Reforming the International Monetary and Financial System

Comments: Lessons from the Czech Experience

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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The Czech Republic’s recent history of economic transition is sure to attract attention from any researcher interested in the topic of boom-bust patterns of capital flows. The mid-1990s was a period of massive capital inflows into the country. Net capital inflow as a share of GDP reached 8.5 percent in 1994 and peaked at a record level of 16.6 percent one year later. During this same period official external reserves increased from almost zero at the beginning of 1993 (after the breakup of Czechoslovakia) to $14 billion at the end of 1995. The share of net foreign assets as a component of the change in the money supply almost doubled from 45 percent in 1993 to 80 percent in the last quarter of 1995. In the first quarter of 1997 the Czech economy was exposed to a new wave of capital inflow in the form of Eurobond issues valued at an astonishing $1.7 billion. The exchange rate reacted with a sharp appreciation, just as the current account deficit was widening sharply.

In May 1997, the Czech currency came under attack from severe exchange rate speculation. As a result, the monetary authorities gave up supporting the koruna’s currency band and let the exchange rate float. The central bank interest rate climbed in just two weeks from 12.5 percent to 86 percent. The volume of foreign exchange reserves spent in direct interventions was approximately 20 percent of the preattack value. Commercial banks were also hit by a massive liquidity squeeze.

The government launched two austerity packages that imposed budget cuts of as much as 2.7 percent of GDP and a wage freeze in the public sector. Economic instability was quickly followed by political instability. The economy was effectively pushed into recession, with a 4.1 percent decline in output in the last quarter of 1998.

Causes of Monetary Instability

The Czech National Bank maintains a fairly straightforward argument for the currency turbulence in the country—the primary cause was that macroeconomic imbalances were underestimated. The positive macroeconomic results in 1993-95 deflected the critics of the economic transformation who pointed out that several institutional and structural problems existed, namely, the losses incurred as a result of the crisis of small banks, failed attempts at health care reform, cases of embezzlement of investment funds, slow restructuring, and several unsuccessful privatization projects.

The need to have a ready and convincing defense against critics of the transformation caused the government not to accept the signs of the economy’s overheating and of a loosening of macroeconomic discipline, which were evident from the following:

  • The gap between growth in labor productivity and growth in real wages widened with an obvious link between increased wages and an increasing demand for consumer imports.
  • Unlike a previous trend toward a balanced budget position, the system of public budgets was beginning to slide into permanent deficits.
  • The key issue was a widening current account deficit that, at the beginning of 1997, was one of the largest among emerging economies.

The size of the external imbalance proved to be a major economic problem. The Czech economy was suddenly seen as being vulnerable to potential turbulence. The situation called for a prompt, preemptive, and coordinated reaction in economic policies. Instead, contrary to what would have been corrective action, the government launched a neo-Keynesian program, blaming the deceleration of growth on monetary tightening. A correct analysis would have identified the root problem as being an unsustainable aggregate demand overhang, which called for some reining in, even at the cost of short-term growth deceleration. Consequently, the first stabilization package was seen as too little, too late. The Czech currency was exposed to speculative attack and the Czech economy was forced to withstand harsh austerity measures.

What is the lesson to be learned from this experience? It is that the growth during the transition period made the economy highly vulnerable and exposed it to the risks of unsustainable current account deficits. Usually an austerity package is needed to regain the confidence of foreign capital. Austerity packages also bring declining output, growing unemployment, and almost inevitable political crisis. With all the priority placed on economic growth, it is costly to risk any further violation of sound macroeconomic behavior.

Difficult Policy Choices Given Excess Capital Flows

Large capital flows, both into or out of a country, present serious policy dilemmas and trouble policymakers all over the world. The Czech experience was no exception. But there are no obvious solutions, however, and all methods of defense suffer a number of drawbacks.

Monetary Policy. With large capital flows, monetary policy becomes, to a large extent, ineffective. Monetary tightening, undertaken with the aim of cooling aggregate demand, pushes up interest rates, and this usually aggravates the problems with subsequent exchange rate appreciation and current account deficits. The sterilized interventions are costly for the central bank’s balance sheet, and the outstanding central bank debt then becomes a ready liquidity in the banking system, which could cripple future monetary policy.

Fiscal Spending Restraint. This generally recommended strategy for handling excess aggregate demand has a major limitation in that the effective level of fiscal restraint usually goes beyond what is politically tolerable. For example, in order to accommodate a 10 percent capital inflow in terms of GDP, fiscal expenditure cuts of about 33 percent would be required in the Czech Republic. Moreover, the budget has its mandatory outlays that can be changed only by law. Cuts are mostly made in investment expenditures, which worsens the outlook for future growth opportunities.

Incomes Policies. Wage controls in the private sector are mostly ineffective but the government can freeze salaries in the public sector. Measures like these are only possible for a relatively short period of time, however.

Impediments to Short-Term Capital Movements (or “Throwing Sand into the Wheels of Capital Flows”). In the aftermath of the Asian crisis, it appears that the international financial community is less reluctant about impeding capital mobility, influenced in part by Chile and its experience with deposit requirements. The Czech experience, however, is not as encouraging. To give an example, while capital was flowing in, regulatory measures were applied to the open, short-term positions of nonresidents. And when speculators were on the move, the Czech National Bank tried to have the offshore market administratively separated from the domestic banking system. In both cases, however, the effect of regulation proved to be minimal, as the markets were quick to find other channels of escape.

Separation of Short-Term from Long-Term Capital. One possible approach to the problem may be to ascertain which part of the capital flows can be defined as “hot money” and to let it flow in and out even at the risk of considerable fluctuations. But as a rule, during a financial panic all capital is short-term capital. Moreover, the distinction between short-term and long-term capital is difficult to make on liquid financial markets.

Knife-Edge Equilibrium. This particular approach subsumes the diverse ways of introducing exchange rate risk so as to offset the effect of the interestrate differential. For instance, a current account deficit could be allowed to moderately exceed a safe level, but the problem is that the perception of what is a safe level may quite easily vary. That would mean resorting to a rather perverse tool of economic policy, if only because it would repel both the undesirable and desirable components of capital inflow.

If, for any reason, currency turbulence does occur and the problem of large capital inflow is replaced by the problem of fast capital outflow, the art of keeping this kind of emergency under control takes on vital importance. In deriving the lesson from the monetary crisis in the Czech Republic, one should stress the following: the first step should be to prevent a downward overshoot of the exchange rate. The real chances of successful direct interventions without running out of all foreign exchange reserves should be assessed and if necessary, a central bank should not hesitate to raise interest rates sharply. The immediate second step should then be to draft and declare a rescue program that foreign investors will find credible.

Steps at the Systemic Level

The Czech Republic belongs to a group of small, open economies that have achieved substantial liberalization in both the current and financial accounts of the balance of payments, and have been experiencing a continuous loss in the autonomy of domestic policies. They are, therefore, interested in the progress of all initiatives aimed at strengthening the international financial architecture. At the same time, the Czech Republic also belongs to a group of Central European countries that have started the process of negotiations for accession to the European Union (EU). This fact has profound implications for a systemic response to large capital flows.

First, the objective of joining the EU substantially takes away the choice of using capital controls. The commitment to get rid of existing controls must be honored in the preaccession period. After all, the candidate countries are aiming to join a community that considers a high degree of capital mobility a natural feature of its institutional setup. The candidate countries have to adapt to these rules as well as manifest sincere intentions of proceeding toward policy convergence.

Second, after EU accession, new members are granted a temporary exception regarding the introduction of the euro, but their macroeconomic policies must still be aligned with the goal of meeting the Maastricht convergence criteria in the medium term. In other words, macroeconomic policies must show a high degree of discipline in terms of inflation, interest rates, and general budget and exchange rate behavior. In such an environment, much less room is given to tackling destabilizing capital movements.

The most important systemic change will take place when the candidate countries adopt the euro. By entering the euro area the economy is set free from the macroeconomic balance of payments constraint. This constraint will disappear into a series of financial constraints on the microeconomic level. The exchange rate will be lost as an adjustment mechanism, but this systemic change should not be seen as a true loss for autonomous policymaking. In a small, open economy with liberalized capital flows, exchange rate behavior is hardly determined by the view of a desired current account position, and adjustment through the exchange rate tends to bring about substantial stress and mismatch with the underlying fundamentals.

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