Yugoslavia - Financial sector restructuring : policies and priorities (Vol. 1 of 2) : Main report

Repoit No. 7869-YU Yugoslavia Financial Sector Restructuring: Policies and Priorities (In Two Volumes) Volume 1: Main Report Novefie 30, 1989 Country Operations Department IV Europe, Middle East and Nonh Africa Region FOR OFFICIAL USE ONLY Documen of the WwM Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not ohrwise be disclosed without World Bank authorization.  CURRENCY EOUIVALENTS Currency Unit - Dinar (Din.) Currency Unit Calendar Year 1988 1/ Seotember 30. 1989 US$1 Dinar 2,522.6 Dinar 32,521.0 Dinar 1 US$0.0003964 US$0.00003 Dinar 1,000,000 US$396.42 US$30.75 WEIGHTS AND MEASURES Metric System GLOSSARY OF ABBREVIATIONS AND ACRONYMS BOAL Basic Organization of Associated Labor DFEL Deferred Foreign Exchange Losses G.AP Generally Accepted Accounting Principles GDP Gross Domestic Product GSP Gross Social Product IEF Inter-Enterprise Financing IMF International Monetary Fund IAS International Accounting Standard JLF Joint Liability Fund JRF Joint Reserve Fund LBL Ljubljanska Banka Ljubljana-Associated Bank LT Long-Term MLT Medium- and Long-Term NBFI Non-Bank Financial Institution NBY National Bank of Yugoslavia OAL Organization of Associated Labor PEF Preperty and Equipment Funds RAP Republic and Autonomous Province ST Short-term SDK Social Accounting Service (Sluzba Drustvenog Kujigovodstva) SMA Self-Management Agreement YBA Yugoslav Bankers' Association 1/ Period Average.  FOR OFFICIAL USE ONLY 1. The macroeconomic instability and the high rates of inflation in Yugoslavia have their roots in the substantial losses incurred by the enterprises and the National Bank of Yugoslavia (NBY). The enterprise losses consist of current losses associated with the continuation of unprofitable activities and capital losses resulting from the impact of the devaluations on their stock of foreign exchange debt--enterprises hold most of Yugoslavia's external debt. NBY's losses consist mostly of foreign exchange losses resulting from a foreign exchange insurance scheme designed to protect commercial banks from the risks associated with their foreign exchange deposits. The losses of enterprises have been financed through subsidized commercial bank credits and ultimately through excessive monetary expansion by NBY. NBY's own losses have added pressure to the process of monetary creation and have led to the acceleration of inflation. 2. Yugoslavia repeatedly attempted to stabilize the economy in the 1980s, but, failed to do so because it did not impose financial discipline on losa- making enterprises. Recent attempts at stabilization, aimed a8.' restraining credit and increasing interest rates to positive levqls, have also failed to control inflation in the presence of distress borrowing and an active market for inter-enterprise credits. In fact, there has been a sharp acceleration of the inflation rate. Inflation has reached 40-45 percent a month in the third quarter of 1989. 3. The current macroeconomic instability is closely associated with the problems in the financial system. In addition, the disruptions in the financial system caused by macroeconomic instability have been serious enough to severely undermine the system's functioning. To break this cycle, it is necessary to resolve the financial crisis through the financial restructuring of NBY, commercial banks and enterprises. This approach would prevent the further growth of losses and would eliminate the main source of macroeconomic instability. The implementation of such a complex program presents a major challenge and requires a strong :-mmitment to fiscal adjustment. 4. This report examines the causes of the failure of the financial system to further macroeconomic stability and provide efficient financial intermediation. The report proposes ways to cover the foreign exchange losses of NBY and the portfolio losses of the commercial banks in a non-inflationary way. It also recommends changes in monetary and fiscal policies and proposes reforms in the structure and operations of the financial system to ensure the success of the stabilization and restructuring program. The most important reform would be to sever the links between ownership of the banks and borrowers. If these links remain unchanged, resources will again flow to loss-making enterprises and undermine the effectiveness of the macroeconomic policies in reducing domestic demand and the rate of inflation. This documnent has a restricted distribution and may be used by recipients onty in the pe-formance of their official duties. Its contents may not otherwise be disclosed without World Bank authorinzation.  ACXNOWnLEDOMMN This report is based on the findings of two World Bank missions that visited Yugoslavia in May/June and in October/November 1988. The missions were led by Mr. Mansour Farsad and Ms. Ilham Zurayk and comprised of: Messrs. Roberto Rocha, Jose da Silva Lopes, Chauncey Dewey, Sani El-Darwish, Safi Harb, Mark Heitner, Baudouin Hubert, David Kochav, Chaung "in Pang, Vincent Polizatto, Emanuel Sharon, Stan Silverberg, and Jacob Yaron. Mr. Anton Op de Beke of the IMF also participated in the second mission. The mission is grateful for the support it received from the various Federal and Republican agencies, the National Bank of Yugoslavia, the commercial banks, and other institutions in the financial system. The mission would particularly like to thank members of the counterpart team, Messrs. H. Gaspari, D. Gajic, N. Mates, D. Mramor, I. Ribnikar, and S. Valant for their valuable contributions to the work of the mission. The mission also wishes to thank Mr. Manuel Hinds for his valuable comments and contributions. Maria Luisa de la Puente was responsible for the production of the report. This report was discussed with the Yugoslav Government officials in October 1989.  FLNANCIAL SECT3OR RESTRUCTURING: POLICIES AND PRIORITIES Pone No. BASIC DATA SUMMARY AND RECOMMENDATIONS . . . . i PART ONE: MACRO-FMIANCIAL POLICIES CHAPTER I- INTRODUCTION . . . . . 1 CHAPTER II- CREDIT SUBSIDIES. 7OREIGN EXCHARGE LOSSES AND INFLATION 3 A. The Causes of Inflation: An Overview 3 B. The Operations of the Central Banking System . . 5 C. The Sources of Money Creation . . . 9 1. Monetization from Stock Variations . 13 2. Monetization from Flows . . 15 3. The Total Impact on Base Money . . . . . 16 D. Inflation Tax and Seignorage Revenues on Base Money . 18 1. The Size of the Inflation Tax and Seignorage Revenues . 18 2. The Incidence of the Inflation Tax Collected on Base Money 19 E. Inflation Gains and Losses . . . . . 20 F. Wealth Effects . . . . . . 22 CHAPTER III- RESOURCE MOBILIZATION. CREDIT ALLOCATION. AND INTEREST RATES 25 A. Resource Mobilization Policies . . . . . . 25 1. Deposit Rates . . . . . . . . 25 2. Demand for Money . . . . . . . 27 3. Foreign Exchange Deposits and Currency Substitution . 30 4. Banks' Efforts to Mobilize Deposits . . . 32 B. Credit Allocation Policies . . . . . . 33 1. Bank Credit and Inter-enterprise Credits . . . 33 2. Lending Interest Rates . . . . . . 35 C. The New Interest Rate Policy . . . . . 35 1. Deposit Rates . . . . . . . . 36 2. Lending Rates . . . . . . . 36 3. Intermediation Spreads . . . . . 37 4. Currency Mismatching . . . . . . 38 CHAPTER IV- THE REAL SOURCES OF DISEOUILIBRIUM . . . . 39 A. The Resource Transfers . . . . . . 39 B. The Origins of Chronic Instability . . . . . 42 1. The Inward Oriented Strategy . . . . . 42 2. The Shift in Relative Prices . . . . . 43  -ii - Page No. C. The Structural Sources of Imbalance . . 44 1. The Structure of Enterprise Ownership 44 2. The Ownership of Banks and Financial Discipline . . 45 D. Inflationary Approach and Distortions . . . 46 E. Attempts to Stabilize . . . . . 47 1. Stabilization Efforts Prior to 1988 . . . 47 2. Recent Stabilization Attempts . . . 48 CHAPTER V- THE INSTRUMENTS OF MONETARY MANAGEMENT . . . 51 A. Introduction . . . . . . . 51 B. Credit Control Instruments . . . . . . 51 1. Credit Ceilings . . . . . . 51 2. Reserve Requirements . . . . . . 53 3. Refinancing and Other Lending Operations . . . 54 4. NBY Bills . . . . . . . . 56 C. The Role of NBY . . . . . . . . 57 CHAPTER VI- POLICY RECOMMENDATION . . . . . . 59 A. The Stabilization Strategy . . . . . . 59 1. Macroeconomic Policy and Financial Discipline . . 59 2. Recapitalization of the Banking System . . . 60 B. Losses of the Banking System . . . . . . 61 1. Avoiding the Accumulation of New Losses in the Banking System 61 2. Financing the Flow of Losses . . . . . 63 3. Stock Effects . . . . . . . 67 C. Fiscal and Macroeconomic Implications of Restructuring . . 68 D. Interest Rate Policy . . . . . . . 70 E. Monetary Policy Instruments . . . . . . 71 PART TWO: COMMRCAL BANKNG POLICI CHAPTER VII- THE STRUCTURE AND REFORM OF THE COMMERCIAL BANKING MYThH 74 A. Introduction . . . . . . . . . 74 B. Structural Flaws in the System . . . . . 74 C. Reform of the Commercial Banking System . . . . 76 1. Objectives and Prerequisites . . . . . 76 2. Important Beginning: The 1989 Banking Law . . . 77 3. Essential Actions . . . . . . . 81  - iii Page No- CHAPTER VIII- FINANCIAL CONDITION OF THE CONMERCIAL BANKS . . 84 A. Introduction . . . . . . . . 84 B. Past Performance and Financial Position . . . . 84 1. The Banks' Financial Statements . . . 84 2. Liabilities . . . . 85 3. Loans and Portfolio Quality . . . . . 87 4. Contingent Liabilities . . . . . 87 5. Foreign Exchange Exposure and Losses . . . . 89 6. Profitability . . . . . . 90 7. Capital Funds . . . . . . 90 8. Cost of Intermediation . . . . 92 CHAPTER IX- RESTRUCTURING OF THE BANKING SYSTEM . . 98 A. Introduction . . . . . . . 98 B. Approaches to the Restructuring of the Banking System . . 98 1. Diagnostic Evaluation . . . . 98 2. Restructuring Insolvent Banks . . . . iOO 3. Operational Restructuring . . . . . i4 C. Restructuri. of the Banks in Yugoslavia . . . 105 1. Preparatory and Initial Actions . . . . 105 2. Options for Dealing with Losses . . 107 D. Restructuring of Enterprises . . . 110 1. Approaches to Enterprise Restructuring . . 110 2. Legal Framework . . . . . . 111 3. Transformation from Socially to Directly-owned Capital . 112 CHAPTER X- STRENGTHENING THE SUPPORTING STRUCTURE . . 114 A. Supervision and Regulation of the Commercial Banks . . 114 1. Introduction . . . . . . . . 114 2. The Role of Banking Supervision and Prudential Regulation 114 3. Development of Prudential Supervision in Yugoslavia . 116 B. Accounting an4 Auditing . . . . . . . 123 1. The Accounting System . . . . . . 123 2. Deviations from the GAAP . . . . . . 124 3. 'Current Cost' Concept . . . . . . 124 4. The 1989 Accounting Law . . . . . . 125 5. Auditing . . . . . . . . 127 6. Assessment . . . . . . . . 128 CHAPTER XI- NON-BANK FINANCIAk INTERHEDIARIES AND DEVELOPMENT OF SECURITIES MARKET . . . . . . . 129 A. Introduction . . . . . . . . . 129 B. Non-bank Financial Intermediaries . . . . . 129  - iv - Pga- No, C. Money and Capital Markets . . . . 132 D. Institutional and Regulatory Reform . . . 134 CHaPTER XII- POLICY RLCOQMINDATINS . . . . . . 139 A. The Existing Banking System . . . . 139 B. Legislative Framework for Banks and Enterprises . . . 140 1. Banking Legislation . . . . . 140 2. Enterprise Legislation . . . . . . 142 3. Related Legislation . . . . . 142 4. Accounting and Auditing . . . . . . 143 C. Restructuring of the Banks and Enterprises . . . . 144 1. Overall Scope and Objectives . . . . . 144 2. Restructuring of the Banks . . . . 144 3. Restructuring of Enterprises . . . . . 148 CHAPTER XIII- MUNAGEMT OF THE TRANSITION . . . . 149 A. Introduction . . . . . . . . . 149 B. Leadership . . . . . . . 149 C. Implementation of the Restructuring Programs . . . 150 D. Bridging the Skills Gap . . . . . . 153 ALE IN Tm 1: Balance Sheet of the National Bank, 1979-87 . . 10 2: Interest Rates on the Assets and Liabilities of the National Banks 11 3: Estimation of Losses Monetized Through Stocks Variations . 14 4: Monetization of Losses Through Interest Flows . . . 16 5: Sources of Monetary Expansion . . . . . 18 6: Inflation Tax and Seignorage Revenues of Base Money . . 19 7: Inflation Tax and Seignoraga on Broad Money . . 21 8: Total Inflation Gains and Losses . . . . . 22 9: Average Monetary Aggregates . . . . . . 28 10: Average Credits of the Financial Institutions . . . 34 11: Current Account and Net Inflation Gains of Enterprises . 41 12: Credits From the National Banks to Commercial Banks . 54 13: Structure of Deposits and Borrowing, 1987 . . . 86 14: 1987 Change in Dinar and Foreign Exchange Liabilities of the Commercial Banks in Real Terms . 86 15: Structure of Dinar Liabilities of the Banking System . . 86 16: Structure of Assets of the Banking System . . . . 88 17: Change in Loans of Commercial Banks During 1987 in Real Terms 88 18: Loans of the Banking System, 1987 . . . . 88 19: Contingent Liabilities Banking System, 1987 . . . 89 20: Income Statement 1987 as per SKD Audit Reports . . 91 21: Adjustments of Net Income for 1987 Based on the Mission's Assumptions on Collectibility of Revaluation Interest . 91 22: Capital Funds as per SDK Report . . . . . 93  - V TABLES IN TEXT (continued) Page-Np 23: Capital According to Different Assumptions for Uncollectibility of Estimated Problem Loans, 1987 , 93 24: Net Equity of the Banks Under Different Assumption as to the Ratio of Provisions to Loans, 1987 93 25: Factors Contributing to Nominal Interest Rates on Non-Priority Loans, 1987 94 26: Factors Contributing to Interest Rates on Non-Priority Loans (revaluation adjusted), 1987 95 27: Total Assets of Financial Institutions 130 28: Inter-Enterprise Financing and Bank Credits 131 FIGURES IN TEXT 1: Public Sector Surplus/GSP Inflation Rates (CPI, Dec-Dec) 3 2: Inflation and Changes in Base Money 20 3: Interest Rates and Inflation (Backward Looking) Interest Rates and Inflation (Forward Looking) 26 4: Domestic and Foreign Interest Rates Domestic and Foreign Interest Rates 26 5: Interest Rats on 1-Year DM Deposits 27 6: Interest Rates on FX Deposits and Inflation 27 7: Exports and Imports of Goods Real GSP Growth 40 8: Current Account and Non-Interest Current Account Inflation (CPI-Dec/Dec) 40 9: Material Costs as a Percent of Revenues Interest Payments as a Percent of Revenues 43 10: Financial Burden of Alterative Strategies 65 ARM B AILlE 1: OLS/TSLS Estimates of Households' Demand for Money in 155 Yugoslavia, 1980-87 2: OLS Estimates of the Households' Demand for Money, 1980-85 156 3: Expected Devaluation and the Households' Demand for Dinar 157 and Foreign Currency Deposits 4: OLS/TSLS Estimates of the Enterprises Demand for Money 158 in Yugoslavia, 1980-87 5: Net Foreign Assets of the National Banks and Foreign Currency 159 Deposits 6: Average Monetary Aggregates, 1980-87 . 160 7: Average Credits, 1980-87, Financial Institutions (FIs) . . and Inter-Enterprise (IE) 8: Consolidated Enterprise Accounts . . 162 9. Total Revenues From Inflation (X of GSP) . . 163 MAP (IBRD 20317R)  )RJMIA~~~~~~~~~~~~~~~~~~~~~~VQUI LUW IWtA rUOCMA0* -sWC IlM1tU 'e41,196 PIUAMiOl (BIll. '9 Per Com GP In uSa .0.... .. .................... . ........ .... . ................... --,... ... A. hwu of Gras O_ttzt PuUt I. ESe w ("M GAT" gnu dBW (frw M M e 0f ............................. 0........................ ........ .............................................. .......... .......................... 196 "973 '98