Nominal Anchors in EU-Accession Countries Recent Experiences - PDF document

Nominal Anchors in EU-Accession Countries – Recent Experiences Michael Frömmel, Universität Hannover a Franziska Schobert, Deutsche Bundesbank b Abstract: We investigate official and implicit nominal anchors for five Central and Eastern European countries (the Czech and Slovak Republic, Slovenia, Poland and Hungary) during 1994 to 2002. Most of these countries have moved from fixed to more flexible regimes and adopted a form of inflation targeting. Our findings show a mixed success in achieving their new nominal anchors and they show some evidence for implicit exchange rate targeting. It seems to be most pronounced for Slovenia, the only country with a managed floating regime during the whole period, whereas the results for Hungary and Poland fit best to the officially announced regimes. Preliminary draft, November, 2002 JEL classification: F31 Keywords: Transition economies, exchange rate regimes, official regimes, de facto regimes, nominal anchors, fear of floating, exchange rate volatility, GARCH, T-GARCH a Corresponding author. Department of Economics, Universität Hannover, Königsworther Platz 1, 30167 Hannover, Germany; email address: froemmel@gif.uni-hannover.de b The findings, interpretations, and conclusions expressed here are entirely those of the authors and do not necessarily represent the views of the Deutsche Bundesbank .

1. Introduction: Objectives and procedure Which nominal anchor can EU accession countries choose on their way to EMU? In principle several options exist, e.g. using the exchange rate or a monetary aggregate as an intermediate target, pursuing direct inflation targeting or even using an implicit nominal anchor. Monetary and exchange rate targeting have certain disadvantages, which make them less attractive to EU accession countries: A precondition for monetary targeting are fairly stable money demand functions, which are less likely in most EU accession countries due to the rapid emergence of financial innovations and their gradual opening of their capital accounts. An explicit exchange rate target may expose the economy to speculative attacks, which are most feared by these countries after entering the ERMII. The last option, an implicit nominal anchor, is perceived as highly discretionary and thereby less credible. Why are exchange rate movements generally important for EU accession countries? Most of them belong to the class of small open economies, which are highly dependent on exchange rate movements. Furthermore, it seems that these countries try to pursue a delicate balance between lowering inflation and preserving competitiveness. Accordingly, real appreciations are sometimes perceived as “bubbles” than as a fundamental development, which central banks try to reverse by interest rate changes or by interventions combined with costly sterilizations. Moreover, entering the ERMII with an “overvalued” exchange rate would challenge a fast entry to EMU as during the minimum of two years nominal revaluations but not devaluations are allowed. And why will exchange rate movements still be important even if the countries have subsequently chosen other strategies? Four out of the five countries observed have moved from fixed to more flexible regimes and the most popular new strategy seems to be inflation targeting. But even inflation targeting usually includes the exchange rate as one of several inflation indicators and especially emerging market countries with small open economies will need to take the exchange rate into account in the setting of monetary policy. Of course, the credibility of the inflation-targeting strategy requires that monetary policy should not aim at targeted levels of the exchange rate. The exchange rate objectives have to be clearly subordinated to the inflation target. Nevertheless, their monetary policy may need to take exchange rate movements into account because the exchange rate has an important impact on inflation. Disruptive exchange rate volatility arising from a thin foreign exchange market or temporary shocks could be further reasons to smooth exchange rate movements, even if 2

countries have official floating exchange rate regimes with inflation targeting frameworks (Carare et al., 2002, p. 3-5). However, in some cases it might be hard to distinguish, whether the central bank just tries to smooth the exchange rate or whether it prevents the exchange rate to follow a certain path. The paper addresses these questions by looking at the recent experience of EU accession countries in Central and Eastern Europe. First we summarize the nominal anchors, these countries have officially chosen and evaluate the success of their implementation. Then we assess implicit exchange rate targeting by comparing Central and Eastern European countries over time and between each other. We therefore use static and dynamic volatility measures, frequency distributions and regression analysis for sub-periods during which different official regimes prevailed. The study concentrates on the Czech Republic, Poland, the Slovak Republic, Slovenia and Hungary, five advanced EU accession countries in Central and Eastern Europe and on the time period since 1994. So the study excludes less advanced countries as Romania and Bulgaria, but it also excludes Estonia, Latvia and Lithuania, whose central banks pursued rather fixed exchange rate regimes during the sample period without any significant regime shifts to more flexible arrangements. Current state of the art in the research field If we assume that countries have still pursued exchange rate target although they have officially claimed to target other nominal anchors, the most relevant literature to this topic is the literature on de facto exchange rate regimes. Generally two approaches may be taken to disentangle de facto exchange rate regimes from the officially announced arrangements. The first one looks at official reserves as well as interest rate management, and tries to derive the preferences of the government. Popper and Lowell (1994) use this approach and study changes in foreign reserve holdings and the behavior of prices in response to exchange rate changes for four Pacific Basin countries. The second approach looks at the results of the exchange rate policies, i.e. at the variations of exchange rates. Haldane and Hall (1991) follow this approach by analyzing the Sterling’s transition from a dollar peg to a DM peg as well as Frankel and Wei (1992, 1993), who evidence an increasing influence of the yen in the nominal exchange rate policies of some Asian countries since the early 1980s. Bénassy-Quéré (1996) applies the second approach and uses statistical and econometric methods in order to analyze de facto exchange rate regimes. She concludes that Western Europe already 3

constitutes a strong monetary bloc pegging to the DM during 1989-1995 that was not pulled down by the ERM crises. She also concludes, that East European countries have not adopted a DM nominal peg during this early period, although they positively have weighed the DM in their de facto basket peg and that Asian countries rarely have weighed the yen in their implicit basket pegs, although the peg to the US Dollar was loser than for European currencies vis-à- vis the DM. More recent studies use both approaches in order to study de facto exchange rate regimes. Calvo and Reinhart (2000) compare volatilities of the exchange rate, interest rate and international reserves across 154 exchange rate arrangements and use a vector autoregression between these variables. Levy-Yeyati and Sturzenegger (2000) construct a de facto classification of exchange rate regimes. Using cluster analysis techniques for data from all IMF-reporting countries over the period 1974-99 different regimes are grouped according to the behavior of the exchange rates and international reserves. The result of both studies do not support the hypothesis that intermediate regimes have been disappearing in recent years, but that countries that say they allow their exchange rate to float mostly do not. Frankel et. al. (2001) tests the verifiability of official exchange rate regimes, a related topic. They use regression analysis to investigate whether and how the exchange rate is given by a weighted combination of foreign currencies taking account of possible rates of crawl. Their findings support that more complicated regimes with basket pegs, wider or frequently changing bands are harder to verify and that this may be a reason for the popularity of corner solutions. For a small sample of countries with officially declared floating exchange rate regimes (Brazil, Mexico, Peru, South Korea and Thailand) and by using the same methodology their tests do not show evidence against the hypothesis that the exchange rates of these countries are indeed floating, with the exception of Peru and part of the post-Tequila period in Mexico. A paper explicitly dealing with de facto and official exchange rate regimes in transition countries is that by von Hagen and Zhou (2002). In a sample of 25 transition countries they use probit models to describe the joint determination of the two regime choices and the determination of regime discrepancies. They find that official regimes are more persistent and change in less frequent but large steps than de facto regimes and apart from other factors they find that countries with more developed monetary systems are more likely to adopt an official floating-rate regime, thus supporting the fact, that some Central and Eastern countries move to more flexible arrangements on their way to EU accession. 4