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17.06.1997 00:00

Financial Inflows Cause Problems for Transition Economies

Christoph Schneider Office of Public Information
Internationales Institut für Angewandte Systemanalyse Laxenburg

IIASA MEDIA BACKGROUNDER

Financial Inflows Cause Problems for Transition Economies

Laxenburg, Austria - 18 June 1997 - Contrary to common belief, large financial inflows* to a country can cause undesirable and costly economic side effects. A study by the Economic Transition and Integration (ETI) Project at the International Institute for Applied Systems Analysis (IIASA) is analyzing how policymakers and economists in the transition economies of Central and Eastern Europe (CEE) can best grapple with these problems.

The study, titled "Financial Investments in Transition Economies," is based on the cooperative work of IIASA scholars and experts from CEE (mostly from Central Banks) and other international institutions (IMF, ECE, EIB, World Bank, etc.). The study covers eight transition countries (Czech Republic, Hungary, Poland, Russia, Slovenia and the three Baltic republics) and the developments in these countries are compared with experiences of several Latin American and Asian economies.

"The 1990s mark a major change from previous decades in which countries in the process of development constantly felt themselves short of foreign exchange. Now, these countries find themselves attracting too much foreign exchange at once," states Richard Cooper, scientific advisor of the IIASA study. He adds, "In principle, this is good, but every new situation brings new problems. At least in the short term, policymakers in the former communist countries now must deal with the undesirable, side effects of otherwise cherished major inflows of foreign money."

As part of the IIASA/ETI research, international experts met in Laxenburg in search of a consensus on how to deal with the most pressing issues, including real currency appreciation, higher inflation and excessive reserves of foreign currencies. In Poland, the Czech Republic and Hungary economists and policymakers are in the midst of dealing with the effects of large short-term and fluctuating financial inflows.

In Poland, most signs regarding financial inflows are positive. The investments from abroad are steadily increasing even though these have caused the real value of the Zloty to increase. Foreign exchange reserves are now equivalent to 6.5 months of imports. Because recent financial inflows are primarily in the form of foreign direct investment, Polish experts do not expect a drain on the reserves or a short term reversal of inflows. The major problem from the Central Bank's perspective is dealing with the rising amount of domestic credit facilitated by an increasing money supply fueled by the inflows.

The situation regarding financial inflows in the Czech Republic is partially successful and partially problematic. After a record year in 1995, with financial inflows at 18 per cent of gross domestic product (GDP), Czech policymakers are trying to keep the economic system credible enough to continue attracting capital inflows while reducing the swings in short-term flows. To combat the upward pressure on the national currency, the Koruna, the Central Bank increased the band of fluctuation around the fixed exchange rate in early 1996, causing a significant amount of short-term capital to leave the country.

However, recent developments in the Czech Republic reveal the difficulties in identifying the true amounts of short-term capital. Government indecisiveness in dealing with growing trade deficits and budgetary problems induced business and households to rid themselves of holdings in Korunas, eventually forcing the financial authorities to let the currency substantially fall in value. In only a few months, the Czech situation abruptly changed from calm and stable to one with massive financial outflows (from business and official reserves) and the threat of triggering a Mexico-like financial crisis (which happened in late 1994 and early 1995).

In Hungary, the increase in financial inflows since 1995 resulted in no direct macroeconomic effects (i.e., output, investment, consumption, inflation, etc.) due to extensive Central Bank intervention (change of foreign currency to domestic currency) and sterilization (withdrawing part of the unplanned money supply through various financial instruments). The actual costs of these policies are presently being analyzed. Also, little has been done to discourage financial inflows due to memories of the need to raise foreign capital to finance national debt. In fact, net financial inflows went from 16 per cent of GDP in 1995 to practically zero in 1996 because the government used its significant share of total inflows to pay off the large outstanding debt incurred during Hungary's communist past. Financial inflows, mainly as foreign direct investment, remain stable to the private sector of the economy.

"Financial inflows are a mixed blessing for the transition countries - benefits are offset by uncertainties and fluctuations. Even a combination of complex policies will only mitigate but can never eliminate the unavoidable side effects of participating in the global economy," summarizes János Gács, leader of the ETI Project. The international group at the IIASA meeting agreed that:

1. High financial inflows to the transition economies in Central and Eastern Europe are primarily a reward for significantly improved economic performance following a long period of poor economic achievements and uncertain prospects.

2. Financial inflows have positive implications and outflows have negative implications for economic development from the point of view of catching up with developed market economies and establishing a base for long term economic growth. There is little consensus that emerging economies should resist financial inflows.

3. Financial inflows can have destabilizing short term effects. However, the reasons for this have to be carefully analyzed. If inflows are responding to market failures or weak banking, these weaknesses have to be remedied, rather than applying other costly treatments. Rules of bank supervision, for instance, have to be more stringent in transition economies than in mature market economies. Although Latin American and Asian experiences are useful to compare, one should not forget that Eastern European countries operate with less developed financial markets and banking systems.

4. Exchange rates should be made more flexible: wider bands around the central rate make exchange rate movements more volatile and deter short term speculative flows. In contrast, there was little agreement about the use of capital control measures: there is no conclusive experience on whether controls should be applied temporarily or permanently, against short term or long term flows, or if controls are effective at all in dealing with the inflows.

* In the IIASA/ETI study, financial inflows are foreign funds/foreign exchange used to buy domestic property, businesses, stocks, bonds, treasury bills and speculative investments ("hot money"), or foreign funds taken as credits by domestic enterprises or commercial banks.

For more information, contact: János Gács, Project Leader, Economic Transitions and Integration Project, IIASA Tel: +43 (0)2236 807 326, Fax: +43 (0)2236 71313, E-mail: gacs@iiasa.ac.at

The International Institute for Applied Systems Analysis (Laxenburg, Austria) is a non-governmental research institution sponsored by a consortium of National Member Organizations in 17 nations. The Institute's research focuses on sustainability and the human dimensions of global change. The studies are international and interdisciplinary, providing timely and relevant information and options for the scientific community, policy makers and the public.

For further information, please contact: Christoph M. Schneider, Office of Public Information, IIASA phone: (02236) 807 ext. 299, fax: (02236) 73149, e-mail: schneid@iiasa.ac.at

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