At a CEPR lunchtime meeting on 29 May, Peter Bofinger presented the results of his recent research on alternative exchange rate systems for Eastern Europe. Peter Bofinger is at the Landeszentralbank Stuttgart, a visiting scholar at the Universität Konstanz, and a Research Fellow in the Centre's International Macroeconomics programme. His remarks were based on CEPR Discussion Paper No. 545, `Options for the Payments and Exchange Rate System in Eastern Europe', prepared with financial support from the Commission of the European Communities within the framework of the PHARE programme to assist economic reform in the countries of Central and Eastern Europe, and also available in a Special Issue of European Economy, June 1991. The Commission of the European Communities and the UK Department of Trade and Industry and Foreign and Commonwealth Office provided financial support for the meeting, which formed part of the Centre's research programme on `Economic Transformation in Eastern Europe'. The views expressed by Dr Bofinger were his own, however, and not those of the Landeszentralbank Stuttgart, the above organizations nor of CEPR, which takes no institutional policy positions.

Bofinger argued that East European countries have paid insufficient attention to the role of the exchange rate regime in their transition, and this has impeded the effectiveness of their macroeconomic policies. The failure of Czechoslovakia, Poland and Yugoslavia to enhance the credibility of their exchange rate pegs through announcement effects or institutional devices has been a major cause of their inadequate control over prices and wages. Proceeding early to current account convertibility was an important precondition for enhancing their competitiveness and achieving undistorted price structures, but convertibility must be grounded in an overall exchange rate policy designed for their eventual monetary integration with the European Community. These three countries have restricted their currency convertibility to domestic residents, so all trade transactions within Eastern Europe now require payment in hard currency, which largely accounts for the recent collapse of East European intra-trade.

They never seriously considered the alternative proposal of an East European Payments Union, modelled on the post-war (West) European Payments Union (EPU), since none of the reforming countries wanted to join a `poor man's club' for political reasons, and the economic conditions the two groups of countries faced were quite different. The EPU included all the major market economies outside the US, and their transition to the free market following temporary wartime controls involved much less disruption than that of Eastern Europe from full-scale central planning.

The East European governments' outright renunciation of flexible rates as recommended by some economists, especially for East Germany forms a very positive element in their approach to convertibility. Floating would have led to serious problems of exchange rate volatility because these economies' financial markets remain poorly developed, their macroeconomic fundamentals are generally unstable, and most are relatively small. Some countries have used the exchange rate as the most important `nominal anchor' of their reform programmes by pegging their currencies to the dollar (in Czechoslovakia and Poland) or the Deutschmark (in Yugoslavia), which requires that the exchange rate become exogenous to movements of domestic wages and prices. Austria's experience of unilaterally pegging the Schilling to the Deutschmark with no support from the Bundesbank demonstrates that this requires the government to make a credible commitment to such a peg over time. East European governments are still far from achieving this credibility, however, so they require additional domestic `nominal anchors'; and the present high levels of inflation throughout the region show that these are currently ineffective. An exogenous exchange rate need not be an absolutely stable rate, however, since an adjustable peg with a preannounced annual devaluation rate i.e. one that will not vary in response to the development of wages and prices may provide an effective alternative.

Bofinger maintained that East European governments should choose their anchor currencies in accordance with their trade structures and their eventual integration into international monetary arrangements. Czechoslovakia and Poland should therefore peg their currencies to the ecu, since the EMS member countries account for the major shares of their external trade and a commitment to such a peg is clearly visible. Czechoslovakia's current policy of pegging the crown to a basket of Western currencies, while announcing its exchange rate against the dollar, entails the further disadvantage that its citizens cannot clearly see whether the commitment to the external peg is maintained or not. Moreover, if Poland had pegged the zloty to the ecu rather than the dollar, it could have avoided the devaluation of 17 May, the greater part of which was forced by the recent appreciation of the dollar vis-à-vis the EMS member currencies.

Bofinger noted that developing countries' experience indicates that national authorities who seek to establish a credible exchange rate peg by themselves, even with an independent central bank, encounter severe difficulties. He proposed that the East European countries could achieve both a convertible and stable currency and a highly credible monetary policy by joining the planned European Monetary Union. Prohibiting the financing of government deficits by national central banks would create a stringent external financial constraint, and hence a strong `commitment technology' with which to establish `hard budget constraints' for the enterprise sector. A European Central Bank independent of political control could also act as a useful `foreign scapegoat' to take the blame for the closing down of enterprises that the restructuring of the East European economies will require. Indeed, without such an external constraint, it is doubtful whether any East European government could resist the political pressures from its citizens to slow the pace of reform.

Alternatively, the East European economies could achieve similar results by establishing their own monetary union. They could enhance the credibility of any Board of Governors appointed by their national governments through a `franchise system', i.e. by also appointing representatives from appropriate intergovernmental organizations such as the IMF and the European Bank for Reconstruction and Development. Bofinger concluded that the reforming governments' exchange rate policies were basically well designed, but the absence of a credible peg for their currencies and a bankruptcy constraint for their enterprises is currently impeding their effectiveness.