研究ノート

Exchange Rate Policy and Capital Flowin NewEntrants of EU

Yutaka Kurihara

Abstract
The purpose of this paper is to examine CEE (Central and Eastern Economies) countries' experience both with exchange rate management and thepolicies implemented to deal with capital flows. A key issue of this paper iscredibility of exchange rate band. This paper focuses on this point and analyzes the deviation of the spot rate from the center of the band to be kept
for participating in the common currency, euro. Countries have conducteddifferent measures to keep exchange rate stable and keep exchange rates
within the narrow band under sometimes strong pressures of capital flows
from all over the world.Most countries have been manipulating domestic
interest rate successfully against strong pressure in most cases. In the second period, namely, after entering the ERM (Exchange Rate Mechanism)in Europe, monetary authorities could have set interest rates adequately tokeep exchange rate stable in a band. Moreover, foreign reserves have sometimes played important roles for keeping a band. Most countries might
have chosen to stabilize the exchange rate by reserves through a target― 57 ―

zone mechanism.

１. Introduction
Since the EU started, market integration has increased gradually andlargely. Market obstacles of promoting trade and investment have been almost eliminated. Foreign direct investment (FDI) has increased rapidly asmarket integration has increased. Many countries have enjoyed the meritsof integration. The EU economy has been in relatively in good condition before financial crisis occurred in 2008.
The process of European economic and political integration has been ongoing and has extended more to the Central and Eastern Economies (CEEs)
recently. Eight countries of central and eastern Europe − the Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland, Slovenia and Slovakia −joined the EU, finally ending the division of Europe decided by the GreatPowers 60 years earlier at Yalta. Cyprus and Malta also become members.
From 2004, 12 CEE countries joined the EU after satisfying severe requirements. Even before Bulgaria and Romania joined the Union, entry negotiations with two more candidate countries, Turkey and Croatia, had begun.
In June 2010, the European Council decided to open negotiations with
Iceland.All of them were admitted to the World Trade Organization(WTO), and some have been already been admitted to the Organization for
Economic Cooperation and Development (OECD) and NATO. This integration has been facilitated by economic and political reforms that have led tothe institutional convergence of the CEE countries.
When the euro was launched on 1 January 1999, it became the new official currency of 11 countries, replacing the old national currencies. First― 58 ―

Exchange Rate Policy and Capital Flow in NewEntrants of EU

introduced as a virtual currency for cash-less payments and accounting
purposes, it appeared in physical form on 1 January 2002. The euro is not
the currency of all EU countries. Two countries (Denmark and the United
Kingdom) agreed an 'opt-out' clause in the Treaty exempting them fromparticipation, while the remainders (many of the newest EU members plus
Sweden) have yet to meet the conditions for adopting it.
Foreign exchange system in most countries has evolved from a fixednominal exchange rate one to managed float to facilitate accession to the
Economic and Monetary Union (EMU: Economic and Monetary Union).
This requires participation in the Exchange Rate Mechanism (ERMⅡ: Exchange Rate MechanismⅡ), leading to irrevocable monetary integration,
the adoption of the euro and forgoing independent monetary policy1.
After joining the common currency, euro, the Maastricht criterion requires participation in ERMⅡfor two years without significant exchange
rate disruptions or pressures prior to becoming a member of the EMU. Thisobligation to keep the domestic currency within a narrow band may present a challenge.
The purpose of this paper is to examine CEE countries' experience bothwith exchange rate management and the policies implemented to deal withcapital flows. A key issue of this paper is credibility of exchange rate band.
This paper focuses on this point and analyzes the deviation of the spot ratefrom the center of the band to be kept for participating in the euro. Countries have conducted different measures to keep exchange rate stable andthe narrow band under sometimes strong pressures of capital flows.
This paper is structured as follows. Section 2 reviews the movement of
exchange rates in each country. Along with exchange rates, other economic
variables related with exchange rates are examined. Section 3 analyses― 59 ―

theoretically credibility of the exchange rate band for empirical analysis.
Section 4 provide the results and examines them. Finally this paper ends
with a brief summary.

２. Exchange Rate and Some Other Variables Performances
The absolute and conditional convergence of economic variables or performance in the Central and Eastern European countries is expected toincrease2. Given that these countries have common roots3 and their economies have experienced similar challenges over time, the regional convergence in the CEE region may be seen as an intermediary stage of the CEE
participation to the EMU. Szeles andMarinescu (2010) suggest empiricalevidence on both absolute and conditional convergence in the CEE countries, for example. Exchange rate is related with economic performance.
Arratibelet al. (2011) find that lower exchange rate volatility is associatedwith higher growth, higher stocks of FDI, higher current account deficits,
and higher excess credit in the CEE countries.
In this paper, firstly, exchange rate volatility is examined. It is necessary
to examine whether exchange rate policy has actually had the desired stabilizing effects on the exchange rates The sample period is different fromeach country as they participate in ERM at different stage. Also, somecountries have not yet introduced euro. Table 1 is the time of a) entering
ERMdate and b) introducing the euro date.
The sample period is divided into two according to Table 1. The first one
is from 1999: 1, the starting time of the euro before participating in the
ERM4. The second one is from the time to now (Feb. 2011). However, testsof unit roots for all the variables did not reject the hypothesis of unit roots― 60 ―

Exchange Rate Policy and Capital Flow in NewEntrants of EU

Table 1. ERM Participation and Introduction of the EurocountryEntering ERM date

Introducing the euro date

CyprusApril 29, 2005

Denmark

January 1, 1999

Estonia

June 27, 2004

LatviaApril 29, 2005

Lithuania

June 27, 2004

Malta

April 29, 2005

January 1, 2008

Slovakia

November 25, 2005

January 1, 2009

Slovenia

June 27, 2004

January 1, 2007

January 1, 2011

Table 2. Volatility of the Exchange Ratecountry

Cyprus Denmark Estonia Latvia Lithuania Malta Slovakia Slovenia

First period

0.0398

Second period

0.01530.07980.47870.00780.06370.0523

1.13966.59761.37590.01690.07980.01480.84240.1271at conventional significance level (5％), so volatility was measured as thestandard deviation of the first differences of each variable. The data isagainst the euro and monthly. The results are presented in Table 2.
The results are interesting. In some countries exchange rate volatility
has shrank greatly, however, the volatility is similar and not so different
across periods. Introducing the band or limitation of exchange rates fluctuation has not reduced the volatility at least in some countries. One reason
is that there issome big turmoil in international financial markets.
Rehman shock is one of them. The other reason is that to reduce volatility
costs side effects. Bertola and Caballero (1992) and Werner (1995) indicate― 61 ―

Table 3. Volatility of fundamental variables of exchange rates
Cyprus Denmark Estonia Latvia Lithuania Malta Slovakia Slovenia
GDP
First
indicator period

0.8032

7.0467 13.1821

5.18576.59220.43573.44990.1895

Secondperiod

0.942315.8576

4.4006

7.04670.7331

6.16712.5418Interest First
rate
period0.5076

0.94931.01500.56700.07100.42470.5237

Secondperiod

0.48320.35833.40320.40450.09580.22810.12710.4045that although the variability within the band may fall for narrow bands,
expectations of realignment may be greater.
Examining volatility by looking at the evolution of exchange rates only
may be misleading because the variability of exchange rate fundamentals
may have changed across periods5. Along with exchange rates, other economic variables should be examined. Table 3 is volatility of exchange ratefundamentals. Volatility was also measured as the standard deviation of
the first differences of each variable. The data is also monthly. Interest
rates are money market rates in each country.
The results show that economic activity (GDP)6 are almost same acrossperiods, however, some countries show that interest rates7 have been stable
during the second period. Introducing euro requireskeeping interest rates
low, however, one of the reasons may be the result of foreign reserve accumulation. A lot of countries have increased foreign reserves to combat
speculative attacks against domestic currency. It may have contributed tostable economic conditions.
Finally, Table 4 is foreign reserves in each country. We can say that most

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Exchange Rate Policy and Capital Flow in NewEntrants of EU

Table 4. Foreign Reserve Accumulation (million; US dollar)
Cyprus Denmark Estonia

Latvia Lithuania

Malta

Slovakia Slovenia

1999

1783.80 21145.00

852.12868.921190.61

1701.903369.903058.79

2000

1694.00 14469.00

920.62850.831310.211385.80

4021.803110.00

2001

2221.90 16117.00

820.201148.59

1599.27

1582.40

4140.30

4244.33

2002

2953.20 25901.00

1000.34

1241.272295.862115.258807.506852.572003

3154.50 36004.00

1373.271432.223371.892624.53 11676.80

8343.092004

3832.70 38196.00

1788.131911.743512.47

2621.68 14416.10

8662.27

2005

4155.90 32510.00

1943.122231.913720.142473.00 14899.40

8013.12

2006

5621.50 29160.00

2781.144353.135654.26

2865.00 12645.20

6987.082007

6100.10 32029.00

3262.595553.117565.613662.00 18025.80

942.04

2008

585.53 39823.00

3964.775027.176281.33

288.29 17804.90

809.91

2009

562.92 71259.00

3874.69

6444.996237.91329.6850.42

589.55

2010

276.21 70334.00

2460.367069.486362.04

340.4952.11

543.18Note) Data source is from IFS (IMF).

countries have increased the reserves. This reason is examined in later.

３. Theoretical and Empirical Framework: Credibility of the Exchange rate band
A key point in the functioning of an exchange rate band is credibility.
Rose and Svensson (1994) examined the expected changes of the exchange
rate implied by the interest rate differential and infer whether it is consistent with the exchange rate staying within the band. However, because of
the existence of foreign reserves for capital inflows and the absence of any
cost for outflows, interest rate differentials do not reflect expectations of― 63 ―

exchange rates depreciation. Also, Svensson (1992) has argued that themethod is inclusive for short horizon expected rates of realignments vary
more than interest rate differentials. Moreover, although the method canidentify when the band is not credible it cannot identify when it is credible,
because forward rates may be inside the band regardless of credibility.
Afonso et al. (2011) indicates that foreign reserves and default history areimportant long-run determinants of sovereign debt credit ratings in the
CEE countries.Liesenfeld et al. (2010) suggest that current account balance, terms of trades,foreign reserves and concessional debt are important
determinants of current account reversal.
This paper employs another method following Helpman, Leiderman, andBufman (1994).
st＝ct＋dt(1)

st is the log of the each country's spot exchange rate against the euro attime tis assumed to be the sum of two components: One is the log of thecentral parity (ct) and the other is the deviation of the spot rate from thecenter of the band (dt). Helpman, Leiderman, and Bufman (1994) andMagendzo, Rojas, and Vergara (1996) used interest rate differentials as aproxy. On the other hand, foreign reserve sometimes may play importantrole for exchange rate determination.
A linear model is where futurethe difference between st - ctdepends on thedomestic interest rate i (domestic interesttate), and international interest
rates i* (the euro interest rate:einterest) and the foreign reserve (reserve).
et−ct＝α＋β1it＋β2i*t＋β3RESERVEt(2)

β1 is expected to be minus, as the domestic interest rate decreases (increases), exchange rate (et) appreciates (depreciates). On the other hand,
β2 should be positive. β3 should be positive. As foreign reserve increases― 64 ―

Exchange Rate Policy and Capital Flow in NewEntrants of EU(decreases), depreciation of exchange rate occurs. However, there is somepossibility that accumulating foreign reserves result in appreciation of domestic currency as measures against speculative attacks or future selling
preparation of foreign currencies would be sufficient. In this case, β3
should be negative. Which is correct is checked by empirical method. In thenext section, empirical analysis is performed and the results are examined.

４. Empirical results and its implications
For regression, GMM (Generalized Method of Moments) is employed.
The estimates are chosen to minimize the weighted distance between thetheoretical and actual values. GMM is a robust estimator in that, unlike
maximum likelihood estimation, it does not require information of theexact distribution of the disturbance. The results of the equation (2) are
shown in Table 5.
For the interest rates, the results are as expected in most cases. Compared to the first period, the second period is more in accordance the expectation mentioned above. On the other hand, euro interest rate has not
moved in both periods as expected. It has made countries difficult to keepexchange rates in a band. However, each country may have been manipulating domestic interest rate successfully against strong pressure in somecases. Target zone or ERM systemshould have stabilizing effects on theevolution of exchange rate successfully. It may have stabilizing effects aslong as the band is maintained at its edges through explicit intervention tokeep the exchange rate within the band.
The results are inconclusive for foreign reserves. It is interesting to notethat there are some opposite movements to exchange rate in the second pe-― 65 ―

Table 5. Determinants of Change in the Exchange Rate Position (GMM)
country

periodcinterest

einterest

reserve

F-statistic Adj. R2

CyprusFirst
period-0.4529(-7.3742)

0.0341(3.4956)

0.0383(3.4991)

7.37E-05(5.8212)20.0883

0.4362

Secondperiod0.1504(2.8505)

0.0005-0.0503(0.1015) (-6.2903)

1.87E-06(0.1856)54.7456

0.8344First
period

2.9422(6.5374)

0.6041-0.9490 -6.10E-05(2.6247) (-3.9419) (-9.5985)

50.41260.5142-0.0032(-4.5874)

91.2657

0.8088Denmark

SecondperiodEstonia

LatviaFirst
period

-0.9048-0.3029(-0.8673) (-3.4468)

Secondperiod0.1545(8.5303)

0.0046-0.0060 -4.03E-05(1.2391) (-1.6240) (-5.4812)

31.1265

0.5600First
period-0.0325(-1.5061)

0.0011(0.5784)0.0197 -3.11E-05(6.0363) (-3.2594)

52.82070.6775

Secondperiod0.1194-0.0028-0.0090 -1.89E-05(10.0521) (-2.4586) (-4.2094) (-9.9034)

39.7591

0.64140.0051-0.0006 594.2455(0.3030) (-27.9917)

0.9652

Lithuania First
periodMalta

Slovakia

Slovenia

1.2515-0.0306(12.7590) (-4.5524)

Secondperiod

0.4676(4.5961)First
period

0.0340-0.0309(0.0696) (-0.6358)

Secondperiod

0.3528(5.2871)

First
period-5.3002-0.6579(-3.1973) (-1.8965)

Secondperiod1.5306(9.4283)

0.0328-0.0130-0.0001(1.7926) (-1.3817) (-12.4125)
0.0241(0.8833)

8.72E-06(0.0731)0.0555-0.0103 -4.13E-05(2.4439) (-0.7323) (-2.5628)

63.9701

0.72680.9609 -0.0015
72.3726

0.8699-0.0006 240.6632(-7.0788)

0.898724.1593-0.5086-3.1329(5.6528) (-0.6558) (-5.2853)-0.0006(-2.8673)

86.10070.8734First
period-73.7861-5.2983
21.9317(-7.2433) (-3.9052) (12.1555)

0.0058(7.4959)

65.19100.7505

Secondperiod-41.6082(-0.8759)-0.0011(-1.4068)

2.41040.123613.5204(1.2927)

3.6220(9.5613)0.6257(0.1508)Note) t-statistics are shown in parentheses.

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Exchange Rate Policy and Capital Flow in NewEntrants of EU

riod. As already mentioned, accumulating foreign reserves may result inappreciation of domestic currency as domestic monetary policies against
speculative attacks or future selling of foreign currencies would be sufficient or large. Also, some countries may have been positive stance in keeping exchange rates depreciation for promoting exports.
Central bank holdings of reserves currency assets have risen sharply inthese countries 8. Most countries might have chosen to dampen the share ofthese capital inflows through the use of a reserve and to stabilize the exchange rate through a target zone mechanism. It imposes a relatively
higher cost on short-term inflows. The reserve might have permitted maintaining domestic interest rates above international interest rates without
imposing excessive pressures on the exchange rate.

５. Conclusions
To accomplish the criterion that requires participation in ERMⅡwithout
significant exchange rate disruptions or pressures prior to becoming amember of the EMU is not easy task. However, CEE countries have mademuch effort and have succeeded in realizing good economic conditions toward the road to participating ERM or introducing a common currency,
euro.
They have succeeded in performing good economic condition and attaining the requirements for not going out of the ERM, however, their policies
taken in every aspect is different. Along with domestic interest rates, foreign reserves have sometimes played important roles for keeping a band.
Most countries might have chosen to stabilize the exchange rate through atarget zone mechanism via foreign reserve accumulation.

― 67 ―

Most countries have been manipulating domestic interest rate successfully against strong pressure in some cases. In the second period, namely,
after entering the ERM, monetary authorities could have set interest rates
adequately to keep exchange rate stable in a band.
It should be noted that capital flows have grew largely in CEE countries.
Sometimes there are strong pressures to exchange rates. Under such circumstances, CEE countries have been able to conduct monetary policies adequately and attain good economic conditions, so they could enter the ERM
or introduce a common currency, euro.

Notes
１. Syllignakis and Kouretas (2010) suggest that the financial linkages between the
CEE markets and the world markets increased with the beginning of the EU accession
process.
２. Tanja (2011) indicates that at the moment Croatia is far from ready for the common
monetary policy of the EMU, while among other CEE countries Slovenia and Latvia
have the closest connection between their business cycles and those of the EMU.
３. Schnabl and Ziegler (2011) show that workers in countries with fixed exchange
rates are likely to benefit in the long run from higher wage increases.
４. To participate in the euro, they have to limit the exchange rate volatility in the bandfor two years according to the ERM agreement.
５. Jimnez-Rodrguez et al. (2010) find that some countries like Slovakia and Sloveniaalready euro area members - react stronger to foreign industrial production shocks
than other countries and that the responses to such shocks are strongly correlated forselected CEE countries.
６. Industrial production is used instead of GDP for data availability.
７. From 1985 to 1998: 12, money market rate in Germany is used and after that eurointerest rate is used.
８. Policymakers in central banks in Asia seem to have selected to get foreign reserves
for self-insurance or precautionary motives against future crises or exchange rate
movements. See, Kurihara (2011).

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Exchange Rate Policy and Capital Flow in NewEntrants of EU

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