Until now, there has been little detailed analysis of the roles of monetary and exchange rate policies in the economic transformation of Eastern Europe. In particular, the possible integration of East European currencies into the present or future monetary arrangements of the European Community has been largely neglected.

In Discussion Paper No. 457, Research Affiliate Peter Bofinger analyses the specific inflationary risks associated with price liberalization, the welfare costs of inflation and the problems of East European central banks in pursuing non-inflationary policies. He finds that the implementation of traditional monetary policy strategies is severely impeded by the low credibility of current stabilization policies and by a `strategy problem' related to the high instability of the real and financial sectors in Eastern Europe.

Bofinger then analyses the possible contributions of three alternative strategies based on an `ecu-peg' for the East European currencies for solving the specific problems of monetary policy during the transition. First, a `unilateral peg' to the ecu with no support from the EC following the `Austrian model' countries may provide an adequate intermediate target for monetary policy during reform but will not fundamentally improve the credibility of central banks. Second, East European membership of the ERM and participation in the West European transition to EMU would enhance the credibility of their commitment to fixed exchange rates by the provision of large credit facilities for countries with weak currencies, but at the cost of considerable inflationary risks for existing member countries. Third, East European participation in the projected European System of Central Banks, involving the irrevocable fixing of rates between member currencies or a complete substitution of national currencies by the ecu, would simultaneously solve the credibility and strategy problems, while also safeguarding present EC members against the risks of over- expansionary monetary and fiscal policies in the East.

These results have significant implications for the sequencing of reforms. Reform of the real sector without an efficient monetary policy will be unlikely to achieve its targets, but the peg to a stable foreign currency that is required to establish such a framework will only be achieved if most trade restrictions are removed and central banks can control the asset side of their balance sheets. This in turn necessitates the simultaneous establishment of `hard budget constraints' and creation of property rights on firms' capital through a far-reaching privatization. Bofinger therefore concludes that it is not a sequencing but rather a simultaneous achievement of the central reforms that is required.

In Discussion Paper No. 458 Bofinger focuses on the convertibility of the East European currencies and in particular on the possibility that an East European Payments Union (EEPU) following the model of the European Payments Union (EPU) of the early 1950s might represent a useful intermediate stage for the East European economies in the transition to the full liberalization of international transactions.

Such a multilateral payments union would include a clearing mechanism, a multilateral credit facility and a mechanism for coordinating the transition to full convertibility. Multilateral clearing transforms the bilateral budget constraint that characterizes each inconvertible currency into an aggregate budget constraint vis-à-vis the rest of the group. This provides a financial framework for a regionally-limited trade liberalization, which may lead to scale economies and improved resource allocation. Credit facilities allow a breathing space if temporary disequilibria arise and a more intensive use of existing bilateral credits. The coordination mechanism internalizes the externalities produced by uncoordinated moves towards convertibility.

Bofinger shows that a payments union will improve on continuing bilateralism among member states and that bilateralism vis-à- vis the rest of the world will be justified, if member countries' intra-trade is in balance and the union runs a fundamental current account deficit that could not be corrected either by an exchange rate devaluation or by more restrictive macroeconomic policies. Comparing the payments union with the case of full convertibility including free capital movements indicates that removing restrictions on current transactions only impairs the automatic adjustment of interest rates and thus tends to create permanent deficits. This limits trade liberalization and places a major burden on permanent creditors. Moreover, if central banks' foreign exchange reserves are low, restrictions on private capital flows may perversely require higher variations and stocks of official reserves.

Bofinger also assesses the relative benefits of restricted convertibility vis-à-vis the rest of the world and the rapid liberalization of external trade by comparing the economic conditions in the prospective EEPU's member countries with those that applied historically to the EPU. He finds that the trade- enhancing effects of the EEPU will be much smaller since the economies concerned are smaller and few in number (especially if the Soviet Union is excluded). A greater expansion could be achieved with convertible currencies, but only at the cost of unacceptable trade discrimination within the union. It is doubtful whether trade creation among East European countries could produce any real adjustment to enhance their international competitiveness, since they all face similar distortions in output and trade, considerable monopoly power and unresolved issues of privatization. Moreover, East European trade restrictions vis-à-vis outside countries would preclude monetary stabilization strategies that rely on the exchange rate as nominal anchor.
The EEPU and the EPU also differ in that the EPU was firmly embedded in the Bretton Woods monetary system of exchange rates, while the new international monetary order of Eastern Europe remains unresolved. The role of an EEPU in reform process can only be evaluated if its members develop a clear view of their further integration with European or international monetary arrangements. This would provide the framework required to forecast the fundamental current account deficits of the East European countries, which provide the only justification for maintaining bilateralism against outside countries.

The Role of Monetary Policy in the Process of Economic Reform in Eastern Europe
A Multilateral Payments Union for Eastern Europe?
Peter Bofinger

Discussion Papers Nos. 457-8, August 1990 (IM)