Euro Adoption in Central and Eastern Europe

5 Real Convergence, Capital Flows, and Monetary Policy: Notes on the European Transition Countries

Susan Schadler
Published Date:
April 2005
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Leslie Lipschitz and Timothy Lane  and Alex Mourmouras*

Capital inflows have been a fact of life for a number of European transition countries over the past several years. These inflows are sometimes viewed as a vote of confidence in these economies’ transformations into vibrant market economies and their convergence to Western Europe. At the same time, large capital flows may render the economies more vulnerable to external influences and may complicate monetary and exchange rate policy.

This paper analyzes the potential dilemmas capital flows may create for monetary and exchange rate policies in the more advanced transition countries of Central and Eastern Europe (CEE). It starts from some very simple fundamentals: a stylized characterization of the evolution of the process of production, and basic arbitrage conditions in financial markets.1 It argues that there are real mechanisms, intrinsic to the process of convergence between the CEE countries and Western Europe, that may lead to large and erratic capital flows with the potential to overwhelm the authorities’ stabilization objectives.

The paper points to a number of factors that have a critical bearing on the analysis of stabilization policy: the level and rate of convergence of capital/labor ratios and of institutions and technology relevant for production, the equilibrium real exchange rate path, and volatility in the pricing of risk. While there are no surefire policy solutions to the problems described, the paper presents a set of policy desiderata that will help render the problems more manageable.

Real Convergence

In conventional economic theory, in the presence of free trade and factor mobility, convergence of per capita output usually requires convergence in technology, institutions, and capital/labor ratios, with capital construed broadly to include human capital. Suppose output in both Western Europe and the CEE countries is produced by a single sector, with the same Cobb-Douglas production function: output per worker (y) is a function of capital per worker (k),yi=Akia. The marginal product of capital is ri=Aαki(1α).

This simple equation is the basis of the usual growth accounting exercise. While the main focus of neoclassical growth theory was initially on factor accumulation, there is now a great deal of evidence that what is important for development—or convergence—is the A term: total factor productivity, a portmanteau that incorporates the whole configuration of technology and institutions. Clearly, given the same value for the A term, the marginal product of capital would be greater in the countries with lower capital/labor ratios, and there would naturally be large capital flows to these countries. Indeed, following Lucas (1990), it is not clear why there would be any investment in the more advanced, capital-abundant countries. But lower levels of technology and institutions—a less advantageous environment for the employment of capital—would reduce returns and militate against such flows.2

The case of EU accession countries is interesting in that, in general, education levels are high but physical capital is scarce. Moreover, it is envisaged that, with the adoption of various EU directives, there will be a very rapid diffusion of institutional arrangements—besides the basics (e.g., strong judicial systems with laws that protect private property, effective governance that limits corruption and discourages other aspects of rent-seeking behavior) there will be similar rules governing the financial sectors, trade, competition policy, and the like. Thus the A terms in the production functions—which incorporate the most important elements in the convergence process—should move relatively quickly to something like Western European levels.

It is, therefore, interesting and not entirely idle to speculate on differences in the marginal products of capital between Western Europe and the CEE transition countries in the limiting case of identical institutions and technologies—that is, identical A terms. It is also interesting to speculate on the potential capital inflows.

Table 1 shows the marginal product of capital in each of the CEE countries derived on the basis of data from 2002 and a value of ⅓ for the α parameter, taking Germany as a reference point. The case of identical A terms is shown in the first column, with alternative cases of less-than-identical “technology” in the other columns. The results for the identical-A-term cases are quite dramatic: the marginal product in the transition economies is between 1.7 and 31.0 times the marginal product of capital in Germany. But even in the cases where the A terms differ—the second, third, and fourth columns of Table 1—in most cases the marginal product of capital is appreciably above that in Germany. If this simple model were true and world capital markets were free and complete, these differences in marginal returns on capital would induce massive flows of investment goods from Germany and other capital-abundant countries to the transition economies of the CEE countries.

Table 1.Central and Eastern European Countries: Marginal Product of Capital Relative to Germany
MPKi/MPKger1 on the Assumption That
AI =AGAI = 0.9AGAI = 0.8AGAI = 0.7AG
Czech Republic5.
Slovak Republic7.
Note: Calculations based on data for 2002 and Cobb-Douglas production functions yI = Aikα, with α = ⅓. See Lipschitz, Lane, and Mourmouras (2002) for a discussion of the calculations.

Historically, however, the CEE countries received limited inflows in the early years of the transition despite their sizable gaps in per capita incomes and physical capital. The largest inflows initially went to Hungary, Estonia, and, to a lesser extent, Latvia. Annual foreign direct investment (FDI) inflows to these countries in 1989—92 averaged about 3 percent of gross domestic product (GDP), compared with less than one-half of 1 percent of GDP elsewhere in the CEE countries. This poses a challenge for the frictionless neoclassical model: Why were capital flows to the CEE countries so limited?

Institutional weaknesses are the leading explanation of the Lucas paradox—that is, the tendency for capital not to flow from rich to poor countries.3 The CEE countries’ experience appears to be consistent with this explanation. Available indicators point to the presence of sizable institutional gaps between the CEE countries and the countries of Western Europe in the early years of the transition. The overall International Country Risk Guide (ICRG) scores of CEE countries in 1989 were between 44 and 82 percent of those in West Germany.4 The purely institutional components of the ICRG index reveal an even starker picture. The average CEE score for four ICRG indicators that have a direct bearing on institutional quality (law and order, corruption in government, bureaucracy quality, and investment profile) ranged from 28 to 75 percent of West German scores in 1989 (Table 2).

Table 2.Central and Eastern European Countries: The ICRG-4 Relative Index of Institutional Quality
Czech Republic0.680.900.760.850.86
Slovak Republic0.680.830.760.840.81
Source: International Country Risk Guide (2003).Note: Ratio of the sum of four ICRG indicators (investment profile, corruption in government, law and order, and bureaucracy quality) to the sum of the same indicators for Germany. Investment profile is in the range 0–12; corruption in government 0—4; law and order, and bureaucracy quality, 0–6; higher values indicate better institutions. Pre-1990 figures for Germany refer to those of West Germany. Pre-1992 figures for the Czech and Slovak republics refer to those of Czechoslovakia. ICRG = International Country Risk Guide.

Similar results—that is, substantial institutional gaps—are evident in the transition index of the European Bank for Reconstruction and Development (EBRD): in 1990, the indices for the CEE countries indicate institutional standards between one-fourth and one-half of those in industrial countries.5

CEE institutions improved significantly, and capital inflows increased, once the CEE countries overcame the turbulence of early transition. As is clear from Table 2, by the late 1990s microeconomic and structural reforms had narrowed institutional gaps considerably. In the period 1997—2002 CEE ICRG-4 scores rose to between 69 and 97 percent of German levels. At the same time, median annual FDI inflows increased markedly—to 3.2 percent of GDP annually in the period 1997—2002.

Institutional development is especially impressive in several early EU accession countries. Various factors may account for their relatively accelerated progress: favorable initial conditions (e.g., shorter distances to Western Europe and a history—and some residual memory—of market institutions), strong and early domestic ownership of reforms, a drive to harmonize laws and procedures with those of the EU, and external pressures (including IMF policy advice and financial assistance).6

Differences in institutional quality and income per capita have a direct bearing on relative marginal products of capital and the size of potential capital inflows. The size of potential inflows—that is, those that would occur under frictionless full capital mobility—can be assessed using estimates of CEE countries’ technological development (the relative A terms) and their capital-labor ratios. In deriving these results, we use the relative ICRG-4 indices as proxies for the relative A terms; this use of the indices is, of course, somewhat heroic, though it would seem consistent with the findings of Grogan and Moers (2001). In any event, based on this measure, the level of technology and institutional quality in the CEE countries was between 69 and 97 percent of German levels during 1997–2002. CEE capital intensities can then be backed out of World Economic Outlook (WEO) data on purchasing power parity (PPP) income per worker.

The relative marginal products of capital (with the subscript i denoting the particular CEE country and the subscript G denoting Germany) are then given by

and potential (frictionless) interest rate-equalizing inflows, in relation to preflow annual GDPs, are given by

All of this assumes that per capita income differentials are attributable to only two factors: a technological-institutional gap, and a shortage of capital. Thus, for a given income gap, the relative marginal product of capital is higher and the potential inflow is larger when the technological-institutional gap is smaller. Conversely, given the technological-institutional deficit, inflows rise when the income gap is larger. Taken together, these figures suggest a median potential inflow of 370 percent of GDP in 1997–2002 (Table 3). These large potential inflows are made possible by the convergence of CEE institutions and technology to Western levels.

Table 3.Central and Eastern European Countries: Potential Capital Inflows, 1997–2002
Czech Republic0.863.3265
Slovak Republic0.813.8294
Source: Authors’ calculations based on WEO data on income per worker (in PPP terms) and data on institutions from the ICRG-4 index for 1997–2002.

Table 3 also raises an interesting question about the equilibrium real rate of interest in the CEE countries. If one equates the equilibrium real rate of interest with the marginal product of capital and assumes a real rate of interest of 2½ percent in Germany, then the equilibrium (notional closed-economy) real rate of interest in the CEE countries varies from 3¼ to 30¾ percent with a median value of 13½ percent. At rates of interest below these notional equilibrium rates, there will be an incentive to borrow and invest; therefore, there will be very rapid capital accumulation. The difference between this investment and domestic saving will entail large current account deficits and a significant accumulation of external obligations—not necessarily a problem, but certainly a development that will increase vulnerability to global capital market events.

Open Economy Influences: Trend Appreciation and Interest Arbitrage

Having established the real (production) side of the analysis that equilibrium real interest rates in the CEE countries will be relatively high, we should revisit the issue of interest rates from the point of view of financial arbitrage.

Table 4 shows cumulated real GDP growth for the first decade of the transition (1992–2002). GDP growth measured in conventional real terms is relatively modest, but GDP measured in terms of the deutsche mark is very high, reflecting a very large real appreciation vis-à-vis the deutsche mark (RER). While the trend rate of appreciation slowed down in the latter half of the period, it remained considerable.

Table 4.Real GDP and Real Exchange Rates: 10 CEE Countries(In cumulative percentage change)
Source: IMF, World Economic Outlook database.Note: The 10 CEE countries are Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia.

One may interpret these real appreciations in a variety of ways: slow adjustment to an undervalued currency at the start of the transition, conventional Balassa-Samuelson effects based on intersectoral differences in the evolution of total factor productivity, rapid capital accumulation and labor productivity growth in the wage-setting traded-goods sectors, or a simple unsustainable monetary phenomenon.7 The critical point is that insofar as these real appreciations are seen as part of a longer-term equilibrating process (that is, not as being due simply to unsustainable monetary factors), they will influence interest arbitrage and thus the relationships between exchange rates and relative interest rates.

Uncovered interest parity requires arbitrage to move real interest rates in the transition country toward the real interest rate in Germany minus the expected real appreciation of the transition currency. The parity real interest rates calculated in column four of Table 5 reflect an assumption that the trend real appreciations of recent history will continue.8

Table 5.Actual and Parity Real Interest Rates for Selected European Transition Countries, December 1999
CountriesActual Real

Interest Rate1
Real Currency

Parity Real

Interest Rate3
Czech Republic−2.04.9−2.6
Slovak Republic7.44.4−2.1
Sources: IMF, International Financial Statistics and staff calculations.

These results indicate that, under the assumptions made, unfettered capital mobility—with full portfolio substitutability between domestic and foreign securities—would imply real interest rates well in negative territory. With a couple of exceptions, these calculations indicate substantial gaps between actual and parity interest rates that, other things being equal, create a strong incentive to import capital into these countries. In practice, of course, there are many hindrances to capital inflows—institutional and regulatory hurdles on the one hand and risk premiums on the other. But nevertheless, the interest parity mechanisms discussed here have frequently acted as a serious constraint on monetary policy in the CEE countries—that is, central banks have been sharply aware that attempts to raise interest rates above a certain level could elicit capital inflows capable of undermining the intended restraint. The issue of the pricing of risk is critical to resolving these difficulties in the formulation of monetary policy and is discussed further below.

A Dilemma for Policy

The analysis of the “Real Convergence” and “Open Economy Influences” sections sets up a dilemma for monetary policy. In a fixed exchange rate regime, the interest arbitrage conditions (of Table 5) suggest that if the central bank in the transition country attempts to set interest rates, ex ante, high enough to reflect the real capital scarcity in the country (as reflected in Table 3), there will be large arbitraging capital inflows that will elicit a huge accumulation of international reserves. The monetary authorities may try to sterilize the monetary impact, but such sterilization will be very costly and ultimately unsuccessful. In any event, the capital inflow will almost certainly eventually mean a correspondingly large current account deficit. On the other hand, a strategy of keeping interest rates low enough to forestall such arbitraging inflows—the parity rates of Table 5—would set real interest rates far below the marginal product of capital. This would elicit investment flows well above domestic savings and could be maintained only temporarily and through massive domestic credit expansion. Here too, the result will be some combination of inflation, real appreciation, and large current account deficits.

Much the same result occurs, through other channels, under a flexible rate regime: the capital flows will force an appreciation of the exchange rate that generates an equal current account deficit.

The dilemma is attenuated, of course, to the extent that there are disincentives or impediments that contain the pace of capital flows; we have alluded to various such factors. It is clear, moreover, from Table 5 that actual arbitrage flows have been insufficient to eliminate real interest rate differentials. For the analytic purposes of this paper, it is most useful to consider one particular influence on arbitrage flows: the existence of risk premiums.

The dilemma characterized above may be solved by the way the market prices risk. Consider a simple case where the market sets risk premiums as a smooth, increasing function of the current account deficit. In this case every country, no matter how small relative to global capital markets, would face an upward-sloping supply of funds. As capital flowed in and the current account deficit increased, risk premiums would rise; this would permit some increase in domestic interest rates above those abroad. Eventually, at some equilibrium level of the current account deficit, the risk premium on the currency would be large enough to allow the authorities to set domestic interest rates at a level that would equilibrate saving (plus the resource transfer from abroad) with investment. If risk were priced in this way, the transition countries would be able to pursue real convergence—that is, convergence of capital/labor ratios and productivity levels—with optimal assistance from global capital markets.

In the real world, risk premiums will be determined by a broad array of variables—domestic economic, financial, and political developments; exogenous global capital market conditions; and, perhaps, seemingly erratic bandwagon effects, contagion, and the like—and are unlikely to be so well-behaved and benign. There are numerous cases of shifts in the pricing of risk that lead to sudden stops or reversals of capital inflows. After a capital account reversal, it takes time and a painful compression of demand to effect current account adjustment. The different pace of adjustment between the current account and the capital account, moreover, usually entails a costly overshooting. Thus, large capital inflows, even when they reflect equilibrating real forces, may be of considerable concern; they represent a serious challenge for economic policy and often result in a significant buildup of vulnerabilities.9

Conclusions and Policy Implications

The conclusions of the analysis thus far are threefold:

  • Real economic forces—related to the conditions of production and the equilibrium path of the real exchange rate—limit monetary independence in the CEE countries and make these countries highly sensitive to conditions in external capital markets.

  • The choice of exchange rate regime will not solve this problem, because it is a real not a nominal phenomenon. (However, we will argue below that the exchange rate regime will have significant ancillary implications.)

  • In certain circumstances, risk premiums can provide some protection against overwhelming influences from external capital markets. But, insofar as they are determined by external developments and contagion, they can subject the CEE economies to large and erratic shocks.

A fundamental point is this: the CEE countries are likely (i) to see sizable capital inflows and (ii) to be buffeted by shifts in capital market conditions whatever transitional exchange arrangements are in place. The notion of flexible exchange rates and monetary independence buffering these influences may be largely illusory. On the other hand, as argued below, implicit exchange rate guarantees or “lines in the sand” drawn by the monetary authorities may exacerbate discontinuities in the pricing of risk.

Small shifts in global portfolios can have profound implications for CEE economies, because the capital markets are very large relative to their GDPs.10 While there are no simple policy solutions to these problems, there are policy choices that will reduce vulnerabilities. These policy responses are of two types: managing capital inflows, or learning to live with them.

With regard to managing capital inflows, capital account liberalization should proceed with care. The long side of the market should be opened up before the short—that is, FDI before short-term debt and portfolio flows. To the extent that erratic changes in risk premiums can be construed as a market failure, there is an intellectual case to be made for retaining some capital controls.11 In practice, the case for capital controls may be less compelling, especially for the CEE countries. It is difficult to reintroduce capital controls after an initial liberalization, particularly for countries with very open current accounts. Moreover, it is generally hard to make controls stick, even in more amenable circumstances; controls that can be circumvented produce a variety of distortions and a culture of evasion. Therefore, over the longer term, controls may well both distort allocation and reduce the volume of beneficial inflows.

Exchange rate policy is important in influencing capital inflows, not because it can resolve the basic dilemma for monetary policy described above, but because it can exert a profound influence on market perceptions and behavior. For the accession countries, monetary and exchange rate policies during the interregnum between joining the EU and adopting the euro will be particularly difficult to formulate and will depend enormously on the real factors discussed above (including the equilibrium rate of real appreciation and various structural characteristics) as well as other factors, such as the credibility of the central rate vis-à-vis the euro as the terminal rate. It is unlikely that the same strategy will be appropriate for all the accession countries.

As a general proposition, a flexible exchange rate with a relatively large amplitude of exchange rate swings is most likely to contain vulnerability. From the point of view of domestic borrowers, it will reduce the incentive for excessive foreign exchange exposure. From the point of view of the domestic authorities, less foreign exchange exposure militates against a “fear of floating” phenomenon with the government trying to resist market-driven exchange rate changes.12 And, from the point of view of speculators, less intervention of this sort will reduce one-way bets and opportunistic speculation.

For most accession countries, a degree of exchange rate flexibility is likely to be required during the interregnum. In this case, an asymmetric band with an ostensible guarantee against significant depreciation would seem to be the most dangerous policy. It seems likely that the capital account mechanisms described above will produce the following pattern: an initial overappreciation of the nominal exchange rate upon accession, coupled with an expected depreciation and a correspondingly higher interest rate than in the euro area—similar to the experience of Greece. In this scenario, a larger interest differential is associated with a higher equilibrium rate of depreciation and thus, for a given risk premium, a larger initial overshoot. This situation may create a difficult trade-off for the authorities: to avoid domestic overheating, they may wish to raise interest rates above euro-area levels, but they may also want to limit appreciations because of the consequences for competitiveness. Given that this trade-off hinges on the risk premium, it is essential to avoid false assurances that distort the pricing of risk—in particular, by allowing room for significant exchange rate flexibility through wide margins on both sides of the central rate, or the possibility of changes in the central rate, or a less-than-rigid timetable for euro adoption.

The vulnerability of this stylized country is exacerbated if domestic borrowers and/or foreign investors believe that there is a floor on the value of the currency—especially a floor that is not that far from the current value. Such circumstances will encourage the buildup of foreign exchange exposures. In this case, any domestic setback or capital market event could lead to speculation against the currency, futile official resistance, and crippling balance-sheet losses.

For some accession countries, it may be possible to adopt a central rate as the terminal rate and to stay very close to it throughout the interregnum—that is, to establish a credible euro peg early on. Here, of course, credibility is everything. The advantage of this strategy is that the likely large capital inflows will not be allowed to push nominal exchange rates up to high, uncompetitive levels that will stifle growth. Instead, the country will relinquish control over its interest rates, will build reserves at a rapid rate, and will have to live with very large current account deficits and the risk of asset bubbles in some sectors (e.g., real estate), making it difficult to hold inflation down to euro-area levels as required by the Maastricht criteria. This strategy is only likely to work for a highly open economy with substantial intersectoral wage flexibility and labor mobility, relatively complete adjustment, and a strong fiscal position that allows a degree of fiscal activism. The risks of the associated capital inflows are more likely to be manageable where these flows take the form of direct investment rather than debt, and where the regulatory regime governing domestic financial intermediation is sufficiently strong to limit the tendency for these flows to spill over into asset price bubbles.

To the extent that large capital inflows are accepted as an unavoidable and beneficial aspect of the real convergence process, it is important to take action to reduce the risk that they become destabilizing. The experience of crises in emerging market countries during the past decade suggests the following lessons:13

  • 1. In many recent crises the inadequacy of shock absorbers was a critical weakness. The management of foreign exchange reserves and the size and composition of public debt should be sharply alert to the need to build adequate cushions against adverse circumstances.

  • 2. A key element in financial crises has been the authorities’ inability to mount an effective policy response. Preventing crises thus requires maintaining the capacity to act in the event that market pressures emerge. Insofar as openness to global capital markets reduces the possible range of action for monetary policy, fiscal policy becomes the preeminent tool of stabilization policy. A strong fiscal position creates room to adopt an expansionary stance in response to a sharp turnaround in the capital account. Conversely, high public debt—particularly if it is of short maturity or exchange-rate linked—can severely constrain macroeconomic policies. But there are practical limits to what should be expected of fiscal policy: it is highly unlikely that any government will be able to change the stance of fiscal policy in the magnitudes and with the rapidity required to offset shifts in the capital account.14

  • 3. A number of recent crises have resulted from financial systems that were not ready to face globalized financial flows. A strong prudential and regulatory regime should be in place before the capital account is fully liberalized. Banks’ open foreign exchange positions should be strictly limited. In addition, banks’ prudential management and lending decisions should be alert to the risks entailed by excessive foreign exchange exposure on the part of corporate borrowers.

  • 4. Many recent crises were exacerbated when information on vulnerabilities became available to markets at the worst possible time. Transparency and data dissemination are important complements to good policies. Access to information allows investors to assess risks independently and to discriminate among emerging market countries; it may not eradicate erratic influences from abroad, but it is likely to militate against herd behavior.

These policies are essential to ensuring that capital inflows can serve the real convergence process, rather than becoming a source of vulnerability that can result in major setbacks to this process.


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