1. INTRODUCTION The end of the 80’s and the beginning of the 90’s of the last century was the time of big changes for the countries in the Eastern and Central Europe. The change of almost 50 years of tradition started with the fall of the Berlin wall, disintegration of the Czechoslovakia and Yugoslavia, and reached its pinnacle with the fall of the Soviet Union and the so-called Iron Curtain. This meant that these countries were exposed almost immediately to the market economy and thus faced with great problems. The consequence of being economically and politically closed and self-sufficient for almost half a century meant that these countries were less economically developed than the neighboring Western European countries. The institutions and the infrastructure for the market economy were non-existent or badly functioning.
This was especially true for the financial markets and the labor, which was vastly underemployed. Another great problem that had in common all these countries was inflation, which is directly connected with instability of the exchange rate. Therefore it is interesting to see that the choice of the exchange rate systems in these countries was all but similar. For these reasons I have chosen to present the selected exchange rate mechanism for 5 Eastern European countries that have selected basically all the types of the exchange rate mechanism on the scale from fixed exchanged rate (Estonia) to flexible (managed) exchange rate (Slovenia).
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From the mid 90’s onwards these countries have been able to more or less stabilize their economies. So a new idea (direction) came sneaking into their plans.
And this was the inclusion of their economies to the European Monetary Union (EMU) as soon as possible after joining the EU. First these countries will probably have to join the EMS 2 (European Monetary System 2) and show consistency in the results for 2 years. The countries will have to fulfill the 5 Maastricht criteria – regarding inflation, long-term interest rates, government deficit, public debt and exchange rate behavior. Therefore the goal of this paper is to present different kinds of the exchange rate systems these countries have chosen and analyze which might be the most appropriate for joining the EMS 2 and later EMU. 2. EXCHANGE RATE SYSTEMS In theory we know three types of the exchange rate mechanisms; fixed, flexible and mixed exchange rate mechanism.
Within these three basic types we differentiate several other real types of the exchange rate mechanism that are used by countries in practice. 1. 1 PURE FLEXIBLE EXCHANGE rate system This system is more or less just a theoretical system as in practice it is very rarely used. In this case exclusively the market forces determine the level of the exchange rate.
This means that the external economic equilibrium of a country is automatically achieved by appreciation or depreciation of the domestic currency without any kind of intervention of the government or monetary authorities. We can divide the factors that influence on the level of the exchange rate into two groups; the ones that influence through the balance of payments (current and capital account), and the individual macroeconomic factors like inflation, interest rates, income, expectation, etc. In general there are 5 arguments in favor of the pure flexible exchange rate system. The first two are clear from the basic definition of this type of the exchange rate mechanism – the automatically balanced balance of payments and “stabilizing” speculation. The other three are the advantages that the countries get with this system for managing their domestic economic policies. These arguments are higher economic stability, monetary autonomy (the country is able to influence by monetary economy the level of unemployment and inflation) and security from the external shocks.
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As mentioned in the beginning the system of the pure flexible exchange rate system is more a theoretical than practical aspect. Nevertheless some countries were forced to use it at certain periods of their history due to the lack of the foreign reserves. 1. 2 PURE FIXED EXCHANGE RATE SYSTEM This system is an exact opposite to the one described above. It means that a country with its intervention on the foreign currency market keeps the exchange rate for the domestic currency on a fixed level.
This means that the country does not allow that the exchange rate would be changing freely, depending solely on the supply and demand for its currency. A country can tie its currency to a single foreign currency or to a basket of foreign currencies. How the countries decide which and how many currencies they should consider mainly depends on two factors. The first factor investigates with which countries (currencies) the country in question has most of its international transactions. The second factor is considering in which currency the foreign debt is denominated. As we said in the pure fixed exchange rate system the authorities in the country determine the exchange rate value and the central bank has the obligation to keep the domestic currency at this value.
If the market equilibrium is lower than the agreed level, the central bank will intervene by buying foreign currency and selling the domestic one and thus increasing the foreign reserves, and vice versa. In this case we can clearly see that the country looses its option of using the monetary policy for internal adjustments and macroeconomic stability. Therefore the stabilizing of the shocks is left to the fiscal policy only. To gain all the advantages, which the fixed exchange rate brings, the country needs to persuade the market that the parity is fixed and unchangeable.
In case it does not convince the market completely it will be a target of speculative attacks, which is very common in the last years (UK lb in 1992/1993, Thai Baht 1997, Brazilian Real 1997-1999).
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The lesson we can take from these crises is that the combination of the free capital flows, fixed exchange rate and monetary sovereignty is inconsistent. One of the three should be given up. As the capital movement is getting incredibly fast and unpredictable in the recent history, the two years of the EMS 2 period might prove destructive for some of the transitional countries if the international community will not help them in an efficient way. Similarly to the pure flexible exchange rate system, neither the pure fixed exchange rate system is often used in practice. The exception was the golden standard regime used before the 1 st World War, where the value of a currency has been determined with a quantity of gold.
For this system it is significant that the problem of a deficit in the balance of payment was solved by the outflow of gold from the country and the countries with a surplus in the balance of payments had an inflow of gold. 1. 3 MIXED EXCHANGE RATE SYSTEM Mixed exchange rate system means that the country does not explicitly declare the official exchange rate and neither if, when and how much it will intervene. The intervention in the market is completely discretional and takes place when the authorities decide that the value of the exchange rate is not moving according to their expectations or desires. The mixed exchange rate is somewhere between the two already mentioned systems of the exchange rate policy and thus the external imbalance has effect partly in the change of the exchange rate level and partly in the change of the foreign reserves. The main reason why most of the countries decide for the mixed exchange rate system is that there are no firm evidence of pure advantages of fixed and flexible exchange rate systems.
The commonly accepted argument in favor of the mixed exchange rate system is that with it the country can take advantage of the good sides of both systems and at the same time efficiently minimizes the flaws of both. The mixed systems can be divided into two groups of systems. In one group are the systems that are closer to the pure fixed exchange rate system and in the other group are those that are closer to the pure flexible exchange rate system. 1.
3. 1 Systems within the fixed exchange rate system For this systems (an exception is currency board) is significant that the country decides on the value of its currency in relation to the chosen currency (or basket of currencies) but at the same time determines the borders within which it will allow the value of the domestic currency to move. The country intervenes only if the market value of the domestic currency goes over or falls under these previously determined bands. a) Currency Board The currency board is the system that is the closest to the idea of the pure fixed exchange rate system. It represents a clear promise to intervene on the foreign currency exchange market to buy or sell foreign currency on a predetermined level. Currency boards cannot give out loans to the government, banking system or whoever else and thus the interest rates are entirely determined by the market forces and related to the currency of the country to which the domestic currency is fixed.
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Of course this promise from the currency board to buy the foreign currency by the predetermined value requires big enough foreign exchange reserves. b) Permanent Peg This is a very rigid system in which the value of the domestic currency cannot be changed or adjusted and is therefore long term fixed. The value can only fluctuate as much as it is determined. This holds in short and long term.
This means that no matter what kind of changes occur in the economies of the countries, the value and its allowed fluctuation are not changed. This system is more of a hypothetical option, but is very close to the system of the EMS and EMS 2. c) Adjustable Peg This system is basically the same to the permanent peg, but the difference is that the central bank has the right to change the exchange rate in order to improve the country’s balance of payments. These changes can occur frequently but are normally very small – only 1% or so. Through history countries have decided for very different values of the limits where the exchange rate can move.
For example one of the strictest system has been the Breton-Woods system where the currencies could move only by 1% around the parity value. Similarly small (later proven to be too small) was the EMS within the European Monetary Union. Here the limit has been set to +/-2, 25%. As we know after the speculative attacks on the British lb these limits have been increased to +/-15%. This is quite logical, as we know that the capital flows today are immensely greater than they were during the times of the Breton-Woods system. d) Crawling Peg For this system it is typical that the parity value is being changed in predetermined time intervals (each or every second month) and the changes are typically very small.
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These changes can be determined before or can be calculated each month with the help of significant economic data (the difference between the foreign and domestic inflation, the difference in expected foreign and domestic inflation, etc. ).
2 Systems within the flexible exchange rate systems The main difference between the systems described in the previous point and the ones described here is that the monetary agents do intervene in the market when the system chosen is from the “flexible group” in later systems, but does so without previously described goals or warnings. This means that in these systems the government (central bank) is able to use its monetary policy to influence on the output. a) Managed Float In this system the monetary agents decide, based on their calculations and analysis, which is the exchange rate level that is most suitable for the country. The indicators usually used to determine this value are information on the balance of payments, foreign reserves and observation of the parallel foreign currency markets.
The objective of the intervention can be different. The intervention can be used just to stabilize the short-term fluctuations and not to influence the long-term trend of the movement, but it can also serve to influence the long-term trend itself of the exchange rate. Some countries use this system to keep the domestic currency on an artificially low level and thus stimulate the exports. This is so called “dirty floating.” b) Independent Floating This system allows even more independence to the central bank to lead its desired monetary policy as fundamentally the exchange rate in this system should be practically entirely determined by the market forces. In this system the interventions of the central bank are mainly meant to prevent big oscillations of the exchange rate to which it comes due to speculative attacks, and thus the interventions are very short lasting. 1.
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4 FACTORS TO BE CONSIDERED WHEN DECIDING WHICH EXCHANGE RATE SYSTEM TO CHOOSE In the case of the transitional countries inflation was one of the key factors on deciding what type of the exchange rate system to choose. The inflation still today represents one of the main problems of the transitional countries. To stabilize an economy of a country with the problem of a high inflation needs nominal anchors. Historically, the chosen anchors have been either the nominal exchange rate or the growth of the money supply. These two anchors have proved to be the best tool to fight inflation all over the world. Normally the stabilization programs based on the control of the money supply have corresponded to the flexible exchange rate systems, and stabilization programs based on the exchange rate corresponded to the fixed exchange rate systems.
The choice of the nominal anchor largely depends on two factors: reason for the high inflation and how the public perceives the inflation. If the reason for the inflation is unbalanced government budget and thus constant need to print the money, it is more likely that the government will choose stabilizing program based on the money supply. In this case the central bank would decrease the money supply and hence cures the main reason for the inflation. But if the high inflation is due to a crisis in the balance of payments, the answer lies in the stabilization program based on exchange rate system. With fixing the exchange rate the government decreases volatility in the foreign currency market and consequently decreases inflationary pressures on the economy.
On the other hand the public has to believe in the stabilization program. That means they have to change their everyday behavior, which so far has been set to protect their wealth from inflation. In this case stabilization programs with nominal exchange rate as an anchor have proved to be better than of choosing money supply as an anchor as it gives more credibility to the government and is clearer to the public. Of course if the public does not believe that the government can defend the chosen parity for the domestic currency it will lead to more inflationary expectation, which is, as we know, a self-fulfilling prophecy. There are two main differences between the two anchors.
1. Choosing the money supply as an anchor causes the recession right in the beginning of the stabilization program, while with choosing the nominal exchange rate as an anchor the recession comes later on. From this perspective the money supply as an anchor has certain advantage, as it is better for an economy to face the problem of a recession as soon as possible. Choosing the nominal exchange rate as an anchor can cause that the recession takes place when it already seems that the economy is “back in the saddle” and therefore creates a lot of negative expectation in the public. 2. Although the economy is pushed into recession in both cases, the loss of the output is considerably smaller with choosing the nominal exchange rate as an anchor.
As all the transitional countries were faced with inflation for several years, therefore the inflationary expectations became part of their lives. Therefore most of the governments chose the nominal exchange rate as an anchor and thus try put an end to the inflationary expectation of the public. 3. EXCHANGE RATE SYSTEMS IN THE CHOSEN TRANSITIONAL COUNTRIES In this chapter I will describe the chosen exchange rate regimes from the acquired “independence from communism” until today.
We will see how these regimes were developing through time, if they did at all. It is interesting to see that countries with similar history and same suggestions from the international community (IMF, WB, etc. ) on how to develop their economies fastest possibly, chose very different exchange rate systems; everything from very fixed (Estonia) to a quite flexible ones (Slovenia).
1 ESTONIA After the collapse of the Soviet Union Estonia, still with the hyper inflationary Russian Ruble as their national currency, faced a political and economic instability. What Estonia needed was a stable and credible currency and an institution that would be able to introduce the firm budget constrictions. To acquire all this quickly Estonia decided in July 1992 to step out of the Russian Ruble and as the first one of the Baltic countries created their own currency; Estonian Krona (EEK).
This was subsequently tied to the German Mark (DEM).
German Mark because of its famous stability and the wish of the Estonian public to join the so-called “area of the German Mark.” The relation has been fixed at 8 EEK = 1 DEM, based on the relation between German Mark and Russian Ruble at that time. The regime of the currency board seemed at that time as the best choice for a small unstable country, especially due to its simplicity, transparency, credible and resistance to the foreign pressures. But the main reason why Estonia was able to implement the currency board lies in its huge amounts of the foreign reserves and gold that has been put into English and other central banks before the 2 nd World War and has been returned to Estonia after it won back its independence. Nevertheless Estonia did not decide for the strictest version of the currency board. The Estonian central bank kept the right to judge how much the capital flows can influence on the monetary base, and also kept the right to decide the minimum reserves needed to be held by the commercial banks. But on the other hand it kept a strict rule of not lending money to the government or commercial banks.
Also the interest rates have been set completely by the market forces. What even raised the credibility into the currency board in Estonia was the manner the central bank acted, or better said not acted during the banking crisis in the end of 1992 and beginning of 1993. Due to the bad bank management and passing the Law on Banking in that year, the number of banks in Estonia grew from 3 in 1989 to 41 by 1992. To compare, there are only 5 commercial banks in Estonia today. As an answer to the crisis the central bank denied help to the commercial banks with problems and left them collapse or to find a solution by themselves. The currency board regime has been extremely successful in the case of Estonia.
Firstly, and most importantly, it has managed to decrease the hyperinflation that has been quite out of hand. The inflation has been reduced from more than 1000% in 1992 to less than 100% in 1993 and continued the trend and is today, with Czech Republic, the country with lowest inflation among all the transitional countries. Another thing that can be considered as a great success is that it successfully defended against the global financial crisis, even though one of them (Russia) took place in their immediate vicinity. Many feared that creating Krona and tying it to the German Mark would cause an outflow of the gold and foreign reserves. Surprisingly occurred the opposite. The foreign reserves multiplied by factor 7 until the end of the century.
This was due to the increased demand for Krona as one of the few stable currencies in the area. On the other hand Estonia paid the stable currency with big swings in its growth. For example growth went from 8% in 1990 to -13, 6 in 1991, -14, 2 in 1992 and -8, 5 in 1993 and back into positive 10% in 1997. Estonia and the Krona reached its full convertibility in March 1994, when it changed the regulation about the foreign currency deposits.
At the same time Estonia enabled almost completely free movement of the capital, without limiting transactions for its current or capital account. 3. 2 HUNGARY The main difference between Hungary and other transitional countries was that Hungary entered the “post-communist” ‘epoque in a lot better situation. Hungary had less distorted price system, the international macroeconomic situation has been more stable, the labor has been highly qualified and moreover the domestic currency has been less overvalued than currencies of the other countries. In the beginning Hungary chose adjustable peg as the exchange rate system. The value has been tied to the basket of two currencies (50% DEM, 50% US$) and it could freely move within limit that has been set at +/-2, 25%.
In May 1994 the content of the basket changed – 70% ECU, 30% US$. All through the 1991-1995 period devaluations have been taking place. 8% in August 1994, 9% in March 1995 just to mention two of the biggest although there have been numerous smaller ones. After March 1995 Hungary changed its regime to the regime of the crawling peg with predetermined devaluations each months in value between 1, 2% and 1, 9%.
The reasons why Hungary did not choose a tighter exchange rate regime lie especially in three reasons. 1. The stabilization program in Hungary has been based on the nominal money supply as the anchor. 2.
The inflationary expectations have not been very intense for the Hungarian public and thus there has been no need for a tighter exchange rate mechanism that would lower these expectations. 3. Even in the beginning of the transition it has been clear that as a result of liberalizing the economy the raises in prices would follow due to the changes in relative prices and unbalanced supply and demand. The principal policy in Hungary until March 1995 has been to keep the real exchange rate on a constant level. This policy came upon problems after the deficit of the current account became to grow intensely in 1993 (even to 9-10% in 1993-1994).
This meant that exchange rate had to support two opposing goals – keeping inflation on low levels and assisting the current account.
In the end of 1994 the choice has been made in favor of the current account. The result of this have been the two previously mentioned devaluations and change of the exchange rate regime to the crawling peg. The monthly adjusting of the exchange rate has been stabilizing through time and came down from 1, 9% in 1995 to settle at 0, 2% monthly after 1996. In year 2000 Hungary tied its currency 100% to the Euro and dropped the US$. The limit to fluctuate remained the same until May 2001 (+/-2, 25%), when the Hungarian National Bank announced enlarging the band to +/-15%. Hungary never has been a victim of hyperinflation from the start of the reforms.
Furthermore Hungary introduced liberalization step-by-step and not based on so-called “big-bang” reforms. The consequence has been that Hungary rarely exceeded inflation of 30% but also rarely fell under 20% in the first half of the 90’s. The introduction of the crawling peg in 1995 made it possible to decrease the inflation from almost 30% in 1995 to 10, 1% in 1999 and further to 7, 5% in 2000. But here the development stopped, especially due to the higher prices of energy, raises of wages, looser fiscal policy due to the expected elections that took place in 2002, etc. All this led that the inflation rose to 12, 2% in 2001. 3.
3 POLAND Right in the beginning of the transition period Poland had a typical hyperinflation problem. To solve this problem it introduced a stabilization program in 1990 of which main point has been a fixed exchange rate system, tied to the US$ in relation 1 US$ = 0, 95 PLN. It is important to mention here that the Polish Zloty has been significantly devaluated even before starting with this stabilization program. This devaluation has been needed due to the low amount of the foreign reserves and to obtain credibility of the newly established parity. The main goals of the stabilization program have been blocking the hyperinflation and decreasing the budget deficit.
Later has been observed that the hyperinflation has been only a short-term phenomenon, but the high inflation persisted a lot longer than expected. This led to a high real appreciation of the Zloty and caused problems in the current account balance. Therefore in May 1991 occurred devaluation of the Zloty to 1 US$ = 1, 11 PLN and changing the structure of the basket of the currencies to 45% US$, 35% DEM, 10% GBl b, 5% FRF and 5% CHF, which reflected polish international trade. Due to the persistent high inflation and therefore real appreciation of the Zloty, still low foreign reserves and incompatible monetary and fiscal policies, came to a change of the exchange rate regime in 1991. Poland decided for the crawling peg regime. But again in the following period, Polish monetary policy had two contradictory goals – keeping the stable trend of depreciation and acquiring a significant amount of the foreign reserves.
This conflict of interests came to new heights in 1994, which was the first year of big increases in foreign exchange. This meant big increases of the money supply and consequently pressures on raising prices. The central bank reacted by a few careful monthly devaluations of the Zloty (1, 6% monthly in August 1993 until 1, 2% monthly in February 1995) and adjusting the interest rates. However all this did not have a desired effect on the accumulation of the foreign reserves.
All this led to a change of the exchange rate regime in Poland in 1995. The new regime has been “crawling band.” This regime is very similar to the crawling peg only that it is allowed for a currency to fluctuate within previously determined limits. This limit (band) has been set in the case of Poland to +/-7%. This new system meant that the Polish central bank now had more flexibility with the monetary policy and could thus react better to short-term crisis.
But this was not the end of the changes in Poland. Big differences in interest rates and good economic forecasts for Poland resulted that there were great inflows of portfolio investments. This again endangered the stability of the exchange rate stability. Poland has again been confronted with the dilemma, whether to keep with the stable exchange rate goal, or change it and start stabilizing the inflation. Due to the size and openness of the Polish economy, the optimal solution to choose has been lowering the inflation. Due to the characteristics of Polish economy it was impossible to keep the chosen regime.
Hence in June 1999 the government dropped the law, which obliged the central bank to intervene in the foreign exchange market. And finally in April 2000 Poland passed to a floating exchange rate mechanism. 3. 4 CZECH REPUBLIC Also the case of the Czech Republic has history of exchange rate regimes that is quite colorful.
The first chosen regime being from the group of fixed regimes (with nominal exchange rate as the anchor), through independent floating to the managed floating. As mentioned above, in the first faze of the transition the chosen regime has been formed in a way to keep the nominal exchange rate as the anchor to stabilize the economy. Like in Poland, also in Czech Republic there were several devaluations before setting the fixed value for the exchange rate between Czech Krona and US$. All together this adjustments summed up to almost 90% devaluation of the Krona against US$. On December 28 th 1990 the parity was established at 28 CSK = 1 US$ with a very tight band of fluctuation – +/-0, 5%. This exchange rate has been more or less stable for quite some time.
The Krona has been tied to a basket of five currencies until May 1993, which was then changed to a basket of two currencies – 65% DEM and 35% US$. Looking back one can conclude that in order to keep the macroeconomic environment fairly stable, the nominal exchange rate as the anchor has been proven to be a fairly successful tool. After the liberalization of the prices the inflation stopped on average values that were not a lot higher than 10%. The inflation fell from about 20% in 1993 to about 10% in 1994. For the successful implementation of this exchange rate regime was crucial the specific characteristics that the Czech Republic had. With this is meant especially the friction – particularly regarding the capital flows – which enabled to the monetary authorities a considerable degree of autonomous decision making, which has been used for a fast disinflation.
In the period that followed (1994-1996) the Czech economy has been faced with growing imbalances. Main problem for this has been inadequate response of the domestic production to the growing domestic demand. This low flexibility of the production sector has been due to the imperfect restructuring of the sector, incomplete privatization and other microeconomic, institutional and judicial limitations of the economic activity. This has been additionally aggravated by the enormous capital inflows to the country (increased from 8, 5% of GDP in 1994 to record 16, 6% of GDP in 1995) due to the liberalization of the capital flows, higher interest rates and positive expectations for the Czech economy. This caused the nominal money supply to grow faster than the nominal output and hence led to inflationary pressures. This trend could not be supported in the long-tern so the Czech central bank widened the band of fluctuation for the Krona in 1996, from +/-0, 5% to +/-7, 5%.
This decision has been crucial as the main reason for the instability in the economy has been the short-term speculative capital. With this resolution the Czech economy stepped into a new faze of the exchange rate systems, as now it could be described as independent floating with wide bands. But this was not the only problem the Czech economy was facing. On May 26, 1997 the Czech Republic moved to the system of the managed floating.
They were forced into this due to the huge speculation on the exchange rate of the Krona. The bases for this were ever growing macroeconomic imbalances. Growth of the real wages was still too big in relation with the growth of the productivity. Next to this the government budget unexpectedly slipped into deficit. This led to more demand, while the supply has still been very rigid. The current account deficit reached more than 8% of GDP.
Investors knew that this would not be sustainable in the long run and the negative expectations began to grow. This uneasiness among the investors has been amplified by the Asian financial crisis. As a result of all these pressures the monetary authorities stopped defending the Krona in May 1997 and left the exchange rate to start floating (managed floating) and at the same time decided to follow policies to lower inflation. Choosing inflation shooting as the main goal in the end of 1997 has been the only way out for the Czech economy. Some analysts argue that this policy (strict monetary policy in order to lower the inflation) was the main reason for the recession that followed.
Nevertheless the chosen policy successfully lowered the inflation from 10% in 1997 to less than 4% in year 2000, which was one of the lowest (next to Estonia’s) inflations among all the transitional countries. 3. 5 SLOVENIA Slovenia chose the most unorthodox and according to the specialist’s opinions the wrong regime for the exchange rate system. Slovenia chose the system of managed floating for its currency. This decision was due to the good state in which Slovenian economy has been in comparison with the other transitional economies. Next to this Slovenian central bank was a completely new institution (founded in 1991) and largely independent and therefore had quite high credibility.
The principal goal of the newly established bank has been the battle against the inflation. At that time the inflation has been higher than 20%. The manner in which it battled inflation has been through the monetary aggregates. That is why the chosen regime for the exchange rate has been of a managed floating.
The exchange rate has been more or less decided by the market forces, but due to the restrictive monetary policy of the central bank there were some interventions in the market. Another reason for choosing this system is that Slovenia, as a newly established country, did not have any foreign reserves or gold. Therefore Slovenia was the only country among the five chosen transitional countries that based its stabilization program on money supply as the anchor. Almost constantly from the independence Slovenia was increasing its foreign reserves. The acquired foreign reserves in the period 1992-1999 was mainly due to the high capital inflows while the current account has been more or less balanced all through this period. Only in the first year, due to the so-called “emergency export” there has been a surplus in the current account.
After 1992 this surplus has been decreasing while the capital inflows have been growing. These flows were increasing the pressure on the appreciation of the Tolar, stimulating the private expenditure and real growth of the money supply. But in 1998 the capital inflows became less economically and politically important, as they substantially decreased due to the global financial crisis. The consequence of all this has been that in 1999 Slovenia had a slight deficit in the current account and a slight surplus in the capital account. As we have said before the principal goal of the Slovenian central bank has been to control the inflation.
But at the same time the central bank has been trying to keep the exchange rate to move as much under control as possible. This means that it has been sterilizing the capital inflow in a way that it was paying (sort of capital outflow subventions) for the outflow of the capital and thus kept the net capital at the appropriate level. This it achieved by paying more for the foreign assets than it got from them. That is how it used the main part of its seigniorage. This sterilization has been proved to be long and expensive. But in the end we can conclude that it was very successful as in the period of 1992-1999 the real appreciation of the Tolar was very small – up to 1, 5% per year.
At the same time inflation as the primary goal of the central bank did not suffer too badly although it has been put into the second plan at times. The inflation fell from three digit figures in 1991 to one digit figures in 1995. In 1999 the inflation in Slovenia reached its minimum (6, 1%) but has risen to about 9% today. 4. EXCHANGE RATE REGIMES IN THE PROCESS OF JOINING THE EMU Ever since the collapse of the Breton-Woods system Europe desired more economic and political integration. Slowly Europe has been moving towards monetary union and creating single monetary unit.
With this intention they created the European Monetary System (EMS) in 1979. This system has been very successful during the 80’s but has collapsed in 1992-1993. This problem did not stop the process of single monetary unit. On the contrary, it accelerated it. The main lesson from this crisis was that the combination of free capital flow, fixed exchange rate and monetary sovereignty is impossible. One of the three should be given up.
As controlling capital flows would be a serious step back in the economic integration and floating exchange rate would mean the end of the single currency dream, the only possible solution was monetary centralization, with a single central bank and a single monetary policy. The consequence of the crisis and this understanding was that on January 1, 1999 the new currency as “electronic money” came into force, and by 2002 Euro was officially the new currency of the “Euro-land.” One of the main desires of the transitional countries is not only to join the European Union but also in the end to be a part of the full integration, meaning joining the monetary union. This means they will have to fulfill the Maastricht criteria and hold them for two years. Due to this many of them are considering joining the Exchange Rate Mechanism 2 (ERM 2) right after joining the EU. Why are the candidate countries so eager to join the monetary union? The main advantages that the country would obtain are: – lower transactional costs as a consequence of no exchange of the currencies, – lower costs for the financial services as a consequence of higher competition within the financial sector, – positive effects as a consequence of a stable currency and – dynamic effects on growth as a result of more efficient allocation of capital. Next to these advantages there are of course also the clear ones like increased trade with the EU, higher possibilities for exports, higher integration, etc.
But not all is good about the single currency. Joining the Euro zone and before the ERM 2 means that these countries will loose the exchange rate mechanism as an instrument for correcting its balance of payments (as an instrument of improving the competitiveness of the domestic economy) and loose its national monetary sovereignty and in the final faze of the integration it will also loose the national currency as well. 4. 1 CHOOSING THE EXCHANGE RATE REGIME BEFORE ENTERING THE EMU How to ease the transitional period to enter to the EMU is another question that the candidate countries will have to answer very soon. The goal is known; joining the Euro zone.
Conditions as well are known; Maastricht criteria and two years of participation in the ERM 2. The big question is whether these countries should join the EMR 2 right after joining the EU or should they try to lead another regime for a while to make it easier to follow EMR 2 afterwards? If so, which regime should they choose? Szapary points out four main characteristics that these countries have, which will influence their decision about the exchange rate regime in the future. These characteristics are: 1. The prices of the non-exchangeable goods and wages in the candidate countries are lower due to the lower productivity and lower technical development, but we can expect that in the following periods the prices and wages will grow and get closer to the levels in the EU. This means real appreciation of their currencies, which may cause the loss of competitiveness and causing serious problems for their balance of payments. 2.
These countries will have to (some already have) liberalize the capital flows in their countries. This means they will be more opened to the global market and hence more exposed and vulnerable. Due to their status as less developed countries they will remain victims of volatile capital flows, no matter what exchange rate regime they choose to follow. 3. The process of transition (liberalization, privatization, structural reforms, etc.
) is still not complete. This means further adjustments of the relative prices will follow, which may cause inflationary pressures. 4. The common characteristic of all this countries is also a small domestic market. This means that investments and consequently growth are greatly dependent on export and import, while any loss of competitiveness will influence on worsening the balance of payments. 1.
1. 1 The question of capital flow liberalization Liberalization of the capital flows is one of the most important questions regarding the exchange rate regimes in the transitional countries (and others as well).
As we have seen it is impossible to keep the “magic triangle” (free capital flow, fixed exchange rate and monetary sovereignty).
Therefore the main issue according to many authors is whether the transitional countries should decide for some sort of control on the capital flows, and if so for how long should they keep these restrictions. As we know capital flows not only enable the country to use its growth potential to its maximum, but also can cause great recessions if these flows are reversed at some point. It is a fact that financial markets are still quite underdeveloped in these countries.
Higher liquidity following the financial liberalization within the weak sector could cause accumulation of bad portfolios. The residents would borrow money on the foreign market where the interest rates are lower and invest in the domestic market. The consequences would be two; firstly the current account deficit grows and hence the foreign debt, and secondly these inflows are only temporary and cannot be detained in the long run. When the country realizes that the burden of ever growing foreign debt has become unsustainable, the investors reverse their capital flows, which results in a crisis for the domestic currency, which in the end translates into a real sector recession.
We could observe this in the Asian financial crisis in 1997. We can therefore conclude that restricting capital flows can be beneficial, at least in the initial periods of the transition. This also admitted indirectly the IMF in 1998, when it said that “certain preconditions are necessary to liberalize the capital flows.” IMF has been almost forced to declare this after the financial crisis in Asian and Latin American countries, which were taking the “IMF medicine” without considering the side effects. The conclusion is that a complete liberalization of the capital and financial flows is not an option for the emerging markets. Some restrictions should be kept, until the situation of the market is strong enough that it can withstand temporary drawbacks, without severely changing the investors’ expectations and thus causing the withdrawal off all the capital. The problem is that a gradual liberalization, although considered as the better option, can take up to 10, 20 or more years.
And the transitional countries do not have that much time. Already now the pressures from the EU countries are taking place to “force” the candidate countries to open up their capital markets. This means than the candidate countries will have to liberalize their capital flows, and use other instruments to fight of the crisis. 1.
1. 2 Choosing the exchange rate for the 5 selected countries prior to the entry into the EMU The opinions of the experts are very divided on this topic. Even the opinion of the same author is sometimes very divided, or better said typical for an economists. Here I would just like to mention a few of the most concrete solutions suggested by the analysts. Fisher recommends for all five countries fixed exchange rate regime.
He says that this is especially important for the small economies, which are due to the trade and capital flows very dependent on a big economy (EU).
He backs up his decision with saying that any country that does not fix its exchange rate makes its integration in the global markets a lot more difficult. Taking his recommendation means that these countries would loose its ability to lead monetary policy and through that to defend their domestic economy from the shock. And as we have realized before, the financial markets in these emerging economies are quite weak and moreover these countries are still considered as less developed. Therefore these countries would be good targets for speculative attacks, as we all know that most of them would not be able to defend their currency with their weak foreign reserves.
The exception is Estonia, for which I would agree that keeping the currency board and simply adjusting it to EMR 2 is the best solution and should make their joining into the Euro zone quite easy. One the other hand Backe defends regimes between the extreme fixed and extreme flexible exchange rate systems. Backe is proving the appropriateness of these systems by investigating the cases of Czech Republic, Slovak Republic, Hungary and Poland during the currency crisis they had throughout the 90’s. He concludes that with certain condition fulfilled (main one being that the chosen regimes must be backed by suitable and consistent macroeconomic and structural policies – especially good reforms in the financial sector) the mixed exchange rate systems are no worse, if not better, than other alternatives. But when he is exploring the optimum flexibility of the exchange rate for the transitional countries he gives an ambiguous answer.
He states that a certain level of flexibility is a reasonable decision for most of these countries, but there are also some very good arguments for choosing fixed or quasi-fixed systems if the required preconditions are fulfilled. It is interesting that in the end when he investigates the speculative attacks, he considers currency board as a very good option for countries like Hungary, Poland or Czech Republic. We can conclude that Backe was presenting all possible options, stating that all are good option, if they are backed by appropriate domestic and foreign policies. The next author I would like to mention is Wyplosz. He clearly states that the most appropriate exchange rate mechanism for the transitional countries would be the tightly managed regime and at the same time restricting the capital flows (which is what Slovenia has chosen in 1992) or as the other option the regime of the currency board. At the same time he recognizes that the countries are not likely to adopt the regime of the currency board as it is usually considered as a short-term solution.
The exception is Estonia, which has it for more than 10 years and should therefore keep it until getting included in the EMR 2. Wyplosz claims that a certain level of flexibility of the exchange rate is necessary during the process of liberalization. With this instrument the economy can be cooled down during inflow of capital through appreciation of the exchange rate, and vice versa. But there is another option, defended by Tullio and Ribnikar. This suggestion is based on a simple fact that the candidate countries should not rush and thus risk their wealth, for which they have worked so hard in the last 10 years of the transition period.
Tullio as a main reason states the big difference between the GDP per capita levels (with exception of Slovenia), which means the candidate countries can expect in this race to catch up a lot of asymmetric shocks due to the structural changes and higher specialization of the markets. Therefore Tullio suggests an exchange rate regime that will be flexible enough to avoid current account deficits and at the same time enable maximum possible anchor in the battle against inflation. As a solution he makes a concrete suggestion; “exchange rate corridor.” This is a system that implemented Israel in 1991 and also Russia in 1995. With this it should be possible to avoid real appreciation of the currency. The idea of this system is that the monetary authorities decide on the value of the exchange rate and determine the band (+/- certain percentage) where the value of the domestic currency can move.
The secret of this system is that the value and the bands have a positive slope through time, which means it is expected and let that the domestic currency will be depreciating through time and thus prevent its real appreciation. The central bank would only intervene when the value would be outside this band. Ribnikar on the other hand states simply that a country should “clean it own house” before thinking of something else. Therefore first it should carry out all the reforms and strengthen their financial system. All this time the exchange rate regime should be flexible enough to allow absorption of the shocks and the capital movement should be regulated. 5.
CONCLUSION As we have seen there is a whole palette of different exchange rate regimes. Each has its advantages and disadvantages. The chosen countries have decided for the regime that they seemed most appropriate. Apart of Slovenia and Estonia the other three had to change their system and also parities several times since the beginning of their transition to the market economies. All of them moving more toward the flexible exchange rate regime.
This means all of them had to use exchange rate as a mechanism to protect their economies from severe shocks. As we have observed Estonia was the only one that decided for the fixed exchange rate regime (currency board).
This was possible due to its great foreign reserves and gold. As the currency board in Estonia has sustained all the external and internal upsets, Estonia will probably have least problems to join the EMR 2 and will probably do so right after joining the EU.
Hungary’s system is already very similar to the EMR 2. The changes they will have to do are tie the Furint only to Euro and drop its tie to the US$. At the same time it will have to continue with its efforts to lower the inflation, because otherwise Furint will get overvalued, which would put pressure and speculation on their tie with Euro. Poland and Czech Republic are the only two that in the end have decided for free floating of their currencies. This have helped them with their internal reforms, but when it will join the EMR 2 it might be submitted to great speculative attacks, as history shows they could not defend it in the past.
Nevertheless Czech Republic has managed to lower their inflation to levels below 4%, which will make it a lot easier for them to join the EMR 2 as there should not be real appreciation of the Czech Krona. In the end Slovenia has led the policy of constant depreciation of the Tolar and thus prevented real appreciation of its currency. It is still following this policy today. With its intervention in the market it has more or less stabilized the exchange rate – meaning decreased to a minimum the fast swings of its value.
The problem of Slovenia still lies in a too high inflation, which might cause vast difficulties once the authorities decide to keep more stable value of the Tolar. According to the politicians of the chosen countries, all five countries will try to join the EMR 2 right after joining the EU. I believe that Estonia and possibly Czech Republic will not experience greater problems, as they have done very good work within their home economies. Although Slovenia seems to have the strongest economy (which due to most of the economic indicators does) I do not believe it would be a good idea for it to join the EMR 2 before lowering the inflation to 4% or less and keep it there for a year or two before deciding to join the EMR 2. Hungary’s exchange rate system is as said above already very close to the conditions of the EMR 2. But in case Hungary does not lower its inflation and completes its internal reforms it will not be able to sustain the pressures and stay within the EMR 2 in case of joining it.
Poland with structural problem, high inflation, flexible exchange rate, huge difference in GDP per capita between Poland and EU average topped with almost 40 million of population and high unemployment, I believe it would be better for Poland to not even try to join the EMR 2 right after joining the EU. This might result in big speculative attacks against Zloty, which might push Poland 5 years or more of growth and development back in the past. To conclude, we all know what regime the five countries must choose to join the Euro zone – EMR 2 and keep it for 2 years. The only question is if they can defend it. As pointing out above I believe Czech Republic and especially Estonia will be able to join right after admission into EU. Slovenia and Hungary could be candidates after lowering their inflation (maybe in 2 or 3 years).
And unfortunately for Poland I do not see them joining in the next 5 years. I therefore defend the slow but secure approach. All these are of course economic reasons. Which countries will join and when is of course not only an economic but also a political reason. Being included in the EMR 2 is not only a signal of economic stability, but also a statement of political prestige. Therefore maybe all of the countries might join at the same time, also due to the high costs of including new countries, but in my opinion this might occur in 5 years or so, so more countries will be prepared for the Euro..