6 Monetary and Exchange Rate Regimes
Author: Ms. Rachel Elkan, Mr. Robert A Feldman, Louis Kuijs1, and Mr. Maxwell Watson
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Language:
English
Keywords:
BOOK; bank; country; monetary policy; CEC5; EU accession; headline inflation; transmission mechanism; core inflation; inflation goal; incomes policy; Inflation targeting; Exchange rate arrangements; Capital controls; Europe; Global
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Abstract

The policy challenges confronting monetary authorities in central Europe over the next few years—as they design and modify their monetary and exchange rate regimes—are in many respects similar to those facing other emerging market economies.61 The central challenge is to complete and consolidate disinflation, and secure financial stability, against the backdrop of major structural changes in the real economy and sizable—possibly volatile—international capital flows. But the CEC5 are undertaking, in addition, a specific policy agenda: the reforms required for EU and, ultimately, euro area membership. Policymakers, therefore, must also be attentive to developing monetary, exchange rate, and financial frameworks that are consistent with these goals.

The policy challenges confronting monetary authorities in central Europe over the next few years—as they design and modify their monetary and exchange rate regimes—are in many respects similar to those facing other emerging market economies.61 The central challenge is to complete and consolidate disinflation, and secure financial stability, against the backdrop of major structural changes in the real economy and sizable—possibly volatile—international capital flows. But the CEC5 are undertaking, in addition, a specific policy agenda: the reforms required for EU and, ultimately, euro area membership. Policymakers, therefore, must also be attentive to developing monetary, exchange rate, and financial frameworks that are consistent with these goals.

While the choice of appropriate monetary and exchange rate regimes can contribute crucially to assuring low inflation and real convergence in a stable setting, success will also depend to a high degree on supporting policies. In a setting marked by sizable capital inflows, support from fiscal and financial sector policies, in particular, will be key. Realistically, however, monetary authorities must reckon that this support could prove variable over time. Fiscal policy, for example, will face serious stresses as real convergence continues and as countries, with the aid of substantial EU support, mobilize their own resources in parallel to implement the acquis communautaire and modernize their economies. And domestic financial systems, even where deeply restructured, are still maturing—a process fraught with hazards. A broad range of policies will need to be properly coordinated, and over a sustained period—a difficult task, but one that is essential to parry the undeniable risks surrounding the convergence process. Among other things, these elements introduce more than the usual degree of uncertainty over the impact of monetary policy on the economy.

In this setting, four questions are likely to be at the core of monetary authorities’ concerns. First, what monetary and exchange rate regimes—and what specific anchors for policy—offer the best prospects of delivering disinflation securely, while mitigating risks of financial instability and supporting growth? Second, in a setting of real convergence, what is a realistic target for inflation over the medium term—bearing in mind the impact of relative price adjustments still underway? Third, what are the preconditions for moving to a wide exchange rate band and declaring a fixed central rate against the euro—such as an ERM2-like band?62 And fourth, how rapidly should remaining capital controls be removed, and what policy safeguards are needed in this regard?

To shed light on these admittedly complex questions, this chapter seeks to draw on recent experience in other emerging markets, and to blend this with considerations specific to the late stages of transition and the EU accession process. It suggests a number of priorities for policy:

  • Given the likelihood of continuing real appreciation, due to Balassa-Samuelson effects and other relative price changes, there is a plausible case for aiming over the medium term for CPI inflation in low single digits—but not necessarily as low as 1 to 2 percent per annum. Such a strategy poses a potential dilemma, down the line, in relation to the Maastricht requirement of sustaining low inflation—though not necessarily to a degree that is insuperable in pragmatic terms when the time comes.

  • To get to that point, it will be important to progress further on price liberalization. The share of regulated prices in the CPIs of the candidate countries is much higher than of the euro area countries and, in some cases, prices are regulated below cost recovery levels.

  • Well-functioning labor markets, in addition to a prudent macroeconomic policy stance, are key ingredients to supporting and/or maintaining the disinflation process—a substantial challenge requiring sustained policy resolve.

  • While exchange rate pegs were useful in the early stages of disinflation, the balance of advantage in central Europe has tipped toward more flexible regimes—in particular to avoid providing an exchange rate “guarantee” to domestic borrowers or offering too easy a target for speculative attack.63 Nonetheless, even under flexible regimes, the exchange rate will remain too important to be neglected, and adjustments in the policy mix may be called for to moderate wide swings in the rate—a consideration that will become critical once, with major structural transformations completed and the adoption of the euro in view, countries move to participate in ERM2.

  • Where policymakers opt for flexibility in the form of a free float or a wide band over the next few years, a specific nominal anchor will be called for to guide inflation expectations. Any hard band wide enough to discourage speculation will likely prove too wide to guide inflation expectations forcefully. One obvious candidate as an anchor is inflation targeting (freely, or subject to a wide-band constraint). The use of some “soft” exchange rate target—for example, an undeclared inner band—should not be ruled out as the focus of short-term monetary policy operating procedures, but a declared band poses financial market hazards, while an undeclared band alone lacks the virtue of transparency.

  • As they move from “emerging” to “converging” status, these countries may be at least as vulnerable to financial crises as earlier EU and EMU candidates. High quality observance of international standards and codes can help parry crises—as could use of the IMF’s Contingent Credit Lines. In addition, removal of residual capital controls needs to be prudently phased with the attainment of sustainable and suitably flexible macroeconomic policies and, crucially, the completion of financial reforms that reduce the balance sheet risks and hence the prospect and costs of a crisis. The existing latitude for EU members to reimpose controls temporarily in a crisis (with the approval of the Council of Ministers) will, of course, remain available, including in the period before mutual commitments with the European Central Bank are in place to support exchange rate commitments under ERM2.

Disinflation: Initial Success and Current Tensions

A majority of the central European economies began transition with high—in some cases very high—rates of inflation. This reflected rapid price liberalization, the unwinding of overvalued exchange rates, and the realization of pent-up demand associated, in some cases, with the elimination of monetary overhangs. Typically, monetary authorities adopted exchange rate pegs to anchor expectations; fiscal reforms were pursued vigorously, while the development of government debt markets reduced pressure for the monetization of deficits;64 and in most cases incomes policy or tripartite understandings played a supporting role, which, among other things, compensated to some degree for remaining soft budget constraints in the enterprise sector.

By the end of 1994, year-on-year CPI inflation in all these economies stood at moderate levels—in a range of about 10 to 30 percent; and, despite some setbacks, there has been no tendency for serious inflationary pressures to reemerge (Figures 6.1 and 6.2). This was the case even though fiscal or quasi-fiscal pressures continued to put pressure on resources in some countries. This success in taming inflation, and avoiding a serious relapse, is a testimony to the strong commitment of monetary authorities. It also reflected a choice of exchange regimes that matched quite well the evolving circumstances of each country (Corker and others, 2000).

Figure 6.1.
Figure 6.1.

Monthly Headline Inflation in CEC5: 1991–2001

(Percent, year-on-year)

Sources: Data provided by national authorities; and IMF staff estimates.
Figure 6.2.
Figure 6.2.

Monthly Core Inflation in CEC5: 1993–2001

(Percent, year-on-year)

Sources: Data provided by national authorities; and IMF staff estimates1Net inflation excludes regulated prices and the impact of indirect tax changes.2Core inflation is calculated by removing seasonal foods, nonregulated fuels, motor fuels, and pharmaceutical goods from the CPI.3Net inflation excludes food and fuels.4Core inflation excludes regulated prices and the impact of indirect taxes.5Series excludes food and energy. Estimates ore prepared by the Institute for Macroeconomic Analysis and Development, Slovenia.

As a preliminary to discussing future options, it is helpful to examine this recent degree of fit between regimes and country circumstances. Initially, as small open economies addressing major risks of inflation (and with newly reformed institutions), a majority of them found it advantageous to peg the value of their currencies to that of a much larger, low inflation, country in order to import credibility and fix the inflation rate of traded goods. (Slovenia was an exception in this regard.) Crucially, goods and factor markets were relatively flexible, allowing pegs to put more onus on adjustment of wages and prices. This was especially important given the need to absorb major structural upheavals in the real economy: ongoing reforms—notably in the enterprise and financial sectors—created an independent source of potential shocks to supply and demand, as well as complications for fiscal policy.

Over the past few years, however, pegs gave way to more flexible regimes—and countries’ speed of movement in this direction maps plausibly to differences in economic characteristics (Tables 6.1 and 6.2). Poland’s relatively early move to exchange rate flexibility was in keeping with its relatively large size (its population is equivalent to about 10 percent of that of the EU, although its total GDP is less than 2 percent of that in the EU), lower degree of openness (trade volume relative to GDP is less than half of that in the other CEC5), and its greater restructuring needs in key sectors. The need to address restructuring, eliminate remaining quasi-fiscal pressures, and improve the functioning of labor and product markets supported the moves to flexible exchange rate policy in the Czech and Slovak Republics and in Slovenia. Hungary’s lengthy perseverance with a narrow band regime was relatively well supported by a particularly flexible labor market, a healthy financial system, and the advanced stage of enterprise reform. However, cross country differences in these metrics should not be exaggerated, and at a broader level, all five countries share similarities: a high degree of openness, rapidly growing commonality of their trade and output structures with those in the EU and, for the most part, sufficient labor market flexibility to justify some degree of alignment of their exchange rates to the euro.

Table 6.1.

Exchange Rate and Monetary Policy Regimes in the CEC5

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Table 6.2.

Exchange Rate Regimes and Basic Economic Characteristics of the CEC5

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IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions, 2000, updated for recent changes (for Hungary).

Data from Eurostat Memo 10/99, December 7, 1999, unless otherwise indicated.

Trade is merchandise imports plus merchandise exports.

IMF’s World Economic Outlook data for 2000.

Sum of the absolute deviations from EU trade shares of food and drink, raw materials, energy, chemicals, manufactures, and machinery. The number in the EU column shows the average of the deviations for the EU countries.

EBRD, 2000 (average of all structural indicators).

IMF Staff estimates, IMF’s World Economic Outlook.

Index where 0=too restrictive, 8=flexible enough, from World Competitiveness Yearbook, 2000.

Index where 0=weak incentives for job search, 8=strong incentives for job search, from World Competitiveness Yearbook, 2000.

The specific course of each country is summarized in Box 6.1—and from this experience three areas emerge in which monetary policy has encountered tensions. In addition to cyclical factors, key issues have been the degree of support from fiscal policy in containing external current account pressures, and the constraints of chosen exchange rate regimes, taking into account external capital flows:

  • Relative cyclical positions appear to have been associated to a growing degree with recent divergences in inflation performance. In Hungary and Slovenia, where inflation in 2000 picked up to near 10 percent, the increase tended to coincide with a strengthening in aggregate demand. The increase in demand likely reduced the gap between potential and actual output, creating conditions in which a pass-through of exogenous price pressures to the general price level was more likely. In contrast, underlying inflation in the Czech and Slovak Republics has been less responsive to these exogenous price shocks owing to the excess capacity that remained in these economies. These observations suggest that cyclical constraints may have become increasingly important determinants of inflation, a feature that tends to characterize inflation dynamics in mature market-based economies.

  • To varying degrees, monetary authorities have felt bound to straddle domestic and external objectives in the conduct of policy. In Hungary (under the narrow band regime) and Slovenia, for example, the monetary authorities’ approach implicitly factored in concerns about competitiveness, implying that at times disinflation could not be viewed as an exclusive or overriding goal. In the Czech Republic and Poland in recent years, by contrast, central banks felt freer to pursue single-mindedly the goal of reducing inflation—although urging in the latter case the need for strong fiscal consolidation to safeguard the external current account deficit. In Slovakia, with major budgetary stresses to handle, there was at times hesitation in implementing the degree of fiscal adjustment that would have been needed for monetary policy to address inflation without regard to the impact of exchange rate appreciation on competitiveness. Also, unlike in Hungary or Poland, the weakness of the banking system in the Slovak Republic at times impeded a tightening of monetary conditions.

  • The shift to free floating regimes—by all four central banks that initially adopted pegs—reflected financial market tensions and associated concerns about inflation (rather than “real shocks”). In the Czech Republic, Poland, and Slovakia, exchange rate pegs were abandoned in the second half of the 1990s under the pressure of heavy capital inflows and outflows rather than necessarily being part of a strategic move to allow a more flexible monetary policy. Nevertheless, the ensuing flexible regimes posed no particular constraints on tightening monetary conditions, including through discretionary interest rate increases. Hungary moved to a wider band in May 2001, reflecting concern that the narrow band and crawling peg regime limited the scope for monetary tightening substantially without triggering sizable capital inflows, but also against the background of concerns about the incentives for speculation created by the narrow band. In Slovenia, the monetary targeting regime coupled with restrictive capital controls left the authorities a free hand, as regards the exchange rate—which has been heavily managed—and concerns about competitiveness have influenced policy.

Policies for Disinflation

Within a common overall experience, specifics in the implementation of monetary policy varied significantly among these five countries:

  • The Czech Republic has consistently been a top performer among the central European transition countries as regards progress with disinflation. A strict peg (initially to the U.S. dollar and later to a basket) with a narrow fluctuation band (± 0.5 percent) remained in place following independence in 1993, and was effective in anchoring inflation expectations. As a result, inflation dropped below 10 percent in early 1994. By early 1996, large short-term capital inflows (facilitated by the rapid liberalization of capital transactions) WERE: threatening the viability of the narrow band peg, and sterilization was proving to be ineffective since—by keeping interest rates high—it encouraged additional inflows. In response, the CNB widened the fluctuation band to ±7.5 percent in order to discourage capital inflows through increased exchange rate risk, while also preserving the nominal anchor role for the exchange rate. Growing fiscal and external current account deficits raised concerns in early 1997 about the sustainability of the peg, and culminated in an attack on the koruna in May. The CNB then abandoned the peg in favor of a managed float, which it defended through high interest rates. Following an initial depreciation of about 10 percent, the koruna rebounded rapidly. However, strong domestic demand and the effect of the initial depreciation pushed up inflation in mid-1997 to near 14 percent. The ensuing tight monetary policy, within the context of a newly adopted inflation targeting framework, rapidly contained overheating pressures and reduced inflation to low single digits, but at a cost to economic growth. Tight monetary (and fiscal) policies remained in place until late 1998 partly out of concern over contagion from the Russian crisis. Despite the current low level of interest rates, the upward trending exchange rate is helping to moderate inflation, which was expected to remain below 4 percent in 2002. With inflation at very low levels, administered price changes were having a significant effect on growth in consumer prices, accounting for about 2 percentage points of headline inflation in late 2001.

  • At the start of transition, Hungary did not experience an explosion in prices, since it had already introduced a series of price reforms much earlier. Following far-reaching structural reforms, the crucial fiscal underpinning of stabilization was achieved with the 1995 adjustment package—and was briefly followed by a pick-up in 12-month inflation (to over 30 percent by mid-1995 from about 20 percent a year earlier). This pickup reflected the direct impact of elements in the package, including an increase in the effective VAT rate, a 9 percent devaluation, and a temporary import surcharge, in addition to the lagged effects of the easier macroeconomic policy stance of the preceding years. A preannounced crawling exchange rate band was also introduced as part of the 1995 package, to anchor expectations. The band width was narrow (±2¼ percent) to provide a clear indication of the exchange rate path, and combined with controls on short-term capital. The initial rate of crawl aimed to safeguard competitiveness—but monetary policy also relied, with considerable success, on lowering the crawl rate to both influence inflation expectations and wages, and to contain the domestic price of traded goods. While inflation fell to single digits at the beginning of 1999, the steady downward trend subsequently stalled and partially reversed. This was partly attributable to exogenous shocks (for example, rising oil prices and the impact of drought and floods on food prices) but was increasingly due to underlying factors. Controls on short-term capital only partially shielded monetary policy from strong capital inflows, and the narrow band limited the central bank’s ability to tighten monetary conditions. Also, core inflation rose sharply from a low of 7 percent in mid-2000 to almost 11 percent in February 2001. The authorities therefore widened the exchange rate band to ±15 percent in May 2001, adopted inflation targeting in June 2001, and eliminated the crawl of the central rate against the euro in October 2001. Disinflation resumed, with the year-on-year headline rate falling to 6.8. percent in December 2001.

  • In Poland, judicious use of crawling and, over time, widening exchange rate hands has provided a successful framework to help address capital surges and external shocks, while supporting the authorities’ gradualist approach to disinflation. The approach saw inflation fall from hyperinflation to moderate levels, and more recently to below 5 percent. Through most of the 1990s, the exchange rate anchor was further aided by an explicit incomes policy and a generally supportive fiscal policy. After initially pegging to a basket of currencies and experiencing a few stepwise devaluations, a crawling peg was introduced, with the rate of crawl gradually reduced as inflation decreased. In response to pressures from capital inflows, flexibility was increased to a ± 7 percent band in 1995 around the central parity. After steps to widen the band, in April 2000 the crawling band regime was abolished and the zloty has since been floating freely under an inflation targeting regime. Monetary policy decisions are now made to attain the inflation target, while exchange rate flexibility is allowed to absorb the impact of swings in capital flows. However, the tensions latent in the monetary framework have been evident, particularly in 1999 when inflation started to pick up but there were also concerns about the increase in the current account deficit to 7½ percent of GDP—as well as about the ability and flexibility of fiscal policy to support external objectives. As activity slowed sharply in 2000 and the current account deficit narrowed, these policy tensions eased somewhat—but were not entirely resolved. Uncertainty about the fiscal stance impeded an easing of monetary policy to support activity—and this policy mix contributed to the appreciation of the real exchange rate. Nonetheless, the forceful approach to monetary policy resulted in the outlook for inflation improving sharply, laying a strong basis to achieve low single digit inflation in the short to medium term.

  • Slovakia’s relatively good inflation performance during transition reflected forceful monetary policy and, in the face of high unemployment, moderate wage pressures—which were facilitated by a tripartite consensus. Postponement of administrated price increases further moderated pressure on prices. After inflation of 25 percent in 1993 (the first year as an independent country) on the heels of the introduction of the VAT and a 10 percent devaluation, inflation fell gradually to some 7 percent at end 1995, and remained at about this level until mid-1999, despite considerable turmoil in the foreign exchange market. Three years of current account deficits at 10 percent of GDP during 1996—98–partly reflecting a lax fiscal stance—capital account variability led to a stepwise widening of the fluctuation bands for the peg to a deutsche mark/U.S. dollar basket. Finally, in the context of pressure on the foreign exchange market, and despite a very tight monetary stance, the koruna was forced to float in 1998. Under the float, monetary policy has been predominantly geared toward inflation goals. Although the National Bank of Slovakia views a stable, competitive exchange rate as important for the very open Slovak economy, it has adopted a policy of only intervening in the foreign exchange market to avoid sharp oscillations of the exchange rate—indeed, it has abstained from intervention since January 2001. In 1999–2000, administered prices were raised in the context of tightening the fiscal stance, temporarily boosting headline inflation; but with the domestic economy weak, core inflation remained subdued at 5–6 percent, falling below 4 percent by end-2001, despite a recovery of domestic demand. Current account pressures resurfaced during 2001, and could pose dilemmas for the policy mix in the period ahead.

  • Following independence in 1991, Slovenia rapidly reduced inflation from 200 percent in 1992 to the single digits in 1996, despite widespread indexation in the economy. After a pause in 1997, disinflation continued and, in the first half of 1999, inflation fell below 5 percent. This success was the result of an eclectic disinflation strategy that combined a money target (Slovenia was the only country of the five to use a money target) with a managed floating exchange rate aimed at controlling liquidity by discouraging interest-sensitive capital inflows and containing external imbalances. Until they were liberalized beginning in 1999, capital controls were crucial to buttressing this framework. Disinflation and external objectives were also supported by conservative fiscal policy (the fiscal deficit peaked in 2000 at 1.4 percent of GDP) and wage moderation. The introduction of a VAT in mid-1999 and sharply higher world oil prices in 1999 and 2000, in the context of a buoyant economy and widespread indexation, led to the persistence of these price shocks. As a result, inflation remained at 9–10 percent during the first half of 2001, but fell to 7 percent at end 2001 as monetary policy was tightened and exogenous price shocks were unwound. With the capital account now essentially open, thereby reducing control over broad money, and the need to establish a viable central parity for ERM2, a new monetary framework was adopted in November 2001 that bears some of the hallmarks of inflation targeting, and that aims to achieve 3–4 percent inflation in 2005. Deindexation of the economy is also underway with the shift to forward-looking wage indexation in the public and private sectors and the elimination of indexation in new financial contracts with a maturity of less than one year as of July 2002, as a first step to complete deindexation.

Thus, in addition to the “traditional” real economy benchmarks discussed above, financial market issues have increasingly influenced regime choice—and across the board have weighed in on the side of more flexible regimes. There is a growing consensus that adjustable peg regimes (but not very hard pegs such as currency boards) pose particular hazards in a liberalized financial setting.65 First, they are more prone to speculative attack. Second, and compounding this problem, they may encourage the build-up of unhedged foreign currency liabilities by domestic firms. In the event of a successful attack on the peg, the impact of a devaluation on these liabilities can result in major costs to the banking system, and ultimately to the budget and the economy. The desirability of minimizing financial vulnerability and problems associated with capital inflows suggests the attraction of exchange rate flexibility (in the absence of a hard peg). Indeed, even in a case such as Hungary, where more traditional optimal currency area arguments could have justified maintaining a peg within a narrow band (possibly with some revaluation of the central rate), these considerations support the decision to move to a more flexible regime.

The discussion above tends to underscore the advantages of flexibility (at least for countries without currency boards); but this judgment must be qualified over time to the extent that EU accession, involving a firm commitment to adopt the euro in due course, provides a clear end-point for these countries’ monetary and exchange regimes. The timetable is pressing enough to be a consideration in determining the current monetary strategies in the CEC5—for example, in setting medium-term inflation goals. But the route to the end point is not mapped out precisely. Countries have some latitude to adjust their regimes during the interim in a manner that best serves their transition and macroeconomic policy needs, as they lay the groundwork for their eventual return to a fixed rate regime.

The Run-Up to Accession: Regime Requirements and Goals in Context

It is generally accepted that the CEC5 could become EU members within a few years—perhaps by early 2004—and that after a further two years they could be eligible to adopt the euro. In practical terms, the implications of this EU and euro destiny for medium-term inflation goals, interim anchors, and the phasing of paths back toward greater fixity thus need to be assessed fairly urgently. These issues are complicated by the outlook for real appreciation (but uncertainty about its equilibrium magnitude); and the prospect of large and volatile capital flows against a background of having removed remaining capital controls in line with existing commitments.

Regime Requirements for Accession

Prior to accession, countries may choose whatever exchange rate system suits them, mindful of the requirements of accession. In particular, countries are expected to complete the liberalization of capital accounts, make their central banks fully independent, eliminate direct public sector financing by the central bank, and create efficient, market-oriented financial sectors.66 In practice, however, they have some leeway to negotiate the terms of their membership, not least because the main economic requirements—the existence of a functioning market economy and the capacity to cope with competitive pressures and market forces inside the EU67—are open to interpretation. New members may, in principle, be granted temporary exemptions (transition periods) from compliance with parts of the EU’s body of laws and rules (the acquis communautaire), including those regarding capital mobility and financial market development.

Upon EU membership, exchange rate policy becomes a matter of common interest. The new member is obliged to avoid rates that are inconsistent with economic fundamentals, excessive exchange rate fluctuations and competitive devaluations, while embarking on a phased process toward adoption of the euro. (No opt-outs will be granted to new members with respect to adoption of the single currency.) The first step in this process is participation in the new exchange rate mechanism (ERM2), although there is no compulsion to enter ERM2 immediately.

ERM2 was designed to advance convergence among potential euro area participants—while building in significant degrees of flexibility. The economic rationale behind it is to provide a framework that aims for moderate exchange rate stability while also allowing flexibility to adjust including by changing central parities—if macroeconomic developments or shocks make this necessary. In this sense, ERM2 has been conceived not as a mere “antechamber” prior to the adoption of the euro. It is also a tool to achieve greater nominal and real convergence, and, when judged appropriate, to also function as a test of parity and institutional competence for moving forward with euro adoption. And, through the breadth of the band, it may reduce risks of crises.68

Participants in ERM2 must meet several requirements. They are required to agree on a central parity of their currency against the euro with the European Central Bank (ECB), euro-area ministers, and ministers and central bank governors of non-euro-area EU member states participating in ERM2, and to maintain the exchange rate within a band of ± 15 percent for at least two years prior to adopting the euro. The ECB is obliged to support the currency of the participating country when the exchange rate limit is reached, provided that ECB intervention does not threaten its primary objective of price stability and the ERM2 participant has made appropriate use of other policy instruments (including interest rates) before the exchange rate has reached the edge of the band. While devaluations are not consistent with convergence requirements, revaluations of central parities may be permitted, without restarting the clock on the two years needed in ERM2.

In principle, ERM2 is compatible with a range of monetary and exchange rate frameworks. For example, if a country had made substantial progress with structural and nominal convergence, it could be permitted to adopt narrower fluctuation bands, as is the case at present with Denmark. And from an economic perspective, a CBA would also seem to be consistent with ERM2.69 (For further discussion of regimes and anchors under ERM2, see later in this chapter.) Other than exchange rate stability within ERM2, the new member will need to meet Maastricht convergence criteria on fiscal deficits, public debt, interest rates, and inflation before it can adopt the euro.

The Real Convergence Context: How Low Should Inflation Go?

The prospect of sustained equilibrium real exchange rate appreciation has implications for the choice of medium-term inflation goals, and potentially for the exchange rate regime. The real appreciation can be achieved through an increase in the nominal value of the domestic currency; higher inflation at home than in countries not subject to significant real appreciation pressures; or some combination of the two. But, in the face of a trend appreciation, growing tensions would arise in pursuing a combination of price and nominal exchange rate stability (Masson, 1999).

The likelihood is that such real exchange rate appreciation may be quite significant and originate from several channels.70 Since these countries’ per capita incomes are well below EU levels (even Slovenia enjoys only 43 percent of EU income levels), a sustained period of high growth can be expected as they catch up, reflecting reform-induced productivity improvements and new investments. As a result, the prices of nontradables may be expected to rise more rapidly than the prices of tradables, resulting in a real appreciation. If productivity improvements are higher in the traded goods sector than in the nontraded sector (as proposed by Balassa (1964) and Samuelson (1964)), the prices of nontraded goods will rise faster than those of traded goods, resulting in a real appreciation. And, ongoing adjustment and deregulation of prices of public utilities (nontradables) will be needed to reflect costs of production—a process likely to be hastened by the ongoing privatization of the energy and telecommunications sectors.

Estimates of the scale of real appreciation and inflation effects vary considerably. Evidence on the size of Balassa-Samuelson effects in the transition and other countries suggests that, if nominal exchange rate movements in the CEC5 are limited, the average headline CPI inflation gap with the euro area resulting from equilibrium real appreciation pressures could be 1–3 percentage points per annum. The presence of other macroeconomic (including cyclical) and structural factors could amplify or dampen this inflation gap.

While there is no compelling economic argument for achieving the real appreciation through any specific channel, a number of considerations favor the option of somewhat faster inflation. First, despite structural reforms to enhance factor and product market flexibility, it may still be difficult to achieve large increases in the relative prices of regulated goods and services without raising the overall price level, particularly in a low inflation environment. Second, quality upgradings to both tradables and nontradables imply a rise in the price level, not a relative price adjustment.71 Third, relative price adjustments within the nontradables grouping cannot be achieved by a change in exchange rate. In the presence of downward price rigidity, these would argue for accepting somewhat higher inflation. Fourth, a sharp drop in inflation may not be perceived as sustainable since—in the presence of real appreciation pressures—inflation would need to rebound when the country eventually adopts the euro (or even earlier if the country chooses a narrow band exchange rate regime in the period ahead of adopting the euro; see below). And fifth, an overly ambitious inflation target in the near term may raise suspicions that needed price deregulations have been postponed—or may give countries a motive to postpone—in order to increase the likelihood of achieving the inflation target. Finally, as long as inflation remains in relatively low single digits, there is unlikely to be any further output growth premium associated with reducing it to 2 percent or less.72

The balance of these arguments suggests that there is a fair case for aiming to reduce consumer price inflation only to some 2 to 4 percent per annum, or slightly higher, and for recognizing that it may persist at this level for a number of years. Of course, it is to be seen as the symptom of a sound process of relative price adjustment in these economies, far from the build-up of disequilibria. And, to the extent that improvements in productivity or product quality underlie the real appreciation, it does not imply any erosion of competitiveness. It is also important to recognize that inflation arising from equilibrium real exchange rate adjustments is the result of the catch-up process and that attempting to suppress this real appreciation—say, out of concern for external competitiveness—could actually slow income convergence.73

An obvious concern, however, is that such a rate of inflation could, on the face of it, be incompatible with the Maastricht criteria for euro area membership—which were not conceived with the circumstances of these economies in mind. Various routes could be considered to address this concern—some of which involve undesirable, temporary and cosmetic devices of the kind adopted by some present member states, while others would involve adjustments to the criterion for inflation to reflect new realities. At all events, the setting of appropriate medium-term inflation goals is a key question and, to this extent, clarification of whether institutional solutions to this concern can be found is more pressing than is generally perceived (Box 6.2). But, at the same time, candidate countries will need to ensure that the changes still underway in their economies do not make it imprudent to move rapidly in seeking to adopt the euro.

The Financial Market Context

Capital flows may be large and possibly quite volatile. The privatization of remaining large state-owned firms may entail a lumpiness in capital flows, while liberalizing outward capital transactions could lead to large foreign exchange outflows as residents seek to diversify their portfolios. Capital flows are also likely to be highly reactive to actual or perceived policy slippages and to news about the timing of EU entry and the size and timing of future transfers from the EU budget. Contagion effects from other emerging market countries also could increase the volatility of flows. In the run-up to ERM2 and adoption of the single currency, a country may also experience an increase in temporary inflows as interest rates are bid down toward levels prevailing in the euro zone and markets speculate about entry central parities. These so-called convergence plays can induce surges in inflows that are quickly reversed once arbitrage opportunities disappear or a credible exchange rate is announced.74

In today’s liberalized capital markets, moreover, the risks and sources of crisis have expanded. According to Begg and others (1999), most episodes of currency crisis through the early 1980s—a period when capital controls were the norm—reflected macroeconomic imbalances. More recently, by comparison, self-fulfilling attacks have become more commonplace, as a consequence of the relaxation of restrictions on capital movements. The sharp increase in the volume of capital transactions that resulted from capital liberalization is consistent with the view that self-fulfilling attacks have become more likely since multiple equilibria arise when markets are able to overwhelm the monetary authorities. However, for multiple equilibria to exist, there must also be some weakness which precludes a determined reaction by the monetary authorities (Krugman, 1996).75 Sources of vulnerability in the transition countries include the less than complete convergence of domestic financial markets and institutions to mature market standards which, along with weakness in financial sector regulation and supervision, could make the monetary authorities reluctant to raise interest rates or let the currency depreciate in order to protect specific segments of the economy.

The Maastricht Inflation Constraint and Szapary’s Boxer

The Maastricht criterion on inflation, as currently framed, may require the current wave of accession countries to implement very tight macroeconomic policies, a policy-induced nominal appreciation, and/or some juggling with indirect tax rates, in order to reduce inflation to within 1½ percentage points of inflation in the three EU economies with the lowest inflation rates. Moreover, once they have adopted the euro, ruling out nominal appreciation vis-à-vis their main trading partners, their CPI inflation rates might be expected to exceed by 2 to 4 percentage points over the medium term inflation rates in core EMU economies in part because Balassa-Samuelson effects and price liberalization (which induce real appreciations) are more important than in the more advanced EU countries.

The strategy of inducing a temporary abatement of inflation has been compared by Szapary (2000) to that of a boxer who loses weight drastically before a prize fight (but then eats normally thereafter). It represents a pragmatic strategy for attaining euro area membership with the minimum damage to the existing institutional framework. But suppressing inflation by delaying price liberalization or reducing taxes has nothing to recommend it from a policy perspective, while stop-go policies will tend to increase the variability of output.

Among countries at a similar stage of development wishing to form a currency union, a narrow limit on the deviation of each country’s inflation rate from the lowest in the group certainly helps to signal readiness to adopt a common monetary policy. However, for countries with a real income level some half of that in an existing union, the case for maintaining the same limit—and relative to the lowest inflation countries, not the group average—is less clear to the extent inflation in the poorer countries reflects relative price adjustments, not a loss of competitiveness or macroeconomic imbalances.

It is not clear at this juncture that the Maastricht criterion on inflation can be adjusted. Nonetheless, suggestions have been contemplated in the literature as to how that could be done. One possibility would be to allow explicitly for the element of CPI inflation corresponding to “warranted” real appreciation—but this is unobservable, and differs across countries and over time. An alternative which would avoid encouraging distortive pricing policies, but avoid any appearance of relaxing the inflation criterion, is suggested by Szapary. This is to define the permissible inflation deviation with reference to average inflation in the EU, instead of the three EU members with the lowest inflation rate. Based on actual inflation rates in July 2000, this would have allowed an additional 0.7 percentage points of inflation compared with the existing criterion. Although this is likely well below the Balassa-Samuelson differential, it would have permitted countries to run an inflation rate of perhaps 3–3½ percent while still meeting the inflation criterion. A further possibility would be to use the average inflation rate in the euro area, rather than the EU—which at present would further increase the latitude for the applicant countries.

Large and volatile capital flows will test the limits of—or tolerance for—any exchange rate regime, but on balance, an exchange rate regime with significant flexibility is likely to remain a less risky option for the CEC5 in the next few years. Under a pegged exchange rate regime, interest rates are endogenously determined. As a result, the ability of monetary policy to achieve disinflation objectives is constrained, thereby transferring responsibility for nominal convergence to fiscal policy at a time when it must accommodate transition and accession spending demands. In the absence of sterilization—either because it is too costly or ineffective—capital inflows will put downward pressure on interest rates and upward pressure on the money supply, thereby potentially conflicting with inflation goals. Pegs are vulnerable to speculative attack and maintaining an exchange rate peg under pressure is costly in terms of spent reserves. Moreover, to the extent that a peg discourages hedging, there is a risk that agents will build up unbalanced portfolios that would severely add to the economic cost of a large shift in the exchange rate or a disorderly exit from a fixed regime. A degree of exchange rate flexibility would raise the exchange risk premium, driving a wedge between domestic and foreign interest rates, which would help to dampen interest-sensitive capital inflows at a time when reliance on capital controls is set to diminish. A variable exchange rate would encourage the development of markets in which to hedge exchange rate risk.76 In the context of variable capital flows, exchange rate movements could absorb variations in liquidity, and exchange rate flexibility would generally allow greater leeway to meet inflation objectives.

Currency Boards

Currency Board Arrangements (CBAs)—the strongest form of exchange rate peg short of a currency union or outright dollarization—currently operate in various countries, including several transition countries (Estonia, Lithuania, Bulgaria, and Bosnia). A CBA is based on a legal commitment to exchange monetary liabilities of the central bank (domestic currency) for a specified foreign currency at a fixed exchange rate. Under a pure CBA, this commitment implies that the monetary authority must hold foreign reserves at least equal to its total monetary liabilities and that changes in monetary liabilities are equal to changes in the central bank’s foreign exchange reserves. As a result, the lender of last resort function (to the government or commercial banks) of the central bank is eliminated.1

The advantages and drawbacks of a CBA are those of an exchange rate peg in a more extreme form. CBAs confer credibility on a fixed rate regime due to the long-term commitment to adhere to rigid exchange and backing rules (often set out directly in the central bank law) and the higher cost of abandoning a fixed parity than is the case for fixed-but-adjustable arrangements. CBAs differ from conventional pegs in the nature of the (legal) restrictions they set on changing the level of the exchange rate, and most importantly on the sources of reserve money creation. The backing rule eliminates (or strictly limits, when less than 100 percent of the monetary base is backed) the scope for issuing unbacked monetary liabilities, hence ensuring that the CBA does not run out of reserves to maintain the parity.

The credibility that a CBA can confer on a peg is particularly relevant when the monetary authorities’ reputation has been weakened by a history of lax fiscal policy, accommodative monetary policy, and failed stabilization attempts, or when the authorities lack an established track record. Indeed, in the last decades, CBAs have been introduced in newly independent countries (Estonia, Lithuania), after hyperinflation episodes (Argentina, Bulgaria), after a political and exchange rate crisis (Hong Kong), and during postconflict reconstruction (Bosnia) (Guide, Kakhonen, and Keller, 2000).

Currency boards imply a far reaching surrender of monetary policy. After a shock (for example, a domestic recession), the economic adjustment has to come by way of wage and price adjustment, instead of via interest rate and/or exchange rate adjustment. This could be both slower and more painful, particularly if structural rigidities, especially in the labor market, have not been removed.2 (Under a CBA, changes in money demand are accommodated by endogenous changes in international reserves, rather than through changes in the central bank’s net domestic assets.) Other consequences of the rigid rules are the inability to smooth out short-term interest rate volatility—perhaps causing difficulties for banks in an environment without recourse to the lender of last resort facility. This suggests a need for a healthy financial system and/or the willingness to let weak banks fail. Therefore, the costs of sticking to the rigid rules of a CBA could at times be high, especially if conditions for the successful operation of a CBA are not fully in place.

CBAs have served a number of transition countries very well and are not considered by the ECB to be incompatible with ERM2. Therefore, in those countries where a CBA is functioning well, there is no strong reason to abandon it ahead of EU and EMU membership. However, in light of the circumstances in which the introduction of CBAs has tended to be most advantageous, as well as the track record already built up by the CEC5 on macroeconomic stability, there is little reason for them to move to a CBA at this stage.

1Under some CBAs, the central bank may still give credit to banks (or governments), but it can only do so if it holds foreign reserves in excess of what is needed to back the monetary base.2However, Estonia, for example, was able to successfully—and quite rapidly—overcome the recession induced by the Russia crisis.

A currency board overcomes some of these limitations of fixed-but-adjustable pegs by rigidly tying the prices of tradable goods to those of the anchor and automatically adjusting money supply to demand through changes in interest rates, with no pressure on the peg. However, while the conditions for a credible currency board may exist, its attractions are less obvious in these economies that have put all risks of very high inflation behind them (Box 6.3). While some advanced transition economies, such as Estonia, may retain successful currency board arrangements, the recent trend toward greater flexibility among the CEC5 is thus likely to endure throughout the run-up to both EU accession and EMU, even it finally in a qualified form under ERM2.

While eliminating the exchange rate instrument puts a greater—or more explicit—onus on fiscal and structural policies for achieving and preserving external competitiveness, a variable exchange rate is not without risks. Persistent foreign exchange inflows could potentially erode external competitiveness more rapidly than under a fixed rate regime, leading to a widening of external current account deficits, especially when fiscal policy is too lax and needs to be adjusted. Moreover, volatile capital flows could generate substantial exchange rate swings, which could damage trade and investment. Under flexible regimes, should special regard be paid to the exchange rate?

Considerations in Managing Flexible Regimes

The discussion above underscored that significant exchange rate flexibility is on balance highly attractive—indeed, in the context of high and potentially variable capital inflows, perhaps a sine qua non for these five economies at the present juncture. But even though narrow bands or overly managed exchange rates—credible currency boards excepted—are unlikely to provide sufficient flexibility to reconcile domestic and external policy objectives and may prove tempting targets for speculators, the exchange rate cannot be neglected for these relatively small and open economies. Moreover, these countries will eventually adopt the euro; over the coming years, as their economies mature, policymakers will need to prepare themselves for the disciplines this entails and the time when policies must be subordinated to the rigors of a shared monetary policy. This is the context for the discussion below: now and over the medium term, it asks, what limits should countries set to the variability of the exchange rate and what does this imply for supporting policies?

Is the Exchange Rate “Special”?

While flexibility will be important until—and plausibly throughout—ERM2, the CEC5 cannot afford to ignore the exchange rate. In a small open economy, movements in the exchange rate are directly and rapidly transmitted to inflation through the prices of tradables and can influence inflation in the medium term through its effect on potential output. In addition, the level and variability of the exchange rate can affect other key macroeconomic variables. Treating the exchange rate with benign indifference can compromise the stability and growth prospects of the economy through the following channels:

  • The exchange rate is a key determinant of external competitiveness and therefore aggregate output. The real exchange rate is what actually matters here, but when domestic prices and wages take time to adjust to changes in the exchange rate, nominal exchange rate changes imply—albeit temporary—real exchange rate movements. For the CEC5, where exports are likely to be the main vehicle for sustained medium-term growth, external competitiveness is clearly of major importance. International experience suggests that sustained rapid growth (defined as more than 6 percent for at least three years) occurs predominantly in countries which operate (de facto) managed floating exchange rate regimes (Williamson, 2000).

  • There are limits to the size of the external current account deficit that markets are willing to finance. Through its impact on external trade, the nominal exchange rate will affect the size of the current account. A rapidly growing developing economy (a group into which the advanced transition countries fall) would be expected to run a current account deficit as domestic saving would tend to be insufficient to meet investment needs. However, there are limits on what is perceived as a prudent deficit level, and the difference between a healthy and a worrisome deficit may not be large (or even known, until it is reached).77 While a large current account deficit may be conducive to rapid growth, markets may not perceive large imbalances as appropriate or even sustainable because of difficulties in enforcing the payment of external debts (Obstfeld, 1995).

  • By changing the domestic currency equivalent of foreign currency assets and liabilities, a change in the exchange rate can intensify financial instability and thus impose economic and fiscal costs. If a country (or a segment of the population) has an unhedged net foreign currency liability position, a depreciation will raise the domestic currency value of these liabilities and their associated debt servicing costs. As a result, firms and financial institutions may not be able to service their foreign currency debt and access to international and domestic sources of credit may be blocked.

  • Exchange rate volatility matters too. Volatility in the prices of traded goods will have a negative impact on trade, especially when hedging opportunities are limited.78 Exchange rate volatility is also associated with a higher risk premium on financial assets, which would adversely affect credit market access and result in higher interest rates and debt servicing costs—although variability of the rate can, for example, help discourage unhedged borrowing.

The exchange rate tends to matter more in emerging market and transition countries than in industrialized economies. First, shocks incurred by emerging or transition countries are often larger than those affecting industrialized countries.79 Second, illiquid foreign exchange and capital markets would likely produce more volatile exchange rate movements than those experienced in more mature markets.80 Third, the impact of a given change in the exchange rate on aggregate output is larger because trade in these countries represents a greater share of GDP and because hedging opportunities are more limited. Fourth, the pass through from the exchange rate to inflation is typically higher—again reflecting the large share of trade in GDP and the lower state of financial sector development. The composition of trade flows may also affect the impact of the exchange rate on the economy. An economy (such as those of the CEC5) in which exports are primarily manufactures with a high domestic labor content may be quite vulnerable to exchange rate appreciations since production could shift to any number of lower unit labor cost countries. Reflecting the costs of an unfettered exchange rate float, Calvo and Reinhart (2000) find that many countries that notionally switched to floating regimes (including some inflation targeters) have been reluctant to accept significant exchange rate variability (see also Williamson, 2000).

Given these acknowledged tensions between the attractions of flexibility and the need for some concern about the exchange rate, the principle of heading over time toward an ERM2-type broad band is not illogical, although it might not be as compelling outside the context of euro area-entry requirements. But the important feature of such an arrangement is not solely—in fact, not mainly—the monetary policy issues of interest rate and sterilization rules. It is the implication that unacceptable wide shifts in the exchange rate need to trigger a review of the broader economic policy stance—and especially the fiscal-monetary policy mix.

The Importance of the Macroeconomic Policy Mix

Situations may well arise in which inflation objectives directly conflict with concerns about the level of the exchange rate in light of external objectives, and these may become more common and severe with the phasing out of remaining capital controls.81 These tensions may arise in the context of a rapidly growing economy with a sizable external current account deficit. In this situation, raising interest rates in order to contain inflationary pressures would, however, tend to worsen the external balance by inducing capital inflows and strengthening the exchange rate.

Dealing with conflicting domestic and external objectives will require enlisting the support of an additional policy instrument. To this end, structural reforms can make an economy more robust to exchange rate fluctuations by strengthening the resilience of financial markets to shocks, while structural reforms more generally increase productivity and make the economy more competitive. However, structural reforms take time to implement and therefore cannot be used to resolve immediate tensions between objectives. An appropriately restrained fiscal policy would not only help to keep the external current account deficit within safe limits, but would also support monetary policy in addressing disinflation goals. Fiscal consolidation would improve the current account directly by lowering import demand and, to the extent that it reduces the relative price of nontradables, could raise exports, and shift consumption to domestic goods. This mix of monetary and fiscal policies, by keeping the real exchange rate more depreciated than otherwise, would also help boost economic growth while keeping the current account deficit in check.

In practice, however, it may be unrealistic to expect that fiscal policy in the CEC5 can consistently resolve the tension between domestic and external concerns of policy. The key to balancing the inflation objective with external considerations will therefore involve weighing the costs to the economy of failing to achieve each individual goal. Some policymakers may decide that allowing the external current account deficit (net of FDI) to exceed 4–5 percent of GDP for several years would adversely impact the economy considerably more than would missing the inflation target by several percentage points if the large current account deficit were to lead to sharp downward pressure on the exchange rate. Moreover, allowing the current account to move into dangerous territory in order to safeguard the inflation target could be counter-productive because, if a large depreciation was triggered, it would lead to higher prices anyway, not to mention potentially severe economic disruptions.

There is, however, a serious risk to the credibility of a flexible exchange rate system if output and external sector considerations too frequently take priority over inflation objectives. In order to enhance credibility of the policy framework in circumstances where other objectives temporarily take priority over inflation, the monetary authorities must make clear to the public that they are putting aside for the moment their inflation goal in order to respond to more pressing concerns. The difficulty in successfully juggling competing priorities should not be underestimated, and finding the appropriate balance between policy credibility and the flexible implementation of these policies will be one of the major challenges facing policymakers from now until full membership in the EMU.

Nominal Anchors Under Flexible Regimes

With fixed-but-adjustable exchange rate pegs viewed as relatively risky and some concern about the ability to ensure the right policy mix, what monetary anchors offer the best chances of securing low inflation while fostering financial stability? As noted above, none of the central European economies has adopted a currency board, and their circumstances are not such that a currency board would in general offer major advantages. The main alternatives are thus domestic anchors in the form of monetary targeting, as in Slovenia, or direct inflation targeting, as in the Czech Republic, Poland, very recently Hungary, and in essential respects Slovakia. A domestic anchor—whether in the form of a money or an inflation target—has the advantage of enabling monetary policy to focus on attaining price stability, as well as responding adequately to shocks affecting the domestic economy. A further possible regime involves a wide exchange rate band—a phase through which all of the countries will have to pass, in the form of ERM2, on their way toward membership of the euro area. But, as also discussed below, a wide band is too flexible an arrangement to serve as a full-fledged anchor for policy, and needs supplementing. Regimes choices are discussed below.

A money target

Maintaining a money target requires a fair degree of stability or at least predictability of money demand. Stability of the aggregates is unlikely to prevail in even the most advanced transition countries, since these are still undergoing financial innovation and capital account liberalization. This does not wholly preclude the use of monetary targeting—and the Bank of Slovenia has indeed had significant success in reducing inflation to moderate levels under monetary targeting. However, even the Bundesbank, arguably the most successful money targeter among the advanced economies, allowed significant under- and overshoots of its money targets for extended periods, and guided policy by keeping a watchful eye on other indicators which had a direct bearing on the inflation outcome (Mishkin, 1999). There are analogies in the use of monetary aggregates by the Federal Reserve in 1979–81.

The kind of pragmatic monetary targeting achieved by the Bundesbank depends for its success on a blend of flexibility and accountability, but judgmental flexibility does not help build credibility from scratch. Indeed the Bundesbank enjoyed an enduring political support and institutional credibility on which few central banks can count. By the same token, however, the more broadly based use of indicators that played a key role in the Bundesbank’s approach finds a fuller expression in direct inflation targeting—with, however, a number of additional components that help in establishing credibility and communicating goals ex ante.

An inflation target

Can inflation targeting provide a viable monetary framework for the advanced transition countries? As a regime, it relies on a strategy which uses all relevant information, thereby placing less reliance on any single intermediate target such as a money aggregate: to that extent, it has attractions for economies undergoing structural transformation and rapid financial development. In addition, an inflation targeting regime emphasizes transparency through regular communication with the public of the goals and limitations of monetary policy, how inflation targets are determined, and the reasons for any deviation from targets. In countries operating inflation targeting, this public outreach by the central bank often includes trade unions and the government, increasing the likelihood that wage decisions and fiscal policies will be consistent with the inflation target.

However, some commentators have questioned whether inflation targeting is a feasible, advisable, or even fully credible choice for many transition countries. A key element in such critiques is the argument that these countries face larger internal and external shocks than industrial countries and that the transmission mechanism through which monetary policy affects output and prices is less reliable, making it difficult for the monetary authorities to credibly commit to a specific inflation target.82 Such commentators also criticize the fact that inflation targeting ignores the consequences of policy for other macroeconomic variables—notably economic growth—and that it subordinates the exchange rate to the pursuit of the inflation target, with ensuing risks to external viability and the stable growth of the economy.

The first criticism—that inflation targeting may not be suitable for emerging market or transition economies since inflation in these economies is not easily controlled by the monetary authorities—is a valid concern, particularly when countries are trying to disinflate and risk missing their targets, resulting in some credibility loss. In order to avoid this problem, it is desirable to phase in a hard inflation targeting framework.83 In the initial stages, inflation goals could be announced and interpreted as inflation projections. During this phase, the exchange rate is likely to retain a prominent role: since the direct exchange rate channel operates rapidly, by inducing exchange rate movements, monetary policy can affect inflation with a relatively short lag (Svensson, 1998). Once the monetary authorities—operating under a “soft” or “more informal” inflation targeting framework—gain experience predicting inflation and understanding the monetary transmission mechanism, while also reducing forecast errors, a fully-fledged inflation targeting system can be implemented.

To shift to fully-fledged inflation targeting, a well-established interest rate transmission channel would be beneficial, since the primary policy instrument in inflation targeting tends to be an official short-term interest rate. Interest rate changes provide a clearer signal of the direction of monetary policy than exchange rate interventions since intervening in the foreign exchange market may send conflicting signals to market participants concerning the central bank’s commitment to inflation targeting and could encourage speculation against the central bank.84 (This is particularly important if a country has recently transitioned from an exchange rate target.) Inflation targeting countries have indeed found that the link between interest rates and the inflation objective has strengthened over time: this may be a direct consequence of the inflation targeting framework itself, or may reflect the ongoing development of domestic financial markets. Thus, to the extent that the transmission mechanism through the interest rate channel is not well understood, there would be concerns about a full-fledged inflation targeting framework insofar as it focuses on interest rates in communicating policy.

The second concern—that inflation targeting may lead to low and unstable growth in output and employment—appears misplaced. Reducing inflation under any monetary framework will be associated with an output loss, and inflation targeting regimes tend to be introduced in order to engineer just such a disinflation. It would therefore be wrong to attribute the output loss to inflation targeting per se.85 Moreover, practitioners of inflation targeting have in reality tended to take output loss considerations into account in judging the speed with which to move to a desired inflation goal.

It is true, however, that an inflation targeting framework subordinates the path of the exchange rate to the inflation goal. To that extent it places responsibility for external sustainability squarely with the fiscal authorities. Of course, depending on the policy formulation in terms of time horizon and trade-offs between output and inflation, it need not necessarily call for sharp or wide swings in the exchange rate. But the experience of Poland, for example, does illustrate the possibility in practice of quite wide swings in the real exchange rate, accompanied by commensurate variations in the external current account.

It is true also that there are a number of important technical issues to be resolved in inflation targeting. While these issues go beyond the scope of this book, they include the choice between a core or headline inflation target, the specification of the target in terms of a point or a broad or narrow range, and the extent to which exchange rate as well as output fluctuations should be taken into account in determining the speed in which inflation is brought on track.86

The criticism that inflation targeting ignores the behavior of other macro variables needs to be qualified heavily. While vigorous use of the direct interest rate channel to stabilize inflation at a short horizon could result in significant variability in the real exchange rate, output, and employment, in practice, however, an inflation targeting framework can avoid these difficulties. In particular, inflation targeting can be a very pragmatic framework that affords a central bank substantial room to build in short-run stabilization and external goals, while retaining its focus on medium- and long-term inflation objectives. Under such an approach, Svensson (1998) illustrated that the variability of other macroeconomic variables can be substantially less than with a narrower inflation targeting approach. A key reservation, however, is that the dedication of monetary policy to an inflation goal implies that fiscal policy will need to take the strain of assuring external viability. And, as the central European economies advance along the road toward membership of the euro area, this implication will become increasingly important. Under ERM2, they will eventually have to accept formal limits on nominal exchange rate movements—a constraint that puts issues of policy mix directly in the foreground.

Wide bands

Wide bands (along the lines of ERM2) are in themselves quite flexible, and they are an option for signaling greater exchange rate prominence without an implied exchange rate “guarantee”; moreover, they can be operated in a way that is compatible with providing a nominal anchor.87 The exchange rate itself would not provide this anchor—both because a wide band would be too flexible for this and in order to avoid the pitfalls of an announced narrow band. Rather, the anchor would be the underlying inflation objectives—for which the behavior of the exchange rate would be a key determinant of inflation and the focus of short-term operating procedures. And the robustness of the anchor would depend on the nature of the inflation objectives (for example, the detail in which they are specified and how they are communicated) and the accuracy of authorities’ inflation projections conditional on the policy of limiting exchange rate movements.

Under this type of arrangement, the exchange rate could be permitted to fluctuate freely within soft inner bands about the central parity, as a kind of intermediate target. This is an especially relevant consideration when the interest rate transmission mechanism is not well developed or understood. Breaching the inner bands would be permitted in response to strong exchange-market pressures, and would elicit a monetary policy response to bring the rate back toward the central parity, unless driven outside by more fundamental factors. Thus, it would be critical that any inner band not be adhered to rigidly to avoid a “guarantee.” In this context, allowing the exchange rate to breach the inner band under heavy market pressures would drive home the point, without loss of credibility, that the currency is not tightly constrained.

Operated along these lines, it is possible that a soft narrow band could avoid speculative perils and help achieve inflation objectives. The level of the band would need to be reviewed regularly to keep it consistent with inflation goals. On this interpretation, the management of the exchange rate, while avoiding a hard inner band, would remain a key signaling device and a major component in the transmission mechanism. Alternatively, as the inflation process becomes better understood and the transmission mechanism develops more fully, the country might wish to shift to more fully fledged inflation targets within the wide exchange rate band. In line with overriding inflation goals, and reflecting particularly the impact be of capital flows, any intention to adhere to the wider exchange rate band would need to be backed by understandings about the policy mix and its adaptability, if the price goal is to be respected. The experience of countries such as Spain suggests nevertheless that too rigid a distinction between fully-fledged inflation targeting and the aim of a relatively stable exchange rate may be somewhat artificial.

Back to the Future: Wide Bands and the Return to Fixity

The discussion above underscored the case for some flexibility in exchange rate regimes at the present juncture—especially for financial market reasons—but the longer run destiny of these economies is nonetheless to move back toward greater fixity. The prime reason for this is their commitment on joining the EU to become a member of monetary union in due course, and on the way to pass necessarily through the wide band ERM2 regime. From a real economy standpoint, moreover, this transition poses ever fewer dilemmas with the passage of time: increasing trade and investment integration are steadily tipping the scale toward membership in a common currency area. But from a financial market standpoint, the process of moving back toward greater fixity can be hazardous—even though the band of ERM2 is very wide. And views on how to navigate this strait may to some degree influence policy—for example on financial sector reform, or on capital controls—even in the run-up to accession, when EMU lies some way still in the future.

There are three key dilemmas in the passage back toward greater fixity to which the central European countries are signing up as they negotiate the chapters of the acquis communautaire. These issues are the main focus of the remainder of this chapter:

  • Any move to declare a wider band and central rate may be perceived by markets as foreshadowing future ERM2 choices—so the timing of such a declaration, and of the final move to ERM2, need to be carefully judged in terms of real economy and financial sector developments.

  • Hard exchange rate bands wide enough to discourage speculative behavior (including notably the ± 15 percent band of ERM2) are almost by definition too wide to serve as a nominal anchor.

  • Over the next few years the candidate countries are likely to face several windows of heightened financial market vulnerability, and this process will begin just as they are likely to dismantle and foreswear their residual controls over short-term capital movements.

As the real economies of central Europe integrate increasingly tightly with the EU, and monetary union approaches, the case for some type of monetary framework that builds in the exchange rate becomes inherently more attractive. As concluded in Corker and others (2000), some formal or informal commitment to allow exchange rate flexibility while avoiding excessively large swings in the rate seems desirable to support credible inflation reduction policies and avoid uncompetitive exchange rates. Such a framework also allows flexibility in coping with foreign exchange market pressures, while raising the exchange risk premium and encouraging hedging and therefore provides an environment conducive to the dismantling of capital controls (which would also facilitate the further development of hedging markets, especially if financial sector strengthening had been proceeding well). In order to reap the benefits of flexibility while avoiding the risks of a pegged regime, it is essential that the exchange rates be allowed to move—in both directions—in response to market forces, during “normal” times so as to encourage agents to prudently manage their foreign exchange risks. Tightly managing the exchange rate during tranquil periods could foster complacency about currency risks,88 so that in turbulent times when sizable movements in the exchange rate do occur, severe financial and social dislocation could result.

To ensure the credibility of the exchange rate band as an interim regime, it must be viable for several years. A wider band about a fixed central parity would be expected to outlive a narrower one, especially in a country with persistent pressure on its real exchange rate. For the CEC5, a wide band (say of at least ±10 percent) would seem to be necessary to, on the one hand, accommodate convergence-related real appreciations while still providing a buffer to cope with potentially volatile capital flows—and, on the other, allow for some depreciation of the currency to preserve competitiveness if moderate inflation were to be sustained. Flexible domestic goods and product markets (which can substitute for exchange rate flexibility in dealing with external shocks) can help keep exchange rate bands viable. Ultimately, however, credibility of the wide exchange rate band will rest on the expectation that macroeconomic policy adjustments will be invoked when the bands are threatened.

Inescapably, this raises the question: how soon should these economies think of moving to ERM2, on the road to adopting the euro? There are real, nominal, and financial aspects to this question.

First, there is a need to revisit the real economy issues noted earlier in this book—issues to be addressed now not just in terms of an adjustable central parity, but of a credible long-term commitment. Strong economic ties with the EU suggest that the euro is ultimately the obvious permanent anchor currency for the countries under study, but there remains the possibility that they will be exposed to large real shocks that are not common to the euro area. The incidence of such asymmetric shocks would tend to reduce the appropriateness of euro zone monetary policy for them, and pegging to the euro could therefore increase the variability of output and employment (compared with a more flexible exchange rate regime) since the monetary policy of the anchor region is unlikely to be appropriate for the pegging country. Empirical evidence on the symmetry of shocks in the EU and the central European accession candidates is, however, inconclusive at this stage. Boone and Maurel (1999) find that shocks to unemployment in Germany—and to a much lesser extent the entire EU—explain a substantial part of the unemployment cycles in the Czech Republic, Hungary, and Poland, and exceed the share of explained unemployment variance in Spain and Italy. Moreover, these economies are still in a steep process of convergence. As linkages and alignment between the EU and the five accession candidates increase and as further structural reforms reduce the risk of transition-related domestic shocks, it is likely that the conditions for a single currency area will more clearly emerge. Of course, in terms of both alignment and flexibility, countries will reach this stage at different times, and among dimensions of flexibility in the economy, the existing responsiveness of the labor market is a trump card to cherish, not to discard.

Second, in terms of nominal convergence, because of the need to get fiscal policy and thus the macroeconomic policy mix under control, as well as getting inflation down to the low single digits while keeping the exchange rate reasonably stable, countries may not want to enter ERM2 too early. A further dimension is that countries need to ensure that their long-term interest rate trajectory is on track to meet the Maastricht criterion (this is substantially an issue of policy credibility with the market in the context of convergence dynamics). Moreover, to the extent that the prevailing market exchange rate is used as a guide to setting the central parity in ERM2, care should be taken at the time that the central rate is determined to avoid an uncompetitive exchange rate on the eve of joining the euro area.89

Third, in terms of financial factors, it must be recognized, for reasons already noted, that the final process of convergence to the euro is a hazardous prospect. Arguably also, most capital controls will have been removed—a situation that can only increase the possibility of sizable unhedged borrowing. Countries would do best from this perspective to maintain de facto (as well as de jure) wider bands up to the stage of adopting the euro, even if a soft inner band is used to guide monetary policy.

As noted above, when a wide band regime is adopted, it is unlikely by itself to provide a sufficient nominal anchor for inflation expectations. Indeed, earlier EMU candidates adopted a range of operating approaches under ERM2 (Box 6.4). A clear possibility is to operate a form of qualified inflation targeting within the broad band. Thus, while operating the broad exchange rate band, a country would want to set inflation objectives and adopt the fiscal stance judged to be consistent with these objectives. Under normal circumstances, operating an inflation targeting under wide bands would be similar to a straight inflation targeting framework—and this was indeed Spain’s strategy in the run-up to EMU. However, in situations in which the inflation target conflicts with the exchange rate band, it is expected that the bands would take priority, triggering preemptive macroeconomic policy adjustments in a timely manner.90 For those CEC5 countries with inflation targeting frameworks already in place and relatively flexible exchange rate regimes (for example, the Czech Republic, Poland, and to some extent, Slovakia), supplementing them with wide exchange rate bands of ± 15 percent (as in Hungary) over the next few years could be seen as an opportunity to test whether they can operate policy within the preset exchange rate boundaries permitted under ERM2 (without feeling as obliged to operate irrevocably within its constraints). This would also avoid the need for an exchange rate regime transition at the time of entry into ERM2, a period when countries may want to shy away from learning by doing.

Capital Controls and Policy Safeguards

During the first decade of transition, the central European economies made major strides in liberalizing their capital accounts, and this process is expected to be in most respects completed by the time of EU accession. A key motive of liberalization in most cases has been to allow the entry of foreign direct investment, as a motor for growth; but there was also a broader goal of comprehensive economic and financial opening—reflected among other things in the commitments to sweeping financial liberalization made in relation to the OECD’s code on capital movements.91 Policymakers in the Czech and Slovak Republics and Poland in practice no longer rely on capital controls to protect the domestic economy or financial system, and this stance is facilitated by the very flexible exchange regimes, combined with inflation targeting, in place in those countries. Until the recent liberalization of all capital controls, the remaining restrictions in Hungary and Slovenia were largely on short-term capital flows, and in part at least this reflected their different monetary regimes—based, until recently, on a narrow exchange rate band and on monetary targeting, respectively. As a precondition for EU accession, candidates are required to fully liberalize capital transactions, except where specific transition periods apply—likely implying that countries will not he able to adopt or maintain an exchange rate regime that relies on support from capital controls once they have joined the EU.

The Many Possible Worlds of ERM2

Austria, Belgium, and the Netherlands observed a very narrow, hard band against the DM in the run-up to euro area entry. By allowing their central banks independence in pursuing a policy geared exclusively to this goal, they effectively established a semihard peg. This was well-known and tested by markets, although the intervention rates were never set firmly by public pronouncements.

Portugal joined the ERM in April 1992 with a declared fluctuation band of 6 percent but, after the period of ERM turbulence in 1992–93, the band was widened to 15 percent, effective in August 1993. The central parity was last adjusted in May 1995 with the central rate set at 102.5 escudos against the DM. The escudo then fluctuated in a de facto soft band of ½–2½ percent around the parity but there was no explicit policy commitment to a narrow band. In the run up to EMU, monetary policy was geared towards maintaining short-term interest rate convergence on a steady path, though price stability considerations were slowing the process. Developments in Italy were in practice rather similar. After being forced out of ERM, Italy joined ERM2 at end-November 1996 with the ± 15 percent bands and then experienced de facto approximate stability against the DM: the central rate was 990 and in the event the lira never tested the outer parts of the bands, as it fluctuated between roughly 960–1,000; but there was no declared intention to keep it within smaller bands.

The Irish authorities used the ERM band quite actively as the central bank tried to postpone monetary easing as late as possible, and the markets were expecting a substantial revaluation of the pound’s central parity rate, both of which supported the currency. The Irish pound was revalued upwards by 3 percent in March 1998. This did not provoke a major market reaction as market expectations had already adjusted. As the start of the EMU came closer, the pound was trading close to its conversion rate for the remainder of 1998. There are some analogies in this active path with the approach taken by Greece. Almost three years before adopting the euro, Greece devalued by 12.3 percent and entered ERM2. The drachma subsequently appreciated within the band to almost 9 percent above its central parity rate, and then remained well above parity rate. Two months before applying to join the euro area (and 11 months before entry), the parity rate was appreciated by 3.5 percent, but the drachma continued to trade well above it until the last few months before euro area entry.

Spain adopted inflation targeting in the period leading up to Stage 3 of EMU, and set as its goal an inflation rate consistent with that of the core countries (2.5 percent at end-1997, 2 percent for 1998). The Bank of Spain cut policy interest rates throughout this period, trying to ensure a “smooth landing” at the start of monetary union: rates were always somewhat higher than in Germany. But under this regime, in practice the peseta remained extremely stable against the core currencies during this period, depreciating only by about 3 percent again the DM, for example, in nominal terms. While the peseta was very close to the central parity rate throughout, the authorities did not make stability of the exchange rate an explicit goal of policy (beyond the very broad commitment to stay within the limits established by ERM2).

To these four somewhat different strategies under ERM2, a further option has been added, with the agreement by the ECB that currency boards can continue to operate under ERM2.

While capital account liberalization has provided major benefits—in terms of FDI inflows, and as a signal of commitment to reform—it also implies ongoing policy challenges, both structural and macroeconomic. Greater exposure to these flows has increased demands on the ability of the domestic financial sector to appropriately intermediate these funds so as to maximize investment yields, limit foreign currency exposure, and contain the cost of capital reversals. The risks associated with many financial inflows can be reduced (but not eliminated) with sound financial institutions and well functioning prudential supervision and regulation. In circumstances where these are not fully in place, capital controls can be a supplementary tool to buttress prudential regulation and limit excessive risk-taking. Without broad-based policy safeguards, full capital account liberalization can impose heavy costs.

These considerations have led some to question whether accession countries should not retain, or at least be prepared to reimpose, some form of capital controls beyond accession, and perhaps well into ERM2.92 A case can be made that the nature of speculative attacks has changed over the past decade, with vulnerability to speculative attacks having increased sharply as a result of the increase in the volume of global capital transactions (itself the result of capital account liberalization). On this view, it might be appropriate to have fully liberalized capital transactions prior to entry into ERM2, both to guide the choice of a central parity and to ensure that a country’s ability to remain within ERM2 is not due to the support of controls—but not necessarily to eliminate controls rapidly earlier on—especially controls over short-term inflows. However, this is not a case that the accession countries themselves have been making: typically they are closing the chapters of the acquis relating to capital markets without requesting transition periods for the liberalization of short-term flows.93

Without denying the potential benefits of being able to reimpose capital controls as part of a strategy to deal with financial market turbulence, the most important priority is to press on with policy reforms that reduce underlying vulnerabilities. One way of translating this into operational terms for policy is to identify the key areas in which controls, at least to some degree, substitute for completion of policy reform, and relate those to the possible incidence of crisis:

  • Fundamentally, sound macroeconomic policies cannot be substituted by capital controls. At the margin, however, controls have been used to allow the pursuit of exchange rate and monetary policies that would otherwise have been incompatible, at least in the absence of a change in policy mix. Until recently, for example, strict controls on most capital inflows and outflows in Slovenia allowed the authorities to pursue a money target while also tightly managing the exchange rate. However, such controls tend to lose their effectiveness over time, as markets circumvent specific restrictions—aided by the increasing range of domestic financial instruments. Over the time horizon of EU accession, it is reasonable to expect that applicants would have established sufficiently sustainable macroeconomic policies to allow full capital liberalization, except perhaps to the extent that they experience unanticipated shocks to which a heavily burdened fiscal policy takes time to adjust.

  • A specific instance of the foregoing relates to the ability to drive a wedge between domestic and international interest rates. In Hungary, for example, the previous narrow exchange rate band would likely have come under extreme appreciation pressures at times in the absence of controls on short-term flows. And current EU/EMU members, such as Spain, enjoyed the ability to use controls to drive such a wedge well after the point of EU accession. Over time, as exchange rate and inflation expectations stabilize, the need for such an artificial wedge should disappear.

  • In countries where the domestic financial system and the prudential framework are not yet robust, capital controls (notably on short-term inflows) can serve as a palliative, reducing the scope for transactions that could result from moral hazard. As with macroeconomic reforms, here too a strong case can be made for advancing as swiftly as possible to strengthen financial systems, rather than relying over the medium-term on capital controls as a partial substitute—and one which, in any case, will only mitigate distortions in the allocation of international (as opposed to domestic) savings.

  • Finally, to some degree speculative attacks unrelated to macroeconomic fundamentals can be considered a form of market imperfection, and there is a plausible case for the retention or reimposition of capital controls to counter these. Within ERM2, countries should be ready to cope with heavy and prolonged foreign exchange market pressures. However, in a situation of incipient major capital inflows or reversals that appear unrelated to policy slippages (for example, convergence plays or contagion effects), there may be a case for reintroducing capital controls on a strictly temporary basis. In this situation of temporary pressures, the appropriate responses are to attempt to reduce the volume of capital flows and to intervene to prevent the exchange rate from breaching the band.94 Together with interest rate adjustments, the temporary reintroduction of capital controls may be an effective method of limiting surges in capital that could reduce the need for coordinated foreign exchange market intervention by the ECB and ERM2 participants.

Economic risks of moving to pegged regimes in today’s markets underscore the importance of macroeconomic and financial policy fundamentals—but also suggests the need for some readiness to allow reimposition of controls in crisis circumstances. It is worth bearing in mind that the last round of members (pre-Maastricht) enjoyed some flexibility in this respect at a time when markets were if anything less prone to attacks on adjustable pegs. The case of Spain is illustrative. After joining the European Community in 1986, Spain was subject to significant capital inflows. Although the authorities had been dismantling controls on capital outflows to comply with EC provisions, several controls on inflows were introduced in and after 1987, including direct controls.95 However, the situation facing Spain in 1986 was different from the one that will face the enlargement countries. On the one hand, the need for controls may have been reduced owing to the substantial widening of the exchange rate band under ERM from ±2.25 percent to ± 15 percent. However, there has also been a huge expansion in global capital flows and the added flexibility afforded by the wider bands is unlikely to be sufficient to accommodate the larger volume and volatility of capital flows, especially in foreign exchange markets where turnover is normally quite small. Thus, the ability to reimpose capital controls to deal with market turbulence remains justified, but cannot substitute for the pursuit of fundamental reforms, especially regarding macroeconomic and financial sector policies.

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Cover Into the EU
Into the EU
Policy Frameworks in Central Europe
Author: International Monetary Fund
ISBN:
9781589060845
Publication Date:
01 May 2002
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589060845.071
Pages:
252
  • View in gallery

    Monthly Headline Inflation in CEC5: 1991–2001

    (Percent, year-on-year)

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    Monthly Core Inflation in CEC5: 1993–2001

    (Percent, year-on-year)

Monthly Headline Inflation in CEC5: 1991–2001

(Percent, year-on-year)

Monthly Core Inflation in CEC5: 1993–2001

(Percent, year-on-year)

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