Over- or Undervalued Euroland Entry?

Jens HölscherUniversity of Brighton

Mariusz JarmużekCASE Foundation

Structure• introduction• points of reference• historical examples• Fundamental Equilibrium Exchange Rate• estimates of the FEER for Poland• the pre-ERM-II scenario• strategic choice under EU restrictions• conclusion

Points of reference• Bofinger, M., Wollmershäuser, T. (2002): EU Accession Countries:

What Path to successful EMU Membership, in: Winkler, A. (ed.): Banking and Monetary Policy in Eastern Europe, Palgrave

• Bratkowski, A., Rostowski, J. (2001): Why Unilateral Euroization Makes Sense for (some) Applicant Countries - a response, with particular reference to Poland

• Driver, Rebecca and Peter Westaway (2001) Concepts of Equilibrium Real Exchange Rates, Bank of England

• Frowen, S. F., Hölscher, J. (eds.) (1997) : The German Currency Union of 1990 - A Critical Assessment, Macmillan

• Hölscher, J. (ed.) (2001): Fifty Years of the German Mark, Palgrave• Orlowski, Lucjan T. (2000): A Dynamic Approach to Inflation

Targeting in Transition Economies, www.zei.de

• Williamson, John ed. (1994) Estimating Equilibrium Exchange Rates, Washington, Institute for International Economics

Historical Examples

• Overvalued ERM-I entry– UK 1990– East Germany 1990

• Undervalued Bretton Woods entry– West Germany after 1950/51

The Pre-ERM-II Scenario

• success: Hungary• on edge: Poland• critical: Czech Republic• Safe option: currency board

– Bulgaria and the Baltics

Box 1: ERM-II components

• Precondition for participation in Euroland (and thereby for EU membership)

• Fixed parity to the Euro (floating within a band up to +/- 15%)

• Unlimited marginal interventions “pre-paid” by national central bank concerned and

financed by the ECB

• Intra-marginal interventions can be financed by the ECB to a limited extent

• Confidential assessment of central parity

Real exchange rate (%change, qoq)

-30

-25

-20

-15

-10

-5

0

5

10

15

1q1993

3q 1q1994

3q 1q1995

3q 1q1996

3q 1q1997

3q 1q1998

3q 1q1999

3q 1q2000

3q 1q2001

(% c

hang

e, q

oq)

-34

-24

-14

-4

6

16

(% c

hang

e, q

oq)

CZK/€ (left-hand axis) EEK/€ (left-hand axis) HUF/€ (left-hand axis) LTL/€ (left-hand axis) PLN/€ (left-hand axis) BGN/€ (right-hand axis)

Real exchange rate Jan 1995=100

40

70

100

130

11995

4 7 10 11996

4 7 10 11997

4 7 10 11998

4 7 10 11999

4 7 10 12000

4 7 10 12001

4 7

BGN/€ CZK/€ EEK/€ HUF/€ LTL/€ PLN/€

Competitiveness and the External BalanceHungary

-2000

-1750

-1500

-1250

-1000

-750

-500

-250

0

250

500

1q1993

4q 3q 2q 1q1996

4q 3q 2q 1q1999

4q 3q 2q

€m

70

83

96

109

122

135

148

161

174

187

200

HU

F/€

(Jan

199

5= 1

00)

HUNGARY current account HUF/€ (right hand scale)real HUF/€ (right hand scale)

Competitiveness and the External BalancePoland

-4000

-3500

-3000

-2500

-2000

-1500

-1000

-500

0

500

1q1993

4q 3q 2q 1q1996

4q 3q 2q 1q1999

4q 3q 2q

€m

60

70

80

90

100

110

120

130

140

150

PLN

/€ (J

an 1

995=

100)

POLAND current account PLN/€ (right hand scale)real PLN/€ (right hand scale)

Competitiveness and the External BalanceCzech Republic

-1800

-1600

-1400-1200

-1000

-800

-600

-400

-2000

200

400

600

1q1993

4q 3q 2q 1q1996

4q 3q 2q 1q1999

4q 3q 2q

€m

70

74

7882

87

91

95

99

103107

112

116

120

CZK

/€ (J

an 1

995=

100)

CZECH REPUBLIC current account CZK/€ (right hand scale)real CZK/€ (right hand scale)

Competitiveness and the External BalanceEstonia

-3500

-3000

-2500

-2000

-1500

-1000

-500

0

500

1000

1q1993

4q 3q 2q 1q1996

4q 3q 2q 1q1999

4q 3q 2q

EE

K m

50

75

100

125

150

175

200

EE

K/€

(Jan

199

5=10

0)

ESTONIA current account EEK/€ (right hand scale)real EEK/€ (right hand scale)

Competitiveness and the External BalanceLithuania

-600

-500

-400

-300

-200

-100

0

100

200

300

1q1993

4q 3q 2q 1q1996

4q 3q 2q 1q1999

4q 3q 2q

€m

40

76

111

147

182

218

253

289

324

360

LTL/

€ (J

an 1

995=

100)

LITHUANIA current account LTL/€ (right hand scale)real LTL/€ (right hand scale)

Competitiveness and the External BalanceBulgaria

-800

-600

-400

-200

0

200

400

1q1993

4q 3q 2q 1q1996

4q 3q 2q 1q1999

4q 3q 2q

€m

0

500

1000

1500

2000

2500

3000

BG

N/€

(Jan

199

5=10

0)

BULGARIA current account BGN/€ (right hand scale)real BGN/€ (right hand scale)

Fundamental Equilibrium Exchange Rate

• model of trend current account

• structural capital flows

• sustainable current account

Model of the trend current account

• model of aggregate trade– replacement of the actual value of exports and imports with the

values the models predict– trade elasticities ensuring internal balance of the economy

• model of trend output– Hodrick-Prescott filter approach

• model of the trend current account consistent with internal balance

Structural capital flows and sustainable current account

• the current account account corresponding to external balance

• estimating the real exchange rate compatible with internal and external balance

Estimates of the FEER for Poland

60.0

70.0

80.0

90.0

100.0

110.0

120.019

93Q

1

1993

Q3

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

PREER FEER

Estimates of the FEER for Estonia

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

200.0

1993

Q1

1993

Q3

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

ESTREER FEER

Estimates of the FEER for Lithuania

40.0

90.0

140.0

190.0

240.0

290.0

340.0

390.019

93Q

1

1993

Q3

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

LITREER FEER

Estimates of the FEER for Bulgaria

40.0

50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

130.019

93Q

1

1993

Q3

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

BULREER FEER

Estimates of the FEER for the Czech Republic

60.0

70.0

80.0

90.0

100.0

110.0

120.0

130.019

93Q

1

1993

Q3

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

CZKREER FEER

Estimates of the FEER for Hungary

90

95

100

105

110

115

12019

93Q

1

1993

Q3

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

HREER FEER

Strategic Choice under EU Restrictions (= Maastricht Straight Jacket)

• currency board

• peg + managed float

• delayed entry

Box 2: Entry strategy and policy options

monetary policypolicy

variable country

U currency board exchange rate targeting

(hard peg)

noneLithuaniaEstoniaBulgaria

Peg+ managed float

income targeting i, P, e Hungary

Managed float inflation targeting i CzechRepublic

Delayed entry(free float)

direct inflation targeting i Poland

Conclusion

• To avoid an overvalued ERM-II entry rate a strategy of stability oriented exchange rate undervaluation is advisable.

• Alternatives are delay or currency boards (= Euroisation?)