Exchange rate problem at the
beginning of the
transformation process
©Libor Žídek (26. 6. 2014)
• Klaus says that the setting of the exchange
rate was the most difficult task in the whole
transformation process.
• One of the reasons was the complexity of the
problem
• Foreign advisers recommended setting
exchange rate between 20 to 40 crowns per
USD. It did not help reformers much. :-)
• We explain the theoretical background and
later on the entire problem in this
presentation
preconditions
• this presentation shows just very simple cases
or impacts. Reality is much more complicated.
• we suppose foremost that
– inflation is equitable – all prices (including wages!)
change the very same way
– all foreign currency reserves are held by the
central bank (it worked like that at the beginning
of the transformation)
• note that we use the direct quotation of
exchange rate … it means that the exchange
rate is expressed in the form 18 CZK per USD.
Instead of the indirect quotation that says 1
CZK is 1/18 of USD!
Contents
• theoretical background –basic terms
– 1. impact of the nominal exchange rate change
– 2. real appreciation
– 3. balance of payment
– 4. functioning of the fix exchange rate regime
• the key decision about exchange rate
– crown is too strong
– crown is too weak
THEORETICAL BACKGROUND –
BASIC TERMS
The first part
1. Impact of the nominal
exchange rate change
• the basic impact is clear – devaluation helps
exports and has negative impact on imports.
Appreciation has the opposite effect.
• we can imagine a basic case. First of all, the
exchange rate is 10 crowns per USD. Crown
devaluates to 20 crowns per USD. It means
that a Czech exporter selling a product in the
USA for 100 USD gets 2000 crowns instead of
1000 crowns. It is good for him or her. :-)
devaluation is good for exports
world market Czech Republic
10 crowns =1 USD
1000 USD (Czech exports) 10 000 crowns
devaluation
20 crowns = 1 USD
1000 USD (Czech exports) 20 000 crowns
• but at the same time. Meanwhile, all the imports
cost more in CZK. Imagine that a product (for
example oil) costs 1000 USD on the world
market. The Czech economy needs it and we
import it. It now costs twice the previous price in
CZK. It means that devaluation causes inflation.
2. Real exchange rate (RER)
• theoretical concept that should say how it is
on average possible to exchange goods and
services between countries
• how many times it is possible to purchase
basket of goods abroad for the same basket in
the home economy
• in practice: changes of RER (appreciation and
depreciation of the RER) are more important,
than absolute level of RER
real exchange rate
• for example … nominal exchange rate is 25 crowns
per euro, price of a product in Germany is 1 euro and
in the CR 25 crowns
• real exchange rate (RER) = 25 * 1/25 = 1
• if RER >1 we have to spend more than one domestic
basket on purchasing one foreign basket
priceDomestic
priceForeignrateexchangeNominal
rateexchangeReal


RER depends on both – nominal exchange
rate and price levels in both of the countries
appreciation of the RER
• There are generally two ways how crown can
appreciate.
– a. change in the nominal value of exchange rate  CZK
nominally appreciates
– b. change in price level  price level in the CR grows more
than abroad
• you can generally see it when the Czechs can
purchase more on the foreign markets (because of
nominal appreciation or because of growth in wages
is higher in the CR than abroad)
Real appreciation of CZK under fix
• If there is fix exchange rate - 10 crowns per DM. Price
level in Germany does not change but price level in
the CR increases by 50 % (all prices including wages).
Then average wage in the CR increases (from 10 000
to 15 000 CZK) and the Czechs can purchase goods in
value 1500 DM in Germany.
Germany Czech Republic
10 crowns =1 DM
1000 DM (price of a products) 10 000 wage
Inflation = 0 % Fix exchange rate Inflation = 50 %
10 crowns = 1 DM
1500 DM (price of a products) 15 000 wage
Impact of real app. on exports
• but this process has cons for exporters. Firstly, they
sell a product in Germany for 1000 DM. They get 10
000 CZK. They have a nice profit of 4000 CZK. Next there
is no inflation in Germany but 50% in the CR.
They still sell the product in Germany for 1000 DM
and get 10000 CZK for it but their profit declines to
1000 CZK.
Germany Czech Republic
10 crowns = 1 DM
1000 DM (price of a exp. product) costs = 6000 CZK
10 000 CZK … profit 4000 CZK
Inflation = 0 % Fix exchange rate Inflation = 50 %
10 crowns = 1 DM costs = 9000 CZK
1000 DM (price of a exp. product) 10 000 CZK … profit 1000 CZK
Impact of real appreciation
• the exporters are under pressure that was caused by
real appreciation of CZK, they will call for nominal
depreciation of crown to balance it.
• trade balance will worsen because exports are
declining and imports are growing
• on the market there is huge demand for foreign
currencies (because of imports) and at the same time
supply is limited (because of small exports)
• it means that there will be overall pressure to
devaluate crown
3. Balance of payment
• balance of payment is the basic indicator of an open
economy. It covers all international transactions with
abroad.
• it has important consequences
• it is always balanced by definition (but informally we
talk about surplus and deficit of balance of payment
– it means inflow and outflow of foreign reserves).
• we first of all define the basic terms and then show
the logic behind
balance of payment
• consists of several accounts. In basic textbooks
there are only:
– current account
• trade balance = Sum of exports – sum of imports
• balance of services = exports of services – imports of
services
– financial account
• different forms of capital (FDI, portfolio, short run, long
run)
• and we again consider a balance between inflow and
outflow of capital from the country
balance of payment
• in these textbooks current account is always equal to
financial account
• if there is surplus in the current account it must be
balanced by outflow of capital in the financial account
• if there is a deficit in the current account it must be
balanced by inflow of capital in the financial account
current account
financial account
=0
balance of payment
• in reality the accounting world is a bit more
complicated
• the balance of payment has to be of course
balanced but there are additional entries. For
our needs we consider especially change in
foreign reserves
balance of payment
for example if surplus in the current account > outflow of capital
in the financial account the foreign reserves increase to
balance the whole balance of payment
(this is a simple explanation in reality double-entry accounting
is used )
reserves – for accounting reasons „+“ means decline in reserves
and „-“ means increase in reserves
current account
financial account
change in foreign reserves
=0
balance of payment - example
• exports of goods > imports of goods and the current
account is due to it in surplus (+10). Outflow of
capital > inflow of capital (-20). Capital leaves the
country. It means that foreign reserves decline by 10
(+10).
• foreign reserves are especially important in the fix
exchange rate regime
current account EX=50, IM=40 EX-IM = 50-40 +10
financial account EXK=100, IMK=80 IMK-EXK= 80-100 -20
change in foreign reserves +10
("+" means decline in foreign
reserves)
=0
4. Fix exchange rate regime
• in the world economy there are several different
forms of exchange rate regimes. In the
transformation process the reformers decided on fix
exchange rate. It was supposed to be an anchor of
the whole system (the anchor means – one stable
value in the changing of the entire environment)
– countries that decided on this regime generally achieved
lower inflation than countries with flexible exchange rate.
• The ultimate goal of the central bank in this regime is
to keep the exchange rate fixed to a currency or a
basket of currencies (the Czech(oslovak) case).
• at the same time. It means an obligation for the
central bank to exchange any amount of local
currency (CZK) per foreign currency in the fix
exchange rate. It implies that the central bank needs
to have enough foreign reserves to be able to meet
this demand.
• We can see it in the following basic example. For
better clearness we show a small fluctuation zone of
the crown. In reality the fluctuation zone is usually in
percentage points and not in units. And in the Czech
case there was the basket of currencies
– the basket means that the currency is fixed to several
currencies – say USD and DEM. If the exchange rate
between USD and DEM changes, then exchange rate
between CZK and USD and CZK and DEM changes as well.
The central bank in the fix regime
• in case A crown is relatively strong. There are a lot of USD on
the market and a small amount of CZK. The CB must sell CZK
and purchase USD to keep CZK in the corridor. On the contrary
in situation B the exchange rate is close to depreciation zone
and the CB must sell USD and purchase CZK. It implies that it
needs to have reserves to purchase CZK on the market. These
reserves are the very same reserves from the balance of
payment!
THE KEY DECISION
THE SECOND PART
Key decision about the exchange
rate
• the crown is too strong
– government decides to
set the exchange rate at
10 crowns per USD
• the crown is too weak
– government decides to
set the exchange rate at
50 crowns per USD
C
L
I
C
K
C
L
I
C
K
Crown is too strong
• Exporting is pointless because the exports
cannot compete on the foreign market
• on the other hand imports are highly
competitive on the domestic market
•  deficit of trade balance  deficit of the
current account (we cannot expect inflow of
capital in the country)  deficit of the balance
of payment (outflow of capital from country)
crown is too strong
• there is natural pressure to devaluate (to
balance the trade balance)
• + central bank does NOT have reserves to
defend the currency (to keep fix exchange
rate)
• it cannot stand up to the situation for long
without reserves and is forced to
DEVALUATE
Crown is too weak
• it is good for exporters but deep devaluation
causes inflation (as a consequence of costly
imports) as well
• inflation leads to real appreciation of crown
• this appreciation can cause situation when the
central bank is not able to defend the
exchange rate and must
DEVALUATE
Summary
• the ultimate goal of the reformers was to keep
fix exchange rate as an anchor of the whole
system
• wrong setting of the exchange rate could
create environment for potential devaluation
– more serious worries were (of course) connected
with too strong crown that would lead directly to
the depleting of foreign reserves
– but too weak currency could create real
appreciation pressure
Summary
• the reformers decided to undershoot crown during
(100 %) devaluations in 1990.
• crown was probably too weak – it means that
exchange rate transformation buffer (cushion) was
created
• this buffer was there to help exporters in the first
months/years of the transformation
• but this buffer was running out in the following years
because inflation in the CR was higher than abroad
(that implies that CZK was appreciating in real terms)
Summary
• the nominal exchange rate stayed fix till the
currency crisis in 1997
• meanwhile crown strongly appreciated in real
terms