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The Tošovský Dilemma
Capital Surges in Transition Countries
Leslie Lipschitz, Timothy Lane, and Alex Mourmouras
Transition countries that open themselves up to global capital markets are like honest citizens in a dangerous world—they are vulnerable to large and potentially erratic flows. Such flows should not be seen as one-off destabilizing events: they are intrinsic to the transition process and therefore need to be factored into policy formulation.
Stylized fact number one: There has been and continues to be a pronounced real appreciation of the currencies of the advanced transition countries of Central and Eastern Europe against the currencies of their industrial neighbors. Unless domestic real interest rates in these transition countries are kept relatively low, the currency appreciation could well attract huge capital inflows—flows so large that they could overwhelm policymakers' efforts to control inflation and contain external current account deficits.
Stylized fact number two: Capital/labor ratios are much lower in the transition countries than in their more advanced Western neighbors. The scarcity of physical capital, coupled with a reasonably strong endowment of workforce skills and infrastructure, means that a relatively high real interest rate is needed to balance saving and investment. If interest rates are low, investment will far exceed saving, fueling inflation and widening the external current account imbalance.
The clash between the low equilibrium real interest rate derived from stylized fact number one and the high equilibrium real interest rate derived from stylized fact number two motivates the arguments that follow and sets up a difficult dilemma for economic policy. This dilemma was first identified in the mid-1990s in discussions with then Czech National Bank Governor Josef Tošovský; it has subsequently been referred to as the "Tošovský Dilemma" by those at the IMF working in the area. The market may resolve this dilemma in the way that it sets risk premiums on investments in the transition economy. But, insofar as risk premiums are sometimes erratic and, in any event, sensitive to factors beyond the reach of the authorities, capital flows can overwhelm efforts to stabilize the economy. This article concludes with some strategic imperatives that policymakers in transition countries should constantly keep in mind; these could also apply to other emerging market countries with relatively well developed human and physical infrastructure.
Currencies on the rise
Table 1 illustrates stylized fact number one: a sustained real appreciation of the currencies of the advanced transition countries against the currencies of Western Europe. It shows that cumulated GDP growth for 10 advanced Central and Eastern European countries is modest when measured in conventional real terms but is high when measured in terms of deutsche marks (most of the period under investigation precedes the introduction of the euro). This difference—which is due chiefly to a very large real appreciation against the deutsche mark—is most pronounced over the first five years of the transition but still considerable over the second five-year period.
Two explanations for this real appreciation—both of which see the trend as equilibrating—are most commonly adduced:
A persistent appreciation has implications for domestic interest rates through the so-called interest parity condition—that is, ignoring risk premiums for the moment, a trend real appreciation of a Central or Eastern European currency against, say, the euro, should mean that the real interest rate is lower for a transition currency than for the euro. If real interest rates were the same or higher in the transition country, money would flow out of the euro area and into the transition country to take advantage of the expected gain from appreciation—these are referred to as interest-arbitraging flows.
For example, the equilibrium real interest rate in Poland should be equivalent to that in Germany minus the expected real appreciation of the zloty. If the real interest rate in Germany is 21/2 percent and the zloty is expected to appreciate, on average, by 6 percent a year in real terms, then, from the point of view of international arbitrage flows, the equilibrium real interest rate of the Polish zloty should be minus 31/2 percent a year. Anything higher would elicit large inflows, putting either downward pressure on the interest rate (under a pegged exchange rate regime) or upward pressure on the currency (under a floating exchange rate regime).
The data for this example correspond roughly to those in Table 2, which shows actual average real interest rates over a five-year period and the real interest rates that, ex post, would have been consistent with interest parity. In most cases, the actual interest rates were well above those calculated from interest parity, reflecting, presumably, the perceived risks on investments or capital market restrictions or imperfections. Nevertheless, the monetary authorities of many countries have been acutely aware of this mechanism limiting their ability to increase interest rates without risking large inflows or strong upward exchange rate pressure.
Capital scarcity and investment
Turning to stylized fact number two, we know that the Central and Eastern European countries' capital endowments are much smaller than those of the advanced countries of Western Europe. The lower the capital/labor ratio—or the output/worker ratio—relative to Western Europe, the higher the relative marginal product of capital and the closed-economy equilibrium real interest rate. Therefore, although the transition country's equilibrium real interest rate may be lower than that in Western Europe from the interest-parity condition described above, the difference in capital endowment means that the notional, closed-economy, equilibrium real interest rate is much higher than in Western Europe.
Deriving relative marginal products of capital is conceptually straightforward, and some illustrative calculations are shown in Table 3.
Column 1 shows GDP per worker in the Central and Eastern European economies as a percent of German GDP per worker. On this basis, column 2 shows relative marginal product of capital: thus, for example, the marginal product of capital in the Czech Republic is three and one-half times that in Germany.
Of course, these figures boggle the mind. If this simple model has any truth to it, the rate of return on capital in the transition countries is massively higher than that in Western Europe. If these transition economies were closed, the real interest rates required to equilibrate saving and investment would be very high. Given that these economies are open and small relative to global capital markets, there should be huge capital inflows.
As a crude polar extreme, assuming frictionless adjustment in a year—that is, that by the end of the year so much capital would have been injected that the transition country worker's output would have grown to equal that of his German counterpart—column 3 shows capital flows ranging from 150 percent to over 800 percent of preflow annual GDP. One can quibble with the calculations, but the magnitudes are so great that one cannot quibble with the basic result. The differential in capital/labor and output/labor ratios between Western Europe and the transition countries is such as to make the notional, closed-economy, equilibrium real interest rate in the transition countries very high relative to that in Western Europe, and the equilibrium capital flow very large if there are no impediments to such flows.
The policy dilemma
The two strands of the argument thus far set up an impossible dilemma for policy. The interest-arbitrage conditions would seem to suggest that if the monetary authority in the transition country sets interest rates, ex ante, high enough to reflect the real capital scarcity in the country (as shown in Table 3), there will be huge capital inflows (to take advantage of the real interest rate differential). Such large capital account inflows would elicit an equally large current account deficit. If the domestic monetary authority sets interest rates low enough to forestall such arbitraging inflows, rates will be so far below the marginal product of capital that there will be an enormous imbalance between saving and investment and a huge current account deficit. In either case, any semblance of financial restraint will be overwhelmed and there will be a correspondingly large current account deficit.
The problem is quite independent of the exchange rate regime. Under a fixed-rate regime, actual capital flows will occur. While the monetary authorities may try to sterilize the monetary impact, such sterilization will be costly and, ultimately, unsuccessful. Thus, the economy will become highly liquid, interest rates will be forced down to well below the real return on capital, and a huge imbalance between domestic saving and investment will produce a large current account deficit. Under a floating exchange rate, the incipient capital flows will force an appreciation of the exchange rate with similar results for the current account. (Indeed, there will almost certainly be an overshooting of the exchange rate, as the exchange rate will have to move to a point where a significant depreciation is expected.)
A market solution
The real world is not quite this dire. Although capital inflows may have been large at times, it is clear from Table 2 that they have been insufficient to arbitrage out real interest rate differentials. Why has this happened? Market frictions, restrictions, and imperfections are part of the story, but risk premiums may be the market solution to the dilemma.
Consider the simplest ideal: the market sets risk premiums that are highly sensitive to current account deficits. In this case, every country, no matter how small it is relative to global capital markets, faces an upward-sloping supply of funds. Thus, for example, with a balanced current account, there would be very large incipient capital inflows and little independence for domestic monetary policy. But as these inflows occurred and the current account deficit increased, risk premiums would rise, permitting some increase in domestic interest rates above those abroad. Eventually, at some equilibrium level of the current account deficit—ideally, a level where investment would be high, but not so high as to lead to significant adjustment friction and high inflation—risk premiums would be large enough to permit the authorities to set domestic interest rates at a level that could equilibrate saving and investment.
If risk premiums were set like this fictional ideal, we would have the best of worlds. The transition countries would be able to pursue real convergence—that is, convergence of capital/labor ratios and productivity levels—with optimal assistance from global capital markets.
The real world, however, is seldom this benign. In practice, risk premiums will be a function of a broad array of variables, some obvious—domestic economic, financial, and political developments—some beyond domestic influences—such as global capital market conditions—and some seemingly erratic—bandwagon effects, contagion, and the like.
The bottom line
So where does this leave us? We know that there are real mechanisms, endemic to the convergence process, that will make transition economies highly sensitive to external capital market conditions and limit domestic monetary independence. We also know that, because these are real, not nominal, mechanisms, the choice of exchange rate regime will not solve the problem (although, as argued below, it may have some significant secondary implications). And we know that well-behaved risk premiums can provide some protection. However, when risk premiums are erratic, the country will be subject to erratic, and potentially overwhelming, influences from abroad—both inflows that will undermine financial restraint and outflows that could cause payments crises and require painful compression of demand.
The implications of these findings are both awkward and profound. Global capital markets are huge relative to the sizes of these economies, so small portfolio shifts can exert an overwhelming influence on capital flows and domestic financial conditions. Therefore, policymakers should be continuously cognizant of the importance of reducing vulnerabilities.
First, governments need to implement sound economic management—including transparency and data dissemination—to ensure that the impetus for changes in capital market sentiment does not emanate from erratic domestic policies. This goes beyond simply having sensible policies; it requires that the market be properly informed about them. Easy access to information (including through candid and accessible IMF reports) would enable investors to assess risks independently and would likely militate against herd behavior.
Second, openness to global capital markets reduces the possible range of action for monetary policy. Thus, the fiscal stance becomes the preeminent tool of stabilization policy. Sustained fiscal austerity will lay the foundation for larger fiscal stabilizers in times of need.
Third, on the best way to open up the capital account, the conventional desiderata apply: the long end of the market should be opened up before the short—that is, foreign direct investment before portfolio flows. Insofar as erratic changes in risk premiums can reasonably be construed as a market failure, there may be a "market-failure" case for imposing or retaining capital controls—especially price-based controls on short-term inflows. But it would be folly to push this line too far in practice. It is often difficult to make controls stick; controls that can be circumvented may produce a culture of evasion; and capital controls may well reduce beneficial inflows over the longer term.
Fourth, the institutional and regulatory regime in the financial sector matters. A strong prudential regime should be in place before the capital account is fully liberalized. Banks' open foreign exchange positions should be strictly limited. Moreover, there may be hidden risks: even if banks seemingly have no direct net foreign exchange exposure, they may be exposed through unhedged corporate and household borrowers. Therefore, countries need to seek policies that force corporations and households to be fully sensitive to currency risk.
Finally, the exchange rate regime can profoundly influence market behavior and the scope for government action. For domestic borrowers, a long-lived peg can induce the private sector to take substantial open positions. For policymakers, large open positions in banks and corporations make it very costly to adjust exchange rates in a crisis; typically, therefore, governments try to resist for a while. For market agents, the exchange regime may encourage large, opportunistic, speculative flows when it becomes evident that the authorities are resisting an inevitable break in a fixed exchange rate regime. Thus, in most circumstances, a floating exchange rate regime is less vulnerable than a pegged regime.
This article is based on the authors' "Capital Flows to Transition Economies: Master or Servant?" IMF Working Paper 02/11 (Washington: International Monetary Fund, 2002).