I. Introduction. II. Exchange rates in European transition economies

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1 EXCHANGE RATE VOLATILITY IN CENTRAL AND EASTERN EUROPE Horobet Alexandra Academy of Economic Studies Bucharest, Department of International Business and Economics, , Tusa Erika Academy of Economic Studies Bucharest, Department of Statistics and Econometrics, , The former communist countries in Central and Eastern Europe are currently faced with the most important challenge of their monetary history, represented by the entrance into Exchange Rate Mechanism II and, eventually, euro adoption. The key of the presence in ERMII is represented by the reduced volatility of the member countries exchange rates of their currencies against the euro. In our research, we have observed the pattern of exchange rate volatility before and after the entrance into ERMII for the eight CEE countries that are EU members since 2004, contrasted against Romania. The conclusion we can draw is that countries that entered ERMII struggled to diminish the volatility of their exchange rates before joining the system, while the remaining countries seem to face difficulties in terms of volatility management on the foreign exchange market. Key words: currency risk, Romania, exchange rate regime, EU accession I. Introduction The evolution of exchange rates represents nowadays a major source of concern from both a micro- and a macroeconomic perspective, given the cvasi-generalised adoption of floating rates since The exchange rate is one of the most synthetic prices in an economy and it can be thought as the expression of a general equilibrium among the market for real goods and services, the money market and the capital market, which has the obvious potential of influencing the general economic equilibrium in any economy. The exchange rate behaviour is influenced, at its turn, by the degree of economic growth, the changes in the general level of prices (inflation), the industry structure of the economy, the country s level of international competitiveness and its degree of trade and financial openness, the political stability and governments ability to solve internal crises which might occur. This diversity of factors that impact directly or indirectly the exchange rate raises the issue of the easiness of managing such a complex and dynamic macroeconomic variable. The choice of an optimal exchange rate regime is an unresolved question of international macroeconomics, as the history of international finance shows. From the band fixed exchange rates in the 40s, 50s and 60s, countries have gradually moved towards more flexibility in their exchange rates, but a number of intermediate regimes have been employed at the international level with the aim of better accommodating a country s specificity with the exchange rate policy. Nevertheless, the currency crises that occurred in the last two decades have generated a growing support for clear cut exchange rate regimes such as hard pegged rates or free floating rates -, considered more appropriated in the current framework of higher financial integration fuelled by unprecedented capital mobility at the global level. II. Exchange rates in European transition economies The enlargement of the European Union in May 2004, by the accession of ten Central and South-Eastern European countries, of which eight were former communist countries (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia), followed by a second wave of accession at the beginning of 2007, that also involved two former communist countries (Bulgaria and Romania), represents an economic and political experiment that is entirely different from all previous accessions. The differences stem not only from the diversity of these countries in terms of culture, population size, territory dimension, but also from the macroeconomic specificity of the region. It is obvious the fact that the integration process of all these countries will directly impact their money and currency markets, with a precise goal represented by the adoption of the common euro currency. The adoption of the euro is by far the greatest challenge all these countries were faced with since the moment of their accession to EU, and one of these countries Slovenia proved that the criteria imposed by the EU in order to adopt the euro can be achieved, as the country adopted the euro as its currency at the begging of The exchange rate regimes of the former communist countries in the region are quite diverse, ranging from free floating to currency boards, as illustrated by Table 1 below. This diversity can be explained by the structural diversity of these countries, on one hand, and by the need felt by these countries to better control inflation and exchange rates at the same time. As an illustration, it is worth pointing that during the past ten years, four of the emerging economies from Central Europe have transformed their monetary policies by adopting the inflation targeting framework: Czech Republic in 1998, Poland in 1999, Hungary in 2001 and, more recently, Romania in The adoption of such a monetary policy framework is closely related and should be understood in connection to the exchange rates regimes used by the three countries: free float in Poland, managed float in Czech Republic and Romania, and fixed rate with a band for Hungary. The objective looked for by all these countries were related to the desired stability of domestic prices and implicitly of the exchange rates. 386

2 Table 1. Exchange rate regimes in CEE countries Country Currency Exchange rate regime ERMII membership Czech Republic Koruna (CZK) Managed floating with nopredetermined path Expected euro adoption date (E) 2010 Hungary Forint (HUF) Pegged to euro with ±15% band (E) 2010 Poland Zloty (PLZ) Independent floating 2008 (E) 2010 Slovenia Tolar (SIT) Euro adopted 2004 Adopted in 2007 Slovakia Koruna (SKK) Managed floating Latvia Lats (LVL) Pegged against composite Lithuania Litas (LTL) Currency board currency pegged to euro Estonia Krone (EEK) Currency board currency pegged to euro Romania Leu (RON) Managed floating (E) Source: IMF, ING Romania, European Central Bank, National Bank of Romania Nevertheless, all of these countries will see their currencies replaced by the euro, but not until they will stay in the Exchange Rate Mechanism II (ERMII) at least two years before the euro adoption. This exchange rate arrangement, similar to the Exchange Rate Mechanism I that eventually led to the euro adoption by the initial twelve EU countries was introduced on January 1, 1999, and its role is to ensure convergence and easier euro adoption, by inducing higher stability at the level of exchange rates against the euro. Participation in ERMII is voluntary for all non-euro area member states; however, as ERMII membership is one of the convergence criteria for the eventual euro adoption, all new member states are expected to join the mechanism sooner or later. For the currency of each member state participating in the mechanism, a central rate against the euro and a standard fluctuation band of ±15% are defined. The countries that have joined the ERM II and are currently under this arrangement are Denmark (with a band of ±2.25% around the parity against euro), and Lithuania, Estonia, Latvia and Slovakia (all with a band of ±15%). Slovenia also spent two years in this system, until it adopted the euro as its currency at January 1, As can be observed from Table 1, a number of countries are expected to join ERM II in 2008 (Czech Republic, Hungary, Slovakia and Bulgaria), with Romania following in , according to the forecasts made by the National Bank of Romania. III. Volatility of exchange rates in Central and Eastern Europe In the framework of future euro adoption and ERMII membership, the expectation regarding the exchange rates of CEE countries was to observe in the market a reduced volatility with respect to the euro domestic currencies exchange rates. Therefore, we should detect a decrease in the volatility of exchange rates at least two years before the adoption of the euro in the case of the country that has already adopted the euro (Slovenia), in the case of countries that are now part of ERMII after the entrance in this arrangements, but also in the other countries cases, given the difficulty of entering in ERMII with previous high volatility in the foreign exchange market. Our research approached this issue by using the exchange rates of the eight transition economies in the region - Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia and observing the behaviour in time of the volatility of their exchange rates against the euro. The period under analysis was January 2001 December 2006, with exchange rates given at the end of month and provided by the central banks of the respective countries. As an alternative, we also observed the volatility of exchange rates of these countries currencies against the US dollar over the same time span and using also exchange rates at end month. Also, we contrasted the experience of these countries against the Romanian Leu evolution in the foreign exchange market during the same period of time. The first observation that one can make by observing the paths of exchange rates against the euro (see Figure 1 below) is that, in nominal terms, most of these currencies appreciated against the common European currency since 2001, with the Czech Koruna (CZK) recording the highest appreciation as compared to January 2001, 387

3 followed by the Slovak Koruna (SKK) 1. Also, the Hungarian Forint (HUF) mostly increased its value against the euro over the period, but with a decrease during June 2006 September 2006, afterwards returning to the appreciating trend. The Polish Zloty (PLZ) case is interesting, as the currency lost in value as compared to January 2001, with the highest value recorded in February 2004, followed by a consistent return to the value in January 2001 in December 2006, the PLZ was practically at the same level with the value at beginning of Of the three CEE countries that are still in ERMII, Latvia and Lithuania virtually rigidly fixed their currencies to the euro Latvian currency (LVL) at a higher level than in January 2001 and the Lithuanian currency (LIT) at a 94.15% level as compared to January Figure 1. Exchange rates against the euro, January 2001 as Romania Poland Latvia 120 Slovenia Hungary Estonia Lithuania Czech Rep Slovakia 70 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Slovenia displays a different path, as the currency gradually depreciated after 2001 (suggesting a type of crawling peg exchange rate arrangement), until it eventually entered the ERMII in June 2004, at a value of SIT/EUR. By contrast, the Romanian currency depreciated to a large extent until the end of 2004 (for a 166% level as compared to January 2001 recorded in September 2004), followed by a persistent appreciation of the currency against the euro, but still foe higher levels as compared to 2001, even at the end of In order to examine in a better way the volatility of these exchange rates against the euro, we have computed the average monthly standard deviations and the rolling standard deviations of the changes in exchange rates over the entire period, the later with a 12 months window. Table 2 and Figure 2 below exhibit these volatilities, excluding the Estonian Krone, given the fixed rate against the euro over the entire period, which makes the standard deviation irrelevant in use. Table 2. Average monthly standard deviations of exchange rates changes in CEE countries, in percentages Year Czech Rep. Hungary Latvia Lithuania Poland Slovakia Slovenia Romania Average The nominal value of the CZK against the euro reached a 79.03% level in December 2006 against the 100 basis level in January 2001, while the SKK also attained the lowest value of the exchange rate against the euro in December 2006, for a value of 79.28% as compared to January The parity against the euro at the entrance in ERMII in May 2005 was LVL/EUR, as compared to an exchange rate of LVL/EUR in January 2001, and LIT/EUR as compared to LIT/EUR in January

4 Note: Highest values for each year in bold. The results reported in the above table show the Polish zloty was the currency with the highest average monthly volatility in three of the years under analysis (2001, 2003 and 2005), while the Romanian leu attained the highest volatility in 2002 and In 2006, as commented above, the Hungarian forint recorded the highest volatility (3.450%), which accentuates our conclusion regarding the problems faced by the Hungarian Central Bank in the management of the exchange rate. This was also one of the reasons that prevented Hungary from entering ERMII in 2006, as initially anticipated. Examining the graphs below, one can notice that five of the currencies (CZK, LTL, LVL, PLZ and SIT) have experienced decreases in volatility during the period, while in the case of HUF and SKK we cannot make a clear statement regarding their volatility. Nevertheless, the Hungarian Central Bank seems to encounter serious problems related to the currency volatility, which shows a sharp increase in the past two years, while the Slovak Central Bank managed better the volatility of the Koruna in the past year, as it went down from a 1.76% level in November 2005 to 1.4% in December Despite the observation of the graphs, the econometric tests performed on the rolling volatilities indicated the presence of a statistically significant trend only in the case of the Czech Koruna (with a negative coefficient of , for a t-statistic of with a 95% confidence level). Overall, the results of our research do not offer clear cut answers with reference to exchange rates volatility in CEE countries, even with regard to the euro, the currency they will eventually adopt. The conclusion we can draw is that countries that entered ERMII struggled to diminish the volatility of their exchange rates before joining the system (as is the case with Latvia, Lithuania and Slovakia), while the remaining countries seem to face difficulties in terms of volatility management on the foreign exchange market. Certainly, unless central banks of these countries handle properly the exchange rate, the entrance to ERMII will be further delayed and so will be the adoption of the euro. We intend to continue the research by observing the interbank exchange rates between these currencies and the euro, as opposed to officially reported rates, and to contrast the evolutions against the euro with evolutions against other major currencies, such as the US dollar or the Swiss franc. 389

5 Figure 2. Rolling standard deviations of changes in exchange rates against the euro, 2001 December 2006 January RSDEURCZK RSDEURHUF RSDEURLTL RSDEURLVL RSDEURPLZ RSDEURRON RSDEURSIT RSDEURSKK Note: The first observation is displayed as January 2002 and includes the standard deviation of monthly changes in exchange rates during January December 2001 References 1. Copeland, L.S. Exchange Rates and International Finance, Fourth Edition, Financial Times Prentice Hall, Pearson Education Limited, Isarescu, M. Convergenta la zona euro, Forumul Bancar Roman, Noiembrie Levich, R. International Financial Markets. Prices and Policies, Irwin McGraw-Hill, Boston, Massachusetts,