New EU members provide lessons in opening up capital accounts

• Author: Zsófia Árvai
• Position: IMF Monetary and Financial Systems Department
• Pages: 56-57

Page 56

Nearly two years ago, on May 1, 2004, eight transition economies-the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia (EU8)-joined the European Union (EU), together with Cyprus and Malta. One of the requirements for membership was full capital account liberalization. Sizable or volatile capital inflows, particularly those sensitive to interest rates, can pose difficulties for monetary and exchange rate policy. A recent IMF Working Paper looks at the EU8's experiences with freeing up capital flows to draw lessons for other countries that will need to take this path.

The Czech Republic and the Baltic countries (Estonia, Latvia, and Lithuania) liberalized their capital accounts relatively quickly, with most transactions already unrestricted by 1995. In contrast, Hungary, Poland, the Slovak Republic, and Slovenia took a more cautious approach, achieving full liberalization only between 2001 and 2004. Different starting conditions help explain the varying liberalization strategies.

Relatively high external debt in Hungary and Poland, for instance, made these countries more vulnerable to external shocks.

In terms of sequencing, the EU8 tended to liberalize foreign direct investment (FDI) before financial credit and portfolio flows, inflows before outflows, and long-term flows before short-term flows. This approach can be explained mainly by initial uncertainty about the success of the transformation.

During the first years of transition, the authorities feared that high inflation and depreciating currencies might trigger capital flight. But the relatively fast macroeconomic stabilization in most of the countries dispelled this fear, and, from the second half of the 1990s onward, it proved more difficult to manage capital inflows than potential outflows.

As for the composition of flows, FDI was the largest component during the period under review (1995-2003), followed by other investment (financial credit) and portfolio investments (see table).More than FDI flows, other investment and interest rate-sensitive portfolio flows posed considerable difficulties for monetary authorities in terms of economic policy, external vulnerability, and financial stability.

These inflows contributed to credit booms and exchange rate appreciation pressures in an environment where monetary authorities had to find a delicate balance among furthering disinflation...