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We would like to thank Stanley Fischer, Jiri Jonas, Carmen Reinhart, Masahiko Takeda, Josef Tošovský, and numerous other IMF colleagues for useful comments. We are especially indebted to Steve Russell, both for comments and for sharing the Mathematica program used to solve the model presented in the Annex. Patricia Gillett and Siba Das provided excellent research assistance. We alone bear responsibility for any remaining errors. A shorter version of our revised paper appeared as “The Tošovský Dilemma: Capital Surges in Transition Countries” in the September 2002 issue of Finance and Development.
Indeed, it may be argued more generally, that capital surges are likely to characterize any successful process of development.
In this paper, CEE is taken to comprise Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia.
There is nonetheless a range of views in the literature over the relative volatility of FDI and other forms of capital. The experience of recent crises suggests that FDI can be quite volatile as illustrated by the marked decline in FDI in Russia in the aftermath of its 1998 crisis; this view is supported by empirical work by Dooley, Fernandez-Arias, and Kletzer, 1994. But the prevailing view is that FDI is nonetheless less volatile than other forms of capital; see, for instance, Sarno and Taylor, 1999.
See Halpern and Wyplosz (1996). In addition to the explanations discussed in this section, in some countries removal of consumer subsidies and price liberalization, as well as the introduction of VAT and excise taxes, also affected CPI real exchange rates without having any direct implications for competitiveness. These effects have been sizable for some countries, including the Baltics.
This derivation uses the usual approximation (1 + a)/(l + b) ≈ (a–b) when a, b are small.
The reader is cautioned regarding the limitations of comparability of data. For instance, in Latvia yields on treasury bills are lower than other interest rates, reflecting their value to banks as collateral. (This would of course amplify the difference between actual and implied real interest rates highlighted in the table.)
For a detailed analysis of supply conditions at the start of the transition see McDonald and Thumann (1990).
For a group of 23 industrialized countries during the 1960s and 1970s, Feldstein and Horioka (1980) found that domestic rates of investment and saving tended to be closely correlated. Feldstein and Horioka originally interpreted this puzzling finding as indicating the presence of substantial barriers to capital flows among industrialized countries. With the move to capital account liberalization in many industrial countries in the 1970s and 1980s, the correlations between S and I appear to have weakened when data for the 1980s are also considered. See Rivera-Batiz and Rivera-Batiz (1994), page 273.
Such concerns are not confined to transition countries, of course, but are among the factors that limit the extent to which we operate in a truly global capital market. Tornell and Velasco (1992) attribute capital flows from poor to rich countries to weak property rights which induce a “tragedy of the commons”. Groups representing special interests in poor countries are able to appropriate other groups’ capital stocks, either directly or indirectly through their influence on the budgetary process. By contrast, investments citizens of poor countries make in rich countries are safe from expropriation risk. Recent findings by Garibaldi et al. (1999) that the distribution of FDI flows across countries is significantly influenced by investor perceptions of country risk as well as survey-based indicators of the legal and political climate are consistent with the view that such factors are important limitations to capital flows.
A useful reference is Schadler et al., 1993, which considered the experience of 6 countries faced with surges of capital inflows: within the five years following the publication of this study, three of these countries had undergone major crises. The countries experiencing crises were Spain (1993), Mexico (1994-95), and Thailand (1997-98); Chile and Colombia weathered international financial crises; while in Egypt, the episode of capital inflows proved short-lived.
While the current paper focuses on transition countries, much of the argument applies to emerging market economies more generally.
This can be illustrated in the simplest Mundell-Fleming model: with fixed exchange rates and capital mobility, monetary policy is irrelevant and only fiscal policy affects economic activity and the current account; with floating exchange rates, a combination of fiscal tightening and monetary easing can be used to reduce the current account deficit.
As an illustration, consider the 1997-98 Asian crisis: given sound initial fiscal positions there was substantial room for fiscal deficits to expand once it became evident that the crisis was leading to a precipitous drop in private domestic demand; but this expansion was not sufficient to prevent severe recessions (Lane et al. (1999)).
In the case of Hungary, these controls were lifted in mid-June 2001 in conjunction with the adoption of inflation targets for monetary policy.
The risk that, if a fixed exchange rate is sustained for some time, more and more private foreign exchange positions will go unhedged, resulting in increasing vulnerability to—and the potential cost of—a change in market sentiment, is illustrated by the experience of the Asian crisis countries in the run up to the 1997-98 crisis (Boorman and others, 2001). In contrast, one may consider the relatively benign reaction of Australia and New Zealand, with floating exchange rates, to the same crisis.
Under other circumstances, an exchange rate peg can have expectations effects that are favorable, for instance in the context of exchange rate based stabilizations and with hard pegs such as currency boards or dollarization; there is considerable evidence that, under propitious conditions, the credibility benefits of such regimes can translate into lower inflation without sacrificing growth performance (see Ghosh et al. (1998); Hamann (1999); Masson (1999); and Corker et al. (2000)). But such regimes are less likely to be promising in the context of substantial equilibrium real exchange rate movements.
Of course, history is important. In the presence of large exchange rate exposures by the government, the banks, or the corporations—due, perhaps, to a prolonged period of more or less fixed rates—a shift from a fixed to a floating exchange rate may give rise to serious balance-sheet effects that would result in substantial overshooting. For this reason, in a highly dollarized economy, the authorities may well be unwilling to accept the large movements in exchange rates that would be likely to result (see Calvo and Reinhart, 2000).