American Economic Association

Economic Transition and the Exchange-Rate Regime Author(s): Jeffrey D. Sachs Reviewed work(s): Source: The American Economic Review, Vol. 86, No. 2, Papers and Proceedings of the Hundredth and Eighth Annual Meeting of the American Economic Association San Francisco, CA, January 5-7, 1996 (May, 1996), pp. 147-152 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2118113 . Accessed: 27/01/2012 16:54

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http://www.jstor.org EXCHANGE-RATEREGIMES AND MACROECONOMICSTABILITYt

Economic Transitionand the Exchange-Rate Regime

By JEFFREYD. SACHS*

Exchange-ratemanagement poses special initialpolicy, even if the countriesshould then challengesin thetransition economies of Eastern move to flexible-ratesystems after one or two Europeand the formerSoviet Union. These yearsof stabilizationand liberalization. countriesare adapting to open,market-based in- Most of the transitioneconomies began the temationaltrade without prior experience with shift to marketswith a commonset of struc- currencyconvertibility. Most are undertaking turalimbalances: repressed , marked stabilizationprograms to end high inflation. by extreme shortagesin consumerand pro- Therefore,monetary and exchange-ratepolicy ducermarkets; large fiscal deficits, including mustbe designedwith an eye towardcurrency an overhang of foreign debt; extreme cur- stabilization.They are undergoingenormous rencyinconvertibility, including a largeblack- structuralchange, with very large movements in marketpremium on the ; low relativeprices and productivity,so thatindica- levels of domesticcompetitiveness; and weak torsof a country'sinternational competitiveness tradeand financial linkages with marketecon- (e.g., relativeunit labor costs, relativeproducer omies, includingWestern Europe. In Central prices)provide a very impreciseguide for pol- Europe,Czechoslovakia stood out as the sole icy. Likemany other countries in thedeveloping case of a countrythat began the reformperiod world,these countries are experiencing large in- withoutextreme prior macroeconomicinsta- flows and outflowsof capitaland are therefore bility. The financialproblems of the former increasinglysubject to shocksemanating from Soviet Union andthe formerYugoslavia were worldcapital markets. greatlycompounded by the suddenemergence In this maelstrom,are there guidelinesfor of new nationstates withoutseparate curren- the appropriatemanagement of the exchange- cies and, thereby,with multiplecentral banks rateregime? What kinds of numericalindica- ostensiblysharing a commoncurrency, with- torsshould be uppermostin the policymaker's out overallcoordination or control. attention?What advice and assistanceshould The first stage of the marketreforms in al- be given by the internationalfinancial com- most all transitioncountries was the liberal- munity,and most importantly,the IMF? izationof prices,the unificationof the official exchangerate and the marketexchange rate, I. EarlyExchange-Rate Management and the opening of the economy to interna- tionaltrade. In Poland,this was combinedwith Exchange-ratemanagement is one of the strongfiscal and monetarymeasures, so that areasof reformwhere optimal transitional pol- inflationvery quickly subsided,falling from icies may well differfrom long-rangeoperat- 586 percentin 1990 to 70 percentin 1991 and ing policies. For example, there are good 43 percentin 1992. In some othercountries in reasonsfor countriesat the startof stabiliza- EasternEurope, notably Bulgaria and Roma- tion and liberalizationprograms to adopt a nia, monetaryand fiscal policies remained lax, pegged exchange-rate regime as part of the and triple-digitinflation persisted for several years. In Hungary,moderate inflation rates (20-40 percentper year) persisted throughout the early 1990's. In the successorstates of the t Discussants: Michael Bruno, World Bank; Stanley Fischer, InternationalMonetary Fund. Soviet Union, high inflationwas pandemic, * HarvardInstitute for InternationalDevelopment, One reaching triple- or quadruple-digitrates in Eliot Street, Cambridge, MA 02138. 1992 in every one of the 15 new nations. 147 148 AEA PAPERS AND PROCEEDINGS MAY 1996

The practical issue facing governments and bank financing of the Russian budget deficit. central banks was the appropriate manage- Russia and the other successor states were able ment of the exchange rate after price liberal- to achieve stabilization only when they be- ization, both in the immediate aftermath and came masters of their own monetary fate (i.e., in the longer term. This choice, of course, was only when they adopted a separate national partof a larger set of choices involving the role not used by other countries). In Rus- of the central bank, the implementation of sia, full monetary independence from the other monetary reforms (in the new nations), the states effectively began in the fall of 1993, scale of fiscal deficits, and their mode of when Soviet currency notes were withdrawn financing. Four countries relied initially on from circulation in Russia, and republics that pegged exchange rates: Czechoslovakia, Es- still lacked their own currency finally moved tonia, Hungary, and Poland. Four others relied to establish new national . on floating exchange rates: Kygyzstan, Latvia, Poland established a patternfor other reform Russia, and Ukraine. By 1994, all but Russia countries with its rapid introduction of con- and Ukraine had succeeded in ending high in- vertibility on January 1, 1990. Ten Western flation, and in carrying out other main aspects governments joined to provide a $1 billion of reform.' zloty stabilization fund to provide reserves to Even before reaching the decision over defend the newly convertible currency. The exchange-rate regime, the successor states to zloty was devalued sharply, unified with the the Soviet Union had to take decisions regard- black-market rate, and then pegged vis-a-vis ing a national currency. In this, the IMF made the dollar. Inflation spiked in the month of a serious mistake in early 1992, in pushing price liberalization, to 100 percent in January, hard for the continuation of a common cur- and then fell to 20 percent in February, and 5 rency for the successor states, despite the ex- percent in March. The nominal exchange-rate istence of 15 separate central banks and little peg held successfully, without resort to the sta- feasibility of monetary coordination among bilization fund, and was maintained until a de- the separate central banks (see Sachs [1995a] valuation in April 1991. Poland adopted a for further discussion). In the spring of 1992, crawling peg in October 1991 and then a the IMF advised all countries that introduction crawling band in July 1995. Czechoslovakia of separate national currencies should be de- followed the Polish example one year later, layed for months (until the fall of 1992 at the when it devalued the koruna, established lim- earliest, in the case of advice to Estonia) or ited convertibility, and pegged the exchange indefinitely. This naive advice set back stabi- rate in January 1991. Hungary eschewed a lization by at least one year in most of the for- one-time step to convertibility but achieved mer Soviet Union, since the common currency substantial convertibility on the trade account effectively gave a license to issue credits to in 1990 and, thereafter, pegged the exchange each of the central banks. The Russian gov- rate, with occasional . ernment continued to accept the ruble credits Under IMF advice, other Eastern European issued by the non-Russian central banks in economies established quick convertibility, payment for imports from Russia and, in the but the IMF urged the other countries to move end, effectively supplied up to 7 percent of directly to a floating rate. Bulgaria and Ro- Russian GDP to the other republics in net ship- mania floated their exchange rates beginning ments financed by credits in the period April- in 1990. A similar pattern played out in the December 1992. This 7 percent of GDP former Soviet Union, once the Soviet ruble showed up in the Russian money supply and was dropped in favor of a national currency. provided a financial impetus to inflation of One country, Estonia, adopted a pegged about the same magnitude as did the central- exchange rate, counter to the initial advice of the IMF (though the IMF agreed to support the Estonian position). All other countries of ' A table summarizing the decisions taken for a repre- the former Soviet Union, under IMF tutelage, sentative selection of eight countries throughoutthe region moved directly to floating-exchange-rate re- is available from the author upon request. gimes. In early 1994, two of the initial floaters, VOL 86 NO. 2 EXCHANGE-RATEREGIMES AND MACROECONOMICSTABILITY 149

Latvia and Lithuania, adopted a pegged rateis usefulin the earlyphase of stabilization exchange rate and currency-boardarrange- fromhigh inflation. While it is difficultto control mentin emulationof Estonia. for all relevantmacroeconomic factors in these Extensivetheoretical and empirical analysis countries, it appearsthat the early peggers gives three main reasons for preferring a (CzechRepublic, Estonia, Hungary, Poland, and pegged exchangerate at the outset of ending Slovakia) outperformedthe floaters,both in high inflation (see Michael Bruno, 1995; termsof the successof disinflationand the costs Sachs, 1995b,c). First, the pegged rate bol- of disinflation.Many floaters, such as Russiaand sters the government's commitment to the Ukraine,were still miredin triple-digitannual stabilization effort, by establishing clear, inflationrates as late as 1995, while Romania monitorabletargets, and by tying the govern- only reducedinflation to double-digitrates in ment'sown hands.Second, the exchange-rate 1994, andBulgaria in 1995.The earlypeggers peg helps price- and wage-setterscoordinate all achievedinflation below 100percent per year their actions and expectationsaround a new by 1994.The reformhistories of the individual low-inflationequilibrium. Third, the pegged- countriessuggest that successful early pegging exchange-ratesystem provides a convenient of the exchangerate in the Czech Republic, way for householdsand enterprisesto rebuild Estonia,and Poland not only supportedmacro- theirreal money balancesafter a bout of high economic stability,but actuallybolstered the inflation.At the start of stabilization,eco- capacityof thegovernments to makeprogress in nomicagents find themselvesdesiring to hold otherareas of reform,in comparisonwith other higher real money balances. Under pegged countriessuch as Russiawhere failures of mac- exchangerates, these desires are satisfiedau- roeconomicstabilization undermined reform ef- tomaticallythrough the balanceof payments, fortsin nonmonetaryaspects of the economy. as agentsrepatriate their offshorecapital and Even where stabilization under floating convertit into domesticcurrency. The central rates was achieved, the costs seem to be bank is committedto purchasingthe repatri- higherthan in the pegged-exchange-ratesta- atedcapital in returnfor domesticmoney. Un- bilizations.A particularlyinteresting case is der a floating-rateregime, by contrast,there is provided by two neighboringBaltic states, no automaticmechanism for householdsto re- Estoniaand Latvia.Estonia stabilized with a buildtheir real moneybalances, since the cen- peggedexchange rate, under a currency-board tralbank is not obligedto purchaserepatriated arrangement,while Latvia initially relied on capitalin returnfor domesticmoney (and in a a . Both countries in purefloat, it will not do this). fact succeeded in ending high inflation,but In principle,the centralbank could support Latvia experienceda much deeper and pro- remonetizationof the bankingsystem by ex- longed recession.At the same time, Latvia's pandingdomestic credit in line with risingde- realinterest rates remained much higher, with mand for real money balances, but such an less remonetizationof the economy, and less action is extremelyhard to carry out, since confidence in the stability of the currency. domesticcredit expansionby itself may un- Accordingto the EuropeanBank for Recon- derminethe credibilityof the stabilizationpro- structionand Development (1995 p. 185), gram.Therefore, many centralbanks refrain Estonia's year-over-yearGDP changes for fromdomestic credit expansion, and the econ- 1993, 1994, and 1995, were: -7, 6, and 6, re- omy remainsundermonetized, suffering from spectively.Latvia's GDP changes for the same excessively high real interest rates and an years were -15, 2, and 1. Perhapsthe proof overvaluedcurrency. The result is that suc- of the puddingis in the eating:Latvia adopted cessful anti-inflationprograms under floating a pegged-rateregime in early 1994. (For a ratestend to be morecontractionary than those more extensive comparisonof the monetary carriedout underpegged exchangerates, and experiences of the Baltic States, see Ardo many attemptsat stabilizationunder flexible Hanssonand Sachs [1994]). ratessimply fail. Kyrgyzstanprovides another example of the The experienceof the transitioneconomies weaknessesof floating-ratestabilization from supportsthe diagnosisthat a peggedexchange high inflation. This Central Asian republic 150 AEA PAPERS AND PROCEEDINGS MAY 1996 introduced a new national currency, the som, usefulness and turn into a danger for the in May 1993, replacing the shared ruble cur- economy. The 1994 Mexican peso crisis is rency, which at that point was depreciating a stark reminder of this proposition. The vis-a-vis the dollar at around 20-30 percent Mexican governmentsuccessfully used the per month. The economy was deeply demon- pegged rate to end high inflationin the late etized at the outset of the new currency, with 1980's but then became attached to the the ratio of M2 to GDP around4 percent. This pegged rate as a measure of the govern- was a clear case where remonetization was ment's overall monetarycredibility during needed as part of the stabilization program. the 1990's. When a devaluationwas called The IMF insisted upon a floating-rate regime, for in early 1994, it demurredand eventually however, and upon domestic credit targets too experienceda loss of foreign reserves and a low to supportremonetization (under the IMF balance-of-paymentscrisis at the end of the program, the M2/GDP ratio was actually tar- year (see Sachs et al., 1996). Successful geted to decline further). The high inflation stabilizers, in most cases, began with a was in fact ended, but with a huge drop in real pegged rate and then addedflexibility to the GDP, which fell by 16 percent in 1993 and 27 exchange-rateregime over time, as in the percent in 1994. case of Chile, Israel, and Poland. The reluctance of the IMF to advise in favor There are limited circumstancesin which of pegged rates at the outset of stabilization a "permanent"pegged rate is appropriate. from high inflation seems to be the result of The first is for very small open economies the institution's reluctance to support the in- with a high degree of wage-price flexibility, ternational provision of stabilization funds to in which nominal magnitudes can adjust countries that lack adequate foreign reserves readily to exogenous shocks. Hong Kong is to defend a pegged rate. In principle, a pegged the best case of a successful sustained rate can be defended even without initial re- pegged rateunder a currency-boardarrange- serves, if fundamentalmonetary and fiscal pol- ment. The Baltic states are also plausible icies are in order, although a pegged rate candidatesfor this kind of monetaryarrange- unbacked by reserves is vulnerable to self- ment. The second case is a true monetary fulfilling speculative attacks. The -loty stabi- union, where two or more economies con- lization fund showed how the mere existence stituting an optimal currencyarea adopt an of reserve backing can strengthen the public's irrevocable peg under a single currency, confidence in the currency, without the need with a single issuer. A thirdcase, debatably, to draw upon the fund. Nonetheless, in all is a countrylike Argentina,which over the other transition countries, the IMF has refused course of decades proves incapableof man- to support the implementation of a stabiliza- aging a discretionarymonetary system with tion fund at the outset of a stabilization pro- low inflation and, thereby, adopts a mone- gram. In late 1995, the IMF formally approved tary "straitjacket"in the form of a currency the possible future use of stabilization funds board and an irrevocably fixed exchange in IMF programs, but in practice it continued rate.Argentina's own monetaryand banking to inform countries (e.g., Ukraine) that such crisis in 1995, in the wake of the Mex- funds could be arranged only after inflation ican crisis, clearly shows the costs of such a had been brought under control for several policy, even if those costs may be out- months. weighedby the benefitsof extrememonetary discipline. II. Long-TermExchange-Rate Policies In the case of the transitioneconomies, there is a strongcase for movingto a more flexible One of the greatest practical challenges of exchange-ratearrangement once high infla- exchange-rate policy is to recognize that a tion has been eliminatedand the economyhas policy regime appropriate for ending high been substantiallyremonetized. The transition inflation may well be inappropriate for long- economiesstill sufferfrom chronicstructural run economic management. In particular, a weaknessesthat limit the flexibilityof the do- pegged exchange rate can easily overlast its mestic economy.These weaknessesinclude a VOL. 86 NO. 2 EXCHANGE-RATEREGIMES AND MACROECONOMICSTABILITY 151 high degree of state ownership;wage-setting nominal exchange-ratetarget (e.g., for the in state-ownedenterprises strongly influenced centralparity of a crawlingband) from the by insiders; various inherited rigidities in point of view of long-terminternational com- wage-setting,such as stronglegal or informal petitiveness.All of the transitioneconomies normsconcerning relative wages across sec- beganwith tradablesectors with verylow pro- torsof the economy;moderate rather than high ductivity and deep organizationaldisarray. opennessto internationalmarkets; and chronic Wagelevels in dollarterms were consequently fiscal problems,including very high rates of very low. In the past five years, productivity taxation, resulting from the hypertrophied has begunto rise sharplyin the leadingreform state sectorand inheritedhigh levels of inter- economies,as has theirexport capacity. Dollar nationalindebtedness in somecountries. There wages, as a result,have begunto rise sharply are two main implicationsof these debilities. in severalcountries. The policy challengelies First,monetary and fiscal policies arelikely to in distinguishingbetween dollar-wage in- remaintoo expansionaryin the next few years creasesjustified by risingtradables productiv- to underpina permanentlypegged rate. Sec- ity, and dollar-wageincreases that result from ond, the domesticeconomy is unlikelyto pos- internalinflationary pressures. sess the high degree of flexibility needed to The policy of simplymaintaining the nom- absorb adverse shocks under a permanent inal exchangerate unchanged is likely to pro- pegged-ratesystem. voke growingovervaluation of the currency. This suggests a monetary-policyregime in This might alreadybe evidentin 1995 in the whichthe exchangerate is mademore flexible Czech Republic,where dollar wages have in- (e.g., in a crawlingband ratherthan a rigid creasedrapidly and export growth has slowed. peg), and in which price stability is under- A pure float, combinedwith tight monetary pinned by strengtheneddomestic , on the otherhand, could well lead to targetsand institutions.Chile providesan il- currency overvaluation in the short term. A lustration. Chile's exchange rate is kept crawlingband, therefore, may avoid the dan- withina crawlingband, where the centralpar- gers of currency overvaluationposed both ity of the band is adjustedmonthly in line by pegged and purelyfloating exchange-rate with the differencein inflationbetween Chile regimes. andits maintrading partners. Domestic infla- As in manycases of stabilizationand trade tion targets are achieved through domestic liberalization,the leading reformeconomies monetary-policyinstruments, undergirded by in Eastern Europe are currently subject to a governmentbudget surplus and an indepen- rapidcapital inflows that could well subside dent centralbank. in the next few years.The capitalinflows are No transitioneconomy in EasternEurope or anothersource of pressurestoward currency theformer Soviet Union has explicitlyadopted appreciation.There is still no consensus on such a policy assignment,though Poland of- the appropriatepolicy response to sharp fers an importantexample of a countrymoving increasesin short-termcapital inflows. Caution in thatdirection. Poland began its stabilization in the transitioneconomies in removingre- programwith a pegged exchangerate in Jan- mainingbarriers to short-termcapital mobility uary 1990. After one devaluationunder the seems to be called for, especiallywith regard pegged-ratearrangement in April 1991, it to short-terminternational borrowing by do- adopteda crawlingpeg in October 1991. In mesticcommercial banks. The recentfinancial May 1995, it adopteda widenedband for the crises in Argentina,Mexico, and Venezuela crawl.It has also establishedcentral-bank in- demonstratethat undercapitalizedbanking dependenceand has workedtoward strength- sectors may exacerbatemacroeconomic in- ening underlyingfiscal policies, though like stabilitiesby engaging in large-scaleforeign most of the countriesin the region,it remains borrowingat the time of capital-marketlib- burdenedby a chronicfiscal deficit. eralization(see Sachs [1995c] for a discus- The hardestpractical problem in exchange- sion of capital controls and the risks of rate managementunder such a policy assign- bankingcrises accompanyingcapital-market ment is to judge the appropriatenessof the liberalization). 152 AEA PAPERS AND PROCEEDINGS MAY 1996

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