Exchange rate regimes Exchange rate regimes and shocksand shocks

Fabrizio CoricelliFabrizio Coricelli

Budapest, November 28, 2002Budapest, November 28, 2002

OutlineOutlineCEECs are characterized by high

volatilityVolatility of shocks, volatility of policyExchange rate regime: shock absorber

or source of shocksReal and financial shocksReal: structural change and productivity

shocks (Balassa-Samuelson)Financial: emerging market featuresConclusons: Skepticism on flexibility

VolatilityVolatilityGDP Terms of

trade**Real

effective exchange

rate**

Real interest

rate**

Gov’t revenue/G

DP

CEECs* 4,10 4,40 12,66 6,34 2,31Latin America 3,74 8,70 18,00 13,18 2,19

Emerging Asia 4,11 5,92 8,65 2,52 1,82

Advanced countries

2,09 3,73 5,90 2,07 1,02

*1993-2001

**Only Czech republic, Hungary, Poland and Romania

Evolution of shocksEvolution of shocks

Initially: price liberalization and structural change

Over time: trade opening and integration with EU

Over time: opening to capital flows (financial shocks)

Trend effects and dynamicsTrend effects and dynamics

Trend real appreciation (Balassa-Samuelson): productivity shocks

Cyclical co-movements

External shocks: contagion

Accounting for REAAccounting for REA log(PT/PN)i,t = αoi - α1log(aT – aN)i,t - α2sharei,t - α3govreali,t + α4labi,t + εi,t

-2

-1,5

-1

-0,5

0

0,5

1

1,5

T=1 T=2 T=3 T=4 T=5 T=6 T=7 T=8

govreal

share

lab

prod

Actual RER

Fitted Values

Balassa-Samuelson: SloveniaBalassa-Samuelson: Slovenia

0

20

40

60

80

100

120

140

1992 1993 1994 1995 1996 1997 1998

Labor (IND/SER) Productivity diff. Poli. (Labor (IND/SER)) Poli. (Productivity diff.)

Cyclical co-movementsCyclical co-movementsIndustrial production annual changes

3month moving average

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Sep

-94

Dec

-94

Mar

-95

Jun-

95

Sep

-95

Dec

-95

Mar

-96

Jun-

96

Sep

-96

Dec

-96

Mar

-97

Jun-

97

Sep

-97

Dec

-97

Mar

-98

Jun-

98

Sep

-98

Dec

-98

Mar

-99

Jun-

99

Sep

-99

Dec

-99

Mar

-00

Jun-

00

Sep

-00

Dec

-00

Mar

-01

Jun-

01

Sep

-01

Dec

-01

Mar

-02

Jun-

02

Sep

-02

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

eu hungary Poland

Trade opennessTrade openness

0

50

100

150

200

250

300

LU

XE

MB

OU

RG

ES

TO

NIA

IRE

LA

ND

BE

LG

IUM

SL

OV

AK

RE

P.

CZ

EC

H R

EP.

NE

TH

ER

LA

ND

S

HU

NG

AR

Y

BU

LG

AR

IA

SL

OV

EN

IA

LA

TV

IA

AU

ST

RIA

LIT

HU

AN

IA

SW

ED

EN

DE

NM

AR

K

FIN

LA

ND

PO

RT

UG

AL

RO

MA

NIA

GE

RM

AN

Y

SPA

IN

PO

LA

ND

*

UK

GR

EE

CE

FR

AN

CE

ITA

LY

* 1999Source: IMF: International Financial Statistics

%

EU

CEECs

Figure 1: Degree of Openness in the EU and the CEECs (exports plus imports of goods and services as percent of GDP in 2000)

Poland: Flexible exchange ratesPoland: Flexible exchange rates

Risk premium: PolandRisk premium: Poland

0

200

400

600

800

1000

1200

1400

1600

1/30/1998 10/30/1998 7/30/1999 4/30/2000 1/30/2001 10/30/2001 7/30/20020

50

100

150

200

250

300

350

400EMBI +EMBI + Poland

Risk premium: PolandRisk premium: Poland 2 2

After adoption of flexible rates (in 2000) risk premium jumps up

Before and after high correlation with EMBI+

Evolution of regimesEvolution of regimes

Fix Intermediate Float

Stabilisation phase Czech Rep. Cyprus Bulgaria1990-1994 Estonia Slovenia

Hungary RomaniaLatvia Lithuania MaltaPolandSlovakia

Transition phase Bulgaria Czech Rep. Slovenia1995-2000 Estonia Cyprus Romania

Latvia HungaryLithuania Poland Malta Slovakia

Preparatory phase Bulgaria Cyprus Czech Rep.2001 - ERMII Estonia Hungary Poland

Latvia SlovakiaLithuania SloveniaMalta Romania

De jure classification according to the IMF. Fix: currency board, conventional peg, narrow band;

Intermediate : tightly managed, broad band; Float : managed float, free float

HeterogeneityHeterogeneity

Movement towards extremesEuro is the end-point:is the

movement towards more flexibility reasonable?

It depends on the ability of flexible rates to absorb shocks and insulate from currency and financial crises

Exchange rate shock absorber?Exchange rate shock absorber?

Response of exchange rate to external shocks

Response of interest rates Habib (2002): high sensitivity to external

shocks (change in risik premium). Poland and Czech Republic: Exchange rate follows EMBI+ shocks. Hungary and Slovenia: interest rate reacts.

In both cases either real exchange rates and/or real interest rates move in response to international shocks

Contagion and interest ratesContagion and interest rates: : HungaryHungary

0

1

2

3

4

5

6

7

8

Jan-

97

Jul-9

7

Jan-

98

Jul-9

8

Jan-

99

Jul-9

9

Jan-

00

Jul-0

0

Jan-

01

Jul-0

1

Jan-

02

%

0

200

400

600

800

1000

1200

1400

1600

basis points

Forint one-year ex ante real rate Euro one-year zero-coupon yield EMBI+ (right-hand scale)

Poland: interest rate spreadsPoland: interest rate spreads

Short term spreads vs. euro still large

Long-term expectation of entry in the eurozone

0

2

4

6

8

10

12

3m 6m 1y 2y 3y 4y 5y 10y

2001 2002

External constraintExternal constraint

External constraint not to be underestimated

Exposure to swings in foreign financingLow liability “euroization”? Need to be

qualified (example of Hungary) These elements should be factored in

when advising flexibility of exchange rates

External position, External position, 2000-012000-01

External debt/GDP

External debt/Exports

FDI /GDP

Current Account/GDP

Bulgaria 86.4 148.3 8.3 5.9Czech 42.8 56.2 9.1 4.8Estonia 61.4 64.6 6.4 6.8Hungary 67.3 97.3 2.6 3.9Latvia 65.9 144.0 5.6 6.8Lithuania 42.9 95.1 3.3 6.0Poland 42.9 214.5 5.9 6.3Romania 27.0 81.7 2.7 3.7Slovakia 56.3 76.5 10.7 3.7Slovenia 34.3 58.1 0.2 3.3

avg. CEECs 52.7 103.6 5.5 5.1

Exchange rate and inflationExchange rate and inflation 1 1

Pass-through: eg. Darvas (2001); Coricelli et al. 2002

High pass-through, especially in Slovenia and Hungary

Problem with inflation targeting

Exchange rate and inflation 2Exchange rate and inflation 2

Difficulties in bringing down inflation at low rates

Exchange rate flexibility may in fact make it worse

Implicit real exchange rate targets internalized in the price setting………….

SloveniaSlovenia

-20

-15

-10

-5

0

5

10

15

20

25

30

dic-93 feb-95 apr-96 giu-97 ago-98 ott-99 dic-00 feb-02

ip ner

rer cpi

Czech RepublicCzech Republic

-15

-10

-5

0

5

10

15

20

25

mar-94 mag-95 lug-96 set-97 nov-98 gen-00 mar-01 mag-02

ip ner

rer cpi

HungaryHungary

-15

-5

5

15

25

35

apr-94 ago-95 dic-96 apr-98 ago-99 dic-00 apr-02

ip nerrer cpi

PolandPoland

-25

-15

-5

5

15

25

35

mar-94 mag-95 lug-96 set-97 nov-98 gen-00 mar-01 mag-02

ip ner

rer cpi

Advantages of flexibility Advantages of flexibility not obviousnot obvious

True: with inflationary inertia in the non tradable sector fixing the exchange rate may cause a temporary drop in output in non-tradables

However, there would be gains in welfare associated to the reduction of losses due to monopolistic behavior in non tradable sectors (Calvo et al. (2002)

Adoption of the euroAdoption of the euro

Would avoid real appreciation induced by nominal appreciation arising from capital inflows

Would allow immediate convergence in interest rates

Would reduce inefficiency of monopoly power in non-tradable sectors

Thus, nominal convergence may be less costly with euro than with flexibility of exchange rates