Exchange Rate Regime in the Transition Period
8.3 Exchange Rate Policies and Developments in 1990-92
8.3.3.2 Changed Institutional Setting and Exchange Rate Level
Despite its formal existence, the exchange rate was only of minor relevance under the traditional centrally planned economic framework, which persisted until the end of the 1980s in Czechoslovakia. While pegged to the basket described earlier since 1979, the 'official' exchange rate was maintained as unchanged throughout the 1980s despite its increasing overvaluation. On the other hand, various black and parallel market rates, operating outside the legal framework, provided a distorted evaluation of the currency as well, inevitably depressing its value to an unrealistic level. Though more relevant and realistic, the 'implied' exchange ratios and various coefficients used domestically for trade and non-trade flows were widely dispersed between official and parallel market rates.
Only as late as 1990 were steps towards the unification of existing diversified exchange ratios initiated by eliminating the duality of the so-called commercial and non-commercial rates at the beginning of the year and phasing out a special tourist rate at the end of that year. However, this unification could only effectively materialize provided a proper exchange rate level was introduced. The requirements associated with the scheduled general liberalization and opening of the economy called for an initial undervaluation of the exchange rate compared to what could be defined as the 'fundamental equilibrium exchange rate'. The controversial issue was by how much to deviate and, consequently, by how much to devalue? The policy objective was to avoid both an unnecessarily large undervaluation, which would imply inflationary cost-push pressures and mitigate the desirable disciplining function of external competition, and overvaluation, which would result in unsustainable balance-of-payments deficits undermining the very existence of currency convertibility and the active liberalization program.
A wide range of values was proposed: from CSK 16 per USD, which was close to the former 'commercial rate', up to 35-40 CSK per USD, which approached the marginal and parallel market ratios. Czechoslovakia finally started its stabilization and liberalization program at an exchange rate of CSK 28 per USD.
Though it could be argued that the former exchange ratios, including the so-called commercial rate, hardly represented the de facto exchange rate since the resulting depreciation of the CSK was substantial: from CSK 14.29 per USD at the end of December 1989 to CSK 28 per USD on December 28, 1990. The option adopted
Exchange Rate Regime in the Transition Period 143 by the authorities was thus closer to the existing marginal and parallel market rates.
As a result, the depreciation appeared to overshoot an ex-ante acceptable target.
The adopted exchange rate was the outcome of three successive devaluations of the CSK vis-ii-vis convertible currencies in the course of 1990: the CSK was devalued by 16.6% on January 8, by 55.3% on October 15, and by 15.98% on December 28, 1990. The first two devaluations represented more-or-less only administrative corrections of the existing exchange ratios rather than proper devaluations since they were implemented as isolated acts without accompanying price liberalization. Thus, the impact was limited. The second devaluation (of October 15) was originally scheduled for the beginning of 1991 as a component of the liberalization package, which also implied phasing out the so-called foreign exchange retention quotas. As a preannounced policy, the devaluation became the object of much public debate and also gave enterprises and households the opportunity to react accordingly. Imports dramatically increased in the second half of 1990, simultaneous with growing pressure on the liquidity of the banking sector and on foreign exchange reserves. In addition, a substantial share of foreign investors recalled their deposits from Czechoslovakian banks despite the official support from abroad to the reform program of the new, non-communist Czechoslovakian government. Therefore, the second devaluation was thus an 'unplanned' act implemented under distress, with the aim to reverse the depletion of foreign exchange reserves.
These developments reminded authorities about the role of expectations and represented a harsh lesson from their own conduct and policies. However, the resulting tensions also prompted them to err in overshooting the undervaluation rather than the other way around. Consequently, the third of the successive devaluations followed, finally fixing the exchange rate at CSK 28 per USD.
8.3.3.3 Exchange Rate and the Developments of 'Fundamentals'
In order to identify underlying trends affecting the exchange rate of the CSK in the first, stabilization stage of the transition, calculations were made to assess the developments of:
- purchasing power parity (PPP);
-
parallel market rates (PMR);- nominal effective exchange rate (NEER);
- real effective exchange rates (REER), based both on consumer price indexes (CPI) and producer price indexes (PPI); and
- unit labor costs in industry (ULC).[lO]
Purchasing Power Parity Developments
A common feature of the former centrally planned economies was a wide gap between domestic and external purchasing power of their currencies, significantly wider than in comparable market economies (see Summers and Heston, 1988).
The devaluations introduced at the start of the Czechoslovakian economic transition in 1990 widened this gap still further. At that time, most expert studies identified the PPP rate in the range of CSK 7-8 per USD. Using the mid-point of the interval (i.e., 7.50 CSKAJSD) as a benchmark, the resulting trends in the PPP rate are presented in Figure 8.1 (for data see Table 8.3). The registered decrease in the implied purchasing power of the CSK with respect to USD from CSK 7.50 in January 1990, to CSK 13.39 in December 1992 reflects Czechoslovakia's inflation differential as measured by CPIs.
As follows from data in Table 8.3, the ratio between exchange rate and PPP rate, amounting to 2.17 in January 1990, reached a high at the end of 1990 after the devaluations and in expectation of a sweeping liberalization of domestic prices.
Thereafter, it decreased only gradually from the record level of 2.89 in December 1990 to 2.13 two years later. Thus, the December 1992 figure almost matched the initial level of January 1990. A study by PlanEcon (PlanEcon Report 16-17,18, 1992) assessed the PPP rate of the CSK even more favorably: 6.20 CSKAJSD in
-
Purchasing power parity-
Nomlnol effective-
Parallel market raterate (PPP) exchange rate (NEER) (PMR)
I
Figure 8.1 Official Exchange Rate, Parallel Market Rate, and Purchasing Power Parity of CSK
Exchange Rate Regime in the Transition Period 145 Table 8.3 Nominal Effective Exchange Rate, Purchasing Power Parity and Parallel Market Rate of CSK in 1989-1992 (CSK per USD, average per period)
1 2 3 4 5
p p p p
Note: 1 = Purchasing power parity rate (PPP). 2 = Nominal effective exchange rate (NEER), 3 = Parallel market rate (PMR), 4 = NEERIPPP (2:1), 5 = PMRMEER (3:2).
January 1990 and 10.30 CSWUSD in May 1992. While deviating at the initial level, the rate of change coincides with our estimates.
Unlike in the Czechoslovakian case, the exchange rate/PPP rate ratio decreased significantly in both Poland and Hungary. In January 1990, the level dropped from 3.88 in Poland and 2.15 in Hungary to 1.70 and 1.68 respectively by May 1992.
Comparing these findings, one might conclude that the CSK remained undervalued based on the PPP criterion.
Parallel Market Rate
Contrary to PPP developments, the initial wide spread between parallel market and official exchange rates of the CSK (coefficient of almost 3 in 1989 and 2.5 in January 1990) was virtually eliminated since April-May 199 1 after successful introduction of internal currency convertibility (compare Figure 8.1 and Table 8.3).
The remaining spread was, as a rule, only marginal - as low as 2% in the first half of 1992:However, it did widen again to as much as 6-8% by the end of the year due to the re-appearing uncertainties associated with the forthcoming split of Czechoslovakia.
Real Effective Exchange Rates
The International Monetary Fund (IMF) regularly calculates and publishes real effective exchange rate (REER) indices only for Hungary and Poland. Our own calculations were made for Czechoslovakia and, therefore, cannot be considered strictly comparable with the IMF figures. Although the concept of real effective exchange rate itself is unambiguous there is a number of methodological and technical issues that may qualify the results and their interpretation when REER is defined as a nominal effective exchange rate index adjusted for relative movements in national price (or cost) indicators of the home country and its partner (or competitor) countries. Without engaging to deeply in their discussion,[l I ] some notes specifying the approach adopted in the calculations of the CSK REERs presented in this paper (see Table 8.4 and Figure 8.2) are necessary and described below.
(a) REER appreciation and depreciation.
A country's exchange rate is considered to appreciate in real effective terms if:
the devaluation (depreciation) of its nominal exchange rate is less than its relative inflation; or if the revaluation (appreciation) of its nominal exchange rate is less
Exchange Rate Regime in the Transition Period 147 Table 8.4 Effective Exchange Rates, 0.65 DEM
+
0.35 USD per CSK (Indices,January 1990 = 100)
Note: 1 = NEER, 2 = CPI Czechoslovakia, 3 = CPI basket currency countries, 4 = WPI Czechoslovakia. 5 = WPI basket currency countries, 6 = REER (consumer prices), 7 = REER (wholesale prices).
I
-NEER-
REER (consumer prices) x - REER (wholesale prices)Figure 8.2 Nominal and Real Effective Exchange Rates
than its relative deflation compared to the (weighted) average of its partner countries. In the type of formula adopted here, real appreciation of the domestic currency materializes when the index value is above 100 (or, in relative terms, when its value increases) and vice-versa for real depreciation.
(b) The choice of partner countries and of the weighting criterion for the selected currencies.
The calculations presented in Figure 8.2 and Table 8.4 are based on the composition and weights of the basket to which the CZK has been pegged since May 2, 1993 (DEM 65% and USD 35%). Just for comparison, parallel calculations were also made adopting composition and weights of the basket as valid for the CSK peg in 1992; namely, USD 49.07%, DEM 36.15%, ATS 8.07%, CHF 3.79%, and FRF 2.92%. In principle, the resulting trends of both versions coincided: after a substantial real depreciation of the CSK in the fourth quarter of 1990, a reversal recurred in January 1991. Since then, the CSK was gradually appreciating in real terms throughout 1991 and 1992, until at the end of 1992 it virtually reverted to the ratios of early 1990; that is, to the situation at the start of the Czechoslovakian economic transition. Nevertheless, the shift in the basket's composition (particularly in the relative weights of DEM and USD) affected the data as expressed by the deviations of 9% to 10%.
Exchange Rate Regime in the Transition Period 149 Comparing the December 1992 figures, the REER index based on the CPI was 96% and on the PPI 102% in the first option (as presented in Table 8.4), while 102% and 107% respectively in the second option. This comparison shows the sensitivity of the REER's calculations depending on the choice of the basket and points to the necessity for caution in discussing and interpreting the obtained figures.
(c) Options in price (cost) indices.
Calculations of REERs presented in this paper are based on both CPI and PPI indices as quoted in the international financial statistics (IFS).[12] An alternative basis for the calculation could be various selected cost indicators, such as relative labor costs.
The price data for Czechoslovakia was not, however, entirely comparable to that from the basket market economies in the period under consideration. In the years 1990-92, the entire institutional framework of price setting changed in Czechoslovakia. In 1990, most prices were still regulated. One year later, at the beginning of 1991, approximately 87% of consumer prices had been effectively liberalized. As a consequence, both the comparability with prices from countries in the currency basket as well as consistency in time series were subject to qualifications.
(d) Choice of the base period.
Although the choice of the base period for REER evidently affects the results, its criteria are far from being clear-cut even in stabilized market economies. In principle, the base period should represent an interval of time in which the current exchange rate closely corresponded to its 'equilibrium value'. Such an approach is, however, hardly relevant for the former centrally planned economies in the initial stage of their transition.
Instead, January 1990 was selected as the base period for REER and other calculations in this paper due to its quality as the starting point of the Czechoslovakian transition (even though the main liberalization and stabilization measures were taken only one year later). Thus, the reservation made above with respect to price consistency applies here as well. Despite the limitations and possible errors involved, the REER indexes provide an insight into the underlying trends of exchange rate developments.
In 1990, both the NEER and REERs largely developed in a parallel way;
depreciating only modestly in the first nine months (REER based on CPI even started to appreciate in the third quarter of 1990), while a rather sharp depreciation materialized in the fourth quarter (compare Table 8.4 and Figure 8.2). Since the
start of 1991, the trends of NEER and REER of the CSK deviated. While the NEER remained almost stable for two years, the calculated REER indicates gradual but persistent appreciation. The REER based on CPI appreciated by 41 % and that based on PPI by more than 44% in the period from December 1990 to December 1992. According to standard reasoning, this implied a corresponding loss in relative competitiveness. Nevertheless, the REER values at the end of 1992 just about matched the initial levels of January 1990, considered as the base period.
Unlike the CSK, both the Hungarian forint and especially the Polish zloty appreciated considerably in the period examined. Parallel calculations for the time from January 1990 to May 1992 showed appreciation by 140% of the zloty and 32% of the forint. The divergent trends in the REERs across the three reforming countries were linked to the differences in their inflation records and nominal exchange rate adjustments.
Inflation DifSerential
The inflation record of former Czechoslovakia was relatively favorable in terms of the transition economies (see Table 8.5). Apart from the price outburst following the sweeping price liberalization in January 1991, inflation has remained well under control throughout the entire period. Nonetheless, the inflation rate (partially fuelled by various institutional changes and shocks) considerably surpassed the average of the EC and OECD members (compare Table 8.6).
Table 8.5 Consumer Prices in Czechoslovakia, Hungary and Poland in 1986-92 (average annual percentage changes over the previous year)
1986 1987 1988 1989 1990 1991 1992
Czechoslovakia 0.5 0.1 0.2 1.4 10.0 57.9 10.3
Hungary 5.3 8.6 15.5 17.0 28.9 35.0 23.0
Poland 17.7 25.0 60.0 251.0 586.0 70.0 40.0
Source: Monthly Statistical Bulletin, Federal Statistical Office, Prague, ~ S F R , International Financial Statistics, Federal Statistical Office, Prague, ~ S F R .
Unit Labor Costs in Czechoslovakian Industry
The data which approximates the changes in unit labor costs (ULC) in Czechoslovakian industry reveal a dramatic decrease in the first half of 1991
Exchange Rate Regime in the Transition Period
Table 8.6 Inflation Differential with Respect to Market ~conomies' (CPI, 1985 = 100)
1990 1991 1992
Czechoslovakia 1 12.3 177.2 195.6
Austria France Germany Switzerland USA
OECD 124.1 130.5 136.1
EC 123.4 129.7 135.3
'
Czechoslovakia compared to its 'currency basket' countries and to OECD and EC averages.Sources: OECD Main EEonomic Indicators, International Financial Statistics, Czech National Bank.
(associated with a 24% drop in real wages in 1991), followed by a gradual recovery in the course of which the January 1990 level was finally regained towards the end of 1992 (compare Table 8.1A and Figure 8.1A in the Appendix). Accordingly, unit labor costs in industrial branches did not exceed their value at the start of the transition within the first three years of reform. It goes to follow that income and wage increases were evidently not the major causes of the inflationary pressures.
The formula used to calculate ULC (see Estrin et al., 1992) was as follows:
ULC = ( W/P) I (Y/L) where: W = wages in industry
P = producer prices Y = output in industry L = employment in industry and: W/P denotes real product wage
Y/L denotes labor productivity
The developments of ULC in Czechoslovakian industry as well as that of its two components are summarized in Table 8.7. In 1991, the large fall of real product wage outweighed the parallel decline in labor productivity resulting in a 20%
decrease in ULC compared to 1990. In 1992, unlike the previous year, a further decrease in labor productivity (though relatively modest) reinforced the impact of the real product wage increase. As a result, ULC started to grow again since 1992.
Table 8.7 Unit Labor Costs, Real Product Wage, and Labor Productivity (January 1990 = 100)
ULC W E Y/L
Annual Changes in %
Source: Monthly Statistical Bulletin, Federal Statistical Office.