EXCHANGE-RATE REGIME AND RESPONSE TO THE CRISIS IN THE EU NEW MEMBER STATES KALIN HRISTOV

1. EXCHANGE-RATE REGIME AND RESPONSE TO THE CRISIS IN THE EU NEW MEMBER STATES KALIN HRISTOV

2. OUTLINE • CONVENTIONAL VIEW ON EXCHANGE RATE REGIMES AND COMPETITIVENESS • DEVELOPMENTS IN PRICE BASED MEASURES OF COMPETITIVENESS – ULC, REER • VALIDITY OF CONVENTIONAL VIEW IN PRACTICE • EXPERIENCE DURING THE RECENT CRISIS – EXCHANGE RATE DEVELOPMENTS, EXPORT PERFORMANCE, GROWTH AND INFLATION

3. CONVENTIONAL VIEW EXCHANGE RATE AND COMPETITIVENESS • There is a conventional view that exchange rate flexibility allows a conduct of a countercyclical monetary policy and provides short term competitive advantage. This view is based on a number of assumptions: • Law of one price holds • Exchange rate pass-through (ERPT) is low • No balance sheet (BS) effects ( no borrowing and saving in foreign currency) • Low bargaining power of the labor unions • Marshall-Lerner condition holds • No “fear of floating” or “fear of losing international reserves”

4. DEVELOPMENTS IN COMPETITIVENESS– ULC • EU NMS experience a process of deepening trade and financial integration and rapid nominal and real convergence. This is reflected in ULC and REER developments • The dynamics of ULC in the EU NMS shows two common trends: • the nominal convergence with EU 15 is related to an increase in prices and wages which is reflected in a steady increase in nominal ULC before the crisis • competitiveness is however maintained which is reflected in the relatively stable real ULC for the majority of the countries

8. DEVELOPMENTS IN COMPETITIVENESS – REER • The dynamics of the real effective exchange rate based on nominal ULC shows trend of gradual increase during the last ten years in all EU new member countries which is due to the process of nominal and real convergence • The appreciation reflects productivity gains in these countries • Reflecting predominantly equilibrium trend appreciation the rise in REER does not erode competitiveness

11. VALIDITY OF CONVENTIONAL VIEW IN PRACTICE • The assumptions of the traditional view are rarely met in practice: • EU NMS are small open economies with free capital mobility and trade • Their recent development has been influenced by large capital inflows • High level of euroisation (credit, deposits) which implies big balance sheet effects • NMS’ exporters have low international pricing power • The impacts of the ERPT, BS effects, labor unions and Marshall-Lerner condition vary across EU NMS • Hence, competitiveness implications of ER regime are not straightforward (contrary to the traditional view)

12. EXPERIENCE DURING THE RECENT CRISIS – EXCHANGE RATE DEVELOPMENTS • Is the view of a higher vulnerability of the fixed exchange rate regime supported by the latest empirical data? • Do countries with flexible exchange rate which potentially can allow depreciation of their exchange rate have better export performance during the current crisis? • Is the division between countries with fixed and flexible exchange rate regime relevant during the current crisis?

13. EXPERIENCE DURING THE RECENT CRISIS – REAL ACTIVITY AND EXPORT PERFORMANCE • GDP and unemployment developments as well as export dynamics in euro follow similar patterns across countries (although magnitudes vary) • The exchange rate regime (fixed or flexible) not a dividing characteristic • Trade is shrinking in all countries (having fixed or flexible exchange rate) because of the common shock – decrease of the volume of the world trade

15. GDP GROWTH RATES

16. FISCAL POSITION

17. CURRENT ACCOUNT

22. EXCHANGE RATE FLEXIBILITY AND COMPETITIVENESS – RECENT EXPERIENCE • Possible reasons for the failure of the nominal exchange rate depreciation to improve competitiveness: • depreciation leads to more expensive imports (imports of raw materials and investment goods), thus increases costs of production • depreciation increases the inflation rate which pushes up wages • depreciation leads to balance sheet effects and increases cost of financing for the corporate sector • External demand is depressed

24. EXCHANGE RATE DEVELOPMENTS

25. Source: ECB, BNB

26. EXCHANGE RATE REGIME AND MONETARY CONDITIONS DURING THE RECENT CRISIS • The choice of an exchange rate regime cannot unequivocally be associated with advantages or disadvantages • Problems of the autonomous monetary policy’s capabilities during the crisis: • Transmission of the conducted monetary policy is limited • Pursuing multiple domestic economic objectives is difficult • Asymmetric autonomy (“Yes” in “good times”, “No” in “bad times”)