Exchange Market Pressure in the Formerly Planned Central and Eastern European Countries. The Role of Institutions

In this paper we find evidence that institutional improvements such as economic liberalization, improved corporate governance, banking sector reform, improvements of rule of law and pushing back corruption have significantly reduced tensions on the exchange market in the formerly planned Central and Eastern European transition economies. We also show that countries with extreme exchange rate arrangements (such as a currency board or a freely floating exchange rate) have – ceteris paribus – been less vulnerable to turbulence on the exchange market than countries with intermediate exchange rate arrangements, such as an adjustable fixed peg. This confirms the so-called bi-polar view on exchange rate regimes for this group of countries. Testing for the interaction between economic fundamentals (current account, domestic credit growth and the inflation differential) and institutions our results are in general quite supporting to the hypothesis that a higher quality of institutions lessens the adverse effect of weak economic fundamentals. Low corruption, efficient banking regulatory and supervisory systems and profound economic liberalization significantly reduce the impact on exchange market pressure of domestic credit growth and inflation.