Interview for radiosarajevo.ba: Governor Softić warns-Inflation and prices will continue to rise!

The Central Bank of Bosnia and Herzegovina (CBBH) recently published worrying news for all citizens. Nowcast on inflation for the first half of 2022 have been significantly corrected, compared to expectations from December 2021.

Since then, we have witnessed a rise in prices, especially of basic foodstuffs, and a decrease in the value of money, which in a situation of equal or lower incomes, significantly complicates the lives of citizens of Bosnia and Herzegovina, already full of challenges.

Unfortunately, instead of key economic topics and questions on how to survive the economic crisis after the pandemic, futile political and other debates dominate.

Governor of the Central Bank of BH, prof. Senad Softić, Ph.D. has no good news, but he expresses the determination of this institution to maintain financial stability – in order that the life of BH citizens would not be even more difficult. For the portal radiosarajevo.ba, Governor Softić talks about inflation in the second half of 2022, its possible trends, reflections on Russia's aggression against Ukraine, stability of the Bosnian mark[i] (BAM), and comments on speeches by Milorad Dodik, member of the BH Presidency, often directed against the Central Bank.

 

Radiosarajevo.ba: The Central Bank of BH (CBBH) announced at the end of March that BH expects an extremely strong inflationary shock. We are approaching the end of the first half of the year, what do the new analyses of the CBBH show? Does the Central Bank also have projections for the second half of the year on how inflation should move and what it means for citizens?

Softić: We are currently in the process of making nowcast on inflation in the first half of 2022. It is very likely that the nowcast of inflation in the first half of the year will be significantly revised to higher level than the last ones from November 2021.

We then communicated that it is certain that inflation in the first half of the year is likely to significantly exceed 4%. We took into account the base effect, the then information on oil and gas prices in international delivery markets in the first half of 2022, trends in food prices and other relevant goods and services.

At the time of the autumn round of medium-term projections and quick estimates, there was no war in Ukraine, no sanctions imposed on Russia, and no additional frictions in supply chains and production chains. The fact that central banks and supranational institutions have significantly revised their estimates and inflation projections, including us in BH, shows how much price turbulence in world markets is caused by the war in Ukraine and the impact on global supply chains.

According to our baseline projections from March 2022, we have announced an increase in inflationary pressures. Thus, our central inflation projection for the first half of 2022 was 9.2%. In addition, we published for the first time an estimate, based on extreme market uncertainties, and it amounted to 12.3%.

We will publish the inflation estimate for 2022 with the spring round of macroeconomic projections, i.e. at the end of May. In BH, due to a combination of unfavourable circumstances, the global shock on the supply side coincided with our structural vulnerabilities, which further strengthened inflation and which could affect inflation for some time to come.

Radiosarajevo.ba: Due to inflation, the value of money is declining, i.e. the prices of goods and services are rising. Does the Bank have the instruments to influence these processes? Can citizens, more specifically, expect the growth trend to stop, although, clearly, the CB has no impact on price formation itself?

Softić: It is clear to everyone that inflation reduces the available income of citizens and their purchasing power, i.e. standard. The CBBH, within its legal mandate, undertakes what it can, i.e. ensures monetary stability and stability of the domestic currency, which is of special importance in such situations.

Imagine what the situation would be like if the exchange rate of the domestic currency is changing every day and in that way additionally contributes to uncertainty and changes in purchasing power.

Of course, it is necessary to think about additional measures that need to be taken, which are not within the competence of the CBBH in terms of strengthening purchasing power and standards, and measures to subsidize and protect the most vulnerable categories of the citizens, at least in the short term. A significant part of the current pressures has a structural nature and solutions must be linked to long-term economic policies, implemented through a series of reforms.

Perhaps the current problem with inflation is the best indicator of the consequences of non-implementation of the necessary reforms and slowing down of the convergence towards EU members, and slower access to EU integration.

I am convinced that the authorities in BH will do everything necessary to make the current situation easier for the citizens and the economy. In any case, solutions to the inflation problem must be linked to long-term economic policies and implemented through a series of reforms. Otherwise, the productivity of domestic industries will decline, resulting in inflationary pressures being stronger.

With the current level of available income and demographic trends, persistent inflationary pressures will contribute to a further slowdown in convergence towards EU members in terms of quality of life. There are several instruments on how this global inflationary blow to the living standard of citizens can be mitigated. Interim measures, such as subsidies for the most vulnerable categories of the population, a moratorium on excise duties, a moratorium on the application of income and profit taxes, can have a mitigating effect of the inflatory blow. I believe that the fiscal authorities in BH will adopt adequate measures, as it was at the beginning of the pandemic, in the spring of 2020.

We at the CBBH are doing everything in our power to ensure monetary stability in the country as a basic prerequisite for the stability and development of our economy.

The crisis in Ukraine and the consequences for us

Radiosarajevo.ba: How much did Russia's invasion of Ukraine affect the stability of the financial sector in BH, and specifically the work of the Central Bank? How do you see its impact on our economy in general?

Softić: The Russian Federation had majority ownership in two banks from the Sber Group that operated in BH as separate legal entities. Immediately after the exclusion of Russian banks from the SWIFT system, the management of these banks was taken over by the Entities' Banking Agencies, and then they started a restructuring process over these banks. The process was successfully completed in just a few days.

The bank in FBH was bought by ASA banka dd Sarajevo, and the bank in Republika Srpska by Nova banka ad Banja Luka. Banks continued to operate regularly and these events, generally speaking, did not have a significant impact on financial stability in BH. Other banks in BH have almost no direct business activities with Russia. According to the data from the end of 2021, the total claims of the domestic banking sector towards Russia amount to a negligible KM 2.9 million.

The CBBH has no claims against Russia, given that it does not invest foreign exchange reserves in government bonds of Russia, Russian banks or other financial instruments.

Ukraine, which is in the previous year participated with only 0.2% in total trade of BH, cannont be considered a significant trade partner of BH. In goods trade with Russia, BH is net importer, and its share in total trade was 2.1%. The main inported products from Russia are oil and gas.

Imports from Russia have dropped significantly over the past ten years, from 10.5% in 2011 to 2.9% in 2021. Russia is only the sventh most important country when it comes to Bosnia and Herzegovina imports, and it can be concluded that the current effects of the war in Ukraine should not be particularly dramatic.

However, the indirect effects of the impact of the war are already visible, through a significant rise in inflation, which is primarily caused by structural disruption in the energy market and rising food prices. It is certain that disruptions in the oil and gas market, following the narrowing supply chains, will lead to continued growth in fuel prices.

Supply disruptions could slow economic activity in European countries that are BH's main trading partners, and we can expect these pressures through trade. The reduction in foreign demand could lead to an additional increase in the cost of domestic production and a further decline in available income in BH. Available income is particiluraly vulnerable to long-term inflationary shocks and is already at very low levels. All of the above indicates that there is a ceratin slowdown in economic activitiy in BH, with continued inflatory pressures in 2022.

Bosnian mark is stable

Radiosarajevo.ba: What is the current position of Bosnian mark (BAM) and is its position endangered in any way?

Softić: The position of convertible mark is the same as in the previous years, so, it is stable and fixed.

Monetary policy of BH, i.e. Central Bank, is reflected in currency board mechanism, which means that each banknote and coin of KM is fully covered by euro. Citizens can be sure that each convertible mark is fully covered by euro, which is guaranteed by law, meaning that convertible mark cannot devaluate compared to euro. As KM is tied to euro, KM purchase is carried out at fixed exchange rate which has contributed throughout the years to the achievement of monetary policy objectives by keeping monetary stability and keeping financial stability.

Unfounded statements of Milorad Dodik

Radiosarajevo.ba: What is your comment on statements of a member of BH Presidency Milorad Dodik saying that pegging to euro by the CBBH is destroying Bosnian mark (BAM)?

Softić: Comments on BH monetary policy appear in public from time to time. Statements that pegging of KM to euro is destroying KM are completely unfounded. Firstly, the exchange rate of KM and euro is fixed, so we are not exposed to the oscillations of foreign exchange rate, secondly, the highest number of foreign trade parents of BH is from the EU.

Thirdly, KM enjoys public confidence for the very reasons of its stability and link to euro. Should we risk the stability of the currency which we have and endanger BH economy and citizens? Why would we change something which is stable and provides security? Any changes in the area of monetary policy are a very risky response to crisis in a small and open economy such as the one of Bosnia and Herzegovina.

The CBBH will remain consistent with the CBBH Law, which has defined a fixed exchange rate of KM and euro. The response is in something which we call “reforms”, which is beyond the monetary policy field. So, competitiveness, good policies, responsible fiscal policy, progress of institutions, integration and cooperation with international institutions are issues which require attention.

Decline of foreign exchange reserves

Radiosarajevo.ba: The Bank has confirmed a decline of foreign exchange reserves. Why is this happening and what are possible consequences?

Softić: The CBBH foreign exchange reserves amounted to KM 15.68 billion in the end of April, which is lower compared to the end of the previous year. The decrease of the foreign exchange reserves was mainly brought about by a negative KM purchase and sale balance, which is usual for the first quarter. In March, increased demand for euro cash was present, which additionally affected the decrease of foreign exchange reserves.

The CBBH successfully fulfilled all the requests of commercial banks.

We have to be aware that in the currency board arrangement, the foreign exchange reserve level depends on demand for local currency and the foreign exchange reserves oscillations are quite common. In moments of increased demand for foreign exchange funds, the central bank purchases its local currency, and sells reserve foreign currency. In moments when demand for local currency increases, the central bank carries out a reverse transaction, i.e. it purchases foreign exchange funds and sells local currency. During 2021, a significant growth of foreign exchange reserves was recorded. All this, and also changes in the foreign exchange reserve level, confirm that the CBBH successfully performs its function and meets the requests of commercial banks, and citizens, both in cases of purchase and sale of KM.

When managing foreign exchange reserves, the CBBH adheres to the principles of safety and liquidity, while trying to achieve an adequate level of income in current conditions. According to everything said, the foreign exchange reserves are mainly invested in easily marketable financial instruments - government bonds of the euro area member countries - which are traded in financial markets on daily basis and in high extent, which can be converted into cash in a short period for purpose of timely settlement of due and potential liabilities while respecting the criterion of investment liquidity.

By investing in high quality securities and investing funds with financial institutions such as central, international financial institutions and foreign commercial banks with the highest credit rating, we try to provide safety of foreign exchange reserve investment.

When investing the foreign exchange reserves, the CBBH takes into account all the relevant available information and expectations related to market trends, primarily from financial markets of the euro area, as almost total foreign exchange reserves are invested in the financial market of the euro area due to the rules defined by the Law.

Due to expected growth of market yields on the bonds of the European Monetary Union member countries, the structure of the foreign exchange reserve portfolio managed by the CBBH was duly adjusted by significantly decreasing the exposure of foreign exchange reserves to interest rate risk and also vulnerability of foreign exchange reserves to changes of market yields as a specific form of interest rate.

Why has the Central Bank capital decreased?

Radiosarajevo.ba: At the same time, the bank capital is said to have been decreasing, which brings about speculations of possible recapitalisation. Is this true? In case it is, what would such scenario mean?

Softić: According to the latest available data, the total CBBH capital on 30 April 2022 amounted to KM 689 million, and on 31 December 2021 it amounted to KM 861 million. Accordingly, in the first four months of the current year 2022, the CBBH capital decreased by KM 172 million.

It is important to mention that such decrease is mainly the consequence of a decreased price of securities held by the CBBH in its foreign exchange reserve portfolio. Prices of securities decreased due to increased inflation expectations in the euro area and also the expectations that the European Central Bank will start the process of raising interest rates.

The expected growth of interest rates on relevant financial markets can have a negative effect on the CBBH capital, but we estimate such effect to be limited.

The Central Bank of Bosnia and Herzegovina has no direct impact on the trend of market interest rates or inflation in the euro area, the market where it invests its foreign exchange reserves. Due to expected strong growth of market yields on the euro bonds of the European Monetary Union member countries, the structure of the foreign exchange reserve portfolio managed by the CBBH was duly adjusted by significantly decreasing the exposure of foreign exchange reserves to interest rate risk and also vulnerability of foreign exchange reserves to changes of market yields as a specific form of interest rate.

The Central Bank of Bosnia and Herzegovina continuously carries out portfolio adjustments, with the aim to preserve the value of net foreign exchange reserves, i.e. monetary stability of currency board.

 

We do not support taking of the Central Bank reserves

Radiosarajevo.ba: Are there bases for statements that some political forces such as Dodik and his political party are behind attacks on the CBBH and what is your opinion on the requests for example for allocation of KM 400 million from foreign exchange reserves for RS commodity reserves? Do the pressures come maybe from other political addresses as well?

Softić: As I have already said, the CBBH will consistently implement the CBBH Law and currency board. Currency board has proved to be a good anchor for BH economy and a guarantee for monetary stability. We do not support initiatives aimed at taking any reserves of the Central Bank, as they endanger monetary stability of the country and the CBBH Law. Those who are familiar with monetary economy know there are no “excess” reserves in the CBBH and that each reserve has its purpose.

The joint objective of holding all reserves is strengthening currency board, i.e. monetary stability as a basic precondition for development of our economy. In that respect, the Central Bank will consistently adhere to its legal mandate in achieving monetary stability. Besides, I would remind that the authorities in BH, and both Entities, when concluding Agreement with the International Monetary Fund committed not to start any initiatives related to the Law on the CBBH.

[i] Translator's Note: For own writing style reasons, the author uses term „Bosnian mark“ for convertible mark, the official name of the national currency of Bosnia and Herzegovina.