Drowning In An Ocean Of Money

Only a couple of years ago, with their countries in recession and with little portfolio investment coming in from abroad, Eastern Europe's money authorities had a simple tactic for fighting triple-digit inflation: They could crush domestic demand with blunt instruments such as tight credit and taxes. But life is more complicated now. As commercial activity grows brisk, central bankers face a new problem: Their currency policies are attracting so much foreign capital that it's all but impossible to bring inflation down by raising interest rates.

The Czech crown and Polish zloty are linked to hard currencies--a strategy originally aimed at boosting confidence in their economies. But now, more foreign money is pouring in than the Czech and Polish monetary systems can soak up--from portfolio investors in the Czech Republic and from exports in Poland. Higher interest rates would only attract more investment. So, while inflation has indeed dropped since the early 1990s--from 60% in the Czech Republic and an average 150% in Poland--it's still stuck in double digits: about 10% and 25%, respectively.

In the Czech Republic, the crown, which is fixed daily to a basket of the U.S. dollar and German mark, has appreciated by more than 40% in real terms since 1991. Add in short-term interest rates that are about four percentage points higher than those in Western Europe, and you have a winning bet for speculators. Already, $1.2 billion in short-term money flooded into the economy in the first quarter of 1995--faster than the central bank can issue Treasury bills to absorb it. "We are a little bit afraid of these capital inflows," says Jiri Pospisil, board member of the Czech central bank.

In June, central banker Josef Tosovsky braved political opposition and raised the discount rate by one percentage point. Then, to prevent more capital inflows, he also increased banks' minimum reserve requirements for foreign deposits, making it less appetizing for banks to hold speculators' accounts. But these measures don't address the underlying problem of a fixed crown. Many private economists are urging a wider trading band. "This [currency problem] needs to be addressed much more aggressively," urges Zdenek Drabek, an economist at the World Trade Organization.

In Poland, booming exports are behind the bulging money supply, because companies must turn in their foreign currency to banks in exchange for zlotys. Foreign reserves leaped to $9.1 billion by the end of April, up 50% from the end of 1994. Cross-border trade adds fuel to the fire, as Germans driving over for cheap gas or clothes take advantage of price differentials of 50% to 100%. Economist Krzysztof Bledowski at Pioneer First Polish Trust Fund Co. estimates that $2 billion to $3 billion has come into Poland through cross-border shopping in 1995 so far.

CUTBACKS. In May, with inflation stuck at 30%, Poland's central bank president, Hanna Gronkiewicz-Waltz, cut a deal with Finance Minister Grzegorz Kolodko. She relented slightly on lowering interest rates, in exchange for a more flexible float of the zloty. It now fluctuates 7% around a basket of five currencies, up from 2%. Since the change, the zloty has risen about 5% against the dollar, slightly slowing export earnings.

Ultimately Eastern European governments will have to fight inflation by cutting their social spending and privatizing the state-run companies that devour subsidies. Meanwhile, as long as their fixed currencies give foreign investors a sure thing to bet on, the money is bound to keep pouring in.

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