned Economy. In: R.E.Quandt and D. Triska (eds.): Optimal Decisions in Markets and Planned Economies. Westview Press, London 1990.

Triska Dusan: Political, Organizational, and Legislative Aspects of Mass Privatization

- Czechoslovakia. (Marko Simoneti and Andreja Bohm (eds.): Privatization in Central and Eastern Europe 1991, Proceeding of the Second Annual Conference of the CEEPN.)
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22 The whole package could be brought again to the Government only After the elections in June 1990.
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