Volatility of Central European Exchange Rates : Reaction to Financial Contagion, and Policy Recommendations for European Union Accession

Among other preparatory tasks for integration with the European Union, economies of Central Europe are under pressure to achieve high degrees of economic stability, including stability of currencies. The introduction of flexible currency exchange-rates regimes as well as the application of crawling pegs and bands initiated greater discretion of policy makers in conducting domestic policies, as opposed to a fixed peg currency regime. The key investigative question of the study is, "Have the Central European countries achieved economic transformation consistent with tying their currencies exclusively to the euro?". The paper addresses this and other questions by examining the elasticity of the U.S. dollar exchange rate for each Central European currency. In addition, further discussions includes the "pecking order" of capital inflows relative to fixed pegs and short-term capital compared to flexible regimes tied to long-term portfolio and foreign direct investments. The spillover effects of the Asian and Russian crises on Central European exchange rates conclude that the German mark has succeeded the U.S. dollar as the vital force behind the Central European currency movements. The study shows that the Asian financial crisis of 1997 had a more lasting effect on Central European exchange rate than did the Russian crisis of August and September 1998. However, the most important finding in examining the effects of the Asian and Russian financial crises are the systemic similarities in the transmission of financial contagion. The study concludes that EU candidate nations should try to align their currencies more towards to the euro by de-emphasizing the U.S. dollar in their currency baskets, while continuing to attract foreign capital by strengthening their financial institutions. Additionally, continued regulatory and governance systems will indeed encourage growth as well as build confidence in domestic and foreign investors