Taking Stock of Monetary and Exchange Rate Regimes in Emerging Europe Nazim Belhocine, Ernesto Crivelli, Nan Geng, Tiberiu Scutaru, Johannes Wiegand, and Zaijin Zhan Based on EUR Departmental Paper 03/16, https://www.imf.org/external/pubs/ft/dp/2016/eur1603.pdf International Monetary Fund March 2017
Almost any Monetary and Exchange Rate Regime can be Found in CESEE Unilateral use of the euro: Kosovo, Montenegro Currency boards: Bosnia & Herzegovina, Bulgaria Managed arrangements: Croatia, Macedonia Inflation targeting and floating: Albania, Czech Republic, Hungary, Poland, Romania, Serbia but with different degrees of effective exchange rate flexibility (see below) Euro area membership: Estonia, Latvia, Lithuania, Slovak Republic, Slovenia
A Good Quarter Century After Transition, Time to Take Stock Questions: Why do countries have the Monetary and Exchange Rate Regimes (MEERs) they have? Have they fulfilled their objectives? Looking ahead, how can monetary regimes assist in addressing the challenges countries are likely to face? If a regime looks sub-optimal, could a country switch, and how?
Debate in CESEE is Different from Western Europe Broad topic is fixed vs. floating - discussed in Western Europe for the past 40 years (since end of Bretton Woods). But: additional factors in Eastern Europe influence and complicate policy choices. Regimes have been shaped by countries experiences during transition from socialism in the 1990s. Most CESEE economies are emerging economies: often lack (elements of) the institutional setting that is, for the most part, taken for granted in Western Europe.
Geographical Scope Countries that are part of the European integration process: EU members, accession/pre-accession countries Not CIS Also not Turkey while an accession country, its historical path and current constellation are quite different.
Themes Stock taking: How did MERRs evolve since transition? How did MERRs perform? What is the rationale behind fixed rate regimes? Forward looking: Monetary strategies going forward
The Past is Critical to Understand the Present Transition and price liberalization in the early 1990s: all CESEE countries struggle with inflation, and some with hyperinflation: Baltics (1992), former Yugoslavia (1993/94), Bulgaria (1996/97) Exchange rate based stabilization. Fairly rapid in Baltics/CEE, less rapid in the Balkans Gradual switch to more flexible regimes starts with the Czech move to inflation targeting in 1997 MERRs mostly settled by the early 2000s. Slovenia (2007), Slovak R. (2009), Baltics (2011-15) adopt the euro
Inflation during Transition Maximum Annual Inflation During Transition (percent) EST LTU LVA > 1,000,000 1,000-1,000,000 100-1000 < 100 POL CZE SVK SVN HRV BIH HUN SRB ROU BGR MNE UVK ALB MKD
MEERs: IMF Classification 1995 2005 2015 No legal tender Managed Arrangement Float Currency Board Managed Float Euro Peg EST LTU LVA EST LTU LVA EST LTU LVA CZE POL SVK SVN HRV BIH HUN ALB MKD ROU BGR CZE POL SVK SVN HRV BIH MNE UVK HUN SRB ALB MKD ROU BGR CZE POL SVN HRV BIH MNE UVK SVK HUN SRB ALB MKD ROU BGR
Effective Exchange Rate Flexibility Differs within Floaters 2,0 1,5 1,0 Effective Exchange Rate Flexibility, 2003-15 (Calvo-Reinhart "Fear of Floating" index, average over quartely values) 3.02 Pre-crisis (2003-2007) Crisis (2008-2010) Post-crisis (2011-2015) Entire period (2003-2015) 0,5 0,0 CZE POL HUN ROU SRB HRV ALB MKD
Themes Stock taking: How did MERRs evolve since transition? How did MERRs perform? What is the rationale behind fixed exchange rate regimes? Forward looking: Monetary strategies going forward
(i) Monetary Stability: Achieved since the late 1990s - with all MERRs Distribution of Inflation Outcomes, 1996-2015 100 Percent of Countries 90 80 70 60 50 40 30 20 10 Deflation Low Inflation (<10%) Elevated Inflation (>10%) High inflation (>100%) Hyperinflation (>1000%) 0 1996 1999 2002 2005 2008 2011 2014
(ii) Alignment of Monetary Conditions Focus on 2003-2015/16: MERRs well established by early 2000s no more major regime changes other than euro adoption. Turbulent period that tests MERRs: rapid growth and convergence to Western European income levels until 2007/08 global financial crisis in 2008/09 hits the region hard deep recession, gradual recovery thereafter
Boom-and-Bust Growth Pattern More Pronounced with Fixed Rates... Real GDP Growth, 2003 16 High XR flexibility Low XR flexibility Difference (rhs) 10 5 6 3 2 1-2 -1-6 -3-10 2003 2006 2009 2012 2015 Sources: Haver Analytics; and IMF staff calculations. -5
Resulting in More Volatile Growth 1,2 Growth Volatility and Exchange Rate Regime, 2003-15 1 CZE Calvo-Reinhart Index 0,8 0,6 0,4 0,2 POL HUN High Exchange Rate Flexiblity Other Low/Moderate Flexibility SRB SVK ALB HRV ROU Baltics 0 BIH MKD BGRMNE SLV LTU EST LVA UVK 0 1 2 3 4 5 6 7 8 Real GDP Growth volatility (std)
and More Volatile Inflation. Inflation Volatility and Exchange Rate Flexibility (Standard Deviation, 2003-15) 5 4 Max 3 Average 2 Max 1 0 High Flexibility Moderate/Low Flexibility
Volatility: a Monetary Interpretation Transmission mechanism goes through inflation and real interest rates. (i) Floaters: in boom, nominal exchange rate appreciation keeps inflation low and therefore real interest rates high. Reverse mechanism during the bust. (ii) Peggers: in boom, real appreciation through inflation - reduces interest rates and boosts demand for credit. In bust: deflation pressures increase real interest rates. Note: even limited exchange rate flexibility has been helpful in containing volatility (Albania, Serbia)
Boom 2003-07: Monetary Conditions for Floaters Tighten Effective Exchange Rate Flexibility and Real Monetary Conditions, 2003-07 (average; percent) 0,6 Calvo-Reinhart Index 0,5 0,4 0,3 0,2 0,1 0 HUN More Flexibility POL CZE SVK ROU Less Flexibility HRV LVA ALB MNE UVK MKD BGR SRB EST LTU BIH -3-2 -1 0 1 2 3 4 5 Monetary conditions (+tighter)
as Exrate Appreciation Keeps Inflation Low and Real Interest Rates High... 5 4 3 2 Contributions to Monetary Conditions (2003-07; percent) Real Effective Exchange Rate Real Interest Rate Monetary Conditions Index 1 0-1 -2-3 LTU MNE MKD BGR BiH LVA EST ROU HRV ALB SRB POL HUN CZE SVK
. thus Containing Credit and Growth Imbalances. Financial Conditions and Domestic Demand Growth (2003-07 average; percent; low C/R labeled red) 14 Domestic demand growth 12 10 8 6 4 2 LTU MKD LVA BGR BIH R² = 0,424 EST ROU SRB ALB HRV POL HUN CZE SVK 0-3 -2-1 0 1 2 3 4 5 Monetary conditions (+tighter)
2008-14: Nominal Depreciation Boosts Inflation and Lowers Real Interest Rates Exchange Rate Regime and Real Monetary Conditions (2008-14 average; percent) 1,6 Calvo-Reinhart Index 1,4 1,2 1,0 0,8 0,6 0,4 POL CZE ROU HUN SRB 0,2 0,0 ALB HRVSVK BIH EST MNE LVA LTU BGRSVN -6-4 -2 0 2 4 6 Monetary conditions (+tighter)
thus Supporting Demand Monetary Conditions and Domestic Demand Growth (2008-14 average; percent; low C/R labeled red) Domestic demand growth 3 2 1 0-1 -2-3 POL R² = 0,5061 ALB BIH SVK SRB BGR ROU CZE EST HUN LTU SVN HRV LVA -6-4 -2 0 2 4 6 Monetary conditions (+tighter)
and Contributing to a Faster Recovery. Length of Recession (Number of quarters with negative GDP growth; 2008-14) 30 25 20 15 MAX AVG MIN 10 5 0 Low/Moderate Flexibility High Flexibility
We Checked Alternative Explanations for Differences in Macro-Volatility Cross-country differences are not explained by Size Quality of institutions Fiscal stance Macro-prudential policies Size and composition of capital inflows. These factors account for some variation within groups (floaters / peggers), but not between groups.
Boom-Bust Growth Pattern Has a Potentially Long-Lasting Impact Potential growth on average lower in countries with fixed exchange rates. Key reason: low investment which, in turn, owes to debt overhang. Real Potential Real GDP Growth (Percent) High Exchange Rate Flexibility Low Exchange Rate Flexibility 6 4 2 0 2003 2005 2007 2009 2011 2013 2015
(iii) Non-Monetary Objectives The Argument: Fixed exchange rate regimes introduce more volatility, and eliminate the ability of monetary policy to support demand. -> This forces fiscal/structural policies to be of higher quality (and institutional quality is what ultimately matters)
Evidence is Mixed Fiscal balances were stronger among peggers precrisis, but not post-crisis Institutional quality is better (on average) among floaters, but peggers have been catching up In Percent of Potential GDP Structural Primary Balance 2 High C/R 1 Low C/R 0-1 -2-3 Index Institutional Quality 0.7 0.6 0.5 0.4 0.3 0.2 0.1 High C/R -4 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Low C/R
Key Issues Stock taking: How did MERRs evolve since transition? How did MERRs perform? What rationale is behind fixed exchange rate regimes? Forward looking: Monetary strategies going forward
Factor I: Size Exchange Rate Flexibility and Size ROU POL Real GDP (logarithmic scale) 100 10 1 SVN BGR LTU LVA EST BIH MKD UVK MNE HRV ALB SRB SVK HUN Sources: Haver Analytics; World Bank, WDI; and IMF staff calculations. CZE 0.0 0.5 1.0 Average C/R index, 2006-15
Factor II: Fear of Floating - Loan Euroization Exchange Rate Flexibility and Loan Euroization FX Loans in Percent of to Total Loans, 2006 1,0 0,8 0,6 0,4 0,2 0,0 UVK MNE EST HRV LVA ALB R² = 0,8215 BiH SRB SVN ROU MKD HUN BGR POL SVK CZE 0 0,2 0,4 0,6 0,8 1 1,2 Calvo -Reinhart Index, 2006-2010 average
Loan Euroization Is Very Persistent FX loans as in percent of total loans, 2006 1/ 100 90 80 70 60 50 40 30 20 10 0 Loan Euroization, 2006 vs. 2015 (FX loans as a share of total loans) EST LVA SVN LTU SVK Euro adoption CZE HUN POL MKD ALB BGR ROU HRV BIH SRB UVK MNE 0 10 20 30 40 50 60 70 80 90 100 FX loans in percent total loans, 2015 1/ 2008 for SRBand2007 for ALB, BGR and ROM.
Why are Loans Euroized? Two forces triggering loan euroization: Carry trade. Loans are in foreign but deposits in domestic currency: borrowers exploit interest rate differentials. Prevalent in central Europe and in the Baltics before the global financial crisis. Deposit-driven. Deposits are in foreign currency, reflecting distrust in the domestic currency as savings vehicle. Banks hedge by extending loans in FX. Prevalent in the Balkans.
Carry Trade vs. Hedging 100 Loan and Deposit Euroization, 2006 (FX loans/deposits as a share of total loans/deposits) UVK FX loans as a share of total loans, 2006 1/ 90 80 70 60 50 40 30 20 10 0 Carry Trade SVK CZE EST HUN POL LTU ROU ALB SLV Little Euroization BGR BIH LVA MKD Deposit-Driven 0 10 20 30 40 50 60 70 80 90 100 FX deposits as a share of total deposits, 2006 1/ 2008 for SRBand2007 for ALB, BGR and ROU. HRV SRB MNE
Carry Trade Euroization has Mostly Disappeared in the Wake of the Crisis FX loans as a share of total loans 100 90 80 70 60 50 40 30 Loan and Deposit Euroization, 2015 (FX loans/deposits as a share of total loans/deposits) POL HUN ROU MKD BGR BIH 20 CZE 10 SVN EST LVA Euro adoptees 0SVK LTU 0 10 20 30 40 50 60 70 FX deposits as a share of total deposits 80 90 100 ALB HRV SRB UVK MNE
Hence, Deposit Euroization is the Main Remaining Issue Minimum variance portfolio (MVP): standard model for deposit euroization. Predicts that euroization is high when the volatility of inflation is high relative to the volatility of the exchange rate. In CESEE: MVP-approach does not work with recent data. Only works if data are being stretched back to the early 1990s. Results improve further when including a control for hyperinflation during transition. -> transition experience still determines deposit euroization, 20+ years later!
Minimum Variance Portfolio Minimum Variance Portfolio and Deposit Euroization Share of FX deposits in total deposits, 2006 100 90 80 70 60 50 40 30 20 10 LTU CZE POL LVA SVK SRB ROU EST R² = 0,3946 ALB SVN HUN UVK MNE HRV BIH MKD BGR 0 0,0 0,2 0,4 0,6 0,8 1,0 MVP
The Long Shadow of Hyperinflation Effective Exchange Rate Flexibility 1/ Hyperinflation Legacy and Exhange Rate Flexibility 1.2 1.0 0.8 0.6 0.4 0.2 0.0 HUN CZE SVK ALB ROU High Inflation POL LVAEST LTU Hyperinflation MKD HRV BGR 0 1,000 2,000 3,000 Peak Annual Inflation During Transition 1/ Calvo-Reinhart "Fear of Floating" Index, average for 2006-08 (before the first CESEE economies adopted the euro) SRB BIH, MNE, UVK >3,000
Themes Stock taking: How did MERRs evolve since transition? How did MERRs perform? What rationale is behind fixed rate regimes? Forward looking: Monetary strategies going forward
Purpose of this Section: Outline Strategic Options and discuss their feasibility, pros and cons. The section is not prescriptive. For countries with flexible exchange rates: little reason for strategic re-orientation (as regards the monetary and exchange rate regime!) For countries with fixed/quasi-fixed exchange rates?
Two Strategies: Stick or Move? (i) Stick to fixed exchange rate. Avoids financial stability risks by sticking to tried and tested regime. Adopt euro once the opportunity arises, until then, employ other policies than monetary policy to limit macro-volatility. (ii) Move to a flexible exchange rate regime. Holds the prospect of more balanced and less volatile growth. But: the transition is risky, requires inter alia dealing simultaneously with euroization. Bottom line: neither option is easy.
Stick: How Can Fixed Rate Regimes be Made to Work Better? Strong countercyclical fiscal policy - difficult for emerging economies (financial and political economy constraints, small multipliers) Macro-prudential policies to manage credit growth. Work better in EMs than in AEs: harder to circumvent bank lending regulations. But: only strong measures help. In the EU, circumvention via direct cross-border lending (single EU passport) Labor market flexibility: micro (reallocation of workforce) and macro (wage flexibility)
Stick Got the Baltics Into the Euro but can this be reproduced elsewhere? Three caveats: Most CESEE countries would likely need to stay on the Baltic path for longer than the Baltics Baltics met macro-volatility with strong institutions, strong fiscal positions, rapid wage adjustment, high productivity growth difficult to reproduce elsewhere Still, a crisis and recession were needed to get inflation down to levels required for passing ERM2
The Baltics Path into the Euro HICP Inflation, 2004-2015 (Percent) 16 14 12 10 EST LVA LTU ERMII Criteria EST Euro adoption LVA LTU 8 6 4 2 0-2 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Moving to More Exchange Rate Flexibility What Does it Take? Review of experiences suggests that 3 conditions are key: Disinflation & stable macroeconomic environment. Crucial element: stability-oriented fiscal policy that eliminates the need for monetary financing of the budget. Mostly achieved in CESEE Establish a credible domestic monetary anchor Supportive regulatory and structural policies that encourage the use of the domestic currency.
Establish a Credible Domestic Monetary Anchor (1) Ideal: gradual, carefully planned transition Grants time to HHs/corps/banks to get used to flexibility, and to monetary/supervisory authorities to build technical capacities. May take 10-20 years. Expectations of exchange rate appreciation facilitate the initial move to more flexibility: gives savers financial incentive to hold deposits in domestic currency. -> The last 7-8 years were the wrong time for switching -> But: real appreciation expectations should return once convergence resumes
Establish a Credible Domestic Monetary Anchor (2) Real Effective Exchange Rate, Floaters 1/ (CPI based, index, 2000 = 100) 130 120 Trend appreciation 110 100 Trend depreciation 90 80 2003 2006 2009 2012 2015 Sources: Haver Analytics; and IMF staff calculations. 1/ Simple average for the Czech Republic, Hungary, Poland, and Romania.
Establish a Credible Domestic Monetary Anchor (3) Complication: keep euroization low in times of financial stress - savers fear return to depreciation/inflation Spiral. Example: GFC Deposit Dollarization/Euroization in Selected Countries, 2004 12 (Percent) 90 80 70 60 Armenia Croatia Macedonia Lehman Brothers bankruptcy 50 An external anchor could help. 40 30 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: National central banks.
Regulatory and Structural Policies (1) What has worked? Deposit-side regulations: (i) higher reserve requirements for FX deposits (ii) higher remuneration for required reserves in LC, or required reserves for FX deposits in LC, (iii) charge higher risk premia for FX deposits covered by the deposit guarantee fund, (iv) mandatory holding periods for FX deposits. Lending-side regulations: capital surcharges / higher risk weights for FX loans But: latent conflict with EU s free movement of capital provision
Regulatory and Structural Policies (2) Develop domestic securities markets to provide alternative savings vehicles to FX deposits, for example inflation indexed bonds What has not worked? Heavy handed regulation/coercive measures. For example, forced conversion of FX deposits into local currency - or of FX loans in the context of deposit-driven euroization - has often provoked financial disintermediation, inciting depositors to withdraw their savings from banks
Main Takeaways (1) Floating has tended to come with better alignment of monetary conditions with CESEE economies needs. Results: lower macro-economic volatility, better medium-term growth prospects But this does not mean peggers simply got the exchange rate regime wrong. Pegging is (mostly) born out of necessity, reflects distrust of populations burned by hyperinflation in a domestic monetary anchor.
Main Takeaways (2) Policy options: Stay with peg -> avoids financial stability risks. But countries will likely have to live with elevated macrovolatility options to deal with this are limited. Can complicate development prospects. Transition to floating: should not be attempted without a coherent strategy -> risks financial instability. Resumption of growth convergence may provide an opportunity for some countries. European institutions can help