Monetary Policy in Hungary 2000 National Bank of Hungary

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MONETARYPOLICY

IN HUNGARY

May 2000


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Produced bystaff members of the Monetary Policy Department of the National Bank of Hungary

Edited by: Ilona Boz

The publication presents an overview of the monetary policy of the National Bank of Hungary.This, however, does not preclude the manifestation of personal views of the authors in certain chapters.

These do not necessarily reflect the official standpoint of the NBH.

Produced by the Monetary Policy Department of the National Bank of HungaryHeaded by Gyrgy Sndor, Managing Director

Published by the Secretariat of the National Bank of HungaryPublisher in charge: Dr. Jzsef Kajdi

Translated by Nmeth & Psztor International KftDesign typography and typesetting by the Publications Group of the Information Division

1850 Budapest, V. Szabadsg tr 89.

Internet: http://www.mnb.huISBN: 963 9057 72X


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FOREWORD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

I. THE ROLE OF THE CENTRAL BANK IN HUNGARY

A BRIEF HISTORY OF THE NATIONAL BANK OF HUNGARY(Ilona Boz, Jzsef Szab ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

The Austrian National Bank and the Austro-Hungarian Bank. . . . . . . . . . 9The Independent Hungarian Central Bank . . . . . . . . . . . . . . . . . . . 11

Preparations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11From the Foundation of the NBH until the Second World War . . . . . . . 12Shift to a Command Economy . . . . . . . . . . . . . . . . . . . . . . . 13

The Central Bank in the Period of the Socialist Command Economy . . . . . . 13The Transformation of the National Bank of Hungary and the Banking Sector

in 1987. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

THE ROLE OF THE NATIONAL BANK OF HUNGARY IN THE FINANCIAL SYSTEM(Ilona Boz, Zsolt rsek, Jzsef Szab , Henrik Tth) . . . . . . . . . . . . . . 17The Functions and Role of the Central Bank in the Financial System. . . . . . 17

Issue of Banknotes and Coins . . . . . . . . . . . . . . . . . . . . . . . 19The Central Bank as the Banker of banks . . . . . . . . . . . . . . . . . 20The Lender of Last Resort Function . . . . . . . . . . . . . . . . . . . . 21The Central Bank as the Governments banker. . . . . . . . . . . . . . . 23Foreign Exchange Reserve Management at the NBH . . . . . . . . . . . . 25The Regulatory Function . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Bank Supervision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Maintenance of the Payment System. . . . . . . . . . . . . . . . . . . . 30Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Organisational Structure and Decision-Making . . . . . . . . . . . . . . . . . 35The Bodies of the NBH Defined by the Act on the Central Bank . . . . . . 35

Central Bank Independence . . . . . . . . . . . . . . . . . . . . . . . . . . 38The Importance of Independence. . . . . . . . . . . . . . . . . . . . . . 38Personal Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . 39Operational Independence . . . . . . . . . . . . . . . . . . . . . . . . . 40Financial Independence . . . . . . . . . . . . . . . . . . . . . . . . . . 41The Requirement of Transparency in Central Banks . . . . . . . . . . . . 42

MONETARY POLICY IN HUNGARY 3

CONTENTS


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II. THE OBJECTIVES OF MONETARY POLICY

AND ITS IMPACT ON THE ECONOMY

THE OBJECTIVES OF MONETARY POLICY (ron Gereben, Zsolt Kondrt) . . . . 45The Ultimate Goal of Monetary Policy . . . . . . . . . . . . . . . . . . . . . 45

Price Stability versus Economic Growth . . . . . . . . . . . . . . . . . . 47The Ultimate Goal of Hungarian Monetary Policy. . . . . . . . . . . . . . 49Intermediate Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

The Hierarchy of Objectives . . . . . . . . . . . . . . . . . . . . . . . . 51The Intermediate Target of the NBH . . . . . . . . . . . . . . . . . . . . 53

The Lower Level of the Set of Objectives . . . . . . . . . . . . . . . . . . . . 56The Operating Target of the NBH . . . . . . . . . . . . . . . . . . . . . 57

INDICATORS (Gyula Barabs, Emma Boros, Csaba Horvth, Anna Kerekes) . . . 59Monetary Aggregates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59Credit Aggregates and the Net Financing Capacity. . . . . . . . . . . . . . . 62The Information Content of the Yield Curve for Monetary Policy . . . . . . . . 63

MONETARY TRANSMISSION (Andrs Krmn) . . . . . . . . . . . . . . . . . . 68The Channels of Monetary Transmission . . . . . . . . . . . . . . . . . . . . 68Interest Rate Transmission . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

The Effectiveness of Transmission . . . . . . . . . . . . . . . . . . . . . 71The Effectiveness of Interest Rate Transmission in Hungary . . . . . . . . 72The Interest Rate Policy of the NBH . . . . . . . . . . . . . . . . . . . . 73Transmission Along the Yield Curve . . . . . . . . . . . . . . . . . . . . 75

III. THE INSTRUMENTS OF MONETARY POLICY

A HISTORICAL OVERVIEW OF THE DEVELOPMENT OF THE INSTRUMENTS

(Ilona Boz) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81The Use of Direct Monetary Instruments . . . . . . . . . . . . . . . . . . . . 81Money Market DevelopmentUse of Indirect Instruments . . . . . . . . . . . 83

THE OPERATION OF THE INSTRUMENTS TODAY (Ilona Boz, Tams Glanz,Henrik Tth) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87Foreign Exchange Market Intervention . . . . . . . . . . . . . . . . . . . . . 87The Operation of the Forint Instruments . . . . . . . . . . . . . . . . . . . . 88

Reserve requirement system . . . . . . . . . . . . . . . . . . . . . . . . 89The Basic Set of Current Central Bank Instruments . . . . . . . . . . . . 94Interest Rate Corridor. . . . . . . . . . . . . . . . . . . . . . . . . . . . 97The Policy Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

The Instruments of Sterilisation. . . . . . . . . . . . . . . . . . . . . . . 101Liquidity Planning and Fine-Tuning (Quick Tender) . . . . . . . . . . . . 104Individual Elements in Operating the Instruments . . . . . . . . . . . . . 111

BIBLIOGRAPHY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113ANNEX. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

4 NATIONAL BANK OF HUNGARY


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Hungarys transition to a market economy has by nowessentially come to an end. The judicious conduct ofmonetary policy has been an important factor in help -ing the economy develop along a balanced and sustain-able path.

The National Bank of Hungary (NBH) re-lies on an established and properly func-tioning set of instruments in the pursuit of itsmonetary policy objectives. The success ofmonetary policy depends, however, not onlyon the instruments available to the centralbank and the experience gained in usingthese instruments. External shocks and the

economys ability to withstand them, thestability of the financial sector and the matu-rity of the money and capital markets areequally important factors which influenceand constrain monetary policy decision-making.

Hungary has coped successfully withthe challenges of economic transition. Theeconomy is now growing at a relatively fastrate, inflation is declining steadily and thecurrent account deficit is at a manageable

level. Monetary policy has promoted thisprocess through the deployment of mone-tary policy instruments which have sup-ported Hungarys fixed exchange rate re-gime.

The expert deployment of monetarypolicy instruments is a necessary, but notsufficient condition for the effective func-tioning of the transmission mechanism ofmonetary policy. An equally important fac-

tor is that economic agents, ranging fromprofessional financial organisations to

households, have a good understanding ofour intentions and of the conditions for theachievement of our objectives of maintain-ing economic equilibrium and reducing in-flation. Transparency and predictability im-prove the effectiveness of monetary policy,because they enable economic agents toanticipate monetary policy actions and cal-

culate with their effects in their economicdecisions.

To ease finding their way and with anintention of providing a compass, we annu-ally present the Monetary Policy Guidelinesto the public in general and to Parliament inparticular. The NBH regularly publishes itsInflation Report. Communications disclosedabout specific steps of the Central Bank andcommuniqus issued after meetings of theCentral Bank Council are discussed exten-

sively by the press. Once approved by itsGeneral Meeting, the NBH presents its An-nual Report to Parliament. Nevertheless, wefeel that this publication, which focuses noton the peculiarities of the momentary situa-tion but on the operating framework and thegeneral features of the Central Bank instru-ments, fills a vacuum.

This publication, Monetary Policy inHungary, was compiled by members of the

Monetary Policy Department of the NBH,who themselves are party to the everyday


FOREWORD


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workings of monetary policy, decision sup-port activities and the formation and opera-tion of the set of applied instruments. This isintended as a summary based on practicalexperience which, by virtue of its very sub-ject, cannot in all of its parts be regarded aseasy reading. While required to report on itsactivities to society at large, the NationalBank of Hungary desires to provide informa-

tion first and foremost to readers interestedin the subject matter of this publication.

I trust that, in its own way, this hand-book will render the transmission mecha-nism of monetary policy smoother and, al-beit indirectly, may contribute to the futuredevelopment of the Hungarian economy.

Werner Riecke



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I. THE ROLE OF THE CENTRAL

BANK IN HUNGARY


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Although historically the SwedensSveriges Riksbank, established in 1668,is the oldest central bank, institutions actingas the governments banker came into beingall over Europe, modelled in general on theBank of England, which was established in1694.

On the continent, the Austrian centralbank was one of the first to be established;owing to the political framework, its scopeof authority also extended to the territory ofthe Hungary of those days. Hungarys politi-cal significance, which increased within theempire as a result of the historic Compro-

mise of 1867, was also expressed by thedual structure of the central bank, in accor-dance with the dualistic principles of thestructure of the state. An independent Hun-garian central bank came into being only af-ter the break-up of the Monarchy.

The Austrian National Bankand the Austro-Hungarian

Bank

The Habsburgs regarded Hungary as aland conquered by arms while fightingthe Turks and, in conducting their economicpolicy, they focused primarily on the inter-ests of the Austrian hereditary provinces.The Napoleonic wars went hand in hand withinflation and an erosion of the value ofmoney across Europe, hence the Austrian

government attempted to keep the statedebt and the issue of paper money under

control by setting up an independent gov-ernments banker.

The Austrian National Bank (ANB), es-tablished by the Emperors patent on 1 June1816, was a patented private institutionunder the special protection of public ad-ministration2 whose business relations tothe state were very close and secret. Duringthose hard times, the Austrian NationalBank regarded providing assistance to thestate as its obligation and these highlyimportant services were acknowledgedwith gratitude by the monarch.3 ANB en-joyed a monopoly position regarding issu-

ing banknotes and setting up branches inthe territory of the Austrian Empire. In addi-tion to lending to the state, the discountingof commercial bills of exchange and lendingon collateral security grew into importantlines of business. Uniquely among Euro-pean central banks owing to a mixture ofcentral banking and commercial bankingfunctions ANB also pursued mortgagelending and debenture issues.

The Banking Act of 1862 was intended

to regulate the relationship between thestate and the central bank, not least with aview to dismantling the considerable accu-mulated state debt. According to the spirit ofthe Banking Act, the Austrian National Bankcould be regarded as more independent


A BRIEF HISTORYOF THE NATIONAL BANK

OF HUNGARY1

1 For an explanation of the terms printed in bold in thetext, see the glossary in alphabetical order.

2 A Magyar Nemzeti Bank Trtnete (History of the Na-tionalBank of Hungary)I, KJK, Budapest, 1993, p.155.

3 Expressions used in the Emperors patent of 20 June,1849; source: A Magyar Nemzeti Bank Trtnete (History ofthe National Bank of Hungary) I, KJK, Budapest, 1993. p.157.


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than the Prussian Bank or even the Banquede France of the Second Empire in thosedays. The Emperors right to appoint thebanks governor and the government com-missioner was merely formal. According tothe intention of the legislators, the bankcould take action only as a commissionagent handling the states transactions andwas under the obligation to discount onlythe bills regularly presented by the state.The acceptance of government papers ascollateral for credit was excluded. This inde-pendence was maintained with minor modi-fications until 1878 when the Austro-Hun-garian Bank was established.

Right from the very beginning, the Hun-garian Estates disputed whether the Vien-nese banks issuing powers extended to Hun-gary in terms of public law. The Batthynygovernment attempted to issue its own cur-rency through the Pesti Magyar Kereske-delmi Bank (Hungarian Commercial Bank ofPest). However, this experiment failed to-gether with the 184849 War of Independ-ence. The question of an independent Hun-garian central bank was raised during the ne-gotiations of the Compromise. Eventually,

the issue was closed with a compromise withthe establishment of the dually structuredcentral bank of the Dual Monarchy under thename ofAustro-Hungarian Bank (AHB).Thebank held its statutory meeting on 30 Sep-tember 1878. AHBs Deed of Foundation alsobore this dual nature: on the one hand, itfunctioned as the central bank of the Monar-chy covering its entire territory, on the otherhand, however, in the spirit of equality in or-ganisation and management, Budapest, like

Vienna, acquired rights of administration andpossibilities of influence.Owing to the dualistic state establish-

ment, the organisation of the Austro-Hungarian Bank was complex. The man-agement of the bank was divided into deci-sion-making and executive arms, the lowerlevels of which were dualised. Of the deci-sion-making bodies, the Supreme Board,

the Governor and the committees of the Su-preme Board were centralised, while therewere two Boards of Directors functioning ateach of the two headquarters, each headedby a Deputy Governor. The Supreme Boardperformed general supervisory functionsover the entire banking operation. Each ofthe countries elected two representatives tothe Supreme Board, who were also mem-bers of the Boards of Directors. The repre-sentatives of the Boards of Directors andeven the government commissioners of thestate participated in the meetings of the Su-preme Board. The government commis-sioners were also members of the commit-tees, increasing in number as time passed(Executive, Mortgage, Administration andForeign Exchange Committees). Of the ex-ecutive bodies, management and the cen-tral service functioned in Vienna with localservices present in both capitals within theframework of a head institute in both cities.

At the time the Austro-Hungarian Bankwas set up, the coverage system inheritedfrom the practice of the Austrian NationalBank was in operation with silver coins incirculation. Owing to the stocks of silver ac-

cumulated, compliance with the coveragerequirement did not impede increasing thevolume of banknotes, aligned with paymentneeds, at first. However, in addition to silvercoins and banknotes, government noteswere also in circulation, conversion on de-mand was not typical, hence it cannot be re-garded as an unadulterated silver standard.4

After 1878, European countries mi-grated towards the gold standard one afterthe other and, beside the rise in the output ofsilver, this also led to a decline in the price ofsilver. By 1878, the premium on silveragainst the paper currency disappeared,moreover, a disagio of the silver florinevolved, that is, the face value of the silverflorin exceeded its intrinsic value. Minting ofcoins by individuals for speculative pur-poses began to take on substantial dimen-sions, which was subsequently suspended.

It was under these conditions that the

new monetary system of the Monarchy, thearanykorona (gold crown) system, was de-



4Conversion on demandwas suspendedon 29 April 1859and this did not change in the course of the subsequent his-tory of the Monarchy, not even with the introduction of thegold currency system (the aranykorona) in 1892.


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veloped. Due to the absence of conversionon demand and the use of silver coins as le-gal tender, it could not be regarded as a puregold standard (limping gold currency). Fol-lowing the example of the GermanReichsbank, a 5 per cent banknote taxwasintroduced as an indirect instrument. Withthis transformation of the coverage system,the Austro-Hungarian Bank set out on thepath of becoming a genuine central bank,the banker of banks.

The Deed of Foundation of the Bankwas suspended in the middle of 1914 afterthe outbreak of the First World War, and thedisbursement of government loans began.The principles of coverage for the gold cur-rency were gradually softened. The Austro-Hungarian Bank accepted war bonds ascollateral up to 75 per cent of their facevalue, whereby the central bank covertly fi-nanced the governments military expendi-ture. The continuous deterioration in the ex-change rate of the korona (crown) and thedepletion of the stock of precious metals ne-cessitated the setting up of the Foreign Ex-change Centreon 1 February 1916, follow-ing the similar German example with a de-

lay of one month.The successor states of the Monarchy,falling apart in the wave of revolutions fol-lowing the Great War, created their inde-pendent currencies one after the other. TheHungarian economy was in a difficult posi-tion. The level of investments declined, for-eign exchange reserves were depleted andthe sources of foreign capital ebbed away.Inflation ran high because the war was fi-nanced by running the banknote presses

and heaps of banknotes flew in from thesuccessor states.

The Independent HungarianCentral Bank

Preparations

In the wake of the Great War, European

bankers felt that the political powers of theEuropean Reparations Commission greatly

impeded the recoveryof the financial system,hence they made efforts to curb its politicalinfluence in general and to reinforce the cen-tral banks independence in particular.

It was during this period that the Na-tional Bank of Hungary was established withsubstantial international, particularly Brit-ish, support.

By the mid-1920s, the victorious westEuropean states overcame the economicand political crisis following the war and sta-bilisation of the entire continent becametheir primary concern. One of the precondi-tions of the loan to be granted by the Leagueof Nations to promote stabilisation in Hun-gary was the setting up of an independent

Hungarian central bank.The Austrian peace treaty, signed on

10 September 1919, provided for the liqui-dation of the Austro-Hungarian Bank. TheHungarian peace treaty took over the rele-vant part verbatim. The temporarily ex-tended licence of the joint central bank ulti-mately expired on 31 December 1919.

The Austrian and the Hungarian man-agement of the joint bank were separated as

of 1 January 1920 and banking operationswere pursued separately even in accountingterms with headquarters in Vienna and inBudapest, albeit retaining the name ofAustro-Hungarian Bank.

The Magyar Kirlyi llami Jegyintzet(Royal Hungarian Note Issuing Institute)was established in August 1921 with Dr.Sndor Popovics, the former finance minis-ter of the third Wekerle government andhead of the financial mission of the Hungar-

ian peace delegation, at its head.According to the idea entertained by

Minister of Finance Lrnt Hegeds, theNote Issuing Institute was called upon toprepare for the migration from the koronato the new legal tender in support of theconsolidation. The Note Issuing Institutetook over the assets, employees and part ofthe business of the former joint centralbank.

To curb profiteering in currency and tohalt the erosion of the value of the korona,




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the Foreign Exchange Centre5 was calledback to life on 8 August 1922.

From the Foundationof the NBH until

the Second World War

In February 1924, the Reparations Commit-tee accepted the Hungarian reorganisationprogramme and, in order to re-establish thecreditworthiness of the Hungarian State, re-leased the rights of pledge for reparations.As part of the legislation package on reor-ganisation, Act V determined the establish-ment and scope of operations of the National

Bank of Hungary on 26 April 1924. In thisAct, the state conferred the exclusive rightof issuing banknotes on the NBH until 31 De-cember 1943. The statutory meeting washeld in the Ceremonial Hall of the Academyon 24 May 1924; Sndor Popovics took theposition of President and Bla Schrberwas appointed Director General. The Bankbegan its operation on 24 June 19246 andpublished its opening balance sheet on30 June.

The state was the largest of the Banksfounders with its 39.5 per cent holding. Inaddition to the community of the Budapest-based financial institutions (TEBE Taka-rkpnztrak s Bankok Egyeslete Asso-ciation of Savings Banks and Banks), Aus-trian, Swiss, Dutch, Romanian and Czecho-slovak financial institutions and companiessubscribed to the Banks shares. The sharesof the National Bank were introduced to theBudapest Stock Exchange7 on 21 Septem-ber 1925. The National Bank of Hungarytook over the management of the states ac-count and the national debt. It has been ashareholder in and an active member of theBank of International Payments (BIS) rightfrom the foundation of the latter (1930).

By the summer of 1924 inflation haddeclined significantly, the NBH stabilisingthe exchange rate of the korona, pegging itto the British pound. In April 1925, the goldstandard was adopted again for the poundsterling, consequently the koronaagain be-came a gold-based currency. The new cur-rency, the peng, which was founded on thestabilisation of the korona, was introducedin November 1925, although it entered cir-

culation only from 27 December 1926.The stabilisation of the 1920s relied to

a great extent on foreign funds. Short of fun-damental structural reforms, the world eco-nomic crisis, which exploded in the autumnof 1929, hit a Hungarian economy deeply indebt and non-competitive in many respects.The financial crisis reached Hungary in July1931 and there was a run on the banks bydeposit holders. To protect reserves, foreignexchange controls were reintroduced andmaintained over the long term.8

With the shift to a wartime economy,announced in the 1938 Gyr Programme,there was a sudden surge in printing bank-notes and the national debt began to in-crease. In order to finance the budget, theindependence of the NBH was curtailed andthe Bank was obligated to finance the state.With the declaration of war, the state be-came the most important consumer and a

major portion of industrial output was put tosatisfy the states needs.



5 The Institution existed from 1 January 1916 until 25 No-vember 1925 within the framework of the National Bank ofHungary. At first, the intention was but to maintain a registryof demand and supply and an organised, transparent marketof foreign currencies, hence those acceding to the Institutionhad to make their receipts of foreign currencies intended forsale available to the Centre and to obtain their foreign ex -change andcurrency needs from the Foreign Exchange Cen-tre indicating the purpose of use. Foreign currencies requiredfor the purposes of the state were handled separately fromthe Foreign Exchange Centre. The Austro-Hungarian Bankwas given the management of the Foreign Exchange Centre.The bank agreed to make available the cash it had from ex -porttransactionstotheCentreandalsotosatisfytheneedsofits clients from the Centre. As the Foreign Exchange Centrewas already running a deficit in the first months of its opera -tion, the AHB used its own stocks and later borrowing fromabroad also became necessary. Central exchange ratesbroke away from market rates (for greater detail,see the His-tory of the NBH, pp. 373377). By a decree, issued on23 December 1916, trading in foreign currencies was madesubject to official licensing and the independence of theForeign Exchange Centre was abolished.

6 The base rate was set at 10% and the korona waspegged to the British pound (pound sterling 1 = 346,000 pa-per korona, 1 aranykorona (gold crown) = 17,000 paperkorona).

7 Theconsideration behind taking the Banks shares to thestock exchange was that the state should divest itself of theshares it had received in exchange for transferring assets ofthe Bank to private hands as soon as possible, thus guaran-teeing the central bank independence from the state.

8 From then on, the National Bank of Hungary continuedto apply foreign exchange controls until the early 1990s.


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Lending by private banks was alsomade subject to state control. War spendingwas financed by issuing short-term govern-ment papers, which were discounted by thecentral bank. Increasing the money supplyin this manner stoked inflation from194142, resulting in unprecedented accel-eration and hyperinflationfrom 1944.

With the conclusion of the armisticeagreement, the tasks of the NBH were takenover by coalition committees set up on po-litical grounds; all the central bank was al-lowed to do was to run the banknotepresses. Control of the economy was al-ready divided politically at that time.

Shift to a Command Economy

With the rebuilding of the economy in thewake of the war, industrial output increasedgradually and agriculture also became moreorganised. With gold stocks returned andshort-term foreign loans, there seemed tobe a chance ofstabilisation. To support this,lending was made subject to close controland companies were instructed to accumu-

late stocks of the most important articles.By limiting the amount and the period oflending to the state, the NBH contributedsignificantly to the successful introductionof the new currency, the forint9 on 1 August1946. A banknote ceiling was set at Ft1 bil-lion and strict compliance with the ceilingalso supported the strength of the new cur-rency.

The Central Bankin the Periodof the Socialist CommandEconomy

The artificial shortage of money, createdby restricting banking activity and lend-ing, aimed not only at keeping the money

supply and inflation under control, but alsoat restraining stock exchange and commer-

cial banking activities in preparation for thesubsequent nationalisation of the banks andthe large companies held by them (Act XXXof 1947). During 194748, the NBH wasturned practically into an absolutely new or-ganisation subject to the supervision of theMinistry of Finance. The NBH was given ex-clusive rights to control the financial activi-ties of plants accounting for 80 per cent ofthe countrys industrial output. The NBH su-pervised lending and the management ofstate-owned companies, which contributedhalf of the product turnover. Companieswere obligated to manage their financial andlending activities through their NBH singleaccount. Investments originally planned tohave been financed by credit soon becamegratuitous (that is, financed by budgetaryfunds).

In the one-tier banking system thusestablished, in addition to the commercialbanking functions performed by the NBH,additional specialised financial institutionswere set up (Investment Bank, Co-operativeCredit Institution, National Savings Bank,and Foreign Trade Bank) in the spirit of pro-file clean-up.

The NBH reorganised its functions offoreign exchange authority, managed thepre-war debts as well as the obligationsof war reparations. Although it aimed at pru-dent loan appraisal to protect the stabilityof the forint, the political criteria of the agen-cies of public administration prevailedto an increasing extent over the views of theBanks experts in 19471948. Duringthe period of the first five-year plan(19501954), the monetary policy of the

NBH had to support investments, the forcedmilitary development programme of theCold War and the reorganisation of agricul-ture. The NBH had but an administrative,mechanical role in implementing these. Pur-suant to the 1949 Constitution, nominally,the NBH retained its legal form as a com-pany limited by shares, while it was placed



9 The exchange rate of the forint was determined on thebasis of the consumer prices of the last peace years,19381939; on that basis, one dollar was equivalent toFt11,739.


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under government control.10 Because of itscommercial banking activities, the Banksbranch network expanded substantially: by1952, there were 134 NBH branches operat-ing all over the country (as against the21 branches functioning at the time of na-tionalisation), while the number of its em-ployees reached 9,000.

Execution and licensing of foreign ex-change operations became an exclusiveright of the NBH from 1950. At the sametime, the new management of the NBH (incontrast with the Soviet example of 1917)endeavoured to repay its foreign loans andto compensate the foreign owners of nation-alised assets, which was implemented by1970.11

With the establishment of the CMEA,the NBH was made responsible for the fi-nancial transactions between the memberstates. Although in the course of the consoli-dation of the economy after 1956 the sepa-ration of the tasks of the central bank fromcommercial banking functions was raisedon several occasions, this was never imple-mented. However, the economic reformsenhanced the significance of the monetary

policy instruments available to the NBHand, with the recovery in foreign trade in the1960s, the Bank expanded its domestic for-eign exchange market activities.

In the last quarter of 1960, the networkof regional directorates was gradually dis-mantled and 19 county-based directorateswere set up.

To find a way to improve the align-ment of the command economy and themarket, the experts of the NBH also partici-

pated in the development of the New Eco-nomic Mechanismof 1968. The monopolyrights of the NBH awarded after 1948 con-cerning issuing, the regulation of payments,account management and foreign exchangemanagement were reinforced by decree.

This decree clearly separated the centralbanking and other national economic func-tions of the Bank, leaving the one-tierbanking system and the principle of govern-ment supervision of the NBH intact. Onceagain, the central banks legal form of oper-ation was that of a company limited byshares.

Under the New Economic Mechanism,credit policy guidelineswere developed an-nually by the newly established Credit PolicyCouncil of the NBH. Based on the guide-lines, the NBH was responsible for its imple-mentation and supervised its execution.This meant greater scope for making deci-sions based on economic rationality and

profitability. The so-called supervision bythe Bank, which, in practice, meant admin-istrative intervention in the management ofcompanies and the levying of fines, wasabolished. Steps were also taken towardsliberalising foreign trade by slightly stream-lining import licensing and by adjustment ofthe exchange rate of the dollar. The organi-sational units responsible for central bank-ing functions were more markedly divorced

from those in charge of commercial bankingfunctions.

The historical events of 1968 consti-tuted a turning point for the Hungarian eco-nomic reform, which appeared, inter alia, inthe form ofendeavours to re-centralise theeconomy. From January 1972, the NBHhad exclusive responsibility for financingthe invested and the current assets of or-ganisations pursuing economic activities.The role of the State Development Bank wasrestricted to financing specific major invest-ment projects from the state budget. Thedeterioration in the terms of trade due to theoil crisis narrowed the elbowroom of the re-form, which was limited in any case, and thedebt crisisof the early 1980s was an unmis-takable sign of economic tension. The NBHfinanced the external disequilibrium by bor-rowing from abroad and issuing bonds,which was far from being general practice in

an central-east European country of thosedays.



10 The post of the President was abolished, the DirectorGeneral was appointed upon the recommendation of theMinister of Finance by the Council of Ministers. The posts ofthe President, Vice President and Managing Director werere-established by a law-decree of the Presidential Council inApril 1956.

11 The process of compensating the foreign shareholdersof the NBH was completed somewhat earlier, by 1967.


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In parallel with its international bor-rowing, the NBH developed its network ofinternational representative offices in themajor financial centres of the world(19671995 Paris, 19701995 Zurich,19731995 London, 19731998 Frankfurt,19741975 Beirut, 19771996 New York,1983-to date Tokyo). The NBH provided achannel for continuous communication withthe advanced countries and it was partlydue to this that Hungary acceded to the In-ternational Monetary Fund and the Interna-tional Bank for Reconstruction and Devel-opment in 1982.

The Transformationof the National Bankof Hungary and the BankingSector in 1987

In the 1980s the country had to adjust to analtered international economic environ-ment. As a result of this, the inflexibility ofthe financial system was also softened: newinstitutions came into being, securities in theform of bond issues appeared, a trade lawwas enacted, credit lines were extended andfactoring was launched. The artificial boostto growth led to significant additional debtaccumulation in the short term. It was therecognition of the unsustainability of thisprocess that led to reform of the bankingsector.

The basis for the change was provided

by a change in the approach of economicpolicy: in the 1980s, when genuine stepswere taken to develop market conditions, itbecame evident that a radical transforma-tion of the banking sector was also required.The inflexibility of the one-tier banking sys-tem and the absence of lending based onbusiness criteria under quasi market con-ditions obviously impeded the developmentof the market elements of the economy. Inits December 1984 resolution, the Central

Committee of the Hungarian SocialistWorkers Party declared that the central

banking and commercial banking functionswould have to be separated within the NBHand preparations for the establishment of atwo-tier banking systemwould have to be-gin. The Hungarian banking sector wastransformed into a two-tier one as of 1 Janu-ary 1987. Under the new regime, the Na-tional Bank of Hungary was designatedas the central bank, that is, the bank of is-sue.12

Under the new system, the NBH be-came the bank of the banks and of the state;it was subject to the control of the Presidentof the Council of Ministers. Its responsibili-ties included influencing the money supplyand facilitating the achievement of the eco-nomic policy objectives of the governmentwith the traditional instruments of monetaryand credit policy (interest rate policy, re-serve policy, refinancing, open market op-erations). The NBH continued to be respon-sible for managing the states account andlending to the budget and it retained the li-censing of foreign exchange turnover. TheNBH regulated and controlled the activitiesof the commercial banks. Three of the fivecommercial banks established with the

transformation of the banking system into atwo-tier one (the Hungarian Credit Bank, theHungarian Commercial and Credit Bankand Budapest Bank) came into being byseparating the General Credit Directorate,the Pest County Directorate and certainbranches of the NBH.

The commercial banks came into being notwith a regional or sectoral character (eventhough the predominance of one or the othersector could be observed in the case of the

newly established banks), which implied thepossibility of genuine competition amongthem. Foreign examples, by which bankingsystems organised on a sectoral or regionalbasis could be studied, showed that in thosecases banks enjoying virtual monopoliesstood against the companies, and the differ -ing needs of the sectors and regions impeded



12 The term bank of issue was used extensively in Hun-garian literature on banking even before the transformationof the banking system into a two-tier one, which arose from adecisive classical function, that is, the monopoly of issuingbanknotes, instead of the term central bank used mainly inother languages.


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the establishment of uniform and normativeregulation. After the original central distribu-tion, the banks were free to develop their cli-entele. The banks established with na-tion-wide scope were founded in the form ofcompanies limited by shares with the state astheir majority shareholder, represented by theMinistry of Finance. Companies and co-operatives held minority portfolios.

After the 1990 elections, in the spirit ofthe transition to a market economy, Parlia-ment enacted Act LX of 1991 on the CentralBankand Act LXIX of 1991 on Financial In-stitutions and Banking, since then bothamended several times. The new Act on theCentral Bank re-established the independ-ence of the NBH and re-regulated its opera-

tions. The central bank has an obligation toreport to Parliament and has become inde-pendent of the government. The Bank au-tonomously develops and implements itsmonetary policy.

With the institutional reform in the sec-ond half of the 1990s, non-central bankingfunctions were dismantled. As part of thisprocess, foreign representations and stakeswere liquidated with one exception. In No-vember 1996, the 18 county-based director-ates were wound up to be replaced by eightregional directorates. From 1 January 1999,the number of regional directorates de-creased to four, with their seats in Debrecen,Gyr, Kecskemt and Szkesfehrvr.




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The Functions and Roleof the Cental Bank

in the Financial System

The tasks of the central bank are set forthin most countries in some form of legalregulation (generally an Act of Parliament).A comparative analysis of the central banksof different countries reveals that centralbanks strongly differ from one another interms of their powers and structure, due tothe fact that their functions may also rangeover a wide scale.

Traditionally, central banks have amonopoly of issuing money. Through thisfunction, it is the task of every central bankto mould the supply of credit and moneyand, in relation to this, to influence marketrates, that is, to pursue monetary policy.A central bank may have full or partial re-sponsibility for shaping exchange ratesand managing the foreign exchange re-serves of a country.

Central banks manage the payment(settlement) accounts of commercial banksand safeguard the fixed and freely dispos-able reserves of the banks. They play an im-portant role in the maintenance of paymentsystems. Most of them are responsible forthe stability of the financial system, partlythrough controlling and supervising banksand other credit institutions and partlythrough being the lender of last resort. Mostof the time, the central bank is also the bank

of the government. Its tasks may include ex-change controls; in some countries they

manage either a part or all of the countrysdebt. Units to analyse the economy and toconduct research are also required for the

performance of the tasks of a central bank.The above list illustrates how manifold thefunctions of central banks may be. Thequestion, however, is which of these func-tions are the ones through which a centralbank can exert influence on the economy ofa given country.

The history of central banks revealsthat there are tasks which are common tomost of them, affecting the very heart oftheir operation. Effective instruments ofcentral banks to influence the financial envi-ronment, in which their respective econo-mies operate, include the right and possi-bility of controlling the money and creditsupply and, consequently, of influencingmarket rates. The monopoly of issuingbanknotes and the banker of banks func-tion the management of the banks ac-counts, fixed and free reserves and their fi-nancing (which, typically, is concomitant

with the role of the lender of the last re-sort) provide this opportunity to a centralbank. Management of the exchange rateregime and foreign exchange reserves canhardly be separated from setting interestrates, although the treasury often plays apart in this process. These days, manage-ment of the accounts of the budget hasless of an influence over the money andcredit supply. Nevertheless, being the

states banker is a classic and emphaticrole for most central banks.


THE ROLE OF THE NATIONALBANK OF HUNGARY

IN THE FINANCIAL SYSTEM


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In countries where the central bankhas sufficient independence to set interestrates, legislation frequently specifies the ob-jectives, for the achievement of which thebank may use this power. As in the case ofmost central banks of the world, the funda-mental task of the National Bank of Hun-gary, as set forth by law, is to protect thepurchasing power of the local currency. Thepowers given to the central bank (its func-tions), employed in the interest of protectingthe purchasing power of the currency, con-stitute the monetary policy of the centralbank.

In addition to protecting the purchas-ing power of the forint, another task of theNBH is to support the implementation of thegovernments economic policy programmewith the instruments of monetary policyavailable to it.

That is to say, the NBH plans and im-plements its monetary policy harmonisedwith the economic policy developed by thegovernment.

The objective set by law for the cen-tral banks of many a country may differfrom that of achieving price stability (theremay be other macroeconomic objectivesincluded in the set of objectives, whethersubordinated or on an equal footing) butcentral banks can realise the objectives setthrough their monetary policies every-where.

The first and most important taskamong the functions of the National Bank ofHungary is of a macroeconomic nature: theoperation of monetary policy, that is, influ-encing the money and credit supply with aview to safeguarding the value of the localcurrency. The central bank may implement

this task based on the following classic cen-tral banking functions:

issuing, that is, monopoly over is-suing banknotes,

the banker of banks lender of thelast resort function,

the governments banker, and

management of foreign exchange

reserves.Central banks, however, have a sec-ond set of functions, which includes all thetasks required for the maintenance of thesound operation of a banking system and fi-nancial stability. When a bank functionspoorly, it makes a loss and may even lose itsequity, its consequences are highly detri-mental to the entire economy. It may imperilconfidence in the banking system and,through this, confidence in the currency as

well as the propensity to save. Dependingon the magnitude of the problem, it may dis-turb the operation of the entire bankingsector.

As a central agency, the bank of issueestablishes the conditions which attempt tominimise the risk factors which might en-danger the safe operation of the banks. Thusthe role of the central bank in supporting thebanking sector goes further than assisting

them when needed by being their lenderof last resort.



Abstract 1: The Legal Standingand Fundamental Function of the NBH

Act on the Central Bank, Chapter I

1. The National Bank of Hungary (here-inafter the NBH) is the bank of issueof the Republic of Hungary, the centralbank of the national economy.

3 The NBH shall support the implemen-tation of the governments economic pol-icy programme with the instrumentsof monetary policy (money and creditpolicy) available to it.

4 (1) The fundamental function of theNBH is to protect the domestic and exter-nal purchasing power of the national cur-rency.


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The functions of the National Bank ofHungary, which assist in the sound opera-tion of the banking sector, include the fol-lowing:

regulatory functions,

bank supervisory functions, and

maintenance and development ofthe payment system.

As it was indicated at the beginning ofthis chapter, the central banks of the variouscountries of the world may perform a num-ber of additional functions, but the rangeof the tasks allotted to them may also be

narrower. The functions required for thesound operation of the banking sector maybe and in many places are performed byorganisations other than the central bank,which are independent from it. It is disputedto this day how these tasks may be per-formed with the greatest efficiency whether inside or outside the central bank.The list assigned to the two groups of func-tions reflects the tasks of the National Bankof Hungary as set forth in the Act on the

Central Bankwhich, in the main, coincideswith the functions of the central banks ofmost industrially advanced nations.

Both knowledge and analysis of theappropriate indicators of the economy, themoney and capital markets and the perfor-mance of the banking sector are requiredequally for pursuing monetary policy andmaintaining financial stability. By virtue ofits position, the National Bank of Hungary is

an institution belonging to the official statis-tical service, collecting as well as supplyingdata. Data collection and reportingare spe-cial tasks of the central bank linked to bothsets of its functions.

The following sections provide anoverview of the tasks of the National Bank ofHungary based on Act LX of 1991 on theCentral Bank. The subsequent chapters willunfold the functions, serving as the basis for

pursuing monetary policy, in greater detailfocusing on the objectives and the set of in-

struments of monetary policy and its impactmechanism.

Issue of Banknotesand Coins

Under the Act on the Central Bank, theNational Bank of Hungary has exclusiveauthority to issue domestic legal tender forint banknotes and coins to determineits denominations and to withdraw themfrom circulation in Hungary. When mak-ing payments in the Hungarian legal ten-der, the banknotes and coins issued bythe NBH must be accepted by all at facevalue.

At the time when payments were ef-fected largely in cash, central banks wereable to directly influence the total amount ofmoney in circulation through their issuingmonopoly.

Banknote issue was a key function ofcentral banks. With the technical develop-

ment in payments and the proliferation offorms of cashless payments, the share ofcash taking longer-term trends into ac-count has been declining in the economy.(For categories of money supply, i.e. themonetary aggregates, the monetary baseand its relation to the money supply see thesection on Monetary Aggregates forgreater detail.) Although the regulationof money supply cannot be limited to con -trolling cash turnover, i.e. to the amount

of cash in circulation, the changes of cash incirculation arising from changes in payment



Abstract 2: The Legal Standingof the NBH and its Fundamental Task

Act on the Central Bank, Chapter I

4 (2) The NBH has exclusive authorityto issue banknotes and coins.


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habits, the technical changes of the pay-ment systems and their forecasting con-tinue to play an important role in monetarypolicy. The central bank is responsiblefor fully satisfying the cash needs of turn-over by up-to-date banknotes and coinsin an adequate series of denominations.

The production of banknotes used aslegal tender is a complicated technicalprocess, ranging from design to the de-struction of banknotes that have becomesuperfluous or unsuitable for use. (Preven-tion of counterfeiting is an important crite-rion in banknote design and production.)In addition to issuing banknotes, the Na-tional Bank of Hungary also issues and

puts into circulation forint coins. The com-prehensive renewal of the legal tender wascompleted in 1999, which began with thereplacement of coins in circulation in 1993and continued with the introduction of thefirst element of the new series of bank-notes the 10,000-forint denomination in 1997. The National Bank of Hungarywithdrew all the denominations of the oldseries of banknotes and coins from circu-lation by October 1999; now only the six

denominations in the new series of bank-notes and the seven denominations in theseries of coins are available for cash pay-ments.

The banknotes of the new series weremade using modern base materials, newtechnologies and state-of-the-art securityelements.

Currency denominations shifted to-wards growing face values in accordancewith the requirements of turnover: the facevalue of the highest and the lowest banknotedenominations doubled, while fillr coinswere eliminated from circulation.

As the banknotes of new denomina-tions gained ground and as a result of thewithdrawal of denominations not required incirculation, the overall amount of banknotesand coins in circulation has decreased overthe past few years while the value repre-sented by them has increased dynamically.

Early in 2000, the banknotes andcoins in circulation represented a total

value of Ft810 billion, within which theshare of banknotes was 98 per cent, that ofcoins, 2 cent. About 10 per cent of thevalue of the cash in circulation can befound with financial institutions and 90 percent outside the banking sector (in house-holds, retail trade, cash desks of businessorganisations, etc.).

The Central Bankas the Banker of banks

The special position of the National Bank ofHungary and that of the other central

banks arises from the fact that commercialbanks depend to some extent on centralbank money.13

First, the banks need cash to disbursedeposits placed with them by their clientsand the loans granted to them, which theycan obtain only from the central bank.



Abstract 3: The Tasks

of the NBH:The Account Management Activity

of the NBH

Act on the Central Bank, Chapter II

26 (1) Unless another credit institutionis authorised, the NBH shall managethe settlement accounts of credit institu-tions.

(2) The NBH shall manage the paymentaccounts of clearing houses.

(3) The NBH shall manage the paymentaccounts of the National Deposit Insur-ance Fund and the Investor ProtectionFund.

13 Financial literature tends to mention central bankmoney as the monetary base, which includes cash outsidethe central bank and the banks reserves kept with the cen -tral bank. For greater detail, see the section on MonetaryAggregates in the chapter on Indicators.


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Second, the central bank manages thepayment accounts of credit institutions,which means that these accounts of thecredit institutions always have some kind ofa balance (stock) to settle cashless inter-bank transactions.

Third, banks in Hungary must placedeposits with the NBH corresponding to aspecified ratio of their stock of liabilities (forgreater detail, see the section on Regula-tion of the Reserve requirement). Until theautumn of 1994, the reserve requirementaccounts and the banks payment accountswere separated. With the introduction of thegiro system, the two accounts were mergedand the banks may use the outstanding bal-

ances of their payment accounts in excessof the reserve requirement in the interbankclearing system.

The above three factors taken together cash in circulation, the banks required re-serves and their balances to be used freelyin payments constitute the monetary base,over which the central bank exercises con-trol. By influencing these stocks throughvarious instruments, the central bank can

act upon the amount of money in circulation(the money supply).

An important question of monetarypolicy is to what extent is this relationship for instance, between changing the centralbank rates and the change in the moneysupply close and calculable under givenconditions (see the chapters on monetaryaggregates and transmission).

Not every bank depends directly

on the money provided by the central bank.The amount of central bank money, re-quired for the appropriate magnitude of bal-ances, is not necessarily obtained from thecentral bank. Banks, which for a transitoryor even a sustained period have more cen-tral bank money (liquidity) than necessary,may lend to banks struggling with transitoryliquidity shortages through the interbankmoney market. All in all, however, themoney market does not have more central

bank money than that created by the centralbank.

The Lender of Last ResortFunction

Liquidity needs arising from time to timeamong banks are part of the ordinarycourse of business. Banks have severalmarket instruments to cover such needs(selling government papers or foreign ex-change assets, etc.) and the central bank asthe banker of banks may also extend acredit to a financial institution. It may, how-ever, happen that a banks liquidity short-agebecomes permanent or it may suddenlyget out of hand. The central bank has theopportunity to provide banks, struggling un-der a transitory or lasting liquidity crunch,

with central bank money under an extraor-dinary procedure. Therefore, this functionis closely related to that of ensuring moneysupply to the banks (banker of banks)and that of maintaining a sound bankingsystem.

The question may arise why the cen-tral bank should bail out an ill-functioningbank struggling with liquidity shortages,which may be attributed to mistakes in

conducting business. Beyond the funda-mental problem that, in the event of a bank



Abstract 4: The Tasksof the NBH:

Extraordinary Credit in the eventof an Emergency at a Credit Institution


17 (1) In the event of an emergency, theNBH may extend an extraordinary creditto the credit institution. Availability ofsuch NBH credit may be subject to the

measures to be taken by the StateBanking Supervision in an emergencyand the implementation by the credit in-stitution of the measures initiated by theState Banking Supervision.


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failure, deposit holders may lose their sav-ings, there is the odd chance that, depend-ing on the size of the bank, the crisis mayspread to other banks as well. A run on thebanks may lead to serial insolvency, whichmay paralyse a part or all of the bankingsystem, and thereby violently retard theeconomy.

Therefore, when considering the res-cue of a bank, the implications of a bankfailure, which may shake confidence in thebanking system and the currency, de-crease savings and imperil economic sta-bility, should also be considered in allcases, in addition to protecting investors.To illustrate the importance of preventing

bank failures, the economic crisis of192933 is usually referred to as an exam-ple.

It was bank failures which triggered amajor decline in money supply seen in theUnited States during this period, whichmany economists regard as the causeand driving engine of the economic col-lapse which took place in the course of thecrisis.

The question may also arise: why res-

cue these banks in order to protect deposi-tors when the institution of deposit insur-ance stands between them and any dam-age they might sustain? At first sight, itmay seem that a deposit insurance fund,which exists in most countries to protectand insure deposit holders against lossesarising from bank failure, could render therole of the central bank as lender of the lastresort superfluous.

This, however, is not true for tworeasons. On the one hand, deposit insur-ers insure deposits only up to a certainlimit in Hungary, up to Ft1 million andalthough the small amounts of depositsconstitute only a very small fraction of thetotal deposit portfolio, should bank fail-ures occur in large numbers, the insur-ance funds would be unable to fully covereven the small-value deposits. (Mostprobably, however, the central bank, as

lender of the last resort, would stand be-hind the insurance funds and put up the

necessary funding in most countries.)Secondly, deposits with a value aboveFt1 million are not insured by the depositinsurers. The shaking of large depositholders confidence in the banking sys-tem could easily lead to a run on thebanks, so bank failures may arise in spiteof the deposit insurance system.

The role of lender of the last resortmay not only protect the economy from thedetrimental effects of bank failures but alsoprovide protection against money marketcrisescaused by them.

A financial panic will always have ahighly detrimental impact on an economyas it impedes the fundamental task of fi -

nancial markets of channelling free fundsto efficient investment opportunities. In thecase of a stock exchange collapse, a largenumber of broker firms may find that theyneed supplementary financial assets to fi-nance their activities. Banks may deny thepossibility of additional financing for brokerfirms precisely because of the impendingfailures.

As far as its form is concerned, thelender of last resort function rarely means

some kind of extraordinary lending irre-spective of the monetary policy instru-ments available; it is always closely relatedto the monetary policy instruments of cen-tral bank money supply that characterisesthe given country (see the chapter on TheInstruments of Monetary Policy).

The techniques of central bankmoney supply may be manifold (auctions,rediscounting, standing facility) just as itvaries from country to country how a cen-tral bank may want to influence use of cen-tral bank money via interest rates or otherdirect regulatory instruments (quotas) orany combination thereof. Choice amongand regulation of these instruments is partof regulating money supply, that is, ofmonetary policy.

When, however, the central bank liftssome restriction specified in the regulationswith respect to a single bank to rescue it,

the instrument will fulfil the lender of lastresort function.




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Assistance may also come in the formof a transitory exemption from the reserverequirement. Although banks may use theirrequired reserves to cover their payments,by the end of the month they must, on aver-age, meet the reserve requirement. In thecase of an exemption, liquidity dependingon the magnitude of the reserve require-ment will be released for the given bank.In Hungary, central bank money thus re-leased may substantially expand the liquid-ity of any given bank, owing to the ratiowhich is deemed high in international com-parison (12 per cent).

Although the role of the central bankas the lender of the last resort has the ad-

vantage of preventing bank failures and fi-nancial panic, the declaration of this possi-bility may also have detrimental aspects.It may be that banks, expecting to receiveassistance from the central bank, under-take higher than prudential risk in vari-ous fields of banking operations, largely inlending.

This risk is likely to be higher in thecase of major banks because they may be-lieve that they are too large and too impor-

tant for the central bank to deny them as-sistance, for their eventual failure would,with much greater probability, lead to a runon the bank and the probability of the panicrolling on to other banks is also higher. Thisexplains why a central bank uses the instru-ment of lending as a last resort only when itreally is the last resort.

There is an aspect of the lender of lastresort function which is closely related to

the maintenance and operation of the pay-ment system: the NBH may provide bor-rowing facilities with a view to the smoothoperation of the payment system. Should abank wrongly assess its liquidity position inadvance and should its liquid assets fail toprovide coverage for the items to be trans-ferred at the time of settlement in the clear-ing system, the central bank ensures thecontinuous administration of interbankpayments by lending. But the rate on such

loans is above the money market interestrate.

The Central Bankas the Governments banker

There are several aspects to the relation-ship between the NBH and general govern-

ment. First, the NBH as the governmentsbanker manages the single account of theTreasury.

Second, in relation to the accountmanagement function, the NBH may have afinancing relationship with the budget.

The financing relationship between thestate budget and the central bank has longtraditions in most advanced Europeancountries. In view of past experience, how-ever, legislators may set strict limits for thisactivity so as to prevent the infringement ofthe rights of central banks to pursue autono-mous monetary policy.

Pursuant to the Treaty establishingthe European Union (the MaastrichtTreaty), neither the ECB nor the centralbanks of the member states may extendcurrent account financing or other types ofcredit to community institutions or agen-cies, central, regional or local authorities orother central agencies or publicly owned

companies of the member states; it is alsoprohibited for them to directly purchase



Abstract 5: The Tasks of the NBH:

Relations to General Government,the Account Management Activity

of the NBH


18 (1) The NBH manages the UnifiedTreasury Account and other state ac-counts designated by the Minister of Fi-nance.

(2) The NBH manages the payment ac-count of the State Privatisation andHolding Company, whose balance shallcontinuously be included in the balanceof the Unified Treasury Account at all

times.


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debt securities from these institutions andagencies. The intention of this provision ison the one hand to reinforce budgetary dis-cipline in the member states while eliminat-ing one of the main sources of inflation. Onthe other hand, the prohibition on the dis-bursement of direct credit by the centralbank to the government is an importantfactor with regard to the independence ofthe national central banks and the Euro-pean Central Bank (ECB).

Over the past few years, the financingrelationship between the NBH and the Hun-garian budget has also undergone majorchanges. In 1990, placements by the centralbank to general government exceeded

70 per cent of its total placements (balancesheet total).The restructuring of the economy in

subsequent years necessitated that thecredits of the central bank be redirected infavour of the business sector.

The Act on the Central Bank, enactedin 1991, still reflects the practice which pre-vailed at the time of the adoption of the Act,namely, that the NBH financed the centralbudget by way of lending (on the basis

of loan agreements), albeit putting a ceilingon financing the central budget throughcentral bank credit, declaring that the incre-ment in the portfolio of credit extended tothe central budget in a given year may notexceed, even on a single day of the year,three per cent of the estimated revenue ofthe central budget in the given year.

So that the central budget would notenjoy a privileged position relative to theother agents of the money market, the baserate of the central bank that is, a mar-ket-based interest rate governed lendingto the central budget.

The 1994 amendment of the Act onthe Central Bank (Act IV of 1994) enabledthe restricted financing of the current fundof the budget (today termed as the UnifiedTreasury Account KESZ) in the event of atransitory liquidity crunch of a few days inorder to ensure continuous money supply

because of the asymmetric flow of budget-ary revenues and expenditures within the

month. This loan, which may be extendedup to 2 per cent of the annual revenue esti-mate of the central budget, may be out-standing for no more than 15 days in anymonth, either on several occasions or onend.

The central budget pays the base rateset by the central bank on its debt of liquid-ity credit to the NBH at all times. The prac-tice of the past few years, however, showedthat the budget did not make use of thiscredit facility, as together with the accountof PV Rt., the balance of KESZ has beenpositive.

The 1996 amendment of the Act onthe Central Bank (19 (3) of Act CXXIV of

1996 amending Act LX of 1991), whichconstitutes the legal regulation currently inforce, prohibits lending by the NBH to thecentral budget, with the liquidity credit be-ing the only exception.

The prohibition of direct central bankfinancing could come into being only be-cause, with the development of the domes-tic capital market, the budget had increas-ing opportunity to finance its deficit withoutinvolving the central bank directly from

the market through issuing governmentpapers.

The central bank may also finance thebudget not only by direct lending but alsothrough purchasing government papers. Itdoes make a difference, however, whetherthis is done in the primary market whichin practice would mean that the NBH couldparticipate in government paper auctions or whether government papers are bought

only in the secondary market. In the firstcase, there is a possibility for the centralbank to finance the deficit through the auc-tions under pressure from the eventuallygrowing financing requirement of the bud-get, which implies the threat of distortingyields away from market levels. Purchasesin the secondary market, i.e., when the cen-tral bank buys government papers whichhad already been acquired by marketagents, have less influence on government

paper yields than buying them upon issue inthe primary market, which in fact consti-




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tutes a form of direct financing of the bud-get.

The central banks participation in se-curities trading in the secondary market is,in contrast, necessary for the efficient im-plementation of monetary policy (for theoperation of the instruments and for theopen-market operations) since the centralbank may need an adequate portfolio of se-

curities. Because of these considerations,the Act on the Central Bank prohibits theNBH to directly purchase securities from thestate, i.e., to buy in the primary market.According to an amendment, however,there is nothing to impede the NBH frompurchasing government papers in the sec-ondary securities market in the form ofopen-market operations while pursuing itsmonetary policy objectives.

This regulation is also in harmony withthe principles set forth in the MaastrichtTreaty establishing the European Union, un-der which the central bank is not prohibitedfrom financing the budget, but it is prohib-ited from doing so by avoiding the capital

market.These principles have the purpose ofsafeguarding the independence of the cen -tral banks in the member states of the Euro-pean Union and help to prevent wrong eco-nomic policy decisions being made becauseof distorted information. At the same time,the elbowroom provided to central banks toperform operations in the secondary marketmay be exploited only to achieve the objec-tives of monetary policy and may not serve

to bypass the prohibition on the direct fi -nancing of the central budget.

Foreign Exchange ReserveManagement at the NBH

One of the most important tasks of centralbanks throughout the world is the manage-ment of the foreign exchange reserves

of their countries. The objectives of main-taining reserves are nearly identical ineach country, although the relative impor -tance of individual objectives may be dif-ferent depending on the situation of thegiven state. The main objectives of main-taining reserves are intervention, transac-tion and asset accumulation. The predom-inance of any objective for any centralbank at any given point in time is deter -

mined by a number of factors, includingthe exchange rate regime applied, the




Relationship to General Government,

the Account Management Activityof the NBH


19 (1) The NBH may have a financingrelationship exclusively with the centralbudget of the subsystems of general gov-ernment.

(2) With respect to its financing relation-ship to general government, the NBHshall be responsible to Parliament.

(3) With the exception mentioned underSubsection (4), the NBH shall not extendany credit to the central budget. The NBHmay purchase government papers underopen-market operations. The NBH shallnot purchase government papers directlyfrom the state.

(4) To overcome the transitory liquiditydifficulties in the Unified Treasury Ac-

count, the NBH may extend a liquiditycredit to an amount not exceeding twoper cent of the revenue estimate of thecentral budget in the given year. Thecentral budget may have such debt onliquidity credit outstanding on severaloccasions or on end, but never exceed-ing 15 days in a calendar month; thecentral budget may not have any debton liquidity credit on the last day of theyear.


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magnitude of debt and the balance of pay-ment. In ultimate cases, when economicagents are for some reason (such as war,crisis or natural calamity) no longer ableto do so, the foreign exchange reserves of

the central banks are put towards effectingthe foreign exchange payments of thecountry (imports, etc.).

In Hungarys case, all three fundamen-tal objectives obtain. Under the current ex-change rate regime, the NBH, in principle,assumes unlimited obligation to buy or sellat the two edges of the fluctuation bandspermitted around the centre rate determinedby the currency basket. To meet this obliga-tion, it must have foreign exchange reserves

in an appropriate amount. The interest andprincipal repayments for foreign exchangecredits taken out by the NBH and the stateare also effected directly from such re-serves. A sufficiently high reserve enhancesthe confidence of foreign investors and lend-ers vis--vis the country, which eases andrenders cheaper the raising of funds abroadfor all economic agents.

Ultimately, the source of increasing re-servesmay be a positive balance of the cur-rent account or an influx of capital. The in-vestments of foreigners and the foreign ex-change funds of the domestic private sectorare converted into forints in the interbankforeign exchange market. To reach (or tomaintain) the desirable level of reserves,foreign exchange credit may need to beraised. The state may raise foreign ex-change credits in the domestic or foreignmoney and capital markets or from large in-ternational organisations (IMF, WorldBank). Until 1999, it was the NBH, currentlyit is directly the state that appears in the for-eign markets.

There is no generally accepted for-mula, valid for every country, to determinethe optimum amount of reserves. The mostfrequently used unit of measurement isthe import requirement. According to this,the average amount equivalent to threemonths imports can be regarded as an ac-

ceptable reserve level. This is but an aver-age figure. In practice, the advanced coun-

tries can do with 12 months of import re-quirement, while in the case of the less de-veloped countries, 68 months imports isthe characteristic magnitude. Naturally, thedesirable magnitude of foreign exchange re-serves depends on a number of factors,such as the applied exchange rate regime,the ability of the country to draw in funds,the openness of the economy and the vola-tility of the balance of payments. Thethree-month import requirement is pre-sented as the minimum figure in the reservepolicy of the NBH. The external debt ser-vice, which debits the central banks re-serves, raises the reserve level regarded asdesirable by the value of three-months re-payment on average. In stipulating the finalreserve level, the central bank also takesinto account potential short-term capitalflows.

The currency structure of the reservesgenerally reflects the direction of the foreigntrade relations of individual countries. Ow-ing to this, the share of the dollar and theyen is higher in the foreign exchange re-serves of Far Eastern countries, while in Eu-rope this role is taken over by the euro. It is a

general tendency that the role of gold in re-serve management has declined to the min-imum in most countries. The NBH keeps itsforeign exchange reserves in the major cur-rencies, primarily in euro and dollar, whilethe share of gold is minimal. The currencystructure reflects the composition of the ex-ternal payments of the country and of the fo-rints basket.

From the viewpoint of investment

guidelines, central banks tend to place themain emphasis on security within the holytrinity of investors: security, liquidity andyield. This is understandable as centralbanks manage the foreign exchange re-serves of their country, which usually repre-sents a significant amount both in absolutevalue and as a percentage of GDP. It istherefore no accident that these institutionsare regarded as the largest and at the sametime most conservative investors of the

world. Accordingly, apart from a very fewexceptions, they do not invest in, for in-




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stance, shares or real estate. Characteris-tically, they seek papers of the highestcredit rating in the securities markets andthey generally buy the government papersof the advanced countries.The criterion of li-quidity is important because, in the event ofintervention or an eventual crisis, the re-serves must be deployable immediately andwithout any substantial loss of value in orderto meet their fundamental functions. Yetagain, by virtue of their size, it is only thegovernment papers of the largest and mostadvanced countries that can meet this re-quirement. Bearing in mind the criteria ofsecurity and liquidity, reserve managersaim at investing the reserves in assetspromising the highest possible yield. Theforeign exchange reserve managementguidelines of the National Bank of Hungaryare in line with international central bankingpractice. Only the largest commercialand investment banks and securities housesare listed as counterparties licensed for trad-ing.

The Regulatory Function

The regulatory activities of the central bankare divided between licensing cases requir-ing operative measures and theoretical ac-tivity, i.e. the development of regulatoryproposals applicable to businesses operat-ing in the money and capital markets andproviding opinions on these.

Licensing powers with respect to ac-tivities performed in the money and capitalmarkets are traditionally divided in Hungarybetween the State Money and Capital Mar-ket Supervision (SMCS) and the NBH.Hence, in spite of the fact that the SMCS li-censes the vast majority of financial andsupplementary financial services whichmay be pursued by financial institutions un-der the statutory provisions in force since1997, the NBH continues to be the licensingauthority with respect to certain services.

As for the specific range of financialand supplementary financial services (such

as the issue of means of cashless paymentand the provision of related services, cash

processing, clearing activity) referred by le-gal regulation to the licensing authority ofthe NBH, the assessment of the license ap-plications and decision-support are the re-sponsibility of the NBH. Under this function,

the NBH organises the review and assess-ment of the applications received by theBank as well as the necessary consultationsand, on the basis of its findings, it puts for -ward recommendations for granting the li-cense or refusing to do so.

Although the independent regulatoryauthority of the NBH extends only to subjectmatters related to the central banking taskstaken stricto sensu, prudential regulationaimed at the safe and sound operation of the

money and capital market is of outstandingimportance for the NBH with regard to allthe domestic financial markets, particularlythe banking system. Therefore, with a viewto reducing systemic risk, the central bankparticipates in the preparation and evalua-tion of proposals concerning prudential reg-ulation and, in this context, in supervisoryactivity.

The legislative function includes a re-

view of existing legal regulations, the devel-opment of proposals for amendment and



Abstract 7: Miscellaneous Provisions:

Powers

Act on the Central Bank, Chapter V

71 (1) Within the limits of the law, theNBH may issue mandatory requirementsvia central bank instruments to financialinstitutions, legal entities which do notqualify as financial institutions perform-ing supplementary financial services, in-vestment service providers and clearinghouses,

(2) With respect to payments, centralbank instructions shall apply to legal enti-ties, business organisations that are notlegal entities and natural persons.


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the preparation, development and reconcili-ation of new ideas. While doing this, the cen-tral bank utilises information obtained in thecourse of assessing and evaluating licenseapplications and gleaned from the day-to-day activities of the banks other lines ofbusiness, together with the relevant regula-tory recommendations of the various inter-national bodies and the publications ap-pearing in financial literature.

With respect to the last-mentioned,analysis of the relevant rules of the EUand harmonisation of related fields in thedomestic legal system are of key impor-tance.

A special field of central banking ac-tivities is the foreign exchange licensingfunction based on the powers of the NBH asforeign exchange authority.

Act XCV of 1995 on Foreign Exchangeentered into force on 1 January 1996. Thisenabled convertibility in a wide range for theso-called current payment operations forboth residents and non-residents accordingto foreign exchange regulations, therebysatisfying the requirement of convertibilityaccording to Article VIII of the Articles ofAgreement on the International MonetaryFund, which was also a precondition of ob-taining OECD membership. With respect to

capital operations, rules were substantiallyliberalised in the case of the direct invest-ments of residents abroad (direct acquisi-tion of businesses) and raising and extend-ing foreign exchange credits abroad matur-ing over a year, while the foreign exchangeauthority maintained the licensing of short-term capital import and export in order topre-empt the non-desirable effects of hecticcapital inflow.

When the criteria of assessing an ap-plication with a view to licensing by the for-eign exchange authority are not determinedby foreign exchange legislation, the foreignexchange authority must consider the inter-ests of the national economy or the circum-stances of the applicant or the beneficiarywhen forming its resolution. Bearing in mindthe interests of the national economy, theforeign exchange authority does not issue li-censes for operations which contradict the

monetary policy objectives of the NationalBank of Hungary.




Foreign Exchange Management Tasks


28 The NBH is the central agency of for-eign exchange management. The powersof the NBH as foreign exchange authorityare specified by the legislation on foreignexchange.

29 (1) In agreement with the StateMoney and Capital Market Supervision,the NBH regulates the banking activitiesof credit institutions, financial enterprisesand legal entities which do not qualify asfinancial institutions providing supple-mentary financial services in foreign cur-rencies and, furthermore, in applying for-eign exchange legislation, banking activi-ties performed with foreigners in forintterms. The NBH shall participate in the de-velopment of the principles and conditionsof extending export credit.

(2) With the exception of the governmentcredit specified under 24, foreign creditsmay be taken out and extended by the

NBH and, subject to the licensing or re-porting obligation as set forth in Subsec-tion (3), by credit institutions and otherlegal entities.

(3) Credit institutions, authorised to per-form foreign exchange operations, maytake out foreign credits subject to a re-porting obligation to the NBH. The NBHmay authorise credit institutions to ex-tend credit to non-residents and other le-gal entities to extend and raise creditabroad.


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Bank Supervision

The operation of financial institutions regu-lated by laws and decrees is supervised bytwo institutions: the State Money and Capi-

tal Market Supervision, an agency directlysubordinated to the government, and theNational Bank of Hungary, which has a re-porting obligation vis--vis Parliament.

The State Money and Capital MarketSupervision controls compliance with therequirements of Act CXII of 1996 on CreditInstitutions and Financial Enterprises (capi-tal adequacy ratio, principles of asset valua-tion, requirements concerning their man-

agement, profits, liquidity, solvency, etc.).The expectation of efficiency setagainst monetary and central bank regula-tions presupposes that the NBH should sat-isfy itself that the relevant legal regulationsand the central banks instructions issued onthe basis of authorisation conferred by theselegal regulations are enforced in the every-day practice of financial institutions and, ifso, in what way. This is done in the course ofcentral bank supervision.

The scope of the central banks super-vision extends to compliance with the in-structions of the President of the NBH con-cerning the reserve requirement and with le-gal regulations concerning payments, bankcredits and foreign exchange management,as well as the central banks requirementsissued to implement them. Thus, accordingto the current practice of supervision by thecentral bank, this kind of inspection primar-ily involves examining compliance with leg-islation concerning the reserve requirement,the interest rates to be applied on a manda-tory basis according to legislation, and theregulations concerning information to beprovided under the central banks informa-tion system.

There are certain financial services forwhich only the NBH may issue a license,which it may withdraw. These include the is-sue of instruments of cashless payments

and related services, money exchange ac-tivity, operations

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Monetary Policy in Hungary 2000 National Bank of Hungary

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