Three essays on tight exchange rate regimes and fiscal discipline in transition economies

This dissertation analyses the interaction between tight exchange rate regimes and fiscal discipline in a sample of ten Central and Eastern European countries during their transition period. First, we analyse the influence of currency boards and conventional pegs on public expenditures and deficits. Second, we address the sustainability of public finances and fiscal adjustment. Finally, we investigate whether or not lax fiscal policies affect the risk premiums of CEE governments’ bonds. The results of the second chapter show that currency boards are more efficient than conventional pegs in enhancing fiscal discipline. The empirical evidence shows that currency boards promote lower general and primary government expenditures, and higher general government surpluses. The adoption of a conventional peg, on the other hand, yields a different result: it tends to induce higher public spending and has no significant influence on government balances. Countries with flexible exchange rates, however, are not doing worse in terms of fiscal discipline than the countries with currency boards, but they are doing better than the economies with a conventional peg. Thus the relationship between the rigidity of exchange rate regimes and fiscal discipline is not linear. Our empirical findings suggest that currency boards and flexible rates induce the same degree of fiscal discipline while conventional pegs are associated with laxer fiscal policies. In the third chapter we look at the sustainability of public finances in the framework of an inter-temporal budget constraint. The adoption of a tight exchange rate regime, i. e. keeping inflation under control, implies that the country has to follow a Ricardian rule as otherwise the peg would collapse. First, we test if a positive innovation in the primary surplus leads to a fall in government liabilities. The empirical evidence suggests that the three Baltic countries accumulate primary surpluses in order to repay the outstanding debt stock or restrict further debt accumulation. This is consistent with a Ricardian regime. In the countries with a conventional peg, however, primary surpluses are not associated with changes in government liabilities, which implies a non-Ricardian regime. Next, we test the impact of government liabilities on primary surpluses. All ten Central and Eastern European economies that have been analysed are more likely to accumulate primary surpluses if their public liabilities rose in the last year. This supports a Ricardian regime. So, the overall results imply the monetary dominance in the Baltic countries. In the fourth chapter we find empirical evidence supporting the relevance of the market discipline hypothesis in Central and Eastern European countries. Foreign investors observe fiscal discipline in the transition economies and require higher risk premiums for indebted economies’ bonds. The yield spreads of CEE bonds are significantly positively affected by deteriorating fiscal balances, increasing debt or debt service ratios. An opposite effect on the spreads is exerted by healthy GDP growth rates and increasing tax-to-debt ratios. This result suggests that investors do care for the present value budget constraint. Fiscal consolidation tends to increase investors’ confidence and leads to a lower risk premium.