The transmission of euro area monetary policy to financially euroised countries

Working Paper Series

Isabella Moder The transmission of euro area monetary policy to financially euroised countries

No 2611 / October 2021

Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

Abstract

This paper provides a comprehensive analysis of the interest rate pass-through of euro area monetary policy to retail rates outside the euro area, contributing to the literature on the consequences of unofcial nancial euroisation and on the transmission channels of monetary policy spillovers. The results suggest that in the long run, more than one third of all euro retail rates in euroised countries of central, eastern and south-eastern Europe (CESEE) are linked to the euro area shadow rate. Compared to euro area monetary policy, the share of cointegration of the domestic monetary policy rate is lower, suggesting that domestic central banks in euroised countries with independent monetary policy can only partially control the 'euro part' of the interest rate channel. Furthermore, euro area monetary policy shocks are fast and persistently transmitted into euro retail rates outside the euro area, which constitutes an additional channel of international shock transmission.

Keywords: monetary policy transmission, international monetary policy spillovers, unofcial nancial euroisation, EU integration

JEL-Classication: C22, C32, E43, E52, F42

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Non-technical summary

The use of the euro is not restricted to the euro area. Instead, in a number of European countries outside of the euro area such as the economies of central, eastern and southeastern Europe, the use of the euro is widespread. This paper deals with one particular aspect of this phenomenon, namely the denomination of bank deposits or bank loans in euro instead of the national currency. More speci cally, this paper sheds light on the question to what extent the interest rates of euro deposits or euro loans in those countries are shaped by euro area monetary policy. With this focus, it aims to ll a gap in the literature that has not yet investigated this issue in a comprehensive way.

The responsiveness of interest rates on euro deposits and euro loans to euro area monetary policy is of great interest for central banks in the countries outside of the euro area. First, the behaviour of euro interest rates to euro area monetary policy is especially relevant for countries that are pursuing independent monetary policy. In case the euro interest rates were very responsive to euro area monetary policy, this might question the e ectiveness of domestic monetary policy to inuence nancial conditions in the euro part of the banking sector. Second, if a clear response of euro retail rates to euro area monetary policy was found, this would indicate an additional channel how euro area monetary policy shapes economic conditions in its neighbouring regions that are outside of the currency union.

I employ two di erent empirical approaches based on a dataset of 200 time series consisting of deposit and lending rates of eight countries in central, eastern and southeastern Europe.1 First, I make use of a so-called cointegration test that measures the long-runco-movement between a key euro area interest rate and the respective euro lending or deposit rate, applying it to each individual interest rate in the period between January 2010 (or later depending on data availability) and June 2019. If the result of the test is positive, i.e. if a long-run relationship between those two interest rates is found, I calculate additional metrics to gather further information on the nature of the long-runco-movement. For countries that are pursuing independent monetary policy, the same exercise is conducted for the relationship between domestic monetary policy and euro lending or deposit rates in order to obtain a comparison between the responsiveness to

• Those countries are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, North Macedonia, Roma- nia and Serbia.

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euro area and domestic monetary policy.

In the second part of the analysis I estimate vector autoregression (VAR) models in order to isolate the impact of euro area monetary policy shocks on euro lending or deposit rates, and to obtain further information on the dynamics of the transmission. As this type of analysis needs longer time series than the previous analysis described above, it can only be applied to the common movement of interest rates in a subset of three countries in central, eastern and south-eastern Europe.

The results suggest that euro interest rates in countries of central, eastern and southeastern Europe respond at least as much to euro area monetary policy than they respond to domestic monetary policy. Moreover, some evidence can be found that the co-movement between euro lending and deposit rates and euro area monetary policy is higher for countries that are pegging their currency to the euro. The complementary VAR analysis conrms the immediate and persistent impact of euro area monetary policy shocks on euro lending and deposit rates. Overall, the results indicate that domestic central banks in countries with independent monetary policy can only partially control nancial conditions in the euro part of their banking sectors, which makes domestic monetary policy somewhat ineective. For countries with a xed exchange rate regime linked to the euro the consequences seem to be less dramatic, given that domestic nancial conditions are anyway linked to euro area monetary policy. The fast interest rate pass-through to euro lending and deposit rates might however constitute an additional channel of the international transmission of euro area monetary policy shocks.

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• Introduction

This paper provides a comprehensive analysis of the interest rate pass-through of euro area monetary policy to retail rates of euro loans and euro deposits outside the euro area. To the best of my knowledge, the cross-borderpass-through of euro area monetary policy to nancially euroised countries has not been systematically examined yet.

Since the seminal works on the interest rate pass-through undertaken by Cottarelli and Kourelis (1994) as well as Borio and Fritz (1995), a vast amount of research has emerged in order to estimate the interest rate pass-through in the euro area, linking changes in monetary policy and/or money market rates to changes in commercial banks' retail interest rates.

However, the use of the euro is not restricted to the euro area. Instead, in a number of European countries outside the euro area, mostly in the economies of central, eastern and southeastern Europe (CESEE), economic agents voluntarily choose to hold a share of their deposits in euro, or take out loans in euro { a phenomenon which is called unof cial nancial euroisation.2 Unof cial nancial euroisation is a common phenomenon in CESEE countries, as over 40% of total outstanding loans and more than one third of total deposits are denominated in euro instead of the national currency (see Table 1).3

Two main questions thus arise: First, does a relationship between euro area monetary policy and euro retail rates in unof cially euroised economies exist? Second, if such a relationship exists, to what extent can domestic monetary policy inuence the euro part of the interest rate channel?

This paper is related to two strands in the literature: First, it contributes to the literature on the consequences of unof cial nancial euroisation. While the discussion has focused mostly on its impact on nancial stability and ination, the implications for monetary policy effectiveness have not received much attention yet. A stronger interest rate pass-through to CESEE countries' retail rates for euro loans and deposits of euro area monetary policy compared to domestic monetary policy would indicate that domestic central banks can only partially control the euro part of the interest rate channel. This in turn would suggest adverse consequences for monetary policy effectiveness of CESEE countries that are pursuing independent monetary policy.

Second, and closely related, this paper contributes to the discussion on international spillovers

• Other types of unofcial euroisation include currency substitution, where the euro is used for nancial trans-
  action purposes, as well as real euroisation when prices and wages are indexed to euro.
  3Unweighted average of CESEE countries excluding the Czech Republic and Poland where unofcial euroisation is less prevalent.

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