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Three years after the currency crisis: A recapitulation of events and how they were linked, to make sure they do not fade from memory

English Pages, 10. 8. 2000

Three years have passed since the biggest economic disturbance of the post-communist era in one country. I said the biggest, and with the hindsight of three years, and with the knowledge of economic statistics for that period, as well as for the period that followed, I dare say that the events of that period constituted a political rather than economic crisis.

I shall therefore to distinguish

- what happened before the of crisis?

- what occurred between the first deliberate macroeconomic restrictive intervention, and the beginning of a currency crisis?

- what happened during the crisis itself?

- what happened when the most acute crisis was over?

I. The anatomy of our currency crisis

I distinguish four basic periods which have a number of different characteristics:

(a) Before the crisis, in 1994 and 1995 and during the first half of 1996, the Czech Republic experienced a relatively high rate of economic growth, and in 1995 its GDP reached an almost unbelievable year–on-year growth rate of 6.4 per cent.

This was a “classical” transformation recovery.

Given the very low rate of unemployment (which throughout most of this period did not exceed 3 per cent), the fact that inflation was not falling (its annual rate remained at roughly 10 per cent, in those days considerably less than in other economies undergoing transformation) was not a cause for concern or for a change of policy. Neither were we concerned with the country’s fiscal situation because throughout this period we achieved balanced budgets. It is true that some economists, including influential official institutions like the Czech National Bank (CNB) and the IMF, were critical of some phenomena but their main concern was the supposed rapid growth of wages. I would therefore argue that in those days growth of wages was unacceptable only to those who wanted to achieve, in a relatively short time, a drastic reduction in inflation.

For those of us who - on the contrary - considered such a sharp drop in inflation to be extremely dangerous and irresponsible because we were aware – given that expectations concerning the development of nominal variables remained unchanged – that this would dramatically endanger economic growth, the growth in average earnings in itself was not a serious problem.

For six years since the last days of December 1990 the nominal rate of exchange was totally stable, even though the actual rate, due to inflation differential, was visibly rising. This resulted in the gradual emptying of another transformation cushion, and the only question was how full or how empty this cushion was at any given time. No big change in this respect occurred even after 2 October 1995, when the crown officially became a fully convertible currency. A more significant change occurred in February 1996, when the crown’s fluctuation band was widened to 7.5 per cent in both directions, which did mark a change in the exchange policy but – as became clear later – not an adequate one. This became evident throughout the following year, 1996, when the position of the crown continued to strengthen, for instance against the German mark from 18.45 crowns (for 1 DM) in February to 17.63 in December.

It is also worth pointing out that in November 1995 the Standard & Poor’s granted the Czech Republic, as the first post-communist country, the rating “A” and that in December the Czech Republic – again as the first – became a full member of OECD.

However, tensions in the economy continued to grow. Even then the authorities were not denying it. The main problem was the very high level of investment (considerably exceeding domestic savings) which was, moreover, in addition to environmental and infrastructural investments, directed chiefly towards the tertiary sector, so that a relatively small proportion of funds remained available for modernising industry. The total amount of investments was not identical to their ability to create new capacities. Let us also mention the fact that in those days this high level of investment was generally praised (not criticised) and that the government was not able to intervene in order to change the structure of investment. Nor can I remember anybody systematically criticising such a rate of investment. Representatives of the Czech National Bank who attended all Government meetings did not put forward a single important proposal. No one tried to reduce the rate of investment and neither did the debate on earnings explicitly aim at that even though it could be said that implicitly it was concerned with the ratio between consumption and savings.

The imbalance between savings and investment was mirrored in the external imbalance as demonstrated by the deficit in the trade balance and the current-account balance which occurred more or less irrespective of the rate of exchange, or which a slight alteration of the rate of exchange would not have significantly affected. Only when this internal imbalance was seen to “spill over” into the external imbalance, as happened during 1996, did it begin to be taken seriously. The balance of payments turned to be the most worrying issue of the economy. However, as long as the country remained politically stable, retained its high creditworthiness abroad and thus also a sufficient flow of foreign investment, the current-account deficit was not thought to pose an immediate problem.

Many of us realised even then that this was an extremely dangerous situation which could change rapidly and unexpectedly. We knew how suddenly such a crisis could develop, as demonstrated by the example of Mexico, which was for us a serious warning. We were definitely not being naïve and unconcerned.

We knew quite well how easily the political situation could change, both at home and abroad, how unexpectedly the economy could suffer an unpleasant exogenous shock, we knew that investors were capable of panicking on the basis of quite innocuous impulses, leading to a domino or avalanche effect, that the economy could also find itself in difficulties due to its own, i.e. endogenous processes, etc., etc. We also knew that in real life one was more likely to encounter a combination of all of these aspects which can augment each other, and that it was therefore extremely important to discourage their mutual synergy by all means available to domestic economic policy.

Another point worth making is the relatively unfavourable structure of foreign investment which was caused, apart from the general character and fundamental logic of our transformation, by the manner in, which our economy was opened up to the outside world (above all in the financial sphere). The key moment in this opening up to the world was October 1995 – before we had entered OECD – when financial flows were liberalised even in the balance-of-payments capital account. The Czech Republic thus has become quite unique among all the transition economies. The crown began to be widely traded on international money markets resulting in tens of billions of Eurocrowns to be outside the control of our Central Bank. Nothing similar to that existed then, or exists now, in the case, for instance, of the forint or the zloty, not to mention other currencies. This premature opening up of the capital account, which made me feel very uneasy then, was motivated – apart from reasons of prestige – by the efforts of the Czech National Bank to bring down the cost of sterilising the flow of speculative capital into the country but – it must be said – the desired effect did not occur. Quite the opposite, the doors were opened wide, enabling rapid movements of speculative capital, unfortunately in both directions.

A rational look at our situation should have led to attempts to start careful slowing down the economy. This would have reduced the existing tensions, but not disrupted the economy. Domestic and foreign investors would not have become alarmed, our banking and financial system would not have been endangered and the Czech way of economic transformation would not have been discredited. It is clear that measures to slow down the economy should have ideally been taken already in the middle of 1995 but for a number of reasons this did not happen. The Government had little desire to start slowing down the economy in the run-up to the elections.

(b) It was in this complicated economic situation that parliamentary elections were held in June 1996 and their result – rather surprisingly – failed to confirm the previous position of the parties in the governing coalition. The complicated coalition negotiations which followed resulted in a very unstable minority Government (made possible by the consent of the social democrats, but without any firm basis such as an opposition agreement). The Government’s space for manoeuvring was thus further curtailed. I hope people have not forgotten these facts. The weakness of the Government was exploited by forces both at home and abroad for a fundamental attack on the “Czech way of transformation”. The Czech economy fell to the political ambitions of some segments of the Czech political scene, rather than being a victim to its own imperfections.

Given the circumstances, the most important thing was not to make mistakes and to ensure that the Government and the Central Bank did not create unnecessary disturbances. Unfortunately this did not happen. On June 19, before coalition negotiations on setting up a new Government were concluded, and without any consultation with the existing, “old”, outgoing Government, the CNB announced strict restrictive measures. It is clear, that the Central Bank wanted to slow down the economy and that this step was taken deliberately. However, the Central Bank did not know to what extent this measure would be effective. It considerably raised minimum reserve requirements (from 8.5 to 11.5 per cent) and at the same time interbank interest rates (bank rate, Lombard rate and repo rate). Our weak banks with their inadequate capital resources, many of them for a number of easily explained reasons in a very precarious position and at the limit of their possibilities, were affected by this intervention much more than our Central Bank anticipated or took into consideration even afterwards. Commercial banks were obliged to withdraw billions of crowns from circulation by August 9. Unless there is no idle money, such a measure is not and cannot be easy, painless and without consequences. Some banks failed to cope and soon ceased to exist, others survived but paid a price in the form of enormous problems in the future and of disturbing the fragile balance of the corporate sphere, where attempts to cope with the CNB’s intervention led to mass cancellation of credit or refusal to extend existing credits. The relatively well known statistics on the amount of money in circulation and on newly proffered credits amply support this conclusions.

I would like to suggest that it was precisely at this point that the direct route to the currency crisis began. First came a very unpleasant signal – the collapse of První kreditní a úvěrová banka (First Credit and Loan Bank) in Pilsen. Shortly afterwards the CNB clashed with our biggest private bank, Agrobanka, which was later practically forced into liquidation. (There is still no proper explanation of the events because the versions that were put forward by Agrobanka and the CNB differed substantially and still do).

The Government failed to react decisively and convincingly, but without the cooperation of the CNB it could hardly have been possible. The Government had problems of its own, particularly with the preparation of the budget for 1997, and the budget debate - in a split Parliament - considerably destabilised the political situation. In the following months the economy took its lead from politics, rather than being “the cause” of its own instability. Tensions inside the Government coalition continued to deepen. The unexpected fall of ODA chairman J. Kalvoda (for rather absurd reasons) cast a great cloud over the trustworthiness of this small political party and another party, KDU-ČSL, and in particular its chairman, were behaving ostentatiously as if they did not form part of the Government coalition.

This was the moment not only for the opposition but also for Czech and foreign media and, last but not least, for influential consulting companies which had been waiting for a long time for the opportunity to “deal with” the Czech way of transformation and with our unwillingness to become a passive object of their – well paid – advice and recommendations. But the main thing they could not forgive us was our voucher privatisation, which deprived them of a considerable part of the profits they had anticipated.

However, it has to be admitted that the Government had failed to appreciate the effect that measures adopted by the CNB would have on the macro-situation, on the amount of money in circulation and on aggregate demand and that the Government dealt – more or less as a fire brigade – only with the micro-effects of these steps, both on banks and on companies. The Government together with the CNB and with all those extremely wise and authoritative domestic and foreign “analysts” and consultants, forecasted continuing rapid growth of the economy in 1997 and this was obviously a mistake. The Government based its draft of the budget on this assumption. In the end it succeeded in getting the budget passed but lacked the strength to conduct any other, more active, policy, both in view of its internal disunity and of strong external pressures (from Parliament and the media).

At the beginning of 1997 the economy – with almost text-book timing– stumbled. The reason was the absence of adequate aggregate demand and that was exclusively, or at least mainly, the result of the monetary measures. The first signal came in January with the unexpected slump in budget revenues, even though this was to some extent obscured by very low temperatures and, above all, by the week-long rail strike towards the end of the month. We therefore waited impatiently for further statistics. In mid-February output data arrived – confirming the slowdown - and at the beginning of March we realised that February budgetary revenues had dropped as well. It began to be evident – to us in Government - that economic growth had come to a sudden halt.

The exchange rate was behaving in a strange way. During the politically controversial year of 1996, and at the beginning of 1997, the currency grew conspicuously stronger, despite the rise in the external imbalance caused by the asymmetrical developments of exports and imports. The crown reached its “highest” point in the middle of February 1997 when it was stronger – for instance against the German mark by 2 crowns - than a year before. This had been helped by a relatively big issue of Eurocrown bonds in January. Only then did a perceptible drop begin (even though it did not fall to its original par value until mid-May). It was, however, a tragic mistake that the problem was never raised between the Government and the CNB. In the spring of 1997 it must have been obvious to all involved that changes in the crown’s rate of exchange were totally in the hands of speculators and that it had hardly anything to do with the economy as such. The exchange rate rose despite increasingly alarming figures showing that the external imbalance continued to slide. This only confirmed the assumption that speculators were preparing to put the rate of exchange down.

The Government was getting ready to intervene and was preparing radical steps in order to increase as much as possible the credibility both of the Government and of the economy as a whole. However, the debate on these proposals, known as package No. I, which was intended to prevent a huge budget deficit by cutting the expenditures of the budget and by accelerating legislative measures intended to increase the transparency of financial markets led, as was expected, to a deep political confrontation.

Cuts in budget expenditures of 25 billion crowns (which, moreover, had to be carried out in 8 instead of 12 months) were, indeed, very deep. This led - among other things - to a further slump in aggregate demand and rather quickly slowed down investments, above all in the construction industry and, as a result, the whole sector slumped. Today it can be said that the measure was probably too extreme but there were many reasons, including sending out the right signals, why we stressed the priority of a balanced budget.

The main problem with package no. I was that the CNB did not share our views and therefore did not deal with the problems of the currency. Only by changing the exchange-rate policy - despite the surprising development of the rate - could the risk of speculative attacks on the currency be reduced. We all realised that the import deposits which we had introduced would not be seen as a credible attempt to solve the problem. Strong budgetary restrictions were therefore the only way how the Government could demonstrate its resolution to foreign countries while, at the same time, exert pressure on the Central Bank.

Package no. I, of 16 April, was a courageous political and economic step and could have played an important role in preventing both the currency crisis and the economic recession which followed. It might have achieved this goal, provided its credibility had not been undermined by Josef Lux on the very day that the Government approved the plan . Perhaps some of you still remember that Lux, chairman of one of the coalition parties and a deputy prime minister with key responsibilities, declared as soon as the plan was approved that it was worthless without a thorough Government reshuffle (which would in fact have meant a new Government and a new coalition agreement). The positive signal which the package was intended to send out was thus almost immediately lost. This led to even more arguments, not only within the coalition Government but also inside the parties themselves. In ODS for instance, vicechairman Zieleniec decided to attack me personally for allegedly suppressing a letter from the IMF. All this resulted in the destabilisation both of the economy and of the political situation. A considerable role was also played by the crisis in south-east Asia, which led to serious anxiety among investors everywhere in the world.

For a long time the CNB failed to act. It was particularly reluctant to act preventively and devalue the crown (despite the fact that the Government exerted strong pressure on the Bank to do it in the moment of package No. I). The Bank presumably relied on its strength, its good reputation and its considerable powers of intervention - or it had its own, completely different economic (or perhaps even political) intentions. But I do not want to speculate on this. The positive effect of all these measures was zero, the crown came under strong attack and thus an acute currency crisis began.

c) In the chaos that followed the CNB tried to “blow into the wind” and intervened by buying crowns to support the exchange rate. As we know, it lost roughly 3 billion dollars of its (or our) currency reserves. Simultaneously, in line with the doctrine held at the time by the IMF and accepted almost everywhere in the world, the Central Bank, in order to forestall the flight of foreign capital, sharply increased interest rates (the repo rate was raised from 14 to 50 per cent). This, of course, failed to prevent an onslaught by currency speculators because there was nothing to stop those who wanted to withdraw their capital. Extremely high rates of interest did not prevent the flight of capital but they did have another, perhaps intended, side-effect: the currency crisis turned into a banking crisis, then into a financial crisis and eventually into a general economic crisis which continued long after the currency crisis itself was over. The shock was too much for our fragile banking, financial and corporate sectors. One is therefore entitled to argue that the economy was not brought down by the currency crisis itself but by the way it was dealt with.

The crown was devalued by 10 per cent and floating, which was certainly the right decision, albeit taken too late.

The Government then decided on a second package – more as a political than economic initiative – which meant more budget cuts (by another roughly 18 billion crowns) and tried to formulate proposals for further institutional reforms. There was also a reshuffle involving the ministers of finance and trade and industry, i.e. two prominent Government members.

From a macroeconomic point of view package No. II represented an unnecessary stepping up of restrictions and, as I have already said, was due more to political than economic reasons. It was an attempt to save the Government, to prove that it was capable of action, but it was also an attempt to demonstrate the power of those who in the autumn caused the Government to fall. Politicians from all parties were trying to emancipate themselves, the media were on principle opposed to everything that was being done, and even so-called experts repeated over and over again that the first package did not go far enough and that the economy needed much stronger measures. Idolisation of the IMF, which is now generally criticised for its failures and fatal mistakes precisely at the time of the 1997 currency crises, was at its peak and any hesitation in implementing any of its recommendations was seen as arrogance, as a fundamental mistake or incompetence. Now it is, on the contrary, generally accepted that the IMF’s recommendations were one of the main reasons why the crises deepened and spread.

The CNB was totally devoted to the strategy recommended by the IMF and therefore, instead of accepting that a rise in inflation in the period immediately following the crash was unavoidable, concentrated on fighting inflation even though the price that had to be paid was a devastating slump in economic performance and the risk of crisis in the entire domestic banking and corporate sphere. The CNB was, however, unwilling to discuss its policy with the Government.

I cannot accept the assertion, repeated for instance by the Bank’s vice-governor O. Dědek, that the CNB resorted to such a restrictive policy because the Government was not willing to discuss institutional problems and that the CNB therefore had no choice but to save the economy, whose future stability was being jeopardised. The truth of the matter is quite the opposite. CNB representatives never showed any initiative which would have drawn attention to institutional problems, not to mention calling for a radical solution. Neither is it in the least true that Government was unwilling to debate such matters. I personally cannot imagine, given the composition of the coalition Government at the time, that it would have been possible to turn down any initiative of this kind had there actually been one.

Both packages contained a number of measures which were aimed at moving towards a solution of some of our institutional and legal problems and imperfections. However, the political chaos that ensued prevented most of them being implemented. They are only being implemented now, several years later. This explains why two years after the events I am describing, most of these proposals could be incorporated in what became known as the “Dřevíč appeal” and could be presented by the media, with great clamour, as a new and fundamental initiative aimed at overcoming our problems.

The currency crises created, above all, a profound political and psychological shock. Politics and petty politics became the order of the day, and any real governance was paralysed. The parliament, or at least its opposition parties, turned radical, tensions inside the governing coalition rocketed. The media, or rather politicians pretending to be journalists, launched a major counter-attack.

To sum up, the currency crisis was an important reminder of the problems of our economy. It could have been avoided, and its repercussions could have been overcome, had everybody who was involved been willing to work together as partners. But that did not happen.

It is only rarely mentioned that thanks to the relative strength of the Czech economy the currency crisis – in the narrow sense of the word – was overcome comparatively quickly, that in the second half of 1997 the rate of exchange stabilised and gradually returned to its original value, that industrial production stabilised as well and export growth was resumed. In summer and autumn rather surprisingly, the economy was relatively calm (despite disastrous floods). However, instead of moving forward we suddenly found ourselves in a full-blown banking and financial crisis which turned into a general economic recession.

(d) When the worst of the currency crisis was over, the main question was whether the policies of the Government and of the Central Bank could be united in a joint effort to overcome the deep disruption caused to our banking, financial and corporate sectors.

The opposition, the smaller coalition parties, the B team inside ODS, and even the President himself, realised this was an opportunity to change the political situation, and since this was their aim they were not too concerned about the fate of the economy. In addition, as a logical outcome of their attitudes, they interpreted the economic situation as a failure of the concept of transformation, or at least the Czech way of accomplishing it, and they therefore started a political struggle, rather than an attempt to stabilise the economy.

The shock of the currency crisis (which in itself was not as deep as is sometimes thought) was used as the main argument for discrediting the Government’s entire economic policy and as the tangible confirmation of its failure. It became a trigger for a political crisis. Political crisis continued in this latent form until what became known as Sarajevo, i.e. until the fall of the coalition Government.

Countries such as Hungary in 1995 or South Korea in 1997 quickly managed, by using sensible policies, to regain their breath and return to growth. In our country, the Central Bank opted for a policy of rapidly reducing inflation to EU levels, irrespective of the impact this would have on the financially fragile business and banking sectors. In this case it was “blowing with the wind”. In such circumstances it is however the job of the Central Bank, on the contrary, to “blow into the wind”.

A key factor in the development of the economy was the procedures adopted by the CNB towards the end of 1997 and during the first half of 1998. This must not be forgotten. These were primarily the introduction of inflation targets, extension of restrictive and stricter terms for the cautious running of commercial banks.

Inflation targeting is a method which is quite unsuitable for an economy in transition. After all, the announcement of an inflation target in itself had much less of an effect than our bankers assumed and, moreover, it is not a “tool” in the classic sense of the word. But what was even worse was the fact that the inflation target was set very low, and that the assessment of the transmission mechanism between monetary policy and the real economy was wrong, or rather that there was a wrong assessment of its parameters, and therefore that disastrous mistakes were made in estimating actual inflation. Today it is presumably abundantly clear what we were worried about. The sudden reduction of inflation was enormously costly. And either the CNB actually aimed at such low inflation (which in a number of months in 1998 and 1999 was a deflation) or this was not what was intended, in which case low inflation was an unwanted by-product of the CNB’s policy. Targeting inflation at about 6 per cent and arriving at zero resulted in a considerable spread of disinformation among companies and to an unnecessarily high nominal movement of salaries and wages and of some other budgetary expenditures.

More important than creating expectations by setting targets for inflation were monetary macro restrictions, chief among them being the late reductions in nominal interest rates, or to put it differently, the fact that they were falling more slowly than inflation. This resulted in a disastrous rise in real interest rates, even though this was quite unnecessary. It is perhaps too obvious to have to explain that what the economy needed at this point was movement in exactly the opposite direction and that there was no reason why the banks and companies should have been further restricted. But these measures were not adopted by accident. The extreme independence of our Central Bank meant that it followed solely its own interests. And I do not even want to speculate whether this was just bad economics, or a well thought-out policy.

When I talked about more stringent conditions for commercial banks, I had in mind

- the requirement by the CNB for additional reserves to cover mortgages on unrepaid loans and

- higher requirements concerning the consolidated balances of commercial banks.

Statistics indicate that these measures, introduced at such a time, further considerably increased the costs incurred by our banks, that their hitherto profitable results turned into losses and that to all intents and purposes this prevented them from granting any more loans. This was the last blow to our economy which then, with a boomerang effect, returned from companies back to the banks. It is not a question of whether these measures were or were not in themselves economically rational and, from a banking point of view, sufficiently circumspect – the only question must be whether they were carried out at the right time.

All in all I would suggest that given the considerable passivity, and at the same time almost irrelevance, of Government fiscal policy (due to the floating exchange rate) the monetary policy did not help to stabilise the economy and led to exactly the opposite, to the widespread economic recession. There is no easy way out of recession, as we can see even now, but that is a different topic altogether.

II. General conclusions

- a fixed rate of exchange

- immature (fragile, vulnerable) banking and financial institutions

- an economy which is totally open to a strongly interlinked (or in today’s parlance “globalised”) world

- any macroeconomic disturbance (inflation, current account deficit, budget deficit).

Unfortunately the Czech economy in the second half of the nineties had all four of these characteristics. Which of them could have been avoided?

There was no need for a fixed rate of exchange but I do not believe that this would have fundamentally altered the situation. Speculative capital would have probably moved around in the same way. The movements would have probably created an unwelcome exchange bubble, first moving up and then rapidly sinking. The Central Bank would “only” not have had to squander billions of dollars on an intervention which was condemned to failure, but it can be assumed that it would have intervened against a sharp drop in the exchange rate anyway and would not have permitted clean floating.

It was not possible for the banking and financial institutions to be better and less unstable than they were. The idea that more regulation and supervision from above would improve their quality is wrong. All these institutions were passing through a stage in their development which could not be avoided.

Perhaps we could have been less open to the outside world because, in this respect in particular, there was no need to be ahead of other countries in a similar position.

It is unlikely that the macroeconomic situation could have been completely different. The Central Bank did not have to have such ambitious inflation targets.

And so, in my view, much more important than these economic “fundamentals” was the failure of “crisis management”, i.e. of the reaction to crisis. All economically positive periods in history have been judged not by their achievements but by the way they ended. And that is also the problem of our era. The previous period was positive but its end negated everything.

By the same token it is now clear that structural reforms, which were announced or carried out at the time of crisis did not have, and could not have had, any short-term effect. They could only send a signal that our country was trying to cope with the situation.

It was shown, once again, that the most important aspect is correct timing. Macroeconomic policy should have been moderately restrictive before, certainly not after the event.

There is a vast literature on currency crises, but the key dilemma remains unresolved. The writers have not answered the question whether currency crises were – given the conditions prevailing at the time – avoidable or not. There is, of course, a number of elegant text-book solutions, but transition economies do not lend themselves to text-book solutions. It is therefore my view that this kind of crisis could not have been wholly avoided. But they could have run a completely different course and had different consequences.

Václav Klaus, Notes for the SVU Congress, Washington, D.C., August 10, 2000.