Is the Inflation in Albania too Low?

1. Is the Inflation in Albania too Low? Mimi KODHELI Economics Dept-University of Verona

2. Is the Inflation in Albania too Low?-Background- • The fall of communism in late 1990 was followed by economic collapse, social disorder and widespread emigration; • A one-year reform program began in 1992-target: “to reduce annual inflation from over 300% to below 20%”. Monetary policy was based on direct instruments of monetary control; • A two-tier banking system was established in April 1992; • The banking system, in first half of ’90s, was dominated by 3 state-owned banks which quickly accumulated debt problems; • The Rural Comm. Bank was liquidated in January 1998, the National Comm. Bank was privatized to foreign investors in 2000, and the largest state-owned bank, the Savings was privatized to Raiffeisen Bank of Austria in late 2003.

3. Is the Inflation in Albania too Low?-Background- • The performance of the Albanian economy during transition has pleasantly surprised many people; • Albania has quickly moved to high GDP growth and falling inflation, making serious efforts towards market reforms; • A bond and T Bill market started to emerge in 1995 which helped public debt management and monetary policy; • In early 1996, some licenses where issued to several foreign banks; • Nevertheless, BoA continued to impose ceilings on deposit rates offered by state-owned banks; • New private banks have encouraged the use of indirect instruments of monetary control and inter-bank competition;

4. Is the Inflation in Albania too Low?-Background- • These achievements were jeopardized, by a period of turmoil and quite anarchy in early 1997; • Several large pyramid schemes, into which much of the population had put their savings, collapsed; • Since then, Albanian economy has enjoyed high annual growth rates and low inflation; • Nevertheless, financial sector development is still at an early stage, and informal markets flourish; • Albania is paying attention to the role of monetary policy, especially to the costs and benefits of new instruments and moving to more explicit inflation targeting;

5. Is the Inflation in Albania too Low?-The Environment- • 4 of the channels that operate in market economies are: • Interest rates, • Credit ceilings, • Exchange rate, and • Inflation expectations. • In case of Albania channels like equity prices or housing market are less relevant; • During 90s, the exchange rate channel was the most promising route for explaining inflationary developments; • This link of two variables is seen clearly during 1997, when both the exchange and inflation rate jumped sharply (these rates fell rapidly once the situation was under control);

6. Is the Inflation in Albania too Low?-The Environment- • Foreign currency circulates widely, both because of high inflow of remittances and from contraband activities; • The stable exchange rate has played a key role in anchoring inflationary expectations; • The independence of BoA was sanctioned through Law “On the Central Bank” of December 1997; • BoA undertook many steps in order to reestablish an environment in which prices would have a relative stability, and public regained the confidence in Lek (local currency); • Deposits increase with an average of 6% of GDP during’03-04 • The quantity of Lek outside of banks as a % of money at large decrease from 32 to 27% during the same period;

7. Is the Inflation in Albania too Low?-The Environment- • Despite the last years’ achievements, the economists consider Lek as an “over valuated” currency; • It is important to underline that BoA targets the inflation and not the exchange rate; • During the recent years, the 12 month interest rate has dropped towards the 2-4% floor, thus the monetary policy of a strong Lek is considered by the economists “utterly tense”; • But, a strong Lek would not hurt the international competition for as long as it reflects a result of the stable equilibrium caused by internal factors of the Albanian economy; • Several economist reached the conclusion that: ”Albania may find itself in facing the dilemma of holding the inflation at low levels, or fulfilling the process of the market liberalization, but not both at the same time”.

8. Is the Inflation in Albania too Low?-The Inflation and the Economical Growth- • The difficult challenge of today lays in obtaining “the invisible profits” of a low inflation period which would explain the small but constant effects on the economic growth; • The average growth of Albania’s GDP of 6% during 2000-’05 has passed that of every country in the region; while the average increase in prices of 2.2% were lower that others; • An environment of low inflation seems to have been in favor of that part of society with fix income. Some data: During ’95-’98 (average inflation was 18.5%) the pensions in the city as a % of GDP/capita were reduced annually by 4.8%, from 47.3% in 1995 to 38.2% in 1998. On the contrary, during 2000-’03 (average inflation was 3.2%), the pensions increased by 0.5%-from 36.5% in 2000 to 37.4% in 2003;

9. Is the Inflation in Albania so Low?-Expectation on Inflation- • In the last 5-year period, the level of prices started to get closer to that of other regional countries with ambitions to join the EU. Here is an important question: Can the inflation remain so low and stable in countries with an economy in transition? • “The disaggregating” of the data on inflation shows that two important factors have been: 1- the structural reforms in industries, where the tariffs were increased in order to cover costs, and 2- the seasonal changes in the supply, especially in agricultural sector; • Firstly, after the year 1998, the general interest rate started to stabilize while prices in various sectors started to differentiate:

10. Is the Inflation in Albania too Low?-Expectation on Inflation- • Prices of import goods reflected the overpricing of Lek dropped by an annual average of 2.5% during 2001-2005; • Prices of traditional public sectors (electric power, health, education) have grown by an annual av. of more then 6%; • Prices of groups consisting of domestic products grew by an annual average of 3% that was generally in line with overall price growth (3.4%), during the same period; • In the banking system, the combination of low inflation, consolidation of fiscal system, and additional liquidity provided by the privatization of the Savings Bank (2003), resulted in increased loans and reduced financial costs for investments; • As a result, the loan for the economy grew 30-40%;

11. Is the Inflation in Albania too Low?-Expectation on Inflation-

12. Is the Inflation in Albania too Low?-Expectation on Inflation- • Secondly, prices have traditionally shown a stable seasonal model. The monthly inflation rates observed in Sept. and Dec. (respectively an av. of 0.8% and 3.6% during ’99-’05) are in contrast with the average deflecting rate of 0.2% for all the other months; • The seasonal influence reflects the importance of agriculture in the domestic product (27% of GDP) as well as remittances & income generated by tourism. The latter ones culminate in summer and Dec. when Albanian emigrants visit their families and bring money, mainly Euros. • In Dec. the Albanian families seem to pre-finance their shopping for the end of the year, thus causing a constant growth of prices in Dec. and lower exchange rate in January;

13. Is the Inflation in Albania too Low?-What is the Explanation for the Valuation of Lek?- • From the macroeconomic point of view there are no indicators of the efforts by the Albanian monetary authorities to artificially increase the external value of the market; • It seems there are two essential reasons that can explain the strength of Lek: 1- a growth of the remittances and other money entries, and 2- improvement in the productivity of the sectors of tradable goods that in line with the predictions of the Balassa-Samuelson model, would have caused a valuation of the real exchange rate;

14. Is the Inflation in Albania too Low?-Increased productivity & valuation of the (real) exchange rate- • The highest growth rate of transitional economies as compared to those of more advanced economies, must be based in comparable growth (higher) in the ratio capital/work and in the total factor of productivity, especially in commercial sectors; • The available data in Albania on the development of the average salaries in various industries are inaccurate, mainly due to transactions in cash, fiscal evasion and a large informal sector; • However, official data on the salaries may show the possibility that the Balassa-Samuelson assumption may be true:

15. Is the Inflation in Albania too Low?-Increased productivity & valuation of the (real) exchange rate-

16. Is the Inflation in Albania too Low?-Increased productivity & valuation of the (real) exchange rate- • Data shows that a correspondence between proportions in ratios of relative prices with the ratios of the real exchange rate, which implies that the valuation of lek is in proportion with the growth in productivity, transmitted in the ICP through transitory inflation; • Another phenomenon of the Albanian economy that might be explain by B-S effect is the fact that the reduction of comm. deficit from 26% of GDP in 2002 to 20% in 2005-06, is consistent with the interpretation that the valuation of the exchange rate was a result of the increased productivity (Albanian export was part of world export at 0.011% in 2000 and 0.019% in 2005);

17. Is the Inflation in Albania too Low?-Increased productivity & valuation of the (real) exchange rate- • But, De Broek and Slok found clear evidence of the B-S effect in the EU candidate countries, while such evidence is not so strong in other transitional countries (including Albania) because their majority has gone through long periods of economic growth; • The results must be similar even for particular countries with fixed exchange rates such as Estonia & Slovenia that joined euro zone in mid ’04; • Contrary to countries with flexible exchange rates such as Albania, the B-S effect in such cases is manifested through high inflation rates and not through a valuation of the exchange rate;

18. Is the Inflation in Albania too Low? • In general terms, there are not indicators showing why Albania cannot and must not keep an environment of low inflation, while at the same time it completes the program of structural reforms; • BoA, through its monetary policy has increased the credibility of its policy for an inflation rate within the limits of 2-4%, which is 2% higher then the band used by the Central European Bank; • The theoretical and empirical problems for qualifying the permanent effects of the low inflation rate on the economic growth are multiplied because of the lack of data in Albania;

19. Recommendations: • Due to a continuous low inflation rate, the BoA can and must attenuate the monetary policy by supporting the commercial bank sector, that is now completely privatized, in order to increase loans for the economy by encouraging investments in the private sector and by maintaining economic growth in the same levels.

20. Balassa – Samuelson Model • The BS effect is either of two related things: • the observation that consumer price levels in wealthier countries are systematically higher than in poorer ones (the Penn effect); • An economic model predicting the above, based on the assumption that productivity or productivity growth-rates vary more by country in the traded goods’ sectors than in other sectors (the BS hypothesis). • Every economy is presumed to manufacture two kind of products, where the companies that max their profit produce tradable and non-tradable goods. Both sectors produce commodities according to a standard constant function production:

21. Balassa – Samuelson Model ↔ ↔ ↔ ↔ • Yt = At x Ltα x Kt1-α, 0<α<1 (A1) ^ ^ ^ ^ • Yt = At x Ltβ x Kt1-β, 0<β<1 (A2) where: ↔ ^ • Yt = Yt + Yt ; A= total factor of productivity; L= Work; K= Capital (A1) – tradable goods (A2) – non tradable goods

22. Balassa – Samuelson Model • Prices of tradable goods and interest rates are determined at world trade market, and salaries are determined by the highest productivity sector (in general the tradable goods sector); • Assumptions of the B–S effect result in an internal transmission mechanism: “The traded goods have a higher productivity growth than the non-tradable goods sector, leading to higher relative non-tradable goods’ prices and inflation”. • …..to be continued