The Tosovský Dilemma: Capital Surges in Transition Countries

• Author: Leslie Lipschitz, Timothy Lane, and Alex Mourmouras
• Position: Deputy Director/Division Chief of Policy Review/Senior Economist

Transition countries that open themselves up to global capital markets are like honest citizens in a dangerous world-they are vulnerable to large and potentially erratic flows. Such flows should not be seen as one-off destabilizing events: they are intrinsic to the transition process and therefore need to be factored into policy formulation.

Stylized fact number one: There has been and continues to be a pronounced real appreciation of the currencies of the advanced transition countries of Central and Eastern Europe against the currencies of their industrial neighbors. Unless domestic real interest rates in these transition countries are kept relatively low, the currency appreciation could well attract huge capital inflows-flows so large that they could overwhelm policymakers' efforts to control inflation and contain external current account deficits.

Stylized fact number two: Capital/labor ratios are much lower in the transition countries than in their more advanced Western neighbors. The scarcity of physical capital, coupled with a reasonably strong endowment of workforce skills and infrastructure, means that a relatively high real interest rate is needed to balance saving and investment. If interest rates are low, investment will far exceed saving, fueling inflation and widening the external current account imbalance.

The clash between the low equilibrium real interest rate derived from stylized fact number one and the high equilibrium real interest rate derived from stylized fact number two motivates the arguments that follow and sets up a difficult dilemma for economic policy. This dilemma was first identified in the mid-1990s in discussions with then Czech National Bank Governor Josef Tovovský; it has subsequently been referred to as the "Tovovský Dilemma" by those at the IMF working in the area. The market may resolve this dilemma in the way that it sets risk premiums on investments in the transition economy. But, insofar as risk premiums are sometimes erratic and, in any event, sensitive to factors beyond the reach of the authorities, capital flows can overwhelm efforts to stabilize the economy. This article concludes with some strategic imperatives that policymakers in transition countries should constantly keep in mind; these could also apply to other emerging market countries with relatively well developed human and physical infrastructure.

Currencies on the rise

Table 1 illustrates stylized fact number one: a sustained real appreciation of the currencies of the advanced transition countries against the currencies of Western Europe. It shows that cumulated GDP growth for 10 advanced Central and Eastern European countries is modest when measured in conventional real terms but is high when measured in terms of deutsche marks (most of the period under investigation precedes the introduction of the euro). This difference-which is due chiefly to a very large real appreciation against the deutsche mark-is most pronounced over the first five years of the transition but still considerable over the second five-year period.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

Two explanations for this real appreciation-both of which see the trend as equilibrating-are most commonly adduced:

* The real value of the currency may have been very low at the start of the transition, reflecting the demise of the traditional Soviet market and the absence of any market penetration or product reputation in Western markets. Some trend real appreciation would...