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Did Nominal Exchange Rate Flexibility Matter During the Global Recession? a Czech and Slovak Case Study Anton Jevčák

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Did Nominal Exchange Rate Flexibility Matter During the Global Recession? a Czech and Slovak Case Study Anton Jevčák Issue 14| May 2011 Did nominal exchange rate flexibility matter during the global recession? A Czech and Slovak case study Anton Jevčák Introduction – a tale of two exchange rate regimes Summary On 8 July 2008, the ECOFIN Council decided that Slovakia would Prior to Slovakia’s entry into the join the euro area on 1 January 2009 and set the rate at which the euro area, Slovak and Czech NEER movements were highly correlated. Slovak koruna would be converted into euro. The conversion rate During the financial crisis, the Czech was set equal to the prevailing central rate of the Slovak koruna (SKK) koruna temporarily weakened against in the Exchange Rate Mechanism II (ERM II). The nominal exchange the euro, while the Slovak exchange rate against the euro was thus effectively fixed by this decision. This was rate versus euro was already de facto confirmed by subsequent market developments, with SKK trading close fixed since mid-2008. Given the to the conversion rate until the end of 2008 despite considerable global otherwise comparable economic structure and level of development financial market turbulences. Meanwhile, the Czech Republic continued of the two countries, this brief to enjoy full exchange rate flexibility. The exchange rate of the Czech analyses whether the switch in its koruna (CZK) depreciated sharply against the euro between July 2008 monetary policy regime (joining the and February 2009 and, despite a subsequent strong rebound, it euro area) had any significant impact remained weaker than its June 2008 level until the end of 2010. on how the Slovak economy coped during the recent crisis period as Graph 1: Exchange rate versus the euro compared to its Western neighbour. 90 The analysis suggests that both Index June 2008 = 100 economies continued to evolve in a 95 (inverted scale) highly similar manner. Czech real 100 exports, as well as manufacturing 105 production and employment, 110 performed somewhat better, 115 especially during the peak of the crisis. However, Slovak and Czech 120 export performance was basically 125 identical in nominal euro terms. CZK/EUR 130 Moreover, Slovakia enjoyed a more SKK/EUR 135 stable local financial market Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 situation and also benefited from Source: Reuters EcoWin looser monetary policy conditions in the euro area, which resulted in more favourable non-financial The CZK and SKK had evolved broadly in parallel between private sector credit developments. around end-2003 and mid-2008, with both currencies recording Price developments in both countries substantial nominal-effective appreciation, particularly in the second were broadly similar. A larger half of the period. As a result, the exchange rate between the two deterioration in the Slovak public currencies had remained broadly stable, oscillating around 1.25 finance situation might have been to SKK/CZK some extent driven by higher discretionary spending. ECFIN economic briefs are occasional working papers by the European Commission's Directorate-General for Economic and Financial Affairs which provide background to policy discussions. They can be downloaded from ec.europa.eu/economy_finance/publications © European Union, 2011 Reproduction is authorised provided the source is acknowledged. ECFIN Economic Brief · Issue 14 · May 2011 Graph 2: NEER and the bilateral SKK/CZK ER (NMS10)1. Both economies were highly export 170 2 dependent, with their exports exceeding 80% of CZK NEER (Jannuary 2000 = 100, lhs) 2 160 GDP, in contrast to the NMS8 average of just 48% SKK NEER (Jannuary 2000 = 100, lhs) 150 of GDP. Moreover, manufacturing accounted for SKK/CZK (rhs) 1.75 140 around 90% of exports and for some 25% of total GVA in the two countries, compared to on average 130 1.5 some 77% and 19% in the NMS8. Wage pressures 120 were also better contained than among regional 110 peers, with ULC increasing by 0.2% in Slovakia and 1.25 100 2.9% in the Czech Republic, as opposed to the 90 NMS8 average of 11.4%. The labour market 80 1 performance was, nevertheless, clearly inferior in 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Slovakia with the unemployment rate at above 11%, Source: Reuters EcoWin compared to 5.3% in the Czech Republic and on average 6.3% in the NMS8. This was despite the fact Trend nominal appreciation had been that GDP growth in Slovakia exceeded 10%, while it accommodated in the context of both countries' attained just 6% in the Czech Republic and 7% in the inflation targeting frameworks. The Czech NMS8. Republic and Slovakia both abandoned their currency peg arrangements in 1998. The Czech Graph 3: Real convergence in 2007 100 12 Republic has since then operated a floating exchange CZ SK NMS8 90 rate regime within an explicit inflation targeting 80 10 framework. The Czech National Bank has abstained 70 8 60 from currency interventions (since early 2000s), 50 6 40 though the instrument remains available in principle. 4 30 Slovakia had initially operated a managed floating 20 2 regime, using verbal and open market interventions 10 to reduce excessive volatility and to offset exchange 0 0 rate pressures that were deemed inconsistent with Exports of (rhs) (rhs) Share of ULC growth (rhs)rate economic fundamentals. At the end of 2004, Slovakia GDP growth in total GVA total in Export share manufacturing Unemployment switched from implicit to explicit inflation targeting. GDP percapita manufacturing in PPS, % in % of in % The Slovak koruna entered ERM II on 28 November of EU27 GDP 2005 with an initial central parity at 38.455 Source: Eurostat, Ameco SKK/EUR, and a standard fluctuation band of ±15%. In order to accommodate ongoing Both countries also exhibited a considerable improvements in underlying fundamentals the central level of nominal convergence before Slovakia's parity of the koruna was revalued by 7.8% to 35.4424 entry into the euro area was confirmed, while SKK/EUR, with effect from 19 March 2007 and by macro-financial imbalances were limited in 15% to 30.1260 SKK/EUR, with effect from 29 May comparison with regional peers. In 2007, annual 2008. HICP inflation reached less than 3% in both countries and was thus significantly below the NMS8 The Czech and Slovak economies in 2007 average of some 6%. Long-term government yields – a snapshot of 4.3% in the Czech Republic and 4.5% in Slovakia were the lowest among the NMS10 in 2007. A stylised look at the Czech and Slovak Moreover, the share of FX denominated credit at economies at the time of the Slovak euro-entry some 10% in the Czech Republic and 20% in decision shows many common characteristics. In Slovakia was also well below the NMS8 average of 2007, GDP per capita in Purchasing Power 47%. At the same time, although gross government Standards (PPS) reached 80% of EU27 average in the Czech Republic and 68% in Slovakia, which was the 1 Bulgaria, the Czech Republic, Estonia, Latvia, Lithuania, second and the fourth highest level among new EU Hungary, Poland, Romania, Slovakia, Slovenia. Member States from Central and Eastern Europe 2 Non-weighted average, NMS8 = NMS10 excluding the Czech Republic and Slovakia 2 ECFIN Economic Brief · Issue 14 · May 2011 debt of close to 30% of GDP in both countries fixed exchange rate vis-à-vis the euro since mid-2008 somewhat exceeded the NMS8 average of 25% of and euro-area membership since January 2009, while GDP, net foreign liabilities totalled 32% of GDP in the Czech Republic continued to operate a floating the Czech Republic and 46% of GDP in Slovakia, far exchange rate regime within its independent below the NMS8 average of 76% of GDP. This was monetary policy framework. The fact that, after mainly thanks to more sustainable current account having recorded a similar NEER evolution for deficits, which amounted to some 2.5% of GDP in almost a decade, these two broadly comparable and the Czech Republic and 5% of GDP in Slovakia in highly open economies entered the peak of the crisis 2007, compared to the NMS8 average of 13% of with different exchange rate regimes seems to GDP. Finally, general government deficits declined provide a unique empirical test on how much leeway to less than 2% of GDP in both countries in 2007. exchange rate flexibility and an independent Graph 4: Nominal convergence in 2007 monetary policy (as compared to a fixed exchange 14 80 rate/euro-area membership) can offer to a small CZ SK NMS8 open economy hit by a severe negative external 70 12 demand shock, and how this weighs against the risk 60 10 50 of excess financial market volatility. 8 40 Notwithstanding the broad similarities, some 6 30 structural differences between the two 4 20 economies also need to be taken into account, 2 10 suggesting that a degree of divergence in 0 0 economic developments during the crisis period LT IR would likely have occurred even if the two deficit Current (rhs) account liabilities GG gross GG deficit (rhs)debt Net foreign Net countries had operated under the same monetary credit (rhs) credit denominated HICP inflation HICP Share of FX- in % in % of GDP policy framework. For example, the largest manufacturing sector in both countries, production Source: Ameco, National Central Banks, IFS (IMF) of transport equipment (automotive industry), Czech and Slovak exchange rate accounted for around 22% of manufacturing output in Slovakia in 2007, compared to some 17% in the strategies during the crisis – a natural Czech Republic. Moreover, demand for various types experiment of cars produced in the two countries might have Given the large number of similarities, it appears evolved differently during the crisis.
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