Exchange rate arrangements

Table 10 presents the current exchange rate arrangements of TE. From the table we see that TE have many different exchange arrangements, ranging from currency boards (or rigidly fixed exchange rates to a foreign currency) to independent floating, and different monetary policy framework, from IMF-supported programs to inflation targeting. The question then arises as to the best exchange rate system in preparation for admission into the EU. Here, however, TE face the dilemma of achieving simultaneously stable exchange rates and stable prices, as required for admission into the EU. Specifically, with fixed exchange rates and high productivity growth, TE will not be able to contain price increases to 2 percent but may instead face inflation in the range of 3-5% per year.

Although these rates of inflation are not excessive, they violate the nominal inflation convergence criterion required for ultimate admission into the EU. On the other hand, if they allow their exchange rates to appreciate (as a reflection of their strong productivity growth – as postulated by the Balassa-Samuelson effect), TE will violate the stability-of-exchange rate criterion for admission.

Table 10: Exchange rate arrangements and monetary policy framework of Central Europe, Baltic States and South-Eastern Europe transition economies, May 2000

exchange rate arrangements monetary policy framework Central Europe:

Czech Republic managed floating inflation targeting Hungary crawling peg exchange rate anchor Poland managed floating inflation targeting Croatia managed floating IMF-supported program Slovak Republic managed floating monitors various indicators Slovenia managed floating monetary aggregate target Baltic States:

Estonia currency board (€) exchange rate anchor Latvia fixed peg against SDR exchange rate anchor Lithuania currency board (US Dollar) exchange rate anchor South-Eastern Europe:

Albania independent floating IMF-supported program Bulgaria currency board (€) IMF-supported program

FYR Macedonia fixed peg against € IMF-supported program Romania managed floating IMF-supported program Source: IMF, International Financial Statistics, May 2000.

The Balassa-Samuelson effect refers to the pressure on the non-tradable-goods prices to rise when the prices of tradable non-tradable-goods are not allowed to fall (as it occurs if the domestic currency is not allowed to appreciate) when the productivity in tradable goods rises rapidly (a feature of economies undergoing a productivity catch-up to advanced-economy levels). To be pointed out, however, is that the Balassa-Samuelson price increases are not symptoms of macroeconomic imbalance and are required to preserve microeconomic equilibrium, and so there would be justification for the EU to relax either the price or exchange rate convergence criterion for admission for the TE that face this dilemma.

More generally, a fixed exchange rate system appears to be a natural anchor for open economies that are converging rapidly with a major currency bloc. On the other hand, exchange rate pegs are open to the criticisms that they heighten market pressures in a world of liberalized international capital flows because they can be viewed by the markets as a safe one-way bet and attacked – exactly as it happened in the financial crisis in South-East-Asia emerging market crisis of the mid-1997.

Concerns about the vulnerability of pegs have led to the adoption of a

currency board in Estonia, Lithuania and Bulgaria, and led to interest in early "euroization" in some TE. These regimes, however, have drawbacks for economies in rapid transformation because they allow limited room for banking support, and eliminate a key safety valve in the event of financial shocks.

As an alternative to currency boards or euroization is inflation targeting, as in the Czech Republic and Poland. One fundamental issue is whether inflation targeting, on the road to EU accession, will prove less vulnerable than pegs to speculative pressures. Although many observers believe pegs are exceptionally demanding on policy makers, they also recognize that inflation targeting regimes present the serious dilemma at times of large potential capital inflows of abandoning the inflation target or allowing a real appreciation of the nation’s currency, which could lead to an unsustainable current account deterioration.

Given these uncertainties, some have advocated hybrid regimes of crawling pegs and inflation targeting in the range of 3 to 5 percent. But these violate both the stable-exchange-rate and the inflation criteria for partiipating in the euro. Here, however, it is important to keep in mind that the requirements for joining the EU (the Copenhagen criteria) are different from the Maastricht and Stability Pact criteria for joining the euro area. The Copenhagen criteria include, among others, the existence of a functioning market economy able to meet EU competitive pressures and able to sustain the obligations of membership. This means that the most advanced TE may satisfy the Copenhagen criteria for admission into the EU before being able to meet the more stringent Maastricht and Stability Pact criteria for participating into the euro. That would leave the problem of reconciling exchange rate and price stability in TE.

7. Conclusions

After a decade of restructuring, most transition economies have yet to reach the GDP they had before the collapse of communism and conquered inflation only during the past few years. By 1998, the PPP GDP/capita was only 51.0 percent of the EU15 for Central European TE, 32.6 percent for the Baltic States and 22.1 for the South-Eastern European TE. Although the overstressing of industry that had characterized the communist period had declined significantly by 1998,

it was still excessive in most TE. Gross domestic investment as a percentage of GDP was similar to other developing countries with similar level of per capita incomes, government deficits and the external debt seems sustainable, but current account deficits seem excessive, except for the Czech Republic and Slovenia, in view of the limited inflow of foreign capital (especially FDI) into these economies.

A model of economic restructuring shows how the inflow of FDI shifts E’s factor-ratio curves upward while lowering the rate of return on capital and increasing wages. From 55 percent to 80 percent of the economy of TE has now been privatized. Small firms and foreign trade and exchange systems have achieved the standards of performance of advanced industrial nations in TE, but large-scale privatization, price liberalization, competition policy, banking and interest liberalization, and securities markets and non-bank financial institutions are only between 50% and 75% of the level in the advanced industrial nations (closer to 75% in Central Europe and the Baltic States and closer to the 50% mark in the TE of South-Eastern Europe). Thus, TE still have a great deal of restructuring to undertake before they are ready for admission into the EU.

The most advanced Central European TE (the Czech Republic, Hungary and Poland) have average per capita incomes about 42 percent lower than for the three least advanced EU members Greece, Portugal and Spain). As a percentage of GDP, their gross domestic investment is higher, but so are their government deficit and current account deficit (which, however, remain entirely sustainable). Their international competitiveness is between 20 and 30 percent lower than that of the least advanced EU members. With a much lower per capita incomes and competitiveness, TE would contribute much less than they would benefit from EU resources, especially EU regional funds, and this is one serious obstacle to the early admission of even the most advanced TE of Central Europe into the EU.

The hotly debated question that took place after the fall of the Berlin wall as to how much TE should trade among themselves or with Western Europe was a false choice. Trade theory clearly shows that TE should trade as much as market principles allow – without concern of whether this is intra-TE or TE-Western European trade. Although precise data are not available, it seems that the share of TE trade with the West increased from about 10-15 percent a decade a decade ago to between 55 percent to 85

percent today. TE now engage in international trade as much or more than other market economies of similar size and level of economic development.

Most TE have a comparative advantage in labor-intensive commodities, especially clothing, except for the Czech Republic (where the principal export is vehicles), Hungary (electrical products), the Slovak Republic (iron and steel) and Estonia and Latvia (oil).

TE have many different exchange arrangements, ranging from currency boards to independent floating, and different monetary policy frameworks, from IMF-supported programs to inflation targeting. TE, however, face the dilemma of targeting the exchange-rate or inflation and may not be able to achieve both as required for participating in the euro. A pragmatic solution would be to have a crawling peg and inflation targeting in the range of 3-5 percent. This means that TE may qualify for admission into the EU before being able to join the euro.

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