II Trade and Financial Effects of EMU on Selected Transition and Mediterranean Countries
Author:
Mr. Dominique Desruelle
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Mr. Robert A Feldman
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Mr. Klaus-Stefan Enders
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Mr. Karim A. Nashashibi
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Mr. Peter Allum
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Heliodoro Temprano-Arroyo https://isni.org/isni/0000000404811396 International Monetary Fund

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Mr. Roger Nord
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Mr. Robert Brandon Kahn https://isni.org/isni/0000000404811396 International Monetary Fund

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Language:
English
Print Publication Date:
11 Feb 1999
Keywords:
OP; MENA country; euro; CEE country; euro area; U.S. dollar; deutsche mark; EU country; institutional investor; Currencies; Exports; Western Europe
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Abstract

Robert A. Feldman and Heliodoro Temprano-Arroyo

Robert A. Feldman and Heliodoro Temprano-Arroyo

Focusing on trade and financial linkages, this chapter analyzes several aspects of how the European Economic and Monetary Union (EMU) might affect the transition countries of Central and Eastern Europe (CEE) and a group of selected Mediterranean countries.1 The first part of the chapter attempts to gauge the extent to which EMU—through its impact on the economies of participating countries—might affect trade flows and thereby economic activity in the countries under analysis. The second part looks into financial linkages. The linkages considered largely operate through changes in capital flows that might accompany EMU and reflect several important channels of influence such as changes in interest rates in the euro area, portfolio diversification effects, and the possible diversion of foreign direct investment (FDI) flows. We also examine how possible changes in euro-area interest and exchange rates might affect the external debt services of the countries under study, and the potential effect of EMU-related developments on the structure and functioning of their financial systems. The final section provides a summary and the main conclusions of the study.

Linkages Through External Trade

External trade linkages are potentially an important channel through which EMU will affect the CEE countries and selected Mediterranean countries. This section considers first the CEE countries, beginning with a concise description of recent trade developments between this group of countries and the EU. The fact that the exports of the CEE countries have become highly dependent on the EU market suggests that EMU could have a significant effect on them: this section examines with greater specificity some of the relevant factors that could come into play, A similar, but briefer, analysis is undertaken for the selected Mediterranean countries.

Importance of the EU Countries for CEE Country Trade: Recent Developments

Since the beginning of the transition process, CEE exports to and imports from the EU have grown very rapidly, leading to a major reorientation of CEE countries’ foreign trade toward the EU (Tables2.1 and 2.2). By the mid-1990s. CEE countries were directing on average 56 percent of their merchandise exports to the EU market and acquiring a similar proportion of their merchandise imports from the EU (Figure 2.1). As discussed below, while this reorientation of trade toward the EU has been accompanied by some restructuring in the commodity composition of exports, the manufacturing sector continues to be a mainstay of CEE exports and it has been an important contributor to recent export growth.

Figure 2.1.
Figure 2.1.

EU’s Share of CEE Countries’ Trade1

Source: IMF. Direction of Trade Statistics database1 Based on EU-15.
Table 2.1.

Growth of CEE Countries’ Trade with the European Union 1

(Annual percentage change)

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Source; IMF, Direction of Trade Statistics database.

Refers to EU 15. Calculated from data valued In U.S. dollar

Table 2.2.

Reorientation of CEE Countries’Trade Toward the European Union1

(In percent of each CEE country’ total exports/imports)

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Source: IMF, Direction of Trade Statistics database.

Based on EU 15.

Several factors contributed to the dynamics of expanding CEE-EU trade. First was trade liberalization, through the extension by the EU of the Generalized System of Preferences, and the signing of new trade agreements.2 A second element was the tendency for trade to gravitate toward western Europe once markets became freer. Based on gravity models, several studies predicted a substantial increase in trade with the EU. implying a rapid and substantial reorientation of exports toward western Europe from Council of Mutual Economic Assistance (CMEA) structures based on bureaucratic commands.3 Third, there is some econometric evidence to suggest that increased exports to the EU reflected in part a redirection of goods from the CMEA to other markets through significant cuts in price, or so-called distress exports.4 Finally, the successes achieved in the area of macro-economic stabilization and the supply effects of structural reforms in the various transition economies also contributed to growing trade.

Drawing on various studies on the commodity composition of CEE exports reveals that manufacturing exports dominated CEE exports to the EU in the early 1990s. Sheets and Boata (1996), using data up to 1994, also found that over 80 percent of the net increase in exports to the EU of Czechoslovakia, Hungary, and Poland were in the three one-digit industries principally engaged in manufacturing (manufactured goods, miscellaneous manufactures, and machinery and transport equipment).5 More recent empirical work by the European Bank for Reconstruction and Development (EBRD) (1997) supported the conclusion that manufacturing has been a particularly dynamic segment of CEE exports to the EU. An earlier study by Halpern (1995) reported that the structure of CEE exports to the EU was similar to that of Greece and Portugal.6 Another earlier study, by Graziani (1994), also used data through 1991 and indicated that the relative specialization of several CEE countries (Bulgaria, Czechoslovakia, Hungary, Poland, and Romania) had expressed itself in those sectors where competition with the newly industrialized countries was comparatively strong and competitive phenomena appeared among CEE countries themselves. In all, the concentration of trade in manufactures and the presence of other competitors would suggest that the exports of individual CEE countries could be rather sensitive to relative prices and, therefore, to movements in their real effective exchange rates.7

Trade Effects of EMU on the CEE Countries

To undertake an analysis of the potential effects of different euro-area growth and exchange rate scenarios on the exports of the CEE countries to the euro area, it would have been helpful if econometric estimates, such as those produced by standard trade equations, were generally available. Such estimates would have given, for each of the CEE countries, an idea of the elasticity of exports to the euro area with respect to both euro-area real GDP growth and the real effective exchange rate of the individual CEE country. Unfortunately, it is difficult to isolate such effects, especially given the relatively short time series available since the transition began and the structural changes that have occurred and will continue to occur, which tend to render estimates unstable and uncertain. Nevertheless, the importance of the euro-area market to exports from the CEE countries and the composition of those exports suggest changes in euro-area real GDP growth and EMU-induced changes in the real effective exchange rates would influence CEE trade significantly.

Activity Effects

By relying on data concerning euro-area imports, we attempted to gauge the order of magnitude of the effects of potential variations in real growth in the euro area on CEE exports to that market (Table 2.3).8 First, the impact of higher euro-area growth on euro-area imports was estimated by applying the income elasticities of imports, obtained from the IMF’s multi-region macroeconometric model (MULTIMOD). Second, the effect of higher euro-area import demand on CEE countries’ exports was estimated assuming that the market shares of each of the CEE countries in each of the EU countries remain at their 1996 levels.

Table 2.3.

Estimated Effects of Changes in EU-11 Real GDP on Exports from CEE Countries

(in million of U.S. dollars, unless otherwise indicated)

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Sources: IMF; Direction of Trade Statistics, database: IMF, World Economic Outlook database (for GDP only);and IMF staff calculations.

These calculations are, however, very rough. One important reason is that EMU, by eliminating currency risk and currency-related transaction costs, will reduce the cost of intra-euro-area trade. This process, which is equivalent to a reduction in tariffs between euro-area countries, will tend to increase the competitiveness of euro-area producers relative to non-EU suppliers and will, therefore, tend to divert trade away from the latter. Thus, any increase in the euro area’s demand for imports stemming from higher real growth may fall more heavily on intra-euro-area trade and thereby reduce the share of imports from nonmembers.9 In this sense, the calculations contained in Table 2.3 should be considered upper bounds.10

As shown in the table, the effects of a 1 percent increase in real GDP in each of the EU-11 countries results in an increase in exports from the CEE countries that ranges from 0.7 percent to 1.6 percent of their total exports in 1996. Such increases in exports represent 0.2 percent to 0.5 percent of the 1996 GDP of the individual CEE countries, effects of a meaningful magnitude. Thus, should it turn out that EMU has a positive (or negative) effect on real growth in the EU countries, CEE countries could benefit (be harmed) in significant ways. The results of a survey of IMF country desk staff generally corroborated these conclusions: a 1 percent increase in real GDP in each of the EU-11 countries was estimated to increase exports by 0,5 percent to 1.1 percent, except in Albania, Poland, and Slovenia, where exports were estimated to rise by more than 2 percent. The range of estimated effects on real GDP growth tended to be somewhat higher than the corresponding figures in Table 2.3, reflecting the impact of multiplier effects

Effects Through Changes in Real Effective Exchange Rates

It is more difficult to gauge the potential effects of EMU-induced exchange rate changes than to estimate the effects of changes in economic growth in the euro area. However, even though empirical estimates of the effects of (exogenously treated) changes in real effective exchange rates on trade are generally unavailable, on a priori grounds there is reason to believe that CEE exports should be sensitive to these changes. As mentioned earlier, the structure of CEE exports is one important factor. Some econometric evidence is also consistent with this conclusion.11

The implications for the effective exchange rates of CEE currencies of a given change in the exchange rate of the euro against other major currencies will depend on the interplay between the exchange rate regimes of the CEE countries and the geographical composition of their trade. Table 2.4 summarizes the exchange rate regimes of the CEE countries. Several of them (e.g., Bulgaria, Croatia, the former Yugoslav Republic of Macedonia, and Slovenia) currently peg or maintain their currencies within narrow bounds against the deutsche mark and can be assumed to replace it as a reference currency with the euro, upon the launching of EMU. In the event of, for example, an appreciation of the euro, the currencies of these countries would appreciate in effective terms and these countries would thereby lose competitiveness, the more so the lower the share of the euro area in their trade. A survey of IMF economist staff suggests that, for these countries, a 10 percent appreciation of the euro could result in a current account deterioration of 1–3 percent of GDP and could lower cumulative real GDP growth by roughly the same amount over a four-year period. Countries that peg to a basket would experience comparatively minor effects as a result of an appreciation of the euro to the extent that the basket peg closely approximates the geographical pattern of their trade (e.g., Hungary and the Slovak Republic). For a third group (notably Poland), the imbalance between the basket peg and the direction of trade could result in more significant effects: an effective depreciation of the currency if the euro appreciates, which would tend to have a positive effect on real GDP growth and contribute to narrowing the current account deficit.

Table 2.4.

Exchange Rate Regimes, July 31,1998

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Sources: IMF, Annual Report on Exchange Arrangements and Restrictions 1997; and IMF staff reports. Note: DM = deutsche mark; ECU = European currency unit; F = French franc; C = pound sterling; SWF = Swiss franc: USJ = US, dollar; ¥ = Japanese yen.

The National Bank of Slovakia decided on October 1, 1998, to float the koruna.

In June 1997, the authorities approved a widening of the band from 14 (±7) percent to 28 percent but only by adjusting downward the depreciation limit At the same time the slope (the rate of crawl) of the appreciation limit was decreased to 4 percent a year from 6 percent while the slope of the depreciation limit was maintained at 6 percent, implying a widening of the band by an additional 2 percentage points over the following year

Mediterranean Countries

Our estimates of the potential effects of EMU on selected Mediterranean countries through changes in economic activity in the euro area are set out in Table 2.5. It shows that the effects on Malta are potentially very large: a 1 percent increase in real GDP in the EU-11 is estimated to raise total exports from Malta by almost 3 percent; this increase in exports represents about 1 1/2 percent of GDP. Higher growth in the EU would raise exports in Turkey by 0.8 percent according to the estimates, but this increase represents only 0.1 percent of GDP since exports are a relatively small proportion of economic activity. For both Cyprus and Israel, the effect on exports is much smaller (a 0.4 percent increase for Cyprus and a 0.5 percent increase for Israel), representing a minor portion of economic activity in each country (0.1 percent).12

Table 2.5.

Estimated Effects of Changes in EU-11 Real GDP on Exports from Selected Mediterranean Countries

(in millions of U.S. dollars, unless otherwise indicated)

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Sources: IMF, Direction of Trade Statistic: database: IMF. World Economic Outlook database (for GDP only): and IMF staff calculations.

In terms of exchange rate changes, a survey of IMF economist staff indicated that an appreciation of the euro might be expected to have relatively little impact on Malta since it pegs its currency to a basket closely approximating its direction of trade. Such an appreciation could result in some effective depreciation of the Israeli shekel and the Turkish lira, which would be expected to increase exports and real growth in Israel and Turkey. By comparison, Cyprus, which pegs to the ECU, would be likely to experience some effective exchange rate appreciation and a consequent reduction in exports and real GDP growth.

Financial Linkages

EMU may also affect the CEE countries and the selected Mediterranean countries through a number of financial channels. The most obvious of these financial linkages operate through capital flows between the euro area and the non-EU countries under analysis; they can be divided into two main categories. The first is changes in capital flows other than FDI, resulting from EMU-induced changes in interest rates in the euro area, portfolio diversification effects, and the increased attractiveness of lending and borrowing in the financial markets of the euro area as EMU increases their depth and liquidity. The second category is changes in FDI flows, resulting from EMU-induced changes in economic growth, in the marginal productivity of capital, and in transaction costs within the euro area. Other financial repercussions of EMU include its possible impact on the external debt service of the countries under analysis and the potential impact on the structure of their financial systems.

This section introduces the analysis by focusing on the various ways in which EMU may encourage movements in non-FDI capital flows. Since the extent to which these flows will be affected by EMU will depend on the degree of international financial integration of the countries concerned, this section examines a number of relevant indicators and, when available, econometric tests. It then discusses the possible impact of EMU, in combination with the full implementation of the EU directives in the area of financial services, on the structure of the financial sectors of the countries under study. Finally, the effects through FDI flows and debt service are discussed.

Effect on Capital Flows Other than Foreign Direct Investment

As highlighted above, there are several channels through which EMU may have an effect on capital flows to the CEE and selected Mediterranean countries. Some of these may result in increased capital inflows to them, while others would tend to attract capital into the euro area. All told, it is difficult to know how these various effects may balance out in the end or how investors’ appetite for risk vis-à-vis emerging market assets might change over time. Thus, the focus of the discussion that follows is on understanding the various considerations that may come into play rather than on their relative quantitative importance.

Changes in the Level of Interest Rate in the Euro Area

The level of interest rates in the euro area following the realization of EMU is perhaps the most evident financial variable through which EMU will affect outside countries. In conjunction with possible changes in expectations about the exchange rate of the euro against other world currencies, any changes in interest rates in the euro area will affect interest-sensitive capital flows between the EMU participants and the CEE countries and selected Mediterranean countries.

There is, however, considerable uncertainty among analysts about how EMU may actually affect interest rates in the participating countries. Moreover, the discussion on the interest rate implications of EMU is often couched in a wider policy context that takes into account not only the new regime for monetary and exchange rate policies, but also changes in fiscal and structural policies that are only partly related to EMU itself. Thus, while it is often argued that a successful EMU could bring about a decline in interest rates in the euro area, this favorable scenario normally assumes that EMU also serves as a catalyst for accelerating fiscal consolidation and structural reforms (particularly in the labor market). Downward pressure on interest rates results from lower budget deficits and public debts, as well as from the favorable supply-side effects of structural reforms. Furthermore, these factors could allow the European Central Bank (ECB) to pursue a less restrictive monetary policy without compromising its credibility, possibly reducing the anti-inflation bias that some expect the ECB to have in the early years of EMU.

Of course, EMU need not be accompanied by these virtuous fiscal and structural policies, even though fiscal policies will be constrained by the EU’s Excessive Deficit Procedure and the Stability and Growth Pact. In this regard, the different interest rate implications of two scenarios for EMU and their accompanying fiscal and structural policies were presented in the October 1997 World Economic Outlook. These scenarios are reproduced in Table 2.6.13 Under a first, “successful EMU scenario,” long-term interest rates gradually fall to about half a percentage point below the baseline level by 2003. Under a second, “reform fatigue scenario,” by contrast, interest rates end up about half a percentage point above the baseline level.14

Table 2.6.

Effects in Euro Area of EMU Scenarios Under Different Assumptions Regarding Fiscal and Structural Policies

(Deviations from baseline, in percent, unless otherwise indicated)1

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Source: IMF World Economic Outlook (October 1997).

Baseline in the World Economic Outlook of October 1997. Adherence Co the Stability and Growth Pact is assumed in both scenarios. It is also assumed that all current EU member countries participate in EMU from the start.

While the actual behavior of euro-area interest rates will therefore depend significantly on the accompanying fiscal and structural policies, other factors—not necessarily EMU-related—could also come into play. Some of these could tend to make interest rates higher in the first years of EMU. First, interest rates in the euro area are currently at historically low levels. Should the ongoing cyclical recovery of the economies of prospective EMU countries gather momentum, the ECB may have to raise interest rates in the early years of EMU to keep inflationary pressures at bay.15 Second, the ECB could initially show a deflationary bias in order to establish credibility. Third, the introduction of a single currency is expected to reduce transaction costs, enhance total factor productivity, and boost investment demand within the EU.16 This is particularly likely under the favorable scenario, where structural reforms will contribute to productivity improvements, and investors’ “animal spirits” could be positively affected by a climate of growth and optimism. To the extent that EMU promotes investment demand, upward pressure on real interest rates should ensue.

Whatever the effect of EMU on interest rates in the euro area, the impact on outside countries through the capital flow channel will depend on the extent of their international financial integration (discussed below) and on their monetary and exchange rate regimes. In countries that peg their currencies to the euro, or attempt to maintain relatively stable exchange rates against it, domestic interest rates and domestic demand are likely to respond more to changes in euro-area interest rates than they will in countries that maintain relatively flexible exchange rates, where most of the adjustment is likely to take place via changes in the exchange rate.

Table 2.7 illustrates this point by highlighting the results of a survey of IMF country desk economists concerning the possible impact of a change in interest rates in the euro area on growth, the current account, and debt service in the countries under study. The analysis, expressed in terms of estimated deviations from baseline, is based on examining the effect of a 2 percentage point increase (relative to baseline) in short-term interest rates in the euro area in 1999–2000 and a 1 percentage point increase (relative to baseline) in 2001; long-term interest rates partially reflect this increase. In order to concentrate on the impact of interest rate changes, it is assumed that the euro/dollar exchange rate and economic growth within the euro area remain constant, but the analysis takes into account the particular exchange rate regimes that the different CEE countries and selected Mediterranean countries are likely to have in place when EMU is launched.

Table 2.7.

Estimated Effects of an Increase in Euro-Area Interest Rates on CEE Countries and Selected Mediterranean Countries1

(Deviations from baseline)

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Source: IMF staff estimates.

Simple averages of estimated effects on Albania, Bulgaria. Croatia. Cyprus, the Czech Republic. Hungary, Israel, former Yugoslav Republic of Macedonia. Malta. Poland, Romania, the Slovak Republic, Slovenia, and Turkey. The estimates assume no change in the Euro/dollar exchange rate and no change in the rate of economic growth within the euro area.

Debt service as a percentage of exports of goods and nonfactor services.

The survey suggests that an increase of interest rates in the euro area would, on average, result in some decline in GDP growth, some improvement in the current account, and some deterioration in the debt-service ratio. These results in turn reflect various underlying factors. First, on average, the countries under review experience an increase in their interest rates in response to the increase in euro-area interest rates. Second, on average, the negative impact of higher interest rates on growth (via lower domestic demand) outweighs any possible impact on growth through the depreciation of the domestic currency against the euro (and higher net exports) in countries that have floating exchange rates or adjust their pegs downward. And third, on average, the negative impact on debt service resulting from higher interest payments on euro-denominated foreign debt more than offsets the favorable impact on debt service stemming from an improved current account and foreign debt position.

Portfolio Diversification Effects

Whatever its impact on the average level of interest rates in the euro area, EMU should result in a reduction in interest rate differentials between local-currency-denominated debt issued by participating southern countries and comparable debt issued by core EMU countries. By eliminating exchange rate risk, EMU should make the spreads on local-currency government bonds move in line with those observed on foreign-currency public debt, so that they will reflect only differences in perceived credit risk and, to a lesser extent, differences in liquidity, settlement, and legal risks. In fact, this effect has essentially already taken place over the past two years in Italy, Portugal, and Spain, as these countries have made progress in the areas of Fiscal consolidation and inflation reduction, and as the perceived probability of EMU taking place and including these countries has increased (see Figure 2.2). Long-term yield spreads between domestic-currency-denominated debt issued by these three southern countries and comparable German treasury bonds are now similar to those observed between their foreign-currency-denominated debt and the foreign-currency-denominated debt issued by core EMU countries.

Figure 2.2.
Figure 2.2.

Long-Term Interest Rate Differentials vis-á-vis Germany1

(in percentage points)

Source; IMF staff.1 Differentials between government bonds of 10-year or nearest maturity. For Greece, differential between 12-month treasury bills.

Table 2.8 shows the spreads over comparable U.S. Treasury issues paid by different EU sovereigns on their dollar-denominated debt in recent years. Spain and Italy paid, depending on the maturities, only between 5 and 15 basis points more than the EU country with the lowest spread. This provides a reference for the spreads that are likely to prevail on domestic-currency debt under EMU. The spreads between sovereign issues could, in fact, all but disappear if a country’s participation in EMU increased the perception that it will be bailed out by other member countries, the EU budget, or the ECB in the event of a budgetary crisis. However, the “no bail-out” clause contained in Article 104b of the Maastricht Treaty, the prohibition of ECB financing of EMU governments, and the experience of federal states such as Canada or the United States (where the cost of provincial or state debt bears a close relation to the assigned credit ratings) make this rather unlikely. Thus, some interest rate spreads will probably remain.

Table 2.8.

Spreads on Long-Term U.S. Dollar-Denominated International Bonds1

(In basis points)

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Sources; Paribas Capital Markets, London; and Bloomberg Financial Markets LR

Spreads between bonds of 10-year or nearest maturity issued by EU sovereigns and comparable bonds issued by the U.S. Treasury.

Difference between the average spread shown by the country in question in the three months of observation and the average spread shown by the EU country with the lowest spread among those for which data were available.

Average of September 1996 and June 1997.

The convergence of long-term interest rates in southern EMU countries toward those prevailing in core EMU members could stimulate portfolio capital flows from the EMU area (as well as from other industrial countries) into the CEE countries and Mediterranean countries under consideration, as investors try to maintain the desired diversification of their portfolios between assets with different yield/risk combinations. In this respect, it should be noted that portfolio diversification by institutional investors in industrial countries seems to have been an important driving force behind the surge in private capital flows to developing countries seen in the 1990s. With spreads for potential southern EMU participants having narrowed to unprecedented levels, this effect may have already begun to operate ahead of the launching of Stage III of EMU.

Some of the countries under analysis are particularly well suited to replace the southern EU countries in the portfolios of international investors. This would appear to be the case for the Czech Republic, Hungary, Poland, and Slovenia, all of which offer assets with a higher-yield/higher-but-mode rate-risk combination that broadly resembles those offered until recently by southern EU countries. These are all European countries, have or are expected to have annual inflation rates in the 5–15 percent range by the time EMU is launched, have made substantial progress in the area of macroeconomic stabilization and structural reform, have been granted investment-grade credit ratings by the major international rating agencies (discussed in more detail below), have relatively developed stock exchanges, are liberalizing their capital accounts, and enjoy a rather stable political situation and close links with the EU (including the prospect of early accession to the EU).17 In addition, the Czech Republic, Hungary, and Poland have recently become members of the Organization for Economic Cooperation and Development (OECD), an important factor since many institutional investors are by law or by their own statutes limited to investing in OECD countries. Thus, these CEE countries seem the most natural substitutes for the southern EMU countries in the portfolios of institutional investors.

OECD membership could also facilitate a portfolio shift toward Turkey, although higher inflation, weaker links with the EU, and higher macroeconomic and political risk make this country a less obvious substitute.18 Israel is neither a European nor an OECD country and may be seen to exhibit higher political risk than the above-mentioned CEE countries. But having an inflation rate in the 5–15 percent range, an open capital account, relatively developed capital markets, and an investment-grade credit rating, it could also benefit significantly from portfolio shifts.

This “search for higher yields” effect is likely to be reinforced by other EMU-induced portfolio shifts. For example, EMU could lead to a higher degree of synchronization of macroeconomic performance and financial asset price movements between the different EMU countries.19 This would encourage investors to find new opportunities for portfolio diversification outside the euro area, including in the countries under analysis. In addition, EMU (in combination with other factors such as the development within EU countries of parallel, privately managed pension pillars) is expected to lead to an acceleration in the process of securitization that is already being observed in the financial systems of EU countries.20 This will expand the size of the portfolios of institutional investors located in the euro area, and these investors are likely to place part of this increase in their available funds in assets of neighboring non-EU countries. Also, as some CEE countries and Mediterranean countries join the EU and start to approach participation in EMU, the markets may further increase their holdings of bonds denominated in those countries’ currencies under so-called convergence plays, where traders bet that the gap in bond yields between peripheral countries and EMU countries will shrink rapidly. Finally, EMU will ease the constraints imposed by currency-matching requirements on foreign-currency-denominated investments by insurance companies, pension funds, and mutual funds located in the euro area. These rules aim at limiting the foreign exchange risk associated with having obligations to policyholders or shareholders denominated in local currency while some investments are denominated in foreign currency. With EMU, foreign currency investments made by affected institutions in other EMU currencies will automatically be reclassified as domestic-currency investments, thus increasing the margin available to those institutions for investing in non-euro currencies. Some national (or statutory) regulations define currency-matching requirements in terms of the nationality of the issuer, in which case the requirement would continue to be binding despite EMU.21 Whatever their exact definition, however, matching requirements within the EU are expected to be eased in the context of either the future Pension Funds Directive or a stricter interpretation of the directive of 1998 liberalizing capital movements.22 The OECD is also bringing into the discipline of the Capital Movements Code certain restrictions on portfolio investment abroad by pension funds and insurance companies, which would have the effect of easing constraints on diversification.23

In sum, EMU is likely to trigger or intensify a number of portfolio effects that, in combination, should contribute significantly to increasing portfolio flows from the EU and other industrial countries into the countries under analysis. Among these countries, those that stand to benefit most from these portfolio shifts are those with relatively open capital accounts and developed domestic securities markets, with a higher degree of macroeconomic and political stability, with relatively low inflation rates (although not as low as in the euro area), with close links with the EU, and that are members of the OECD.

Increased Investment and Borrowing in Euros by Non-EU Countries

It is often argued that, by creating more highly integrated, larger, and more liquid securities markets in the euro area, EMU will attract international investment flows to that area.24 Those non-EU countries that have made more progress in liberalizing capital outflows (particularly portfolio flows) and developing an institutional investor base could therefore experience an increase in outflows to the euro area as a result of EMU, although this effect is likely to be moderate. The enhanced depth and liquidity of EMU bond and equity markets will also tend to increase their relative attractiveness for investors located in the countries participating in EMU and other industrial countries. This could divert certain investment flows away from non-EU emerging economies and into the euro area, thus partially offsetting the portfolio effects referred to in the previous section.

EMU is also likely to increase borrowing in euros by non-EU countries (for a given interest rate differential vis-à-vis the euro area), since non-EU borrowers would have access to the larger, more liquid, and more competitive financial markets that EMU will generate. First, EMU is expected to increase substantially competition in the markets for the underwriting of bond issues and syndicated bank loans.25 This will tend to reduce the cost of issuing in the European bond markets and of obtaining syndicated loans. A second reason, noted by McCauley and White (1997), is that, to the extent that the government bond market in the euro area becomes more liquid, the costs to underwriters of hedging a new issue through taking a short position in government bonds in the cash or futures market would decline, and this saving would also be expected to be passed through to the borrower. Third, EMU is expected to increase the efficiency of the euro-area payment system and improve its linkages with those of surrounding non-EU countries (discussed below). Combined with ongoing deregulation and technological progress in the financial systems of both EMU and non-EU countries, and capital account liberalization in the latter, these factors should also stimulate borrowing by non-EU countries in the euro area. Finally, EMU is likely to make EU equity markets more efficient by accelerating the process of competition, integration, and technological innovation that has characterized them in recent years. Equity issues by non-EU countries in the EU stock exchanges may therefore increase to take advantage of the latter’s higher efficiency and wider investor base.

This expansion of euro-denominated borrowing would tend to increase the still relatively low share of the currencies of prospective EMU participants in the total foreign debt of non-EU countries, which would have implications for the sensitivity of their debt-service payments to changes in euro interest and exchange rates (discussed below). Moreover, when combined with the stimulating effect of KMU on portfolio flows from non-EU countries into the euro area and with the various other portfolio effects discussed earlier, higher euro borrowing by non-EU countries should result in an increased degree of financial integration between the two areas.

Measuring the International Financial Integration of the Countries Under Study

The actual response of capital flows to EMU-induced changes in interest rates and to the other factors discussed above will depend not just on the extent of financial interaction between EMU participants and non-EU countries, but also, more generally, on the overall degree of international financial integration of the latter group. For example, a decline in yield spreads in the southern EU countries as a result of their participation in EMU could induce a portfolio reallocation toward certain non-EU countries by institutional investors located in, say, New York or Hong Kong SAR, in addition to those located in the EMU countries. The extent to which changes in interest rates in the euro area influence capital flows to the non-EU countries will also depend on the ability of investors located in third countries to shift funds easily between the euro area and the non-EU countries.

This section and the accompanying Table 2.9, through Table 2.6, and Figure 2.3 and 2.4) examine a number of indicators of the degree of financial openness of the countries under review.26 The bottom line of the analysis is that, while international financial integration seems to be increasing in most of the countries examined, and at a relatively fast pace in some of them, the degree of integration already achieved differs considerably across countries. Financial openness seems highest in the Czech Republic, Hungary, Israel, and Poland. Thus, these four countries could be significantly more affected than the others by EMU-related financial shocks, even if it is difficult to estimate the magnitude of the corresponding effects. Croatia, Cyprus, Malta, the Slovak Republic. Slovenia, and Turkey show an intermediate, though significant and growing, degree of integration. At the lower end of the financial integration spectrum—though with differentiation within the group—are Albania, Bosnia-Herzegovina, Bulgaria, the former Yugoslav Republic of Macedonia. Romania, and the Federal Republic of Yugoslavia. These countries continue to impose restrictions on most of their capital transactions and have weak credit ratings and limited or no access to the international capital markets; they are the least likely to be affected by financial developments in the euro area.

Figure 2.3.
Figure 2.3.

Stock Market Indices in Selected CEE Countries1

(January 1995 = 1OO)

Source: International Finance Corporation (IFC), Emerging Markets Database.1 IFC weekly global indices.
Figure 2.4.
Figure 2.4.

Stock Market Indices in Selected Mediterranean Countries1

(January 1995 = 100)

Sources: International Finance Corporation (IFC), Emerging Markets Database: and Bloomberg Financial Markets LP.1 IFC weekly global indices. For Israel, local market index (monthly data).
Table 2.9.

Selected Capital Controls in CEE Countries and Mediterranean Countries

(Position as of March 31,1997)

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Table 2.9
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Table 2.9
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Table 2.9
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Sources: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions 1997 and various Recent Economic Developments reports: and Organization for Economic Cooperation and Development.

With the exception of investments in sectors normally considered sensitive or of strategic national interest.

Borrowed or extended by residents Other than banks.

Securities with more than one year of original maturity, such as shares and other securities of a participatory nature, and bonds.

Securities with one year or less of original maturity, such as treasury bills, certificates of deposit, and bills of exchange.

The index can take values between 0 and 100, with 100 representing the maximum degree of liberalization of the capital flows under consideration, The index for a given country is constructed by adding up the values obtained in each category of capital flows and dividing this total by the maximum possible score. Flows not subject to controls (“no” in the table) are assigned a value of 2 flows classified as being subject to partial controls (“partial” in the table) are assigned a value of I; flows subject to serious controls (“yes” in the table) are given a value of zero. When information on a given capital transaction is not available, a value of zero is assigned in both the numerator and the denominator.

Capital Account Regulations

The degree of financial integration should be related to capital account regulations to the extent that these regulations are enforced. In examining such regulations, this section emphasizes when relevant any specific rules applied only to flows with prospective EMU participants.27

Most CEE countries lifted the restrictions on FDI inflows (except in a few sensitive or defense-related sectors) at the beginning of their transition to a market economy. They also guaranteed in most cases the free repatriation of both profits (current account convertibility) and FDI capital. FDI inflows were welcomed as a not-easily-reversible source of foreign exchange and because of the usual externalities associated with FDI (introduction of new technologies and managerial skills, access to export networks, and so forth). In addition, FDI was to play a key role both in these countries’ privatization and enterprise restructuring processes and as a source of government revenues. Most CEE countries initially required authorization for FDI outflows, but the authorization was normally granted liberally when the investment was thought to help exports. Since early in the reform process, most CEE countries have also applied a quite liberal treatment to trade credits (in the case of outward trade credits because of their positive effect on exports), and allowed individuals to hold and operate foreign exchange accounts at local banks, a privilege that most industrial countries accorded only at the last stage of liberalization of their capital accounts.28

With the exception of FDI-related transactions, however, most other capital movements remained very restricted in CEE countries, as these countries feared the potentially destabilizing effects of an open capital account at a time when they were still trying to put their macroeconomic houses in order. In particular, financial credits, portfolio flows, and real estate operations remained severely restricted for years in practically all countries. A general pattern, and one that has endured until today, was the existence (legally and de facto) of much tighter controls on outflows than on inflows and more serious restrictions on short-term than on long-term transactions.29

Since 1995, a number of CEE countries have been gradually easing restrictions on capital movements. This process has been led by the Czech Republic, Hungary, and Poland, all of which have undertaken substantial liberalization commitments as part of their accession to the OECD in December 1995, May 1996, and November 1996, respectively.-30 But other CEE countries have also taken measures in recent years to ease their capital controls.

In the context of their accession to the OECD, the Czech Republic, Hungary, and Poland have liberalized FDI outflows (vis-à-vis OECD countries and countries having signed bilateral investment protection agreements in the case of Hungary and Poland), outward trade credits, and personal capital movements. They have also liberalized other outflows (particularly long-term outflows) to varying degrees. Thus, the Czech Republic has fully liberalized the purchase abroad by residents of any foreign security, as well as Czech investment in real estate abroad, although it continues to require authorization for the admission of foreign securities to its capital and money markets. Hungary has allowed residents to invest in securities of more than one year of original maturity, issued by OECD governments or OECD-based companies with an investment grade rating. Poland has liberalized, for maturities of more than one year, outward financial credits and purchases of securities issued by OECD countries. On the side of inflows, the Foreign Exchange Law passed by the Czech Republic on October 1, 1995, removed the requirement of prior authorization for most inflows, while Poland and Hungary have removed all restrictions on medium- and long-term inflows (maturities of more than one year).31

Overall, these measures have contributed to a substantial liberalization of flows (including portfolio flows) in these three countries, particularly with respect to medium- and long-term flows and on the side of inflows. The acceptance of the OECD Capital Movements Code also implies for these countries the need to comply with its standstill, nondiscrimination, and transparency clauses.32 Finally, the Czech Republic and Hungary have also committed themselves to abolishing all remaining capital controls within three to four years of their dates of OECD membership, if the macroeconomic situation permits, while Poland has committed itself within the OECD to removing all remaining restrictions by end-1999.

Another institutional process that is having a bearing on the capital account regulations of the countries under analysis is the signing of Association Agreements with the EU and, for a number of countries, the prospect of early accession to the EU. The Europe Agreements concluded between the EU and some CEE countries oblige both parties to liberalize FDI-related flows between themselves. They also encourage CEE countries to take further liberalization measures with the ultimate objective of fully liberalizing flows with the EU. Furthermore, countries joining the EU will have to free capital movements visa-vis all countries from the date of membership, unless they obtain a transitory period for this part of the acquis communautaire:.33 Those countries that started accession negotiations in early 1998 (Cyprus, the Czech Republic, Hungary, Poland, and Slovenia, among the countries considered here), could join the EU as soon as in 2002, meaning that they would in principle have to have a completely open capital account by then. The commitments before the OECD undertaken by Poland to lift all remaining restrictions by end-1999, and by Hungary and the Czech Republic to do so within three to four years, therefore, are consistent with their prospect of EU membership.

Empirical Tests of International Financial Integration for Mediterranean Countries

A number of empirical tests of financial openness have been conducted in the literature, based, for example, on interest parity conditions, saving and investment correlations, or correlations of consumption levels across countries.1 In the case of the CEE countries, however, empirical tests of financial openness are generally not available, reflecting the lack of appropriate national account statistics or sufficiently long time series, and the econometric difficulties in dealing with rapid structural change. For the four Mediterranean countries under analysis, a number of formal estimates have been produced in the context of more general tests for developing countries.

An important finding of the empirical tests of capital mobility in developing countries performed in the 1980s and early 1990s was that these countries are more financially open than had been assumed (see Montiel, 1993). This conclusion was reached even though most of these studies were done before the surge in private capital inflows experienced by a number of developing countries in the 1990s. Available empirical estimates for Cyprus, Israel, Malta, and Turkey, shown in the table, are in line with the main conclusions of this literature. They generally tend to classify Israel as a country with a relatively high degree of international financial integration, and the other three countries as having an intermediate-to-high degree of financial openness.

Haque and Montiel (1990), using the methodology proposed in Edwards and Khan (1985) to test the uncovered interest parity condition, concluded that during the period 1969–87 both Malta and Turkey showed intermediate degrees of international financial integration. Montiel (1989) and Dowla and Chowdhury (1991) tested for the hypothesis of monetary autonomy in a number of developing countries. The idea behind these two studies was that, with perfect international capital mobility and fixed exchange rates, the domestic credit or money supply should not cause, in the Granger sense, movements in nominal income. Using annual data for the period 1962–86, Montiel rejected the hypothesis that these domestic financial aggregates Granger-caused nominal income in Turkey, implying a relatively high degree of financial openness in this country. Dowla and Chowdhury reached a similar conclusion for Israel, using quarterly data for the period 1957–89.

Montiel (1993) performed a number of tests of financial openness with data for several developing countries, including the computation of gross capital inflows and outflows as a percentage of GDP, Feldstein-Ho-rioka type of saving and investment correlations, tests of uncovered interest parity, and correlations of national and world consumption. The data covered, depending on the test and the country, different subsets of years within the period 1960–90. Montiel concluded that the degree of financial integration was high in Israel and intermediate in Cyprus and Turkey. Among the tests performed by Montiel (1993), those that distinguished different subperiods detected an increase in financial integration over time in Cyprus and Israel, but not in Turkey. For Malta, the results were inconclusive.

Mamingi (1993) estimated saving and investment correlations for 58 developing countries over the period 1970–90. He concluded that Turkey had an intermediate and Malta an intermediate-to-high degree of capital mobility. Finally, Obstfeld (1994) tested for the correlation of national consumption with world consumption in a sample of industrial and developing countries including Cyprus and Turkey for the periods 1951–72 and 1973–88. Cyprus was found to have in the second period the highest correlation among the developing countries included in the sample, with the coefficient of correlation (0.64) close to the highest coefficients obtained by industrial countries, implying a relatively high degree of international financial integration.2 The coefficient also increased between the two periods, consistent with the findings by Montiel (1993). For Turkey, by contrast, the coefficient of correlation was very low and (also consistent with Montiel’s results) slightly declining.

Results of Empirical Tests of International Financial Integration in Mediterranean Countries

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Combines degree of access to international capital markers total private capital inflows/GDR and a measure of the level of diversification of the country’s financing.

For the period 1992–94.

Not too much emphasis should be put on the suggestion in these studies that international financial integration in Turkey may have actually declined during the 1970s and 1980s. Apart from the general caution with which all the results of these tests should be interpreted, these tests do not cover, as noted, the surge in private capital flows to developing countries of the 1990s, of which Turkey has been an important beneficiary (see below). In this respect, a study recently published by the World Bank, which classified a sample of 65 developing countries according to their degree of financial integration using data up to 1994, concluded that Turkey had moved from an intermediate level of integration in 1985–87 to a high level in 1992–94.3

1 For a discussion of different approaches to measuring international financial integration, see Goldstein and Mussa f 1993), Montiel (1993). and Obstfeld (1994). For a survey of the growing body of literature applying these techniques to developing countries, see Montiel (1993). 2 A coefficient of 1 implies, under certain assumptions, perfect capital mobility. 3 See World Bank (1997a). The World Bank constructed an overall index of financial integration by combining a measure of access to the international capital markets, a measure of a country’s ability to attract private capital inflows (based on total gross inflows over GDP but adjusted to weight more heavily flows other than FDI), and a measure of the level of diversification of a country’s financing (with higher diversification reflecting higher integration). Interestingly, the World Bank calculations showed Hungary, the only CEE country included in the sample, moving from the group of developing countries with low integration in 1985–87 to the group of highly integrated countries in 1992–94.

Measures in the area of capital account liberalization are also contained in the Euro-Mediterranean Agreement signed in 1995 between Israel and the EU, though not in the Association Agreements concluded by the EU with Cyprus, Malta, and Turkey. Among these Mediterranean countries, the liberalization efforts are currently being led by Israel, which has already achieved a relatively high degree of capital account openness and has announced its intention to do away with virtually all remaining restrictions in 1998, Turkey undertook a substantial liberalization of its capital account during the 1980s and first half of the 1990s, partly reflecting its obligations as a member of the OECD, Cyprus, for its part, has taken steps in recent years to liberalize its capital account and plans to take further measures in the coming years, in preparation for its integration into the EU.34

(Table 2.9) provides a summary description of existing controls on selected capital flows in the countries under analysis. It focuses on FDI, real estate, and portfolio and credit flows not involving the domestic banking system, thus leaving aside the specific provisions affecting banks and other financial institutions, the investment restrictions affecting institutional investors, and the regulations determining the capacity of residents and nonresidents to hold and operate foreign- and domestic-currency-denominated accounts. While some of the regulations excluded from the analysis are admittedly important, they are often too complex to be characterized in a simple way, and the overall degree of liberalization of the capital account might reasonably be expected to show a high degree of correlation with the overall degree of liberalization of the capital flows included in Table 2.9. An index of liberalization of these selected flows was calculated as a proxy for the overall degree of capital account openness; it is also reported as a memorandum item in table 2.9.

This index can take values between 0 and 100, with 100 representing the maximum degree of liberalization. It shows that the Czech Republic, with an index of 74 percent, was, by a substantial margin, the country that had as of early 1997 made the most progress in opening its capital account, followed, in order, by Israel, Hungary, Poland, and Turkey (all with indices in the 50–62 percent range). Bulgaria, Croatia, Cyprus, Malta, and Slovenia stood at an intermediate level of liberalization. All other countries showed indices below 25 percent, although in some of these countries (in particular, Albania and Bosnia-Herzegovina) the enforcement of capital controls is so weak that the index is likely to significantly underestimate the actual openness of their capital accounts.

Evidence from Net Capital Flows

The regulatory framework is only a partial indicator of actual international financial integration. First, controls on capital flows are often circumvented so that it is possible to have a country with a very closed capital account on paper but, because of weak enforcement, a relatively open capital account in practice. Conversely, despite the removal of many capital account restrictions, a country may show little international capital mobility, reflecting underdeveloped domestic capital markets, lack of market access, or other factors. Because of such considerations, the analysis is complemented in the remainder of this section by looking at the trends in total net capital inflows, indicators of market access (such as ratings, spreads, and actual presence in the international capital markets), and, for some countries, correlations between their stock market indices and those of other stock exchanges.

As shown in Table 2.10, most CEE countries have experienced a significant increase in net capital inflows since 1993. After an initial period characterized by weak private inflows (largely limited to FDI inflows and international bond issuance concentrated in a few countries), a predominance of official assistance, and capital flight in some countries, several CEE countries began to experience in 1993 a sharp increase in private capital inflows. Those were largely countries where the stabilization and structural reform efforts were most advanced. In particular, the Czech Republic and Hungary were among the main beneficiaries of the surge in private capital inflows to emerging countries observed since the early 1990s.-35 Net capital inflows into the CEE countries as a whole peaked in 1995, with the Czech Republic and Hungary both receiving record net inflows of nearly 18 percent of GDP. They abated substantially in 1996–97, led by the deceleration and subsequent partial reversal of inflows into the Czech Republic and Hungary, but remained high in most countries (Croatia and the Slovak Republic in particular).36

Table 2.10.

Net Capital Inflows1

(in percent of GDP)

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Sources: IMF, Balance of Payments Statistics Yearbook 1997; IMF International Financial Statistics; and IMF staff estimates.

Met capital inflows are defined as the balance on the financial account of the balance of payments, excluding changes in international reserves, plus net errors and omissions. In a number of countries, the net errors and omissions item is large.

Until 1992. refers to the former Czechoslovakia

Bulgaria. Czech Republic, Hungary. Poland. Romania, and the Slovak Republic.

With the exception of Cyprus, the Mediterranean countries have also experienced this trend, with Israel and Malta receiving average net capital inflows in the period 1993–97 of about 8 percent and 10 percent of GDP, respectively, and capital inflows into Turkey resuming at a healthy rate after the 1994 balance of payments crisis.

Ratings and Access to the International Capital Markets

Ratings. The majority of the countries included in this analysis have seen an improvement, very marked in a number of cases, in their credit ratings in recent years (see Table 2.11), Twelve countries have already been assigned long-term foreign-currency sovereign ratings by the major international rating agencies. Among the CEE countries, five (Croatia, the Czech Republic, Hungary, Poland, and Slovenia) enjoy investment grade ratings from both Moody’s and Standard & Poor’s, with the Czech Republic and Slovenia having been granted an A level mark by at least one of those rating agencies.37 The last CEE country to have joined this group is Croatia, which was assigned the lowest investment grade ratings by both Moody’s and Standard & Poor’s in January 1997. The Slovak Republic had also been assigned investment grade ratings by Moody’s and Standard & Poor’s in 1995–96, but Moody’s downgraded the country’s debt from Baa3 to Bal in March 1998, Bulgaria and Romania remain at the subinvestment grade category, and the rest of the CEE countries have not yet been rated. Among the Mediterranean countries considered here, Israel, Malta, and Cyprus all enjoy A level ratings at present. In contrast with this generally positive trend, Turkey has been successively downgraded since 1994 from an investment grade mark to the lowest mark in the noninvestment grade.38

Table 2.11.

Sovereign Credit Ratings1

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Sources: Moody’s Investor Service; and Standard & Poor’s

Ratings on long-term foreign currency bonds. The ratings are ranked in descending order according to the degree of creditworthiness as follows:

  • Moody’sStandard & Poor’s

  • Investment gradeAaa, Aa, A, BaaAAA, AA, A, BBB

  • Noninvestment gradeBa, BBB, B

  • Default gradeCaa, Ca, CCCC, CC, C, D

Borrowers within a given grade are differentiated by attaching either numbers from \ (highest creditworthiness) to 3 (Moody’s), or + and - signs (Standard & Poor’s).

Israel was assigned a BBS rating by Standard & Poor’s in October J 986.

This picture is confirmed by the widely monitored country-risk ratings and rankings regularly published by Euromoney and The Institutional Investor (see Table 2.12, and Table 2.13).39 After declining in the early years of transition and reaching a trough in 1993, the average rating of the eight most advanced CEE countries has recovered quite markedly and exceeds significantly the levels seen in 1990.40 The average position of these eight CEE countries in the rankings has also improved considerably, despite an increase in the number of countries rated by the magazines.

Table 2.12.

Euromoney Country Risk Ratings and Rankings1

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Source: Euromoney.

Euromoney publishes ratings twice a year, The data shown in the table are the September ratings. Before 1992, Euromoney produced the ratings only once a year, N.R. = not rated. Credit rating = countries are rated on a scale of zero to 100, with 100 representing the least chance of default. Position in ranking = the higher the ranking number, die lower the degree of creditworthiness of the country.

Until 1991, rating and position in the ranking assigned to the former Czechoslovakia.

Until 1991, rating and position in the ranking Assigned to the former Czechoslovakia.

CEE countries shown in the table except Albania Bosnia-Herzegovina, the former Yugoslav Republic of Macedonia, and the Federal Republic of Yugoslavia.

Table 2.13.

The Institutional Investor Country Risk Ratings and Rankings1

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Source: The Institutional Investor.

The institutional investor publishes ratings twice a year. The data shown in the table are the September ratings, N.R. = not rated. Credit rating = countries are rated on a scale of zero to 100, with f GO representing the least chance of default Position in ranking = the higher the ranking number, the lower the degree of creditworthiness of the country.

Until 1991, rating and position in the ranking assigned to the former Yugoslavia.

Until 1992, rating and position in the ranking assigned to the former Czechoslovakia.

CEE countries shown in the table except Albania, Bosnia-Herzegovina the former Yugoslav Republic of Macedonia, and the Federal Republic of Yugoslavia.

As highlighted by the magazines’ comments, many CEE countries are among the countries that have moved up most rapidly in their rankings in recent years. The rating increases for Croatia. Poland, and Slovenia have been particularly sharp. Slovenia’s ratings and those of the Czech Republic (which improved less markedly but from a higher level) are already quite close to those enjoyed by the prospective southern EMU countries (see Table 2.12 and Table 2.13). The Slovak Republic’s rating also improved significantly from a relatively favorable position, after a delay caused by the uncertainties associated with the dissolution of Czechoslovakia and its expected negative impact on the Slovak Republic’s fiscal and balance of payments positions. Success with macroeconomic and political stabilization and, except in the case of Croatia, closer economic and political ties with the EU (including the signing of Association Agreements) seem to be major factors behind the positive evolution of these five countries’ ratings.41 Bulgaria and Romania stand at an intermediate level, having seen moderate improvements from rather low levels. Finally, Albania and the other republics of the former Yugoslavia have seen no improvement in their ratings, which remain very low reflecting a combination of political and economic instability, low per capita income, and structural problems.42

As for the Mediterranean countries, Cyprus and Israel have both seen in recent years substantial improvements in the ratings published by Euromoney and The Institutional Investor, while Malta’s ratings have remained approximately stable. As in the case of the Czech Republic and Slovenia, these countries’ ratings are currently not far from those of prospective southern EMU countries. Turkey’s ratings, by contrast, have fallen substantially below those of the most advanced CEE countries, mirroring the negative trend observed in its agency ratings.

Market access, Table 2.14 provides data on the total funds raised by the countries under study in the markets for international bonds, international equity placements, and medium- and long-term syndicated bank loans since 1991. Total borrowing in these three international capital markets had until recently been highly concentrated in a handful of countries (the Czech Republic, Hungary, Israel, and Turkey), but the number of countries with access to these markets increased rapidly over the last three years as new ratings were assigned (often, as noted, of the investment grade category) and existing ratings upgraded, and as some countries normalized their relations with commercial bank creditors. Total borrowing in these three markets, as a percentage of these countries’ combined GDP, has increased substantially since the early 1990s. At the same time, spreads on bond issues and bank loans have narrowed considerably for most countries; in the first half of 1997, just before the East Asian financial crisis, the Czech Republic, Cyprus, Hungary, Israel, and Slovenia were able to place bonds at spreads of fewer than 60 basis points over comparable U.S. Treasury bonds and/or to obtain bank loans at margins of fewer than 30 basis points over LIBOR.43

Table 2.14.

Funds Raised in the International Capital Markets1

(In percent of GDP)

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Source: IMF, Private Market Financing for Developing Countries.

Gross issuance of international bonds and international equity, and new commitments of medium- and long-term syndicated bank loans.

Appendix II provides more details on trends in market access in the countries under review by examining data on issues of international bonds, international equity placements, and syndicated bank loans.

Correlations Between Stock Market Indices

As another indication of international financial integration, this section provides background data and discusses evidence on international correlations between stock market indices for those countries under study for which data are available from the International Financial Corporation’s (IFC) Emerging Market Database (the Czech Republic, Hungary, Poland, and Turkey). These four countries, together with Israel, are the only ones that have managed to develop stock markets with significant levels of capitalization and liquidity.

As shown in Table 2.15—which reports market capitalization, turnover, and the number of listed companies—the Czech and Polish stock exchanges and, to a lesser extent, the Hungarian one have been expanding rapidly. The Hungarian, Polish, and Turkish exchanges have also been among the emerging stock exchanges with the best price performance in recent years (see Figure 2.3 and 2.4).44 The Warsaw Stock Exchange has become the largest in Central and Eastern Europe, and enjoys relatively high turnover and liquidity. The Istanbul Stock Exchange has also grown at a rapid pace, and is now one of the stock markets with the highest turnover ratios worldwide and the 29th in terms of market capitalization. Regarding the participation of foreign investors, there is evidence of a relatively important presence in the Istanbul and Warsaw exchanges but of a more modest involvement in the Budapest and Prague exchanges. The role of foreign investors, however, seems to be increasing in all of them.45

Table 2.15.

Stock Markets of Selected Non-EU Countries

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Sources: International Finance Corporation, Emerging Stock Markets factbook 1998; and national stock exchanges.

Trading in shares of companies listed on Bulgaria s stock exchange was suspended in October 1996.

Excludes investment companies.

The sharp decline in the number of listed companies recorded in 1997 largely reflects a tightening of listing requirements.

Table 2.16 shows a matrix of price index correlations, based on monthly changes in the relevant indices during the period December 1991-December 1996. The four markets considered (particularly the Czech and Turkish exchanges) show higher correlations with regional indices that contain a predominant share of emerging markets (such as the IFCG Composite) than with indices based on the major stock markets of industrial countries. This is what one might expect, given that emerging stock markets tend to move together to some extent (particularly those where foreign institutional investors play a significant role). It is also in line with the pattern observed in other emerging markets for which the IFC provides correlations. A particularly interesting observation is that the Budapest and Warsaw stock markets show correlations vis-à-vis industrial country stock exchanges that are substantially higher than those shown on average by other emerging markets.46 Also, the correlations of the Istanbul, Prague, and Warsaw stock exchanges vis-à-vis developed markets indices tend to be higher with those indices that have a high content of European stocks (such as the Financial Times47 Europac and the index calculated by Morgan Stanley Capital International). Finally, all four markets show relatively high correlations with individual EU emerging markets, such as the Lisbon and Athens stock exchanges.

Table 2.16.

Correlations of Stock Market Indices1

(December 1991-December 1996)

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Source: International finance Corporation, Emerging Stock Markets Factbook, 1997.

Coefficient of correlation of monthly changes in U.S. dollar-converted indices during the period December 1991-December 1996.

Simple average of Czech Republic Hungary, and Poland.

Simple average of 23 non-European emerging markets for which correlations were available.

Index calculated by Morgan Stanley Capital International. It includes stocks from markets in western Europe, Australasia and the Far East. European stocks have a combined weight of about 60 percent in the index.

Index calculated by FTSE International, a Financial Times subsidiary, on the basis of stocks from western European markets.

Index constructed by the International Finance Corporation on the basis of stocks from some 30 emerging stock markets from all over the world.

The evidence for Hungary and Poland is consistent with the idea of a relatively higher degree of international financial integration and, in particular, exposure to international portfolio flows, in the most advanced CEE countries. The relatively higher correlations vis-à-vis European indices also suggest that financial integration may be proceeding somewhat faster with the European countries (and in particular the prospective EMU countries) than with other regions of the world.

Structural Effects

EMU could influence the development of the Financial systems of non-EU countries in structural ways. Take, for example, the derivative markets. The disappearance of the currencies of the EMU participants is expected to lead to the consolidation of different futures and options contracts into a few contracts based on the euro. This, in turn, should promote increased competition among the 16 EU futures and option exchanges that currently exist. Some of the small exchanges are likely to disappear, while the size, liquidity, and technological sophistication of the larger markets like the MATIF in France and the DTB in Germany could well increase. Since progress in communications technology and the improved efficiency and interlinking of payments systems will make it less costly for non-EU financial institutions to operate in the large EU derivative exchanges, local derivative markets in non-EU countries will face increasing competition from the big EU exchanges and will only be able to develop or survive to the extent that they successfully concentrate in their local-currency contracts.

In the case of equity markets, the information advantages of local stock exchanges vis-à-vis local (particularly small and medium-sized) companies should ensure the survival of these markets in non-EU countries. But the shares of the largest and most international companies of non-EU countries are likely to be increasingly listed or issued in the largest EU stock exchanges, as a Europe-wide equity market for “blue chips” emerges. In fact, this has already started to happen.

To some extent, the countries under analysis will also be drawn into the structural changes in the EU banking systems that EMU, in conjunction with the existing EU legislation on financial services, will bring about, such as increased cross-border competition, mergers and alliances, concentration of wholesale banking, securitization, and reduced margins. This will be facilitated by the commitments on liberalization of trade in financial services, right of establishment of financial institutions, and harmonization of financial legislation made by most of these countries in the context of their Association Agreements with the EU, reinforced in some of them by the prospect of early EU membership.

In a number of CEE countries, structural change will also be promoted by the existence of an already significant involvement (by way of both the establishment of new branches and subsidiaries, and the acquisition of stakes in local banks) of euro-area banks (notably from Germany and Austria) in their banking sectors. Non-EU banks are likely to participate in (and suffer from) the accelerated securitization trend in the euro area. As suggested above, the development of deep and liquid markets for corporate bond and commercial paper within the euro area is likely to accelerate as a result of EMU, encouraging CEE companies to tap those markets. By and large, however, this will not be done at the expense of the local corporate bond or commercial paper markets, which remain underdeveloped in most of the countries considered here. Rather, the shift in the financing source can be expected to be at the expense of domestic banks (which remain the main providers of external corporate finance in those countries), implying a process of disintermediation from the local banking system and securitization.

Finally, EMU could have significant implications for the payment systems of the countries under study, most of which remain rudimentary. As discussed in Temprano-Arroyo and Feldman (1998), the establishment by EMU countries of an EU-wide payment system (TARGET) should encourage non-EU countries to accelerate the adoption of modern, real-time gross settlement systems (RTGS) capable of making payments in euros, so as to be able to connect themselves to TARGET.47 This connection will be made all that more important if, as the analysis above suggests, EMU leads to an increase in cross-border transactions between EMU and non-EU countries. The improved interlinking of the payment systems of both areas should in turn deepen their financial integration.

The Case of Foreign Direct Investment

It is sometimes argued that, by lowering intra-euro-area transaction costs (including those stemming from exchange rate variability), EMU may divert trade and direct investment away from non-EU countries and into the euro area. For example, an EMU-induced reduction in transaction costs inside the euro area may lead a U.S. company seeking to supply the euro-area market to set up a factory in Paris despite higher labor costs rather than in an alternative location in a CEE country, implying a diversion of both trade and investment from the latter. Also, a Hungarian producer exporting to the EMU market who sees its exports threatened by the reduction in transaction costs inside the euro area may decide to supply the euro area locally. In addition, EMU could divert FDI from non-EU countries into the euro area if it results in more rapid growth in the latter.48 The reason is that stronger demand within the euro area will further enhance the locational advantages of the area as a production base, encouraging firms to replace their exports with local production.49

One relevant factor when assessing the possible diversion effects of EMU on net FDI inflows to outside areas is the motivation behind FDI. While, at the margin, a reduction in transaction costs or an increase in demand in the euro area will tend to divert investments from outside countries regardless of their main motivation, diversion effects are more likely to take place in cases where FDI is fundamentally driven by relative cost considerations than in cases where the dominant motivation is to access the local or regional market or to exploit first-mover advantages. In this respect, most surveys of foreign direct investors in CEE countries suggest that market seeking has until now been the prime investment motive.50 On the other hand, the share of investment projects that are primarily export-oriented and motivated by the desire to exploit the comparative advantage of the host country tends to be larger in those countries that are more advanced in transition and geographically closer to the EU.51 This evidence suggests that the diversion effects of EMU on FDI into CEE countries may be rather limited except perhaps for countries such as the Czech Republic, Hungary, and Poland.

No survey evidence on the motivation of FDI flows into the selected Mediterranean countries was available, but market seeking seems to have been an important factor in all them. In Cyprus, about 70 percent of the FDI inflows received since the early 1990s have been directed to the tourism and other tertiary sectors, where serving local markets is likely to have been the main objective.52 The construction or exploitation of tourism facilities has also been a traditional source of FDI inflows in Malta and Turkey. The large size of the Turkish market also suggests an important role for market seeking in FDI into Turkey. In Israel, there seems to be a mix of motivations. The recent expansion in FDI into Israel has been largely driven by the privatization of companies in both the nontradable goods sectors (banking, construction, public utilities), where market exploitation is likely to have been a prime motive, and the tradable goods sectors (in particular trade, chemicals, and other industry), where cost and export considerations may have been important.53 There have also been a significant number of non-privatization related footloose investments in the Israeli high technology industry, which take advantage of Israel’s relatively low-priced human capital.

The importance of market seeking as a motivation for FDI in many of the countries under analysis, and the moderate magnitude of the reductions in transaction costs that EMU is expected to bring about, advise against overemphasizing the extent of any possible negative diversion effects on FDI flows into those countries. This point is strengthened by the marked increase observed in FDI flows from the EU into the CEE countries since the mid-1990s (see 2.17 and Appendix III). Since EMU has long been anticipated by EU companies, this increase in investment would probably not have occurred if the EMU-induced reduction in transaction costs was expected to be significant. Furthermore. EMU may also have some positive impact on outward FDI from the euro area.54 First, as EMU increases the opportunities for EMU-based firms to operate in an integrated market, they will acquire experience in managing multidivisional, geographically separated units, and this accumulated knowledge could assist and stimulate their investment in non-EU countries as well. Second, the search for improved productivity to cope with increased competition from within the euro area could encourage EMU firms to seek lower production costs in neighboring non-EU countries. Third, if EMU boosts investment demand within the euro area, it is reasonable to expect that some of this increased capital formation will spill over into geographically close non-EU countries. In sum, the possible impact of EMU on net FDI inflows into the countries under review is of an uncertain sign, and it is likely to be moderate and overshadowed by other factors influencing FDI,55

Table 2.17.

Net Inflows of Foreign Direct Investment

(in percent of GDP, unless otherwise indicated)

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Sources: IMF, Balance of Payments Statistical Yearbook 1997, and IMF staff estimates. For aggregate data for developing and transition countries. World Bank, Global Development Finance 1998.

IMF staff estimates.

percent IMF staff estimates.

Cumulative 1990–97 per capita inflows in U.S. dollars. For country groups, simple averages.

Whatever their net impact, the magnitude of the various effects discussed in this section is likely to be more significant the larger the total FDI inflows the countries under study were receiving prior to the launching of EMU, and the higher the share of FDI from EMU participants. In this respect, the data shown in Table 2.17 provide a mixed picture. On the one hand, the EU is the main investor partner in all the countries under review for which estimates were available, accounting for 50–85 percent of net FDI inflows in all of them. The EU is also believed to be the main investor partner in the countries for which no breakdown by investor country was available, with the exception of Israel, whose FDI inflows seem to be dominated by the United States.

On the other hand, net FDI inflows have remained relatively low as a percentage of GDP in all but a handful of countries (Hungary, the Czech Republic, Malta, and Albania), even though certain other countries (Bulgaria, Croatia, Israel, and Poland) seem to be catching up. Appendix III discusses in more detail trends in net FDI inflows into the countries under analysis.

Debt-Service Considerations

To the extent that EMU results in changes in interest rates in the euro area or in changes in the exchange rate of the euro against other major international currencies, there could be implications for the debt-service payments of the countries under study. These two channels are discussed in turn below.

Changes in Euro-Area Interest Rates

The larger the share of euro-denominated debt in total external debt and, in the short term, the larger the share of short-term and variable-rate medium-and long-term debt in total euro-denominated debt, the greater the effect on a country’s debt-service payments of changes in euro-area interest rates. In the calculations below, it is assumed for simplicity that the currency composition of foreign debt is kept stable when euro interest rates change so that changes in euro interest rates lead to corresponding changes in debt-service costs,56

The impact of a change in euro interest rates on a country’s debt-service-to-exports ratio (DSR) will also depend on the size of its debt and on the degree of openness of the economy, measured by the ratios of debt to GDP and exports to GDP, respectively. For a given share of euro-denominated debt and a given maturity profile of this debt, the higher the country’s foreign debt and the lower its exports in terms of GDP, the stronger will be the impact on its DSR.

Algebraically, this can be illustrated with the following expression;

Δ D S R = Δ i e u r × S E M U 100 × S S V 100 × D / G D P X / G D P ,

where ADSR is the change, expressed in percentage points, in the country’s DSR; Δieur is the percentage point change in the interest rate of the euro; SEMU is the share of euro-denominated debt in total foreign debt; and D/GDP and X/GDP is the share of short-term plus variable-rate medium- and long-term debt in foreign debt; and D/GDP and X/GDP are the shares of foreign debt to GDP and exports to GDP, respectively.57

Table 2.18 reports the data on the currency and maturity composition of debt and on the debt and debt-service ratios for the countries under analysis (except Cyprus, for which the relevant information was unavailable on a comparable basis). The share of foreign debt that would be affected by a change in euro-area interest rates is obtained by combining SEMU and SSV(reported as the first memorandum item in Table 2.18).

Table 2.18.

Composition of Foreign Debt by Currency and Maturity, 1996

(in percent of total foreign debt, unless otherwise indicated)

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Source world Bank, Global Development Finance 1998; national authorities; and IMF staff estimates.

Long-term debt is debt with an original maturity of more than one year. Store-term debt is debt with an original maturity of one year or less. For Israel, currency composition in percent of long-term debt.

For Israel, table shows share of debt denominated in the currencies of all EU countries (including those not participating In EMU).

Assuming that the currency composition of short-term and variable-rate long-term rate is the same as that of total Long-term debt, and assuming mat the interest rate of the Swiss franc follows that of the euro.

Exports of goods and nonfactor services.

The debt-service ratio for Hungary includes early repayments.

Table 2.19 illustrates the potential effect on DSRs of an EMU-induced increase in euro-area interest rates of 1 percentage point. The share of euro-denominated debt in 1999 is proxied by the share of the currencies of prospective EMU countries (subsequently referred to as “EMU currencies,” for expositional convenience) at end-1996, the last year for which comparable information was available for practically all countries. Other assumptions behind the calculations are explained in the note to 2.19.

Table 2.19.

Impact of a 1 Percent Increase in Euro-Area Interest Rates on Foreign Debt Service1

(Increase in the debt-service-to-exports ratio, in percentage points)

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Source: IMF staff estimates based on data in the preceding table.

Based on the following assumptions: (i) euro-area interest rates increase by 1 percent in 1999 and stay at this higher level through 2002; (ii) there are no changes in domestic interest rates, exchange rates, debt stocks, or exports as a result of the change in euro-area interest rates; (iii) the currency Composition of short-term and variable-rate long-term debt is the same as that of total long-term debt;(iv) the interest rate of the Swiss franc follows chat of the euro; and (v) all fixed-rate long-term debt matures within 10 /ears, with one-tenth of it falling due each year and being refinanced at an interest rate 1 percent higher than the original rate.

The main results of this exercise are the following:

  • The impact of a 1 percentage point increase in euro interest rates is moderate but, for most countries, not insignificant. The DSR rises at most by 0.3 percentage point in the first year of EMU and by at most about 1 percentage point by 2003, with the average for the CEE countries being 0.1 and 0.5 percentage point, respectively.

  • The most affected country is Albania, followed by Hungary, Bulgaria, and Poland. Albania’s apparent vulnerability—in spite of its relatively low foreign debt, its low share of debt denominated in EMU currencies, and its low share of short-term and floating-rate debt—is explained by the fact that Albania is by far the most closed economy in the group. In the other countries, the following factors contribute to the higher estimated effects; Hungary and Poland have the highest shares of debt denominated in EMU currencies; Bulgaria and Hungary have by far the highest debt-to-GDP ratios of the countries under analysis; Bulgaria has the highest share of short-term and floating-rate long-term debt in the group; and Poland is a relatively closed economy. These factors outweigh Hungary’s relatively low share of short-term and variable-rate debt and Bulgaria’s relatively high degree of openness.

  • The countries showing the smallest estimated effects over the five-year period are Malta and Slovenia. This may seem somewhat surprising since these countries have the highest shares of “affected debt,” showing above-average shares of debt denominated in EMU currencies and extremely high shares of short-term debt (Malta) or variable-rate long-term debt (Slovenia). However, serving as offsets, their debt-to-GDP ratios are well below average and their economies are highly open (particularly Malta, where exports of goods and nonfactor services account for nearly 90 percent of GDP). In the short term, countries with very low shares of affected debt and below-average debt-to-GDP ratios (Croatia, the Czech Republic, the Slovak Republic, and the former Yugoslav Republic of Macedonia) are less affected than Malta and Slovenia. In the medium term, however, Malta’s and Slovenia’s low ratios of debt to GDP and exports to GDP become the dominant factors.58

Changes in the Exchange Rate of the Euro

The impact on non-EU countries’ debt service of a change in the euro exchange rate against other major international currencies depends on the share of euro-denominated debt in total debt and on the exchange rate regime of the country in question.59 Thus, for example, a country that pegs its currency to the euro and has a low share of euro-denominated debt will experience important fluctuations in its debt-service costs as a result of changes in the exchange rate of the euro against other major currencies, with these costs increasing if the euro depreciates and declining it’ it appreciates. On the other hand, the debt service of a country with a peg to the euro but a high share of euro-denominated debt, a peg to the U.S. dollar but a low share of euro-denominated debt, or with a currency composition of its debt reflecting the weights of the different currencies in the basket of peg, will be little affected by a change in the exchange rate of the euro against third currencies. The exchange rate regimes of the countries under analysis were summarized in Table 2.4.

Apart from the fact that the currency composition of debt, the debt-to-export ratio, and the exchange rate regime may have significantly changed by the time EMU materializes, an important limitation of an analysis based exclusively on the information shown in the tables is that it would not take into account possible operations aimed at hedging the foreign exchange exposure associated with the currency composition of debt. Thus, for example, in January 1997, Hungary undertook swap operations aimed at ensuring that the currency composition of its foreign debt was the same as that of the currency basket to which its currency is linked, thus insulating its debt service from changes in cross rates. Since Hungary’s reference basket assigns weights of 70 percent to the deutsche mark and 30 percent to the U.S. dollar, these swaps imply a higher effective share of debt denominated in the currencies of EMU participants than shown in Table 2.18.

The main conclusion to be drawn from the information in Table 2.18 and Table 2.4 is that a large number of countries combine a relatively low share of debt denominated in EMU currencies with an exchange rate regime emphasizing stability vis-à-vis these currencies or the ECU, making their debt service highly vulnerable to changes in the exchange rate of the euro against third currencies. These countries include Bosnia-Herzegovina, Bulgaria, Croatia, Cyprus, the former Yugoslav Republic of Macedonia, Malta, the Slovak Republic, and Slovenia. Many of these countries peg dc jure or de facto their currencies to the deutsche mark, the ECU, or a basket of currencies in which the deutsche mark has a predominant weight. And in all of them, except Malta and perhaps Cyprus, debt in EMU currencies accounts for less than 15 percent (in most cases less than 10 percent) of total debt.60” The Czech Republic could also be included in this group. Although this country abandoned its peg to a deutsche-mark-dominated basket in May 1997, the Czech authorities continue to aim at achieving a relatively high degree of exchange rate stability vis-à-vis the German currency.61

Among this group of vulnerable countries, Bulgaria stands out because it has the highest debt-to-GDP ratio and the most rigid peg to the deutsche mark of all the countries under analysis. Moreover, its currency board arrangement foresees the replacement of the peg to the deutsche mark with a peg to the euro once EMU is launched. Thus, an EMU-induced depreciation of the euro could create serious debt-service difficulties in this country/’ 62

At the other extreme, the countries whose debt service seems most protected from fluctuations in the euro are Hungary, which, although it has the highest DSR, has insulated its debt service from changes in the exchange rates of the currencies in which it has borrowed: Poland, where EMU currencies account for similar proportions of its debt and its basket (32 percent and 40 percent, respectively); and Israel, which has a relatively low DSR, practically no debt denominated in EMU currencies, and a crawling peg with respect to a basket in which EMU currencies have a weight below 30 percent.61 Albania, Romania, and Turkey are in an intermediate situation: the share of EMU currencies in their debt is relatively low but they operate independent or managed floating exchange regimes that are not particularly geared toward a stable relationship with the euro.

The analysis above suggests that a significant number of the countries under review may want to gear the composition of their debt more toward their basket or currency of peg if they want to better insulate their debt service from changes in the euro exchange rate. More generally, the analysis underscores that countries that are vulnerable to interest and exchange rate changes in the euro area could usefully rethink their debt management policies.

Summary and Conclusions

Exports of CEE countries have become highly dependent on the EU market. Thus, external trade linkages are a potentially important channel through which EMU may affect the CEE countries. In particular, any changes induced by EMU in EU real GDP growth or the foreign exchange value of the euro can be expected to have consequences for CEE trade. Although it is difficult to estimate the magnitude of these effects with any degree of precision, this chapter has attempted to provide some reasonable orders of magnitude and finds that they are of meaningful size. The potential effects of EMU-induced exchange rate changes are more difficult to gauge than the effects of changes in EU growth. Nevertheless, this chapter has argued on a priori grounds that there is reason to believe that CEE exports will be rather sensitive to changes in the value of the euro. This reflects partial econometric evidence on trade elasticities and the fact that several CEE countries will likely peg or maintain their domestic currencies in a narrow range against the euro. It also takes into account the commodity composition of trade of these countries, which suggests that their exports should be responsive to relative price changes spurred by exchange rate developments. Some of the Mediterranean countries could be significantly affected by EMU as well.

This chapter has also examined the potential financial implications of EMU for the CEE countries and selected Mediterranean countries in terms of changes in non-FDI capital flows; the structure of the financial systems of the countries studied; changes in FDI flows: and the sensitivity of foreign-debt-service ratios to changes in interest and exchange rates in the euro area.

Non-FDI capital flows into the countries reviewed may be affected by EMU-induced changes in interest rates in the euro area. The actual behavior of the euro’s interest rates will depend crucially on the accompanying fiscal and structural policies implemented by the countries participating in EMU. How ever, a number of factors (including the ongoing cyclical recovery of participant economies, the possible positive effect of EMU on investment demand within the euro area, and the ECB’s efforts to establish its credibility) raise the probability that euro-area interest rates will increase during the first years of EMU.

Although an EMU-related increase in interest rates in the euro area could act to reduce interest-sensitive flows into outside countries, several portfolio diversification effects are expected to work in the opposite direction. These effects stem from the convergence of yield spreads between southern and core EMU countries, the expected increase in the degree of synchronization of financial asset price movements across EMU participants, the acceleration in the process of securitization in the euro area, and an easing of the investment constraints faced by institutional investors based in the euro area. A number of CEE countries and Mediterranean countries (notably the Czech Republic, Hungary, Poland, and Slovenia) seem particularly well placed to benefit from the portfolio effects that these factors imply. At the same time, by increasing competition, deepness, and liquidity in the financial markets of participant countries. EMU will also encourage investment and borrowing in euros by the countries examined. These different effects should result in greater financial interaction between the two groups of countries.

The degree of international financial integration of the countries reviewed is an important consideration for how they will be affected by developments in the euro area. The analysis suggests that such integration is increasing in most countries. Institutional forces (including the commitments undertaken in the Association Agreements with the EU, the prospect of EU membership, and the accession of some countries to the OECD) are helping to accelerate the liberalization of capital movements in many countries. Many CEE countries, as well as Israel and Malta, have experienced a surge in capital inflows since 1993, credit ratings have been improving rapidly in most countries, and many have gained (or regained) access to the international capital markets after a period during which such access had been denied to all but a handful of them.

The countries examined, however, differ considerably regarding the level of international financial integration already achieved. At one extreme, the Czech Republic, Hungary, Israel, and Poland have already opened their capital accounts to a substantial degree and plan to eliminate all or most remaining capital controls in the coming years. They also enjoy favorable (investment grade) credit ratings and easy access to the international capital markets, and have relatively developed domestic equity markets that tend to exhibit a rather high degree of price correlation with world (and, in particular, European) stock markets. These countries are also among those where the post-1993 surge in capital inflows has been strongest. It is this group of countries—containing most of the countries that stand to benefit from portfolio diversification effects—that is relatively more exposed to EMU-induced changes in portfolio and bank lending flows.

A second group of countries, comprising Croatia, Cyprus, Malta, the Slovak Republic, Slovenia, and Turkey, show an intermediate degree of international financial integration. All except Turkey have investment grade ratings and have been accessing the international capital markets at relatively narrow spreads. Some (notably Croatia, Malta, and the Slovak Republic) have also received substantial private capital inflows in recent years. Except for Turkey, however, their capital accounts are considerably less open than in the first group of countries, although some are planning to take liberalization measures in this field in the coining years to prepare for EU accession.

The rest of the countries examined continue to impose pervasive controls on their capital movements, have low credit ratings (apart from Bulgaria and Romania, none has been rated by the major international rating agencies), and have very restricted access to the international capital markets. The effect of EMU on non-FDI flows into these countries is unlikely to be significant.

EMU could also have structural implications for the financial systems of non-EU countries. The adoption of a common currency, in conjunction with EU legislation in the area of financial services, is expected to accelerate the structural transformation of the financial systems of EMU participants. The countries reviewed are likely to participate to some extent in these trends, which include securitization, concentration of wholesale banking and equity and derivative markets, and cross-border integration of payment systems. This will be particularly true for those countries where EU financial institutions are significantly involved. This structural contagion process will be facilitated by the efforts made by some countries, in the context of their Association Agreements with the EU and in preparation for early accession to the EU, to liberalize trade in financial services with the EU. remove legal impediments to the establishment of EU financial institutions in their territories, and harmonize their financial legislation with that of the EU.

EMU may result in some diversion of FDI flows away from CEE countries and the selected Mediterranean countries and into the EU, as producers try to take advantage of lower transaction costs and, possibly, stronger demand within the EMU area. But the paper has argued that these diversion effects are unlikely to be particularly important to the extent that FDI is largely driven by market-access considerations.

Finally, EMU could affect foreign debt service in the countries examined through its impact on the interest rate and the exchange rate of the euro. The analysis showed that the effect of interest rate changes is likely to be moderate but significant, with Albania, Bulgaria, Hungary, and Poland being the most exposed among the countries examined. Regarding the exposure to changes in the euro exchange rate, it was noted that a large number of countries combine a relatively low share of debt denominated in the currencies of prospective EMU members with an exchange rate regime emphasizing stability vis-avis those currencies, which makes their debt-service ratios vulnerable to changes in the euro exchange rate (with Bulgaria being particularly exposed). Countries that are particularly vulnerable to interest and exchange rate changes in the euro area could usefully rethink their debt management strategies.

Appendix I: A Brief Review of “Gravity” Studies on CEE Exports to Western Europe

Based on gravity models, several studies predicted a substantial reorientation of CEE exports toward western Europe.

  • Wang and Winters (1991) concluded that to reach their potential levels of exports to the EU. Bulgaria, Czechoslovakia. Hungary, Poland, and Romania would each have to double their exports from their 1985 levels.

  • Baldwin (1994), in a study that included additionally Albania, Croatia, the Slovak Republic, and Slovenia, drew a similar conclusion, estimating that potential exports to the EU were about twice the actual level of exports recorded in 1989.

  • Piazolo (1996), studying the same countries as Baldwin (1994), but treating the Czech Republic and Slovak Republic separately, found that potential exports from these countries to the EU in 1994 were 71 percent of total exports while actual exports were 64 percent of the total, implying prospects for a further expansion of exports to the EU.

  • Other papers predicting significant increases in the share of CEE exports to EU countries include Collins and Rodrik (1991) and Hamilton and Winters (1992).

  • Sheets and Boata (1996), using data through 1994, concluded that the magnitude of the increase in exports had tended to exceed the predictions of the models developed by Collins and Rodrik and Hamilton and Winters for Czechoslovakia. Poland, and Romania, with weaker evidence to this effect for Bulgaria and Hungary (the five countries included in their study). This suggested that the prospects for further expansion to the EU were much more limited.

  • The figures in Table 2.2 suggest that the peak of the expansion of exports into the EU market has been approached for a majority of the CEE countries. Only the Czech Republic, the former Yugoslav Republic of Macedonia, and, to a lesser extent, Romania and the Slovak Republic-still appear to have been increasingly reorienting their exports to the EU and augmenting their relative market shares. Of the other CEE countries, Bulgaria, Croatia, Hungary, and Poland seem to have reached the peak relatively earlier on.

Appendix II: Access to Capital Markets by Non-EU Countries—Recent Trends

Issues of International Bonds

Until 1994. borrowing in the international bond market was limited to Hungary. Czechoslovakia and its successor republics, Turkey, and Israel, with issuance (largely sovereign) by Hungary and Turkey alone accounting for about 70 percent of the amounts issued between 1990 and 1994 Table 2.20.64 With the exception of Bulgaria, Bosnia-Herzegovina, the former Yugoslav Republic of Macedonia, and the Federal Republic of Yugoslavia, however, all the other countries under analysis have tapped this market at some point since 1995. Following the debt restructuring agreed with commercial banks and the assignment of favorable ratings by Moody’s and Standard & Poor’s, Poland made a successful comeback to the international capital markets with the issuance of a five-year, $250 million Eurobond in June 1995. Since then, Polish issuance has accelerated quite markedly, with Poland becoming by far the most active issuer among CEE countries in 1997.65 The normalization of relations with their creditors and the investment grade marks obtained from the rating agencies have also allowed Croatia and Slovenia to raise substantial funds in the international bond market in 1996–97.66 Romania, despite its subinvestment grade ratings, has been present in this market since 1996.

Table 2.20.

Issues of International Bonds and Equity

(in millions of U.S. dollars, unless indicated otherwise)

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Source: IMR Private Market Financing for Developing Countries.

Including note issues under Euro Medium-Term Notes (EMNT) programs.

Total international bond issues by the countries under analysis peaked in 1993 as Hungarian and Turkish issuance reached record levels and Israeli is sues increased sharply. Bond issues diminished in 1994–95 reflecting lower issues by Hungary and the abrupt decline in Turkish issuance in the wake of the 1994 financial crisis in Turkey, They recovered gradually in 1996 and more markedly in the first three quarters of 1997, although they came to a halt in all but three countries in the fourth quarter of 1997.67 These trends largely mirrored those seen in emerging countries as a whole: a boom in issuance in 1993; a decline in 1994–95 (partly reflecting the impact of the Mexican crisis): an abrupt recovery in 1996 and the first three quarters of 1997; and a sharp decline in the fourth quarter of 1997 as the turmoil in East Asia depressed the market.

Yield spreads at launch over comparable government bonds issued by industrial countries have sharply declined in countries with investment grade ratings in recent years, with a few of them (the Czech Republic, Cyprus, Hungary, Israel, and Slovenia) having been able to place bonds at spreads of 60 basis points or less in the 12 months preceding the East Asian crisis (Table 2.21). These spreads are very narrow when compared with the average spreads paid by emerging economies as a whole (see memorandum items in Table 2.21). In fact, they are similar to those paid by many Western and East Asian advanced countries. Particularly noteworthy are the 37 basis points spread paid by Cyprus in the first half of 1997, and the placement by Slovenia of a DM 400 million seven-year sovereign issue at a spread of only 43 basis points in the spring of 1997, which set a new pricing low for CEE issuers. It is also significant that Croatia and Poland, both of which have below A level investment ratings, have been able to place international bonds at spreads of only about 80 basis points before the East Asian turmoil: in the first half of 1997, Croatia issued successfully a $300 million sovereign Eurobond at an 80 basis points spread and Poland placed at an 83 basis points spread the 10-year tranche of a two-tranche sovereign issue in the dollar sector. Romania and Turkey, by contrast, have continued to pay spreads of 300 basis points or more in their latest issues, with Turkey’s spread having substantially widened since 1994, consistent with the evolution of its ratings. The spreads paid by these two countries, however, are in line with the average spreads paid by emerging countries as a whole.

Table 2.21.

Yield Spread at Launch for Unenhanced Bond Issues1

(in basis paints)

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Source: IMF: Private Market Financing for Developing Countries.

Excludes issues not denominated in U.S. dollars. Yield spread measured as the difference between the bond yield at issue and the prevailing yield for industrial Country government bonds in the same currency and comparable maturity. AH figures are weighted averages.

International Equity Placements

Until 1993, only a few of the countries under analysis (Hungary, Israel, and Turkey) issued equity internationally, in line with the pattern observed in international bond issuance. Since 1994, however, four additional countries (Croatia, the Czech Republic, Romania, and the Slovak Republic) have entered the international equity market, while Poland, which had already launched a small issue in 1993, has become increasingly active (see Table 2.20). Total issues by CEE countries rose rather sharply in 1997, supported by a number of privatization-related issues by Hungary and Poland. The latter included the placement by Matav, a Hungarian company, of $785 million in American Depository Receipts (ADRs) in the last quarter of 1997, the largest equity issue to date from Eastern Europe, and the placement by Bank Handlowy w Warszawie, Poland’s largest bank, of some $210 million in Global Depository Receipts (GDRs).

Regarding the Mediterranean countries. Israel has stepped up its issuance since 1996, partly reflecting privatization deals such as the offering of some $130 million by Bank Leumi in the first half of 1997. Turkish issues also recovered markedly in 1997, following two years of subdued issuance. Cyprus and Malta did not tap this market during the period examined.

After declining to insignificant levels during 1990–93, the share of CEE countries in total international equity issues by emerging economies increased considerably, reaching a record of 9.6 percent in 1997. Furthermore, although some issues had to be postponed due to unfavorable market conditions, CEE countries showed considerable resilience in the final months of 1997 despite the East Asian crisis.68 The combined share of Israel and Turkey in emerging markets’ issuance has remained relatively stable in recent years.

Syndicated Bank Loans

During the early 1990s, syndicated loan commitments to the CEE countries stagnated or grew only moderately (Table 2.22). The political upheaval and macroeconomic instability that characterized the early transition period seem to have led international banks to reduce exposure on CEE countries: total claims on these countries held by banks reporting to the Bank for International Settlements consistently fell during 1990–93.69 Since 1994, however, new syndicated loan commitments to CEE countries have shown an upward trend, which was also reflected until 1996 in the share of CEE countries as a group in total new commitments to emerging markets. Hungary and the Czech Republic have been the main recipients of syndicated bank loans, followed at some distance by Poland, Smaller and less advanced transition economies like Croatia, Romania, the Slovak Republic, and Slovenia, however, have increasingly been approaching this market, some of them borrowing at very low spreads. Bulgaria returned to the market in 1994, after a two-year absence, but has not obtained any new commitments since then. Albania and the former Yugoslav republics other than Croatia and Slovenia remain excluded from this market.

Table 2.22.

Medium- and Long-Term Syndicated Bank Loan Commitments

(In millions of U.S. dollars, unless indicated otherwise)

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Source; IMF, Private Market Financing far Developing Countries.

On unenhanced loans.

The four Mediterranean countries have been very active in this market, enjoying a share over total commitments to emerging markets similar to, or higher than, CEE countries, despite their smaller number and combined GDP (see Table 2.22). New commitments to Turkey, by far the main beneficiary among these four countries, have remained strong despite the weakening of Turkey’s ratings 70 Turkey’s market share has declined in recent years, however, reflecting the simultaneous expansion in total commitments to emerging economies.

Consistent with the trends observed in other emerging markets, margins on loans to European emerging markets (including all the countries under analysis except Israel) gradually declined from an average of 162 basis points in 1993 to 93 basis points in 1997 (see Table 2.22). The National Bank of Hungary pushed spreads to an all-time low for the region in December 1996 with a 4.4-year loan for $350 million at a spread of 20 basis points over LIBOR. Other Hungarian borrowers have also enjoyed a substantial decline in their spreads, partly reflecting Hungary’s membership in the OECD, which has reduced capital adequacy requirements for international banks wishing to extend loans to Hungarian entities.71 Israel has also benefited from this narrowing of spreads, with two companies (Telecommunications Corp. and Israel Electricity Corp. Ltd) signing in the first quarter of 1997 seven-year loans at 30 basis points spreads.

Appendix III: Trends in Net FDI Inflows in Non-EU Countries

CEE Countries

Net FDI into the CEE countries, which was practically nonexistent at the beginning of the transition process, rose rapidly in the first half of the 1990s. Net FDI inflows into the 10 CEE countries included in Table 2.17 peaked at about S9 billion in 1995, supported by strong privatization-driven inflows in Hungary and the Czech Republic. Reflecting the slowdown of the privatization programs in these two countries, total FDI inflows into the region fell to $7.6 billion in 1996, but recovered partially in 1997 as inflows expanded significantly in most other countries (particularly in Poland, which has replaced Hungary as the region’s leading recipient of FDI in dollar terms),72 The evolution of the share of the 10 CEE countries in total FDI into developing and transition countries has largely mirrored that of inflows in dollar terms (Figure 2.5), At 6.7 percent in 1997, this share is somewhat above the share of these 10 CEE countries in the combined GDP of all developing and transition countries (5,6 percent).

Figure 2.5.
Figure 2.5.

Share of 10 CEE Countries in Total FDI Inflows Received by Developing and Transition Countries1

(In percent)

Sources: IMF, Balance of Payments Statistics yearbook 1997, and IMF staff reports, and World Bank, Global Development Finance 1998.1 Includes Albania, Bulgaria, Croatia, and Czech Republic. Hungary, the former Yugoslav Republic of Macedonia, Poland. Romania, the Slovak Republic, and Slovenia.

Despite the overall increase seen since 1990, net FDI inflows into CEE countries have been relatively small compared with those of other emerging regions and with the high initial expectations. For the region as a whole, net FDI was equivalent to 2.2 percent of GDP in 1996, compared with a ratio of 4.2 percent in the region of East Asia and Pacific. Only Hungary—which was one of the 10 major recipients of FDI among developing and transition countries during 1990–97—and the Czech Republic have attracted FDI inflows that were relatively high both in absolute terms and as a percentage of GDP. Poland, by far the largest country in the region, has also received substantial FDI inflows in absolute terms, although until 1995 these inflows remained very low as a percentage of Poland’s GDP. As shown in Figure 2.6, net FDI into the region has been highly concentrated in Hungary, the Czech Republic, and Poland, which together account for about 84 percent of the total net FDI inflows received by the 10 CEE countries in 1992–97.73

Figure 2.6.
Figure 2.6.

Country Shares in Total Net FDI Inflows Received by 10 CEE Countries Between 1992 and 1997

Table 2.17 indicates that EU countries play a predominant role in FDI inflows into CEE countries, accounting, depending on the country, for 50–85 percent of the stock of FDI. Germany is the leading investor country in the region. Other important investor partners from the EU are Austria, Italy, France, and the Netherlands, all of which are also prospective EMU countries,74 The United States is the second main provider of FDI flows, playing a particularly important role in Poland.75 Japanese companies, by contrast, continue to show only a moderate interest in the region.

Selected Mediterranean Countries

With the exception of Malta, net FDI inflows into the selected Mediterranean countries have been relatively small as a percentage of GDP in recent years (see Table 2.18). In contrast with the trend seen in other emerging economies, FDI stagnated or declined in all of them in the early 1990s. Since 1994, however, Malta and Israel have seen a significant acceleration of FDI inflows, in the context of the more general surge in capital inflows experienced by these two countries. Much of the strong FDI inflow recorded by Malta in recent years reflects reinvested earnings by foreign companies based in Malta (particularly in the electronics sector), and loans between foreign parent companies and their Malta-based subsidiaries. In Israel, inward FDI remained very small during much of the first half of the 1990s and was consistently exceeded by outward FDI. However, supported by the liberalization of controls on inward FDI. the privatization of some major banks and enterprises, and the improved outlook initially brought about by the Middle East peace process, net FDI into Israel turned positive in 1995 and has steadily increased since then, reaching 2.7 percent of GDP in 1997.

In Cyprus. FDI peaked at about 4 percent of GDP in the late 1970s, reflecting reconstruction and tourist resort development (see Figure 2.7). Since then, it has shown a downward trend. With the exception of 1996, net inflows have been on the order of only 1 percent of GDP in recent years, partly because of regulatory restrictions. Finally, in Turkey net FDI inflows have stagnated at half a percentage point of GDP or less during the 1990s, a very low-level considering Turkey’s large domestic market, strong growth, and advantageous geographical position vis-à-vis the EU, Middle East, and former Soviet Union countries.

Figure 2.7.
Figure 2.7.

Net Foreign Direct Investment into Cyprus

(In percent of GDP)

Source: IMF, international Financial Statistics.

A breakdown of FDI inflows by investor country is available only for Malta and Turkey. In both cases, EU countries play a predominant role (see Table 2.18). The EU is also thought to account for a large share of FDI inflows into Cyprus, In Israel, by contrast, the United States seems to be by far the leading investor country, with FDI from the EU accounting for a much lower, though probably sizable, share of total inflows.

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1

The transition economies covered in this paper are Albania, Bosnia-Herzegovina. Bulgaria, Croatia, the Czech Republic. Hungary, the former Yugoslav Republic of Macedonia, Poland. Romania, the Slovak Republic. Slovenia, and the Federal Republic of Yugoslavia. The Mediterranean countries are Cyprus. Israel, Malta, and Turkey.

2

The liberalization of trade arrangement with these countries entailed exceptions and was part of a phased process meant to advance over time. It included Trade and Cooperation Agreements that entered into force, depending on the particular country, in 1988–93; interim Europe Agreements that replaced the Trade and Cooperation Agreements and entered into force in 1992–97; and Europe Agreements that entered into force in 1994–95. The interim Europe Agreements implied the abolition from their date of entry into force of tariffs and quantitative restrictions on about 50 percent of the value of all industrial products from CEE countries, with further liberalization to be implemented in later years. These interim agreements for six countries (Bulgaria, the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic) entered into force comparatively early (in 1992 and 1993). Imports from them accounted for almost 85 percent of all EU-15 imports from CEE countries, based on data for 1996. Temprano-Arroyo and Feldman (1998) provide further details on trade arrangements between the CEE countries and the EU. Detailed discussions of trade liberalization efforts by the EU also appear in European Commission (1994b). Graziani (1994). Faini and Portes (1995), Havlik (1996), Kaminski and others (1996). and OECD (1997).

3

A summary of these studies is provided in Appendix I. In the 1980s, CMEA comprised Bulgaria. Cuba, Czechoslovakia, East Germany, Hungary. Mongolia, Poland, Romania. Vietnam, and the U.S.S.R. Yugoslavia was an associate member.

5

Based on United Nations series D trade data. The time periods were 1985–94 for Hungary, 1985–93 for Poland, and 1989–90 and 1994 for Czechoslovakia. By 1996, these three countries accounted for slightly more than 70 percent of EU-15 imports from CEE countries. Romania, for which data ran from 1989 to 1994, experienced a sharp decline in exports of mineral fuels to the EU, while “miscellaneous manufactures” was the only Romanian one-digit manufacturing industry that experienced meaningful growth in its exports to the EU. according to the authors. Data for Bulgaria were not included in the United Nations’ data set. The composition of exports to the EU remained relatively stable for Czechoslovakia, whereas Hungary. Poland, and Romania experienced substantial changes in their export composition.

6

The countries covered were Czechoslovakia. Hungary, and Poland. Data, which ran up to 1991, were from Eurostat Volimex. Halpern found more modest changes in the composition of exports to the EU, based on earlier data, than Sheets and Boata.

7

A related issue is whether further shifts in the composition or trade can be expected to the extent that the observed patterns of trade do not correspond to comparative advantage. Sheets and Boata (1996) argued that current exports reflected underlying comparative advantage for Czechoslovakia and Poland in particular because these exports originated increasingly from new industries. The earlier studies by Graziani (1994) and Halpern (1995), which also used less recent data, argued that revealed comparative advantage was misleading because it still reflected old non-market-determined production structures. They both pointed to more labor- and skill-intensive production as the true but underutilized comparative advantage of CEE countries.

8

Note that these are first-round effects. Higher export growth in CEE countries would raise their income and in that way conceivably also raise exports and trade within the CEE countries.

9

Indeed, concerns about similar “trade-diversion” effects stemming from the EU’s single market program and the potential threat they represented to European Free Trade Association (EFTA) firms served to raise the interest of EFTA countries in participating in the European Economic Area (EEA) established in 1993. The EEA was meant to counter this threat by giving single market status to EFTA-based firms. Eventually, however, some countries apparently concluded that EU membership was the best way to reduce the single market threat to EFTA industry, a decision that may have included implicit assumptions about the ultimate viability of the EEA. See Baldwin and Flam (1994).

10

Work by Helpman and Krugman (1985) suggested that countries with relatively similar per capita income tend to have a high proportion of intra-industry trade. If future incomes rise significantly in the CEE countries in the face of increases in the quality and price of their goods to EU levels, intra-industry trade between these regions could expand strongly, especially for those countries joining the EU. This factor would tend to raise the share in EU imports of goods produced by the CEE countries but would be a longer-term phenomenon. See Fischer and others (1998) for estimates of how long it could take for income levels in the CEE countries to catch up to those in the low-income EU countries.

11

One estimate of the elasticity of export volume with respect to the real effective exchange rate (in terms of unit labor costs) for Poland is 0.36 (see IMF (1997f)). Recall that Graziani (1994) reported that the structure of CEE exports was similar to that of Portugal. The elasticity of exports of goods and services with respect to the real effective exchange rate for that country was estimated in the neighborhood of one half by Mello and Manteu (1992). For Croatia, Mervar (1993) estimated an elasticity of exports with respect to the real effective exchange rate of 0.41. From a gravity model formulation, Havrylyshyn and Al-Alrash (1997) reported preliminary pooled cross-section/time series regression results for 1995 and 1996, in which they regressed the share of exports to the EU in total exports from various transition economies on an index of structural reforms, distance to the middle of Europe (Frankfurt), and the real effective exchange rate. The sample comprised 17 countries, including Bulgaria, the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic, as well as the Baltics, Russia, and other former Soviet Union countries. In log-linear form, the coefficient on the real effective exchange rate was statistically significant and equal to 0.12, suggesting, subject to several caveats, that differences in these exchange rates contributed to faster exports to the EU. In another regression using exports to nontransition countries as the dependent variable, the coefficient on the real effective exchange rate was also statistically significant and equal to 0.21.

12

Adding the United Kingdom and Greece to the EU more than doubles the effect on Cypriot exports. The resulting 0.8 percent increase in exports, however, still accounts for only about 0.1 percent of GDP.

13

See IMF (1997c: pp. 75–77 and Annex II).

14

These two scenarios, like all the discussion in this chapter, assume that Stage III of EMU—that is. the irrevocable fixing of exchange rates and adoption of a common monetary policy by participating EU countries—is launched on January 1, 1999, as confirmed by the EU summit of Brussels in May 1998.

15

There are also factors that could act in the opposite direction, for example the potential negative impact of the current difficulties in emerging economies on trade and economic performance in western Europe.

16

See, for example, Baldwin (1991 and 1992).

17

Being European is particularly relevant in this context since institutional investors often follow regional risk-diversification rules and some mutual funds are region-specific.

18

The only OECD countries where inflation and interest rates still significantly exceed the average seen in the other OECD members are the Czech Republic, Greece, Hungary, Poland, and Turkey. These five countries offer the only higher yield/higher risk investment options that remain open to those institutional investors that are legally constrained to investing in OECD assets.

19

There is some evidence that exchange rate stability and economic integration tend to increase the correlation of securities prices across countries. See Bodarl and Reding (1996) and Frankel (1996).

22

The Pension Funds Directive proposed by the Commission would liberalize the supply of pension services across EU countries. It foresees the elimination of currency-matching requirements not justified on prudential grounds, and of requirements to localize assets in individual EU countries. This directive has not been adopted, but the European Commission is attempting to achieve similar objectives through the EU’s 1988 directive on capital movements. See OECD (1996b).

25

One important reason for this is that EMU will eliminate the competitive advantage for home-country lead-managers in the underwriting of local-currency-denominated issues or loans. See McCauley and White (1997) for further discussion.

26

BoxBox 2.1 reviews empirical tests of capital mobility previously performed for the selected Mediterranean countries.

27

Capital account transactions in EU countries have been fully liberalized vis-à-vis all countries.

28

This must generally be seen, on the one hand, as a response to the wish of residents to hedge against high inflation, which had resulted in a significant rate of “dollarization” during the late years of the socialist regimes, and, on the other, as an attempt to induce residents to deposit their foreign exchange holdings in the domestic banking system.

29

See OECD (1993) for a description of exchange control policies in CEE countries in the first years of transition.

30

OECD membership requires the acceptance of the obligations under the OECD Code of Liberalization of Capital Movements. See Ley and Poret (1997) for a description of the liberalization commitments undertaken by the Czech Republic. Hungary, and Poland in the context of their integration into the OECD.

31

It should be noted that even these three countries continue to impose relatively tight controls on purchases of real estate by nonresidents.

32

Under these clauses, OECD member countries may not introduce additional restrictions (except under specific conditions), must apply any remaining controls without discrimination among OECD countries, and must notify the OECD of existing restrictions and submit themselves to a peer-review process that aims at progressively removing the remaining restrictions over time. See Ley and Poret (1997).

33

The acquis communautaire—that is, the EU’s institutional and legal provisions—in the area of capital movements is further discussed in Temprano-Arroyo and Feldman (1998).

34

In 1996, the rules on portfolio flows were eased. In particular, the limits on nonresidents’ total participation in the share capital of companies admitted to Cyprus’ stock exchange were increased, and investment companies listed on Cyprus’stock exchange were allowed to invest in stock exchanges abroad up to 20 percent of their portfolio. In 1997, administrative procedures for inward FD1 were simplified and foreign participation of up to 100 percent was allowed in most industrial and service sectors. The criteria applied by the central bank to authorize outward FD1 have also been eased.

35

The surge in private capital inflows and the simultaneous decline in the role of official inflows experienced by CEE countries in recent years are analyzed in Calvo, Sahay, and Vegh (1998), IMF (1997b and 1997c), and Temprano-Arroyo (1996).

36

Table 2.10 also shows large net capital inflows in 1996–97 for Albania, the former Yugoslav Republic of Macedonia, and Romania, but this partly reflects large errors and omissions items, part of which may not reflect capital inflows but unrecorded current transactions.

37

Among the emerging market borrowers rated by Moody’s and Standard & Poor’s, fewer than 15 countries have an A level rating.

38

Turkey was downgraded three times by Standard & Poor’s and twice by Moody’s in 1994 alone, reflecting the exchange rate and financial crisis of that year.

39

These ratings are partially (Euromoney) or totally (The Institutional Investor) based on polls of country-risk analysts at major international banks and other institutions. As such, they can be used as indicators of the markets’ perception of the countries’ creditworthiness. One advantage over the ratings assigned by major agencies is that they are available for a very large number of countries and not only for those that are actively tapping the international capital markets.

40

The crisis and breakup of Yugoslavia resulted in a sharp deterioration in the country’s rating and in those of its successor republics from a quite favorable position before the war.

41

Slovenia’s rating posted a spectacular recovery soon after the end of the 1991 war of independence. Croatia’s successful stabilization program of 1993 allowed it to regain creditworthiness despite the resumption of the war in 1995. The improvement in the Croatian, Polish, and Slovenian ratings was facilitated by the normalization of relations with commercial creditors.

42

Albania’s rating even deteriorated significantly in 1997 in the wake of the violent political events of dial year.

43

In the fourth quarter of 1997, secondary market spreads on international bonds issued by the countries under analysis increased considerably (rather markedly in some cases), and only a few of them issued bonds or equity. Nevertheless, these countries seemed to fare relatively well as a group in terms of market access in the immediate aftermath of the East Asian crisis. Partly reflecting a couple of big issues by Hungary and Turkey, total funds raised by the CEE countries and the selected Mediterranean countries in the international capital markets increased moderately as a percentage of their combined GDP in the fourth quarter of 1997 (relative to the first three quarters of the year).

44

In 1996, Hungary and Poland showed, respectively, the third and fifth largest price gains of all the developed and emerging stock markets, as measured by the internationally comparable IFC Global indices. Turkey and the Czech Republic were eighth and fifteenth, respectively. While the stock market indices of most of the countries under analysis were negatively affected in the fourth quarter of 1997 by the East Asian crisis and the October turmoil in world equity markets. Hungary and Turkey were the two emerging stock markets with the best recorded price performance, being in fact the only two emerging markets to record gains in that quarter. In 1997 as a whole, the Hungarian and Turkish markets showed, respectively, the fourth and ninth best price performance in the world. See IFC (1998).

45

See World Bank (1997b, pp. 101–105). Market reports suggest that foreign investors may account for about 25 percent of the average daily turnover of the Warsaw Stock Exchange and for about 20 percent of its market capitalization.

46

By comparison, the correlations of the Istanbul and Prague markets with industrial countries’ indices arc relatively low, though in line with those seen on average in other emerging stock markets.

47

For a description of the main features of the TARGET system, see IMF (l997e: pp. 170–74).

48

Baldwin 1991 and 1992) discusses the positive static and dynamic effects EMU may have on growth in the euro area.

49

On the effects of economic integration within the EU on FD1 flows between the EU and third countries, see Yannopoulos (1992) and Dunning (1991).

50

See Lankes and Venables (1996), who present the results of a survey conducted by the EBRD in early 1995. as well as an overview of the results of previous surveys.

52

See Cyprus. Central Bank (1997).

53

IMF (1997a).

55

For example, any possible impact of EMU on FDI flows between the EU and Cyprus is likely to be dwarfed by the effects from the country’s lifting of restrictions on FDI inflows in preparation for its membership in the EU.

56

In the case of short-term debt, a country could in principle refinance its euro-denominated debt in a different currency following an increase in euro interest rates. However, the extent to which it will wish to do so will depend on its expectations on the exchange rate of the euro and on the country’s targeted currency composition of debt. Such considerations imply that the share of euro-denominated short-term debt would often be adjusted only partially to a change in euro interest rates, rendering this simplifying assumption more realistic than might first appear. See Claessens (1992) for a discussion of the optimal choice of the currency composition of external debt.

57

The term (D/GDPVIX/GDP) boils down to the debt-to-exports ratio. These three ratios are shown as memorandum items in Table 2.18.

58

saSincc Malta’s and Slovenia’s shares of fixed-rate long-term debt are very low, the increases in debt service in subsequent years related to the progressive maturing of this debt arc relatively less important (when expressed in terms of the stock of debt). Furthermore, these subsequent increases in foreign debt service have a relatively small impact on these countries’ DSR by virtue of their favorable debt-to-CDP and exports-to-GDP ratios.

59

For a discussion of the possible effects of EMU on the exchange rate of the euro, sec Masson. Krueger, and Turtelboom (1997).

60

Data on the currency composition of foreign debt was not available for Cyprus and Bosnia-Herzegovina, but debt denominated in EMU currencies is believed to represent less than 20 percent of Cyprus’s debt. Since most of Bosnia-Herzegovina’s debt was inherited from the Yugoslav federation, and since the other former Yugoslav republics all have rather low shares of their debt denominated in EMU currencies, it seems reasonable to assume a low weight of such currencies in the debt of Bosnia-Herzegovina.

61

The Czech crown had remained stable against a deutsche-mark-dominated basket of currencies ever since its federal predecessor, the Czechoslovak crown, was devalued in 1990–91. at the start of transition. The fluctuation band was, however, widened from ±0.5 to ±7.5 percent in February 1996.

62

The Bulgarian government maintains a “fiscal reserve account” at the central bank, which it uses to service its foreign debt obligations. Its management of exchange risk exposure is largely limited to trying to match the currency composition of this account with the debt-service obligations falling due in the short term.

63

Admittedly, this weight is relatively high compared with Israel’s almost nonexistent debt in EMU currencies, but it still implies a rather mild link of the shekel to the euro, which is unlikely 10 create any significant debt-service problems, particularly given Israel’s moderate DSR.

64

Hungary and Turkey are among the 15 emerging economics that have issued the largest volumes of international bonds during the 1990s. Other countries in this group include Argentina. Brazil, China, Mexico, and the advanced economies of East Asia.

65

This included the issuance of Eastern Europe’s first convertible bond by Stalexport. a private oil and gas company.

66

Croatia was even able to issue domestic-currency-denominated Eurobonds in December 1996.

67

As the East Asian financial turmoil intensified in the last quarter of 1997. secondary market spreads on international bonds issued by the countries under analysis increased significantly. The increased uncertainties and price volatility deterred both investors and borrowers, and some planned issues were postponed. Nevertheless, in the fourth quarter of 1997, Turkey successfully placed a jumbo (DM 1.5 billion) 10-year issue in the deutsche mark sector and Poland and Israel were also able to step up their issuance of international bonds.

68

In particular, the $785 million ADR issue from Matav was rather well placed despite extremely turbulent market conditions and a fall of 20 percent in the Budapest Stock Exchange three days prior to launch.

70

Commitments to Turkey accelerated in the final months of 1997 despite the East Asian crisis, reaching $1.3 billion.

71

For example, in the second quarter of 1997, the Hungarian oil and gas company MOL refinanced a five-year $500 million loan at a 35 basis points spread.

72

For a further analysis of FDI inflows in transition countries, see IMF (1997b, Chapter V). Stern (1996), and Sehmidu 1996).

73

Hungary and the Czech Republic alone attracted about 60 percent of total inflows.

75

this helps explain why the share of the EU in FDI inflows is smaller in Poland than in the other CEE countries.

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Cover Impact of EMU on Selected Non-European Union Countries
Impact of EMU on Selected Non-European Union Countries
ISBN:
9781557757784
ISSN:
0251-6365
Publication Date:
11 Feb 1999
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557757784.084
Pages:
98
  • Figure 2.1.
    View in gallery
    Figure 2.1.

    EU’s Share of CEE Countries’ Trade1

  • Figure 2.2.
    View in gallery
    Figure 2.2.

    Long-Term Interest Rate Differentials vis-á-vis Germany1

    (in percentage points)

  • Figure 2.3.
    View in gallery
    Figure 2.3.

    Stock Market Indices in Selected CEE Countries1

    (January 1995 = 1OO)

  • Figure 2.4.
    View in gallery
    Figure 2.4.

    Stock Market Indices in Selected Mediterranean Countries1

    (January 1995 = 100)

  • Figure 2.5.
    View in gallery
    Figure 2.5.

    Share of 10 CEE Countries in Total FDI Inflows Received by Developing and Transition Countries1

    (In percent)

  • Figure 2.6.
    View in gallery
    Figure 2.6.

    Country Shares in Total Net FDI Inflows Received by 10 CEE Countries Between 1992 and 1997

  • Figure 2.7.
    View in gallery
    Figure 2.7.

    Net Foreign Direct Investment into Cyprus

    (In percent of GDP)

Figure 2.1.

EU’s Share of CEE Countries’ Trade1
Figure 2.2.

Long-Term Interest Rate Differentials vis-á-vis Germany1

(in percentage points)
Figure 2.3.

Stock Market Indices in Selected CEE Countries1

(January 1995 = 1OO)
Figure 2.4.

Stock Market Indices in Selected Mediterranean Countries1

(January 1995 = 100)
Figure 2.5.

Share of 10 CEE Countries in Total FDI Inflows Received by Developing and Transition Countries1

(In percent)
Figure 2.6.

Country Shares in Total Net FDI Inflows Received by 10 CEE Countries Between 1992 and 1997
Figure 2.7.

Net Foreign Direct Investment into Cyprus

(In percent of GDP)