V. Capital Flows in Europe: The Effect of the Opening Up of Eastern Europe
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund


In sharp contrast to the last decade, capital has been flowing in abundance from industrial to developing countries since the early 1990s. During 1990–92, capital inflows to Latin America amounted to $117 billion (1.2 percent of GDP), roughly the same amount that flowed to the region during the entire 1982-89 period. Similarly, capital inflows to Asia during the period 1989–92 amounted to $144 billion (3.2 percent of GDP). In several instances, domestic factors, such as structural reforms and successful stabilization programs, have played a key role in attracting capital flows. Despite enormous differences in individual countries’ economic environments, however, foreign capital has flooded the entire region, suggesting that external factors such as low international interest rates and recessionary conditions in industrial countries have been major factors in explaining the recent capital inflows episode.1

1. Introduction

In sharp contrast to the last decade, capital has been flowing in abundance from industrial to developing countries since the early 1990s. During 1990–92, capital inflows to Latin America amounted to $117 billion (1.2 percent of GDP), roughly the same amount that flowed to the region during the entire 1982-89 period. Similarly, capital inflows to Asia during the period 1989–92 amounted to $144 billion (3.2 percent of GDP). In several instances, domestic factors, such as structural reforms and successful stabilization programs, have played a key role in attracting capital flows. Despite enormous differences in individual countries’ economic environments, however, foreign capital has flooded the entire region, suggesting that external factors such as low international interest rates and recessionary conditions in industrial countries have been major factors in explaining the recent capital inflows episode.1

In contrast to Latin America and Asia, the transition economies of Central and Eastern Europe as a group exported capital in 1990–91. These exports were most likely triggered by the collapse of the communist regimes, which aggravated the buildup of internal and external macroeconomic imbalances of the 1980s. With the advent of market-oriented reforms in these economies, capital flows began to reverse, and in some countries (such as the former Czechoslovakia and Hungary), inflows have assumed significant proportions. This reversal began in 1992–93, when the region’s capital account shifted from a deficit of $8 billion in 1991 to a surplus of more than $12 billion in 1993 (Table 1).2 This paper takes a preliminary look at capital flows in Central and Eastern Europe. Although events continue to unfold as this paper is written, it should prove useful to take a broad look at the events so far, examine emerging trends, and analyze policy options for these countries in light of the experiences of Latin America and Asia.

Table 1.

Central and Eastern Europe: Balance of Payments, 1987-93 1

(In billions of U.S. dollars)

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Source: IMF, World Economic Outlook.

The countries included are Bulgaria, the former Czechoslovakia (until 1991), the Czech Republic (1992–93), Hungary, Poland, Romania, and the Slovak Republic (1992–93).

Balance on goods, services and private transfers is equal to the current account balance less official transfers. Official transfers are included in the capital account.

A minus sign indicates an increase in reserves.

The paper proceeds as follows. Section 2 documents the external sector developments for individual countries. Section 3 examines in detail the magnitude, nature, and effects of capital flows in Central and Eastern Europe. Section 4 provides an assessment of the main issues raised by the recent episode of capital flows into this region. The paper then turns to a discussion of the main policy issues raised by capital inflows, which are presented in Section 5 and analyzed in Section 6. Section 7 examines the inflationary consequences of capital inflows and the impact on financial vulnerability, while Section 8 discusses issues related to sterilization. The final remarks are presented in Section 9.

2. External Sector Developments in Central and Eastern Europe

Before turning to a detailed discussion of capital flows in Eastern and Central Europe, we present a broad picture of developments in the external sector for the transition economies discussed here: Bulgaria, the Czech Republic, the Slovak Republic, Hungary, Poland, and Romania.3 This section will thus provide the necessary background for a general discussion of capital flows in the region.

a. The prereform period

The timing of the final demise of the economic and political systems in Central and Eastern Europe in 1990–91 was not a coincidence. With the notable exception of the former Czechoslovakia, the buildup of internal and external macroeconomic imbalances during the 1980s was common to all transition economies. Even Hungary, which began reforming its economic system as early as the late 1960s and experienced relatively low inflation, had accumulated a substantial stock of external debt by the end of the 1980s. Having pursued extremely lax financial policies and borrowed heavily from abroad (also in the 1980s), Bulgaria, Poland, and Romania experienced severe debt-servicing difficulties and were forced to reschedule their external debt payments.

Following Romania’s debt rescheduling in 1986, President Nikolae Ceauşescu’s economic policies were dominated by the desire to reduce external dependence at all costs. Consequently, with little regard to the adverse effects on the domestic economy, Romania manipulated its saving-investment balance to ensure that current account surpluses were available to repay (and sometimes even prepay) external debt. The domestic counterpart of the large current account surpluses in the late 1980s was savings generated by steep taxes on state enterprises and a sharp contraction of social spending.4 By March 1989, nearly all external debt had been repaid. The primary cost to the Romanian economy of this extremely inward-looking policy was a sharp decline in both the quality of investment and economic growth and a rapid deterioration in living standards.

During 1985-89, convertible currency debt in Bulgaria nearly tripled as the economy became increasingly dependent on imported inputs. At the same time, the economy performed poorly, and the competitiveness of Bulgarian exports declined sharply. By 1989, Bulgaria had been forced to cut back imports and draw down reserves to such dangerously low levels that in March 1990 a moratorium on external debt was declared.5 Poland, beset by high inflation, was also weighed down by a significant debt burden during this period and went into arrears in 1990. Both countries had very large capital outflows in the late 1980s concurrently with current account deficits (Tables 2 and 3).

Table 2.

Central and Eastern Europe: Key Macroeconomic Development, 1987-93

(In percent of GDP)

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Source: IMF, World Economic Outlook.

Data for 1987–91 are for the former Czechoslovakia.

Table 3.

Central and Eastern Europe: External Sector Indicators, 1987-93

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Source: IMF, World Economic Outlook.

Data for 1987–91 are for the former Czechoslovakia.

While Hungary’s macroeconomic policies in the late 1980s can best be characterized as shifting between expansion and restraint, the government remained current on its payment obligations on its large external debt (Table 3). In 1990, concerns developed in the international community regarding Hungary’s debt-servicing capacity, not only because of the uncertainty surrounding national elections and Hungary’s erratic economic policies but, to a greater extent, because of the emergence of debt-servicing arrears in the two heavily indebted neighboring CMEA countries. Consequently, the trend in the late 1980s of growing capital inflows that had been unique to Hungary was reversed in 1990.

The experience of the former Czechoslovakia in the late 1980s is distinct from that of the other transition economies because Czechoslovakia had very low levels of external debt (unlike Bulgaria, Hungary, and Poland) and had pursued balanced macroeconomic policies (unlike Romania) (Table 4). In response to more stringent lending practices by international commercial banks in the early 1980s, the country successfully pursued export-oriented economic policies throughout the decade. By the end of the 1980s, it had not only lower levels of external debt but substantially greater reserves (measured in months of imports) than any other East European country.6

Table 4.

Central and Eastern Europe: Selected Economic Indicators, 1989-93

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Sources: National authorities; and IMF staff estimates.

General government.

Cash basis.

Consolidated state budget.

General government balance on a commitment basis, except external interest, which is on a cash basis.

Includes nonconvertible currency-denominated debt.

b. The postreform experience

While the transition economies went through diverse experiences during the 1980s, the period 1990–91 proved, in many ways, to be a common turning point for all. As a result of (i) the breakup of the CMEA, (ii) the opening up of these economies to the rest of the world, (iii) the adverse terms of trade shock (stemming mainly from market-determined prices for oil and other raw materials under the new regime), and most important, (iv) the uncertainties regarding the large-scale upheaval of the economic and political systems, the current account for the region as a whole swung sharply into deficit, and speculative capital outflows led to a depletion of reserves (Table 1).

All transition economies launched ambitious stabilization programs concurrently with structural reforms in 1990–91.7 Faced with sharp declines in output and rising inflation, these countries turned to the international community for financial support (Table 4). With the exception of Bulgaria, all these countries’ capital accounts turned positive in net terms in 1992–93; official assistance was given across the board, and some also benefited from private flows (Table 3).

Among the transition economies, the former Czechoslovakia was best poised to benefit from a relatively favorable external environment, given the initial favorable conditions and the country’s remarkable progress in adapting to the new conditions (Tables 5 and 6). At the end of 1990, it unified and pegged its exchange rate to a basket of currencies and undertook an aggressive policy of building up reserves. These actions were possible in 1991 and the first half of 1992 because of the strong current account surplus, the inflow of official assistance, and the direct foreign investment triggered by direct sales of public assets and mass privatization.8 The developments in the second half of 1992 were mainly influenced by the uncertainties regarding the country’s breakup, resulting in a temporary reversal in the current account and a decline in capital inflows that lead to a drawing down of reserves.

Table 5.

Stabilization Programs and External Debt

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Table 6.

Exchange Rate and Capital Account Regimes

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The formal split of the former Czechoslovakia occurred in January 1993, with the Czech Republic in a relatively favorable position. During 1993 and the first quarter of 1994, the trade deficit in the Czech Republic was in fact reversed, and the inflow of foreign capital resumed. The accumulation of external reserves was spectacular during this period (Figure 1). The dissolution caused greater disruption for the Slovak Republic; its fiscal deficit widened considerably, mainly due to a loss of transfers from the Czech Republic, and capital flew out of the new country (Table 4). By early 1993, reserves had reached very low levels (Figure 1). Tight financial policies, a one-step devaluation of 10 percent, and some temporary external controls in 1993 helped partly to revive capital inflows and build external reserves.

Figure 1:
Figure 1:

Central & Eastern Europe: Total Reserves Minus Gold

(in millions of US$)

Sources: IFS; national authorities.1/ Czechoslovakia through end of 1992.

Capital flows into Hungary, which had stopped in 1990, resumed in 1991 and gained momentum in 1993. During this period, the current account (which had shown a small surplus in 1991-92) began to decline and turned sharply negative in 1993, reaching a deficit of over $4 billion. Nevertheless, the net result was a substantial increase in reserves brought about by some direct foreign investment and, more prominently, by a sharp increase in bond issues in international markets by the National Bank of Hungary (Figure 1).

While both Poland and Bulgaria faced severe debt-servicing difficulties and large macroeconomic imbalances at the start of the 1990s, Poland recovered much faster on both fronts. In contrast to Bulgaria, Poland had succeeded in reviving output and reigning in inflation by the end of 1993 (Table 4). Even though both countries received significant debt relief from the Paris Club and made progress with the London Club, Poland now faces a more favorable external environment, since most of its past debt is official, while Bulgaria’s is predominantly commercial. External accounts for both countries reflected increasing current account deficits in 1992–93 that were countered by a shift in the capital account in Poland after 1992 and in Bulgaria after 1993. In Bulgaria, capital flows are now dominated by exceptional financing by international financial institutions.

Since the start of its reform program in 1991, Romania has been plagued by high inflation and poor economic performance (Table 4). Internal imbalances have been reflected in current account deficits since Ceauşescu’s downfall (Table 2). While capital has begun to flow in since 1991, it represents predominantly medium- and long-term financing from official creditors.

3. Evidence on Capital Flows in Central and Eastern Europe

Having reviewed the main external sector developments in Central and Eastern Europe during both the prereform (the 1980s) and postreform periods (the early 1990s), we turn to a detailed discussion of capital flows. References to the experiences of both Latin America and Asia will help to put the evidence in a comparative perspective.9

a. The global picture

During the 1970s and 1980s, the East European economies’ access to international capital markets was comparable to that of other developing countries. As a result, the ripples of the 1982 international debt crisis were also felt in Eastern Europe, and capital inflows declined temporarily in response to tight lending practices on the part of Western banks. The former Yugoslavia, which had accumulated a substantial stock of hard currency debt by the late 1970s, was hit the hardest by the worldwide credit squeeze and soaring interest rates in international capital markets in the early 1980s.

In spite of the increased difficulty of gaining access to Western capital, the region (with the notable exception of Czechoslovakia) continued to borrow from abroad and eventually became heavily indebted. As discussed above, Romania (in the mid-1980s) and Bulgaria and Poland (in 1990) were forced to reschedule their external debt. In light of the difficult external and macroeconomic situation, the late 1980s witnessed a period of increasing capital outflows and reserve losses that reached a climax with a loss of reserves of $10.9 billion in 1991. For the period 1987-91, capital outflows for the region as a whole totaled $24 billion, financed essentially by a loss of international reserves of $25.8 billion (Table 1). The region’s deteriorating macroeconomic condition, together with the rapidly collapsing economic structure, led to a substantial reduction in private consumption and investment.

During 1990–91, as the East European economies embarked on macroeconomic stabilization programs and far-reaching structural reforms, they also turned to the international community for financial support. In a remarkable turnaround, the capital account improved by $9.6 billion in 1992, climbing from a deficit of $8 billion to a surplus of $1.6 billion, and by a further $10.6 billion in 1993 (Table 1). Given the alarming rate at which the stock of international reserves was being depleted, it should come as no surprise that the initial improvement in the capital account in 1992 was used solely to reduce reserve losses, with the overall balance of payments improving by $9.8 billion and the current account balance remaining essentially unchanged. However, in 1993 only $4.1 billion (roughly 40 percent) of the additional $10.6 billion that came to the region was accumulated as international reserves. The rest ($6.5 billion) was used to finance a more than threefold increase in the current account deficit, which reached $9.2 billion in 1993. This increase reflected primarily the expansion of private consumption.10

The order of magnitude involved is worth noting. Table 4 indicates that the GDP for the region as whole in 1993 was about $200 billion. Hence, capital inflows during 1993, which amounted to $12.2 billion, represented 6.1 percent of GDP for the region as a whole. This figure is not only quite impressive in absolute terms but also considerably larger than that observed in most countries in Latin America and Asia (Calvo, Leiderman, and Reinhart 1994a).

b. Composition of capital flows

The significant changes in the capital account during 1987–93 mirror primarily developments in external borrowing (Table 7). In particular, external borrowing hit a low of –$11.3 billion in 1991—the year in which capital outflows peaked. This drop reflects the culmination of a period during which debt servicing was in full swing in virtually all countries and either fresh loans were drying up (as in Bulgaria, Poland, and, to some degree, Hungary) or countries were following a deliberate policy of not increasing external liabilities (Romania and the former Czechoslovakia). During 1992–93, all countries received external assistance from official creditors, and some (like Hungary and the Czech Republic) raised funds in international capital markets. In 1993, net external borrowing accounted for almost 70 percent of the capital inflows. This pattern is similar to that observed in 1990–91 in Latin America, where net external borrowing accounted for more than 70 percent of the net capital inflows. The corresponding figure for Asia was about 50 percent.

Table 7.

Central and Eastern Europe: Composition of Capital Account 1,2

(In billions of U.S. dollars)

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Source: IMF, World Economic Outlook.

The countries included are Bulgaria, the former Czechoslovakia (until 1991), the Czech Republic (1992–93), Hungary, Poland, Romania, and the Slovak Republic (1992–93).

The capital account figures reported in this table differ from those in column (3) in Table 1 to the extent that the latter include official transfers.

A notable feature in the composition of the region’s capital account is that, starting from negligible amounts during the late 1980s, foreign direct investment rapidly gained momentum during the 1990s (Table 7). This development should not come as a surprise in light of the sudden opening up of the transition economies and the massive privatization of state enterprises in some countries. As a share of GDP, direct foreign investment was also significant in the region during 1992–93, particularly in the Czech Republic and Hungary (Table 3). On average, direct foreign investment was about 1.5 percent of GDP during 1992–93 in the region, compared with about 1.1 percent in Latin America in 1990–92 and 3.0 percent in Asia in 1989–92. Unlike Asia and Latin America, portfolio investment in the region was negligible between 1987 and 1993. Within the region, however, it gained ground in the Czech Republic, where it accounted for nearly 25 percent of the capital inflows in 1993.

c. Consumption and investment

As Table 1 indicates, $6.3 billion of the $20.2 billion increase in capital inflows in 1992–93 were used to finance the increase in the current account deficit, which reached $9.2 billion (roughly 4.5 percent of the region’s GDP) in 1993. The larger current account deficits in 1992–93 reflected mainly increases in consumption rather than investment (Tables 2 and 8). In fact, total consumption as a share of GDP rose by fairly large amounts from 1987–91 to 1992–93 across all countries, ranging from an increase of 18 percentage points for Bulgaria to about 7–8 percentage points for the Czech Republic and Romania. Most of this increase has been reflected in private rather than government consumption (Tables 2 and 8). However, during the same period gross capital formation declined in practically all countries, particularly Bulgaria and Poland. In Asia, investment as a share of GDP rose by about 3 percentage points during 1989–92, but the trend in Latin America was similar to that in the transition economies, with investment falling and consumption rising during 1990–92.

Table 8.

Central and Eastern Europe: Consumption, 1991–93

(In millions of U.S. dollars)

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Source: IMF, World Economic Outlook.

d. Real exchange rate appreciation

If domestic consumption—rather than investment—increases in response to capital inflows, there is likely to be upward pressure on the real exchange rate, since domestic consumption tends to fall relatively more on nontraded goods and domestic capital formation is likely to be more import intensive (Calvo, Leiderman, and Reinhart 1994b). Figure 2 illustrates the fact that, to varying degrees, the real exchange rate appreciated in virtually all the transition economies during 1992–93. Again, the same trend was seen in the majority of the Latin American countries but not in most Asian economies during the same period.

Figure 2:
Figure 2:

Central & Eastern Europe: Real Effective Exchange Rates 1/

(Jan 1991=100)

Source: National authorities.1/ An increase in the index indicates an appreciation.

Among the transition economies, the appreciation of the real exchange rate was most noticeable in Bulgaria, the Czech Republic, Hungary, and Poland. In Hungary and Poland, appreciation began even before 1992. The regional trend toward real exchange rate appreciation receives strong support from the cross-country correlation of real effective exchange rates presented in Table 9. This table reveals a sharp shift from very low (or even negative) coefficients during 1990–91 to very high coefficients during 1992–93 for practically all the countries, suggesting a stronger degree of comovement in real effective exchange rates.

Table 9.

Cross-Country Correlations: Real Effective Exchange Rates, 1990–94

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Sources: IMF, International Financial Statistics; and national authorities.

The sample period for cross-country correlations for Bulgaria, Hungary, and the Slovak Republic is 1991:1 to 1991:12 (data for 1990 are not available for these three countries).

Number of observations: 24.

Number of observations: 27.

e. Reserve accumulation

While virtually all the transition economies intervened in the foreign exchange markets to build reserves in 1992–93, the Czech Republic and Hungary pursued the policy most vigorously. The Hungarian authorities followed a deliberate policy of accumulating reserves to take advantage of their increased access to markets abroad (where low interest rates prevailed), partly in anticipation of the need to meet large debt repayments in 1995-96. This strategy, of course, increased the country’s debt burden in 1992–93.

To the extent that movements in the capital account were reflected in the reserve account, changes in reserves were a reasonable proxy for the inflows, although, as noted, the proportion of inflows going into reserve accumulation changed over time. Figure 1 illustrates that reserves, in general, rose for most countries after 1992. The cross-country correlations (Table 10) have also been fairly high since 1992, although there is no obvious pattern before that.11

Table 10.

Cross-Country Correlations: Total Reserves Minus Gold, 1990–94

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Sources: IMF, International Financial Statistics; and national authorities.

The sample period for cross-country correlations between Bulgaria and the other countries is 1991:1 to 1991:12 (data for Bulgaria for 1990 are not available).

The sample period for cross-country correlations for the Czech Republic and the Slovak Republic is 1993:1 to 1994:4 (the two countries were created in 1993:1).

Number of observations: 24.

Number of observations: 28.

f. A case study: the Czech Republic

The capital inflows episode has been particularly important to (and has probably raised the most concerns in) the Czech Republic. The steep increase in reserves in the Czech Republic (Figure 1) resulted from the fact that the current account was marginally in surplus at a time when the economy was being flooded by foreign capital. A closer examination of the composition of capital inflows during 1993 reveals that nearly half of the inflows reflected borrowing by Czech enterprises; the rest were mainly foreign direct and portfolio investment. 12 Nearly 70 percent of the enterprise borrowing was undertaken by the private sector, and around half of this amount was lent by neighboring European countries such as Germany and Austria.

The monetary authorities’ policy response has involved partial sterilization of the inflows through the sale of Czech National Bank (CNB) bills. In addition, the reserve requirements were raised from 9 percent to 12 percent in August 1994. Given the country’s more than comfortable external reserves position in 1994, the central bank also repaid in advance the remaining outstanding debt to the International Monetary Fund.

Some have argued that the increase in external borrowing in 1992–93 by domestic enterprises reflected the substitution of domestic for foreign credit. According to this theory, deposit and loan maturities were mismatched in that loans are relatively long term. Consequently, local banks were generally reluctant to extend medium-and long-term credit; this reluctance was in part reflected in a wide gap between the lending and deposit rates. Clearly, some of the 1992–93 inflows to the Czech Republic were arguably linked to inefficiencies in the domestic financial system.

If the banks were reluctant to extend credit, their reluctance should have been reflected in a decline in the loan-to-deposit ratio (given unchanged reserve requirements) and/or an increase in excess reserves. An examination of the data on these series, however, shows that the loan-to-deposit ratio remained virtually unchanged during 1993, although it declined marginally from 1.12 at the end of 1992 to 1.06 at the end of 1993. The reserve requirement ratio was not raised and excess reserves did not increase in absolute terms or relative to total reserves during 1993. Thus, banks’ reluctance to extend credit cannot be confirmed on the basis of the information presented above.

Of course, it is possible that the unwillingness of banks to extend credit was reflected in their unwillingness to accept deposits. A preliminary method of investigating this possibility would be to check whether the spread between lending and deposit rates increased and to assess whether the growth in the deposit rates could be considered too low. The data reveal that while the spread was large (about 6-7 percentage points), it declined marginally from the end of 1992 to the end of 1993; also, deposits grew by 22 percent during the same period—a growth rate close to that of the corresponding previous year.13 Therefore, on the basis of these data, the theory that banks were not accepting deposits cannot be established.

It is possible, then, that enterprises were borrowing abroad not because domestic banks were reluctant to lend but because there was a genuine shortage of credit in the economy, despite the fact that interest rate spreads (particularly with respect to German interest rates) were generally declining over time (Table 11). The continued strengthening of the Czech Government’s credibility (owing to sustained stabilization and structural reforms) and the increase of economic activity can be expected to lead to an increase in the real demand for money. Under these circumstances, the appropriate monetary policy response would appear to be to increase money supply in the economy either by allowing capital inflows (without sterilization) or by increasing base money at a more rapid pace.14

Table 11.

Czech Republic: T-Bill Spreads, 1993:1-1994:1

(In percent per annum)

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Sources: IMF, International Financial Statistics; and Czech authorities.

CNB bills are issued by the Czech National Bank, while T-Bills are issued by the government.

4. Capital Inflows into Eastern and Central Europe: An Assessment

Having documented in some detail the magnitudes and main characteristics of the current capital inflows into Eastern and Central Europe, we now attempt an assessment of some of the main issues.

Given the relatively low initial levels of absorption present in these economies—which reflect the planned economies’ highly inefficient use of available physical and human resources—it seems logical to think of the recent increase in consumption as reflecting a move toward an equilibrium level of consumption consistent with the productive use of all available resources. Since, by its very nature, the process of structural reforms that will eventually lead to a full utilization of resources can proceed only gradually over time, the private (nongovernment) sector is likely to wish to borrow from abroad to satisfy its consumption needs until the productive potential is realized. According to this thinking, the capital inflows are financing a permanently higher level of consumption rather than a temporary binge triggered by lack of credibility.

Insofar as the capital inflows are not financing unsustainably high levels of consumption, the negative effects of capital inflows that are so frequently mentioned should be of much less concern. In particular, real exchange rate appreciation does not reflect huge increases in consumption; rather, it suggests that the increase in desired absorption faces an infinitely elastic supply of traded goods and a relatively inelastic supply of nontraded goods. Hence, whatever future adjustment may be needed in the current account should come about through an increase in income based on improved production that indicates an increasingly efficient use of resources, rather than on a fall in absorption. Capital inflows would be bridging the gap until such better times actually materialize, and any attempts to reduce these capital inflows would also reduce welfare.

Two other factors are also likely to account for the observed real exchange rate appreciation. As argued in the previous section, there has been a surge in foreign direct investment in the East European economies. Such a “bunching” of foreign direct investment, which will probably persist for a while, is likely to require that inputs of nontraded goods—labor and materials—be available; a time lag is necessarily involved before they can be utilized. The demand for these nontraded inputs will bid up the relative price of nontraded goods, contributing to real exchange rate appreciation. Again, this change in relative prices should reverse itself once the first and probably the largest wave of foreign direct investment has taken place.

Unlike the two factors mentioned above, which in principle should result in a temporary real exchange rate appreciation, upgrading and expanding capital stock to its new steady-state level should lead to a permanent appreciation of the real exchange rate, as the increase in the capital stock raises the marginal productivity of labor and thus raises the demand for labor. In sum, the 1993 real exchange rate appreciation probably reflected both permanent and temporary components. In any event, a real exchange rate appreciation per se should be no real cause for concern, as it indicates the change in relative prices required by the adjustment process. Attempting to interfere with these relative price changes would only slow down the adjustment process and thus reduce welfare.15 These arguments contrast with those applicable to Latin America in the early 1990s, where a case could be made for slowing the inflows, since these flows may have been financing unsustainably high levels of absorption. As discussed in the next section, the policy choice would seem to consist of permitting real exchange rate appreciation, through either an appreciation of the nominal exchange rate or higher inflation.

A somewhat surprising piece of evidence reviewed in the previous section is that higher investment ratios had not materialized in Eastern Europe by the end of 1993. Two explanations come to mind in this respect. First, roughly similar investment ratios may be hiding important differences regarding the efficiency of investment. If that is the case, investment in “efficiency units” would increase even if investment ratios did not. Second, to the extent that structural reforms have proceeded more slowly than anticipated, investment activity can be expected to pick up only with a lag.

An interesting aspect of the evidence presented in the previous sections is that contrary to what has been observed in other capital inflows episodes, the cross-correlations for the real exchange rates are higher than those for international reserves (Tables 9 and 10). Several factors may lie behind this pattern. First, it could be argued that even in the absence of capital inflows, the real exchange rate would tend to appreciate throughout the region as price liberalization brought prices of nontraded goods closer to equilibrium levels and consumption began to increase from the very depressed levels prevailing at the time the communist systems collapsed. Second, the relatively low cross-correlations for international reserves are likely to reflect dissimilar policy responses to capital inflows. As noted earlier, the Czech Republic and Hungary have intervened in foreign exchange markets more extensively than other East European countries.

5. Problems and Policies: A First Look

As discussed above, capital inflows have led to an increase in consumption and an appreciation of the real exchange rate in the transition economies. We have argued that (unlike the situation in Latin America) these developments could reflect an adjustment to a new equilibrium and do not necessarily warrant intervention by policymakers. In fact, it can even be argued that capital flows have helped to build reserves and have allowed for larger current account deficits, with the latter improving living standards in these economies either directly (through improvements in both the variety and quality of imports of final goods) or indirectly (through imports of high-quality capital and intermediate goods). Apart from supplying financial resources, direct foreign investment is generally also accompanied by an influx of highly skilled human capital.

If all this sounds like “good news,” why should these countries be concerned? In fact, despite the positive aspects of the capital inflows, the authorities have had cause to be concerned, for the following reasons:16

  • If capital inflows are used to finance a temporary consumption boom, then eventually expenditures will have to fall in order to service the associated debt accumulation.17

  • Even if outside funds are used for capital accumulation, the resulting surge in domestic activity required to install the new capital may call for an overshooting of the real wage. Thus, the real wage will eventually have to fell, creating adjustment problems, unless the labor market exhibits very high flexibility.

  • Capital inflows induce (i) growth in monetary aggregates that far exceeds target inflation and/or (ii) significant appreciation of the nominal exchange rate. Case (i) is likely associated with unexpectedly high inflation, while case (ii) gives rise to an immediate loss of international competitiveness (through the resulting appreciation of the real exchange rate). Moreover, case (i) is also likely to result in an eventual real exchange rate appreciation.

The first-best reaction to the first two concerns is likely to be a deepening of reforms in order for market forces to operate in an environment that is free from distortions, and such a process clearly takes time. A second-best solution would be to attempt to slow the flow of funds to the private sector and/or to provide incentives for the private sector to decrease its current expenditure. These second-best policies include direct controls on, or taxation of, new international loans (usually with adjustments for loan maturity); higher taxes (to lower private expenditure); and higher interest rates on government debt to attract international funds away from the private sector—a policy that is closely related to the “sterilized intervention” policy discussed below.

The second-best solutions all have their drawbacks, however. Direct controls or taxes are hard to implement because there are a variety of ways for the private sector to camouflage financial transactions. Raising taxes is not likely to be sufficiently effective, unless the tax hike is substantial—a highly unpopular move—or perceived as long term, but long-term tax hikes may be hard to justify when a policy is aimed at offsetting short-term developments.18 Finally, raising interest rates may be effective but may also end up discouraging the most desirable type of expenditure—investment, since investment projects are guided by their internal rate of return. In contrast, consumption projects may not, and in general will not, be self-financing; consumers and consumption loans are often guided by consumers’ ability to pay for credit. Consumer credit is normally extended until the individual’s credit-service obligations reach a given level. Below that level, interest rate hikes are likely to have a relatively small impact on consumption. Another negative aspect of higher interest rates is that to the extent that interest rates rise above international levels, such a policy will generate a larger fiscal deficit, which is likely to worsen over time as the interest rate differential keeps attracting foreign capital flows.

However, it is perhaps fair to say that the most widespread and evident problem with a surge of capital inflows is of a monetary nature. This problem can be explained in part by the fact that monetary phenomena surface very quickly. Capital inflows put pressure on the foreign exchange market, forcing the central bank to decide quickly whether to let the exchange rate appreciate or to intervene to buy foreign exchange. Thus, in the very short run—when there is no time for changing regulations and little is known about the nature of the capital inflows episode—the central bank has basically two policy options: sterilized or nonsterilized intervention. Sterilized intervention consists of buying foreign exchange by issuing government (interest-bearing) debt, while nonsterilized intervention takes place through the issuance of domestic money (non-interest-bearing government debt).

In practice, policymakers have shown a predisposition at the beginning of capital inflows episodes to prevent the exchange rate from appreciating by resorting to sterilized intervention (Frankel 1994). Later on, as the costs of sterilized intervention grow large, sterilization tends to be abandoned for nonsterilized intervention or some form of taxation.19

6. A Simple Analysis

This section develops a simple analytical tool that should prove useful in understanding some of the more subtle implications of capital inflows. Suppose that, starting from an initial equilibrium, structural reforms or the opening of new markets make a certain number of new investment projects profitable. As a result, investment rises and, with it, construction activity and employment. Thus, the demand for domestic money is likely to rise, reflecting the higher activity level. Figure 3 shows a standard demand for real monetary balances, md, which is inversely related to the nominal interest rate, i. For a constant real money supply, ms, a rise in the demand for money results in a higher interest rate.

Figure 3.
Figure 3.

Monetary Effects of Capital Inflows

To carry the analysis one step further, we assume a simple economy in which the price level and the exchange rate are the same (P = E). M and E denote the supply of money and the exchange rate (the price of foreign exchange in terms of domestic currency), respectively. Thus, by definition, the supply of real monetary balances, ms, is equal to M/E. The higher real money demand provokes an incipient capital inflow and/or a nominal appreciation of the exchange rate (a fall in the price level).

As noted above, the central banker’s first instinct is not to let the supply of money expand. Thus, real supply of money is constant, as in the above experiment, and domestic interest rates will rise. However, in order to keep both M and E constant, the central bank must buy all the foreign exchange offered at that exchange rate and then quickly turn around and sell public debt (certificates of deposit) in the same amount, in order to mop up the initially created new money. In other words, the central bank has to engage in sterilized intervention.

Two implications should be highlighted. First, if the domestic interest rate exceeds the international rate, then, assuming a fixed exchange rate, the central bank will have undertaken a loss-making operation. Second, by raising interest rates, the new projects “crowd out” outstanding projects, especially those that depend on domestic financing. Alternatively, the central bank could acquire the new supply of foreign exchange by issuing domestic money (nonsterilized intervention)—that is, by letting M increase in order to keep the initial interest rate constant (point A in Figure 3). Since domestic money yields no return, while reserves can be invested in U.S. Treasury bills, for example, the central bank now stands to make a profit. Moreover, there is no crowding out of outstanding projects. Thus, under the present circumstances, nonsterilized intervention is clearly preferable to sterilized intervention.

Finally, the central bank could provoke the same shift in the money supply by lowering the exchange rate, E, by means of a nominal appreciation. The implications are very similar to those for nonsterilized intervention, with one important difference: to the extent that the appreciation is not fully anticipated by the public, lenders (in domestic currency) will gain and borrowers will lose in real terms (that is, in terms of goods and services).

In practice, not all promising projects are started at the same time. Thus, as new projects filter in over time, the demand for money keeps rising, and with it the domestic interest rate (if the central bank maintains its sterilization policy). Thus, all the negative aspects of sterilized intervention mentioned above tend to grow over time. Furthermore, even if there are no new investment projects, the central bank may still experience serious difficulties—for example, if sterilization raises interest rates to levels that look attractive to “portfolio investors” interested in short-term liquid assets. Under these circumstances, the economy will be flooded with foreign funds in search of domestic deposits. The sums that will have to be sterilized will skyrocket, and central bank losses are likely to become unsustainable as a result.20

The recent experience in Colombia is very revealing. Capital started to flow in around 1990. At the beginning, the central bank followed a strict sterilization policy but abandoned it toward the end of 1991. Figure 4 shows that interest rates remained relatively flat from 1990 until the end of 1991 and then fell by about 10 points in 1992. Interestingly, the same chart shows that the dollar equivalent, i*, displayed no fall.21 It became considerably more volatile and, if anything, exhibited a slight tendency to rise. Figure 5 shows that when sterilization was abandoned, the money supply (M1) rose sharply, while inflation remained about the same or fell. This change of policy is also reflected in Figure 6; before sterilization, the ratio of M2 to reserves fell sharply, as it did in Central and Eastern Europe (Figure 7); after sterilization, this ratio flattened out.22

Figure 4.
Figure 4.

Colombia: Deposit Interest Rate

Source: National authorities.
Figure 5.
Figure 5.

Colombia: M1 Growth and Inflation (month over month)

Source: National authorities.
Figure 6.
Figure 6.

Colombia: Ratio of M2 to International Reserves

Source: National authorities.
Figure 7:
Figure 7:

Central & Eastern Europe: M2/Reserves Ratio

Sources: IFS; national authorities.

7. Fear of Inflation and Financial Vulnerability

The above discussion gives strong support to nonsterilized intervention and currency appreciation as policy responses to a surge in capital inflows. In this section, this support will be somewhat tempered by additional relevant considerations. The discussion now focuses on the case in which the nominal exchange rate is kept constant throughout.

A popular reason for disliking nonsterilized intervention is the fear that the resulting expansion in money supply will fuel inflation. This consideration had no role to play in the previous section because the price level, P, was identified with the exchange rate, E. However, this assumption is highly unrealistic. In practice, domestic and international prices are not so closely linked, particularly for services that do not face strong international competition. Goods that have no international markets are usually referred to as “home goods”; their price is denoted in terms of domestic currency, by Ph. Thus, the price level can be expressed as a weighted average of the prices of home and international goods; for example, P = θE + (1 - θ)Ph, where θ is a number between 0 and 1 (in the previous section, θ was implicitly set at 1). In the present setup the real exchange rate, e, is defined by the equation e = E/P.

The popular view referred to above often relies on extending the closed-economy monetarist statement that prices are caused by money, to an open-economy setup. Thus, it is conjectured that nonsterilized intervention, by allowing M to grow, will foster a rise in Ph and, consequently, in P. If capital inflows persist for some time, inflation (the rate of growth of P) will increase. We will argue that such a view is valid only under certain, but sometimes relevant, circumstances.

First, we show a case where the view is not valid. In this case, the relevant price level for the concept of real monetary balances is P. Furthermore, we assume, as in the previous section, that a surge in economic activity gives rise to an increase in the demand for money, leading to capital inflow. If the money supply stays put by means of, say, sterilized intervention, then two things may happen: given the price level, the nominal interest rate i will rise (as in Figure 3); and given the nominal interest rate, the price of home goods, Ph, will tend to fall. Thus, capital inflows could be accompanied by deflation, not inflation (as the popular view would have it).

The explanation for the apparent contradiction between an episode of capital inflows and deflation is straightforward. If capital inflows have been brought about by an increase in the demand for money, no inflationary forces need be set in motion. A good illustration is the Portuguese experience in 1990–92 (Bento 1994). In brief, Portugal became a member of the then European Community (EC) in 1986. Immediately after joining, Portugal began to adopt macroeconomic policies that facilitated a sequence of EC convergence programs. As investors perceived a reduction in risk and an increase in the expected profitability of the economy, capital (mostly foreign direct investment) began to flow in, reaching 5-6 percent of GDP during 1989–92. Inevitably, these inflows caused a significant appreciation of the real exchange rate, to which the authorities responded in mid-1990 by imposing capital controls. One consequence of these measures was that the economy experienced a sharp disinflation of about 7 percentage points in 1992.23

However, there is one important instance in which the popular view holds true. Suppose a capital inflows episode takes place during a stabilization program that is not fully credible. As argued in Calvo and Végh (1993), if a stabilization program is not fully credible and inflation is expected to resume in the near future, the prices of home goods will show a tendency to rise before the anticipated end of the program. The demand for nominal monetary balances will rise in tandem with those prices. If there is no international capital mobility (at the margin), then keeping the money supply constant may, by previous arguments, create downward pressure on prices, preventing the lack of credibility from generating unexpectedly high inflation (Calvo and Végh 1993). Under capital mobility, the same result could be obtained by means of sterilized intervention. Consequently, if keeping inflation within the program’s limits is an important policy objective, then partial sterilization of capital inflows may be called for.

A more fundamental criticism has to do with the greater financial vulnerability that nonsterilized intervention can cause. As a general rule, nonsterilized funds will find their way through the banking system, most likely provoking an increase in bank deposits. If banks are not subject to 100 percent reserve requirements, this increase will lead to an expansion of bank credit. Because bank credit is likely to be of longer maturity than bank deposits, a sudden and significant deposit withdrawal may generate a banking crisis. Clearly, the probability of a crisis will be a function of the stability of funds channeled through the banking sector and, of course, of the extent of the maturities mismatch between deposits and loans. In the very short run, when the nature of the capital inflows episode is still not well understood, it may thus be advisable to resort to sterilized intervention, but measures should later be taken to lessen the extent of the maturities mismatch. As an intermediate step before fundamental measures are undertaken, it may be desirable to increase banks’ reserve requirements, at least at the margin—a measure that has lower fiscal costs than standard sterilization but is still prone to crowding out outstanding projects.

At the heart of financial vulnerability is the maturity mismatch between deposits and loans. To some extent, this problem may be associated with some bank regulations. A prominent example of such regulations is bank deposit insurance, which is common to banking systems around the world. It serves the obvious purpose of protecting depositors—especially small depositors—from bank failures. But it has another key function: to enhance the liquidity of bank deposits (by lowering the costs of assessing the financial health of the institution on which a check is drawn, for example) and thus to enhance the role of banks in the domestic payments mechanisms. Deposit insurance is also likely to induce banks to extend credit over a longer period than they would otherwise have offered, because they are assured of an automatic credit line from the central bank in case of a sudden deposit withdrawal. One proposal that aims at eliminating this problem of moral hazard has received a great deal of attention, although it does not seem to have been implemented anywhere in its pure form thus far. The proposal, called the “Chicago Plan,” was developed by Henry C. Simons in 1936 and would subject sight deposits to 100 percent requirements and treat time deposits as mutual funds. According to this scheme, time deposits are a claim on the assets a bank acquires against those deposits; the value of the claim represents the market value of those assets and is bound to fluctuate. If a bank fails, for example, the value of time deposits may collapse. Therefore, there would be de facto full deposit insurance on M1, and no insurance on the rest of banking liabilities.

Space limitations do not allow for a full discussion of these issues. However, it is important to note that the Chicago Plan may run into difficulties if the public strongly expects that the central bank will not allow the value of time deposits to collapse. In these circumstances, the public will expect some kind of implicit deposit insurance; if, contrary to expectations, the central bank allows the value of time deposits to plummet, serious financial strain will ensue, possibly forcing the central bank to bail out the banking system, and invalidating the Chicago Plan.

8. Sterilization: Relevant Monetary Aggregates

Sterilization may not be effective if it targets the wrong monetary aggregate. For instance, if vulnerability is a key issue, then sterilization should aim at controlling the expansion of bank liabilities as a whole (broad money), taking into account the quality of bank assets. In particular, if treasury bills in local currency are deemed completely safe and liquid, then perhaps a suitable variable to target would be broad money minus bank holdings of treasury bills.

On the other hand, if sterilization is driven by fear of inflation, then targeting broad money (without subtracting anything from it) could be more appropriate. Sometimes, however, this tactic may not be enough. A relevant example is a “dollarized” economy, in which dollar deposits constitute a significant proportion of broad money. Controlling the banking “dollar” component may not be enough, because this action leaves out foreign currency (on which there is no reliable, timely information) and foreign checking accounts.24

In practice, central banks use sterilization to target narrow monetary aggregates, such as M1, something that would clearly be inappropriate in a highly dollarized economy. In general, targeting M1 is also inappropriate in economies in which time deposits are perceived as being highly liquid.25 The problem that arises, then, is that the larger the monetary aggregate, the harder it is to affect that aggregate via sterilization. For instance, if government bonds are very liquid, standard sterilization will simply change the composition of “money” in favor of bonds and against cash and sight deposits, but it will fail to change the total amount. Thus, no perceptible effect on prices is likely to take place.

Even if a relatively narrow monetary aggregate such as M2 is targeted, sterilization may not be effective. It is not unusual in developing countries for banks to be the main holders of government debt (Calvo and Végh 1995). If the legal cash/deposit reserve requirement is 10 percent, and there is an inflow of capital of 100 million (in local currency) taking the form of time deposits, the government will have to issue public debt or this amount will be multiplied and may result in an increase in M2 of more than 100 million. However, if the government issues 90 million in public debt, it will be able to soak up the additional loanable funds, and the “bank multiplier” will be one. Effective as this measure is, however, it will not be enough to sterilize the initial 100 million increase in liquidity (M2). To do so requires luring the funds away from banks. Otherwise, a new round of sterilization will simply attract more foreign funds into the banking system—resulting in an increase in M2 accompanied, most likely, by an increase in domestic interest rates.

9. Final Remarks

The Central and East European countries experienced a dramatic turnaround in the capital account beginning in 1992, after an extended period of capital outflows. International capital has flowed unevenly into the region, although the degree of comovement in some key macroeconomic indicators has increased in comparison with the 1987-91 period, indicating that the phenomenon is regional and not just country specific. The phenomenon has strong parallels in experiences in Asia and Latin America. It started later but, as in the other regions, there has been a tendency for real exchange rates to appreciate and for international reserves to exhibit a sharp increase. This analysis suggests that up until the end of 1993, there were no particular reasons to be concerned about the recent episode of capital inflows—at least given its characteristics and extent.26

A more detailed analysis does show some worrisome developments side by side with very good ones. For example, a very positive development that contrasts favorably with the experience in Latin America is a significant increase in foreign direct investment. This investment, however, has not been reflected in higher investment ratios, which have actually fallen, although consumption as a share of GDP has increased. On the whole, an increase in consumption ratios is a normal development in the transition economies, since prior to reform, these ratios were lower than those in comparable market economies. The pattern of consumption may well represent a redressing of a previous imbalance rather than an unsustainable “consumption boom,” unlike similar developments in some Latin American countries. Still, the fall in investment will become somewhat worrisome if “efficiency units” of current investment do not rise.

As in other capital inflows episodes, there has also been an expansion in monetary aggregates, showing that sterilized intervention played a relatively minor role, despite the fact that it seems a reasonable monetary strategy to have followed, because capital inflows are usually characterized by a sharp increase in the demand for money. However, this paper has also discussed the possible dangers of nonsterilized intervention. A major point of concern in this regard is that the resulting expansion of domestic credit to the private sector, accompanied by the likely maturity mismatch between loans and deposits, may increase the degree of financial vulnerability.


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This presentation is based on a longer document by the authors, Capital Flows in Central and Eastern Europe: Evidence and Policy Options, issued as IMF Working Paper WP/95/57 and available from the International Monetary Fund.


This swing in the flow of capital toward Eastern Europe in 1992–93 coincides with the ebbing of investment opportunities in Latin America and Asia.


Tables 2 through 4 contain relevant economic indicators.


In fact, a decree in 1989 forbade Romanian entities from contracting new external debt. See Demekas and Khan (1991).


It should be mentioned that Bulgaria was a particularly hapless case because it had a net creditor position vis-à-vis the Council for Mutual Economic Assistance (CMEA) countries. Full resolution of former bilateral payments arrangements is still pending in many cases.


See Prust and others (1990) for a more detailed discussion.


For a detailed discussion of the stabilization programs, see Bruno (1993, Chapter 7) and Sahay and Végh (1995a).


A surge in imports resulting from trade liberalization did not materialize due to large declines in output, but the country showed great versatility in reorienting exports to industrial countries.


All figures on Latin America and Asia are taken from Calvo, Leiderman, and Reinhart (1993. 1994a. 1994b).


This pattern of using the initial wave of capital inflows to build up reserves and later to finance widening current account deficits has also been observed in Latin America. In Asia, however, capital inflows have predominantly been used to build reserves.


One exception to the high values of cross-correlations is Bulgaria, where authorities have intermittently intervened in the foreign exchange market to prevent rapid depreciation of the currency.


Portfolio investment, in large part, reflects the resale of stocks received by domestic residents to foreigners during the mass privatization of state enterprises in 1991-92.


Although the growth in deposits was similar in nominal terms, it should be mentioned that growth was lower in 1993 in real terms, with period-end annual inflation increasing from 12 percent in 1992 to 18 percent in 1993. Also, economic growth picked up marginally in 1993.


This argument is further strengthened by the fact that the money multiplier declined during 1993, recording a significant fall of over 35 percent in March 1994 compared with a year earlier.


However, to the extent that these inflows cause volatility in real effective exchange rates, they can adversely affect exports (Grobar 1993).


For a more comprehensive discussion, see Calvo, Leiderman, and Reinhart (1993, 1994a, 1994b).


A related concern is that the consumption boom will contribute to an appreciation of the real exchange rate and undermine export competitiveness. This expenditure cycle may not occur if funds are used for productive capital accumulation, because under this scenario, output will grow and contribute to financing the debt.


If there is no fear of capital flow reversal, then the associated developments will have a strong permanent component.


Sterilized intervention is costly because domestic interest rates (adjusted for the rate of devaluation) tend to exceed international ones. Some examples of taxation are higher cash/deposit reserve requirements or a tax on foreign assets (Reinhart 1991).


These policy choices would remain essentially unchanged even when capital inflows are not responding to an increase in real money demand, along the lines of Rodriguez (1993). In the face of such an “exogenous” capital inflow, policymakers would still need to choose between letting the exchange rate fall (with a fall in interest rates)—a move that would be captured by a rightward shift in the real money supply in Figure 7—or engaging in sterilization, thereby preventing the real money supply from increasing and interest rates from falling.


The dollar equivalent, i, is defined as follows:


See Bento (1994) for an interesting analysis of interventionist measures used to contain the surge of capital inflows in Portugal in 1990–92.


The disinflation reported here excludes the 2 percentage points of the increase in the consumer price index (CPI) caused by an adjustment in the value-added tax (VAT).


Dollarization is already becoming a major policy challenge in economies in transition (see Sahay and Végh 1995b).


We suspect that the liquidity of time deposits is particularly high in high-inflation countries.


However, more recent data show that there may be some cause for concern regarding Hungary’s external situation, as the government is increasingly issuing bonds denominated in short-term foreign currency to finance the fiscal deficit.

Impact of Opening Up Eastern Europe