The IMF Did Not Request a Flexible Exchange Rate Policy from Croatia

Any depreciation of the exchange rate would only increase the indebtedness and external sensitivity of the domestic economy. Furthermore, the negative impact of depreciation would also be felt on inflation, interest rates, and financial stability. A greater appreciation, on the other hand, would harm the competitiveness of the domestic economy. Therefore, maintaining exchange rate stability is a natural choice of monetary policy

Written by: Boris Vujčić, Deputy Governor of the HNB *

Last week in Washington, at the annual meetings of the International Monetary Fund and the World Bank, the IMF warned that the tightening of credit conditions and problems in the financial market that emerged last summer would continue to affect the markets for some time, making it difficult to assess whether the worst is behind us or whether losses and disruptions in the global financial market will increase in the coming weeks, perhaps months. Shortly thereafter, Merrill Lynch announced that the losses of that investment bank, related to the mortgage market crisis, amounted to eight billion dollars, much more than expected during the annual meetings, thus confirming that uncertainty in the markets remains high, and increasing the uncertainty and fear associated with exposure to risks that cannot be precisely assessed even more than two months after the onset of the problems.

The effects of disruptions in the financial market on the global economy have not yet fully materialized, but it is expected that they will have a slight slowing effect on growth in the short term, and the risks related to projections at this moment are negative, emphasized both the IMF and the European Commission. The strongest negative impact is expected in developed economies, while the largest contribution to global growth in 2007 and 2008 should come from developing countries, primarily China. The IMFC (International Monetary and Financial Committee) called for stronger international cooperation in the area of financial stability (supervision). It was stated that risk management of structured financial products, liquidity management, off-balance-sheet instruments of financial institutions, as well as the work and role of rating agencies should be reconsidered to avoid the consequences arising from recent disruptions in the financial market through better regulation.

At one of the seminars that always accompany the meetings, Alan Greenspan emphasized that the disruptions that occurred in August were ‘an accident waiting to happen’ and that it would have occurred in some other segment of the financial markets if the market’s stance on subprime mortgages had not changed. Jürgen Stark, a member of the ECB Council, stated that hedge funds did not cause or worsen the current disruptions, but rather help the efficient functioning of the market. It was also emphasized that it is surprising how both developing and developed countries have successfully adapted to the record high price of oil. Saudi Arabia indicated that it is ready to increase production if needed to meet strong demand, OPEC emphasized that oil supplies are satisfactory, Axel Weber, president of the Bundesbank, stated that he does not expect the recent rise in oil prices to last, and the G7 countries would like OPEC to increase production.

There was also a discussion about the exchange rates of sovereign wealth funds and IMF reforms. The differing views of the IMF, Eurogroup, and the US on the exchange rate of the euro and the dollar were interesting. US Treasury Secretary Paulson reiterated that a strong dollar is still in the interest of the US, Jean Claude-Juncker, president of the Eurogroup, stated that the eurozone has accepted Paulson’s statement with ‘great attention’ and warned investors of the ‘risk of unilateral betting’ in the foreign exchange market, while Rato stated that the dollar is still fundamentally overvalued against other currencies and that the markets are ‘just betting’ on when its overvaluation will be removed.

The G7 reiterated that China should allow the appreciation of the yuan, and the People’s Bank of China agreed that a large trade surplus is becoming a burden for the country, but that currency appreciation is not the answer that will enable a more balanced foreign trade exchange. Instead, it sees the high and increasing savings rate in China, especially in relation to the US, as the main cause of the balance of payments imbalance. The IMFC assessed that sovereign funds (funds established by states to manage their money) are beneficial and improve market liquidity and allocation of financial resources, and warned that protectionism should be avoided and instead a dialogue should be opened on the best way to operate such funds. It was clear that the US and EU are concerned that these funds could be used to purchase companies of strategic interest, or that investments could be managed by others, rather than commercial interests.

Sovereign funds are, in fact, very large sources of capital for investment under the direct supervision of the governments of the countries that establish them. The largest have recently been established by China and Saudi Arabia, but they have existed for a long time, for example, in Norway and Singapore. However, it is clear that protectionism towards the capital of these funds would be counterproductive. Therefore, a dialogue has been initiated in Washington between the EU and the US and countries that control large sovereign funds about the principles of investing these funds. The reform of the voting system in the IMF will be completed by the next meetings in April 2008, and will ensure a relative increase in the voting weight of fast-growing developing countries, whose voting quotas today significantly underestimate their economic size.

In short, these are the highlights from this year’s meetings of the IMF and the World Bank. Interestingly, in the domestic press, the greatest attention was drawn to an article in the Financial Times regarding the IMF’s assessment of economic vulnerability in Southeast Europe. Interesting because there has already been talk about all this in Croatia, primarily at the HNB, and there have been a number of research papers and conferences on the same topic in the last three to four years. In the official analysis of the global economic situation that accompanies the annual meetings, the so-called Economic Outlook, which anyone can view on the IMF’s website, Croatia is mentioned only in the context of the IMF’s assessment that under the conditions of a stable exchange rate policy, limiting strong domestic demand, which increases the vulnerability of the economy, should primarily rely on restrictive fiscal policy. This, however, is also stated in every more advanced macroeconomics textbook (that is, one that deals with possible choices of economic policy).

Interpretations that have also emerged, namely that the IMF is requesting a flexible exchange rate policy from Croatia, have no basis. The IMF does not recommend this to Croatia either in the Economic Outlook or during bilateral meetings. Even if that were the case, the HNB’s stance on this matter is very clear, and the governor reiterated it in this context last week. Any change in the exchange rate carries significantly greater risks than potential benefits. The greatest risk is related to the very high currency indexing of loans, which is why any depreciation of the exchange rate would only increase the indebtedness and external sensitivity of the domestic economy. Furthermore, the negative impact of depreciation would also be felt on inflation, interest rates, and financial stability. Significant appreciation, on the other hand, would harm the competitiveness of the domestic economy. Therefore, maintaining exchange rate stability is a natural choice of monetary policy.

The article in the FT evidently relied more on a working paper on vulnerability in Southeast Europe that I, knowing some of the authors, read before publication. That paper does not reflect the IMF’s stance, but solely that of the authors, which is the rule when publishing such papers. However, that paper does not state anything sensationally new, nothing that has not already been discussed in one way or another in Croatia. It does not state, of course, that a financial crisis is looming in Croatia. That the increase in external debt, especially short-term and especially under conditions of high currency indexing, high credit growth, and relative inflexibility of the exchange rate increases the vulnerability of the economy to external shocks, we have known for a long time. For that reason, the HNB has been taking a number of measures for years to slow down credit growth and the accumulation of external debt and to limit the growth of the current account deficit.

For this reason, it is necessary to continue with a policy aimed at stabilizing the share of external debt in GDP and stopping the relatively rapid growth of short-term debt after 2002. Both with measures in the field of monetary policy and with relatively restrictive fiscal policy. Why is this necessary? To reduce the vulnerability of the domestic economy to possible economic shocks, external or domestic. What kind of shocks can these be? A disruption in the inflow of capital into the country, for example, due to disruptions in financial markets and/or changes in the country’s risk assessment; a sudden rise in interest rates in the financial market, currency shocks, a sharp decline in asset prices (stocks, real estate…), changes in trading conditions in global markets, or a significant slowdown in economic growth. A characteristic of such shocks is that they rarely come individually, but usually several of them simultaneously. We know that they occur from time to time, as history shows, and that in those moments the countries most vulnerable to such shocks suffer. However, economists’ ability to predict when and with what strength such shocks will occur somewhere is still limited. Therefore, the vulnerability of the economy to such shocks must be kept under constant control.

* The views of the author do not necessarily reflect the views of the HNB