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UNIVERSITY OF MICHIGAN Estonia: An Economy in Transition Joanna Kopicka, Arman Parimbekov, Valerie Roth -1- Introduction Estonia has faced extreme challenges over the last decade in the transition from a socialist, centrally planned economy as a part of the Soviet Union to a market-based, capitalist economy as a part of the European Union. However, Estonia’s economic struggles have not yet ended. As of 2006, its estimated GDP per capita (PPP) was $19,600, far behind the European Union average of $29,4001. Estonia will rely on continued economic growth to catch up to its richer Western European neighbors. This paper will explore the currency dilemma that Estonian government officials faced during the transition from a socialist economy and the choice of a fixed exchange rate regime, determine if the economic data of Estonia as a transition economy support various macroeconomic theories, and offer recommendations for future economic policy. Estonian Independence and the Effects of Russian Monetary Policy During the late 1980’s, Estonia was beginning to push for independence from the Soviet Union, a desire that was evident in their economic policies. As early as 1987, the Estonians were drafting plans that would end central control of the economy. Unfortunately, they were unable to implement these plans until after independence in August of 1991, due to the opposition of Soviet leaders2. However, this did not stop the Estonian government from adopting some economic reforms deemed necessary even in the face of Soviet disapproval. For example, the Bank of Estonia was reestablished on January 1, 1990, and plans for a new Estonian currency to replace the Russian ruble were made3. In part, the plan to reestablish the Bank of Estonia, the Eesti Pank, was symbolic. The first Eesti Pank had been founded in 1919 after Estonia gained independence after World War I, and had been dismantled when the Soviet Union annexed Estonia in 1940. The reestablishment of the Eesti Pank in 1990 and the reintroduction of the kroon in 1992 were significant. They confirmed Estonia’s independence from the former Soviet Union4. Plans for the reintroduction of the Estonian currency became more urgent during the early 1990’s with the hyperinflation of the Russian ruble caused by expansionary monetary policy on the part of the Russian government, which was used as seigniorage to pay for large government deficits.5 Expansionary monetary policy in Russia had a drastic impact on inflation in Estonia, and this rising price level in turn significantly impacted Estonian GDP. In 1989, Estonian inflation as measured by the percent change in the GDP deflator was 8.2%; in 1990, it rose to 33.7%, and continued to climb in 1991 and 1992, respectively at 132.6% and 873.6%. Although the Classical model, as described by the quantity theory of money, suggests that there will be no change in output as a result of the increase in the money supply, this was clearly not the case in Estonia. While Estonian GDP had grown modestly from 1985 to 1989, in 1990, it fell by 7.1%, by 8% in 1991, by 21.2% in 1992, and by 8.4% in 1993. It seems plausible that the aggregate demand curve shifted to the left during this period, as the political turmoil that began in 1989 with the slow break-up of the Soviet Union resulted in loss of investor and consumer confidence lowering both demand for investment and consumption, resulting in a lower equilibrium output. A more detailed discussion of this economic event is described in Appendix A. Choosing an Exchange Rate Regime -2- The Estonian kroon was introduced on June 20, 1992. It was pegged at 1 German mark for 8 Estonian kroons 6. There are costs and benefits to fixed and floating exchange rate regimes, and Estonia had economic and political reasons for choosing a fixed exchange rate regime. Firstly, Estonia was trying to integrate itself into Western Europe, and considered pegging its currency to the German currency. This was a political maneuver to prove the nation’s intention to become friendlier with Western European countries. Furthermore, Estonia viewed the German Bundesbank’s focus on keeping price levels stable as an asset, and for that reason it was interested in pegging its kroon to the German mark, especially after experiencing a hyperinflation caused by Russia’s expansionary monetary policy. Also, as long as Estonia was able to maintain a stable pegged value indefinitely, foreign investors could be confident about investing in Estonia, as the fixed exchange rate guaranteed them the same nominal exchange rate for any capital flows that they chose to take out of the country as the rate at which they had brought the capital into the country. Lastly, it is important to note that a fixed exchange rate regime prevents the Central Bank from printing money to satisfy government debts as the Russian Central Bank did during the early 1990’s hyperinflation. There are also costs that Estonia has had to incur in adopting a fixed exchange rate regime. When the kroon was introduced, there was speculation that Estonia did not have enough reserves of foreign currency (only $120 million of gold reserves) to maintain the fixed value7. At the time, a devaluation of the kroon shortly after its introduction due to insufficient reserves could have scared foreign investors away, hindering trade. The foreign investors would loose confidence in the fixed exchange rate, worrying that the kroon would be devalued on a regular basis and that they would lose money when converting their profits from Estonian investments to their domestic currencies. In addition, a fixed nominal exchange rate does not fix the real exchange rate, which is still subject to fluctuations. This is true especially when a country pegs their currency to another whose growth rates or inflation are very different. According to the quantity theory of money, assuming that the velocity of money is constant, the percentage change in the money supply each year should equal the percentage change in GDP in order to maintain a stable price level. If this is true, then the money supply in the country to which the other county’s currency is pegged may grow more or less than is ideal for the country with the pegged currency. Estonia may have to decrease or increase its money supply in order to maintain the peg, in turn affecting the price level in Estonia, thus in the long-run affecting the real exchange rate and current account balance. The most significant disadvantage of a fixed exchange rate is that it prevents the Central Bank from using monetary policy for anything other than maintaining the fixed exchange rate. The loss of monetary policy as a tool to stimulate an economy in recession or to curb inflation is a major sacrifice. The Mundell-Fleming model explains why monetary policy is ineffective under a fixed exchange rate regime. When the monetary authority expands the money supply, the LM curve shifts right, putting downward pressure on the currency and causing it to depreciate. However, this effect is immediately reversed by the Central Bank as it is obligated to keep the nominal exchange rate at its fixed value. Through open market operations, the Central Bank buys up currency from sellers at a higher nominal price than one offered in the market. This in -3- turn results in a decrease in the money supply and an appreciation of the currency to its fixed level (Appendix B). Likewise, monetary policy cannot be used to reduce inflation by contracting the money supply, since the Central Bank would then have to expand the money supply in order to maintain the fixed exchange rate. As monetary policy is often the fastest way to respond to recessions, loss of monetary policy is a sacrifice that countries with fixed exchange rates have to make. Exchange Rate Data and Analysis One important issue that surrounds the choice of a fixed exchange rate regime is at what value the exchange rate should be fixed. Although the Estonian kroon has been fixed to the German mark (and later to the euro) at the same rate for 15 years, the real exchange rate has fluctuated over time. Assuming that the real exchange rate is equal to the nominal exchange rate multiplied by the domestic price level divided by the foreign price level (ε = e*Pdomestic/Pforeign) and using the CPI of both countries with a base year of 1995 as the respective price levels, the real exchange rate has appreciated over time. Using the base year of 1995, the nominal exchange rate was 0.125 German marks per kroon and the real exchange rate was 0.125 German marks per kroon; as the base year used to calculate the price level was 1995, both price levels are at 100 in this year. By 1999, while the nominal exchange remained at 0.125 German marks per kroon, the real exchange rate had appreciated to 0.181 German marks per kroon (Appendix C). As the kroon appreciated, net exports decreased, and Estonian goods became more expensive. The appreciation of the real exchange rate can be explained by the high inflation in Estonia relative to the currencies to which the kroon is pegged. The Mundell-Fleming model can be adjusted for the long-run to explain the impact of inflation on the real exchange rate. With an increase in the price level, the LM curve will shift to the left, as real money balances have been decreased by the rise in the price level. This will appreciate the real exchange rate, leading to fewer net exports and therefore a lower equilibrium income. Evidence supporting this model can be seen both in the appreciation of the real exchange rate and the chronic current account deficit. As Estonian goods become relatively more expensive than foreign goods by appreciation of the real exchange rate, Estonian exports become less competitive on foreign markets and should decrease. Estonia has had a current account deficit every year since 1994, which suggests that the appreciation of the real exchange rate has made Estonian goods less competitive. Furthermore, imports as a percentage of GDP were only 54.4% in 1992; by 2001, the number had grown to 94.4%. While exports as a percentage of GDP have risen from 60.3% in 1992 to 90.6% in 2001, imports are a greater percentage of GDP (Appendix D). Economic Challenges and Policy Options There are two major issues threatening Estonia’s economic health: the current account deficit and inflation. Both can be addressed through policy initiatives, but these policy initiatives may be more problematic than the issues they are meant to address. Inflation Although Estonia’s inflation rate is not particularly high for that of a transition economy, it is preventing Estonia from being able to adopt the euro as its currency. -4- Estonia currently meets all of the requirements for adopting the euro except for the stipulation regarding inflation, as they exceed the limit for inflation rates by 1-2%8 (see Appendix E). There are two ways in which Estonia could decrease inflation; they could engage in a fiscal contraction or allow their exchange rate to float in order to engage in a monetary contraction. Estonia could reduce its inflation levels by engaging in a fiscal contraction. In the Mundell-Fleming model, a fiscal contraction would shift the IS curve left, putting downward pressure on the currency. In order to maintain the fixed exchange rate, the Central Bank would be forced to contract the money supply, shifting the LM curve right and returning the currency to its fixed value. At the new equilibrium, output would be lower than before the contraction. This will shift the aggregate demand curve left, assuming that prices are sticky in the short-run, would result in lower equilibrium output. Over time, the price level should drop, and the Estonian economy should return to full employment output at a lower equilibrium price level (Appendix F). However, Estonia may not be willing to sacrifice growth that would be lost with fiscal and monetary contraction. In addition, Estonia is bringing in more money in taxes than the government spends every year. Making further cuts in spending seems unnecessary and may negatively affect the quality of social services provided by the government. Another way Estonia could reduce inflation is by allowing the kroon to float. By doing so, Estonia would gain access to monetary policy and would be able to contract the money supply to reduce inflation. With such a contraction, the LM curve in the IS-LM model would shift to the left, resulting in a lower equilibrium output at each price level. However, with a decrease in the money supply, the kroon would appreciate and net exports would decrease, shifting the IS curve left, which will further decrease output. This in turn would result in a shift of the aggregate demand curve, assuming that in the short-run price levels are sticky, equilibrium output would decrease until the price level fell and brought output back to the full-employment level (Appendix G). To adopt the euro, Estonia’s currency must be valued within a range of 15% of the euro9. Currently the kroon is pegged to the euro, and allowing it to float within in a band of 15% of the value of the euro would provide Estonia with the flexibility in monetary policy that they need in order to meet the inflation criteria. However, there is always the chance that if they were to allow the kroon to float, investors would lose confidence in the kroon and would pull out of Estonia. Furthermore, Estonia is attempting to adopt a common European currency; if they are unable to control inflation without resorting to the use of monetary policy with the kroon pegged to the euro, how will they manage to control inflation when they adopt the euro? A third policy option in regards to inflation would be to do nothing. Eventually, prices in Estonia should converge with the rest of Europe’s. While this process may take a while, any efforts to curb inflation now simply ensure that the process will take longer. Furthermore, doing nothing would not have any negative effects on Estonian GDP, nor would it threaten its relations with other nations that already have adopted the euro. However, following this suggestion would mean that Estonia may not be able to adopt the euro for many years, depending how long it takes for Estonian prices to converge. -5- Current Account Deficit In 1993, Estonian trade surplus was 0.55 percent of their GDP; less than 10 years later, in 2001, Estonia had a trade deficit of 6.14% of their GDP. While the trade deficit may not seem worrisome, as Estonia’s economy in transition is experiencing significant capital inflows for investment from other countries (net inflows of foreign direct investment amounted to 9.76% of their GDP in 2001), there is still reason for concern. Estonia has been running current account deficits of over 3% of GDP every year since 1994. There are two ways in which Estonia could deal with the current account deficit; first, devalue the kroon, or second, attempt to increase the savings rate. As Estonia has a fixed exchange rate, the Central Bank could devalue the kroon, lowering the fixed exchange rate and making Estonian exports more competitive in foreign markets and imports to Estonia more expensive. This should increase Estonian exports and decrease imports, decreasing the current account deficit. The Central Bank could devalue the currency up to 15% of the value of the euro without jeopardizing the future adoption of the euro in Estonia. However, this policy is unlikely to be accepted by the monetary authority. Part of the reason that Estonia has been so successful in attracting foreign investment is because their nominal exchange rate has not changed in 15 years. A devaluation of the currency may scare away foreign investors, which would ultimately hurt the Estonian economy. Furthermore, such a devaluation would not send a positive signal concerning Estonia’s willingness to adhere to a common currency. Estonia could also try to encourage savings in order to decrease the current account deficit. There are two types of saving that the government could encourage: government savings and private savings. It seems unlikely that more government savings will help the situation. In 2001, the Estonian government carried a debt of only 2.68% of GDP, suggesting that the government cannot save much more money than it is already saving. There are ways in which the government could encourage private saving. A tax cut would increase savings; however, consumption would increase with savings, and this would include the consumption of imported goods. Another possible policy would be to provide tax incentives to save. The government could enact new tax laws that would apply a lower tax rate to money that is saved, or even make savings exempt from taxation. These policies would increase savings minus investment, which would lead to a depreciation of the real exchange rate and an increase in net exports (Appendix H). Policy Recommendations Estonia should try to increase the savings rate and should do nothing about inflation but wait for a convergence in price levels. As for the current account deficit, increasing private savings is the best policy. Although it will result in some loss of consumption, it will be less burdensome than devaluing the currency, which will make it more difficult for Estonia to adopt the euro. In regards to inflation, while no policy option is optimal, only waiting for inflation to go down as prices converge with those in the rest of Europe will not negatively affect Estonian GDP, and as they are still a developing economy, it is in their best interest to continue attracting foreign investors through strong GDP growth. -6- Appendices Appendix A Using the IS-LM model and the assumption of sticky prices, an increase in the money supply should have helped to rectify the decrease in aggregate demand by shifting the LM curve to the right, resulting in a higher equilibrium output and lower equilibrium interest rate. However, the assumption of sticky prices is probably not appropriate for Estonia during this time period, as it was still for the most part a planned economy in which many prices were set by the government and would have been change quickly to reflect hyperinflation. If prices were relatively flexible, then the LM curve would shift to the left quickly after its original shift to the right, because after an increase in the money supply shifted the supply of real money balances to the right in the liquidity preference model, the rising prices would shift that supply back to the left. This would lessen any positive effects that the original rightward shift of the LM curve caused by an increase in the money supply would have had on GDP, yielding data similar to that which is observed. Furthermore, when the money supply grows so quickly that there is hyperinflation, any positive effect on economic growth that would be seen with a moderate growth in the money supply will be canceled out by uncertainty about the health of the economy and the drop in consumer and investor confidence that accompanies this phenomena and shifts the IS curve to the left. Furthermore, a shock to the IS curve shifting it to the left, caused by a drop in demand for investment and consumption due to the political turmoil of the time may explain the shift in the aggregate demand curve. Such a shock would push the real interest rate down and decrease equilibrium output. Although there is no data for the Estonian interest rate before 1992, the 1992 real interest rate percentage change of -86.6% and 1993 value of -26.5% (with values of percentage change in the interest rate remaining negative until 1996) provides evidence that this could have been the case. This data is not conclusive however, as increases in the Estonian money supply with the introduction of the kroon probably contributed to the decreases in the interest rate after 1992. Stronger evidence that there was a shift to the left of the IS curve is found in data concerning consumption. Consumption as a percentage of GDP dropped from 77.7% in 1990 to 65.5% and 67.3% in 1991 and 1992 respectively, and then began to grow again in 1993 with an increase in consumer confidence as the political situation stabilized. -7- r LM1 LM2 IS2 IS1 Y In this model, an increase in the money supply leads to a shift from LM 1 to LM2. If prices are flexible, as may have been the case under the planned economy in Estonia when government set prices could be changed whenever the government felt like doing so, the price level would rise, causing LM2 to shift back to its original position of LM1. However, a higher price level, along with uncertainty caused by political instability, could have led to a shift in the IS curve from IS 1 to IS2, which results in a lower real interest rate and lower output. Estonia GDP Growth 15 10 5 % GDP Growth 0 1985 1986 1987 1988 1989 1990 1991 1992 1993 -5 -10 -15 -20 -25 Year *All GDP measures are in real terms -8- 1994 1995 1996 1997 1998 1999 2000 2001 1000 900 800 700 600 500 400 300 200 100 0 -100 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 % Growth in GDP Deflator Inflation Measured by % Growth in GDP Deflator Year Appendix B r* LM2 LM1 BoP IS2 IS1 Y In the Mundell-Fleming model with a fixed exchange rate, a fiscal contraction causes the IS curve to shift from IS1 to IS2. To maintain the fixed exchange rate, the Central Bank then contracts the money supply from LM1 to LM2. -9- Appendix C Estonian and German CPI 180 160 140 120 100 CPI Estonian CPI German CPI 80 60 40 20 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Exchange Rates (German Marks per Kroon) 0.2 0.18 0.16 Exchange Rate 0.14 0.12 Nominal Exchange Rate Real Exchange Rate 0.1 0.08 0.06 0.04 0.02 0 1992 1993 1994 1995 1996 1997 1998 Year - 10 - 1999 2000 2001 Appendix D ε M/P2 M/P1 IS Y When the price level rises with inflation from P1 to P2, the real money balances curve shifts from M/P1 to M/P2. This results in an appreciation of the real exchange rate. Current Account Balance as % of GDP 2 0 Current Accpunt Balance as a % of GDP 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 -2 -4 -6 Current Account Balance as % of GDP -8 -10 -12 -14 Year - 11 - Exports and Imports as a % of GDP 120 100 % of GDP 80 Exports Imports 60 40 20 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Appendix E Estonian Inflation Rate 100 90 80 Inflation Rate 70 60 50 Inflation Rate 40 30 20 10 0 1993 1994 1995 1996 1997 Year - 12 - 1998 1999 2000 2001 Appendix F r* LM2 LM1 BoP IS2 IS1 Y P LRAS SRAS1 SRAS2 AD1 AD2 Y In the Mundell-Fleming model with a fixed exchange rate, a fiscal contraction causes the IS curve to shift from IS1 to IS2. To maintain the fixed exchange rate, the Central Bank then contracts the money supply from LM1 to LM2. This results in a lower output for every price level, which shifts the aggregate demand curve to the left from AD1 to AD2, pulling output below the full employment level. In time, the price level will fall from SRAS1 to SRAS2, and the economy will return to full employment output at a lower equilibrium price level of SRAS2. - 13 - Appendix G r* LM2 LM1 BoP IS2 IS1 Y P LRAS SRAS1 SRAS2 AD1 AD2 Y Using the Mundell-Fleming model, the effects of a monetary contraction under a flexible exchange rate regime are apparent. A contraction of the money supply causes the LM curve to shift left from LM1 to LM2. This causes an appreciation of the real exchange rate, which decreases net exports and causes the IS curve to shift to the left from IS1 to IS2. This in turn shifts the aggregate demand curve to the left from AD1 to AD2, resulting in lower output until the price level falls to equate the aggregate demand curve with the full employment output line. - 14 - Appendix H Central Government Debt as a % of GDP 7 6 % of GDP 5 4 Central Government Debt as a % of GDP 3 2 1 0 1996 1997 1998 1999 2000 2001 Year S1-I S2-I ε NX An increase in the savings rate will cause the saving minus investment curve to shift right from S1 – I to S2 – I, which will result in a lower real exchange rate and an increase in net exports. - 15 - *All data not separately cited as obtained through the World Bank World Development Indicators CD April 2003 1 CIA Factbook, Estonia, https://www.cia.gov/cia/publications/factbook/rankorder/2004rank.html (Accessed April 1, 2007). 2 “Economic Reform History” Library of Congress Country Studies: Estonia, http://lcweb2.loc.gov/frd/cs/eetoc.html (Accessed April 1, 2007). 3 “About Eesti Pank: History,” Bank of Estonia, http://www.eestipank.info/pub/en/yldine/pank/ajalugu/Ajalugu/ajalugu.html?objId=306762 (Accessed April 1, 2007). 4 “About Eesti Pank: History,” Bank of Estonia, http://www.eestipank.info/pub/en/yldine/pank/ajalugu/Ajalugu/ajalugu.html?objId=306762 (Accessed April 1, 2007). 5 “Economy of Russia,” Wikipedia http://en.wikipedia.org/wiki/Russia/Economy#Monetary_and_fiscal_policies (Accessed April 4, 2007). 6 “About Eesti Pank: History,” Bank of Estonia, http://www.eestipank.info/pub/en/yldine/pank/ajalugu/Ajalugu/ajalugu.html?objId=306762 (Accessed April 1, 2007). 7 “Economic Reform History” Library of Congress Country Studies: Estonia, http://lcweb2.loc.gov/frd/cs/eetoc.html (Accessed April 1, 2007). 8 “European Union/Euro,” Bank of Estonia, http://www.eestipank.info/pub/en/majandus/euroopaliit (Accessed April 3, 2007). 9 “FAQ: EU Enlargement and the Economic and Monetary Union,” European Central Bank http://www.ecb.int/ecb/enlargement/html/faqenlarge.en.html#14 (Accessed April 4, 2007). - 16 -