Central Europe towards Monetary Union: Macroeconomic Underpinnings and Financial Reputation

A key objective of the Central European Economies (CEEs) on their transition path from planned to more market-oriented economies has been membership of the European Union (EU). The start of Economic and Monetary Union (EMU) in 1999 has added membership of the EMU to the agenda for the CEEs. EU membership was a key theme at the intergovernmental meeting of Czechoslovakia, Hungary and Poland in Visègrad as these countries embarked on transition. Early in 1993 the Czech Republic and Slovakia separated, so there are now four Visègrad countries. The task of preparing for EU and EMU membership is the key theme underlying the papers in this volume. The Czech Republic, Hungary and Poland have been fast-tracked for EU membership along with Cyprus, Estonia and Slovenia, with 2003 being the earliest feasible date for admission. Slovakia, because of concerns expressed about its political structures, is on the list of CEEs earmarked for a later round of negotiations regarding EU membership.

A framework is developed for macroeconomic policy analysis in four countries of Central Europe (CE) in transition to EU membership (Czech Republic, Hungary, Poland, and Slovakia). A Multi-Annual Fiscal Adjustment Strategy (MAFAS) and a Pre-Pegging Exchange Rate Regime (PPERR) appropriate for maintaining internal and external balance are described and evidence on budgetary procedures is presented, in comparison with those prevailing in EU member states.

The comparison suggests that the four CE countries are better fit for fiscal stabilization than Greece, Spain and Portugal were in the 1970s. Nevertheless, there is still much room for institutional improvement. A stronger commitment mechanism to fiscal targets at the preparatory stage would improve fiscal performance in all four countries. The adoption of a kind of convergence program would also be made easier if some group procedures can be adopted among them.

In this chapter we present a simple micro-macro-economic model to analyze the behavior of equilibrium real exchange rates in transitional economies. The model highlights that such real exchange rates will be driven by the sensitivity of resource allocation and the distribution of consumption to changes in relative prices, and on the nature of shocks to the equilibrium level of unemployment. For an economy experiencing a successful transition process, it is argued that the real exchange rate should be mean reverting. Evidence that the real exchange rates of Hungary and Poland have exhibited some mean reversion since the inception of the transition period is reported.

This chapter summaries some of the main issues surrounding monetary control in the Visegrad economies, focusing on the ability of the countries to satisfy EMU admission criteria.

Prior to 1990, i.e, prior to the start of transition in the former Czechoslovakia, capital flows were strictly controlled and their macroeconomic importance was rather limited. Transition brought a reversal, both the volume and forms of capital flows have expanded and diversified within a few years. Since early 1990s, capital flows became a major factor of economic developments and a major issue of policy-making.

The Central and Eastern European (CEE) countries in transit ion faced two-fold task: getting rid of the inheritance of the centralised model and creating sound, market-oriented fmancial sector at the same time. Transition from the old monobank system of a centrally planned economy to the two tier banking system of a market economy was accompanied by market imperfections and cost a lot. Though the roots of the problems were similar in the region, the answers given by the individual governments were quite different. The differences lie in the sequence of the reform steps rather than in the characteristics ofthe steps themselves.

The general tasks which each country had to solve by reforming the banking system are described below:

The governments of CEE countries analysed here have to face special pressure coming from the intention to become members of the EU and speeding up the transition process. The association agreements of these countries with EU requires further steps of harmonisation and liberalisation in the regulation of the banking system. Creating free market entrance is particularly urgent in those countries (Czech Republic and Hungary) which have become members of OECD. The quick liberalisation of the financial markets means however further challenge for these countries because of strengthening the international competition on the domestic market.

This overview part of this chapter intends to describe the general characteristics of the transition process in the banking systems of CEE countries. The following parts will give more detailed description of individual country experiences, with special consideration of efficiency and regulation of the banking market.

Despite the fact that banks in Central Europe are still struggling with bad loan burdens, and that capital controls have slowly been eliminated, the South East Asian and Russian crises have not led to a massive failure of banks in the region. In this paper, we study economic trends and policies that may have helped to insulate CEECs from international financial contagion. Using data available from the IMF, and the BIS for nine Central European economies (Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, and Slovenia), our results indicate that an economic constellation unique to the early transition period rather than deliberate policy decisions have stabilized the CEECs. Specifically, the lack of recent banking crisis can be attributed to a lack of speculative financing, to underdeveloped asset markets, and to more long-term international capital flows. Future problems may arise as banks are beginning to extend credit more to an expanding real sector than in the past, as asset markets become more developed, or as export growth to the EU may decline with European growth slowing down.

Bond markets are a relatively recent phenomenon in central and eastern European countries. Neither fixed income investment instruments nor the institutional and legal structure for their issuance and exchange existed in centrally planned economies. The monolithic financial sector was designed and used to monitor and enforce planned industrial production and to maintain macroecononomic stability. It was the central plan rather than market forces which determined the allocation and distribution of financial resources. There was therefore no need for bond markets. Neither the treasury nor local government organs, let alone enterprises, issued bonds for households to invest in (Montias, 1994: 12).¹ While somewhat neglected during the early stages of transition, there is now universal consensus that the rapid development of efficient financial systems is a prerequisite for restructuring and economic development in central and eastern European economies (see, e.g., Bonin/Szekely, 1994; Griffith-Jones/Drábek, 1995). Bond markets form an integral part of more developed financial systems and they can be expected to play an increasingly important role in the reform countries of central and eastern Europe.

In the process of economic transformation from a centrally planned economy to a market economy, the establishment of a stock market takes a pivotal role. After the political revolutions in Central and Eastern Europe (CEE) in the late 80s and early 90s, stock exchanges were introduced at an early stage of the transformation process. But the development and structure of stock markets in CEE countries varies considerably. This paper studies the stock markets of the four Visegrad countries (Czech Republic, Hungary, Poland and Slovakia) and addresses two related questions: First, to what extent and why do the four stock markets differ? Secondly, to what extent do the four stock markets still lag behind the development of a mature, efficient and well-established stock market? The benchmark for comparisons is the U.K. stock market.