Comments on “Real Convergence, Capital Flows, and Monetary Policy: Notes on the European Transition Countries,” by José Viñals
- Susan Schadler
- Published Date:
- April 2005
I very much enjoyed reading Lipschitz, Lane, and Mourmouras’s insightful and thought-provoking paper. It addresses extremely important issues for the new member states (NMS), such as how to further real convergence and deal with capital flows. The authors use both real and financial economy arguments—namely, the production function and competitive equilibrium conditions, on one hand, and financial arbitrage conditions, on the other—to argue that capital flows to NMS are bound to be very large. Moreover, they argue that, given the intrinsic volatility of capital flows, these countries are likely to become more vulnerable to capital flow reversals that could complicate the conduct of monetary and exchange rate policies and undermine macroeconomic stability.
A particular merit of the paper is that it reaches powerful conclusions with a deliberately simple conceptual apparatus. My remarks are intended to qualify, further develop, or complement what is said in the paper, mostly concerning (1) the size of capital inflows, and (2) how policy can deal with the vulnerabilities associated with potentially very large capital flows into NMS.
While one can dispute the authors’ precise estimates about the size of potential capital flows, they are indeed bound to be very large. Thus, the comments that follow should be interpreted mainly as qualifying these authors’ results from the real and financial spheres.
First, on the production function approach, the scarcity of capital and the low income per capita relative to European Union countries call for a high marginal product of capital and, thus, high real interest rates in NMS. We know from the Lucas paradox that this is not the whole story since there are other factors that may reduce a country’s marginal return on capital. The most obvious one is technological progress, but there are many others. The article condenses all these factors into one: institutional quality. This is shown to have improved substantially in acceding countries in the past few years. According to the authors, the relatively high institutional quality justifies an even higher real interest rate (a median value of 13 percent) and, thereby, very large capital inflows (between 370 percent and 600 percent of gross domestic product [GDP] before the inflows). Both are, in my view, somewhat overstated. In fact, the same estimation has been conducted for Spain by Fernández de Cordoba and Kehoe (2000), yielding capital inflows of about 86 percent of GDP before the inflows. In addition, if we take a broader definition of technological process, acceding countries are probably worse off than the paper indicates (with only the index of institutional quality). Other important factors are the development of the financial system (much lower in acceding countries than in Spain at the time of accession) and research and development. If included, these factors would reduce the estimation of capital inflows to acceding countries.
On the financial side, the paper states that uncovered interest parity would warrant very low real interest rates in acceding countries because of their trend real exchange rate appreciation on the basis of Balassa-Samuelson effects, among others. Given the relatively high—albeit rapidly decreasing—real interest rates in some of these countries, very large capital inflows are also justified on the financial front. Again, while I agree with the argument, it seems somewhat overstated since there are reasons to believe that real exchange rate appreciation will not continue on the same path it has taken until now.
Turning now to the policy implications, the key challenge for policy is to minimize the risks stemming from the volatility of capital flows and, in particular, from sudden stops or capital reversals. I agree with the authors that potentially very large capital flows—while necessary for real convergence—pose a formidable challenge for NMS regardless of the chosen monetary policy and exchange rate regime. Still, as stated in the paper, this does not render macro policy choices irrelevant. Let me therefore add three points to the rich section of the paper dealing with these issues.
First, not all capital flows carry the same risks for macro stability. As we know, those capital flows—such as foreign direct investment—that are attracted by higher real rates of return in the real economy tend, overall, to be rather more stable than financial arbitraging flows of the “hot money” type. It is thus the latter that have to be much more carefully monitored by the authorities with a view to avoiding bouts of macro and/or financial instability.
Second, policymakers’ room for maneuver to deal with the challenges posed by capital flows is limited, but it is important that policies not pave the way for sudden stops or capital flow reversals. In this respect, it is essential to avoid feeding “overborrowing episodes” like those experienced in the past by a number of emerging market economies.
A factor common in past overborrowing episodes has been an excessively expansionary fiscal policy that ultimately endangers the sustainability of public finances. While capital may flow in initially as a result of the higher interest rates caused by higher fiscal deficits—contributing also to currency appreciation—these inflows are likely to turn into outflows at some point once markets start questioning the sustainability of fiscal and external imbalances. Typically, this leads to exchange rate and economic crises. Moreover, experience also shows that when fiscal policy is excessively expansionary, well-justified attempts by monetary policy to avoid the overheating of the economy and higher inflation may prompt even higher capital inflows in the short term and strong appreciating pressures, with the risk that they will eventually also be reversed and lead to a crisis. Finally, even when fiscal policies are prudent, monetary policy in NMS should avoid the temptation to bring down official interest rates too quickly to converge toward the standard prevailing in the euro area insofar as this is not warranted by a favorable evolution of inflation. Again, experience shows that this can lead to overborrowing, overheating, and dangerous “convergence plays,” all of which may lead to a deterioration of external competitiveness, exchange rate pressures, and instability in the transition to the euro.
A particularly important issue facing NMS is what monetary-cum-exchange-rate policy to choose. Because each country should make the choice that is best suited to its needs, I do not go along with these authors in necessarily recommending a corner solution—fully fixed or fully flexible exchange rates—in the transition to the European Monetary Union. However, I do agree that the authorities should not lead agents to perceive that there is a oneway bet on foreign exchange markets. Indeed, the design of ERM II tries to encourage two-way risk on foreign exchange markets to avoid this problem.
Like macro policies, financial policies can play a valuable role during the transition by preventing capital inflows from being mismanaged through the domestic intermediation process. In particular, prudential regulation and supervision involves being alert to the possibility of credit booms developing in a context where banks underprice credit risk in their lending policies.
Third, because prevention may not be enough, the authors also rightly conclude that policy should stand ready to minimize the adverse consequences of sudden stops and capital flow reversals if and when these occur. In this regard, enhancing the resilience of the domestic financial system seems to be of critical importance given that most NMS have already more or less completely liberalized their capital accounts. Specifically, regulatory and supervisory measures aimed at reducing the degree of currency mismatch in banks’ balance sheets and at taking into account the potential risks stemming from mismatches in nonbank positions appear to be important in light of recent experience in several emerging market economies.
The Lipschitz, Lane, and Mourmouras paper provides a fine blend of theoretical and practical insights into the discussion of a most important and topical issue. It is thus a very valuable contribution to our understanding of the challenges that the NMS are likely to face in fostering both macroeconomic stability and real convergence in an environment of strong—and volatile—capital flows.
This paper draws upon Lipschitz, Lane, and Mourmouras (2002). The authors are grateful to numerous participants in seminars at the International Monetary Fund (IMF), the European Bank for Reconstruction and Development, the European Central Bank, and the Bank of England for useful comments. The views expressed should, nevertheless, be attributed solely to the authors and should not be construed as representing the institutional view of the IMF.
For the purposes of this paper, the CEE countries comprise Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia.
IMF (2003), Chapter 3, presents econometric evidence linking institutions to stronger economic performance. Grogan and Moers (2001) find that better institutions boost growth in transition economies, both directly and by raising FDI. Alfaro, Kalemli-Ozcan, and Volosovych (2003) test directly for the relevance of different explanations of the Lucas paradox. For a sample of 50 countries in the period 1970—98, these authors find that a measure of institutional weakness derived from ICRG indicators is the most important reason why capital does not flow from rich countries to poor countries.
The ICRG political risk index is produced by the Political Risk Services Group of East Syracuse, NY (http://www.prsonline.com). It measures the effectiveness of political institutions on a comparable basis. This index is based on 12 components of political risk: government stability, socioeconomic conditions, investment profile, internal conflict, external conflict, corruption in government, military in politics, religious tensions, law and order, ethnic tensions, democratic accountability, and bureaucracy quality.
The EBRD measures the CEE countries’ progress in liberalization of prices, trade, banking, finance and interest rates, competition, privatization, enterprise restructuring, governance, and infrastructure.
See IMF (2003), Box 3.2, for a fuller discussion of the role of EU accession on institutional development in the CEE accession countries.
See Halpern and Wyplosz (1996) for a discussion of the CEE countries, Obstfeld and Rogoff (1996) for a general discussion of the Balassa-Samuelson effect, and Lipschitz, Lane, and Mourmouras (2002) for a more complete discussion of these particular appreciations. Lipschitz and McDonald (1992) provide a broad discussion of real factors influencing exchange rates.
These figures are intended as illustrative and are subject to caveats regarding the limited comparability of data. For instance, in Latvia treasury bill yields are lower than other interest rates, reflecting their value to banks as collateral.
A useful reference is Schadler and others (1993), who considered the experience of six countries faced with surges of capital inflows: within the five years following the publication of this study, three of these countries had undergone major crises. The countries experiencing crises were Spain (1993), Mexico (1994–95), and Thailand (1997–98); Chile and Colombia weathered international financial crises, while in Egypt, the episode of capital inflows proved short-lived.
While our argument applies particularly to the transition countries, some of the policy implications are more broadly applicable to emerging market economies.
Price-based controls on short-term inflows are a comparatively market-friendly option, and although they may have little immediate impact on the overall volume of flows, they may alter the composition in a way that limits vulnerability (Johnston and others, 1997; Montiel and Reinhart, 1999).
If a fixed exchange rate is sustained for some time, more and more private foreign exchange positions will go unhedged, increasing the vulnerability to—and the potential cost of—a depreciation. Fear of floating arises because, in the presence of large exchange rate exposures by the government, the banks, or the corporations, a shift from a fixed to a floating exchange rate may give rise to serious balance-sheet effects and may result in substantial overshooting (see Calvo and Reinhart, 2000). It is instructive to contrast the harsh experience of the relatively fixed-exchange-rate Asian countries in the 1997–98 crisis with that of floating-rate Australia and New Zealand (see Boorman and others, 2000).
As an illustration, consider the 1997–98 Asian crisis: given sound initial fiscal positions there was substantial room for fiscal deficits to expand once it became evident that the crisis was leading to a precipitous drop in private domestic demand. But once the need for expansion was recognized, the planned expansion was still not implemented; even if it had been, it would not have been sufficient to prevent severe recessions (Lane and others, 1999).