On 29 June the Centre for Economic Policy Research held a research workshop on `East/Central European Payments Union Proposals' in conjunction with the Banca d'Italia. The workshop was organized by CEPR Director Richard Portes, and CEPR is grateful to the Banca d'Italia for providing the facilities for this meeting and to the Ford and Alfred P Sloan Foundations for financing the expenses of the participants as part of their support for the Centre's research programme in International Macroeconomics.
Richard Portes (CEPR and Birkbeck College, London) opened the discussion by noting that in some respects the problems currently faced by East and Central European countries resemble those faced by the West European countries following World War II. A `payments union' for the East and Central European Countries, analogous to the European Payments Union (EPU) of 1950-58, has been proposed by the UN Economic Commission for Europe in its recent Economic Survey of Europe, as part of a new `Marshall Plan' for Eastern Europe.
Introducing the topic, `The Approach to Convertibility and the Domestic Economy', Mario Nuti (European University Institute, Firenze) first noted the striking contrast in the views on the EEPU proposals of different international organizations, in particular between the OECD, which has strongly advocated that the countries involved proceed rapidly to full currency convertibility, and the UNECE, which suggested that a payments union could be established among Czechoslovakia, the GDR, Hungary and Poland with only modest financial aid from Western countries.
Nuti attributed the generally positive attitude adopted towards the EEPU proposals within the European Commission to the same two factors that had motivated the post-war Marshall Plan: the economic advantage to be derived from creating an economically healthy trade partner, and the need to nurture `infant' democracies.
Nuti maintained that there is a useful role for a payments union, since the introduction of some sort of `soft' convertibility of a number of East European currencies with each other or with a currency basket would be feasible even without the help of the West. If `hard' convertibility were introduced for a set of CMEA countries, however, this would have to include the Soviet Union, with which all the other CMEA countries are in deficit. Soviet participation would necessitate a substantial injection of funds from the West, which would not be forthcoming until a serious reform of the Soviet economy was under way.
Nuti noted that the current `ruble glut' in intra-CMEA payments will be replaced by a `ruble shortage' as soon as trade is conducted on a hard currency basis. Present trade imbalances therefore provide a poor indicator of the trade imbalances that will apply once convertibility is established, when greater resources than those currently estimated by the UN would be required to finance the payments union.
The East European currencies are not externally convertible (the so-called `transferable ruble' is merely a unit of account), and even commodity convertibility is severely limited by remaining central controls. Since the exchange rate system must be reformed before convertibility is introduced, one of the main tasks in stabilization policy is to prevent domestic imbalances from spilling over into the foreign exchange markets.
Nuti argued that the East European countries now have three main options: the unilateral declaration of convertibility backed by a stabilization fund, as in Poland; `soft' convertibility within the area; and `hard' convertibility.
The Polish experience cannot be easily applied to the other countries, since Poland's economy was already considerably more `dollarized' than its neighbours'. `Soft' convertibility, on the other hand, would be much easier to introduce, and might foster trade within the area. Indeed a similar arrangement was adopted by France, Italy and the Benelux countries before the inception of the EPU. He argued against the introduction of `hard convertibility', however, since this would require a massive injection of foreign aid.
Complete liberalization is not theoretically necessary to the introduction of some form of convertibility. Nuti proposed an alternative mechanism: that certain specified goods could be traded within the area at predetermined prices for which convertibility is allowed, and that the list of such goods could be gradually enlarged. This would ensure a guaranteed degree of commodity convertibility, which would be compatible with `internal' convertibility on the Polish model. He noted in conclusion that the three main options considered are not mutually exclusive, and that action is urgently required even in the absence of foreign aid.
The discussion that followed focused on the choice of exchange rate system to be adopted by the member countries of the proposed payments union. In response to questions from a number of participants, Nuti suggested that a flexible exchange rate regime was desirable on the grounds of the continued price rigidity of the East European domestic economies, and that the degree of flexibility of exchange rates was more important than the choice of any particular `standard' or `basket' currency. In particular, the proposal to use the ECU as a `basket' currency for trade within the union would not be welcomed by the Soviet Union, because a large share of its external trade is denominated in dollars.
Speaking on `The Reconstruction of International Trade Relations of the CMEA Countries', Dariusz Rosati (Foreign Trade Research Institute, Warsaw) noted that between 50% and 70% of the total trade of the East European countries is accounted for by trade within the CMEA area, but that this is largely a reflection of political pressures rather than of comparative advantage. Poland's trade with the European Community has recently increased to 33% of its external trade, comparable with the 35% of its trade conducted with the other CMEA countries. In contrast, the relative shares of the CMEA countries in the external trade of Bulgaria, Czechoslovakia and the GDR remain much larger.
The proposal originally made by Czechoslovakia, Hungary and Poland to settle payments within the CMEA area in convertible currencies now enjoys the strong support of the Soviet Union. The implications of this change would be much greater for trade with the Soviet Union than for trade within Eastern Europe, since raw materials, which account for the bulk of Soviet exports, have well-established world prices, whereas the manufactures exported by the smaller CMEA countries do not.Settlement in convertible currencies would imply a drop in the relative price of industrial goods of 20-50%, and hence a gap in `mutual trade' of 30-50%, since East European demand for Soviet goods is inelastic. Trade within the area may also be reduced once political motivations for trade are fully replaced by considerations of profit and comparative advantage, and trade will be hampered further by the shortage of convertible currency. This will induce aggressive competition among the East European countries, possibly through dumping or beggar-thy-neighbour policies. These effects may be offset to some extent by the increased revenue from services (such as transport) sold to the Soviet Union.
Rosati noted that this structural change will also affect domestic prices. In particular, the prices of fuel and raw materials will increase, subsidies to enterprises will be reduced, and these developments will inevitably entail high social costs. For the move to world prices and hard currency settlement to be successful, international liquidity within the area must therefore be increased through the introduction of some form of clearing. There remains a serious risk, however, that Eastern Europe will suffer a deep recession during the transition period, owing to its high external debt. In the absence of a suitable recycling mechanism, as the international banks afforded to the Western countries in the wake of the first oil shock, Eastern Europe's debts should therefore be reduced before the introduction of convertibility.
The discussion that followed focused particularly on Poland. It was suggested that a devaluation of the zloty vis-à-vis the ruble would increase the competitiveness of Polish industries. Rosati replied that setting the ruble-zloty rate in line with the zloty-dollar rate already implied a very significant devaluation. Polish exports are competitive even at the current ruble exchange rate. Indeed, in 1989 Poland enjoyed a trade surplus of 5 billion convertible rubles with the Soviet Union, but the problem remained of how to mobilize it.
Introducing the discussion of `The Reconstruction of International Monetary Relations of the CMEA Countries', Peter Kenen (Princeton University) focused on comparing the proposals for an EEPU with the historical experience of the EPU in the 1950s. In the early post-war years, trade among West European countries was governed by bilateral agreements. Credit lines were extended up to a certain limit, known as the `swing', which was intended to allow for small fluctuations in commercial deliveries between the two countries. Beyond this agreed limit, however, settlements had to be made in gold or US dollars. The tendency to discriminate hampered the development of trade, with the result that only a small proportion of total bilateral balances in 1948-9 were settled multilaterally.
The EPU was established as a part of the general tendency towards European integration at that time. The largest imbalances were those between these economies and the US, which did not participate in the EPU. There was a dollar shortage outside the union, whereas for an EEPU including the Soviet Union a ruble shortage would arise inside the union.
Kenen distinguished between the clearing and credit functions of the EPU: the former eliminated the incentive to discriminate whereas the latter promoted liberalization. Initially, trade liberalization took effect more rapidly within Europe than between Europe and the US, and in any case it was mainly attributable to the code of liberalization drawn up by the OEEC (now the OECD).
From 1991 onwards the East European countries will have to settle their external accounts in hard currency, without having first achieved currency convertibility. Their main problem is therefore not the elimination of bilateral settlements, but rather reducing the costs of external convertibility. The East European countries' stated preference for integration with the West rather than among themselves also suggests that proposals for a payments union may be of only marginal relevance for policy.
Kenen argued that the financing of the balance of payments of each deficit country in an EEPU should be made conditional on its implementation of appropriate policies of macroeconomic adjustment. Including the Soviet Union would cause additional problems: having the largest member country in credit for the whole life of such a payments union would raise serious doubts about its ability to survive; and it is not clear why the Soviet Union would wish to join such a scheme.
Kenen's proposed alternative was that the switch to trading at world prices should be phased over a period of two or three years in order to avoid an abrupt increase in intra-CMEA imbalances, and that the switch to settling payments in convertible currencies should be carried out immediately. Balance of payments problems should be resolved using IMF stand-by financing, and the Soviet Union's trade with Eastern Europe governed by agreements of the type governing its current trade with Finland.
In the discussion that followed, Mario Nuti remarked that a significant share of intra-CMEA trade is already settled in hard currency, and he proposed the creation of a payments union based on an exchange rate system similar to the EMS. Other participants argued that exchange rates should be fixed in order to avoid unsustainable speculative pressures, because markets usually are governed by very short-run considerations, and that the choice of exchange rate regime should in any case be resolved before switching to convertibility.
In his remarks on `The Situation in Hungary', János Gács (Institute for Economics, Market Research and Informatics, Budapest) noted that intra-CMEA trade was already in decline in the mid-1980s, as the Soviet Union increasingly demanded higher share of `hard' goods, i.e. those traded in international markets, in its trade with Eastern Europe. Trade between Hungary and the USSR is expected to fall by a further 30% in 1990.
The proposal to shift to hard currency settlements was made by Hungary more than a year ago when developments in the Soviet Union were more encouraging than those in the other CMEA countries: now the reverse applies. It is probable that from 1991 onwards all intra-CMEA trade will be settled in hard currency, so the remaining issue to be decided is the proportions of this trade to be conducted by means of a clearing system and by real convertible currency payments.
Gács noted that Hungarian industries, like those of the other CMEA countries, will not be competitive on international markets in the short term. The shift to trading with the Soviet Union on the basis of world prices and settlement in hard currency may lead to both a terms-of-trade loss and also a negative impact on the government budget, owing to the removal of taxes on trade flows which currently represent a significant share of government income.
Gács noted further that negotiations with the Soviet Union concerning compensation for the terms-of-trade losses are currently in progress. Dariusz Rosati pointed out, however, that these negotiations are still proceeding at a bilateral level and that the switch to the settlement of trade in hard currency should determine the formal end of the CMEA system, which is based on governments' enforcement of bilateral agreements.
Richard Portes then set the agenda for the afternoon's discussion in three broad categories: empirical, analytical and policy. The empirical issues include the size of the projected trade gap between Eastern Europe and the Soviet Union and the speed with which it will open up (determined by the elasticities of Soviet demand for and East European supply of manufactures), the scope for development of trade within Eastern Europe (which would be mainly intra-industry trade), and the ability and willingness of the West to absorb East European exports of agricultural and industrial goods.
Portes identified three principal analytical issues. First, if macroeconomic stabilization and reasonable relative prices are assumed to be preconditions of commodity convertibility, it is unclear whether a staged approach to commodity convertibility, as proposed by Nuti, could nevertheless be brought into effect simultaneously with a gradual approach to satisfying those preconditions fully. Second, since bilateralism in intra-CMEA trade is disappearing already, a payments union may not play a useful role, although pressures on the balance of payments might lead to a renewal of bilateral trading patterns. Third, the option of a payments union may introduce significant new elements into the choice between a fixed or flexible exchange rate regime.
The relevant policy issues include the choice of appropriate Western policies to help East European countries to fill the `trade gap' with the Soviet Union, and whether there should be an initial injection of convertible currency from the West (or indeed from the Soviet Union) if an EEPU were to be established. The establishment of an EEPU would also require rules on trade with non-members and the choice of a reference currency.
The discussion focused initially on the external imbalances of the CMEA countries' trade, which provides the rationale for a payments union. It was argued that the relevant variable is the long-run structural deficit on the current account. Trade gaps will probably not persist if structural reforms are properly implemented, although an EEPU may usefully provide time for the East European countries to increase the competitiveness of their exports. It was suggested that a modified `absorption approach' provided the best framework for assessing the evolution of the current accounts of these countries and the necessary adjustments to their savings-investment balances.
There was general agreement that capital inflows would probably be hampered in the short run by uncertainty regarding the evolution of the reform process. Nuti also noted that large-scale capital inflows, especially to the Soviet Union, are unlikely to take place until wider reforms of private property law and of the exchange rate system are brought into effect. It was noted that a current account deficit may arise either as a result of `useful' capital accumulation or because of an excessive increase in consumption, and that if private capital inflows need to be supplemented by official financing this should be provided only under strict conditions to ensure that only `good' deficits are financed. On the other hand, while the sudden increase in these countries' marginal product of capital clearly warrants borrowing to finance investment, the increase in their permanent incomes in principle also warrants borrowing for consumption.
Rosati supported the establishment of an EEPU as a means of staving off the threat that movement towards currency convertibility will lead to the collapse of intra-CMEA trade, by providing these countries with a `breathing space' in which to switch their production from `soft' to `hard' goods. It was noted that although negotiations currently in progress envisage the application of world prices to intra-CMEA trade and settlement in hard currency, no agreement has been reached on an explicit clearing system, the talks are continuing on a bilateral basis and deficit countries are still able to settle in goods.
Kenen argued that while current negotiations in Eastern Europe envisage hard currency settlement rather than fully-fledged currency convertibility, these countries really need a credit rather than a clearing arrangement. He envisaged a role for World Bank financing, since their problems are of a structural nature.
Rosati maintained that excluding the Soviet Union from an EEPU would require the design of another scheme to finance the imbalances between Eastern Europe and the Soviet Union during the transition period, while Gács feared that Soviet participation might lead to a payments union modelled too closely on the existing CMEA. Nuti noted the need for a leader/sponsor to foster the integration process, and Kenen recalled that this role had been performed by the USA in the 1950s. Such US involvement would not be practicable now because of limitations on the resources available.
Four main areas of concern were singled out as worthy of further analysis: the choice of the most appropriate exchange rate regime; the problem of financing the current account deficits generated by the reconstruction process; the proper sequencing of domestic and external reforms; and the design of suitable trade arrangements to favour the absorption of East European goods by the Western countries. There was considerable agreement with the views that an EEPU would not by itself provide a solution to the immediate problems of the East European countries, and that these problems pertain more to the real than to the monetary domain of economics.