Sunday, May 07, 2006

Re: Re: Exchange rate regimes in selected Transition Economies

And so, a comment sparked by your comment:

Yes, inflation targeting has proven relatively successful in the CEECs, but the success has been more in bringing down inflation, than in allowing the countries to adopt the euro.
So, in my opinion the fixed exchange rate arrangements of the Baltics need not be condemned. Sure, if we take as the main criteria the goal to enter the EMU asap after entering the EU – the fixed exchange rate, as it seems, failed to guarantee them entry in 2007. But entering the EMU is not just about fulfilling or not the inflation criteria by a few decimal points. It is not obvious that the Baltics would have made it, had they let their exchange rate float and adopted an inflation targeting regime. First of all, Slovenia, probably the only CEEC that will adopt the euro next year is not, and in fact never was an explicit inflation targeter. Moreover none of the inflation targeters (and especially Poland and Hungary) are close to fulfilling the Maastricht criteria. Of course, one could say that does not, at the moment, seem a priority to policymakers in those countries. This is communicated through distant or even undeclared (Poland) target EMU-entry dates, but this may be a sheer result of pragmatism i.e. learning not to (officially) desire what one can not achieve, or perhaps the fear of committing and not being able to live up to it.

So perhaps Slovenia was actually the only one that was bound to enter the Eurozone – this is sheer speculation, but I am in favor of saying that at least part of the good shape of the Baltic States according to the Maastricht Criteria (at least the four non-inflation ones) is owed to… their fixed exchange rates.

Currency boards or fixed exchange rate pegs are in fact a tool to combat inflation, as it is attempt to ‘borrow’ credibility by giving up the control of monetary policy. As the credibility should be proportional to the commitment to the regime, a currency board is as highly credible as it is hard to unwind (as for instance ‘unfixing’ a peg is relatively easier). Though this argument is often disputed (a currency board is not perfectly credible) it may be useful to note that perhaps the credibility of monetary policy in the Baltics, at the dawn of transition, was especially low even in comparison to the other now-NMS – mainly for historical and developmental reasons. Thus in the specific circumstances the currency board may have been a better way of achieving stability, low inflation and high growth than the routes chosen by other NMS.
As we are back to our speculations – with the lack of credibility, bringing down inflation may require (at least until the credibility is acquired) quite high interest rate – which, if in place, may have been an impediment to growth in the Baltics, or finally, may have caused trouble in fulfilling the interest rate criterion.

Not to forget, a fixed exchange rate requires a “money-dominant” regime – the maintenance requires a sound fiscal policy and local shocks can be taken care of only through fiscal policy. This requires a prudent stance during upturns in order to be able to accommodate the shocks when things get worse. While the Baltics maintained sound fiscal policy, avoiding a similar crisis to Argentina, even during the Russian Crisis, all the floating regime countries had relatively profligate fiscal stances – as the consequences of such could not be as dangerous to stability as in a fixed exchange regime. And as it turns out it is the persisting fiscal deficits that are the main impediment to Euro adoption in the ‘floating’ NMS.

Dejan, you mention (rightly) that inflation targeting regime enables the country to focus on domestic shocks and therefore it enables the central bank to focus on domestic supply and demand disequilibrium, which could be harmful to the economy. However true this may be, the argument has another side to it – exchange rates can be a source of shocks themselves ( Artis and Ehrmann show that this is possible even in very well established market economies, which suggest it can be of even higher importance in volatile transition countries).
As for your argument that inflation targeting is easily understood by the public and thus highly transparent – I tend to disagree. Why should the setting of the inflation target (which in the history of CEECs was quite often missed – for instance in Poland), the issue of monetary transmission and the setting of the interest rate be more transparent than tying your currency fixed to the euro? I do not think the transparency of the fixed regimes is substantially lower. Finally, Slovenia, had arguably one of the less transparent regimes of a managed float - and yet is about to join the EMU.

Thus the issue, in my opinion, is rather the insistence to execute a criteria that is flawed by construction (in this I agree with Buiters and Siberts comment in the FT 04/05/06). As the ability to develop and reform while maintaining the fixed exchange rate has proven the Baltics suitable for the EMU, this is a much more sensible benchmark than for instance a 0.07% points excess (of the MT criterion benchmark, see FT 01/05/06 ) inflation in Lithuania.

Just to sum up, by no means am I trying to argue that inflation targeting is ‘wrong’, or inferior to a currency board, as I agree with you on most of its virtues - I just claim, that perhaps it would not have helped the Baltics on their way to the euro.


Post a Comment

<< Home