Fear of floating v. twin-deficits in Central Europe

The military conflict in Ukraine represents another significant negative external shock to Central European economies, coming just months after the region began to recover from the last wave of the pandemic. Unlike the pandemic and other negative external shocks that have hit Central European economies in the past, the war in Ukraine is clearly an asymmetric shock. Central Europe, together with the Baltic countries and Bulgaria and Romania, is facing not only high energy commodity prices, but also gas supply constraints, high migration and the need to significantly increase defence spending. The result is a dramatic increase in the twin deficits of all countries. In particular, the current account balance of payments balance of the Central European countries deteriorated in an unprecedented way in one year - by around 4% of GDP. (see figure CEE1) At the same time, there is no significant post-pandemic improvement in public finances, despite the end of COVID-related subsidy programs. 

Thus, the Czech, Hungarian and Polish economies are facing record increases in the twin deficits, with all three economies operating with floating exchange rates that should play the role of a shock-absorber. In theory, not only the nominal but especially the real effective exchange rate of the koruna, forint and zloty should depreciate significantly. In reality, no real depreciation of these currencies has occurred since the start of the Russian invasion. (see figure CEE2) Only the forint has depreciated in real terms since the start of the war, but even its losses are relatively small. How is this possible?

The relative stability of the real exchange rates of the Central European countries can be explained in large part by the policy of the regional central banks, which are not willing to tolerate a dramatic depreciation of the domestic currency in a situation when inflation hovers in double digits and approaching the 20% mark. Specifically, the Czech National Bank is intervening massively in the forex market in favour of the koruna, Hungary’s official interest rates are already at 11.75% and will rise further, and the NBP in Poland continues its tightening cycle, indicating by its comments that it wants a strong zloty.

High inflation, coupled with the reluctance to let the real exchange rate depreciate when the economy is hit by a negative external shock, is reminiscent of the macroeconomic phenomenon called ‘fear of floating’. This is often mentioned in the context of the monetary policies observed in the past in some emerging markets or in Latin America respectively. Here, however, the strategy of not letting one’s own currency depreciate in the face of an external shock has often proved unsustainable in the long term, and the currencies concerned have eventually depreciated significantly anyway. For example, in the Czech case, high FX interventions may act as a substitute for monetary restriction, but only temporarily, as FX reserves could be exhausted (although they are still above 60% of GDP). In the Hungarian case, aggressive defence of the forint via drastic interest rate hikes has its limits too, as it may lead to a significant deterioration of the fiscal situation and indebted households. As for Poland, the current NBP leadership and its loss function give more weight to growth and employment over inflation. Hence, if Poland, for example, falls into a deeper recession, the hiking cycle will be quickly halted with obvious negative (temporary) consequences for the zloty.

The next several months will show whether monetary authorities in Central Europe will be able to limit the (real) exchange rate volatility of their currencies. Winter is coming together with significantly higher energy bills both for CE households and companies. As a result, regional economies could fall into technical recession in the second half of the year. On top of that, central banks in core markets (especially the ECB and the Fed) will continue to hike aggressively. Not a friendly universe for (still) converging economies and their currencies.