Macroeconomic Management With Open Capital Accounts

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1 Macroeconomic Management With Open Capital Accounts György Szapáry Central Bank of Hungary IMF-Singapore Regional Training Institute Seminar, Crisis Prevention in Emerging kets, Singapore, y 1-11, Introduction Financial liberalization has important benefits: Lowers the cost of capital and improves its allocation, thereby promoting growth Promotes trade flows Promotes the development of sound institutions (e.g. better information and legal systems, better financial supervision) However, it can lead to financial instability and crises if not managed properly

2 The issue is not whether financial globalization is inherently good or bad, but whether it can be done right, Frederic S. Mishkin, ( Financial Stability and Globalization: Getting It Right, paper presented at the Bank of Spain Conference, Central Banks in the 1st Century, June -9,, Madrid) Main Themes The presentation evolves around three main themes: Managing expectations The exchange rate and monetary regimes adopted matter Risks of credit booms

3 Chart 1 Hungary - Daily turnover of the various segments of the foreign exchange market HUF billion Q1/ Q Q3 Q Q1/1 Q Q3 Q Q1/ Q Q3 Q Q1/3 Q Q3 Q Q1/ Q Q3 Q Q1/ Q FX swap spot forward Capital account liberalization has a direct effect on the investment strategy of market participants Chart Hungary - Budget Deficits, 199- of GDP, -, -, -, -, -1, -1, * *Gov't forecast Sharp increase in the fiscal deficit in Hungary

4 Chart 3 Hungary - Budget Deficits: Plans and Outcomes, - of GDP Maastricht criteria * PEP 3 PEP CP () CP (December) Fact PEP: Pre-accession Economic Program, CP: Convergence Program *MNB forecast Weak fiscal credibility in Hungary Chart External financing requirements of CEE* and two Baltic countries (3-) CZ 3 CZ HU 3 HU PL 3 PL SK 3 SK LVA 3 LVA EST 3 EST - Non-debt inflow Debt-inflow NEO High budget deficit is associated with large debt financed external deficit in Hungary

5 Chart Hungary Changes in foreign investors net position against HUF and stock of government securities held by non-resident, 1-9 HUF billion HUF billion Jan/1 Aug Oct Jan/ Jan/3 Jan/ Jan/ - Government papers held by foreigners (left scale) Changes in foreigners net long HUF position (right scale, January 1=) Liberalization makes countries vulnerable to speculation Chart Historical volatility of the Polish zloty (PLN) and the HUF exchange rates* / 1 Jan / Jan / 3 Jan / Jan / Jan / PLN volatility HUF volatility The exchange rate regime matters

6 Chart 7 Historical yield volatility of the PLN and the HUF (standard deviation of yields during a moving 9-day period, yields are based on CEBI bond indexes*) / 1 Aug Oct Jan / Jan / 3 Jan / Jan / Jan / PLN yield volatility HUF yield volatility *CEBI, the DrKW s Central European Bond Index, incorporates the CEE local currency denominated government bonds of various maturities More focus on exchange rate stability can lead to more volatile interest rate Chart Exchange rate movements of the Czech, Polish and Greek currencies, 199- Joining ERM 1 1 Russian crisis Brasilian crisis weakening -1 Jan Jan Jan PLN CZK GRD A framework of commitment to stability helps

7 Chart 9 Polish, Czech, Slovak and Hungarian implied forward rate differentials vis-à-vis euro rates in years time (for -year maturity bonds) 7 basispoint basispoint Jan 3 Feb Apr Aug Oct Dec Jan Apr Jun Oct Dec Jan Feb Apr Jun Aug Oct HUF CZK SKK PLN Jan Feb Apr Credibility and fundamentals are essential Chart 1 Hungary - Non-residents share in the outstanding amount and in the secondary market turnover of government bond Jan 1 Apr 1 1 Oct 1 Jan Apr Oct Jan 3 Apr 3 3 Oct 3 Jan Apr Oct Jan Apr Share of non-residents in gov. paper turnover (left scale) Share of non-residents in gov. paper outstanding amount (right scale) When expectations worsen, short-term speculative investments become important

8 Chart 11 3-month interest rates in the Eurozone and the new EU member states (199-) Jan/199 /199 Jan/1997 /1997 Jan/199 /199 Jan/1999 /1999 Jan/ / Jan/1 Euro-zone Czech Republic Estonia Latvia Lithuania Hungary Poland Slovenia Slovakia /1 Strong yield convergence in the new EU members Jan/ / Jan/3 /3 Jan/ / Jan/ / Jan/ Table 1 Long term average yields and standard deviation, and overall performance of CEE bonds* Annual yield in euro (A) Reference indices Annual yield in local currency (B) Appreciation of the exchange rate (A)-(B) Average yield Standard deviation of average yield Performance indicator (3) (1) () (1) / () Index Czech 11,, 1,7 Slovak 1,, 1, Hungarian 1, 9, 1,19 Polish 1, 11, 1,1 CEBI Composite 11,9 7,9 1, iboxx (euro),3 3,1 1,71 Czech, Slovak,7 Hungarian 1, Polish 11,3 Czech 3,1 Slovak 3,3 Hungarian, Polish 1, *CEBI, the Central European Bond Index (CEBI) of Dresdner Kleinwort Wasserstein (DrKW), incorporates the Czech, Polish, Hungarian and Slovak local currency denominated government bonds. The iboxx is the euro-region sovereign euro denominated bond index of the International Index Company. Different performance

9 Chart 1 HUF and PLN Spreads over year euro spot zero coupon interest rate /Jan/3 / /Jun 1/ /Dec 7/Feb/ 1/ 13/Aug / /Jan/ 7/ / 9/ 1/Oct /Dec /Feb/ HUF PLN Difference in HUF and PLN spread Unexpected policy moves have long-term impact Chart 13 Inflation targeting in Hungary, Jan / 1 Apr / 1 / 1 Oct / 1 Jan / Apr / / Oct / Jan / 3 Apr / 3 / 3 Oct / 3 Jan / Apr / / Oct / Jan / Apr / / Oct / Jan / Apr / / Oct / CPI net of taxes' CPI Anchoring expectations is important

10 Chart 1 - Exchange rate movements of the Czech, Slovak, Polish and Hungarian currencies against the euro, and the Turkish currency against the dollar (. jan.1 = ) / Jan / / Jan 13 / Jan / Jan 7 / Jan 3 / Feb 1 / Feb 17 / Feb / Feb 3 / 1 / 17 / / 31 / 7 / Apr 1 / Apr 1 / Apr / Apr / 1 / 19 / / / Jun 9 / Jun 1 / Jun 3 / Jun CZK SKK PLN HUF TRL Vulnerability increases when the fundamentals and credibility are weak Table : Selected macroeconomic indicators in Emerging European countries Czech Republic Slovakia Poland Hungary Turkey Fiscal balance* C/A deficit* Inflation *percent of GDP Source: Eurostat and European Commission, Spring Forecast Turkey and Hungary have the worst fundamentals

11 Chart 1 - Average Growth Rate of Domestic Credit to the Private Sector, Latvia Lithuania Estonia Hungary Slovenia Australia United Kingdom Canada New Zealand Cyprus Euro Area Malta* United States Poland Japan Czech Republic percent Slovak Republic Dangers of credit booms Chart 1 Credit growth in Estonia and Latvia credit/gdp 1,9,,7,,,,3,,1 credit/gdp 1,9,,7,,,,3,, Estonia Latvia min median max Note: min, max and median values correspond to the estimated equilibrium credit/gdp range Dangers of credit booms

12 Chart 17 Budget deficit and current account balance of Estonia and Latvia, Estonia budget Latvian budget Estonia CA Latvia CA -1 The fast credit growth has lead to high current account deficits in Estonia and Latvia despite strong budged positions. Chart 1 Inflation in Estonia and Latvia, Jan/1997 /1997 /1997 Jan/199 /199 /199 Jan/1999 /1999 /1999 Jan/ / / Jan/1 /1 /1 Jan/ / / Jan/3 /3 /3 Jan/ / / Jan/ / / Jan/ Estonia Latvia An additional sign of overheating in Estonia and Latvia is the acceleration of inflation.

13 Chart 19 - Share of foreign currency loans Foreign currency loans in percent of total credit to the private sector* Foreign currency loans as a share of total household credits* EE LT LV HU SI SK PL CZ EE LV LT PL HU SI SK CZ Sources: National authorities, IMF staff estimates *calculated at constant exchange rates Borrowed from Christoph B. Rosenberg, IMF Dangers of currency mismatch Conclusions Capital account liberalization has important benefits, but also carries dangers: Makes countries vulnerable to speculation Can fuel credit booms Can lead to currency mismatch all of which can destabilize the banking system and the economy if not managed properly

14 Conclusions (cont.) With open capital accounts, managing expectations is key to success, sound macroeconomic management is a must because markets will penalize misbehavior: Follow sound fiscal policy, enforce transparent accounting Anchor inflation expectations by transparent monetary policy (e.g. inflation targeting), ensure central bank independence Strengthen financial supervision, give sufficient independence to supervisory agencies so that they can withstand political pressure Strengthen information and legal systems

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