Good advice we can't use

A study recently published by the IFO, the German economic research institute, revealed that some candidates to the European Union, including Romania, should introduce a rigid exchange rate regime against the single European currency. The study’s author, Heidemarie Sherman, said in an interview to a press agency that “these countries have unstable institutions, structural changes have not been very fast, they are weak, therefore the targets of potential attack.” In the same interview, Sherman recommends to the Baltic states “a fixed exchange rate regime, or a currency board – regardless of the form chosen” because “being smaller countries, they cannot afford an independent monetary policy.”

A little flexibility won’t hurt

The IFO standpoint contradicts already established statistical observations that an inflexible exchange rate makes anti-inflation programmes costlier. But Romania is the only country among those negotiating with the EU that struggles to contain inflation under 10-15%, a threshold over which price growth has a direct and negative effect on economic growth. Whereas in Bulgaria’s case, the recommendation of a strict regime may sound amusing (given the present monetary council) and in all other countries in the region except for Russia and Ukraine, it seemed quite doubtful, in Romania, it comes into contradiction with the anti-inflation programme.

The second debatable point as to the benefits a fixed exchange rate would bring to these economies is the elimination of what Sherman calls “speculative attack.” Most financial crises and definitely all speculative attacks have happened against the background of fixed, rigid exchange regimes. True, not with a currency board, where there is nothing to speculate, also not with a free currency, with which, again, there is nothing to speculate. The British pound, the Thai baht and the Russian rouble all fell prey to speculators namely because central banks have absurdly insisted on a fixed exchange rate until they had spent the hard currency reserves. But, since speculators cannot gain more than the Central Bank loses, the probability of a speculative attack is proportional to the amount of currency reserves, which in Romania are among the lowest in the region ($1.6 billion compared to $13bn in the Czech Republic and $25bn in Poland).

The recommendation of the German institute, otherwise a very respected institution, is not a momentary one – in the December 1999 issue of the Viewpoint periodical, the same institute expressed the opinion that a monetary council was the most suitable intermediate stage European Union candidate countries should go through, most likely after their official access into the European organisation and before the introduction of the euro. Therefore, it was not about a fixed exchange rate, but a monetary council, and not about “small and unstable” countries, but relatively developed states in what is called “the first wave.” One of the arguments in favour of this apparently difficult solution is that only an institutionalised anchorage of the exchange rate will diminish the risk perceived by investors and will attract funds into the region. The experience of countries in Southern Europe is cited to back the argument. The second argument is to efficiently combat inflation by anchoring it to a stable currency.

A few essential details

As to the argument of inflation, it is theoretically valid in economies that have already attained price stability around a 10% inflation. Even in this case, it is disproved by the present setting, in which the European currency continuously loses ground to the dollar. Of course, most of the Eastern countries’ trade is with the European Union, with Germany to be exact, but reference prices are still expressed in dollars, and will remain so for a long while ahead. The growing oil prices in the last months of 1999, for instance, would have subjected a currency anchored to the euro to supplementary inflation pressure. Of course, on the other hand, currencies anchored to the dollar suffered in the same period due to the depreciation of the European currency, an appreciation in real terms with a negative impact on the foreign balance of an economy tightly connected to the European zone (it is the case of Lithuania, which decided to abandon its dollar peg and move to the euro in the second half of 2001).

An old dispute

The dispute over the best exchange regime (float, peg, managed peg or currency board) in the context of countries transiting from a planned economy to a market one has been going on for about as long as transition itself, and many arguments and varied statistical observations have failed to produce a definitive answer. What is certain is that solutions applied in a “moderate inflation” (15-40%) differ from those recommended in the case of low inflation, below 15%. Also, foreign balances (foreign debt, trade balance) and domestic ones (budget structure and size) are determining factors in selecting the best exchange rate.

Two and a half stories of inflation

The Czech Republic has been enforcing a de-facto fixed regime, which it has continued to some extent until today. Inflation was curtailed from 56% in 1991 to 8% in 1996 and 2.1% in 1999, but at the cost of several billion dollars spent by the Central Bank, especially ahead of the successful speculative attack in 1997 (a significant fact for the protection offered by a fixed exchange rate from those threats). On the other hand, the current account has undergone a constant erosion from a $.3 billion surplus in 1991 to a $4.3bn deficit in 1996, to remain a deficit to this day. Foreign investments have consistently grown, but this was likely to happen in any case.

Hungary’s story is a little more complicated, although devoid of the perils of an exchange rate crisis. Annual inflation here never exceeded 35%, and the target for this year is 6%. As to anti-inflation programmes, the two episodes, in 1992 and 1995, are perhaps the best illustration to the otherwise sophisticated concept of sustainability. The first programme, in 1992, fixed the real exchange rate (calculated with the Production Prices Index), but it also “froze” energy prices. Lacking alternative financing (the foreign debt was itself sizeable, and the government bond market was not sufficiently liquid), the only variant has been to finance the fiscal and quasi-fiscal deficit by the Central Bank, with inflation consequences. In early 1995, inflation again exceeded 30%.

The new government, formed in 1994, endorsed a programme designed to moderately decrease inflation, based on keeping the exchange rate within a controlled depreciation corridor and on using domestic interest rates to secure foreign balance. The two instruments, because of the capital market development, are not independent, and the critical factor in ensuring success was the confidence of financial and real-economy agents that the Central Bank would not surprise with an inflation shock.

Bulgaria only makes half a story on inflation. The currency board, introduced in 1997, tackled the problem fast enough and without too much fuss. After the exchange rate was nailed down, inflation continued to adjust productivity differences – in 1998 prices did grow by 22% – but today inflation is at the euro zone level. As to the macroeconomic results, they are debatable. In any case, although the average salary exceeds that before the currency board was established, unemployment also grew fast, and was beyond 16% at the end of last year.

And a few lessons

The exchange rate, apparently, is an issue that cannot be treated separately from inflation and, consequently, from fiscal management and the adjustment of relative prices. In fact, along with the inertial factor of inflation (which is inevitable), these are clearly the problems facing Romania today. Only after the restructuring of the real economy allows a decent and stable level of fiscal and quasi-fiscal deficits, and prices are comparable to world levels, inflation will be able to “settle” quietly below 10%, and the IFO recommendation on an exchange rate “tightly anchored” to the euro will be valid in our case, too. And since Hungary, with a fiscal deficit not much below Romania’s, with a higher foreign deficit, has done it, it is to say that only the adjustment of relative prices (especially energy tariffs) and the inertial factor are still in the way of attaining a decent price stability.