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Title: Economic policy under exogenous shocks: EMU and future prospects for CEE accession countries by Katerina Kalcheva


1
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

2
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)

3
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
Research Agenda
4
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
  • 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

5
Maastricht criteria in CEEE
Criterion Inflation Interest FX rate Deficit Debt
Reference value 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
Romania 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
Source Deutsche Bank Research (2002, p.27)
6
Volatility
Source Coricelli (2002)
7
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

8
Source Coricelli (2002)
9
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

10
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)
  • Real shock will lead to more variability in the
    output at fixed exchange rate
  • 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

11
Theoretical review (contd)
  • 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

12
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.

13
Why shocks are important for CEEC? (contd)
  • 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

14
Current accounts (as of GDP)

Source The Economist intelligence country data
2002
15
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

16
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?

17
  • 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),
    ExportImport/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

18
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
    exportimport / GDP (TOT).
  • Two lagged model using data from 19941 to 20014
  • Source IFS and DataStream

19
  • 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
  • Choleski Decomposition of the variance
  • E?Tt2? bTR,j2E?Mt2 ? bTR,j2E?Rt2
    E?Tt

20
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)

21
CEEC current economic situation 2000-2001
Source Coricelli (2002)
22
CURRENCY BOARDS Exchange rate versus Euro (100
01/93)
23
PEGS Exchange rate versus Euro (100 01/93)
24
CRAWLING PEGS Exchange rate versus Euro (100
01/93)
25
MANAGED FLOATS Exchange rate versus Euro (100
01/93)
26
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

27
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.

28
  • 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 lt 15.

    Problem risk of excessive
    volatility, speculative attacks, collapse of
    band, misalignment.

29
  • 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
    Balassa-Samuelson. Could require unnecessary
    recession for 1 year.
  • Target zone with margins lt 15.

    Problem risk of excessive
    volatility, speculative attacks, collapse of
    band, misalignment.

30
Figure 4 Impulse responses
31
  • 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

32
Figure 5 Variance decompositions
33
  • 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.
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