Jeromin Zettermeyer and Daniel A. Citrin
This section discusses issues regarding the choice of exchange rate regime in achieving price stability in the Baltics, Russia, and other states of the former Soviet Union: in particular, the relative merits of exchange rate based stabilization versus the targeting of money (or credit) growth in conjunction with a degree of exchange rate flexibility are examined.1 The main arguments for and against the alternative exchange rate arrangements in the context of stabilizing from high or moderate levels of inflation are reviewed first. Then, the recent policy strategy in the region in light of these arguments is discussed using two benchmark cases of fixed and flexible exchange rates. Throughout, the objective of the section is limited to discussing alternative nominal anchors as tools for achieving a substantial reduction in inflation in the region. No attempt is made to discuss the relative merits of different exchange rate regimes as permanent policy choices, that is, beyond the disinflation phase.
General Considerations and Experience
In reviewing the general arguments affecting the choice of exchange rate strategy for stabilization, one may focus on four key considerations: (1) the costs of stabilization while the program is in place; (2) the effectiveness of the policy approach in bringing down inflation; (3) the costs resulting from program failure; and (4) the chances of failure and the conditions that would minimize the risk of failure.
Relative Costs
In assessing the relative costs of disinflation of money versus exchange rate based programs with comparable stabilization objectives, two distinct considerations apply. First, the process of disinflation itself will usually have consequences for output, although probably less so in transition economies than in more developed market systems (see Section II). Standard arguments suggest that the output costs of a pre-announced disinflation will depend on its credibility.2 Thus, the question is which type of nominal anchor is more likely to be viewed as sustainable—an issue to be taken up separately below. Second, since stabilization from high levels of inflation in transition economies is not instantaneous (see Table 1.7), the total output cost of each approach will also depend on the nature of economic shocks, other than the disinflationary shock itself, that affect the economy during the stabilization period.3 Money demand shocks will have smaller consequences for output under a fixed exchange rate regime, because they can be absorbed by endogenous responses in the money supply. In contrast, under flexible exchange rates such shocks will lead to swings in domestic interest rates and the exchange rate (or, in the absence of a well-developed capital market, rationing, and cash shortages) and consequently fluctuations in output and velocity. On the other hand, unless goods and labor markets were perfectly flexible, real shocks affecting the demand for goods or the terms of trade would tend to be amplified under a fixed exchange rate regime, because the exchange rate and interest rates are not available as adjustment mechanisms.4
Unfortunately, during the initial stabilization phase, both types of shocks are likely to be present in the economies in the region. On the one hand, as discussed in Section III, a number of factors have contributed to substantial volatility in money demand over the past several years. On the other hand, the initial stabilization period has coincided with external opening and domestic and other structural changes that have led to substantial real and external shocks.5 In practice, it is difficult to argue a priori which type of shock, in addition to the impact of disinflation itself, is more likely to impose significant output costs during stabilization. However, it is likely that relative to the huge output declines in the Baltics, Russia, and the remaining countries of former Soviet Union that are an immediate consequence of structural change and political developments, the added output losses from choosing the more “costly” stabilization strategy will be minor. This suggests that the relative costs of stabilization should be a less important consideration in guiding the choice of nominal anchor than the effectiveness of the anchor in reducing inflation quickly and the chances and consequences of failure.6
Effectiveness
There are reasons for believing that exchange rate anchors may be more effective in controling inflation than monetary anchors in the transition economies.7 First, the effectiveness of a disinflationary program will depend on how tightly the intermediate target —that is, either the exchange rate or money—is linked to the ultimate target, namely, the price level. If the situation of transition economies is one of shifts in money demand and unstable velocity—a view corroborated by the findings in Section III—then this will reduce the effectiveness of money as an anchor, while an exchange rate peg continues to anchor the price level through its impact on tradables prices. Second, the control of the money supply may itself require more sophisticated policy mechanisms than the establishment of an exchange rate peg, which merely involves a decision to passively buy or sell foreign exchange at a given price.
While these arguments are valid and important, one should bear in mind that if the objective is to reduce inflation from very high to moderate levels, rather than achieving narrowly defined low inflation targets, then the looseness in inflation control associated with monetary anchors might be of secondary importance. Also, as to the control of the monetary aggregates themselves, bank-by-bank credit ceilings—even though undesirable as permanent policy tools—may in certain circumstances be effective in reigning in monetary expansion during the initial stabilization effort.
Costs of Failure
In general, the costs of failure may be expected to be higher in exchange rate based stabilizations. First, the demise of an exchange rate peg typically involves a speculative attack on the currency, often with a large loss in foreign official reserves. In contrast, failure to attain monetary targets is likely to lead to an exchange rate depreciation broadly in line with excessive money growth, which does not impose a comparable direct cost on the government and may be reversible without requiring the program to be called off immediately. Second, the reputational cost to the government will in general be higher after the failure of an exchange rate based program. The government will be faced with having failed to sustain a highly visible economic objective and the ensuing loss in credibility is likely to make it more difficult to stabilize in the future. This notion is supported by evidence suggesting that failures of exchange rate based stabilizations have typically resulted in a return to inflation levels higher than at the outset of the program (see Vegh (1992)).
The failure to observe monetary objectives under a money-based stabilization, accompanied by downward pressures on the exchange rate, would also damage credibility. Missing monetary targets, however, may be perceived less explicitly as a failure of the government than the forced floating of the currency or a substantial devaluation, and it is easier for the target path to be subsequently adjusted to recoup slippages and preserve the essential goals of the stabilization program.
Probability of Success
It has been argued that the public observability of the exchange rate at any point in time—as opposed to monetary or credit aggregates, which are only observable at substantial intervals based on data that are usually supplied by the government—will enhance the credibility of an exchange rate based approach.8 In addition, since the unpleasant consequences of failure should act as a deterrent to abandoning the program, an exchange rate based stabilization may induce a higher commitment to undertake the necessary accompanying stabilization measures—in particular, fiscal adjustment—and thus a higher probability of success. On the other hand, while losses in confidence and private capital outflows may be harmful under both exchange rate based and money-based approaches, they will pose a direct threat to the program’s nominal anchor only under an exchange rate based stabilization. Thus, success in stabilization under an exchange rate based approach will also require greater confidence in the government’s ability to stick to its target path of fiscal adjustment.9 In addition, the magnitude of necessary fiscal adjustment needed under a fixed exchange rate regime will most likely be higher than that under a money-based program, since pegging one’s exchange rate will dictate a low inflation target that a money-based stabilization would not necessarily need to observe.10
These arguments seem to leave an open question, but one might argue as follows. Exchange rate based stabilization may be preferable whenever the underlying commitment of policymakers to fiscal discipline is high11 and the risk of adverse shocks that are beyond their control is deemed reasonably small—that is, when it is likely that policymakers will be in a position to undertake the necessary fiscal adjustment, thereby increasing success rate of the peg. On the other hand, if there are serious questions regarding the government’s underlying commitment to fiscal restraint or large uncertainties that may render adherence to fiscal targets difficult to achieve, then an exchange rate peg would hardly be credible. If tried, it would soon fail, with high costs to reputation and to reserve holdings.
In short, the commitment to an exchange rate peg is only one of the factors likely to influence fiscal discipline. It may be that the degree of discipline required for the peg to be sustainable simply exceeds the discipline that is likely to arise because of a desire to avoid the costs of failure. A fixed exchange rate regime may enhance the determination to adjust fiscally, but it is unlikely to work political miracles.
A Currency Board
Before turning to a discussion of the experience with alternative anchors, it may be useful to briefly discuss the case of a currency board, which has been established in two countries in the region. A currency board may be viewed as an extreme form of pegging in the sense that it leaves even less room for discretionary monetary policy.12 Thus, the arguments presented so far regarding the standard case of a fixed exchange rate—the potential superiority of the exchange rate as a nominal anchor, the problems associated with adjusting to real shocks, the higher costs of failure and the more stringent implications for fiscal adjustment—will also apply to the currency board arrangement. However, both because of the implied hard currency backing and the institutional shielding of monetary policy from credit demands, a currency board has the advantage of being more credible than a simple peg, implying a lower risk of failure and lower cost of disinflation. This advantage must be traded off against the lack of flexibility that follows from the rigidity of the arrangement, in particular with regard to adjusting the exchange rate peg and supplying short-term liquidity to the banking system. In a situation of financial fragility and external shocks, this rigidity could imply significant costs. A currency board might thus be accompanied with stipulations for the emergency situations that would allow liquidity support without undermining the institution’s integrity in normal circumstances.13
The above arguments on both the relative effectiveness and the risks of exchange rate and money-based stabilization strategies are broadly corroborated by the experience of countries outside the Baltics, Russia, and other countries of the former Soviet Union (the latter will be discussed separately below). First, as shown in Table 1.7 and emphasized by Sahay and Vegh (1995), all three attempts at exchange rate based stabilization in Central Europe (Yugoslavia, Poland, and Czechoslovakia)14 were highly effective in the sense that inflation was reduced to single-digit quarterly levels within less than one year. However, one of the three—Yugoslavia—subsequently failed as the peg soon became unsustainable in the absence of adequate supporting adjustment measures and inflation returned to very high levels. The recent record of money-based stabilizations in Central Europe is also relatively favorable, in the sense that stabilization was effective within a year and there were no major relapses, in four out of six cases—Albania, Slovenia, Croatia, and the Federal Yugoslav Republic of Macedonia (three out of five if the Croatian approach is not interpreted as a money-based stabilization).15 Because this type of comparison does not control for other differences among the countries and circumstances of stabilization, it does not constitute very hard evidence; moreover, the sample sizes involved are small. Nevertheless, it illustrates (1) that exchange rate based stabilization can be very effective in reducing inflation quickly from high levels and (2) that money-based stabilizations can also be both effective and ultimately successful when monetary and credit policies are consistently tight.
With regard to evidence from a broader set of countries, two major studies are noteworthy. Vegh (1992) reviews ten major exchange rate based plans to stop high chronic inflation in market economies (all in Latin American countries, except for the 1985 Israeli stabilization). Seven of these are classified as failures, in the sense that the peg could not be sustained and initial reductions in inflation were subsequently reversed.16 In two cases the failure is attributed to a real appreciation of the currency following slow convergence of inflation, in spite of achieving fiscal balance (Chile and Uruguay, 1978). In the remaining five, however, failure to adjust fiscally is the main culprit. This experience shows that the discipline induced by the exchange rate anchor may not in itself be sufficient to ensure the fiscal adjustment necessary to sustain the peg.
An analysis of a broad set of stabilization experiences between mid-1988 and mid-1991 suggests that—measured by the mean reduction in inflation in the first year after stabilization, as compared with target inflation—exchange rate based stabilizations have been generally more successful than stabilization attempts that did not use the exchange rate as a nominal anchor. At the same time, in the group of five countries (Yugoslavia, Poland, Argentina, Mexico, and the former Czechoslovakia) that used exchange rate anchors to stabilize from high levels of inflation (in excess of 50 percent a year), two failed after the first year (Argentina 1989 and Yugoslavia 1989). Exchange rate anchors should be considered superior in a first best world, but when programs are not as strong as the ideal and indexing is not addressed, exchange rate anchors are more likely to end in crises than to work. Thus, decisions to use an exchange rate anchor in programs should place greatest priority on the prospects for resolute fiscal adjustment. In the context of transition economies, indexation is as yet not a major problem; however, the prospects for fiscal adjustment are indeed critical in deciding whether or not an exchange rate anchor is appropriate.
To sum up, both the arguments and the experiences reviewed suggest that exchange rate anchors are an effective and possibly superior approach to stabilization if supporting adjustment measures are adequate. On the other hand, stabilization attempts in Central Europe that were money-based (or at least did not involve pegging) have in most cases been effective as well. Whether or not a peg can be sustained will largely depend on whether it is accompanied by resolute fiscal adjustment. The latter needs to be assessed explicitly, as the evidence shows that adequate fiscal adjustment is not automatically induced by the commitment to peg. Given the great disparities in the ability and willingness to adjust fiscally across countries in the region that are the subject of this paper, one cannot say in general which approach is likely to be best overall. Careful consideration of the individual circumstances is required.
Exchange Rate Policies in Stabilization Programs
To date, most financial programs supported by Fund resources in the region have entailed a degree of exchange rate flexibility. Of the eleven countries in the region for which programs were approved between August 1992 and December 1994, ten pursued flexible exchange rate strategies during the main stabilization attempt (Armenia, Belarus, Georgia, Kazakstan, Kyrgyz Republic, Latvia, Lithuania,17 Moldova, Russia, and Ukraine). In contrast, Estonia stabilized under a currency board arrangement.
In Armenia, Georgia, and Ukraine, the stabilization effort has only just begun, and it is too early for an assessment.18 For all other countries, inflation data is reproduced in Table 1.7. According to the criteria used above, stabilization has been effective in four out of the seven countries that pursued a money-based approach (Latvia, Lithuania, Kyrgyz Republic, and Moldova). Stabilization has also been effective in Estonia, the only country that stabilized under a fixed exchange rate strategy.
This section first describes the considerations that led to the choice of a given anchor and then reviews the performance of both types of anchors in program countries, beginning with a comparison between Estonia and Latvia and then turning to the experience with monetary anchors in the remaining program countries. Finally, some conclusions regarding future stabilization policies in the region are presented.
Choice of Exchange Rate Regime in Fund-Supported Programs
The choice of a nominal anchor in these program countries has reflected the general arguments and trade-offs described above. While the IMF has encouraged the authorities to adopt ambitious disinflation programs, the key requirements to underpin the success of a fixed exchange rate strategy were not present in most cases. First, the political commitment and implementation capacity required to achieve the fiscal adjustment needed to support an exchange rate peg was generally not apparent. With the exception of the Baltics, prevailing fiscal deficits were extremely large when the first stabilization programs were introduced in these countries (Table 6.1). These underlying imbalances cast serious doubt on the feasibility of achieving the required fiscal adjustment.
IMF-Supported Programs in the Baltics, Russia, and Other Countries of the Former Soviet Union: General Government Fiscal Balance, Actual and Program1
(In percent of GDP)
All program projections refer to original program targets.
Actual 1994 data reflect current estimates.
For the Baltic countries, both actuals and program numbers refer to the financial balance (i.e., they exclude net lending).
Russian numbers refer to enlarged government deficit (i.e. they include unbudgeted import subsidies).
IMF-Supported Programs in the Baltics, Russia, and Other Countries of the Former Soviet Union: General Government Fiscal Balance, Actual and Program1
(In percent of GDP)
| 1991 | 1992 | 1993 | 19942 | ||
|---|---|---|---|---|---|
| Estonia3 | |||||
| Actual | 5.2 | 0.9 | 2.3 | 0.9 | |
| SBA, 8/92 | 0.6 | ||||
| Latvia3 | |||||
| Actual | 6.3 | — | 1.0 | –1.7 | |
| SBA, 8/92 | –1.8 | ||||
| Lithuania3 | |||||
| Actual | 7.2 | 1.0 | 0.9 | –1.3 | |
| SBA, 9/92 | –0.7 | ||||
| SBA, 10/93 | –1.0 | ||||
| Kyrgyz Republic | |||||
| Actual | 4.8 | –14.8 | –8.2 | –3.8 | |
| SBA, 4/93 | –6.9 | ||||
| ESAF, 6/94 | –4.1 | ||||
| Moldova | |||||
| Actual | –23.4 | –8.9 | –7.7 | ||
| SBA, 11/93 | –3.5 | ||||
| Russia4 | |||||
| Actual | –16.0 | –18.8 | –8.0 | –10.3 | |
| STF, 6/93 | –10.0 | ||||
| STF, 4/94 | –6.5 | ||||
| Belarus | |||||
| Actual | 1.2 | –4.5 | –8.3 | –1.5 | |
| STF, 7/93 | –9.7 | ||||
| Kazakstan | |||||
| Actual | –7.9 | –7.4 | –1.2 | –6.0 | |
| STF, 7/93 | … | … | |||
| SBA, 1/94 | –4.0 | ||||
| Ukraine | |||||
| Actual | –15.8 | –29.3 | –13.2 | –8.0 | |
All program projections refer to original program targets.
Actual 1994 data reflect current estimates.
For the Baltic countries, both actuals and program numbers refer to the financial balance (i.e., they exclude net lending).
Russian numbers refer to enlarged government deficit (i.e. they include unbudgeted import subsidies).
IMF-Supported Programs in the Baltics, Russia, and Other Countries of the Former Soviet Union: General Government Fiscal Balance, Actual and Program1
(In percent of GDP)
| 1991 | 1992 | 1993 | 19942 | ||
|---|---|---|---|---|---|
| Estonia3 | |||||
| Actual | 5.2 | 0.9 | 2.3 | 0.9 | |
| SBA, 8/92 | 0.6 | ||||
| Latvia3 | |||||
| Actual | 6.3 | — | 1.0 | –1.7 | |
| SBA, 8/92 | –1.8 | ||||
| Lithuania3 | |||||
| Actual | 7.2 | 1.0 | 0.9 | –1.3 | |
| SBA, 9/92 | –0.7 | ||||
| SBA, 10/93 | –1.0 | ||||
| Kyrgyz Republic | |||||
| Actual | 4.8 | –14.8 | –8.2 | –3.8 | |
| SBA, 4/93 | –6.9 | ||||
| ESAF, 6/94 | –4.1 | ||||
| Moldova | |||||
| Actual | –23.4 | –8.9 | –7.7 | ||
| SBA, 11/93 | –3.5 | ||||
| Russia4 | |||||
| Actual | –16.0 | –18.8 | –8.0 | –10.3 | |
| STF, 6/93 | –10.0 | ||||
| STF, 4/94 | –6.5 | ||||
| Belarus | |||||
| Actual | 1.2 | –4.5 | –8.3 | –1.5 | |
| STF, 7/93 | –9.7 | ||||
| Kazakstan | |||||
| Actual | –7.9 | –7.4 | –1.2 | –6.0 | |
| STF, 7/93 | … | … | |||
| SBA, 1/94 | –4.0 | ||||
| Ukraine | |||||
| Actual | –15.8 | –29.3 | –13.2 | –8.0 | |
All program projections refer to original program targets.
Actual 1994 data reflect current estimates.
For the Baltic countries, both actuals and program numbers refer to the financial balance (i.e., they exclude net lending).
Russian numbers refer to enlarged government deficit (i.e. they include unbudgeted import subsidies).
Moreover, in most of these countries, there was no clear consensus on the desirability of radical stabilization and reform, implying that any program predicated on a sharp fiscal contraction that left little room for maneuver carried great risks. Second, most of these countries lacked access to foreign exchange reserves that would be large enough both to withstand normal temporary swings in the net supply of foreign exchange and to inspire market confidence in the sustainability of the peg (Table 6.2). Indeed, in the seven program countries that have operated with flexible exchange rate regimes, foreign official reserves averaged less than one month of imports at the time of the first Fund-supported program, and it was not clear that most of these countries would have access to borrowed reserves, even in the face of an ex ante strong program.
The Baltics, Russia, and Other Countries of the Former Soviet Union: Gross Reserve Holdings
(In months of imports)
October 1994.
August 1994.
The Baltics, Russia, and Other Countries of the Former Soviet Union: Gross Reserve Holdings
(In months of imports)
| 1992 | 1993 | 1994 | ||||
|---|---|---|---|---|---|---|
| June | Dec. | June | Dec. | June | Sept. | |
| Estonia | 1.4 | 4.5 | 3.4 | 4.8 | 2.8 | 3.0 |
| Latvia | 1.6 | 1.4 | 3.0 | 5.5 | 4.2 | 4.6 |
| Lithuania | 0.4 | 1.2 | 0.9 | 2.3 | 2.6 | 2.8 |
| Kyrgyz Republic | … | 0.9 | 1.4 | 1.5 | 1.5 | 2.3 |
| Moldova | … | — | 0.2 | 0.9 | 2.5 | 2.1 |
| Russia | 0.5 | 0.9 | 1.4 | 1.8 | 1.9 | 1.2 |
| Belarus | … | … | — | 0.2 | 0.6 | 0.6 |
| Kazakstan | … | 0.3 | … | 1.3 | … | 2.6 |
| Ukraine | … | 0.4 | … | 0.7 | … | 0.21 |
| Armenia | … | … | … | 0.1 | 0.1 | 0.2 |
| Azerbaijan | … | 0.6 | … | 0.3 | 0.1 | —2 |
| Georgia | … | — | — | — | 0.1 | — |
| Turkmenistan | … | … | … | 5.9 | 6.6 | 6.6 |
| Uzbekistan | … | 0.5 | 0.3 | 2.2 | 2.6 | 4.9 |
October 1994.
August 1994.
The Baltics, Russia, and Other Countries of the Former Soviet Union: Gross Reserve Holdings
(In months of imports)
| 1992 | 1993 | 1994 | ||||
|---|---|---|---|---|---|---|
| June | Dec. | June | Dec. | June | Sept. | |
| Estonia | 1.4 | 4.5 | 3.4 | 4.8 | 2.8 | 3.0 |
| Latvia | 1.6 | 1.4 | 3.0 | 5.5 | 4.2 | 4.6 |
| Lithuania | 0.4 | 1.2 | 0.9 | 2.3 | 2.6 | 2.8 |
| Kyrgyz Republic | … | 0.9 | 1.4 | 1.5 | 1.5 | 2.3 |
| Moldova | … | — | 0.2 | 0.9 | 2.5 | 2.1 |
| Russia | 0.5 | 0.9 | 1.4 | 1.8 | 1.9 | 1.2 |
| Belarus | … | … | — | 0.2 | 0.6 | 0.6 |
| Kazakstan | … | 0.3 | … | 1.3 | … | 2.6 |
| Ukraine | … | 0.4 | … | 0.7 | … | 0.21 |
| Armenia | … | … | … | 0.1 | 0.1 | 0.2 |
| Azerbaijan | … | 0.6 | … | 0.3 | 0.1 | —2 |
| Georgia | … | — | — | — | 0.1 | — |
| Turkmenistan | … | … | … | 5.9 | 6.6 | 6.6 |
| Uzbekistan | … | 0.5 | 0.3 | 2.2 | 2.6 | 4.9 |
October 1994.
August 1994.
In contrast, a number of conditions prevailed in Estonia that supported the pegging of the exchange rate. Estonia registered budget surpluses in 1991 and the first half of 1992. A deterioration in the fiscal position at the beginning of 1992 was quickly corrected through a strong fiscal package that included a set of revenue-enhancing measures in June. Thus, there was little doubt in Estonia’s ability to undertake the fiscal restraint necessary to sustain the exchange rate peg. Moreover, the return of pre-war Estonian gold from Sweden, the Bank of England, and the Bank for International Settlements (BIS) provided sufficient reserves for the full backing of domestic base money under a currency board arrangement.
As for Lithuania, the currency board was introduced in April 1994 only after the Lithuanian government had demonstrated its capacity to adjust fiscally, reduce inflation, and stabilize the exchange rate. With monetary policy tightened significantly from early 1993, the monthly rate of inflation had been stabilized at low single-digit levels for some time, and the budgetary position was strong. The litas had been stable for some time, and by the time the currency board was established, reserves were sufficient to provide more than 100 percent backing of base money at the then market exchange rate. Thus, while the new currency board arrangement was deemed important to buttress the credibility of stabilization through an institutional anchoring of fiscal and monetary restraint, the authorities’ basic commitment to stabilization policies was clear.
In Latvia, the necessary conditions for pegging were also broadly satisfied, with widespread political support for strong stabilization policies. However, the Latvian authorities opted for a strong independent central bank in conjunction with a flexible exchange rate arrangement. In terms of credibility and the likelihood of fiscal restraint, the Latvian arrangement thus promised to be as effective as a credible exchange rate peg. In view of this, and the advantages of the Latvian arrangement in coping with external and real shocks, the IMF staff supported the authorities’ desire to employ a money-based approach in stabilizing.
Stabilization Performance Under Alternative Anchors: Estonia and Latvia
Estonia and Latvia have been broadly similar in many of the circumstances that have influenced economic performance: location, size, factor endowments, external relations with Russia, and other countries of the former Soviet Union, and the timing of the stabilization effort. Moreover, as Saavalainen (1995) points out, the overall monetary and fiscal stances of the two countries since mid-1992 have been comparable. Thus, Estonia and Latvia present a useful pair of countries for a more detailed comparison of the effects of alternative stabilization approaches.19
In comparing the behavior of macroeconomic variables during the disinflation process in the two countries, the main official indicators would suggest the following:
• The initial disinflation paths were very similar for both. Over the last year, however, inflation has been lower in Latvia than in Estonia (Table 6.3);
• The estimated output decline during disinflation was larger for Latvia than for Estonia;
• A comparison of domestic deposit rates between Latvia and Estonia for 1993 and 1994 (Table 6.4) reveals large nominal interest rate differentials in favor of Latvia. Most important, a substantial differential remains for 1993 and the first half of 1994 even after controlling for differences in domestic credit risk by taking into account differentials between the Latvian and Estonian foreign exchange deposit rates.20 This suggests that a large part of the differential between Estonian and Latvian deposit rates in 1993 and early 1994 can indeed be attributed to the different exchange rate arrangements.
Estonia and Latvia: Disinflation and Output Loss 1992-94
Estonia and Latvia: Disinflation and Output Loss 1992-94
| Percentage Point Change | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 1992 | 1993 | 1994 | 1992: Q2– | ||||||||
| Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | 1994: Q2 | ||
| Estonia | |||||||||||
| Real GDP Index (1991= 100) | 85 | 80 | 76 | 77 | 82 | 85 | 82 | 77 | 85 | –0.5 | |
| Annualized inflation (in percent) | 1,028 | 1,167 | 1,122 | 293 | 135 | 61 | 38 | 44 | 50 | ||
| Latvia | |||||||||||
| Real GDP Index (1991= 100) | 64 | 62 | 60 | 51 | 55 | 56 | 59 | 52 | 56 | –8.6 | |
| Annualized inflation (inpercent) | 722 | 1,097 | 1,272 | 398 | 186 | 85 | 34 | 34 | 37 | ||
Estonia and Latvia: Disinflation and Output Loss 1992-94
| Percentage Point Change | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 1992 | 1993 | 1994 | 1992: Q2– | ||||||||
| Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | 1994: Q2 | ||
| Estonia | |||||||||||
| Real GDP Index (1991= 100) | 85 | 80 | 76 | 77 | 82 | 85 | 82 | 77 | 85 | –0.5 | |
| Annualized inflation (in percent) | 1,028 | 1,167 | 1,122 | 293 | 135 | 61 | 38 | 44 | 50 | ||
| Latvia | |||||||||||
| Real GDP Index (1991= 100) | 64 | 62 | 60 | 51 | 55 | 56 | 59 | 52 | 56 | –8.6 | |
| Annualized inflation (inpercent) | 722 | 1,097 | 1,272 | 398 | 186 | 85 | 34 | 34 | 37 | ||
Latvia and Estonia: Interest Rate Differentials1
(In months of imports)
End-of-month data. All rates refer to three-to-six-month time deposits.
End-September data for Estonia.
Latvia and Estonia: Interest Rate Differentials1
(In months of imports)
| 1993 | 1994 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| January | April | July | October | January | April | July | October2 | |||
| 1. Latvia | ||||||||||
| Deposit rate (A) | 86.4 | 65.8 | 61.0 | 50.1 | 42.5 | 32.3 | 34.0 | 23.7 | ||
| Forex deposit rate (B) | 26.3 | 18.4 | 17.4 | 25.4 | 26.3 | 21.2 | 22.0 | 19.4 | ||
| Difference A-B (C) | 60.1 | 47.4 | 43.6 | 24.7 | 16.2 | 11.1 | 12.0 | 4.3 | ||
| 2. Estonia | ||||||||||
| Deposit rate (A) | 15.5 | 18.6 | 17.7 | 14.2 | 11.5 | 11.5 | 12.1 | 11.2 | ||
| Forex deposit rate (B) | 7.5 | 11.4 | 5.2 | 5.5 | ||||||
| Difference A-B (C) | 4.0 | 0.1 | 6.9 | 5.7 | ||||||
| Differential (1A-2A) | 70.9 | 47.2 | 43.3 | 35.9 | 31.0 | 20.8 | 21.9 | 12.5 | ||
| Differential (1B-2B) | 18.8 | 9.8 | 16.8 | 13.9 | ||||||
| Differential (1C-2C) | 12.2 | 11.0 | 5.1 | –1.4 | ||||||
End-of-month data. All rates refer to three-to-six-month time deposits.
End-September data for Estonia.
Latvia and Estonia: Interest Rate Differentials1
(In months of imports)
| 1993 | 1994 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| January | April | July | October | January | April | July | October2 | |||
| 1. Latvia | ||||||||||
| Deposit rate (A) | 86.4 | 65.8 | 61.0 | 50.1 | 42.5 | 32.3 | 34.0 | 23.7 | ||
| Forex deposit rate (B) | 26.3 | 18.4 | 17.4 | 25.4 | 26.3 | 21.2 | 22.0 | 19.4 | ||
| Difference A-B (C) | 60.1 | 47.4 | 43.6 | 24.7 | 16.2 | 11.1 | 12.0 | 4.3 | ||
| 2. Estonia | ||||||||||
| Deposit rate (A) | 15.5 | 18.6 | 17.7 | 14.2 | 11.5 | 11.5 | 12.1 | 11.2 | ||
| Forex deposit rate (B) | 7.5 | 11.4 | 5.2 | 5.5 | ||||||
| Difference A-B (C) | 4.0 | 0.1 | 6.9 | 5.7 | ||||||
| Differential (1A-2A) | 70.9 | 47.2 | 43.3 | 35.9 | 31.0 | 20.8 | 21.9 | 12.5 | ||
| Differential (1B-2B) | 18.8 | 9.8 | 16.8 | 13.9 | ||||||
| Differential (1C-2C) | 12.2 | 11.0 | 5.1 | –1.4 | ||||||
End-of-month data. All rates refer to three-to-six-month time deposits.
End-September data for Estonia.
The Latvian experience confirms that inflation can be effectively and rapidly reduced under a money-based stabilization and that the exchange rate peg is not a precondition for fiscal discipline and quick stabilization. At the same time, interest rate differentials suggest that Estonia’s exchange rate strategy may have commanded greater credibility than Latvia’s, which may have reduced the real cost of stabilization. And indeed, the path of recorded output appears to favor Estonia.
Substantial care, however, should be exercised in concluding that Estonia had a more favorable output performance because of its fixed exchange rate strategy. Indeed, in spite of their many similarities, there are important differences in the conditions under which Latvia and Estonia stabilized that worked to Estonia’s advantage. In particular, Estonia’s closer ties to Finland and Sweden may have contributed to relatively high foreign investment. In addition, Latvia was slow to privatize relative to the other Baltic countries.21 Finally, and perhaps most important, the data on output for the two countries are not comparable. The official national accounts data for Estonia incorporate an estimate of private sector activity—which is said to have grown rapidly to account for a large share of total value added—whereas the Latvian figures do not include any such estimate. Thus, the recorded difference in output performance almost certainly overstates the actual difference; indeed, the actual situation may not have been significantly different.
Experience with Money-Based Programs Outside the Baltics
We now turn to the stabilization experience in Belarus, Russia, Kazakstan, the Kyrgyz Republic, and Moldova, the five countries that, in addition to Latvia and Lithuania, used money-based strategies to combat high inflation. Belarus and Russia have had programs supported under the Systemic Transformation Facility, while the remaining three countries presently have programs supported by stand-by arrangements (followed by an enhanced structural adjustment facility for the Kyrgyz Republic).
In the absence of a benchmark country operating with a fixed exchange rate but otherwise similar economic conditions, it is impossible to disentangle the effect of the exchange rate arrangement from other factors affecting inflation and output performance. Our approach is thus to ask whether the conditions under which a monetary anchor ought to be the better choice—based on the general arguments—in fact turned out to be present in the five countries. The difficulty with this approach is that it is not straightforward to infer these conditions from the realized paths of economic variables. Our conclusions will thus necessarily remain tentative and will need to consider information about the political environment and the motivation of certain government actions as well as economic conditions.
The experience indicates that, with the exception of Russia, all of these countries experienced large swings in velocity following the adoption of their first stabilization programs (Table 3.2). The instability in velocity has been particularly pronounced since mid-1993, with a large rise at the end of 1993 and the first quarter of 1994. This implies that, at least until the spring of 1994, money was a rather ineffective nominal anchor. Abstracting from all other considerations for the time being, an exchange rate peg might have been warranted for two distinct reasons. First, in the Kyrgyz Republic, Kazakstan, and Moldova, the initial rise in velocity in part may have reflected low confidence in the new national currencies; a credible exchange rate peg may have served to enhance confidence. Second, apart from any confidence effects, an exchange rate anchor may have had a direct moderating impact on inflation through its effect on prices of tradables.
On the other hand, it is also true that during the same period, the five economies (particularly the energy importers) were hit by large real shocks, both internally—because of structural reforms and changes in profitability in the traded and nontraded sectors—and externally—owing to sharp rises in energy import prices (see Table 3.3). As a result, the equilibrium real exchange rate must have been subject to large swings during the period, which might have undermined any given exchange rate peg, even though a significantly undervalued rate at the outset would have guarded against this risk to some extent.
In addition, all countries in this group failed—by a wide margin in certain cases—to meet fiscal and credit targets. Surges in credit to the agricultural sector occurred in the Kyrgyz Republic (September-October 1993) and Kazakstan (March-May 1994); similar credits contributed to excessive monetary expansion in Russia in the fall and winter of 1993, and again from the summer of 1994 onward. In Belarus, fiscal targets were nominally met, but monetary targets were missed by wide margins from late 1993 onward as the government effectively transferred budgetary operations—including credits to agriculture—to the banking system. Slippages in Moldova primarily reflected delays in foreign financing and the effects of natural catastrophes.
Under an exchange rate based program, these slippages would have forced an abandonment of the peg or at least a devaluation. The crucial issue thus becomes whether the commitment induced by a peg would have had a substantial effect in preventing or reducing the slippages. In the absence of a counter-factual, it is impossible to know this with certainty, however, we would argue that the answer is likely to be “no” in all cases. Indeed, some of these targets themselves did not reflect a sufficiently ambitious disinflation that would have been consistent with a fixed exchange rate; and the size and nature of the financial slippages indicate that the even greater fiscal adjustment needed to sustain an exchange rate peg could not have been achieved. In Russia and Belarus, the underlying political willingness and consensus to undertake the required adjustment policies was lacking, in spite of the efforts of some reform-minded government officials.22 This absence of sufficient commitment to disinflation was reflected in the considerable policy failures under various Fund-supported programs in 1992-94 some of which have been highlighted above. In Kazakstan, the main source of fiscal slippage under the 1994 stand-by arrangement was a large, ill-designed bailout of inter-enterprise arrears, which reflected the magnitude of underlying imbalances in the enterprise sector and lack of commitment to financial discipline at that time (see Section IV). For the Kyrgyz Republic, the expansion in credit in late 1993 primarily resulted from the perceived need to sustain agricultural production to ensure oil and gas deliveries under barter agreements with Russia and Uzbekistan. The size of the problem and the authorities’ policy response strongly suggest that a peg would not have been sustained. In Moldova, the domestic slippages were responses to exogenous shocks that were outside the control of the authorities.
The Moldovan case is an example of a situation where a monetary anchor could be the preferable stabilization regime in a transition economy even if a strong underlying commitment to adjust exists. If a transition economy is affected by exogenous shocks of the type experienced in Moldova, a temporary departure from fiscal consolidation may well be warranted. Without large reserves, this would generally require a devaluation under an exchange rate based program that, even though justified by the change in underlying fundamentals, could be seen as a policy failure by the public. A money-based program, however, provides the opportunity of making such adjustments while keeping the reputational losses involved small and ensuring that the deviation is indeed temporary. Moreover, in Moldova, the perception appears to have been that the Fund had modified the program, not that the authorities had failed. Thus, the commitment of the authorities to the stabilization goal and its credibility in the eyes of the public was preserved in a way that may not have been possible under a devaluation.
In short, a review of the shocks that affected the five transition economies during 1993—94 does not point to one or the other exchange rate approach as the preferred choice. It is possible that exchange rate based stabilizations—if they had been successful—would have provided a tighter control of the price level in these countries than was possible under the money-based programs. However, the political economy in these countries during the period of review suggests that exchange rate based programs would have carried unduly high risks and, given changing circumstances, may not have allowed a sufficiently flexible response. In Russia and Belarus, money-based programs appear to have been the only feasible alternative.
Conclusions for Future Stabilization Policies
Experience so far indicates that money-based programs have succeeded in bringing inflation down in a number of countries in the region. Nevertheless, recent developments in many states appear to have strengthened the case for adopting a fixed exchange rate strategy. Specifically, with progress in price and trade liberalization, many of the required real shocks have already been registered in several countries. Moreover, political support for reform and stabilization has recently grown in some countries, perhaps reflecting the increasing realization that the gradualist approach has not yielded favorable results. Thus, the most important precondition for pegging—a strong underlying commitment to fiscal adjustment—may increasingly be present.
In assessing the appropriateness of alternative exchange rate arrangements in the region during the period ahead, the different situations of individual countries need to be borne in mind:
(1) Certain countries (including Armenia, Georgia, Kazakstan, Russia, and Ukraine) are at a stage when fixing the exchange rate could make a valuable contribution to macroeconomic stabilization. Whether or not a peg would ultimately be warranted would depend crucially on whether the fiscal adjustment set out in these programs was sufficiently deep—and the likelihood that it would be followed sufficiently high—to give to the exchange rate peg a reasonable chance of success. In addition, the feasibility of pegging would, of course, depend on sufficient access to reserves from external sources, including possibly a currency stabilization fund.
(2) In other cases (e.g., Latvia, Moldova, and the Kyrgyz Republic), consideration of an exchange rate peg might not be actively pursued, even though the fiscal preconditions for such an approach might be satisfied. In Moldova and the Kyrgyz Republic, money-based programs have been successful in substantially bringing down inflation, and remonetization of the economy is well under way. Thus, there seems little reason to change these arrangements now. Indeed, the authorities in both countries strongly advocate retaining the current money-based approach. As for Latvia, it has maintained an unannounced peg since February 1994, and there is an issue as to whether this state should be formalized through the introduction of a formally fixed exchange rate or through a currency board arrangement. Given that the monetary authorities in Latvia enjoy high credibility, that inflation is the lowest of any country of the former Soviet Union, and that output recovery is under way, there are good reasons for retaining the current arrangement. The credibility gain from switching to a formal peg would seem minor in this case and may be offset by the loss in flexibility.
(3) In the remaining countries, it would appear at the moment that the preconditions for adopting an exchange rate peg are unlikely to prevail in the near future: either the fiscal adjustment required under a peg will not yet be feasible, or the countries will be undergoing severe structural changes that imply large changes in the equilibrium exchange rate, or both.
The appropriate exchange rate regime is likely to remain an important issue as reform in the region progresses. It is likely that political and economic uncertainties will remain unusually large, and underlying circumstances highly fluid. A continual reassessment of what may be the appropriate policy approach will be required.
References
Bennett, Adam G.G., “The Operation of the Estonian Currency Board”, Staff Papers, International Monetary Fund, Vol. 40 (June 1993), pp. 451–70.
Bennett, Adam G.G., “Currency Boards: Issues and Experiences,” IMF Papers on Policy Analysis and Assessment, PPAA 94/18 (Washington: International Monetary Fund, September 1994).
Calvo, Guillermo, “Incredible Reforms”, in Debt, Stabilization and Development, Calvo Guillermo (Oxford: Basil Blackwell, 1989).
Camard, Wayne W., “The Design of Currency Board Arrangements: Discretion with Rules?” (unpublished; Washington: International Monetary Fund, October 1994).
Chadha, Bankim, Paul R. Masson, and Guy Meredith, “Models of Inflation and the Costs of Disinflation,” Staff Papers, International Monetary Fund, Vol. 39 (June 1992), pp. 395–431.
Fischer, Stanley, “Exchange Rate versus Money Targets in Disinflation”, in Indexing, Inflation and Economic Policy, Fischer,Stanley (Cambridge, Massachusetts: MIT Press, 1986), pp. 247–62.
Hansson, Ardo, and Jeffrey Sachs, “Monetary Institutions and Credible Stabilization: A Comparison of Experience in the Baltics” (mimeograph; Stockholm: Stockholm Institute of East European Economics, June 1994).
Saavalainen, Tapio, “Stabilization in the Baltic Countries: A Comparative Analysis,” IMF Working Paper, WP/95/44 (Washington: International Monetary Fund, April 1995).
Sachs, Jeffrey, “Russia’s Struggle with Stabilization: Conceptual Issues and Evidence,” paper prepared for the World Bank’s Annual Conference on Development Economics, held in Washington, April 1994.
Sahay, Ratna, and Carlos Vegh, “Inflation and Stabilization in Transition Economies: A Comparison with Market Economies”, IMF Working Paper, WP/95/8, (Washington: International Monetary Fund, January 1995).
Sargent, Thomas, “The End of Four Big Inflations,” in Inflation: Causes and Effects, Robert E. Hall (Chicago: Chicago University Press, 1982).
Tarr, David G., “The Terms of Trade Effects of Moving to World Prices on Countries of the Former Soviet Union,” Journal of Comparative Economics, Vol. 18 (February 1994), pp. 1–24.
Vegh, Carlos A., (1992), “Stopping High Inflation. An Analytical Overview,” Staff Papers, International Monetary Fund, Vol. 39 (September 1992), pp. 626–95.
IMF-supported programs involving flexible exchange rates in the Baltics, Russia and other countries of the former Soviet Union have typically entailed binding credit targets established on the basis of indicative monetary targets or projections. While, strictly speaking, such programs did not entail a nominal money anchor, with credit expansion the primary factor determining money growth in these countries we follow the literature (e.g., Sahay and Vegh (1995)) in referring to such programs as “money based.”
For example, Sargent (1982). See also Calvo (1989) and Chadha, Masson and Meredith (1992).
See Fischer (1986), pp. 257-59 for a discussion of the effects of shocks under alternative regimes.
These arguments can be appreciated most simply in an open economy IS-LM framework, where a credible fixed exchange rate regime amounts to fixing the interest rate to world levels, implying a complete isolation of the real sector of the economy from money demand shocks, but at the same time eliminating interest rate adjustment to goods demand shocks. Fixing money has the opposite effect, because all short-run adjustment to money demand shifts takes place through the interest rate and exchange rate and is thus passed on to the real sector, while goods demand shocks are mitigated by interest rate adjustment.
For example, see Tarr (1994) and Section I for estimates of terms of trade shocks affecting the Baltic states, Russia, and other countries of former Soviet Union since 1992.
The question of which considerations are important beyond the disinflation phase are a separate matter.
See, for instance, Sahay and Vegh (1995).
See Sachs (1994) and references quoted therein.
This fiscal adjustment would include reductions in quasi-fiscal expenditures, such as central bank directed credits and interest rate subsidies, where they are significant.
Note that this argument need not apply to a crawling peg policy, since under a crawling peg a less stringent path of fiscal adjustment could be accommodated by designing the preannounced exchange rate depreciation schedule accordingly. However, in conditions of uncertainty regarding future economic shocks and the political feasibility of achieving fiscal targets, the relatively high costs of failure associated with an exchange rate based approach may lead to a less ambitious inflation objective under a crawling peg than under a money-based program.
The “underlying commitment of policymakers to fiscal discipline” refers to the exogenous preferences of policymakers, as op-posed to their actual behavior, which will most likely be endogenous to the choice of nominal anchor.
On the problem of introducing some elements of discretion in the currency board arrangement, see Camard (1994).
Note that Hungary has not been included in Table 1.7 as either a case of money-based or exchange rate based stabilization for two reasons. First, inflation in Hungary was never very high, hovering between 5 percent and 15 percent a quarter in 1990-91, and stabilization attempts in 1991 did not make much of a difference. Second, Hungary’s approach to stabilization is difficult to classify, because its policy of “adjustable pegging” can be viewed as either a managed float or an extremely loose exchange rate “anchor.”
Croatia pursued a money-based stabilization strategy in the sense that during the stabilization phase, in which inflation was spectacularly brought down to practically zero in only four weeks (October 3, 1993 to early November 1993), the National Bank of Croatia (NBC) relied on tight and publicly announced base money targets and there was no exchange rate peg. Because of the fast ensuing remonetization of the economy, the original base money targets were allowed to be exceeded, and from mid-November onward the NBC began to focus much more on the exchange rate as the nominal anchor. However, price stability had already been achieved at that point.
See Vegh (1992), pp. 644-48. The successful exceptions are Brazil (1964), Israel (1985), and Mexico (1987).
Subsequent to the main price stabilization phase, Lithuania introduced a currency board in March 1994, while Latvia has maintained a de facto peg against the SDR (without formally committing to a fixed exchange rate) since February 1994, also after the main stabilization phase.
It is important to remember that this paper was written in early 1995. Considerable progress has been achieved in some countries since then. Eds.
This was forcefully argued by Hansson and Sachs (1994) in a first systematic comparison of the Baltic stabilization experiences.
The Latvian deposit rate refers to government securities, whereas the Estonian rate refers to central bank securities. Thus, “some residual risk” may apply to the former relative to the latter, “since only the latter are guaranteed to be honored in cash (which is also a central bank liability), (Saavalainen (1995) pp. 15-16).
For the first half of 1994, there is a substantial differential between the Latvian and Estonian deposit rates, even after subtracting the corresponding foreign exchange deposit rates (which capture differences in credit risk but not in the exchange arrangements—see Table 6.4, last row). For 1993, there is no data on Estonian foreign exchange deposits, since such deposits only became legal in 1994. However, even if we assume that Estonian interest rates on foreign exchange deposits would have been zero at that time, thus maximizing the implicit differences in credit risk between Latvia and Estonia, a substantial differential would have remained between the credit-risk-adjusted Latvian and Estonian rates.
See Saavalainen (1995).
See Section VIII for the case of Russia.