How do exchange rate regimes react during a crisis and do they affect inequality?

UNIVERSITY OF AMSTERDAM

How do exchange rate regimes react during a crisis and do

they affect inequality?

Master Thesis Political Science

By Dimitar Stoichkov

6/22/2018

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Table of Contents:

Introduction pp.2-7 Chapter 2 – Literature Review pp.8-14 Chapter 3 – Exchange Rate Preferences Theory pp.15-23 Chapter 4 - Exchange Rate Regime Preferences and Classification in Eastern Europe Prior to the Crisis pp.24-32 Chapter 5– Exchange Rate Regimes Performance During the Crisis pp.32-43 Chapter 6: Adjustment Strategies During The Crisis pp.44-52 Conclusion pp.53-54 Bibliography pp.54-64

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Chapter 1 – Introduction

The motivation behind this thesis comes from a desire to find out whether different exchange rate regimes can influence inequality differently; especially during a period of financial crisis. While it is true that there is a vast amount of academic literature dedicated to the relationship between exchange rate regimes and macroeconomic policy, there is, limited research dedicated to the link between ERRs and inequality in times of crisis. Lack of research on the matter is surprising since international bodies such as the United Nations have begun to recognize that ERR policies can have important ramifications for inequality. For instance, the United Nations Development Program (UNDP) have reported that the excessive focus on exchange rate and price stability combined with the macroeconomic policies many developed and developing states pursuit during the crisis can have a potentially detrimental effect over income inequality:

‘Macroeconomic policy matters for human development. It influences the quantity and quality of employment, the level of social protection and the provision of public services. There is growing evidence that current macroeconomic policies—especially in developed countries— encourage volatility in output and exchange rates, increase inequality and thus undermine human development. This is due largely to an excessive focus on price stability and the poor timing of austerity policies that exacerbate problems of public and private debt and do little to lay the basis for economic recovery. It is time to reassess the rationale for austerity measures and refocus policy efforts on boosting investments for sustained long-term growth’ (United

Nations Development Programe, 2014, p. 44).

At the core of these stabilization policies is the exchange rate regime. A crucial component of macroeconomic policy. The ERR influences prices, inflation, unemployment and trade. All determinants of living standards in a state. And all affected by financial crises. Meaning that exchange rate regimes must be chosen and managed with utmost consideration of the

economy’s structural features and the predominant economic shocks it might experience. That is why, there is such a wide variety of exchange rate regimes that states can use in order to

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achieve their goals and interests. The table below uses the official IMF classification to give a basic idea about the variety of exchange rate regimes used throughout the world.

Source: IMF Annual Report on Exchange Arrangements and Exchange Restrictions (2016)

Because there is such a wide spectrum of regimes, choosing a particular ERR over another necessarily involves a trade-off between stability and flexibility (Giavazzi & Pagano, (1988). The trade-off is particularly valid to cases where governments must choose between the extremes in the spectrum. A flexible ERR diminishes credibility but enables a state to have a completely independent monetary policy and to retain the ability to respond to domestic and foreign shocks.

There are also certain choices to be made with regard to economic growth. Cecchetti and Ehrmann (1999) speak about lay out an output-inflation spectrum that runs parallel to that of the ERR spectrum. Their argument is that policymakers whom prioritize stability, should opt for a move towards less-flexible arrangement as it leads to less variable inflation at the expense of a potentially more volatile output. Furthermore, such shift may be seen as a commitment mechanism that increases the credibility of a particular state, thus giving the policymakers the opportunity to achieve better overall outcomes (Cecchetti & Ehrmann, 1999).

Acknowledging the existence of these trade-offs and the fact that ERR choices are often made when the economy is not stagnating is crucial when making assumptions about the relationship between the exchange rate regime and inequality during a crisis. It also provides the grounds to

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ask the question this thesis attempts to answer. How do exchange rate regimes performed

during the financial crisis and do they affect inequality?

Coming back to the UNDP quote, in order to answer the question above, we should first explain why the austerity measures that were taken during the crisis focused on exchange rate and price stability, and only after that, to focus on whether this leads to more inequality. On the surface, exchange rate and price stability are important factors leading to export-oriented economic equality. Proponents of this idea including the IMF, the European Central Bank and the European Commission argue that choosing a more fixed exchange rate

arrangement during a crisis increases fiscal policy effectiveness and contributes to economic growth and prosperity – all of which should be good for equality (Hallerberg, 2002) After all, stable currency that is isolated by the effects of the crisis should create a steady business environment which favours trade and investments.

So why then the UNDP states that such measures are bad for equality? One theory suggests that fixed exchange rates, especially in the cases where the currency is pegged to a low-inflation anchor, lead to a mismatch between the real exchange rate and the rate at which a currency is fixed. Such mismatch can hamper inequality in several ways: First, it limits the incentive to export and the access to imports; because large portion of the costs for any sort of production in a given country is paid in that country’s domestic currency, real exchange rate misalignment will reduce the incentive for producers to compete internationally. Naturally this limits the number of foreign exchange receipts (the total number of ‘flows that are effectively exogenous in relation to the external balance policies of the authorities’ see (Hemphill, 1974, p. 644)) thus reducing the ability of the state to purchase imports needed to maintain normal economic activity. Furthermore, it harms the domestic industries that have to compete against imports. They face increased pressure from foreign companies which may lead to protectionism and increased tariffs on imports. Protectionism isolates the economy from the international market and leads to lower growth. (Recent example is the trading relationship between China and the USA) Cottani et al. (1990) also argue that productivity advances are most often

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real exchange rate misalignment, productivity advances are likely to slow down, hampering growth further.

But perhaps the biggest danger comes from the efforts to defend an exchange rate that is out of sync via tight monetary policies, austerity measures, and excessive focus on price stability which can lead to deep recession. This last concern is especially relevant in post-2007 Eastern Europe where states (especially those fixing their exchange rates or using the Euro) are under increasing pressure from their international partners to target inflation and achieve price stability in order to avoid adverse impact on foreign investment and output. Levy-Yeyati & Sturzenegger (2002) point to data from non-industrial countries suggesting that fixed exchange rate arrangements are related to slower rates of economic growth and higher output volatility leading to more inequality. Furthermore, earlier research from Levy-Yeyati & Stuzenegger (2001) argues that an inflation-growth trade-off exists for long-standing pegs in non-industrial countries that is associated with lower inflation and slower growth.

That is why, despite being counterintuitive on the surface, it is nonetheless useful to test whether exchange rate and price stability do indeed improve fiscal policy effectiveness and economic prosperity or do they are harmful to economies in crisis. And whether or not ERRs have any significant impact on inequality during those times.

Case Selection

To put these claims in context, we will focus on the region of Eastern Europe. The transition from centrally planned economy to free market economy is both politically and economically interesting. The exchange rate and monetary policies of the Eastern European states are particularly significant due to the role they played in the economic development of the region even before the crisis. And, while under command economy, the exchange rates were of marginal importance, after the collapse of the soviet system, when the first market institutions were created, the exchange rate served as the most important asset price. (Grittersova, 2014, p. 201). In that sense, it is curious to observe whether decisions made during the transitional period were still relevant during the crisis. Furthermore, the Eastern European states share the same soviet legacy of planned economy. Yet they adopted vastly different exchange rate

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regimes, ranging from free floats, to currency pegs, to joining the Eurozone. Variation that was maintained during the financial crisis. So, discussing the rationale behind the choices these states made will add an additional layer of depth to this thesis.

To put this in methodological terms, using Eastern Europe is justified because the region

possesses a large diversity of cases with low levels of heterogeneity, which makes it possible for the full range of values characterizing the particular relationship between inequality and ERR during the crisis to be examined (for more on diverse case study see Jason Seawright, June 2008) more accurately.

Structure of the Thesis

The thesis is structured in the following way. In the next chapter the review of the literature is presented. The section focuses on the link between exchange rate and price stability, exchange rate regimes, financial crises and inequality. Following the literature review, chapter three is discussing exchange rate preferences theory. In it, the main theories explaining the various exchange rate preferences are discussed. In chapter four we look at the exchange rate

preferences of the EE countries prior to the crisis. A classification of the de-facto nature of the regimes is also provided. Chapter five analyses the performance of the different regimes during the financial crisis. Attention is also paid to the underlying conditions in the Eastern European states as they are largely a product of the exchange rate preferences in these states. After that, chapter six focus on empirically scrutinizing the two main arguments about the performance of fixed exchange regimes during the financial crisis.

1. Using fixed exchange rate arrangements during a crisis increases fiscal policy effectiveness and contributes to economic growth and equality.

2. During crisis fixed exchange rate arrangements provide slower rates of economic growth and more inequality.

Chapter six focuses more on the adjustment policies used by the fixed ERRs during the crisis years. This is done in order to determine whether using exchange rate arrangements

contributes to improving fiscal effectiveness and growth. The final section of the chapter comments more on the consequences the adjustment policies potentially had over inequality

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and whether inequality was higher in countries with fixed exchange rate regimes compared to more flexible arrangements. The chapter also determines whether the return to growth in fixed ERRs was slower compared to floating ERRs. The thesis then ends with a short conclusion and a summary of the results from the empirical study along with a short commentary on the deeply political nature of exchange rate regimes and suggestions for future research. So, without further ado, let’s move on to the literature review.

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Chapter 2: Literature Review

As discussed in the introduction, exchange rates have a significant impact on economic activity – especially in the developing countries. This is so because currency policy determines a state’s economic relationship with its international partners and competitors, and in the case of poorer countries it can steer development in positive or negative direction. Financial crisis only

complicates the choice of exchange rate regime for such countries, as the management of the exchange rate involves a trade-off which Frieden (2017) summarizes as a choice between regulating the relationship between foreign and domestic prices, and stabilizing domestic and international monetary conditions.

Regulating the relationship between domestic and foreign prices

A country’s exchange rate determines the way in which international prices are transformed on the domestic market and vice versa. For instance, if the domestic currency is appreciating, the domestic population’s purchasing power and real income increase and citizens are able to enjoy cheaper imports. This is also known as the income effect. (Greenlaw & Taylor, 2017). However, strong domestic currency may also have negative consequences, as domestically produced goods will become more expensive on the international market. This can potentially harm domestic producers who are looking to import as they face competition from foreign companies. Similarly, if the domestic currency depreciates, domestic goods become more competitive internationally and imports become more expensive on the domestic market. Depreciating currency then can sometimes be beneficial for domestic producers looking to export, as it makes them more competitive. This is also known as the substitution effect. It stimulates domestic consumption to switch from relying on imports to purchasing domestic goods.

In essence, the trade-off here is between competitiveness and purchasing power. While weaker currency makes domestic manufacturers more competitive in both the domestic and foreign markets, it also makes domestic consumers poorer and thus limits their purchasing power. Obviously, this is a serious dilemma when a country is in the midst of a financial crisis. Frieden

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(2017) argues that poorer countries should keep their currencies depreciated as this will protect domestic producers from the international competition and it will stimulate them to develop and sell produce at the bigger international market. States like South Korea, Taiwan, and China are used an example of how adopting such strategy leads to successes at the early developmental stage.

In all these cases the production of internationally competitive goods was actively supported by government-led policies of currency devaluation which is obviously impossible when the

exchange rate is fixed as the government has no control in determining the value of its currency.

However, despite the overall positive effects for human development, weak currencies can potentially aggravate the country’s trading partners. As Chen (2014) argues, the mistrust in the trade relations between China and the US is in large part due to the Chinese government purposely keeping the renminbi low so the Chinese producers can gain competitive advantage over their American rivals. In fact, the US has in the past threatened to declare China ‘currency manipulator’ which enables the Washington government to impose sanctions on China.

Competitive devaluation however becomes a problem only when the country engaging in it has a significant trading power already. The economies of Eastern Europe are not big enough to engage in economies of scale and therefore competitive devaluation is unlikely to have any real impact on the international market. That is why such policies can prove to be beneficial

domestically without aggravating any international partners. In any case though, developing states must choose one or the other – strong currency that prioritizes domestic consumers but puts pressure on producers competing internationally, or weaker currency that helps producers but makes consumers poorer, and potentially endangers trade relations with international partners. Ultimately, the decision depends on the priorities of the government, and the

importance they attribute to each of these issues during a crisis. Such decision also depends on the government’s willingness to let the domestic currency float or keep it fixed. This leads to the second part of the trade-off Frieden described - stabilizing domestic and international monetary conditions.

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Exchange Rate Stability – Balancing International and Domestic Monetary Conditions

At the core of stabilizing monetary conditions lies the degree of flexibility that an exchange rate is allowed. Frieden (2017) puts forward the notion that for developing countries adoption of a fixed exchange rate can be quite beneficial. The reason being that too much currency

fluctuation combined with a financial crisis characterized by high levels of state owned debt can put off international partners and reduce trade and investment. Fluctuation makes planning and prediction more difficult, thus it is more difficult for a country’s producers to take advantage of international market opportunities. Fixing the exchange rate regime alleviates these issues and facilitates trade, investment and finance.

To that end, there are several available options for states to fix their exchange rates. One is the establishment of currency board where the domestic currency is tied to that of another

country’s currency– most often that anchor currency is the dollar or the euro. Another option is currency substitution where the country decides to give up its domestic currency completely and adopt foreign currency as legal tender. Once more, the most widely used adoptive currencies are the dollar and the Euro. In Eastern Europe, Kosovo and Montenegro are examples of states unilaterally adopting the euro as their legal tender.

But perhaps the most intriguing option is joining a currency union. In our case that’s the

Eurozone. The Eurozone was created in order to enhance the already well established freedom of movement of goods and capital. With the creation of a common currency zone like that, the free movement of capital is also secured through lower transaction costs and interest rates. For the developing Eastern European countries this means access to funds in an internationally recognized and strong currency – an important asset during a crisis. But even before the crisis happened, most of the Eastern European states declared their desire to join the Eurozone immediately after their accession to the EU as a way to gain legitimacy on the international stage.

Another major reason why exchange rate stability may be preferred by developing countries is inflation. Many Eastern European countries, have struggled with high inflation that curbs economic development and reduces growth. Example is Bulgaria during the 1990s. The country

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suffered hyperinflation created by excessive currency devaluation. (Nenovsky & Mihaylova, 2007) The crisis conditioned the political elites to favour exchange rate stability in order to curb inflation and stabilize the economy. That is why a decision was made to anchor the local

currency to the Euro which has an inbuilt low inflation requirement. Even outside Europe, currency boards were a common tool to control inflation. Argentina, Venezuela, Mexico, and Brazil all tried fixing their exchange rates in response to financial crises. (Hausmann, et al., 1999)

The experience of South America in the 1990s is important for the thesis’ narrative as all currency boards (with the exception of Venezuela) were abandoned. That swift abandonment shows that there are significant costs in fixing one’s currency. As per the now classic Mundell (1961)-Flemming (1962) model, by gaining exchange rate stability, states sacrifice their monetary policy and with it their ability to use it as a tool to achieve other domestic policy goals. While this may appear highly specific at first, it can make a difference in the event of stagnation.

For instance, if a country keeps its currency fixed during a crisis, the exchange rate and price stability that it is likely to experience will facilitate trade and stimulate foreign borrowing and investment while the inflation will be kept in check. All prerequisits to return to economic growth and possibly to improved income distribution. However, due to the fixed exchange rate arrangement, the state will lose its ability to use monetary policy to dampen the

macroeconomic effects of the crisis on its citizens. Both sides of this trade-off are equally important for the proper functioning of a state. Nonetheless, a choice must be made, and once more it comes down to the government’s economic preferences and agenda. The next section disuccses the literature surrouning states’ macroeconomic priorites during a financial crisis.

Exchange Rate Preferences, Financial Crisis and Inequality

Financial crises are part and parcel of the international economic system. There has been several prominent crises since the Breton Woods system collapsed in the 1970s. Latin America during 1994-5, followed by Asia in 1997-8, and the Europe in 2008-9. Often times these crises were followed by a rapid decline in the economic activity, drop of real GDP and income,

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increase in unemployment and poverty. Empirical studies suggest that during such recessions it is the lowest income layer of society that suffers the most. Both the Great Depression, and the current financial crisis were preceded by an increase in absolute incomes, but also by a sharp increase of income inequality based on the increased debt-to-income ratio in the middle and lowest income households. (Kumhof & Ranciere, 2010, p. 3) This is in unison with standard economic models predicting that during economic downturns households may try to smooth the drop in consumption by borrowing more. (Seefeldt, 2015). The OECD relates this to an increase in income inequality by discovering that during financial crisis, the most jobs and income loss has occurred in low-skill, low-income households. (OECD, 2014, p. 9).

A vacancy and recruitment report by the European Commission from 2014 reaches the same conclusion. The low-educated were hit the worst by unemployment. Their employment rate in 2012 was only 45%, compared to 68% for medium educated and 82% for high educated households. (European Commission, 2014, p. 9) In addition to these figures, the same report determines that 18 out of 25 areas where employment actually increased in the EU between 2011/2012 required higher qualifications. (European Commission, 2014, p. 8) Furthermore, protracted unemployment may have lasting implications for inequality. One of the ways in which unemployment is detrimental to equality is through the loss of skills workers experience after a long period without work. The skills gaps implies wage gap thus putting workers who lost their job in a disadvantageous position even if they manage to find employment. (Stiglitz, 2013) (Breen & Garcia-Penalosa, 2005)

In fact, there are arguments according to which unemployment and income inequality are not just linked but are the same issue. The logic goes that since unemployment limits the bargaining power of workers, social mobility becomes very difficult and unemployment becomes a major source of rising inequality and declining income. (Krugman, 2014). Barlevy & Tsiddon (2006) acknowledge the link and add that recessions will exacerbate inequality only in the cases where inequality was already rising, and in the instances where inequality was dropping, the recession will further contribute to the downward trend.

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And while the state’s response to a financial crisis is surely informed by these tangible

economic consequences, one has to have in mind that ultimately the government’s reaction to a crisis is deeply political. Apart from the economics of a crisis, it should also consider the adjustment costs and distributional conflicts before formulating a response. Gourevitch (1986) calls this the ‘political sociology of political economy’, while Alesina & Drazen (1991) and Rodrik (1996) focus more generally the economic consequences of financial crises. Alesina & Drazen write about policy adjustment while Rodrik about policy reform as possible political response to a financial crises. The bottom line is that the political response depends as much on the

economic consequences of a crisis as it does on the underlying reasons for the crisis, and there are a multitude of them – capital flight, bank failure, profligacy and so forth. For instance, if a crisis is caused by capital flight or hyperinflation, a short-term adjustment of the exchange rate, in the form of devaluation may be sufficient to restore the previous status quo. However, when a crisis is triggered by profligacy for example, short-term policy adjustments may not be

deemed sufficient to restore the country back to health. If the state or international body dealing with the situation considers the cause of the crisis to be structural, then it may decide to undertake policy reforms aimed not at restoring the pre-crisis status quo but at changing it by promoting exchange rate and price stability as means of ensuring that debt will be repaid.

Further complicating the policy preferences is the fact that financial crises are seldom that clear cut. Neither are they exclusively domestically based. As the current European crisis shows, debt and banking crisis can combine in a ‘twin crisis’ spilling over international borders. Furthermore, as Pepinsky points out: (2008, p. 446) ‘the independence of currency and banking crises mean that decisions to manage one have consequences for the other’. Situations like that, where the distributional conflicts are not clearly pronounced, also leave space for ideology to play a part in defining policy preferences. Including those concerning the exchange rate. And here, we come back to the trade-off discussed at the beginning of the chapter. What do governments value more - independent monetary policy or rigid but stable domestic and international monetary conditions? And what do these options mean for inequality. The next chapter introduces the

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theory informing the preferences of the states in Eastern Europe and it lays expectations about the performance of the various arrangements in the region during the crisis.

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Chapter 3: Exchange Rate Preferences Theory

When discussing the economics of exchange rates in Eastern Europe, scholars are focusing on two main issues – the optimal exchange rate regime and the possible welfare outcomes of exchange rate regimes. However, consensus is lacking. Sachs (1996) argues for more flexibility once the issue of high inflation has been put under control, whereas Coricelli (2002) maintained that floating ERRs do not provide enough protection from speculative flows which are to be expected in transitioning countries.

Hanke et al. (1992) use the example of Estonia to argue for the case of currency pegs which enable the states to benefit from lower transaction costs and interest rates, and lower risk of speculative attacks. According to this logic, pegging to the Euro should also make the adoption of the structural and institutional changes needed for full membership in the Eurozone easier. This theory feeds into the larger narrative about optimum currency areas.

Optimum Currency Area Theory

First published by Mundell (1961) and further developed by McKinnon (1963) and Kenen (1969), OCA theory outlines a set of criteria needed for the creation of such optimum currency areas: labor mobility, capital mobility, common risk sharing system, and common business

cycles for the participating countries. By aspiring to join the EU and eventually the EMU, most

Eastern European states are effectively striving to implement reforms in order to create such currency area. OCA also predicts that exchange rate regime choice is influenced by the degree to which a country’s financial system is developed. It expects that states with less developed financial systems will peg their currencies for two reasons: to protect their banks from

exchange rate instability, and to ease open market transaction in the absecnce of the necessary instruments (McKinnon, 1991)

However, as Von Hagen & Jizhong (2005) show, there are certain examples that run contrary to the popular OCA explanations. For example, they find out that larger EE states were more likely to fix their currencies than small countries. According to the OCAs principles it should be the

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opposite. Since reducing the exchange rate risks and transaction costs by fixing the exchange rate leads to more trade and investment, smaller states that are more vulnerable to exchange rate risks have more to gain by pegging their currencies to their bigger economic partners (in this case the EU) (Eichengreen & Bayomi, 2003). However, the evidence suggests that the countries trading the most with Germany are less likely to peg their currencies to the Deutsche mark or later to the Euro. Frieden et al. (2010) argue that this has to do with differences in the initial trading relationship with the West that transition countries had. The argument goes that those with closer ties to Western Europe had less incentive to fix their currencies to the Euro than those with lower EU trade levels. Markiewicz (2006) offers a different interpretation. She refers to the so-called ‘sustainability hypothesis’ according to which open economies with a large geographical trade concentration are more vulnerable to external shocks and therefore will be unable to sustain fixed exchange rate regimes for long periods of time.

Common Business Cycles

Another popular theory related to OCA is the idea of common business cycles. It predicts that the costs of abandoning monetary independence for a monetary union or a peg to a large trading partner are lower where there is a high correlation of business cycles between the participating countries. (Frankel, 1995) The Baltic States seem to run counter to this logic as they used to run strict pegs before joining the Euro even though their business cycles were relatively less connected to those of the euro area. Further example for the weakness of the common business cycles argument is the failed ruble zone. During the 1990s many scholars wanted to keep the ruble zone of post-Soviet states, mainly because of the higher levels of trade these states exhibited between themselves compared to their trade level with the West. (Grittersova, 2014) The argument stemmed by the immediate situation the post-Soviet states found themselves in right after the collapse of the USSR. The trade within the former union was disrupted and the barter system became more popular. Naturally, due to the common business cycles, and the large economic uncertainty at the time, the creation of a optimum currency zone with the Russian ruble at its core was seen as the only route to stabilization (Corden, 1992). Although fully in line with OCA and common business cycle theory, the argument failed to recognize the major concerns creating common ruble zone raised within individual states.

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(Pomfret, 2003) Furthermore Grittersova (2014, p. 207) argues that the primary Russian economic reform was based on an overly-restrictive monetary policy which led to shortage of cash for the entire common currency area, which caused the member states to start using other currencies in order to deal with the lack of cash. Additionally, the set-up of the ruble zone encouraged inflationary monetary policy. There was no institution in place to control the ruble, while every domestic state had kept control over the creation of credit.

The failure of the ruble zone is an example that despite having some explanatroy power over the choice of exchange rate regimes in the region, OCA fails to acknowledge the perspectives of individual states. Another pitfall of the theory, especially in relation to the research question of this thesis is that OCA fails to assess the distributional effects of exchange rate regime choice. OCA considers those to be unclear and insignificant (Giovannini, 1995). That is why, when discussing ERR choice interest group approaches have to be considered.

Interest Group Approaches

The interest (or societal) group apporaches consider the ERR choice to be a proxy of the political competiton between the interest groups, the economic sector, and the voters. Each possessing different influence, power and agenda. Frieden (2002) suggests that groups heavily involved in international trade are more likely to support fixed exchange rate regimes because currency volatility may negatively influence their international trade competetiveness. By comparison, the non-tradeable economic sectors and those that compete with imports are more likely to prefer a flexible exchage rate regime.

Using the interest group apporach in explaining ERR choice in Eastern Europe makes sense because during the transitional period their institutional settings have arguably rewarded narrow interest group interests. (Grittersova, 2014) Hellman (1998) echoes this statement by claiming that the big winners of the immediate economic reforms after the communist collapse were able to build large political influence which was used to steer the subsequent economic reforms (inlcuding the choice of ERR) to their benefit. To fully understand this argument, one has to have knowledge of the industrial and trading landscape in the immediate aftermath of the Soviet collapse. In the majority of the Eastern European states, immediately after the

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collapse of the communist regimes, the industrial sectors were dominated by formerly heavily subsizided manufacturing companies. Naturally, when the states’ economies openned, these companies faced international competition. Instead of adjusting to the new reality however, they used their powerful lobbies to proctect their political power and preserve their positonal rents (Grittersova, 2014). Colombato & Macey (1995) specify that ‘old producers’ used their priviledged position to ‘protect’ the economy by limiting the currency convertibility, and appreciating the exchange rate, so they can benefit from state protection (in the form of subsides e.g.). In contrast, flexible ERR limits the states’ options for intervention and facilitates the entry of international competion. (Grittersova, 2014, p. 208).

Balance Sheet Approach

Despite having a significant explanatory power when it comes to the initial choice of ERR, the interest group approach also posseses a limited power to explain change in sectoral interests. For example, Woodruff (2005) applies balance sheet approach to interest group choice theory in the cases of the financial crises in Russia (1998) in order to empirically test the change in societal exchange rate preferences. The balance sheet approach accounts for a wide variety of choices that can determine the way in which the financial situation of a given firm (or a state) is going to be affected by financial crisis. In this way, one can empirically trace how the exchange rate preferences of countries changed over time. Woodruff makes the claim that exchange rate stabilization regimes employed in Russia in order to curb inflation resulted in the creation of new interest groups. Those groups were openly opposed to devaluation of the state currency and ultimately managed to sway the government into making a decision against devaluing the currency in order to protect the powerful tradable sector companies and banks. Especially those who had to use domestic-currency revenues to pay for their foreign obligations.

(Grittersova, 2014) Moreover, those groups who were in support of currency devaluation were offered another means of achieving their goals – tariff barriers and monetary “surrogates’ (for explanation of the term see Woodruff, 2013). Once more, studies like this are important when assessing the dynamic changes in exchange rate preferences in the developing countries.

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The Eastern European states are an intersting case-study choice when it comes to using the interest groups apporach because they are a reminder of how the post-communist transition can change the balance of power overnight and create a completely different set of interest groups. All with their own preferences for economic reforms and exchange rate regime choice. Grittersova (2014) briefly gives example of that by explaining how the entry of foreign banks on the market of the transition countries practically compelled the government to stick with fixed exchange rate regimes in order to make their states more attractive ot foreign direct

investment. In contrast, in the cases where the bank sector remained dominated by state-owned banks, governments lacked the support and motivation to stick to a low-inflation policy and making fixed ERRs and pegs sustainable.

Apart from the industrial sector, research have also been dedicated to the preferences of individual voters. Valev (2005), studied the determining factor of public support/oppozition to unilateral euroization in Bulgaria. The survey showed that the voter’s preferences conformed with the existing economic theory. The people supported euroization for its promised benefits in reducing devaluation, and improvement in FDI. The opponents of euroization felt that

moving on from the domestic currency will equal to the loss of a national symbol. His study also found out that contrary to the popular belief indvidual voters are actually familiar with the economic theory behind the currency board currently in place in their country and assoicated it with the loss of monetary policy and ficsal austerity. However, despite this understanding the currency board of Bulgaria suffered from a lack of credibility. Valev & Carlson (2007), use survey data in order to find out why this is the case. The results of their research show that the

majority of the voters considered the currency board to be a major contributor to unemployment in their country. Therefore the currency board was considered to be

unsustainable due to the limited effect it had over output stabilization in the conditions of high unemployment. (Valev & Carlson, 2007, p. 120)

All in all, the interst groups approach to exchange regime choice provides a more nuanced look at how the process went in the Eastern European states compared to OCA theory. However, despite providing ‘inside information’ about the interests and preferences of different sectors of society, the interest groups approach is often critised for failing to explain how those

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preferences are aggregated. In order to achieve that, micro-level data should be used in order to understand whether the population perceives the costs and the benefits of a particular ERR choice on the national, sectoral, or individual level. For example Broz et al. (2008), analyses the sectoral level and finds out that the majority of the studied Eastern European businesses in fact did not consider the exchange rate regime to be a negative factor in their business activities. Studies like this based on micro-level data can nicely complement interest groups research in determining the extent to which the choice of a particular exchange rate regime was influenced more by domestic or international factors.

International Factors

The influence of international factors provides an almost equally strong explanation about the prefrences of Eastern European states as the interest groups approach. In fact, there is a

separate strand of ERR choice literature that deals with international factors. The first branch of research on the matter focuses on capital mobility.

Capital Mobility

The argument begins with the influential ‘Mundel-Fleming’ framework according to which in economy with high capital mobility, fixing or pegging the nominal exchange rates is ultimately unsustainable without sacrifising the independent moentary policy. (Mundell, 1961) (Flemming, 1962). Whenever the exchange rate is fixed, increased capital mobility should reduce the

efficiency of monetary policy but improves the efficiency of fiscal policy. Hallberg et al. (2002) take this framework as their basis and analyze the business cycles of the then EU accession states. What they have found out is that in the states with flexible exchange rate regime, the central banks tended to tighten the monetary policy during election cycles.

Studies also focus on the importance of the anchor country. That is the so-called hegemonic stability theory or the belief that the economic and political strength of the anchor country (a.k.a hegemonic power) plays a key role in making pegs sustainable due its function of lender of last resort. (Kindleberger, 1986). Example for the validity of this theory is the experiment with the ruble zone. Scholars have argued that it failed in part because of the lack of a strong leadership on the part of Moscow which maked the ruble an impractical anchor choice

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Smee & Pastor, 2001) The theory however, is too ambigious in terms of explaining the nature and crediblity of such a hegemonic power and it lacks the micro-foundations mentioned in the previous section that are needed to understand the pros and cons of monetary cooperation with a hegemonic power. (Grittersova, 2014).

The EU as an International Factor

Cohen (1994), offers an alternative to the hegemonic power argument by suggesting that closer political ties, shared commitments, and a certain degree of interdependence can replace the need for a hegemonic power and offset domestic political weakness. This is the main idea behind the European Monetary Union. And indeed it seems that the European Union has been the biggest external influence for economic and institutional transformation in Eastern Europe. Despite the fact that the majority of these states are now members of the Union (or are

aspiring to be), not all of them chose to peg their currency to the euro. Undoubtedly, smaller EE states can benefit by anchoring their currency to the Euro as it will help them better insulate themselves from any destabilizing capital movements. However, when discussing the influence of the European Union over ERR choice in the region, one should keep in mind that the EU has legally binding trade and financial liberalization measures, but it does not have a clearly defined suggestion as to which exchange rate regime new applicant should adopt at the pre-acession stage. Only a recommendation exists encouraging states to align their monetary policies to those of the Euro in order to prepare themselves for participation in the EMR-II and eventually the Eurozone. (Directorate-General For Economic and Financial Affaris, September 2003). Additionally, the European Commission is against the unilateral euroization of states. In addition to the potential benefits described by this modified hegemonic power approach, OCA can also be used to outline the positives of EE states joining the euro – lower transaction costs, stable interest rates, low inflation, more transparency, and a better access to foreign trade and inventment.

Potential Drawbacks

Nonetheless, there are a several drawbacks to EE states joining the Euro. One is the potential for real exchange rate misalignment that can occur should accession states enter the EMU with

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overvalued currencies. Furthermore, according to Kenen & Meade (2003), they may experience the so-called Balassa-Samuelson effect of increased inflation during high productivity growth in the tradable sectors (pp.6-9). There is also a debate about the effect that the EE’s exchange rate regime choice may have on their capability of meeting the Maastricht criteria. For

example, Lewis (2009) concludes that states with fixed exchange rate regimes are more likely to have difficulites sustainably meeting the inflation criteria. Grittersova (2014) aruges that

considering all of the potential issues that may arise from the Eastern European countries joining the EMU, it is more than likely that the states that did join the Eurozone did not do it purely because of the economic benefits. Instead, the choice of joining the EMU should be seen as a more dynamic one. For instance, all Eastern European member-states expressed a desire to adopt the Euro as quickly as possible after they joined the EU, but only a few actually followed through – the Baltic states, Slovakia and Slovenia. States like Hungary, the Czhech Republic and Poland are still delaying the process; 14 years after they joined the Union. Johnson (2008) attributes this to the little domestic support that central banks had in their desire to rapidly adopt the Euro. The banks logic was that the sooner the post-communist states adopted the euro, the sooner these states could enjoy the benefits of fiscal discipline and price stability. This notion faced the resistance of the domestic governments who were looking to capitalize on political dividents achieved through nonchalant fiscal and monetary policy.

The IMF as an International Factor

Apart from the EU, the IMF was also a significant international factor for the EE states when they were deciding upon an exchange rate regimes. The IMF’s influence in the region however is peculiar. On the one hand, the IMF’s policies of stabilization in Latin America during the 1970s and 1980s strongly influenced and inspired the economic views of the majority of the first generation Eastern European political leaders. On the other, despite it being at the core of IMF’s theoretical thinking, during the 1990s, the fund was reluctant to advise the EE states to adopt fixed regimes, and it was strictly oppossing currency boards. As Nenovsky et al. (2002) argue, this was due to the funds unwilligness to provide concrete financial guarantees to those states that lacked sufficient foreign reserves to defend the currency boards. So, paradoxically

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the IMF inspired but did not initate many of the exchange rate stabilization programs that were launched in Eastern Europe during the transition period.

Another aspect to the the choice of ERR for the states in Eastern Europe is the fact that some countries related the choice to more general feelings of sovereignty and national identity. The Baltic states, Slovakia and Slovenia are good examples of that. Abdelal (2001) argues that Estonia adopted currency board after the ruble zone failed because it wanted to link itself with Europe and thus affirm its independence from Russia. The rest of the Baltic states and Slovenia also wanted to join the euro in order to obtain the underying European identity shared by the EMU members and thus also detach themselves from the former USSR and Yugoslavia (Dyson, 2006) (Grittersova, 2014).

Exchange Rate Policies are Deeply Political

All in all, different exchange rate policies affect different groups within society. That is why one can make conclusions about the political economy of the country in general and about the social groups and agendas the government cares the most about by looking at a state’s exchange rate policy, For instance, a state embracing globalization, looking to enhance international trade and finance is more likely to focus on inflation-targeting and currency stability. Poorer states may want to keep the currency weak in order to facilitate exports and improve economic growth. The choices are virtually limitless and each complies with a different economic and political logic. The next chapter classifies exchange rate regimes in Eastern Europe in an attempt to understand which of the approaches listed above informed choices in the region.

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Chapter 4: Exchange Rate Regime Preferences and

Classification in Eastern Europe Prior to the Crisis

As the chapters above revealed, states’ exchange rate preferences, are not always determined purely by the macroeconomic situation. Factors like distributional conflicts, interest groups, international factors, credibility, identity, and ideology also play a part. While none of these approaches has tackling inequality as its main purpose, the consequences of these preferences could possibly have an influence over inequality.

That is why an overview of the Eastern European exchange rate regimes is needed in order to determine what are the most common preferences in the region. The result of that is going to enable us to form an opinion about what these states’ hoped to achieve with their exchange rate arrangements and whether these expectations were fulfilled. The chapter also makes the basic assumption that under different exchange rate regimes, monetary institutions have varying degree of influence over the above-mentioned macroeconomic aggregates. Thus different exchange rate regimes should different effect over income inequality.

Before moving on to discuss these expectations and assumptions at length, it should be clarified which states comprised the region of eastern Europe.

For the purposes of this thesis, the former Yugo states of Bosnia and Herzegovina, Macedonia, Montenegro and Serbia, plus Moldova and Ukraine are added to the standard OECD group of Albania, Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, Slovenia, and the three Baltic States: Estonia, Latvia and Lithuania. The groups of states that is formed is close not only in geographical terms but also in political terms due to the common Soviet legacy they share.

While there was a certain degree of variation in terms of openness of each communist regime, the political and economic institutions and structures were essentially the same everywhere. Bunce (1999) discusses at length the political economy of post-socialism. The EE states also possessed similar macroeconomic problems reform and agendas the focus of which was price

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and trade liberalization, macroeconomic stabilization, and privatization. Therefore, numerous authors like Sachs (1991), Fischer et al. (1997) and even the World Bank (1996) expected the EE states to adopt similar exchange rate policies.

The Transition Period (1990-1998)

The table below shows the exchange rate arrangements of the Eastern European countries from the period 1990 to 1998. The various regimes are given a number according to their degree of flexibility where 0 equals the lack of separate legal tender, and the 7 means the exchange rate regime is freely floating. The table uses a de-facto classification of the ERRs as they provide more accurate information about government’s preferences than the officially de-jure classification. 1990 1991 1992 1993 1994 1995 1996 1997 1998 Albania 7 7 7 7 7 7 7 7 7 Bosnia and Herzegovina 3 3 3 3 2 Bulgaria 7 7 7 7 7 7 7 2 2 Croatia 4 4 4 4 4 Czech Republic 4 4 4 4 4 4 4 4 4 Estonia 0 2 2 2 2 2 2 2 Hungary 4 4 4 4 4 4 4 4 4 Latvia 7 7 7 7 4 4 4 4 Lithuania 7 7 7 7 2 2 2 2 Macedonia, FYR 7 7 4 4 4 4 Moldova 0 0 0 0 3 3 3 3 Poland 7 7 7 7 7 4 4 4 4 Romania 7 7 7 7 7 7 7 7 7 Russian Federation 7 7 7 7 7 7 7 7 7 Serbia 0 0 0 0 0 0 0 0 7

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Slovak Republic 4 4 4 4 4 4

Slovenia 0 7 7 7 4 4 4 4 4

Ukraine 7 7 7 7 7 7 7 7

0 = No separate Legal Tender 1 = Euro; 2 = Currency board; 3 = Conventional peg; 4 = Crawl-like arrangement; 5 = Other managed arrangement; 6 = Floating; 7 = Free floating.

Source: _{(Ilzetzki, et al., February 2017)}

As the table shows, the countries did indeed began the decade with similar exchange

arrangements in place. From 1990 to 1994, Albania, Bulgaria, Latvia, Lithuania, Macedonia FYR, Moldova, Poland, Romania, Russia and Ukraine all preferred to keep their monetary

independence and were using freely floating exchange regimes. The Czech Republic, Hungary, Estonia and the Slovak Republic were notable exceptions. Prior to 1993, the Czech and the Slovak Republics comprised the state of Czechoslovakia and thus were using the

Czechoslovakian Koruna that was officially tied with a pre-announced +/-2% band to the German DM. After the split in 1993, each state introduced its own currency but they both stuck to a pre-announced band to the German DM. In the case of Slovakia, the Dollar was also added to the basket but with lower weight. Hungary was also using a pre-announced crawling band to a currency basket with often changing compositions and weightings.

Their choice of an arrangement during this initial period made sense due to their close geographical proximity to each other and to Germany which made the Czech Republic, the Slovak Republic, and Germany close trading partners. In that sense, in line with Frieden’s (2017) argument a degree of stability was preferred in order to facilitate trade and investment. At the same time however, the intermediate nature of the crawling exchange rate regime meant that enough flexibility was preserved in order to shield the economies in the event of sudden economic upheaval .

In the case of Estonia however floating and intermediate exchange rate arrangements were not considered attractive. The reason being the small size of Estonia’s economy and the inflational pressures it was experiencing as part of the ruble zone. That is why, when the decision to introduce its own currency after the independence was made, policy makers preferred the

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currency board for its positive effect on inflation and potential to stabilize the domestic monetary conditions. (Knobl, et al., 2002)

After 1994, with the establishment of the first independent former Yugo republics, a move to more fixed exchange rates can be observed in the region. Following the split from the Yugoslav Dinar, Croatia and Macedonia moved to a crawling bands to the DM in order to protect their economies from the unpredictable fluctuations caused by the war. Whereas Bosnia chose a classic peg to the Deutsche Mark and even introduced convertible marka notes. For reasons very similar to those of Estonia, Moldova pegged its currency to the dollar after leaving the ruble zone.

The last state to switch from a floating arrangement to a currency borad during this time was Bulgaria. The country suffered hyperinflation created by excessive currency devaluation and was basically forced to introduce a currency board to the DM. (Nenovsky & Mihaylova, 2007). The fact that states who chose fixed or intermediate arrangements were predominantly using the DM as their anchor also show that ERR preferences were at least in part informed by ideology and the desire of the Eastern European states to become members of the European Union.

In conclusion, the behaviour of the Eastern European states during this transitional period seem to largely refute the OCA theory and be more in line with the international factors approach. Even in the case of the Czech Republic, the Slovak Republic, and Hungary who had common business cycles, the desire to become members of the EU played a significant role in the decision to anchor their currencies to the Deutsche Mark. Elsewhere the Baltic states and Moldova were suffering the effects of the failed ruble zone which prompted them to prioritize exchange rate stability and lower inflation. The newly independent former Yugo states also needed stability and with the exception of Albania all picked soft pegs and fixed regimes. Interest groups also played a role in determining the exchange rate preferences of the region during the transition period. (Colombato & Macey, 1995) (Grittersova, 2014)

Furthermore, scholars seem to agree that fixing the exchange rate in the immediate post-communist transformation was the most effective way to fight inflation (Obstfeld, 1995, Rosati,

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1996). Despite that, it seems like there is no broad consensus when it comes to which arrangement was better for the overal economic growth in the region. Arratibel et al. (2011) argues that although lower nominal exchange rate volatility is tipically related to higher economic growth it is also associated with excess credit and external imbalances which can result in a greater output decline (compared to flexible exchange rate regimes) during financial crises.

Grittersova (2014), considers this argument to be common outside the transitional literature as well, and maintains that unlike in trade policies where there is a clear economic argument for the welfare benefit of free trade, when it comes to exchange rate regimes, such economic-efficency reasoning is much harder to defend. Scholars like Ghosh et al. (2002) and Klein & Shambaugh (2010) also agree that there is little evidence to argue that the exchange rate regime per se has any substantive influence over economic growth. However, looking at the GDP growth figures for the period it becomes clear that growth was stronger in the countries using soft pegs and fixed regimes than in those using floating arrangements.

Source: World Bank Development Index

Intergation (1999-2007)

Despite the academic uncertainty on the matter, Eastern European states continued to convert to soft pegs and fixed regimes in part believing that the early success of countries like Estonia,

-15.00 -10.00 -5.00 0.00 5.00 10.00 15.00 20.00 25.00 1990 1991 1992 1993 1994 1995 1996 1997 1998

Average GDP Growth %

1990-1998

Average GDP Growth Floating States

Average GDP Growth Soft Pegs

Average GDP Growth Fixed Regimes

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the Czech Republic, Hungary and the Slovak Republic were a direct consequence of their exchange rate regime choice. The table below showcases the clear shift from floatinng to managed and fixed regimes in the region

1999 2000 2001 2002 2003 2004 2005 2006 2007 Albania 4 4 4 4 4 4 4 4 4 Bosnia and Herzegovina 2 2 2 2 2 2 2 2 2 Bulgaria 2 2 2 2 2 2 2 2 2 Croatia 4 3 3 3 3 3 3 3 3 Czech Republic 4 4 4 4 4 4 4 4 4 Estonia 2 2 2 2 2 2 2 2 2 Hungary 4 4 4 4 4 4 4 4 4 Latvia 4 4 4 4 4 3 3 3 3 Lithuania 2 2 2 5 5 5 5 5 5 Macedonia, FYR 3 3 3 3 3 3 3 3 3 Moldova 7 7 4 4 4 4 4 4 4 Montenegro 0 0 0 0 0 0 0 0 0 Poland 4 4 4 4 4 4 4 4 4 Romania 7 7 6 6 6 6 6 6 6 Russian Federation 7 4 4 4 4 4 4 4 4 Serbia 7 7 6 6 6 4 4 4 4 Slovak Republic 4 4 4 4 4 4 4 4 4 Slovenia 4 4 4 3 3 3 3 3 0 Ukraine 4 3 3 3 3 3 3 3 3

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0 = No separate Legal Tender 1 = Euro; 2 = Currency board; 3 = Conventional peg; 4 = Crawl-like arrangement; 5 = Other managed arrangement; 6 = Floating; 7 = Free floating.

Source: _{(Ilzetzki, et al., February 2017)}

The period from 1999 to 2007 is a time of intense political integration for the Eastern European states. In 2004 – The Czech Republic, Estonia, Latvia, Lithuania, Poland, Slovenia, the Slovak Republic and Hungary joined the European Union, followed by Bulgaria and Romania in 2007. The exchanged rate preferences of all of these states were determined in large part by the influence of the European Union. Furthermore, once these states became members of the EU, they became obliged to join the Euro. Despite that, as we mentioned above, the EU does not have a clear timeline as to when the states must comply with the convergence criteria and join. Thu leaving room for the formulation of independent exchange rate regime preferences. And indeed, while the governments of the Baltic states, Slovenia, the Slovak Republic and Bulgaria expressed formal intentions to join the Euro as soon as possible, the enthusiasm was not

shared by their collegues in Poland, the Czech Republic and Poland. This shows, the limits of the influence of international actors over preferences formation, while at the same time it

highlights once more the role of interst groups and domestic politics in making such choices. In Hungary for instance, immediatlly after joining the EU, the government showed little interest in implementing a comprehensive economic reform aimed at reducing the high deficit and instead elected to postpone the reform for the next election cycle, promising tax cuts in the meantime. (Euroactiv, 27 April 2005).

In general during this almost a decade, the exchange rate preferences of the EE countries were almost completely dominated by the influence of the European Union. And while the interest groups within some states were opposing the quick adoption of the Euro, the shift towards exchange rate stability was felt everywhere. Even the states that were at the time at the periphery of the EU felt the need to align more with the Euro. Montenegro underwent full Euroization in 2002 despite some dicontent by the ECB and the European Commision. Following the 1998 default, even Russia had to recognize the increasing influence of the EU in its

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and the Euro. Additionally, after recognizing the increased scale of external operations

nominated in euros and the rising Euro segment of the domestic foreign exchange markets, in 2007 the Russian central bank expanded the weight of the Euro in the dollar/euro basket to 0.55/0.45 respectively. (The Central Bank of the Russian Federation, 2018).

Finally, it must be pointed out that for some of these states the financial crises that they went through in the transition period also played a role in shaping their exchange rate preferences. Like we said, the 1998 financial crisis in Russia, was a major reason behind the adoption of the currency band in Russia. Such was the case with the 1996/7 financial crisis in Bulgaria.

Nenovsky & Mihaylova (2007) explain that prior to 1996, the political elites, the subsidized, and state-owned businesses along with the refinanced state-owned banks (whose debt was in domestic currency) were all in favour of a floating exchange rate regimes. Periodic devaluations of the currency and the subsequent inflation meant a reduction of the real cost of their debts. However it also meant that the savings of the main creditors of these banks – the Bulgarian citizens were reducing as well. This policy of ‘redistribution’ lead to hyperinflation and financial crisis. As a result, a strong political alliance emerged in favour of adopting a currency board with the aim to stabilize the exchange rate and prevent the posibility of monetizing the fiscal debt. (Berlemann & Nenonvsky, 2004). Although these were largely isolated and domestic crises, they echoed around the region and might have contributed to a phenomenon called ‘fear of

floating’. (For more on ‘fear of floating’ see (Calvo & Reinhart, 2002) (Pluemper & Neumayer, 2008)). On a broader scale, the crisis in Russia and Bulgaria gave the region a glipmse of the conqsequences of an inappropriate ERR choice that generated or contributed to a financial crisis.

Naturaly this posed the question of whether or not the exchange rate arrangements with which the EE states entered the crisis years were appropriate? The next chapter divides the states into groups based on their exchange rate regimes and analyzes their macroeconomic performance in the period from 2008 onwards.

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Chapter 5– Exchange Rate Regimes Performance During

the Crisis

As explained in the previous chapter, the analysis of the performance of the Eastern European states begins by diving the states in groups based on the type of exchange rate arrangement they operated. The table below provides a detailed overview of the exchange regimes arrangement in the region.

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Albania 4 4 4 4 4 4 4 3 3 3 Bosnia and Herzegovina 2 2 2 2 2 2 2 2 2 2 Bulgaria 2 2 2 2 2 2 2 2 2 2 Croatia 3 3 3 3 3 3 3 3 3 3 Czech Republic 4 4 4 4 4 4 4 4 4 4 Estonia 2 2 2 1 1 1 1 1 1 1 Hungary 4 4 4 4 4 4 4 4 4 4 Kosovo 0 0 0 0 0 0 0 0 0 0 Latvia 3 3 3 3 3 3 1 1 1 1 Lithuania 3 3 3 3 3 3 3 1 1 1 Macedonia, FYR 3 3 3 3 3 3 3 3 3 3 Moldova 4 4 4 4 4 4 4 4 4 4 Montenegro 0 0 0 0 0 0 0 0 0 0 Poland 4 4 4 4 4 4 4 4 4 4 Romania 4 4 4 4 3 3 3 3 3 3 Russian Federation 4 4 4 4 4 4 4 4 4 4 Serbia 4 4 4 4 4 4 4 4 4 4 Slovak Republic 4 1 1 1 1 1 1 1 1 1 Slovenia 1 1 1 1 1 1 1 1 1 1 Ukraine 3 3 3 3 3 3 3 7 6 6

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0 = No separate Legal Tender 1 = Euro; 2 = Currency board; 3 = Conventional peg; 4 = Crawl-like arrangement; 5 = Other managed arrangement; 6 = Floating; 7 = Free floating.

Source: (Ilzetzki, et al., February 2017)

Based on that, three groups can be defined:

Fixed Soft Pegs Eurozone (Floating)

Bosnia and Herzegovina

Albania Estonia (since 2011)

Bulgaria Croatia Latvia (since 2014) Kosovo Czech Republic Lithuania (since 2015) Estonia (until 2010) Moldova Slovak Republic (since

2009)

Montenegro Poland Slovenia

Croatia Romania

Latvia (until 2013) Russia Lithuania (until 2014) Serbia

Macedonia Slovak Republic (until 2008)

Noticeably, apart from the states members of the eurozone, there are not any other states using floating exchange rate regimes. And despite the fact that the euro is a freely floating, these states have effectively ceded monetary independence to the European Central Bank. It should also be reminded that all the exchange rate classifications used in this thesis are de facto classifications which are based on data from the IMF (2016) and Ilzetzki et al. (2017).

So after this division is established, we can now proceed to evaluating the performance of each groups during the crisis.

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Underlying Conditions

Much in the manner of the East Asia crisis 1997-8, the eastern European countries suffered from the so-called twin crisis, experiencing banking and currency crisis simultaneously. There is a broad consensus among scholars that the reasons for the twin-crises could in part be

attributed to the economic policies these states were pursuing in the period in the previous half-decade. The desire to integrate and converge as quickly as possible with the rest of the European states had led to the formation of a substantial credit, housing booms triggered in large part by the increase in of the net capital inflows. (Darvas, 2011). As discussed in the previous chapter the period 2003-07 was a time during which many EE states converted from floating to soft pegs regimes. Only Romania continued to use a freely floating regime.

The tables below show how the levels of foreign direct investment grew in each group of states.

$5,000,000,000 $10,000,000,000 $15,000,000,000 $20,000,000,000 $25,000,000,000 2003 2004 2005 2006 2007

Foreign Direct Investment - Fixed Regimes 2003-2007

Bosnia and Herzegovina Bulgaria

Estonia Kosovo Montenegro $2,000,000,000.00 $4,000,000,000.00 $6,000,000,000.00 $8,000,000,000.00 $10,000,000,000.00 $12,000,000,000.00

Foreign Direct Investment - Romania 2003-2007

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Source: World Bank: World Development Index

With the notable of exception of Romania where the levels of investment increased at a much lower pace and even decreased slightly during 2007, all others experienced exponential surge in investment. These results can be attributed to the fact that soft pegs, and fixed regimes

enjoyed higher level of credibility, and easier access bank loans (particularly in foreign

currency). In fact, apart from the FDI, bank loans were the other major source of net inflows for the Eastern European states:

$50,000,000,000 $100,000,000,000 $150,000,000,000

2003 2004 2005 2006 2007

Foreign Direct Investment - Soft Pegs 2003-2007

Albania Croatia Czech Republic Hungary Latvia Lithuania Macedonia, FYR Moldova Poland Slovak Republic Slovenia Ukraine

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Source: World Bank: International Development Index

As the tables above show, during the five years before the crisis, there has been a substantial increase in the domestic credit provided to the private sector by banks. Once more, this

tendency was stronger in fixed regimes, with domestic credit peaking in some states at close to 80% of GDP. The trend was also supported by the favourable international environment with liquidity abundance and low risk aversion. Bakker & Gulde (2010) argue that the low interest rates and global volatility in combination with the search for higher returns, prompted a surge in capital flows from the advanced countries to the emerging markets of Eastern Europe. Of course, the easy access to credit in the private sector helped the private sector initiative and investment in socially beneficial projects. Private investment in competitive markets is also a major contributor to economic growth and job creation. However, the rapid increases that we saw in both FDI, and in domestic credit also created unsustainable credit and housing balloons. The creation of these booms, was also helped by the monetary and exchange rate policies the Eastern European states pursued at the time. Research already existed linking the liberalization of financial and capital markets increased the probability of twin crises. So, one would expect that the states of the region would have been more aware of the legacy of the Asian crisis. As explained in the previous chapter, the EE states, were inspired by the success of states like Estonia, and terrified by the crisis in countries like Bulgaria and Russia, and turned to various forms of soft pegs in order to guarantee stability, and entice investment.

0 20 40 60 80 100

Domestic Credit to Private Sector by Banks (% of GDP) Fixed Regimes 2003 2004 2005 2006 2007 0 10 20 30 40 50 60 70 80 A lb an ia Cro ati a Cz ec h R ep u b lic H u n gary Mac ed o n ia, … Mo ld o va Po la n d R u ss ian … Se rb ia Sl o vak… Sl o ve n ia U kr ai n e

Domestic Credit to Private Sector By Banks (% of GDP)

Soft Pegs

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By 2008, the states with the highest credit to GDP ratio also had the highest inflation, and the largest current account deficits. Housing prices were rapidly increasing. The external debt of the majority of the countries was worryingly high. As a result the international investment position of Eastern Europe became highly negative. (Bakker & Gulde, 2010, pp. 7-8).

Source: Eurostat: International Investment Position Data

Source: World Bank: International Development Index

-€ 200,000.00 -€ 180,000.00 -€ 160,000.00 -€ 140,000.00 -€ 120,000.00 -€ 100,000.00 -€ 80,000.00 -€ 60,000.00 -€ 40,000.00 -€ 20,000.00 €

-International Investment Position

2006 2007 2008 -18.00 -16.00 -14.00 -12.00 -10.00 -8.00 -6.00 -4.00 -2.00 0.00 2003 2004 2005 2006 2007

Current Account Balance