III. Monetary and Exchange Rate Policy

James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
Published Date:
October 2014
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After the fall of communism, monetary policy had to take on a more active role, requiring policy and institutional changes, including the establishment of independent central banks. A key choice was whether to use monetary aggregates or fixed exchange rates as the basis for the initial stabilization following price liberalization. Most countries later moved away from their initial choice of nominal anchor, eventually tending towards inflation targeting, hard exchange rate pegs, or euro adoption, with a diminishing number of intermediate regimes.

Establishing monetary policy frameworks

Centrally planned economies had long experienced enormous price distortions, with prices detached from market forces. Trading was confined mostly among Comecon members, with limited trade with the rest of the world. The integration of these economies into the international monetary and trading systems urgently required liberalization of prices (with the monetary overhang leading to large inflationary pressures) and establishment of currencies as units of exchange (which depreciated considerably in the initial phase).

An immediate priority was to establish functioning central banks. The communist “monobanks” encompassed functions of monetary emission and foreign exchange management, commercial banking—in the sense of passively providing financing for transactions arranged by the planning agencies—and even deposit-taking in some cases. These functions needed to be separated into policy-based responsibilities of the central bank, and business activities devolved to commercial banks. Beyond this, instituting central bank independence became one of the most important achievements of the early transition. Studies have shown the success that increased central bank autonomy had in lowering inflation, with that in turn correlated with subsequent real GDP growth.1

Central bank autonomy and accountability required strong legislation. From similar starting points, countries varied widely in the degree of independence attained. In many cases, central bank laws were not specific about the monetary policy goal under the given monetary regime or the degree of instrument autonomy in the context of monetary policy implementation.2 Some countries were already taking important steps at the start of the transition. For example, Poland’s new central bank law in early 1989 established the independence of the governor, passed previous commercial banking activities to nine commercial banks and set a main objective of “strengthening of the Polish currency”. Similar reforms were put in place in Czechoslovakia in early 1990. In the case of countries created from the dissolution of Yugoslavia, asserting monetary sovereignty and departing from the Yugoslav dinar was seen as an important act of legislative independence. Countries that were not able to establish these practices during the initial attempts of stabilization (such as Bulgaria, Romania, Russia and Ukraine) were mostly forced to undergo second rounds of stabilization. IMF technical assistance was used in many cases to adopt and revise central bank laws, with the credibility of monetary policy bolstered by the presence of an IMF-supported program.

For the states emerging from the collapse of the Soviet Union in late 1991 the immediate question was whether to continue using the ruble as a common currency (the “ruble zone”) or to issue separate national currencies. At the start, they all retained the use of the ruble. However, when the new Central Bank of Russia (CBR) took official control over issuance from the communist-era Gosbank in January 1992, it encountered severe difficulties in controlling the money supply. Previous branches of Gosbank became central banks of emerging states and had the right to issue non-cash rubles, but with little incentive to coordinate or limit the emission. The CBR imposed limits on inter-republic lending, which led to further separation of cash and non-cash rubles. The different republics’ non-cash rubles “traded” at varying discounts to Russian non-cash rubles. At the same time, cash rubles issued by the CBR continued to circulate as if a separate currency. Given these conditions, countries—starting with the Baltics—took the lead in leaving the zone and introducing their own currencies. In mid-1993 the CBR suddenly withdrew pre-1993 ruble notes from circulation, prompting more countries to exit the zone, with most issuing their own currency within the year.

The IMF was active in these policy discussions, seeking to balance the interests of its new member countries and encourage their productive cooperation, in line with its mandate. Recognizing the lack of preparedness of many of the new countries to pursue independent monetary policies, the IMF engaged in discussions on how to ensure the effective functioning of the ruble zone. However, as it became apparent that the divergence of political and economic interests was too great—a realization the Fund has been criticized as reaching late—it assisted in the orderly dissolution of the ruble zone and introduction of the new national currencies.3

Nominal anchors: exchange rate or monetary targets?

The extent of monetary overhang dictated the size of the initial price jump. Subsequently, many transition countries experienced price volatility and increases linked to the phasing out of enterprise subsidies and further freeing of prices. As discussed in Chapter II, the transition countries did manage to rein in inflation within the first decade, though for some it took much longer than others. Inflation stabilized first in the countries of Central Europe followed by some of the Balkan countries and the Baltics, given their rapid departure from the ruble zone and the launch of relevant reforms. In Bulgaria and Romania, the first attempts at stabilization failed. CIS states progressed more slowly given their efforts to liberalize initially within the ruble zone, resulting in imported Russian inflation. In many countries, efforts to achieve price stability were hampered by the slow progress of reforms and liberalization.

The choice of a nominal anchor played a large role in determining stabilization paths.

  • An exchange rate peg seemed clear to the population and technically easy to implement, and in most cases could help end a hyperinflationary spiral, engender confidence and induce greater commitment to fiscal adjustment. However the stringent fiscal discipline needed to maintain a peg in the face of countries’ precarious external positions was challenging both economically and politically. In general, fixed exchange rates were seen as more beneficial for smaller, very open economies. Further, pegged rates required sufficient foreign exchange reserves to defend the currency and accommodate shifts in money demand. There was also a lack of adequate data to gauge the “right” exchange rate level to target.

  • Money-based stabilization was the alternative. Targeting a monetary aggregate could help maintain low inflation, while external and real shocks could be much better absorbed given the flexible exchange rate. But the arrangement was less easily understood and was susceptible to sharp fluctuations in money demand.

The IMF also provided advice on these choices, taking into account individual country characteristics such as the strength of macroeconomic fundamentals, the types of shocks that countries faced, the level of reserves, degree of market liberalization, openness of the economy and capital mobility.

Country experience with both types of nominal anchors has been mixed.

  • Exchange rate anchors seem to have been effective so long as the supporting adjustment measures and institutions were adequate. In some countries they were generally effective in stabilizing prices (Poland, Czechoslovakia), inducing fiscal discipline and contributing to large capital inflows (Estonia). In others the experience was mixed, partly because of lack of credibility of the exchange rate anchor. Hungary’s adjustable peg and frequent revisions to the framework (especially before 1995) failed to manage inflationary expectations.

  • Money-based stabilizations had a mixed record, with a number of countries either abandoning the approach at an early stage, or revising it right after the initial stabilization. The initial choice of Latvia and Lithuania for money-based stabilization was driven by low international reserves. Latvia’s new central bank law established a strong, independent institution that signaled tight monetary policies. In Lithuania, central bank independence was weaker and so was the initial commitment to stabilization, before the country eventually adopted a currency board in 1994. In both cases inflation was brought under control, albeit while the countries suffered severe output losses. In Belarus and Russia, the initial money-based programs appear to have been the only practical option to combat high inflation given fiscal and other policy weaknesses, but both subsequently moved to exchange rate pegs. Moldova had a relatively strong and independent central bank, but was exposed to external shocks.

Exchange rate regimes in CEE

Source: AREAER database to 2012 updated by author.

By the late 1990s, more transition countries were fixing or managing their exchange rates than using free-floating regimes. Many countries, including in the CIS, had a “fear of floating,” inclining them towards a more fixed framework. For some, integration with the EU was the motivation for a more fixed exchange rate, as an anchor to ensure stability, maintain competitiveness, promote structural reforms, and help meet inflation targets. In 1997, both Bosnia and Herzegovina and Bulgaria chose hard pegs in the form of currency boards (see Box 2 on Bulgaria’s experience, and the mechanics of the arrangement). For Bosnia and Herzegovina the choice was driven by political considerations as much as economics. After the negative experience preceding the breakup of Yugoslavia, when states had been unable to agree on allocation of central bank credit—with some enjoying preferential access—it was determined that the transparency and automaticity of a currency board would best meet the needs of a country emerging from the complex process of post-war nation building. The credibility of the arrangement was helped by the one-to-one link to the deutschmark, which was widely used and trusted across the country. As in Bulgaria, the Bosnian currency board has stood the test of time, and serves as the principal anchor of the country’s financial stability.4

No fewer than nine countries moved to more flexibility with the onset of the global financial crisis in 2008; since then countries’ choices seem to support the “bipolar” view of opting either for floating or for a fixed peg, with fewer intermediate regimes. By the time of Lithuania’s entry in 2015, five countries in the region will have joined the euro area. For some the move has provided a natural “exit strategy” from hard pegs to the euro, losing little in monetary policy flexibility while reducing vulnerabilities, including through access to ECB facilities.

Box 2.Introducing the Bulgarian Currency Board

In the early years Bulgaria faced significant setbacks in its transition to a market economy. Fiscal slippages repeatedly undermined attempts at money-based stabilization. By mid-1996, the slow and incomplete transformation of state-owned enterprises left the government with mounting debt, a collapsing financial system, a free falling currency, and by the end of the year hyperinflation.

A currency board-based stabilization was proposed in late 1996, following the successful experience in the Baltics. Under such arrangements, the stock of base money is backed fully with foreign exchange, to give confidence in the exchange rate (which is fixed to foreign currency by law) and to provide an automatic adjustment mechanism for external shocks. The idea was initially greeted with skepticism. Obvious concerns were the lack of foreign currency to back such a system, as well as the fragile state of the financial system. However, as monetary and political instability mounted, the idea of a currency board to instill discipline and restore credibility gained appeal. At the same time it became more feasible as hyperinflation reduced the real value of government debt and real monetary balances, and improved banks’ net asset positions (because they had significant foreign currency assets following early recapitalization, and liabilities mostly in leva). These factors both eased financial sector pressures and also reduced the foreign reserves required to back a currency board. The decisive political shift came with the election of a new government in April 1997 vowing to implement an economic stabilization plan based on a currency board. The currency board was enshrined in a new central bank law passed by parliament in June that year.

Along with other important policy changes—notably a newfound fiscal discipline—the currency board contributed to a rapid return of monetary stability and growth. From mid-1997 on, inflation came down rapidly and interest rates started moving close to German levels, while growth resumed in 1998. During the initial years the system weathered a number of challenges, including the 1998 Russian crisis and the closure of a number of smaller banks. Bulgaria joined the EU in 2007. At this time, potential disadvantages of the arrangement were demonstrated by huge swings in capital flows leading up to and during the 2008–09 crisis: as discussed in Chapter X, these swings, and their growth impact, were generally larger for fixed-rate than floating-rate economies. However, the authorities were able to use policy buffers built up prior to the crisis to ameliorate its impact. The currency board is expected to remain in place until eventual euro adoption.

Prepared by Anne-Marie Gulde-Wolf.

Inflation targeting

As their economies stabilized, many transition countries faced new challenges. The more advanced fixed-rate economies experienced increased capital inflows, putting pressure on domestic demand and making it harder to maintain low inflation. Less developed countries like Moldova also faced challenges such as shifts in money demand due to large remittances, making it hard to choose a credible nominal anchor.

Reflecting global trends, a number of transition countries have adopted inflation targeting (IT), with Russia and Ukraine set to join them in 2015. The literature identifies key pre-requisites for successful IT, among them central bank instrument autonomy; lack of fiscal dominance; developed debt and securities markets; established frameworks for transparency and accountability; and sufficiently advanced modeling and forecasting capacity.5 Some of the seven countries that have adopted IT are still missing a number of these, but have still found it an important policy anchor to adopt. IMF technical assistance in this area has focused on institutional and technical changes, building research and forecasting capacity, improving database management, and communications policies, in order to help maximize the benefits from an inflation targeting framework.

Real exchange rate developments

Real exchange rates have moved in dramatically different ways across the region, but on average there has been real appreciation, mirroring relative productivity improvements as the countries have developed.6 Appreciation was particularly pronounced during the mid-2000s boom, with little if any further increase since the crisis that followed. Within this overall pattern, there seems to have been little difference between subsets of countries with predominantly fixed, or predominantly floating, exchange rates: average real appreciation since 1995 has been strikingly similar for the two groups. It does appear though that the floating rate countries had somewhat faster appreciation during the boom, and significant depreciation in the bust, suggesting that flexible rates helped cushion the effects—and possibly also the scale—of capital inflows and their subsequent reversal. In contrast, the fixed rate countries all faced further real appreciation in 2009, likely adding to difficulties in the crisis, before seeing relative prices ease in 2010.

Real effective exchange rate

(average 1995=100)



Source: IMF staff estimates.

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