Consequently we have seen how both Ukraine and Hungary have chosen to loosen the peg to the Euro as well as other floating currencies in Eastern Europe have seen their yield advantage increase in an attempt to flush out inflation. This has not been without problems though or more specifically it is not clear that an appreciation of the currency is all for the good. Two points here would seem particularly important. One is the simple question of whether in fact an appreciation is deflationary in a world where capital flows, and in particular the hot kind, act strongly on yield. However, another point would be specifically tied to the situation in Eastern Europe. As such, nominal appreciation of the currency also increases the purchasing power which is not what many CEE economies need at the present time as they stand before the task of correcting a rather large external balance. Moreover, rising domestic interest rates will increase and exacerbate the credit channel by which loans denominated in Euros and Swiss francs become more attractive. I have shown this to be true, for example, in the context of Lithuania. The important thing to do note here would what would happen to the servicing of these liabilities should the domestic currencies depreciate.

What happens next then? Or more concretely, even though CEE currencies, in general, have enjoyed a rally on the back of market expectations of nominal appreciation fed by hawkish central banks what happens if and when central banks reverese course?

An initial warning shot across the bow was handed to us as the governor of the Czech central bank mused that he might lower rates come next meeting due to the strenght of the Koruna and the subsequent effect on exports. Also Poland recently opted to abandon the hawkish stance as rates were kept steady. In light of this event Macro Man managed, as ever, to hit the proverbial nail on the head. 

There is little more bearish for a currency these days than abandoning the inflation fight in a pursuit of growth; this is particularly the case when the market is heavily positioned the other way.

This is exactly the issue which now confronts many Eastern European economies. What to do as growth visibly tanks at one at the same time as inflation stays high. One thing here would be for the central banks to hold their raising cycle which in itself should ease the pace of appreciation but what if they need to lower rates. 

Now the numbers above do not, in themselves tell anything remotely interesting. For one, the difference between the economies are quite big. For example the Czech Republic has been able to gain, with a comparatively low interest rate,  currency appreciation which has actually helped the external balance in so far as it has made imports cheaper. Obviously, at this point the benign effect on the trade balance is just as much down to decreasing domestic demand as the value shield of a dear currency. On the other hand,  if we consider especially Ukraine, Romania, and Hungary the price has been dearer and the subsequent effect on inflation less pronounced. One could always argue that the situation would have been much worse, but one thing is certain; the ensuing loss of competitiveness has not been compensated for with a decrease in inflation.