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Capital Inflows and Monetary Convergence: Lessons from the Central European Transition Economies
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Lucjan T. Orlowski *
The Central European candidates for accession to the European Union (EU) have advanced the development of modern financial markets over the past decade. To strengthen competitiveness and institutional efficiency of these markets, they have liberalized considerably capital account transactions with abroad. This in turn has contributed to the acceleration of capital inflows to these increasingly open and fast growing transition economies (TEs). But the present stage of transition and institutional advancement of financial systems calls for underpinning their financial stability and reaching a satisfactory level of monetary convergence that would allow for their smooth entry first, to the EU and, at a later stage, to the European Monetary Union (EMU). Price stability along with the corresponding stability of interest rates and exchange rates ought to be reached by the candidates prior to their EU entry so that the institutional integrity of their financial systems will not be jeopardized by the increased exposure to competition from the European financial institutions after the official accession.
In this paper I identify issues pertaining to proper sequencing of monetary policy of the EU candidates that, in the presence of large capital inflows, will facilitate financial stability. I argue that the candidates need to stabilize prices, interest rates and exchange rates in the course of their preparations for the EU accession, in order to develop immunity to possible nominal shocks in the global financial system. By doing so, they will reach a certain level of foundational stability that will qualify them for the EU entry.
There are two critical assumptions underlying my analysis. First, large capital inflows to the leading Candidate Countries for the EU accession, namely Poland, Hungary and the Czech Republic [I omit examination of Slovenia and Estonia as the two remaining frontrunners for the EU accession since, in my opinion, their optimal monetary policies in preparations for the EU accession are different from those suggested for the three larger countries examined in this study. Slovenia and Estonia are better off applying a Euro-peg or adopting Euroization at the earliest possible stage because autonomous monetary policies based on flexible exchange rates could induce large, destabilizing nominal shocks to these very small open economies.], will continue. Thereby, a correct choice for the exchange rate regime is absolutely critical for assuring a favorable risk structure of these inflows, that is, for the advantage of direct and long-term portfolio investments over short-term portfolio inflows. Second, the candidates will be well advised to reach the necessary foundational stability through internal means; that is by pursuing autonomous monetary policies. They can do this by avoiding premature pegging to the Euro and by refraining from embracing a leap to unilateral Euroization. The latter solution would imply borrowing financial stability from the EMU members. It would entail a failure of domestic monetary policies that would otherwise accomplish it.
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The underlying hypothesis is that a proper sequencing of monetary policy by the leading EU candidates starts with autonomous inflation targeting aimed at reaching a foundational price stability. Once the targeted price stability is accomplished, the candidates may consider moving to a Euro-peg followed by a fully-fledged Euroization.
My analysis begins with a brief review of the current state of reforms and monetary stabilization outcomes in Poland, Hungary and the Czech Republic followed by a general examination of their recent experiences with capital inflows. Then, the available monetary policy options along with the debate on the appropriate timing of Euroization are presented. The paper ends with a synthesis of optimal policy solutions.
The Current State of Reform and Monetary Stability
During the first decade of the economic transition, Poland, Hungary and the Czech Republic have achieved remarkable progress in terms of economic growth, deregulation, privatization and macroeconomic stabilization. After a short period of active structural adjustments, declining output and painful effects of corrective inflation [Corrective inflation is attributable to high, or as in the case of Poland, hyper- inflation stemming from one-time price shocks following price liberalization. A wide-spread elimination of price ceilings caused a rapid correction of monetary overhang conditions, which resulted in a strong, short-term inflation (for a comprehensive examination of corrective inflation see Sachs, 1996; as well as the pioneering work of Bruno, 1992 on the early experience of transition).], they have experienced fast-track economic growth.
Table 1 summarizes the general record of economic reforms in these countries along with selected recent indicators of macroeconomic stability.
Table 1: Reform Conditions and Stabilization Outcomes
Source: Fischer and Sahay (2001), Warner (2001) and own calculations based on national statistics.
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As shown in Table 1, the three examined countries have increasingly opened and liberalized their economic systems. The GDP per capita has been the highest in the Czech Republic and the lowest in Poland, although due to the fastest rate of real GDP growth, the Polish per capita GDP has been closing the gap with that of the Czech Republic and the EU relatively fast. Nevertheless, real output per capita in all three TEs is still lagging behind that of the EU, therefore, there is still a lot of room for their output to grow at accelerated rates. The potential for the so-called catching up effects of deep structural adjustments among the Candidate Countries remains vast.
In terms of the macroeconomic policy outcomes, the Czech Republic and Poland have reached a fair degree of price stability. Their anti-inflationary stance continued during the first half of 2001; in June, the year-on-year CPI inflation reached 5.5 per cent in the Czech Republic and 6.2 per cent in Poland. However, the strong commitment to disinflation contributed to these countries' higher unemployment rates (as shown in Table 1). In contrast, Hungary has followed somewhat easier fiscal and monetary policies which has generated considerably lower unemployment, yet a persistently high inflation that stood at 10.5 per cent in June 2001.
These results are closely related to the prevailing macroeconomic policy mix that the examined three countries have applied in recent years
[See Orlowski (2001) for a detailed description of inflation targeting regimes in the Czech Republic and in Poland, along with the empirical examination of their outcomes. Hölscher and Vinhas de Souza (2001) provide a detailed examination of all Central East European currency regimes.].
Poland has focused its monetary policy on the aggressive pursuit of disinflation as well. The National Bank of Poland (NBP) has introduced a system of direct inflation targeting as of January 1999. The NBP has adopted a long-term policy goal of 4.0 per cent CPI
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inflation for the end of 2003 and it has designed a corresponding trajectory of operating CPI inflation targets. Yet, Polish financial authorities have struggled to reach these targets in 1999 and in 2000 as the rate of CPI inflation well exceeded the targeted tolerance bands. The actual inflation at the end of 2000 was 8.5 per cent, e.g. 1.7 per cent above the upper bound of the 5.4-6.8 operating target. One might argue that the path of disinflation assumed by Poland was too ambitious considering the countrys pervasive and highly persistent nominal indexation of prices and wages. The NBP has kept very high interest rates (see Table 1) to contain the growth of credit and domestic demand, so that it could come close to reaching these targets. Nevertheless, the outlook for 2001 looks promising, with the mid-year CPI inflation at 6.3 per cent on a year-on-year basis falling close to the lower band of the 6.0-8.0 target for December 2001. At the same time, the fiscal deficit to GDP ratio is expected to be less than 3.0 per cent, proving a prudent management of the public finance. In consistence with the framework of direct inflation targeting, Polands monetary authorities have applied a floating exchange rate regime (a full float as of April 2000).
Hungary followed exchange rate targeting until May 2001, when the National Bank of Hungary (NBH) decided to widen the band of permitted Forint fluctuations to 15 per cent on either side of parity to the Euro. Under the previous regime of exchange rate targeting, the main operating target of the Hungarian policy was to limit Forint fluctuations against the Euro to a narrow band of plus-minus 2.25 per cent. The system was and still is accompanied by crawling devaluation of the Hungarian currency, presently at a monthly rate of 0.2 per cent. The widening of the exchange rate band has allowed the NBH a higher degree of discretion in altering interest rates in response to price shocks, thus allowing wider exchange rate fluctuations. The Hungarian focus on exchange rate coupled with the aggressive promotion of export through currency devaluation has proven to be more pro-inflationary. After all, the countrys nominal indexation of wages and prices has been enormously sensitive to exchange rate fluctuations (as evidenced by Szapary and Jakab, 1998 and Orlowski, 2000). As a result, the countrys CPI inflation at the end of 2000 was considerably and persistently higher than in the two remaining countries (Table 1). In response to the unresolved problem of stubbornly high inflation and following the experiences of Poland and the Czech Republic with policies aimed at stemming inflation, the NBH has applied a system of direct inflation targeting since June 2001. The new Hungarian monetary regime can therefore be described as flexible (or implicit) inflation targeting, because the NBH has expressed strong commitment to exchange rate stability in addition to adopting ambitious CPI and core inflation targets. The NBH has set a long-term CPI inflation target at 2.0 per cent to be reached by March 2004 and maintained thereafter at least until January 2006 - an anticipated date of accession to the EMU. The intermediate CPI target for December 2001 has been set at 6.0-8.0 per cent and for December 2002 at 3.5-5.5 per cent. Such an ambitious trajectory of disinflation might be extremely difficult to attain since the year-on-year CPI inflation in May was still at 10.8 per cent. Moreover, while announcing the inflation targeting policy, the NBH decided to maintain the crawling devaluation of the Forint against the Euro at a monthly rate of 0.2 per cent, which itself is pro-inflationary.
The choice of monetary policy and exchange rate regimes, in addition to having an impact on capital inflows, has been quite consequential for the current account posi-
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Determinants and the Scale of Capital Inflows
The economic literature on capital inflows to transition and emerging market economies (Folkerts-Landau and Ito, 1995; Ul Haque, Mathieson and Sharma, 1997; Orlowski, 1999) identifies their three underlying principal causes. Two of them are induced internally and one is caused by external factors. Each of the three factors has a different impact on the duration and the intensity of the recipient countrys inflation. As demonstrated by Orlowski (1999), these causes have all played a meaningful role in the large-scale net inflows of foreign capital to Central Europes TEs.
The first internally induced factor that precipitates large capital inflows is an autonomous increase in demand for money that stems mainly from increasing financial deregulation and the institutional development of the countrys financial system. The increasing competitiveness and efficiency of the banking sector and the advancement of efficient financial markets encourage saving and borrowing activities by the private sector and ultimately result in a higher degree of intermediation and monetization. In fact, the ratios of broad money supply to GDP among the analyzed three countries rose from an inferior, by international standards, level of 10-15 per cent in the beginning of the 1990s to the current levels which exceed 40 per cent in all three countries. These levels of monetization mimic those of the incumbent members of the EU. Moreover, the advancing intermediation and bank capitalization have played a crucial role in facilitating the process of economic transition.
The second internal factor encouraging large capital inflows is an increase in domestic productivity of labor and capital. A sustained, long-term productivity growth is likely to precipitate large inflows of foreign direct investment (FDI) as well as long-term portfolio investment. In dynamic terms, capital inflows induced by productivity improvements have a weaker impact on domestic inflation than those encouraged by growing autonomous demand for money. FDI is likely to generate positive supply effects, subsequently lowering inflation tendencies.
The two internal factors described above are often referred to as pull factors. They are frequently augmented by the third factor of declining international interest rates relative to the corresponding domestic rates. In a sharp contrast to domestic determinants, this external, or push factor is likely to contribute to inflows of short-term capital, particularly in the presence of the currency peg that is believed to be unsustainable by the financial community due to inflationary consequences of large capital inflows. If sustainability of the pegged currency regime is questioned, both domestic and international investors (assuming that they are enjoying conditions of full capital account liberalization) are likely to take up short-term investment positions. They stand ready to pull out their funds if the currency is expected to depreciate in the near future. Needless to say, large inflows of short-term capital are likely to precipitate destabilizing inflationary shocks.
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Considering the interplay between the prevailing determinants of capital inflows, Central European TEs should design their monetary policies very carefully. They ought to refrain from excessively high real interest rates (as those currently prevailing in Poland) as such rates would promote large inflows of short-term capital. At the same time, they cannot gear monetary policy towards low or negative real interest rates, as these would hinder productivity improvements. Thus, it is imperative to find an optimal level of interest rates, which would endorse a continuous net flow of foreign capital and, at the same time, would ensure its favorable risk structure.
Taking into consideration the actual scale and the structure of capital inflows, the EU candidate countries ought to be given generally good reviews, although certain worrisome factors are emerging at the present time. Although a detailed examination of balance of payments conditions in these countries goes beyond the limited framework of this analysis, there are some noteworthy general tendencies that ought to be addressed. They can be derived from the general analysis of FDI and portfolio inflows in response to the current account developments shown in Table 2.
Table 2: Current and Capital Account Balances (in EUR millions)
Source: NBP, CNB and NBH data, own calculations for data consistency.
The data demonstrate that these fast-growing TEs are experiencing continuously large current account deficits, which in 2000 amounted to 6.3 per cent of GDP in the case of Poland, 4.9 per cent in the Czech Republic and 3.3 per cent in Hungary. Hungarys current account deficit has been declining, mainly due to the impressive growth of export. The Czech current account position has been visibly deteriorating. The current account deficit has been expanding and it is likely to grow further due to the fast growing domestic aggregate demand, which has been additionally triggered by the accelerating fiscal deficit.
Net FDI inflows have been somewhat decelerating in Hungary in 2000, although the country has attracted their largest cumulative absorption as a share of GDP among Central European TEs over the past ten years (Fischer and Sahay, 2001). FDI inflows to
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the Czech Republic also slowed down in 2000, although they were still quite robust. By comparison, FDI inflows to Poland continued to grow in 2000 to the largest magnitude ever recorded in this country. Net FDI flows compensate fully the current account deficit in the Czech Republic but not in the cases of Poland and Hungary. Therefore, these two countries ought to pay careful attention to attracting long-term portfolio capital investment.
Net portfolio investment assumed unfavorable direction in 2000 in Hungary. Notably, the investment returns in Hungarian equity and bond markets remained mediocre. Moreover, financial investors began to question sustainability of the pegged currency regime, which undeniably contributed to the reversal of their sentiments. The Czech Republic experienced a strong net outflow of portfolio investments, particularly in fixed income securities, as the real interest rates declined, particularly in the second half of 2000. During that period, there was a large net outflow of debt securities to the amount of 1416 million Euros, combined with a considerably smaller net inflow of equity of 202 million Euros.
Poland continues to attract large FDI inflows, but their scale in relation to GDP is much smaller than in the Czech Republic or in Hungary. The country has a large potential for absorption of direct investments, but it needs to lower corporate and personal income taxes to be in line with its southern neighbors in order to exploit this potential. Portfolio inflows continued to grow, primarily into Polish bond markets as the countrys real interest rates remained exorbitantly high in 2000 (see Table 1).
In sum, Central European TEs continue to attract net inflows of foreign capital, although at a lower scale in 2000 than before. Net FDI inflows are still strong, but portfolio investments in the Czech Republic and Hungary show a visible reversal, evidently due to low interest rates. Notably, Poland has recently attracted large net inflows of portfolio investments, primarily to its fixed income securities, as a result of high real interest rates.
In essence, the structure of capital inflows to these small open transition economies depends on at least two key characteristics of their financial system: the degree of capital account liberalization and the monetary policy regime. The latter ultimately determines the level and the degree of stability of interest rates and exchange rates.
Available Choices of Exchange Rate Regimes A Leap to Euroization?
In the course of preparations for the EU accession, the candidates will have to remove the few remaining obstacles to capital transactions. Therefore, I assume that capital account liberalization is an exogenous constraint to their policy decisions. I, therefore, concentrate my analysis on choices of monetary and exchange rate regimes, as they play a critical role in determining the risk structure of capital inflows.
The menu of currency regimes available to the countries opening their economies to capital flows includes flexible exchange rates, implicit target zones and hard pegs (in
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the form of either currency boards or a full-fledged dollarization [Dollarization is a more generic term for adoption, be it consented or unilateral, of a foreign currency as a legal tender. It certainly includes Euroization as a feasible future option for Central European transition economies.]) (Eichengreen, 2001). Recently, flexible exchange rates accompanied by monetary policies based on direct inflation targeting dominate as a policy choice among the leading contenders for the EU accession. It is because other policy options, namely monetary or income targeting, have proven to be either impractical or simply not viable for small open economies (Mishkin 2000; Eichengreen, 2001), particularly the ones in transition (Orlowski, 2001). Fully floating exchange rates diminish the risk of real currency appreciation in the presence of large capital inflows since they allow nominal exchange rate to respond almost instantaneously to inflation differentials. Thus in principle, they help to lower the scale of speculative capital inflows and to increase the maturity of foreign capital investments. Nevertheless, they need to be supported by price stability brought about by a decisive disinflationary stance of monetary policy and by commitment to fiscal discipline in order for a country to attract large-scale capital inflows. They are certainly a viable option for Central European TEs, although they do not underscore commitment to the EU/EMU integration as would be facilitated by a Euro-peg.
For the purpose of reinforcing the EU integration strategy, the Candidate Countries will have to work out policies aimed at converging their currencies to the EMU. At this juncture, they are unlikely to opt for choosing implicit target zones as they have recently departed from such policies. Specifically, the Czech Republic moved to floating in May 1997, Poland abandoned a hard peg in May 1995 and a soft peg in April 2000, and Hungary moved from a hard to a soft peg (expanded the band of permitted currency fluctuations) only in May 2001. The previous regimes of currency bands accompanied by crawling devaluation implied de jure floating, but de facto active interventions aimed at limiting the exchange rate variability as in the case of Poland and Hungary. However, these interventions often signal difficulties with managing or sterilizing large capital inflows to international investors, which has been certainly the case of TEs over the past five years. Such interventions frequently cause perverse effects since they precipitate further inflows of short-term capital making exchange rate regime ultimately indefensible. For the time being, the Central European TEs may be reluctant to return to the regime of implicit target zones. Their resistance may be coming from the necessity to follow a shadow peg to the Euro similar to that implied by the European exchange rate mechanism II (ERM II).
It seems that upon their accession to the EU they will be expected to formally join the ERM II for at least two years before they become eligible to enter the EMU (assuming that the Maastricht criteria for accession to the Euro zone still hold). By the time of ERM II entry the three examined countries are likely to have reached a foundational stability or the degree of monetary convergence approximately comparable with that of the incumbent EU members. This would make their move into the ERM II more easily manageable and, possibly, avoid triggering expectations of significant real currency appreciation (or, less likely, depreciation). Ultimately, price stability is essential for reducing vulnerability of these countries' capital accounts to large externally induced shocks.
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Another option for the candidates would be to fully adopt the Euro as a legal tender. Technically, this may be accomplished either in the two years following the EU accession by gradually pursuing the procedure outlined in the Maastricht Treaty, or at an earlier time through unilateral adoption of the Euro with or without the consent of the European Central Bank. A unilateral adoption of the Euro would entail central bank exchanging a large portion of its foreign exchange reserves for Euros and subsequently introducing the purchased Euro as a legal tender. Bratkowski and Rostkowski (2001) argue that the central banks of the EU candidates have sufficient foreign exchange reserves to expedite such a move and advise them to do so. Euro adoption by consent does not seem politically feasible between now and up to two years following the formal EU accession. A unilateral adoption without consent, while technically possible, it is not politically astute.
The long-term benefits of Euroization are quite apparent. They include lower transactions costs in trade, a better risk structure of capital inflows and an assurance of financial stability that will undeniably help diminish nominal wage indexation. Nevertheless, there are several crucial aspects of Euroization that may undermine rather than underpin stability and institutional integrity of transition economies, at least in the near future. Among them is a loss by the lender of last resort function that will remain critical for these economies as long as the quality of bank assets remains relatively poor. Short-run effects of Euroization will entail a large increase in short-term liabilities of the banking sector (stemming from the introduction of a more stable currency), coupled with a sizeable increase in long-term assets (due to lower interest rates). This may pose an additional challenge to asset/liability management, it may deteriorate domestic banks performance and ultimately lead to bank failures. Thus, asset substitution as one of the key outcomes of Euroization may result in a deep crisis of domestic financial institutions.
Moreover, since Central European TEs are experiencing far-reaching structural adjustments and accelerated growth rates beyond those of the EU members, they need relatively high, rather than low interest rates to promote financial stability and to advance financial intermediation. Adopting the Euro before reaching stability and a decent level of intermediation would precipitate destabilizing effects on domestic economies.
The next meaningful reservation against a premature Euroization stems from the continuous danger of fiscal deficits. The relaxation of fiscal discipline in the Czech Republic in 2000 and 2001 and in Poland in 2001 proves that prudent fiscal policies are yet to be established in the economic culture of the candidates.
Other arguments against Euroization may be less qualified. They include a loss of seigniorage revenues, which are rather marginal - not exceeding one per cent of GDP as in the case of the examined countries. They also include claims that adoption of the Euro may cause a sharp increase in wage demands since the East European wages are considerably lower than those in the EMU. I assume that the much-debated outflow of labour from Central and Eastern to Western Europe will be limited due to the existing vast imperfections in the mobility of labour.
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To reiterate, Euroization may be an appealing policy alternative for the candidates, but only from a long-run perspective. A leap to the Euro may not be prudent prior to establishing the foundational stability by these countries and prior to the strengthening of their financial systems. A proven record of fiscal discipline is also essential in order to avoid disturbances in the common currency system.
The above analysis demonstrates that an autonomous monetary policy based on inflation targeting and accompanied by flexible exchange rates is a prudent policy choice for the countries preparing for the EU/EMU accession. To underpin commitment to price stability, the candidates monetary authorities may start from strict inflation targeting, which means rigorously adhering to predetermined path of disinflation. Unfortunately, such policy requires application of relatively high interest rates and it may induce large output volatility. But reasonably high interest rates are desirable for countries willing to prevent their economies from overheating and to reduce the danger of large current account deficits.
After they establish a fair degree of price stability, the EU candidates may temporarily move to flexible inflation targeting and thus to reducing the rigidity of inflation targets and paying more attention to stability of other macroeconomic variables, such as output or exchange rates. At such time, stability of currency rates in Euro terms may be introduced as a supporting policy target. It will become a viable policy as an intermediate step before the subsequent peg to the Euro and, ultimately, a full Euroization.
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© Friedrich Ebert Stiftung | technical support | net edition fes-library | März 2002