Monetary and exchange rate policy: a delicate balance

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV Media network.

Some economists* have recently been wondering whether the present
appreciation in the CEEC’ currencies ought not to prompt a revision
of the central banks’ inflation targets, which are considered too
low, in particular in the Central European countries, says an
article in the latest issue of MINEFI-DREE
‘s Revue Elargissement.

Companies can draw two lessons from these analyses: 1) the
central banks’ inflation targets appear ambitious and in 2005
inflation might be in the region of the current market consensus,
which is slightly higher (see REA 72); 2). Nominal appreciation of
the currencies might become unsustainable. 

What is the reason for the current nominal appreciation of the
currencies? In 2004, a marked acceleration of capital inflows was
to be observed in the region, in the form of financial investments
or FDI. First of all, with EU accession in May, the international
agencies’ ratings generally improved, which led to a revaluation of
these countries’ share in the international investors’ portfolios.
Next, the yields offered in the region are attractive, particularly
in Hungary, Poland and Slovakia. Lastly, the CEEC territories’
competitiveness in the production of manufactured goods as well as
certain services, continues to stimulate FDI. 

For the central banks, these capital inflows complicate the
adjustment of their monetary policy. On the one hand, they seek to
support the convergence of inflation towards euro zone levels,
which implies a somewhat restrictive monetary policy and which
might possibly also have a negative impact on growth and/or
employment. On the other hand, high interest rates attract capital
inflows and reinforce currencies; the price convergence caused by
nominal appreciation of the exchange rates and inflation then
aggregates, with a negative impact on the competitiveness of
territories **. Over the recent period, we find this situation
occurring in Poland, Slovakia, Hungary and Romania in

What are the possible evolutions and the associated

In 2005 inflation could be slightly higher than the central
banks’ targets; this means, “all things being equal”, that the
central banks which have chosen to manage their exchange rate (the
Czech Republic, Slovakia and Slovenia for example) should continue
to act in order to limit a too strong appreciation (nominal and
actual) of their currency. 

Exports may suffer temporarily from an appreciation in exchange
rates, but trade deficits are related above all to the intermediate
position which these countries occupy in the European division of
labour, with trade balances improving in the long run. In fact,
their evolution is relatively independent of the exchange rates and
seems to be influenced more by sectoral logic and/or industrial

An exogeneous shock or a loss of confidence could cause a sudden
reverse flow of that part of the capital inflows which obeys a
strictly financial logic and a marked correction of the currency.
However, in Poland, the recent appreciation may be partly justified
by the expected improvement in public finances and a high growth
rate. In the same way, in Romania, the acceleration in productivity
gains now seems likely to compensate for the true appreciation of
the exchange rate, and the budgetary efforts made also form a
support for the leu. The risk of a correction exists above all in
Hungary, where inflation remains high, twin deficits progress and
the forint is close to the lower limit of its fluctuation margins.
This context has just led Fitch to lower its rating on the
Hungarian debt. 

Lastly, even in the event of strong turbulence spreading
throughout the region, the risk of an exchange rate crisis which
might, as in Thailand in 1997, extend to the banking sectors seems
unlikely. Indeed, the latter, mainly controlled by foreign banks,
are restructured and cleansed, with “reasonable” levels of doubtful
debts (see Review Elargissement Special Banks, n°50). 

* and among them, Patrick Artus, Director for Economic
Research at CDC Ixis; “What is happening to the Central European
currencies?”; “At what level should the Central European countries’
central banks fix their inflation level targets?” (both articles
are in French). In the latter paper, which concludes with the need
to raise the inflation objectives, the quantified result depends
mainly on the assumptions made over the number of years necessary
for prices and income levels to converge to the EU average level.
In this study, the central banks’ inflation targets look all the
lower as the expected duration of convergence corresponds more to
the bottom of the range. 

** Over the last few months, the following “anomaly” has
been observed: actual and nominal exchange rates are appreciating
simultaneously in Central Europe. Although the first phenomenon may
be considered as “normal” in the context of a convergence of price
and productivity levels, a nominal depreciation in the currencies
should, on the other hand, accompany it, since the CEEC, whose
economic structure converges towards those of the high income
economies of the EU, record higher inflation rates as well as
budgetary and/or current account imbalances. Indeed, if the
assumption is made that the relative PPPS hold firm, a somewhat
fragile assumption, the variation in the real exchange rate (q)
equals the nominal exchange rate variation (e) multiplied by the
price ratio evolution between the two countries. If inflation is
higher in the first country (as for the CEEC), then it “would be
necessary” for “e” to appreciate (nominal depreciation), but in a
smaler proportion than the inflation differential, in order to
allow the domestic price (real appreciation of the currency) the
convergence to occur, as productivity and wages rise.


For more analyses, visit the DREE website.

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