UNIVERSITY OF SARAJEVO

SCHOOL OF ECONOMICS AND BUSINESS SARAJEVO

INDEPENDENCE OF CENTRAL BANK OF BOSNIA AND HERZEGOVINA

(EFFECT OF CURRENCY BOARD ARRANGEMENT)

RESEARCH PAPER

Subject: Financial Markets and Institutions

Professor: Muharem Karamujić, PhD

Teaching Assistant: Mirza Kršo, PhD

Students: Adna Olovčić – 72452

Ajla Omeragić – 72457

Field of study: Financial Management

Sarajevo, October 2016

Abstract

In this research paper we will discuss the independence of Central Bank of Bosnia and
Herzegovina. In the introductory part we will present our topical area, chosen topic and
explain the terms of central bank, transition countries and types of central bank
independencies. Our focus will be on the functional aspect of independency and the most
discussed problem in terms of our Central Bank – the Currency Board arrangement. In our
analysis we will examine how the Arrangement affects B&H Central Bank’s freedom in
conducting goals of monetary policy. Through explaining main elements and history of the
Currency Board, we will make conclusions regarding ways it affects B&H monetary policy
and, ultimately, the independence of B&H Central Bank.

1
Table of Contents
Abstract...............................................................................................................................1

1. Introduction ..................................................................................................................3

2. Hypothesis ...................................................................................................................5

3. Methodology ................................................................................................................7

4. Analysis .......................................................................................................................8

4.1. Fixed Exchange Rate..............................................................................................9

4.2. Full Foreign Exchange Backing ............................................................................ 11

4.3. Full Convertibility................................................................................................ 13

5. Conclusion ................................................................................................................. 14

6. References.................................................................................................................. 15

7. Appendix 1 ................................................................................................................. 18

8. Appendix 2 ................................................................................................................. 19

9. Appendix 3 ................................................................................................................. 20

Table of Figures
Figure 1: BAM pegged to EUR .......................................................................................... 10
Figure 2: EUR USD exchange rate ..................................................................................... 10
Figure 3: BAM USD exchange rate .................................................................................... 11
Figure 4: Full exchange rate backing .................................................................................. 12

2
1. Introduction

The term and concept of central bank has always been a particularly interesting for us. Also,
we live in a transition economy and are faced with its problems and drawbacks every day. So,
having the familiar terms like central bank and transition economies both in the same sentence
led to an immediate agreement of choosing this topical area for our research paper.

Central bank is a national bank that provides financial and banking services; manages
currency of a country, its money supply and interest rates. It is referred to as a monetary
authority. Central banks usually perform variety of functions. Among them are: determining
market interest rates through their control over monetary base, managing the payments
system, managing the foreign exchange reserves, promoting the stability of financial system
by supervising the banks and by serving as lender of last resort, acting as the government’s
banker, determining the exchange rate etc. 1 Now the question we will hopefully answer
through this paper is what role do central banks play in transition economies? How well and
to what extent do such central banks perform their essential function, i.e. monetary policy?

Transition economies are the ones that are changing from central planning to free markets.
Most of transition economies have faced severe short-term difficulties, and longer-term
constraints on development. Some problems that transition economies deal with are:
unemployment, inflation, lack of entrepreneurship and skills, corruption, lack of
2
infrastructure, inequality etc. Successful establishment of aforementioned functions of central
bank is not an easy task and it demands a huge effort, especially in transition economies
which do not satisfy all preconditions or are only in early stages.

We are well aware of the fact that when the term transition economy is mentioned, our
country is most likely to be among the examples of such situation. In 2002 the World Bank
defined Bosnia and Herzegovina as transition economy. 3

The Law of Central Bank in Bosnia and Herzegovina (further in the text CB B&H) clearly
states that the bank is independent from both Federation and Republic of Srpska, and that no

1
Wagner, H. (1998). Central Banking in Transition Countries. International Monetary Fund. [Internet].
Available at: https://www.imf.org/external/pubs/ft/wp/wp98126.pdf [visited: 19.10.2016.]
2
Economics Online. (n.d.). Transition economies. [Internet]. Available at:
http://www.economicsonline.co.uk/Competitive_markets/Transition_economies.html [visited: 19.10.2016.]
3
Wikipedia. (2016). Transition economy. [Internet]. Available at:
https://en.wikipedia.org/wiki/Transition_economy [visited: 24.10.2016.]

3
other authority can interfere in its operations. But we believe that functional independence is a
particularly relevant topic to be researched and learned about, since monetary authority is an
important player in the transition process from developing to a developed country.

In order to understand what functional independence is, we first have to define the broader
term. Independence of a central bank is characterized in its ability to make decisions without a
third party interference, set monetary policy goals, manage its assets and functions or operate
without political influence. Most often, this independence is divided into four types and they
are defined as following according to research conducted by Vlahović, M. and Cerović, S.
from Central Bank of Montenegro:

1. Functional: the freedom of setting monetary policy goals

2. Institutional: the freedom of selecting monetary policy instruments
3. Personal: the role and structure of the highest authority of the central bank
4. Financial: budgetary independence and prohibition of monetary financing. 4

We have decided to focus only on functional independence, since it has been the topic of
many political and analytical controversies in the past period because of the Currency Board
Arrangement and the fact that many believe it limits the freedom of CB B&H to set and
conduct its monetary policy goals.

Our research will examine whether those statements were true, or CB B&H is functionally
independent.

4
Vlahović, M and Cerović, S. (2005). Nezavisnost centralne banke (primjer zemalja Zapadnog Balkana).
Podgorica: Centralna banka Crne Gore. [Internet]. Available at: http://www.cb-
cg.org/slike_i_fajlovi/fajlovi/fajlovi_publikacije/radne_studije/Nezavisnost_Centralne_banke.pdf [visited:
17.10.2016.]. (our own translation)

4
2. Hypothesis
Central Bank of Bosnia and Herzegovina is not functionally independent.

When Central Bank of Bosnia and Herzegovina first began operating in 1997 it found itself in
the beginnings of war recovery, in the process of change from one particular type of economy
to a market oriented economy, and the country was no longer a part of a bigger nation – it had
just become independent. This whole situation required a strong financial system and
monetary policy that would boost the economy and bring the country to a relatively stable
stage. It was determined in the Law of Central Bank of B&H and Dayton Peace Agreement
that Central Bank of Bosnia and Herzegovina will carry out its monetary policy operations
through a Currency Board Arrangement. Currency board arrangement is basically an
alternative to traditional central banking. In our analysis we will explain more about CBA, but
for now it is important to understand that at the time it was the best possible solution.
Currency was stable and inflation was low.

When talking about independency of a central bank in a country that is already a member or
on its way to become a member of European Union and European Monetary Union, general
approach is that the central bank should have a clearly defined goal, focusing mainly on price
stability. Functional independency in particular, is explained in Lisbon Treaty, article 127.1:
“The primary objective of the European System of Central Banks (hereinafter referred to as
"the ESCB") shall be to maintain price stability. Without prejudice to the objective of price
stability, the ESCB shall support the general economic policies in the Union with a view to
contributing to the achievement of the objectives of the Union as laid down in Article 3 of the
Treaty on European Union…”5

Today, when our country is on its way to satisfy many conditions to join the European Union,
we wanted to examine is the monetary policy in the form of currency board arrangement still
working in our favor, or maybe it would be better to have a central bank that freely conducts
its monetary policy operations. Hence, having a hypothesis which states that Central Bank of
Bosnia and Herzegovina is not functionally independent, we will research different functions

5
The Lisbon Treaty. (n.d.). Article 127. [Internet]. Available at: http://www.lisbon-treaty.org/wcm/the-lisbon-
treaty/treaty-on-the-functioning-of-the-european-union-and-comments/part-3-union-policies-and-internal-
actions/title-viii-economic-and-monetary-policy/chapter-2-monetary-policy/395-article-127.html [visited:
20.10.2016.]

5
performed by central banks in general and how are these conducted under currency board
arrangement.

6
3. Methodology

We conducted a theoretical research which involved perusal of already published works. The
approach was quantitative, meaning that we have collected statistics for relevant topic which
we then further transformed and analyzed. Based on our analysis of theories, statistical and
numerical data – conclusion were drawn.

Our research is focused on functions of our Central Bank and its monetary operations, so
naturally we’ve used official data published on the website of Central Bank of Bosnia and
Herzegovina. In the process of collecting necessary materials and data, we focused only on
reliable and well known sources which were as well discussed with professor Karamujić
during consultation hours. We used information found on web pages of European Central
Bank, CB of B&H, Law of CB B&H, Lisbon Treaty etc. Important source of valuable and
relevant information that supplemented our research were different publications, both
international and domestic as well (all listed in References). Very useful source were recent
statements and opinions of our University professors Čičić M., Softić S., Šain Ž. on relevant
topic, published in well-known print media.

We began by finding functions that central bank, by definition, performs. We decided to

follow and further research the ones defined by International Monetary Fund. After that, the
main source, that was our guide through the whole paper was the book “Monetarno kreditna
politika” by doctor Kemal Kozarić, former governor of Central Bank of Bosnia and
Herzegovina and dean of School of Business and Economics in Sarajevo, and doctor Nikola
Fabris, member of Central Bank of Montenegro and member of International Monetary Fund.
The book provides much information about history of CB B&H and its conduct of monetary
policy under Currency Board Arrangement. It provided us with framework to define three
important features of CBA, which were the main part of our analysis. Most popular and
relevant financial software nowadays – Bloomberg.com, was used as a source for analysis of
fixed exchange rate and comparison of relations between BAM, EUR, USD.

7
4. Analysis

The Law on the Central Bank of Bosnia and Herzegovina, article 02.1. states: “The objective
of the Central Bank shall be to achieve and maintain the stability of the domestic currency
(Convertible Mark ) by issuing it according to the rule known as a currency board.” 6

In order to conduct our analysis about CB B&H independence, firstly we have to define the
term of currency board, explain why our Central Bank has one and link its existence with
functional independence of central banks. The Law says that the objective of CB is to
maintain price stability, so we will explain the role that currency board plays there.

A currency board is an alternative to the traditional central bank. Under a currency board
arrangement (CBA), monetary authorities explicitly commit to exchange domestic currency
for a specified foreign currency at a fixed exchange rate. 7

Under which conditions is it introduced?

 After colonies became independent (eg. British colonies)

 After highly expressed macroeconomic imbalances (e.g. transition countries)
 After first transitional reforms and opening of economies (small countries of South -
Eastern Europe)
 After war conflicts (in the case of B&H) 8

One of the main reasons for establishing currency board is to help them overcome different
political and economic problems or situations they have found themselves in. Because of
certain happenings and events, countries aren’t able to recover on their own and to simply
switch from one form of governance to another.

In B&H, currency board was established in 1997. because of the war consequences, as we
have previously noted. B&H, as disrupted country, needed money and many different
regulations in order to recover both economically and socially. Also, the fact that it was

6
Official Gazette of BH. (1997). Law on the Central Bank of Bosnia and Herzegovina. s.l.: Official Gazette of
BH, 1/97
7
Gedeon, S.J. (2010). The Political Economy of Currency Boards: Case of Bosnia and Herzegovina. [Internet].
Available at: https://www.degruyter.com/downloadpdf/j/jeb.2010.5.issue-2/v10033-010-0011-6/v10033-010-
0011-6.xml [visited: 20.10.2016.]
8
Kozarić, dr.K. and Fabris, dr. N. (2012). Monetarno-kreditna politika. Fojnica: Štamparija Fojnica (pg. 210).
(our own translation)

8
divided into two regions meant that it was very hard to establish good institution that would
be trusted by the whole country, so the best possible solution in that moment was the
establishment of a currency board.

One of the main advantages of the currency board are: guaranteeing of domestic currency
convertibility and guaranteeing of price and monetary stability. However, there are as well
disadvantages such as: disabling of active monetary policy, limitations, even prohibition of
9
credit approvals as last resort which can lead to instabilities of banking system.

Those disadvantages, which are the main characteristics of a currency board, were the motive
for us to question the independence of CB B&H. We will now explain the three most
important features of a currency board in B&H and use them as tools to examine our
hypothesis.

4.1. Fixed Exchange Rate

Central Bank of Bosnia and Herzegovina maintains monetary stability by issuing domestic
currency according to the Currency Board arrangement (1 KM: 0,51129 EURO) with full
coverage in freely convertible foreign exchange funds under fixed exchange rate 1 KM:
0,51129 EURO. 10

When the Currency Board Arrangement was first implemented, KM was pegged to DEM
(Deutsche Mark) with fixed exchange rate 1:1. When a currency is said to have a pegged
exchange rate, it means that it has a fixed exchange rate with another currency, but that actual
exchange rate has the possibility to fluctuate around the initial fixed rate. Although this
regime helps the domestic currency to reduce its volatility, it also limits its control over
monetary policy and its tools. 11

9
Kozarić, dr.K. and Fabris, dr. N. (2012). Monetarno-kreditna politika. Fojnica: Štamparija Fojnica (pg. 212).
(our own translation)
10
Central Bank of Bosnia and Herzegovina. (n.d.). General Information About the Bank. [Internet]. Available at:
http://www.cbbh.ba/Content/Read/13 [visited: 19.10.2016.]
11
Investopedia. (n.d.). Fixed vs. Pegged Exchange Rate Systems. [Internet]. Available at:
http://www.investopedia.com/exam-guide/cfa-level-1/global-economic-analysis/fixed-pegged-exchange.asp
[visited: 20.10.2016.]

9
As of 1999, Bosnian Mark was pegged to Euro instead of German Mark. The exchange rate
stayed the same, i.e. BAM adopted the exchange rate between DEM and EURO, so now the
pegged exchange rate is: 1 EUR = 1.95583 BAM.

Figure 1: BAM pegged to EUR

Figure 1 shows the basic information about Bosnian Mark, including the level of fluctuation
around the initial fixed exchange rate. Here we can see that for BAM, that level is 0.00%,
which means that CB B&H cannot control movement of BAM prices against other currencies
at all, it is highly dependent on Euro movements.

Figures 2 and 3 show us the exchange rate movements in one year period between Euro and
US Dollar and between Bosnian Mark and US Dollar. We can see that those movements are
exactly the same and that the last recorded movement as of 21.10.2016. was the same in
percentage. These figures show us the effect of 0.00% fluctuation in the fixed exchange rate
between BAM and EURO.

Figure 2: EUR USD exchange rate

10
 Figure 3: BAM USD exchange rate

4.2. Full Foreign Exchange Backing

When one currency has full foreign exchange backing it means that its domestic currency
liabilities have to be fully backed with convertible foreign assets. 12

One characteristic of an independent central bank is its ability to change the monetary base
and affect the exchange rate through open market operations by changing its monetary assets.
On the other hand, central banks which operate under currency board arrangement do not
have this ability because they have to keep their monetary assets in foreign currency and they
cannot engage in open market operations, thus they do not have the control over monetary
base. Their limitation over this operation clearly classifies them as not independent.

In the BC B&H Annual report for year 2015 it is stated that, among others, “main objectives
and tasks of the Central Bank of Bosnia and Herzegovina are:
 to define, adopt and control the implementation of monetary policy of BiH through the
issuance of local currency (Convertible Mark or “KM”) with full coverage in free ,
convertible foreign exchange assets

12
Kovačević, D. (2003). The currency board and monetary stability in Bosnia and Herzegovina. BIS papers.
[Internet]. Volume 17/Regional currency areas and the use of foreign currencies, pg. 58. Available at:
http://www.bis.org/publ/bppdf/bispap17.pdf [visited: 19.10.2016.]

11
  to keep and manage the official foreign exchange reserves of the Bank in a safe and
profitable manner.“13

Now we will examine those objectives of CB B&H from the data provided in Appendix 1 & 2
which show us the balance sheets from years 2014 and 2015. As we have previously said, the
basic principle of currency board arrangement is for central bank to cover its monetary
liabilities by foreign reserves on the assets side. In the appendices we can see that our central
bank does exactly that. It is shown that foreign assets cover up monetary liabilities and that
we fulfil that condition every year in the period 2006 - 2015. We can see this data easier
presented in the Figure 4, where this coverage is presented in percentage points.

Figure 4: Full exchange rate backing

13
Central Bank of Bosnia and Herzegovina. (2016). Annual Report. Sarajevo: Central Bank of Bosnia and
Herzegovina (pg. 68)

12
 4.3. Full Convertibility

The third feature of currency board arrangement is full convertibility and is basically the
continuation on the previous feature, the full foreign exchange backing, but we have decided
to list it separately in order to emphasize its importance in our analysis.

Full convertibility of one currency means that the CB B&H has to be able to convert BAM to
EUR at an time if it is required that way. Previously it was the DEM and this rule is required
by the Law on the Central Bank of Bosnia and Herzegovina and we have mentioned that
regulation in the previous part when we spoke about full currency backing.

In the Appendix 3 we present data regarding sale and purchase of BAM in the last 9 years.
This data shows us that total cumulative balance of 7,599,818 Bosnian Marks traded since the
establishment of currency board. Besides that, in the table we can see the level of sales and
purchases of BAM, and realize that there have been years when purchase of BAM was higher
that the sale, but that negative balance was offset by other years when sale was substantially
higher than purchase. We can clearly see that every year millions are traded and that
corresponds to this third feature and proves, once again, that Bosnian Mark is completely
linked to Euro and that these operations limit CB B&H from operating monetary policy tools
on its own.

13
5. Conclusion

After getting familiar with the term and function of Currency Board Arrangement, it is clear
why monetary authorities of Bosnia and Herzegovina introduced it back in 1997. Primary
goal was to establish a stable currency and to keep inflation as low as possible, and that is
exactly what CBA did. However, every time currency board is examined and compared to
traditional central banking there are two different viewpoints; the one that sees CBA as
proven successful and simple tool for maintaining price and monetary stability. From a
different perspective, CBA is seen as a barrier, an obstacle which prevents one country’s
monetary authority in conducting its operations freely and actively. By analyzing three
important features of currency board we drew conclusions on functional independence of CB
B&H. Having a currency that is pegged to Euro reduces currency volatility but on the other
hand also limits control over monetary policy. Full foreign exchange backing means that CB
B&H cannot conduct any open market operations nor change the monetary base. CBA gave
us stability, but harmed us in a way that our production is expensive if we want to export and
importing is far more favorable. Given all these, it is clear that CB B&H under CBA is
definitely not functionally independent. Therefore, we can conclude that our hypothesis stands
its ground. However, one could argue whether full functional independency is what our
monetary policy needs at the moment.

Our convertible currency which is pegged to Euro guaranteed stable currency and inflation
lower than 1%. Bosnian experts in the field of monetary policy agree that currency board
brought significantly more benefits than drawbacks for economy of B&H. Given the
circumstance of very unstable political and legal situation in our country, change in concept of
monetary operations would most probably only bring us hyperinflation.

14
6. References

Books:

 Kozarić, dr.K. and Fabris, dr. N. (2012). Monetarno-kreditna politika. Fojnica:

Štamparija Fojnica. (our own translation)

Laws:

 Official Gazette of BH. (1997). Law on the Central Bank of Bosnia and Herzegovina.
s.l.: Official Gazette of BH, 1/97

Articles:

 Kovačević, D. (2003). The currency board and monetary stability in Bosnia and
Herzegovina. BIS papers. [Internet]. Volume 17/Regional currency areas and the use
of foreign currencies, pg. 58. Available at:
http://www.bis.org/publ/bppdf/bispap17.pdf [visited: 19.10.2016.]
 Gedeon, S.J. (2009). Money supply endogeneity under a currency board regime: the
case of Bosna and Herzegovina. Journal of Post Keynesian Economics. [Internet].
Volume 32, pg. 97. Available at:
http://www.uvm.edu/~sgedeon/currencyboard/Gedeon_Money_Supply_Endogeneity.p
df [visited: 19.10.2016.]
 Sadiković, M. (2015). Stabilnost monetarne politike BiH ostaje neupitna. Radio
Slobodna Evropa. [Internet]. 11.08.2015. Available at:
http://www.slobodnaevropa.org/a/stabilnost-monetarne-politike-ostaje-
neupitna/27183308.html [visited: 22.10.2016.]

Publications:

 Wagner, H. (1998). Central Banking in Transition Countries. International Monetary

Fund. [Internet]. Available at: https://www.imf.org/external/pubs/ft/wp/wp98126.pdf
[visited: 19.10.2016.]
 Vlahović, M and Cerović, S. (2005). Nezavisnost centralne banke (primjer zemalja
Zapadnog Balkana). Podgorica: Centralna banka Crne Gore [Internet] Available at:
http://www.cb-

15
 cg.org/slike_i_fajlovi/fajlovi/fajlovi_publikacije/radne_studije/Nezavisnost_Centralne
_banke.pdf [visited: 17.10.2016.]. (our own translation)
 Central Bank of Bosnia and Herzegovina. (2016). Annual Report. Sarajevo: Central
Bank of Bosnia and Herzegovina

Web pages:

 Economics Online. (n.d.). Transition economies. [Internet]. Available at:

http://www.economicsonline.co.uk/Competitive_markets/Transition_economies.html
[visited: 19.10.2016.]
 Wikipedia. (2016). Transition economy. [Internet]. Available at:
https://en.wikipedia.org/wiki/Transition_economy [visited: 24.10.2016.]
 Gedeon, S.J. (2010). The Political Economy of Currency Boards: Case of Bosnia and
Herzegovina. [Internet]. Available at:
https://www.degruyter.com/downloadpdf/j/jeb.2010.5.issue-2/v10033-010-0011-
6/v10033-010-0011-6.xml [visited: 20.10.2016.]
 Central Bank of Bosnia and Herzegovina. (n.d.) General Information About the Bank.
[Internet]. Available at: http://www.cbbh.ba/Content/Read/13 [visited: 19.10.2016.]
 Investopedia. (n.d.). Fixed vs. Pegged Exchange Rate Systems. [Internet]. Available
at: http://www.investopedia.com/exam-guide/cfa-level-1/global-economic-
analysis/fixed-pegged-exchange.asp [visited: 20.10.2016.]
 The Lisbon Treaty. (n.d.). Article 127. [Internet]. Available at: http://www.lisbon-
treaty.org/wcm/the-lisbon-treaty/treaty-on-the-functioning-of-the-european-union-and-
comments/part-3-union-policies-and-internal-actions/title-viii-economic-and-
monetary-policy/chapter-2-monetary-policy/395-article-127.html [visited:
20.10.2016.]
 Quora. (2013). What does it mean for a country to have their currency pegged against
the US dollar?. [Internet]. Available at: https://www.quora.com/What-does-it-mean-
for-a-country-to-have-their-currency-pegged-against-the-US-dollar [visited:
20.10.2016.]
 Wikipedia. (2016). Bosnia and Herzegovina convertible mark. [Internet]. Available at:
https://en.wikipedia.org/wiki/Bosnia_and_Herzegovina_convertible_mark [visited:
20.10.2016.]

16
PhD dissertations:

 Kilibarda, M. (2015). Uporedna analiza nezavisnosti centralnih banaka zemalja

Jugoistočne Evrope. Beograd: Fakultet za bankarstvo, osiguranje i finansije. [Internet].
Available at: http://union.edu.rs/wp-content/uploads/2015/10/Rad-Milica-Kilibarda-
PDF.pdf [visited: 19.10.2016.]

Figures sources:

 Figure 1: Wikipedia. (2016). International status and usage of euro. [Internet].

Available at:
https://en.wikipedia.org/wiki/International_status_and_usage_of_the_euro#Pegged_cu
rrencies [visited: 23.10.2016.]
 Figure 2: Bloomberg Markets. (2016). EURUSD Spot Exchange Market. [Internet].
Available at: http://www.bloomberg.com/quote/EURUSD:CUR [visited: 21.10.2016.]
 Figure 3: Bloomberg Markets. (2016). BAMUSD Spot Exchange Market. [Internet].
Available at: http://www.bloomberg.com/quote/BAMUSD:CUR [visited: 21.10.2016.]
 Figure 4: Central Bank of Bosnia and Herzegovina. (2016). Annual Report. Sarajevo:
Central Bank of Bosnia and Herzegovina (pg. 38)

17
7. Appendix 1

Appendix 1: Balance sheet of CB B&H from years 2014 and 2015

Source: Central Bank of Bosnia and Herzegovina. (2016). Annual Report. Sarajevo: Central
Bank of Bosnia and Herzegovina (pg. 64)

18
8. Appendix 2

Appendix 2: Balance sheet of CB B&H for years 2016 - 2015

Source: Central Bank of Bosnia and Herzegovina. (2016). Annual Report. Sarajevo: Central
Bank of Bosnia and Herzegovina (pg. 119)

19
9. Appendix 3

Appendix 3: Purchase and sale of KM in years 2006 - 2015

Source: Central Bank of Bosnia and Herzegovina. (2016). Annual Report. Sarajevo: Central
Bank of Bosnia and Herzegovina (pg. 130)

20