Impact of unofficial dollarization/euroization on the choice of exchange rate regime: lessons for EU accession countries

What are the implications of the level of currency substitution on the choice of an exchange rate regime in the EU accession countries?

Higher exchange rate flexibility has been seen as a vehicle of macroeconomic adjustment and prevention against volatile short-term international capital flows. Therefore, flexible exchange rate regimes are claimed to be more appropriate in the case of European emerging markets.

However, the author of the paper points out that this notion might be reconsidered in view of the following:

• a floating exchange rate can serve as an adjustment mechanism only if a country represents an optimum currency area
• exchange rate fluctuations can stimulate short-term capital flows because volatility is a prerequisite for speculation
• exchange rate changes may lead to adverse macroeconomic adjustments when large shares of assets and liabilities are denominated or held in foreign currency
• wide exchange rate intervals in some European countries during the last 15 years did not imply lower macroeconomic adjustment costs, and domestic interest rates in a number of countries behaved as if exchange rates were not flexible at all
• if a country experiences the same macroeconomic shocks as a larger monetary area, it may share the monetary policy effects in the larger currency area

The paper argues that the existing impact of dollarization/euroization on the effectiveness of monetary policy has important implications for the exchange rate policy.

According to the empirical evidence found, policy implications for three groups of countries are identified:

• Poland and Hungary have low currency substitution so there are no strong arguments against some degree of exchange rate flexibility for them
• the Czech Republic, Estonia, Lithuania, Romania, Slovenia, Slovakia and Turkey have relatively high unofficial dollarization/ euroization and they may have no substantial benefits or harm from the exchange rate fluctuation; therefore these countries may have no large benefits from fixing the exchange rate or an early adoption of the euro
• Bulgaria, Croatia and Latvia have high currency substitution, therefore monetary policy could be less effective, and even small exchange rate volatility may induce a self- fulfilling speculation. As the seigniorage (the face value of printed money less its cost) argument is weak in such circumstances, one may assume that these countries may prefer earlier adoption of the euro since they may see no benefit arising from exchange rate flexibility