A. Rapid Liberalizers

The Czech Republic was a pioneer among EU8 countries in achieving a high degree of liberalization of its capital account relatively early in the transition process. As in other countries, the liberalization of inflows was somewhat faster than the removal of outflow restrictions, which indicates that the authorities were more concerned about potential outflows than inflows.

As in other cases, FDI was the first major item to be liberalized in the early 1990s,¹¹ and a de facto liberal approach was already being applied also to foreign credits of banks and companies in 1994-95. Most capital transactions were de jure liberalized with the enactment of the new Foreign Exchange Act in September 1995, including short-term portfolio and credit inflows. One of the reasons for accelerated capital account liberalization was OECD accession, which took place in December 1995. The 1995 Foreign Exchange Act contained a safeguard clause that allowed the central bank to introduce deposit requirements on capital inflows if necessary and to stop certain transactions entirely. Although this clause has never been activated, the central bank did instruct commercial banks not to lend to nonresidents in domestic currency during the May 1997 currency crisis.¹²

The remaining restrictions following the 1995 liberalization round pertained mostly to outflows, such as the issuance of debt and money market securities abroad by residents, and the opening of accounts by residents abroad, as well as financial derivatives transactions. To comply with OECD membership obligations and in the framework of EU accession negotiations, the Czech authorities adopted a five-year program in early 1996 to eliminate the remaining limitations. As of January 1, 1999, restrictions on foreign security transactions, financial derivative operations, the sale of collective investment instruments by nonresidents, and the extension of financial credits by residents to nonresidents were abolished. The issuance of debt securities abroad by residents and the opening of deposits by residents abroad were liberalized as of January 1, 2001.

There are signs that capital account liberalization in the Czech Republic was premature and played a major part in the May 1997 currency crisis, when monetary authorities were forced to abandon the fixed exchange rate system. The two years preceding the crisis witnessed heavy inflows, mostly financial credits with increasingly short-term maturities.¹³ The capital account was liberalized and foreign investment flowed in against a backdrop of immature financial markets and incomplete structural reform.

The Baltic countries—Estonia, Latvia, and Lithuania—also belong to the group of rapid liberalizers. Estonia’s liberal economic policy was also reflected in speedy capital account liberalization: by the end of 1994, nearly all controls on capital account transactions had been removed. Some minor limitations—such as restrictions on pension funds’ investments in nongovernment securities of certain countries and in foreign real estate—were eliminated later, but these were irrelevant in terms of managing capital flows. Latvia and Lithuania also removed barriers to capital mobility early in the transition phase, and by 1994-95 most restrictions on FDI, credit, and portfolio flows were gone. Like the other countries in the region, these two Baltic countries also retained some restrictions on real estate investments and pension fund investments for some years. They entered the EU with transitional arrangements for the acquisition of agricultural and forestry land.

Thus, by late 1995 the Czech Republic and the Baltic countries had opened up their capital account to a high degree to interest-rate-sensitive and equity flows. This caused some problems in the Czech Republic—culminating in the May 1997 currency crisis—but posed no particular difficulties for the Baltic countries.

B. Cautious Liberalizers

Hungary began its transition in the first half of the 1990s with high external debt, low foreign exchange reserves, and growing macroeconomic imbalances. As a result, Hungarian authorities adopted a very cautious attitude toward capital account liberalization.¹⁴ Pre-1995, the only major item to be liberalized was inward FDI (rather early, in 1989), and this period was mostly spent gradually liberalizing the current account. Hungary submitted its official application to the OECD in December 1993, but no major progress was achieved in capital account liberalization before 1995.

The next phase commenced with the new Foreign Exchange act of January 1996, which was a major step toward current and capital account liberalization. The main principle guiding this round of liberalization was to liberalize long-term flows before short-term flows. Hungary’s obligations related to OECD accession—which it joined in May 1996—and the improving macroeconomic environment played an important role in accelerating liberalization. Among the most important items to be liberalized in 1996 were the sales and issues of securities to nonresidents with original maturities of more than one year.¹⁵ The July 1996 liberalization of long-term outflow items did not have much noticeable effect, as the improving macroeconomic conditions made domestic investment more attractive. The gradual easing of remaining foreign exchange restrictions and small steps to liberalize the capital account characterized the period until June 2001, when full liberalization eventually took place.¹⁶ Full liberalization was preceded by a change in the exchange rate regime, as the fluctuation band of the Hungarian forint’s exchange rate was widened from ±2.5 percent to ±15 percent.

In addition to the surge of inflows into the government securities market, there are other indications that the remaining capital account restrictions were increasingly ineffective. The London offshore forint market allowed nonresidents to take positions on the currency, which contributed to speculative pressures at times. The dominance of foreign ownership in the financial sector also somewhat diminished the effectiveness of restrictions, as commercial banks could swiftly react to developments in domestic financial markets and often took positions on expected exchange rate movements. They were the biggest players in the derivatives markets as well. However, the restrictions on lending to nonresidents in domestic currency and on their participation in the derivatives market somewhat protected the domestic markets from speculative moves.

Poland also adopted a gradual schedule of capital account liberalization, demonstrating a preference for long-term flows against short-term flows, and liberalizing inflows before outflows.¹⁷ High external debt, very high inflation, and recurrent devaluations caused the authorities to proceed very cautiously in removing restrictions. The liberalization was coordinated to a high degree with macroeconomic developments, especially with monetary and exchange rate policy.

FDI inflows and some portfolio inflows were the first items to be liberalized during 1990-94. In the government securities market, foreign investors were initially allowed to purchase securities with maturities over one year only, but this restriction was removed in 1993. This move opened up the channel for interest-rate-sensitive inflows for nonresident investors, but inflows into treasury securities were limited in the first few years, given the macroeconomic risks and the limited amount of securities available. Portfolio investment on the Warsaw Stock Exchange was liberalized in September 1994.

The liberalization of capital movements speeded up somewhat during the period of OECD accession negotiations between November 1994 and November 1996. A new Foreign Exchange Law was passed in December 1994 (though still restrictive by OECD standards), and, following the acceptance of Article VIII obligations in June 1995, a host of transactions were liberalized, including commercial credits, most FDI outflows, and long-term portfolio investment in OECD markets. Following OECD accession, the authorities liberalized long-term flows first, removing restrictions on inflows before liberalizing outflows. They liberalized certain transactions gradually, increasing the ceiling on these transactions step-by-step after ensuring that the flows did not disrupt monetary policy. Given the large current account deficit and wide interest rate differentials, Poland postponed the elimination of several short-term restrictions in early 1999, when the new Foreign Exchange Law came into effect. Eventually, in October 2002, all remaining short-term restrictions were eliminated.

As in the case of Hungary, the prolonged process hid the fact that restrictions on capital flows were not only not as stringent as they might seem, but also were increasingly ineffective. One of the important items, portfolio investment in treasury securities, was liberalized rather early, and it was a major cause of fluctuation in capital flows. The offshore zloty market in London was also occasionally a source of speculative pressures.

The liberalization of the Slovak Republic’s capital account has received less attention than that of the other countries, mostly because until recently capital inflows to the country have been smaller than to other advanced Central European economies. This was mostly because the Slovak Republic’s political instability and sluggish economic reforms until 2000 were not favorable to FDI and other inflows. The ultimate anchor of the capital account liberalization was EU membership, and the details were driven by OECD talks, as in the case of the other Central European countries.

The Slovak Republic pursued a gradual liberalization strategy following similar principles as the other “cautious” transition countries: liberalization of long-term before short-term flows, and preference for inflows to outflows and FDI to financial credits. Following the liberalization of inward FDI in the early 1990s, a further few items were liberalized in 1996 related to the OECD accession negotiations.¹⁸ After this liberalization round, however, economic reforms and capital account liberalization slowed, and the Slovak Republic missed the 1995-96 OECD accession wave. However, from 1999, when the reform process got a boost, capital account liberalization accelerated. In the 2000 amendment to the Foreign Exchange Act, the remaining restrictions on medium- and long-term capital transactions were lifted including financial credits and the issue of Slovak securities abroad with maturities of one year and longer.

The Slovak Republic joined the OECD in 2000, and, as a response to EU and OECD commitments, it developed a plan for removing the remaining restrictions by the time of EU accession. It adhered to this plan in the run-up to EU accession. Short-term financial credits were liberalized in 2001, and financial derivatives were liberalized and the remaining restrictions on securities transactions removed as of January 1, 2003. The liberalization of several major items was left to the last minute: as of January 1, 2004, the repatriation obligation was abolished, and resident operations with foreign deposit accounts and foreign currency operations were liberalized.

The Slovak Republic’s liberalization of the capital account was among the slowest in the EU8 group. Managing capital inflows did not pose significant problems in the 1990s, owing to the slow reform process. Recently, substantial FDI inflows have been complicating the conduct of monetary policy. Compared with other Central European countries, interest-rate-sensitive inflows have been relatively modest in the Slovak Republic, mainly because of the undeveloped nature of its capital markets.

Slovenia was the only EU candidate country to introduce major capital controls and one of the slowest to liberalize its capital account.¹⁹ The restrictions were introduced because domestic residents were borrowing heavily abroad in the 1990s in response to very large interest rate differentials. Unlike in other accession countries, even FDI inflows faced substantial restrictions during the 1990s.²⁰ Capital account measures had three major phases: capital controls in 1995-99, liberalization of credit operations in 1999-2000, and full liberalization in 2001-02.

In the first phase, interest-rate-sensitive capital inflows—mainly in the form of domestic residents’ borrowing abroad—intensified in 1994-96 due to large domestic/foreign interest rate differentials.²¹ The potentially destabilizing effect of capital inflows and high sterilization costs had been a major concern for monetary authorities and from 1995 on Slovenia introduced the following restrictions on capital flows:²²

• February 1995. Introduction of a 40 percent unremunerated reserve requirement (URR) in tolar on foreign non-trade-related loans with a maturity of less than five years. For longer maturities, the deposit requirement is only 10 percent.

• December 1995. Imposition of a requirement on foreign exchange offices to balance their daily sales and purchases of foreign currency.

• July 1996. Imposition of a requirement on banks to balance any additional liability in foreign currency beyond their position as of July 31, 1996 with corresponding claims in foreign assets.

• August 1996. Lengthening of the maturity of loans subject to the URR to seven years.

• February 1997. Imposition of a requirement on foreign portfolio investments to be conducted through (costly) custody accounts with a fully licensed bank. The cost is borne by foreign portfolio investors when selling such securities to residents earlier than six months after their purchase.

• January 1999. Reduction of the URR to zero (although the system is not abolished in order to reserve the right to reimpose a deposit requirement in case of monetary and exchange rate difficulties).

In the second phase, 1999-2000, restrictions were removed on credit operations, but restrictions on short-term capital flows were retained. In June 2000, a timetable was set for the liberalization of remaining restrictions, according to which custody-account-related restrictions were to be eliminated at the end of 2002. In the third phase, the capital account was fully liberalized. Restrictions on portfolio inflows with maturities above six months were eliminated in July 2001. Liberalization progressed ahead of schedule, and, as of January 1, 2002, all restrictions on cash transactions and on securities operations were abolished, thus achieving almost full liberalization of inflows. Following the liberalization of credit operations, financial credit inflows increased significantly, but portfolio inflows still remained subdued. In fact, the elimination of restrictions on investment in foreign securities by mutual and investment funds in 2004 led to appreciable increase in portfolio outflows.

Slovenia’s case is rather different from other countries in the region. Capital controls were installed mainly as a response to inflows induced by persistent foreign borrowing by domestic banks and enterprises. This is in contrast with other countries in the region experiencing heavy inflows, where the main concern of monetary authorities was the inflow of interest-rate-sensitive portfolio investment by nonresidents, which is potentially more destabilizing and highly mobile. The small size of its capital markets made Slovenia less vulnerable to portfolio flows than the bigger countries in the peer group, such as the Czech Republic, Hungary, and Poland.

A. Other Investment Flows

The category of “other investment flows” recorded the second-largest volume after FDI. The major groups in this category are trade credits and loans (usually referred to as financial credits) as well as currency and deposits. Other investment flows are reported for the monetary authorities, general government, the banking sector, and other sectors (predominantly the enterprise sector). Although other investment inflows have been substantial for EU8 countries as a group, their share in total net inflows in 1995-2003 ranges from -6 percent (in Hungary) to 70 percent (in Latvia). The share of net financial and trade credit flows in total flows was significantly smaller in the larger Central European countries (the Czech Republic, Hungary, and Poland) than in the Baltic states and in the Slovak Republic and Slovenia. Financial credit flows intensified in the late 1990s in most countries—a development that is not only attributable to capital account liberalization, but also to successful macroeconomic stabilization and increasing financial deepening.

The sectoral breakdown of other investment flows reveals not only some common trends, but also some differences across countries during the period (Figure 2). Financial credit flows were channeled mainly through the banking sector in Estonia, Latvia, Slovenia, and Hungary. In the Czech Republic, Lithuania, and Poland, the enterprise sector received the bulk of the inflows, whereas in the Slovak Republic the shares of the banking and enterprise sector were roughly equal. The importance of foreign direct borrowing by the enterprise sector was more pronounced in the 1990s than in the current decade.

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EU8 Countries: Other Investment Flows, 1995-2003

(In millions of U.S. dollars)

Citation: IMF Working Papers 2005, 213; 10.5089/9781451862324.001.A001

Source: IMF, IFS.

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There were several reasons behind the substantial direct foreign borrowing by enterprises during the transition period. High inflation and nominal interest rates, coupled with trend real appreciation, increased the attractiveness of foreign-exchange-denominated borrowing. Although bank restructuring and privatization were under way in most countries in the 1990s, domestic banks were burdened by large shares of nonperforming loans, relatively high reserve requirements, and low efficiency.²⁶ This raised the cost of domestic borrowing for enterprises relative to foreign borrowing and explained the large spread between loans and deposits. Before the privatization and restructuring of large domestic banks, and the spread of syndicated loans, foreign-owned banks were often too small to satisfy the borrowing needs of their larger clients. These banks established links between domestic companies that were deemed creditworthy and the banks’ foreign headquarters. Direct foreign borrowing was also related to FDI, as foreign-owned companies had easy access to foreign banks through their owners. Early enterprise restructuring increased the profitability and, thus, the creditworthiness of companies.

The cross-country patterns tend to confirm these hypotheses. The protracted bank restructuring process in the Czech and Slovak Republics contributed to high direct foreign borrowing by enterprises. High foreign ownership levels in the Polish and the Czech enterprise sectors—among the top recipients of FDI in the region—from the early stages of transition onward led to easy access to foreign banks. The scarcity of large Estonian and Latvian companies likely contributed to the dominance of inflows through the domestic banking system in these countries given the transaction costs of direct foreign borrowing.

The effect of capital controls in Slovenia is not easily discernible, though they most likely contributed to the net outflow in 1996. Hungary was the only country experiencing a cumulative outflow from the enterprise sector; this is somewhat puzzling, as Hungarian companies would have been well-placed to have access to direct foreign borrowing, given the early restructuring of the sector and large FDI inflows. Most likely, the early and successful privatization and restructuring of the banking sector and the heavy competition for creditworthy corporate clients made direct foreign borrowing less attractive for Hungarian companies.

The banking channel of other investment flows became dominant in almost all countries— apart from Lithuania and Poland— from 2000 onward. Banking system restructuring and privatization were nearly completed in all countries, competition in the banking sector increased, reserve requirements were reduced, and nominal interest rates declined, thereby narrowing interest margins.²⁷ As a result, a large part of former direct foreign borrowing by the enterprise sector was channeled through the banking system. In addition, declining profit margins in corporate lending prompted banks to increase lending to households and small and medium-sized enterprises, which had very low indebtedness. The ensuing fierce competition for market shares in retail banking led to credit booms in most countries, fuelled by financial inflows through the banking system.²⁸ This surge of financial credit inflows was triggered mainly by the fight for market share and large profit margins in nascent markets, and not simply by interest rate differentials, which had declined substantially in most countries by this time.

Finally, a net outflow from monetary authorities and the general government of nearly US$10 billion was recorded for the region as a whole during 1995-2003. This was driven by the external debt repayment of some countries: the cumulative net outflow reached US$7.6 billion for Poland and nearly US$3.8 billion for Hungary. However, the monetary authorities and the government were typically net borrowers in countries with lower public debt, such as the Baltic states and the Slovak Republic.

B. Portfolio Flows

Considering the differences in the pace and sequencing of capital account liberalization, it is somewhat surprising that countries with cautious liberalization strategies have been the biggest recipients of interest-rate-sensitive portfolio inflows. This is an indication that other important factors are behind these flows besides capital account liberalization, and that the slow pace of liberalization amounted more to throwing sand into the wheels and tilting the composition of flows toward long-term securities than effectively preventing large interest-rate-sensitive portfolio inflows. Indeed, as was noted above, the relatively early liberalization of Poland’s and Hungary’s government securities markets effectively opened up the channel for highly volatile and potentially destabilizing interest-rate-sensitive inflows, and the effect of the remaining restrictions—however numerous—was relatively minor.

For countries other than Hungary and Poland, the issuance or foreign-exchange-denominated bonds—mainly Eurobonds—was the primary source of portfolio investment in debt securities. Since the decomposition of portfolio inflows by currency denomination is not readily available, interest-rate-sensitive portfolio inflows will be approximated by nonresidents’ investment in the domestic government securities market.²⁹ Portfolio inflows into government securities are reflected in the growing share of nonresident holdings of these securities (Appendix Table A1).

Consistent with intuition, two factors have been crucial for attracting interest-rate-sensitive portfolio inflows: a wide interest rate differential and available financial assets to invest in (Table 2 and Figure 3). Poland and Hungary had sizable interest rate differentials until the early 2000s—corresponding to their slow disinflation process—coupled with relatively high domestic debt. For Slovenia, the interest rate differential was somewhat smaller, and its fixed-income market capitalization was substantially lower. The attractiveness of the Slovak Republic’s high interest rate differential was offset by low fixed-income capitalization and political uncertainty. For these reasons, portfolio inflows were small in these two countries. Falling interest rates accompanying the 1997-99 rapid disinflation and recession made Czech debt securities unattractive, and the capital account mainly recorded portfolio outflows despite the sizable fixed-income market. Nonresident portfolio investors have been largely uninterested in Baltic debt securities given the low interest rates and low market capitalization.

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EU8 Countries: Interest Rate Differentials, 1995-2004

(In percent)

Citation: IMF Working Papers 2005, 213; 10.5089/9781451862324.001.A001

Sources: IMF, IFS; and British Bankers’ Association.Note: The panels depict the difference between local treasury bill rates (deposit rates if treasury bill rates are unavailable) and the three-month EUR Libor rate (ECU rate before 1999).

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Table 2.

EU8 Countries: Size of the Government Securities Market, 1997–2004 (Marketable securities in parantheses when available, in millions of U.S. dollars, unless otherwise noted)

Sources: Ministries of Finance of the respective countries and the Government Debt Management Agency for Hungary.

^1/The jump in the Slovak Republic’s domestic debt between 2000 and 2004 was mainly attributable to bank restructuring bonds.

Table 2.

EU8 Countries: Size of the Government Securities Market, 1997–2004 (Marketable securities in parantheses when available, in millions of U.S. dollars, unless otherwise noted)

		1997	2000	2004
Poland		26,825 (18,341)	30,599 (27,037)	78,435 (74,775)
	(As a percent of GDP)	17.5	18.4	32.5
	(As a percent of GDP)	(11.9)	(16.2)	(31.0)
Hungary		14,156 (8,580)	15,631 (10,861)	42,438 (35,670)
	(As a percent of GDP)	30.6	33.7	41.7
	(As a percent of GDP)	(18.6)	(23.4)	(35.1)
Czech Republic		4,065	6,985	22,233
	(As a percent of GDP)	7.1	12.5	16.0
Slovak Republic 1/		3,108	2,470	11,510
	(As a percent of GDP)	14.7	12.2	28.0
Slovenia		2,228	1,926	4,893
	(As a percent of GDP)	11.4	10.2	15.2
Lithuania		…	621	1,229
	(As a percent of GDP)	…	5.5	5.5
Latvia		298	368	783
	(As a percent of GDP)	4.9	4.8	5.8
Estonia		…	11	0
	(As a percent of GDP)	…	0.2	0.0

Sources: Ministries of Finance of the respective countries and the Government Debt Management Agency for Hungary.

^1/The jump in the Slovak Republic’s domestic debt between 2000 and 2004 was mainly attributable to bank restructuring bonds.

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Table 2.

EU8 Countries: Size of the Government Securities Market, 1997–2004 (Marketable securities in parantheses when available, in millions of U.S. dollars, unless otherwise noted)

		1997	2000	2004
Poland		26,825 (18,341)	30,599 (27,037)	78,435 (74,775)
	(As a percent of GDP)	17.5	18.4	32.5
	(As a percent of GDP)	(11.9)	(16.2)	(31.0)
Hungary		14,156 (8,580)	15,631 (10,861)	42,438 (35,670)
	(As a percent of GDP)	30.6	33.7	41.7
	(As a percent of GDP)	(18.6)	(23.4)	(35.1)
Czech Republic		4,065	6,985	22,233
	(As a percent of GDP)	7.1	12.5	16.0
Slovak Republic 1/		3,108	2,470	11,510
	(As a percent of GDP)	14.7	12.2	28.0
Slovenia		2,228	1,926	4,893
	(As a percent of GDP)	11.4	10.2	15.2
Lithuania		…	621	1,229
	(As a percent of GDP)	…	5.5	5.5
Latvia		298	368	783
	(As a percent of GDP)	4.9	4.8	5.8
Estonia		…	11	0
	(As a percent of GDP)	…	0.2	0.0

Sources: Ministries of Finance of the respective countries and the Government Debt Management Agency for Hungary.

^1/The jump in the Slovak Republic’s domestic debt between 2000 and 2004 was mainly attributable to bank restructuring bonds.

The pattern of interest-rate-sensitive flows to EU8 countries indicates the significance of public debt and inflation. Countries with high public debt and slow disinflation—Hungary and Poland—were the most vulnerable to surges of portfolio inflows (Appendix Figures A1 and A2). Nonresident investors prefer markets with high liquidity, and the main (and, in most cases, only) liquid fixed-income instruments were government securities. Foreign participants in the domestic government securities market make the secondary market more liquid and financial services more sophisticated, which, in turn, attracts further inflows. High liquidity can be a mixed blessing, as Poland and Hungary found out during international capital market turbulence. Because foreign investors can liquidate their positions more easily, and with smaller losses in liquid markets, these markets tend to bear most of the burden in cases of regional outflows.

The pace of disinflation was also a major determinant for portfolio inflows as monetary authorities aimed to maintain positive real interest rates to fight inflation and encourage savings (Appendix Figure A2). The Baltic countries and the Czech Republic managed to achieve low inflation by 1999 and virtually eliminated the interest rate differential vis-à-vis euro rates (Figure 3). However, Poland, the Slovak Republic, and Hungary posted very high interest rate differentials (even after adjusting for exchange rate changes) in the 1990s, with nominal interest rates converging to euro zone levels only recently.

Expected exchange rate trends in transition countries have also made financial assets attractive. Trend real exchange rate appreciation driven by the Balassa-Samuelson effect was partly achieved through nominal appreciation in the Czech Republic, Hungary, Poland, and the Slovak Republic following the floating of their currencies. Despite this trend, exchange rates have been volatile, occasionally going through phases of depreciation (Appendix Figure A3). The Baltic countries successfully maintained fixed exchange rates,³⁰ and Slovenia was the only country with a depreciating currency up to its EU accession.

In summary, a closer look at the data reveals that cautious liberalizers actually received larger portfolio inflows than rapid liberalizers.³¹ This outcome can be explained partly by differences in starting conditions (high domestic public debt) and partly by macroeconomic developments during transition (slower disinflation). Each country chose its pace of liberalization according to the perceived vulnerability to inflows, with the cautious liberalizers having more to worry about. Despite the large inflows and the increasing ineffectiveness of restrictions, the cautious approach to liberalization had some benefits. Where maintained, restrictions on lending to nonresidents in the domestic currency and on financial derivatives mitigated the volatility of capital flows and the scope for speculative attacks. In general, restrictions increased transaction costs, thereby reducing the gains from the interest rate differential.

A. Monetary and Exchange Rate Policies

Monetary and exchange rate policies were the most common responses to capital inflows in the Central European countries.³² The main response to FDI inflows was sterilized intervention, both in flexible and fixed exchange rate settings. Fixed exchange rates were maintained by the Czech Republic until 1997, and the Slovak Republic until 1998. Slovenia maintained a heavily managed float throughout the period, whereas Poland and Hungary had crawling band regimes until 2000 and 2001, respectively, with Poland’s band increasingly widening. Monetary authorities had to find a delicate balance among furthering disinflation, minimizing sterilization costs, and maintaining external competitiveness. Responding to these multiple challenges, countries chose the following mix of policies:

• Sterilized intervention was an active policy tool in Hungary—given the narrow band around the preannounced crawl—until the widening of the band in 2001. Poland phased out sterilized interventions earlier and stopped intervening in 1998 as part of its move to full exchange rate flexibility. Although it did not receive major interest-rate-sensitive inflows during the 1990s, the Slovak Republic’s main response to inflows in its fixed exchange rate period was sterilized intervention. Slovenia also intervened heavily to keep the exchange rate on the desired path, motivated by real exchange rate considerations.

• Slowing the depreciation of the domestic currency by reducing the monthly rate of crawl was a prominent policy tool for disinflation in Hungary and Poland. The timing of crawl adjustments was usually determined by favorable inflation and current account developments, as well as by inflow pressures. In Poland, adjustments in the crawl were also accompanied by a gradual widening of the intervention band from ±2 percent in 1995 to ±15 percent in 1999. Slowing the rate of depreciation was used for disinflation purposes in Slovenia as well.

• Cautious and gradual interest rate cuts following the path of disinflation were also an integral part of the policy mix. Central banks in the EU8 countries followed the market in most cases and aimed at maintaining low positive interest rates so as not to discourage savings.

The move to more flexible exchange rate arrangements was partly motivated by the increased volume of capital flows itself. Following the floating of their currencies, monetary authorities increasingly differentiated their policy responses depending on the nature of the inflow. After 1999, the Czech and Slovak Republics received increasing amounts of FDI to which they continued to react mostly with sterilized interventions. Poland and Hungary attracted large amounts of interest-rate-sensitive inflows in addition to sizable FDI inflows. Both countries abandoned the policy of sterilized intervention and allowed significant appreciations of their nominal exchange rates.³³ At the same time, interest rate policy became more active in the three countries—the Czech Republic, Hungary, and Poland—that introduced formal inflation-targeting (IT) regimes.

Within the framework of IT, Poland, Hungary, and the Czech Republic followed different strategies: in Poland, interest rate policy was used for “pure” IT with little concern over the ensuing capital flows and exchange rate developments (Appendix Figure A3). The policy of nonintervention placed the costs of capital flow volatility on market participants and discouraged one-way bets on exchange rate developments. Hungary, on the contrary, used interest rate policy to try to keep the exchange rate in a relatively narrow band believed to be consistent with the inflation target; this strategy implied a belief in a strong exchange rate pass-through (Figure A3). The resolve to disinflate in the framework of IT was largely successful, and low-single-digit inflation was achieved in 2002 in Poland and in 2005 in Hungary (Figure A2). One of the consequences, however, was the very large inflow of interest-rate-sensitive capital accompanying the tight monetary policy. Interest rate policy in the Czech Republic’s IT regime was less active, as it achieved low inflation soon after the introduction of IT.

Despite uncertain and likely weak interest rate transmission, the larger EU8 countries mostly avoided maintaining negative real policy rates for fear of their effect on inflation and savings, and of a sudden turnaround of capital flows. Among the Central European countries, only the Slovak Republic had prolonged periods of negative real policy rates, as it was more concerned about the effect of large capital inflows on the exchange rate than about their potential effect on inflation (Appendix Figure A3).³⁴

B. Fiscal Policy

The experience with fiscal policy in EU8 countries as a policy response to capital inflows is mixed. Fiscal policy can mitigate the effect of inflows on the real exchange rate, the current account, and inflation, however, it is a relatively inflexible policy tool because of the length of the budgetary procedures and the policy response lag. In addition, during the transition period fiscal policy had to deal with several major structural issues besides the cyclical position of the economy (such as pension reform, the reform of transfers and subsidies, major infrastructure investments, etc.). These circumstances made some countries more reluctant to tighten fiscal policy, even in the face of large capital inflows.

Two main groups can be distinguished in terms of fiscal policy: in the first group— comprising Estonia, Latvia, Lithuania, and Slovenia—fiscal policy generally helped to offset the effect of capital inflows, whereas, in the larger Central European countries, looser fiscal discipline did not help and in some cases exacerbated the difficulties caused by the inflows. The Baltic states maintained prudent fiscal policies almost throughout the entire 1995-2003 period, as required by their currency board and hard peg arrangements, though there were episodes of fiscal loosening following the Russian crisis (Table 3). Slovenia also recorded only modest fiscal deficits during the 1995-2003 period. These countries were also helped by low public debt. Nevertheless, the fiscal stance was less of a direct response to the capital inflows than a general commitment to tight fiscal discipline throughout the period.

Table 3.

Selected EU8 Countries: Government Balance - Countries with Prudent Fiscal Policies, 1995–2003

(As a percent of GDP)

Source: IMF.

Table 3.

Selected EU8 Countries: Government Balance - Countries with Prudent Fiscal Policies, 1995–2003

(As a percent of GDP)

	1995	1996	1997	1998	1999	2000	2001	2002	2003
Estonia	-0.5	-1.6	0	-0.3	-4.3	-0.6	0.4	1.4	2.9
Latvia	-3.9	-1.7	0.1	-0.8	-3.9	-3.0	-2.0	-2.3	-1.6
Lithuania	-4.5	-4.5	-4.8	-4.4	-8.5	-2.8	-1.9	-0.8	-1.7
Slovenia	0.1	0.2	-1.2	-0.5	-0.6	-1.3	-1.3	-1.5	-1.4

Source: IMF.

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Table 3.

Selected EU8 Countries: Government Balance - Countries with Prudent Fiscal Policies, 1995–2003

(As a percent of GDP)

	1995	1996	1997	1998	1999	2000	2001	2002	2003
Estonia	-0.5	-1.6	0	-0.3	-4.3	-0.6	0.4	1.4	2.9
Latvia	-3.9	-1.7	0.1	-0.8	-3.9	-3.0	-2.0	-2.3	-1.6
Lithuania	-4.5	-4.5	-4.8	-4.4	-8.5	-2.8	-1.9	-0.8	-1.7
Slovenia	0.1	0.2	-1.2	-0.5	-0.6	-1.3	-1.3	-1.5	-1.4

Source: IMF.

The larger Central European countries, however, posted rather large deficits, especially from 2001 (Table 4). There was no sign of fiscal tightening as a reaction to large capital inflows during most of the period in the four countries. The Slovak and Czech Republics tightened fiscal policy toward the end of the period, but this was not seen as a direct reaction to capital inflows. Loose fiscal policy contributed to slow disinflation in Hungary and the Slovak Republic, and to large current account deficits in the Czech and Slovak Republics, and Hungary (Appendix Table A2). The lack of fiscal response placed most of the burden of disinflation on monetary and exchange rate policies, especially in Poland and Hungary. Tight monetary policy in Poland in 1999-2001 and in Hungary after 2002 contributed significantly to increased portfolio inflows (Figure 1 and Appendix Figure A3). Having brought inflation down to low-single-digit levels, fiscal consolidation remains the biggest challenge to euro adoption in these four countries.

Table 4.

Selected EU8 Countries: Government Balance - Countries with Loose Fiscal Policies, 1995–2003

(As a percent of GDP)

Source: IMF.

Table 4.

Selected EU8 Countries: Government Balance - Countries with Loose Fiscal Policies, 1995–2003

(As a percent of GDP)

	1995	1996	1997	1998	1999	2000	2001	2002	2003
Czech Republic	0.2	-0.4	-1.2	-0.6	-1.6	-3.3	-5.0	-6.6	-6.0
Hungary	-6.2	-3.1	-4.8	-4.8	-3.7	-3.0	-4.7	-9.4	-7.2
Poland	-3.1	-3.3	-3.1	-3.3	-3.0	-3.0	-5.3	-6.3	-5.8
Slovak Republic	0.4	-1.3	-5.2	-5.0	-3.6	-12.3	-6.0	-5.7	-3.7

Source: IMF.

View Table

Table 4.

Selected EU8 Countries: Government Balance - Countries with Loose Fiscal Policies, 1995–2003

(As a percent of GDP)

	1995	1996	1997	1998	1999	2000	2001	2002	2003
Czech Republic	0.2	-0.4	-1.2	-0.6	-1.6	-3.3	-5.0	-6.6	-6.0
Hungary	-6.2	-3.1	-4.8	-4.8	-3.7	-3.0	-4.7	-9.4	-7.2
Poland	-3.1	-3.3	-3.1	-3.3	-3.0	-3.0	-5.3	-6.3	-5.8
Slovak Republic	0.4	-1.3	-5.2	-5.0	-3.6	-12.3	-6.0	-5.7	-3.7

Source: IMF.

C. Capital Controls

Of the EU8 countries, only Slovenia introduced major capital controls during the period. As was noted above, it seems that the Slovene URR was not effective in reducing total inflows; however, it was somewhat successful in changing the composition by discouraging short-term inflows, and the introduction of custody accounts reduced portfolio inflows. The Czech Republic and Hungary also maintained the possibility of introducing controls (deposit requirements) in their foreign exchange laws, but never activated them. The prolonged process of capital account liberalization itself and the postponement of liberalization steps (such as for short-term transactions in Poland) were also responses to the inflows. The restrictions on financial derivatives and on lending to nonresidents in domestic currency, which were eliminated as some of the last steps taken in most countries, were especially important in reducing vulnerability in outflow episodes, such as the Russian crisis.

D. Debt Management

Some countries employed debt management in their policy tool sets to mitigate the effect of inflows. Hungary used part of its privatization receipts to repay debt to international financial institutions in the second half of the 1990s, and the Slovak Republic also repaid a large amount to the IMF before maturity. Poland established at the central bank a special account from privatization revenues to finance future debt service. This account was also used to fund buybacks of Brady bonds in 2000-02. Several countries shifted from external to domestic borrowing. For example, as a response to the heavy inflows, Hungary decided to renew all its maturing external and domestic debt in domestic currency in 2002. Poland and Slovenia also shifted to borrowing from the domestic market after 2000 and 2001, respectively. This step was also motivated by the desire to develop the domestic market for government securities and by other debt-management strategy considerations, such as risk management.

E. Other Policy Responses

Banking regulation and supervision continuously improved during the transition period in the EU8 countries, helping to monitor and reduce the risks related to heavy capital flows, but measures directly responding to capital flows were rare. One such measure was taken in Latvia, where large financial inflows through the banking system fueled credit growth to the private sector, prompting monetary authorities to tighten reserve requirements. The Czech Republic also introduced measures aimed at reducing short-term speculative inflows in 1995, including a limit on banks’ net short-term liability positions to nonresidents and a limit for “short” short-term positions by banks to nonresidents. These measures were largely ineffective.³⁵ In addition, in order to mitigate the effect of large FDI inflows and the anticipation of future inflows on the exchange rate, the bulk of the Czech Republic’s foreign currency privatization receipts were converted directly at the central bank, thus circumventing the foreign exchange market.³⁶ Large short-term inflows into Hungary through the banking sector in 2000 prompted monetary authorities to reduce reserves remuneration if a bank’s on-balance-sheet open position exceeded 30 percent of its capital. In addition, the central bank used moral suasion and threats of stricter reserve requirements to stem the inflows.³⁷