DANGERS OF THE ABRUPT SWINGS IN THE TRADE BALANCE FACED BY THE TRANSITION ECONOMIES

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1 Cologne, April 2003 Cracow University of Economics Foreign Trade Chair Poland DANGERS OF THE ABRUPT SWINGS IN THE TRADE BALANCE FACED BY THE TRANSITION ECONOMIES Superiority of the FDI financing There are numerous problems faced by the transition economies in the Central Eastern Europe. One of the biggest challenges is to keep the trade balance under control. It is rather self evident that these countries are in long-term position of being in the red within their goods turnover with abroad. All of them are still and will remain in the foreseeable future in the desperate need to modernize their economies up to the standard presented by industrialized countries of the West. It can be done only by fueling their ailing economies with deliveries of the foreign technological advanced equipment and by exerting pressure of the foreign competition on the domestic manufacturers of the consumer goods. However the entire process has to be done with the reasonable dynamic and it must avoid dangers of the balance of payment destabilization. As it is commonly agreed in the theory of economics and it was proved in practice, the possible financing source of the trade balance deficit is the inflow of the foreign capital. Everybody knows that it can take form of either the foreign investment both direct and portfolio or the form of credit instruments whereas the host country sets itself in the debtor s position. The pro and contra arguments of every solution are well known. Having in mind that we all live in a more and more intertwined international economy let us make a short overview of the main advantages and shortcomings of the possible solutions in the field of foreign trade deficit financing. As it can been derived from the presented scheme only the inflow of the foreign direct investment (FDI) secures long-term stabile and profitable cooperation between the host country and the prospective investors. Therefore it is of the crucial importance that the trade balance deficit shall be covered in a maximum amount by the FDI inflow since only such a solution ensures avoidance of the painful adjustment measures necessary to be undertaken in the course of other events developments. When putting emphasis on the FDI financing of the trade balance deficit one has to remember that it can not replace entirely the remaining possibilities of the foreign capital inflow but certainly it contributes to the elimination of the volatility in the balance of payment management

2 Comparison of the various possibilities of the trade deficit financing Foreign investment Assessment Portfolio Direct Long-term bank loans long-term quick and secure commitment of the source of cash for the state investors to the future no need to in case of privatization development of the given present detailed positive sales, country, plans of the upgrade of the quality creation of the base funds in goods and services for the entirely new disbursement provided output increase in the economy negative possibility that the main purpose of the investment is to close down the domestic factory as a competitive to the other factories of the foreign owner, the emphasis on the quick and big return in case of the financial investor, price increases for the domestic customers fear and skeptical attitude of some groups of society that the foreign investor will in fact exert too big influence on the local, domestic life and the host country will loose part of its sovereignty exposure to the interest rate volatility, long term burden for the budget Credit instruments Short-term bank International bonds loans relative easiness of securing the necessary funds exposure to the interest rate volatility, danger of the maturity accumulation and the possibility of loosing control on the roll-over procedures prove of the credibility and trustiness of a given country to the external world exposure to the interest rate volatility, dangers of the speculative rapid inflows and outflows destroying the stability of economy, direct dependence on the country credibility evaluation with the transmission to the interest rate margins single companies can not get better conditions than the whole country - 2 -

3 The CEE story of relation between FDI and trade deficit Knowing all characteristics of the possible mutual influences between the foreign trade deficit and the FDI magnitude it is interesting to scrutinize how these linkages have been developing in the some of the Central Eastern European countries. Are there any similarities or every country has been following its own specific route in this respect? What have been the official administrative responses of the given governments to the continuously occurring need for the smoothing out the fluctuation of the relation between the trade balance deficits and FDI inflow? The study concerns itself with these types of problems on base of the past experiences of three countries: Czech Republic, Hungary and Poland. First, have a look on the development path of the FDI/(trade deficit) ratio in these three countries within the time span of The fluctuation of this ratio are presented at the graph no 1. Graph no 1 - FDI / trade balance Poland Czech Rep. Hungary One can notice remarkable differences in the behavior of the analyzed ratio within these group of three countries. Two extremes are Poland and Hungary. For Poland this ratio fluctuates within the range between 0,23 and 0,63 with a minimum recorded in 1993 and maximum recorded in In the middle of the reviewed period there is another local minimum of 0,27 recorded in

4 For Hungary a very well recognizable upward going trend can be observed with a starting level of 1,97 in 1993 and a maximum achieved in 2000 at the level of 9,37. The results of the Czech Republic are somewhere in between with a clear-cut cyclical fluctuations. It started at the level of 1,24 in 1993 and than dropped to the level of 0,25 in 1996 and 0,27 in Next it reached a peak of 2,93 in 1999, but in the years it stabilized at the level of 1,5. It is interesting to investigate more in detail what have been the reasons of such developments in the given three countries. Hungary The easiest case is presented by the Hungarian example. The critical point of the modern economic history of that Danubian country took place at the turn of 1994 and That was the time when painless policy of the slow structural, economic and social adjustments to the market economy adopted by the first Hungarian non-communist government came to its limits. It is enough to say that only in the field of the foreign trade already in 1993 the export value decreased by 16,8 per cent to 8,9 bill USD and the import value went up by 13,2 per cent reaching the level of 12,5 bill USD. The main remedy applied in this field in 1994 was a series of the seven subsequent devaluation steps with the total magnitude of 16 per cent within the entire year (in 1993 the total devaluation reached the value of 15 per cent five steps). It did not helped a lot. The trade deficit widened to 3,8 bill USD and the gross foreign debt rose within one year by 4,1 bill reaching the level of 28,5 bill USD. Those results prompted the Hungarian government to formulate and adopt in March 1995 a totally new economic strategy which is described as a Bokros Package after the name of the Minister of Finance, who was then in charge of this sphere of economy. The package had a multidimensional targeting and put in force a lot of the new economic instruments not only in the sphere of the economic relations with abroad. For the purpose of the balance restoration in the foreign trade following main steps were taken: one time currency devaluation of 9 per cent with the simultaneous introduction of the crawling peg mechanism based on 1,9 per cent monthly devaluation towards the basket of the main foreign currencies (changed to 1,3 per cent in the second half of the year, for the entire year of 1994 it resulted in devaluation at scale of per cent) temporary introduction of the special import surcharge tax at the starting level of 8 per cent, which was to be gradually abolished within the period of two years and it was levied on all import products with the exception of the energy fuels. The additional very crucial point of the strategy was the decision to open almost entirely for the foreign investors the sectors of the economy which were earlier protected from the foreign ownership. It resulted in a quick sale of the energy production and distribution sectors, gas distribution sectors, telecommunication and petrochemical sector. It gave a rise and stimulated a plenty of other green-field foreign investment. Six years after that somehow revolutionary steps one can observe that the Hungarian trade balance is very much under control which can be traced at the graph no 2. It presents the fluctuation of the Hungarian trade balance starting from the last quarter of 1993 together with its moving average

5 Just after the implementation of the Bokros Package the Hungarian trade deficit started to move towards diminishing its size and lowest figure of 189 mill EURO was reached in the fourth quarter of Next came again substantial increase in the deficit magnitude which lasted with small interruption till the fourth quarter of 2000, when it peaked at the level mill EURO. However that was completely different situation from the one registered 5 years before, since the internal part of economy was well balanced even with the small budgetary surplus and the trade balance deficit did not pose such a danger like it was a case earlier. Recently also the magnitude of the FDI annual inflow is almost ten times bigger that the registered trade deficit. It leaves plenty of space for either reasonable differentiation of the possible foreign funds allocation or gives a shield against unexpected negative changes in the export and import development. Graph no 2 - Hungarian trade balance quarterly mill EURO Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q 2002 real value 4-quarter moving average Source: Hungarian National Bank Czech Republic Czech Republic having inherited a better part of the former Czechoslovakian Federation s economy was able to boost the economy development for a quite long time without application of the sharp and painful structural adjustments. However the problems were slowly appearing and the bomb exploded in 1997 with the presentation of the macroeconomic figures for the first quarter. There was again a combination of the internal and external disequilibria. The best picture of the drastic change in the situation is given in the following table: Variable trade balance / GDP 1,5-2,1-5, ,6-7,7 budget deficit / GDP -3,3-0,4-0,3-2,2-6,1-5,5 Source: Czech Statistical Office - 5 -

6 Such a sharp increase in the trade balance and budget deficit measures as it occurred in 1997 contributed to the speculative pressures on the Czech currency and prompted the capital outflow from that market. In order to counteract those negative tendencies the Czech government adopted in April 1997 the entire set of measures directed both at internal and external economic affairs. Within the framework of the foreign trade policy the most important were the introduction of the import deposits forcing the importers to freeze 20 per cent of the contract value for six months in non-interest bearing governmental accounts and the sharp increase of the interest rates by the Czech National Bank. However the last move did not protect the Czech currency sufficiently from the speculative attacks and the Czech central monetary authority was forced to float it freely on May 27 th, 1997 which resulted in 12 per cent one day decline against the value of the USD. Government was again forced to introduce new stabilisation measures but they were mainly directed on the public sector matters. Only in respect to the monetary policy as having influence on the foreign trade relations it set the rules for the cooperation with the Czech National Bank having as the aim currency stabilisation and rigid credit rationing. Those series of the governmental actions brought certainly the desired effects since the trade deficit diminished from its highest levels in last quarter of 1996 (1.408 mill EUR) and in the first quarter of 1997 (1.216 mill EURO) to the lowest level of 198 mill EURO recorded in the second quarter of However in the last 3 years another worsening of the situation could be observed and in the quarter of 2002 the trade deficit again declined almost to the bottom level of It can cause only some minor worries since the capital inflow and the export revenues are both rising and give a good safeguard against any unexpected changes in the near future. Graph no 3 - Czech trade balance quarterly mill EURO Poland Q Q Q Q Q Q Q 1996 real value 2Q Q Q Q 1998 Source: Czech National Bank 4-quarter moving average 2Q Q Q Q Q Q Q 2002 Poland initiated as a first country from the analysed group the sharp and radical macroeconomic and structural changes at the very beginning of its contemporary history as a - 6 -

7 democratic country. The results in foreign trade were somehow ambiguous since the volume of trade increased very rapidly but the country has been recording bigger and bigger trade deficits. However initially it seemed that the economy situation had been stabilised since all shortcomings was balanced by the very dynamic GDP growth (6-7 per cent in the years ) propelled by the increase in investment and consumption. The economy was correcting itself by adjusting the potential supply volume to the demand side but the main factors behind were the utilisation of the simple reserves, which had been wasted in the previous economic system. The result was very promising. Within the decade of nineties the magnitude of the real GDP rose from about 60 bill USD in 1990 to the level of 160 bill USD in 2000 (increase of more than 2,5 times). Nevertheless those engines of growth started to be overexploited and already in 1996 some economist claimed that the economy is over-heated. For example the current account deficit related to the GDP changed its value from plus 3 per cent in 1994 to minus 4 per cent in 1997 and the move in this direction continued till winter 1999/2000. Then the government adopted the series of the actions directed at cooling down the economy with the main purpose to cause a decline in the domestic demand. The main tool used was the consecutive row of the interest rate increases by the central bank. In the field of the foreign trade one can not easily point out to any specific administrative measures which targeted this sphere of economy as whole. Rather there was a selective approach to some sectors of economy and the government came with assistance in a form of various protective measures against import especially for the producers of the raw resources in the agriculture. Simultaneously there was another drive towards the market opening because of the implementation of Euro Agreement on Association rules and other concluded agreements on the free trade with some countries. Therefore it is rather not possible to pinpoint exactly one turning point in the foreign trade balance when the change started to appear due to the global administrative measures as it was in the case of Hungarian and Czech story. The general fluctuation of the situation in this area are depicted on the graph no 4. Graph no 4 - Polish trade balance quarterly mill EURO Q Q Q Q Q Q Q Q Q Q Q 2002 real value 4-quarter moving average Source: National Bank of Poland - 7 -

8 Summary The comparison of different foreign trade situation in three countries of Central Eastern Europe bring us to the conclusion that they all concentrated more and have better temporary effects in the import control and counteracting measures. The reason is quite obvious. One can have quicker and more visible results in this field since any export boosting activity is both time and money consuming and fast success achievements can not be expected. Even Poland without adopting one general tool in this sphere of import hostile measures managed due to the general cooling of the economy to bring down its trade deficit from more than 4 bill EURO to about 3 bill EURO. As an additional issue must be emphasised that only Hungary was able to use a huge FDI inflow as a driving factor of the continuous export increase which have become now really a matter of live or die in the Hungarian economy. The common instruments used by Hungarian and Czech administration in the time of crisis in the foreign trade was both import tax and import deposits combined with a substantial currency devaluation. It brought of course the expected results but could not last for ever. This is also one of the reasons why the initiated trends in foreign trade deficit diminishing have been always coming after about two years to its end. On the other hand such a drastic import oppressive measures contributed to the bigger volatility in both Hungarian and Czech foreign trade balances as compared to the Polish case. When using as a comparison tool of the foreign trade balances the ratio of the standard deviation to arithmetic mean expressed in percentages one obtains following results: Poland Czech Republic Hungary (standard deviation)/(arithmetic mean) 16,5 per cent 60,0 per cent 39,2 per cent It proves that the situation of the Polish foreign trade is more stabile and therefore better predictable than it is the case of other two countries. It can be quite important for the market participants trying to find the least volatile points of reference. It must however remembered that the magnitude of the Polish foreign trade deficit is three time bigger than in case of Czech and six time bigger than the size of Hungarian. Such relations are not the best for Poland especially remembering that the size of Polish GDP is only little more than two time bigger than the sizes of Czech and Hungarian GDP. The purpose of that short study was to present the basic interrelationships of the trade balance deficits and FDI inflow in some of the CEE countries and to sow a thought of a new approach to the problem