Journal Issue

High capital flows environment: Transition economies preparing for EU accession face challenges in choosing exchange rate regime

International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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In the lead-up to EU membership, an appropriate exchange rate regime can help the Czech Republic, Estonia, Hungary, Poland, and Slovenia balance sometimes competing agendas. With per capita incomes between 16 percent (Estonia) and 43 percent (Slovenia) of EU levels, these countries can expect a sustained period of high growth and real exchange rate appreciation. They must complete the process of transition to market economies, meet accession requirements, and cope with large and potentially volatile capital inflows. The economic transition process in these countries is far advanced but not yet complete. The unfinished transition process increases their vulnerability to adverse domestic and external shocks and constrains fiscal flexibility. At the same time, to meet EU eligibility criteria, they must liberalize their capital accounts, create efficient market-oriented financial sectors, and ensure that their central banks are fully independent.

On current expectations, EU accession is roughly three to five years away for these five countries. The timetable is thus near enough to be a factor in shaping their exchange rate regimes but far enough away to give them latitude in adjusting their regimes to meet transition and macroeconomic policy needs. In the lead-up to accession, candidate countries can choose whichever exchange rate system suits them. Once they become EU members, however, they are obliged to avoid excessive exchange rate fluctuations and competitive devaluations and to embark upon a phased process toward adoption of the euro. The first step will be participation in the new exchange rate mechanism (ERM2). Participants must agree to an entry exchange rate of their currency against the euro and maintain the exchange rate within a band of ±15 percent for at least two years prior to adopting the euro. In principle, ERM2 is compatible with a range of exchange rate regimes, including a narrow-band system or a currency board arrangement. However, the EU would have to agree to departures from the standard ERM2 arrangement.

With competitive labor costs, well-educated labor forces, proximity to western Europe, and the expectation of EU accession, the Czech Republic, Estonia, Hungary, Poland, and Slovenia offer attractive platforms for investment. The sizable capital inflows these countries already enjoy are likely to swell as structural reforms progress and as confidence grows in the countries’ stability and continued free access to the common market. New members will also receive annual net transfers from the European Union amounting in some cases to up to 5 percent of the recipient’s GDP for several decades.

But capital inflows are likely to be highly sensitive to actual or perceived policy slippages and to news regarding the timing of EU entry and the size of future transfers from the EU budget. In the run-up phase, a country may also experience an increase in temporary capital flows, as interest rates are bid down toward euro zone levels and markets speculate about entry central parities. Moreover, the foreign exchange market fortunes of these countries are likely to become more closely intertwined, suggesting a collective as well as an individual interest in each country’s getting its fundamentals in shape to minimize the opportunities for contagious speculative attacks.

Policy options

Against the background of high and variable capital flows, monetary and exchange rate policy decisions in these five countries will be attuned over the next few years to achieving or sustaining inflation at close to EU levels. This goal will be pursued at a time when the countries’ reliance on capital controls will have to diminish, real currency values will likely appreciate, real interest rates may fall, and upward pressure on current account deficits could be substantial. Neither a fixed nor a flexible exchange rate regime is a panacea for policymakers’ problems. And neither regime is a substitute for appropriate supporting fiscal and structural policies.

Under a fixed exchange rate system, capital inflows will, in the absence of sterilization, put downward pressure on interest rates and upward pressure on the money supply, thereby potentially conflicting with inflation goals. Moreover, a peg may discourage hedging, thereby encouraging unbalanced portfolios that would greatly add to the economic costs of an exit from a fixed exchange rate regime. A degree of exchange rate flexibility would raise the exchange risk premium (driving a wedge between the interest rate differential), helping to dampen interest-sensitive capital flows.

But capital inflow problems do not vanish under flexible exchange rate systems. Persistent capital inflows put upward pressure on the exchange rate, potentially weakening competitiveness more rapidly than under a fixed regime and widening external current account deficits. Concerns about external sustainability could increase the vulnerability to wide swings in capital inflows. And considerable exchange rate volatility could damage trade and investment and be inconsistent with low and stable inflation.

Also, what would anchor monetary policy under a flexible exchange rate? In principle, inflation targets can deliver less inflation volatility than a monetary policy centered on a monetary or exchange rate target. In practice, this may not be so because any discretionary policy is open to political pressures, and the technical requirements to forecast inflation and understand policy transmission lags are considerable. And there are added complications for countries that have to dismantle remaining capital controls. Liberalization reduces the scope for using interest rates to achieve domestic monetary policy objectives, and freer capital flows make it easier for investors to take large positions against a currency.

In general, countries would thus do well to avoid too much and too little exchange rate variability. The exception would be where a country has a credible currency board arrangement. In this case, abandoning the currency board would involve discarding considerable institutional and policy investment for uncertain gains of exchange rate flexibility.

Country options

Throughout the course of their transition to market economies, the Czech Republic, Estonia, Hungary, Poland, and Slovenia have differed considerably in the composition of their monetary and exchange rate policies. Different approaches can be rationalized partly by the different economic structures and policy preferences of the five countries. For example, greater exchange rate flexibility in the Czech Republic, Poland, and Slovenia is consistent with these countries’ somewhat greater economic restructuring needs and the relative rigidities in their labor markets. By contrast, the more fixed regimes in Estonia and Hungary are consistent with more flexible labor markets and the relatively advanced state of industrial restructuring. Nonetheless, all five countries have, since transition began, been successful in reducing inflation to 10 percent or less—testimony to the importance of consistent policies rather than the choice of an exchange rate system per se. For the period ahead, the following appear to be key issues for the five countries:

The Czech Republic, which moved to a more flexible exchange rate arrangement in 1997, now uses an inflation-targeting framework to achieve price stability. In view of the expected size and volatility of capital inflows, the uncertain impact of completing transition reforms, potential shocks from domestic sources (including fallout from banking sector difficulties), and likely real exchange rate appreciation, a return to a relatively fixed exchange rate regime appears risky. In addition, the burden on government expenditures from EU-required reforms and the large, unreformed, state-owned enterprise sector suggests that neither fiscal nor wage policy may be sufficiently flexible to support a rigid exchange regime.

Estonia’s currency board arrangement has weathered domestic and external crises. In addition, its banking system has been consolidated, labor markets are quite flexible, and a very low level of public sector debt provides room for fiscal policy flexibility. All in all, the currency board is highly credible and, if it continues to be supported by consistent policies, seems an appropriate arrangement to maintain all the way to adoption of the euro. Indeed, exit from the currency board arrangement could adversely affect stability and policy certainty; instead, early adoption of the euro may be warranted, given the currency board’s long-established record.

Hungary’s crawling peg to the euro and its narrow band regime, together with fairly firm control over short-term capital flows, have so far provided a credible anchor for reducing inflation. The authorities are, however, contemplating widening the bands once they have reduced inflation to 4–5 percent by further slowing the rate of crawl. In due course, a move to a wider band appears appropriate, particularly to help insulate the economy from the monetary effects of large capital inflows. While some increase in the risk premium resulting from more exchange rate volatility would raise debt-service costs, it would help to discourage interest-sensitive flows and could provide more scope to meet inflation objectives. A wider band would also facilitate the phasing out of remaining capital controls.

Poland has made judicious use of a crawling peg and, following successive band widenings, the zloty was floated in April, consistent with the authorities’ reliance on an inflation-targeting framework. As in the Czech Republic and Hungary, flexibility should prove a key element in responding to strong capital inflows. Nonetheless, there are constraints on the authorities’ use of exchange rate flexibility. Further increases in Poland’s current account deficit (7½percent of GDP in 1999) could engender an adverse shift in market sentiment. The key challenge is to support the flexible exchange rate regime with an appropriately ambitious fiscal stance. This would help strengthen performance on inflation and the current account balance and relieve the constraint on inflation targeting.

Slovenia pursues a pragmatic approach to monetary targeting, supported by intervention to limit short-term exchange rate variability. However, a recent relaxation of capital controls and the authorities’ intention to fully liberalize capital flows by 2002 are likely to make it harder for the Bank of Slovenia to balance its objectives of lowering inflation and exerting some control over exchange rate movements. With more volatile capital flows and the expectation that non-debt-creating inflows will increase in the run-up to accession, the authorities will likely have to accept greater exchange rate flexibility. While the balance between money and exchange rate variability will need to be kept under review, commitment to a relatively flexible exchange rate regime and the absence of formal exchange rate bands offer few hostages to speculators.

While differences among these countries are likely to diminish as they adopt more EU-like institutional structures, bolster already strong economic ties with the European Union, and address remaining transition issues, in the near term there is no necessity to adopt a common strategy for monetary and exchange rate policy. In an environment of high and variable capital inflows, narrow bands or overly managed exchange rates (with the exception of credible currency boards) are unlikely to provide sufficient flexibility to reconcile domestic and external policy objectives, and they may offer tempting targets for speculators. On the other hand, benign neglect of the exchange rate also carries risks. Some formal or informal commitment to avoid excessively large exchange rate swings seems desirable to support credible inflation-reduction policies and avoid uncompetitive exchange rates.

Finally, countries wishing to enter ERM2 at an early stage should not leave the required removal of capital controls to the last minute. This would exacerbate exchange rate volatility and compound the difficulties of managing monetary policy at a time when the focus will be on macroeconomic convergence.

Copies of IMF Policy Discussion Paper 00/3, Exchange Rate Regimes in Selected Advanced Transition Economies—Coping with Transition, Capital Flows, and EU Accession, by Robert Corker, Craig Beaumont, Rachel van Elkan, and Dora Iakova, are available for $10.00 each from IMF Publication Services. See page 187 for ordering details.

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