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Wednesday, November 30, 2016

Economy Emerging Europe - The demands on monetary and exchange rate regimes in CESEE have evolved, in line with the region’s development .. - IMF

Publication - Taking Stock of Monetary and Exchange Rate Regimes in Emerging Europe

Executive Summary

In the quarter century since transitioning from socialism, countries in Central, Eastern, and Southeastern Europe (CESEE) have adopted a multitude of monetary strategies. Today, almost every type of monetary and exchange rate regime can be found in the region, from inflation targeting and floating to pegs and the unilateral use of the euro. 

The demands on monetary and exchange rate regimes in the region have evolved. In the early to mid-1990s, the main task was to control inflation, following the liberalization of prices. Once this was achieved—often by means of exchange rate–based stabilization—the focus shifted to aligning monetary conditions with the economies’ needs, among other reasons to manage the process of income convergence with Western Europe. 

Against this yardstick, flexible exchange rate regimes have been associated with more favorable outcomes, owing to better alignment of monetary conditions with cyclical needs. Economies with flexible regimes experienced a more muted boom-bust cycle in 2003–13, and have displayed greater resilience more recently in the face of deflationary pressures, imported in part from the euro area. Their growth outlook also appears, on average, stronger, as they are less saddled with private sector debt, have preserved higher investment ratios, and have suffered lesser human capital losses from unemployment. 

However, obstacles to more exchange rate flexibility are large. Fixed exchange rate regimes in CESEE are often rooted in traumatic experiences with hyperinflation during the transition from socialism, which created lasting distrust in domestic currencies. One consequence is high deposit and loan euroization in many countries, which leaves central banks with little room for maneuver. Some countries also face capacity constraints due to their small size and inadequate institutions. In such circumstances, tying the currency to a strong anchor like the euro provides monetary stability and can support confidence, which can be more important than fine-tuning monetary conditions. 

Looking ahead, both options—sticking to existing fixed-rate regimes and transitioning to more flexibility—come with challenges and require policy efforts to make the regime work, with the balance of benefits and risks depending on country characteristics. Countries that stick to fixed exchange rates should seek to make stronger use of countercyclical fiscal and, especially, macroprudential policies to compensate for monetary misalignment. Alternatively, transitioning to more exchange rate flexibility requires a carefully planned and executed strategy to contain monetary and financial stability risks that an uncontrolled shift could trigger.

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