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Economic policy under exogenous shocks: EMU and future prospects for CEE accession countries by Katerina Kalcheva Munich Graduate School of Economics 6th European Workshop “EMU: Current state and Future Prospects” August, 24 – 31 2003 Overview Motivation Theoretical review Exchange rate credibility and the transmission of asymmetric shocks Structural VAR and Bayesian approach (extension) - Blanchard and Quah (1989), Doan, Litterman, Sims (1984) Research Agenda My thesis focuses on the costs of various shocks and different shock transmission mechanisms. The aim is to analyze the main channels of monetary transmission in CEE countries and to explain their importance in the transmission in case of possible shocks. Three essays: 1. The impact of exogenous shocks on the different exchange rate regimes in CEEC 2. Exogenous shocks, volatility and financial contagion in transition 3. Brinkmanship and speculative attacks Motivation: 12 accession countries: - Group 1 will join EU in May 2004 Hungary, Poland, Slovenia,Czech Republic, Slovak Republic, Estonia, Latvia, Lithuania, Cyprus and Malta - Group 2 is scheduled to join in 2007 Romania and Bulgaria 1. 2. 3. Three stages before joining EMU: Each country is required to meet Maastricht criteria Participation in ERMII in the course of two years Fix to euro and denomination in certain period What still matters is the real convergence, i.e.a similarity of economic cycles in the countries whose intention is to peg their exchange rates to each other. As a result……. Different regimes in the pre EMU phase – the number of EXR regimes should be reduced Maastricht criteria in CEEE Criterion Inflation Interest FX rate Deficit Debt 2001 3.3 10Y 7.4 Deviation ±15% 2001 - 3.0% 2001 60.0% Bulgaria 7.9 5.2 -1.3 -0.9 72.5 Czech Repub 4.7 5.6 -5.5 -3.2 29.0 Estonia 5.8 4.7 -1.2 1.1 6.2 Hungary 8.5 7.0 -4.4 -3.2 64.4 Latvia 2.5 10.7 2.6 -1.9 12.2 Lithuinia 1.3 7.9 8.6 -1.4 29.0 Poland 5.6 8.3 -8.2 -4.0 38.0 34.5 34.9 -33.3 -3.7 31.2 Slovak Rep 7.3 7.8 -1.8 -7.2 42.7 Slovenia 8.5 - -7.4 -1.3 25.4 Reference value Romania Source: Deutsche Bank Research (2002, p.27) Volatility Gov’t Real interest revenue/G DP rate** GDP Terms of trade** Real effective exchange rate** Latin America 4,10 3,74 4,40 8,70 12,66 18,00 6,34 13,18 2,31 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 CEECs* *1993-2001 **Only Czech republic, Hungary, Poland and Romania Source: Coricelli (2002) Acceptable exchange rate regimes under Maastricht criteria for EMU membership: No optimal EXR regime - heterogeneity No euroization: risk of misalignment due to wrong conversion rate or asymmetric shock No further adjustment of exchange rate possible Exposed to the fluctuations of the G3 currencies Case by case EMU as soon as possible after EU 25 members rotation principle, transparency and accountancy Four main questions: The establishment of an appropriate central parity Choice of appropriate date of exchange rate fixing Ability to meet Balassa-Samuelson effect :productivity shock If the magnitude of destabilization risk in various exchange rate regime is comparable Fix Stabilisation phase Czech Rep. 1990-1994 Estonia Hungary Latvia Lithuania Malta Poland Slovakia Transition phase 1995-2000 Bulgaria Estonia Latvia Lithuania Malta Preparatory phase Bulgaria 2001 - ERMII Estonia Latvia Lithuania Malta Intermediate Float Cyprus Bulgaria Slovenia Romania Czech Rep. Cyprus Hungary Poland Slovakia Slovenia Romania Cyprus Hungary Czech Rep. Poland Slovakia Slovenia 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 Source: Coricelli (2002) Aim of the analysis: On the road to EMU transition countries will choose system that combines capital mobility with fixed but adjustable EXR regimes However, from theoretical point of view (Friedman 1953, Poole 1970; DeGrauwe 1996, Chang & Velasco 1998) exists higher vulnerability of fixed EXR regime to external shocks The analysis attempts to determine to what extent an external shock can increase volatility in different regimes and impair the full EMU membership for accession countries The choice of the exchange rate regime is a significant factor in the way different shocks are transmitted through the monetary sector Why are shocks important? Theoretical review Exchange rate regime : absorber of shocks or a source of shocks Friedman (1953) and Mundell (1961) Poole W.(1970), DeGrauwe (1996) Financial shock will be better offset at fixed exchange rate Buiter (2001) introduces “new” OCA. Finds that exchange rate is not just a shock absorber, or part of the transmission mechanism for fundamental shocks originating outside the foreign exchange markets, but a source of excess volatility, unnecessary shocks, instability and misalignment. Artis and Ehrmann (2002) if shocks are symmetric or asymmetric. Using SVAR technique - how strongly the exchange rate responds to asymmetric supply and demand shocks, if it helps to stabilize the economy, also exchange rate is driven by shocks in the exchange rate market and whether these shocks have the potential to distort output or prices Fidurmuc (2002) optimality of currency union using two types of criteria: business cycle synchronization and existence of effective adjustment Moreno and Trehan (2000) : common external shock explains between sixty to eighty percent of the variation in the total number of currency crises over the post Bretton woods period Real shock will lead to more variability in the output at fixed exchange rate Theoretical review (cont’d) Eichengreen, Rose and Wypolsz (1995) and Kaminsky and Reinhart (1999) model the influence of external conditions by focusing on the country specific variables. The impact of supply and demand shocks also related to the monetary policy (e.g. the slopes of IS, LM and BP curves) has been extensively studied by Fry and Lilien (1986), Bayoumi and Eichengreen (1993), Gross (2001), Fidurmuc and Korhonen (2003). Dehejia and Rowe (2001) model fixed exchange rates vs. inflation targeting vs. price level targeting. The difference is explained in terms of unforeseen observed price shock. In contrast to the traditional literature, the authors do not emphasize on the source of shocks but whether a given shock is observed or unobserved. Price level targeting best stabilizes output and the expected real exchange rate and enables the central bank to respond to observed shocks Why shocks are important for CEEC? Asymmetric shocks arguably have been the reason behind the collapse of most fixed exchange rate systems Evolution of shocks :price liberalization and structural change, trade opening, capital liberalization Begg et al. (2002) warn of the danger of enlarged capital flows which can increase the probability of crisis if reversed or of overheating and disinflation if do not reversed. Asymmetry between current EMU members and transition countries (see Fidrmuc and Krohonen 2001; Horvath, 2002) – supply shocks are largely uncorrelated Habib (2002): high sensitivity to external shocks (change in risk premium). Poland and Czech Republic: Exchange rate follows EBC+ shocks. Hungary and Slovenia: interest rate reacts. Why shocks are important for CEEC? (cont’d) External changes may affect the foreign trade transactions in the EMU-11 and CEEC comparably. But different in scale and a presumably passive reaction of the ECB imply de facto an asymmetric character of these shocks. Correlation of shocks may change over time – time varying coefficients of demand and supply shocks. Babetski, Boon and Maurel (2002) The importance of adjustment mechanisms: Current account surplus, mobility of labor and capital, price flexibility or a system of fiscal risk sharing by means of intra-union transfers Otherwise in the extreme case - withdraw from the union Current accounts (as % of GDP) Source: The Economist intelligence country data 2002 Exchange rate credibility and the transmission of asymmetric shocks Traditional argument the “endogeneity” of OCA carries important implications for the credibility of CEEC exchange rate regimes. CEEC will satisfy OCA properties ex post asymmetries will be mitigated by the financial integration before accession all CEE countries have to choose the most credible exchange rate regime – the fixed exchange rate regime contradicts with the prerequisite for fulfillment of Maastricht criteria However, as I show in the paper the main issue for CEEC is not to choose the most credible regime but rather which regime will increase the prospects for real convergence ex ante. A high incidence of asymmetric shocks, differences in the economic structure or swings in foreign financing might bring serious deviations from the criteria if countries rely only on credibility High pass-through and problem with inflation targeting, esp. in Slovenia and Hungary e.g. Darvas (2001); Coricelli et al. 2002 Hypotheses to be tested and questions to be answered: EXR regime matters as shock absorber in the pre EMU phase Which EXR regime is mostly affected by external disturbances ? Which exogenous shocks can have permanent effect depending on the exchange rate regime? What makes different exchange rate regimes sustainable to external shocks? Which are the main transmission mechanisms? How well prepared the accession countries are to absorb shocks? What is the speed of after shock adjustment? Can national or/and supranational regulation smooth shocks? What is new, my contribution? Exogenous shocks and volatility in different exchange rate regimes - a comparative study Test empirically using SVAR In order to have more efficient and reliable estimates and because of the relatively short transition period we use Bayesian VAR Three types of exchange rate regimes – currency board (Estonia), intermediate (Hungary) and floating (Czech Republic) Impulse responses to innovations in Real effective exchange rate (REER), Export+Import/GDP(TOT), M2/International Reserves(M2R) Following Mendis (2002), we create dummy variable for each year if the regime has been hit by a shock Research in progress So far my research follows Blanchard and Quah (1989), Doan, Litterman, Sims (1984) to follow the shock transmission mechanism to look at the speed of after shock adjustment A structural VAR model is constructed (see Hamilton 1994, Green 2003) with three dependent variables – real effective exchange rate (REER), the ratio of M2 and foreign reserves (M2R) and export+import / GDP (TOT). Two lagged model using data from 1994:1 to 2001:4 Source: IFS and DataStream The joint process can be written as an infinite moving average representation of disturbances: REERt = aY + ∑ bRR,jRt-1-j + ∑ bRM, Tt-1-j + ∑ bRT,jMt-1-j +Rt M2Rt = aE + ∑ bMR,jRt-1-j + ∑ bMT, Tt-1-j+ ∑ bMM,jMt-1-j+Mt TOTt = aP + ∑ bTR,jREERt-1-j + ∑ bTT, Tt-1-j+ ∑ bTM,jMt-1-j+Tt Y = (A1 + A2D)Yt-1 + Orthogonalized impulse response function: Yt= a + et +et-1+ et-2+….= (L)et Y ts a e s j t Choleski Decomposition of the variance E[Tt]2=[∑ bTR,j]2E[Mt]2 + [∑ bTR,j]2E[Rt]2 + E[Tt] Summary: EMU participation requires stronger adjustment efforts than EU membership Asymmetric shocks have significant importance for the CEEC Forex regime and rates – of decisive importance: They reflect the performance of all reshaping markets and affect them as well Large benefits of enlargement However risk of destabilizing shocks ERM II regimes (+- 15% band or tighter are particularly vulnerable to speculative attacks) CEEC current economic situation 2000-2001 External External debt/GDP debt/Exports Current Account/ GDP FDI /GDP Bulgaria Czech Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia 86.4 42.8 61.4 67.3 65.9 42.9 42.9 27.0 56.3 34.3 148.3 56.2 64.6 97.3 144.0 95.1 214.5 81.7 76.5 58.1 8.3 9.1 6.4 2.6 5.6 3.3 5.9 2.7 10.7 0.2 5.9 4.8 6.8 3.9 6.8 6.0 6.3 3.7 3.7 3.3 avg. CEECs 52.7 103.6 5.5 5.1 Source: Coricelli (2002) CURRENCY BOARDS Estonia Exchange rate versus Euro (100 = 01/93) 350 Lithuania 800 700 300 April 1994 Currency board 600 250 500 200 400 300 150 200 100 100 50 0 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 Bulgarie 1200 1000 800 600 400 July 1997 Currency board 200 0 -200 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 Basis 100 = January 1993 An increase in the real and nominal exchange rates stands for an appreciation. Source : ECB, IMF Nominal exchange rate RER calculated with CPI prices RER calculated with PPI prices PEGS Exchange rate versus Euro (100 = 01/93) LATVIA CZECH REPUBLIC 450 180 Peg 400 160 350 300 April 1997 Managed float 140 250 120 200 150 100 100 80 50 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 Nominal exchange rate Nominal exchange RER calculated with CPIrate prices Basis 100 = January 1993 RER calculated with CPI prices RER calculated with PPI prices RER calculated with PPI prices An increase in the real and nominal exchange rates stands for an appreciation. Source : ECB, IMF CRAWLING PEGS Exchange rate versus Euro (100 = 01/93) HUNGARY POLAND 140 200 Crawling peg 180 120 Crawling peg 160 100 80 140 120 April 2001 Float 100 60 80 April 2000 Float 60 40 40 20 20 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 Nominal exchange rate RER calculated with CPI prices Basis 100 = January 1993 RER calculated with PPI prices An increase in the real and nominal exchange rates stands for an appreciation. Source : ECB, IMF MANAGED FLOATS Exchange rate versus Euro Slovak Republic (100 = 01/93) 160 120 150 110 140 100 130 Slovenia 90 120 80 110 70 100 60 90 80 50 70 40 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 Roumanie 250 200 150 100 Nominal exchange rate 50 RER calculated with CPI prices 0 RER calculated with PPI prices -50 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 Basis 100 = January 1993 An increase in the real and nominal exchange rates stands for an appreciation. Source : ECB, IMF Maastricht Conditions for EMU Membership: Inflation: (no more than 1.5% above average of 3 lowest inflation countries). Nominal interest rate: ( no more than 2.0% above average of the 3 lowest inflation countries). Nominal exchange rate: Respect normal fluctuation margins for ERM without severe tensions for at least 2 years before the examination. No devaluation ‘on own initiative’. [At least 2 years of ERMII plus unrestricted financial capital mobility: risk of speculative attacks and crises]. Italy and Finland precedents 1998/9; Greece precedent 2000/1. Council of Ministers decides conversion rate. Fiscal criteria: Budget deficit should not be higher than 3% of GDP public debt should not be higher 60% of GDP Central Bank independence The theory of optimum currency areas The theory of OCAs is a collection of various economic indicators determining how a currency area will function after bilateral exchange rates are fixed. The most famous characteristics for participation in OCA are: countries face symmetrical disturbances (as type, direction and speed of adjustment) (R.Mundell, 1961), degree of factor mobility and similarity of production structures (R.Mundell, 1961), openness of the economy (R.I.McKinnon, Optimum Currency Areas, — The American Economic Review, vol. 53, no. 4/1963) price and wage flexibility (B. Eichengreen, European Monetary Unification, —Journal of Economic Literaturel,, vol. 31, no. 3/1993), low inflation rates differentials (G.Haberler, The International Monetary System: Some Recent Developments and Discussions in: Approaches to Greater Flexibility of Exchange Rates, ed.G. Halm, Princeton University Press,1970; J. Fleming , On Exchange Rate Unification, in Economic Journalli, vol. 81/1971.) The latter condition has been adopted as the Maastricht convergence criterion on price stability. All accession candidates should aim to become full EMU members ASP. Pre-EU free float with inflation targeting most credible fixed exchange rate regime. Unilateral euroisation inconsistent with future EMU membership. ‘Consensual’ euroisation worth pursuing. Post-EU but pre-EMU. First-best: achieve inflation convergence and join EMU as soon as possible after joining EMU. Could even be at same time as EU, if ERM membership (for at least 2 years) is not required to satisfy normal ERM fluctuation margins. Precedents: Italy, Finland, Greece. Second-best: (unavoidable problem: purgatory of unrestricted capital mobility, risk of speculative attacks, collapsing peg, excess volatility, misalignment). most credible fixed exchange rate regime. Cannot be unilateral euroisation. Could be currency board. Could be currency board with euro as parallel currency. Might even be ‘consensual’ euroisation. Problem with any pre-EMU fixed exchange rate regime : inflation criterion meets Balassa-Samuelson. Could require unnecessary recession for 1 year. Target zone with margins < ±15%. Problem: risk of excessive volatility, speculative attacks, collapse of band, misalignment. Second-best: (unavoidable problem: purgatory of unrestricted capital mobility, risk of speculative attacks, collapsing peg, excess volatility, misalignment). most credible fixed exchange rate regime. Cannot be unilateral euroisation. Could be currency board. Could be currency board with euro as parallel currency. Problem with any pre-EMU fixed exchange rate regime : inflation criterion meets BalassaSamuelson. Could require unnecessary recession for 1 year. Target zone with margins < ±15%. Problem: risk of excessive volatility, speculative attacks, collapse of band, misalignment. Figure 4: Impulse responses Estonia - Response to One S.D. Innov ations ± 2 S.E. Response of GDPE to GDPE Response of GDPE to GLNE E Response of GDPE to GCPIE 0.08 0.08 0.08 0.06 0.06 0.06 0.04 0.04 0.04 0.02 0.02 0.02 0.00 0.00 0.00 -0.02 -0.02 -0.02 -0.04 -0.04 -0.04 -0.06 -0.06 -0.06 -0.08 1 -0.08 1 2 3 4 5 6 7 8 2 3 4 5 6 7 8 -0.08 1 2 3 4 5 6 7 8 Lithuania - Response to One S.D. Innov ations ± 2 S.E. Response of GDP L to GCP IL Response of GDP L to GDP L Response of GDP L to GLNE L 0.08 0.08 0.08 0.06 0.06 0.06 0.04 0.04 0.04 0.02 0.02 0.02 0.00 0.00 0.00 -0.02 -0.02 -0.02 -0.04 -0.04 -0.04 -0.06 -0.06 -0.06 -0.08 1 -0.08 1 2 3 4 5 6 7 8 2 3 4 5 6 7 8 -0.08 1 2 3 4 5 6 7 8 Bulgaria - Response to One S.D. Innovations ± 2 S.E. Response of GDPB to GDPB Response of GDPB to GCPIB Response of GDPB to GLNEB 0.4 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.0 0.0 0.0 -0.1 -0.1 -0.1 -0.2 -0.2 1 2 3 4 5 6 7 8 -0.2 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 Show the reaction of the output to one standard deviation shock over a time horizon of two years; Bulgaria: higher increase in the level of output, although the confidence band of the impulse response is wider over time; the impact of the supply shock on the output tapers off, a price shock and shock in employment provide temporally increase in the level of output followed by a stabilization within a year; Estonia and Lithuania: smaller increase in the level of output, as compared to Bulgaria; the confidence band of the impulse response increases; the impact of the supply shock is not stable and takes long time to adjust; in Estonia, a shock to employment has negative effect on the output in the initial period and the positive impact comes after three quarters Figure 5: Variance decompositions Lithuania - Variance Decomposition of GDPL Estonia - Variance Decomposition of GDPE 100 100 80 80 60 60 40 40 20 20 0 0 1 2 3 GDPE 4 5 GCPIE 6 7 GLNEE 1 8 Bulgaria - Variance Decomposition of GDPB 100 80 60 40 20 0 1 2 3 GDPB 4 5 GCPIB 6 7 GLNEB 8 2 3 GDPL 4 5 GCPIL 6 7 GLNEL 8 Variance decomposition: gives an information about the the contribution of the different random shocks to the development of the variables in VAR Results: • • • the variation in the output of the three CBA countries is attributed mainly to the supply shocks – about 80 percent for Estonia and Lithuania and 90 per cent for Bulgaria; the price contribution in the output variance is around 20 per cent in Estonia and Lithuania but it is much less for Bulgaria; the employment shocks do not contribute significantly to the variance of the output.