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Adoption of the Euro in Estonia:
A view from outside
Zsolt Darvas
19 March 2009, Tallinn
Joint seminar of Estonian Cooperation
Assembly and the European Commission
Representation in Estonia
1
The World is in a deep crisis;
the Baltic countries are especially
GDP growth forecasts for 2009 of the DG ECFIN of EC
November 2007 forecast
January 2009 forecast
Change
Bulgaria
6.2
1.8
-4.4
Czech Republic
4.9
1.7
-3.2
Estonia
6.2
-4.7
-10.9
Latvia
6.2
-6.9
-13.1
Lithuania
6.3
-4.0
-10.3
Hungary
3.4
-1.6
-5.0
Poland
5.2
2.0
-3.2
Romania
5.8
1.8
-4.0
Slovakia
6.2
2.7
-3.5
Slovenia
4.0
0.6
-3.4
EU15
2.2
-2.0
-4.2
Note: the January 2009 forecast is outdated and too optimistic, but
more recent forecast for the whole region is not available. E.g. Eesti
Pank expects growth in Estonia in the range -5.5% and -8.9%.
The crisis challenges the catching-up
process in the Baltic countries
90
GDP per capita in Purchasing Power Standards
(EU-15 = 100),
1995-2010
90
90
90
80
80
80
80
70
70
70
70
60
60
60
60
50
50
50
50
40
40
40
40
30
30
30
30
20
20
20
96
98
00
02
Czech Republic
Poland
Slovenia
04
06
08
Hungary
Slovakia
10
20
96
98
00
02
Estonia
Lithuania
Bulgaria
04
06
08
10
Latvia
Romania
The 2009-2010 values were calculated using the January 2009 DG ECFIN forecasts
which are too optimistic
3
Despite the huge growth in GDP, productivity
in manufacturing did not grow faster in Baltic
countries than in other New Member States
Real wages and productivity in manufacturing
(average annual growth in per cent), 2001-2007
10
Productivity
Real wage
8
6
4
2
Note: Nominal wages were deflated by the manufacturing PPI. Productivity was
calculated by dividing real output by hours worked in manufacturing
Slovenia
Latvia
Czech Rep.
Slovakia
Romania
Lithuania
Estonia
Bulgaria
Poland
Hungary
0
4
Credit growth was incredibly fast in Estonia
and Latvia
200
Domestic credit / GDP, 1995-2007
200 200
200
100 100
100
70
60
50
70
60
50
70
60
50
70
60
50
40
40
40
40
30
30
30
30
20
20
20
20
10
10
10
10
100
1996 1998 2000 2002 2004 2006
EA12
Czech Rep.
Hungary
Poland
Slovakia
Slovenia
Cyprus
1996 1998 2000 2002 2004 2006
EA12
Malta
Estonia
Latvia
Lithuania
Romania
Bulgaria
5
Domestic Credit and Current Account
 Mid 1990s: low level of credit in countries having low
per capita GDP → fast growth of credit
 Credit growth: fuelled by both demand and supply
factors
 Fuelled also by low real interest rates in fixed
exchange rate systems
 Equilibrium level vs. speed of adjustment
 Dangers: feeds inflation, wage growth, housing prices,
consumption, could deteriorate competitiveness, risks
financial crisis
 Fastest credit growth → largest current account deficit
6
Indeed, strong relation between GDP
growth and the current account balance
GDP growth and the current account, 2003-2007
Current acconut/GDP (average of 2003-2007)
-2
Slovenia
Poland
Czech Republic
-4
Slovakia
-6
Hungary
-8
Romania
-10
Lithuania
-12
Bulgaria
-14
Estonia
Regression line
Latvia
-16
3
4
5
6
7
8
9
GDP growth (average of 2003-2007)
10
7
As a result: external indebtedness rose sharply
Estonia: International investment position in 2000
and in 2007 (in % of GDP)
200%
Estonia

Huge increase in gross
external indebtedness:

Total: 186 % of GDP

FDI and equity investment
are more stable

Gross external
loans+bonds=97% of GDP
in 2007 vs. 41% in 2000

Net external loans+bonds:
47 % of GDP in 2007 vs.
16% in 2000
180%
160%
140%
loans
120%
100%
reserves
80%
bonds
shares
loans
60%
bonds
40%
shares
20%
FDI
FDI
0%
Assets Liabilities
2000
2000
Assets Liabilities
2007
2007
8
Compare to the Czech Republic
Czech Republic: International investment position in
2000 and in 2007 (in % of GDP)
120%
Czech Republic

Czech Republic: mild
increase in external
indebtedness

Total gross external
indebtedness = 110% of
GDP in 2007 (vs. 186 % in
Estonia)

External loans+bonds =
39% of GDP in 2007 (vs.
97% of Estonia)

Net external loans+bonds =
6% of GDP (vs. 47% in
Estonia)
100%
loans
80%
bonds
shares
60%
reserves
40%
loans
FDI
20%
bonds
shares
0%
FDI
Assets Liabilities
2000
2000
Assets Liabilities
2007
2007
9
The fixed exchange rate system: cornerstone of economic policy of Estonia
 Andres Lipstok, Governor of Eesti Pank, on 10 March
2009:
“One of the most significant points of the IMF report is
that the IMF reaffirmed once again our currency board
arrangement and the fixed exchange rate of the kroon
serve as the pillars of the country's monetary policy and
financial stability. This system will be maintained until
Estonia joins the euro area.”
 Do markets believe in that?
10
Cost of insurance against government default:
sharp rises indicate lack of confidence
Credit default swap on 5-year government bonds
2 January 2008 – 16 March 2009
1,200
1,100
1,000
900
800
700
600
1,200
Latvia
Lithuania
Estonia
Romania
Bulgaria
Hungary
Poland
Czech Rep.
Slovakia
Slovenia
1,100
1,000
900
800
700
600
500
500
400
400
300
300
200
200
100
100
0
2008:01
0
2008:04
2008:07
2008:10
2009:01
11
Why such a large default risk? (When
government debt is quite low)
 The most likely reason is the risk inherent in huge
private sector debt, which is mostly in euros
 Should the exchange rate collapse: even deeper crisis,
more bankruptcies, unmanageable losses of banks,
complete dry up of foreign capital  may end in a
government default as well
 Indeed, rising government default risk is related to the
current account and external indebtedness after the
crisis, not before (see next two charts)
12
Cost of insurance against government default is
now related to the current account …
5 Year Credit Default Swap on Gov Bond
0
500
1000
LV
LT
RO
EE
BG
HU
Estonia
PL
IE
CZ
GR
AT
SK
SI
PT
IT
ES GB
BE
FR
LV
EE BG
RO
LT
GRPT ES
-30
HU
SK CY
SE
NL
DK
FI
DE
PL
SI
CZ
IE IT
FR
DK
AT
BE
FI
DE
-20
-10
0
Current Account over GDP
NMS Dec 2006
NMS Mar 2009
Rest of EU Dec 2006
Rest of EU Mar 2009
SE
NL
10
13
1200
… Cost of insurance against government default
is also related to external debt
1000
LV
Estonia
800
LT
RO
EE
400
600
BG
HU
PL
200
CZ
SK
SI
-80
-60
-40
-20
0
Net foreign loan and debt liabilities over GDP 2007
14
Current account adjustment (parallel with fall
of GDP) is ongoing in the Baltic countries
0
0
0
0
-4
-4
-4
-4
-8
-8
-8
-8
-12
-12
-12
-12
-16
-16
-16
-16
Bulgaria
Estonia
Latvia
Lithuania
Slovenia
-20
-24
00
01
02
03
04
05
06
07
08
09
-20
-20
-24
-24
Czech Republic
Hungary
Poland
Romania
Slovakia
00
01
02
03
04
-20
-24
05
06
07
The 2009 values are taken from the January 2009 DG ECFIN forecasts
08
15
09
Summary: Macroeconomic history of Baltic
countries in the past few years
 Fixed exchange rate was credible before the crisis
 Huge increases in
– Credit (mostly in euros)
– Housing prices
– Wages
– Inflation
– Consumption
– Current account deficit and external debt
 Exactly these factors preceded many financial crises and
exchange rate collapses
16
To be avoided: an exchange rate collapse,
like in Argentina
The exchange rate of the Argentine peso against the
US dollar, February 1992 – March 2009
4
3.5
3
2.5
2
1.5
1
0.5
2009.02.01
2008.02.01
2007.02.01
2006.02.01
2005.02.01
2004.02.01
2003.02.01
2002.02.01
2001.02.01
2000.02.01
1999.02.01
1998.02.01
1997.02.01
1996.02.01
1995.02.01
1994.02.01
1993.02.01
1992.02.01
1991.02.01
0
17
Government and central bank officials strengthened their commitment to the
currency board even a few days before the crash.
An exchange rate collapse must be avoided
 Option 1: Try to survive as in the past without the
euro, use fiscal policy to dampen the economic and
social impacts of the crisis; rush for the euro only after
the crisis
 Option 2: Devalue, but keep the peg
 Option 3: Introduce a floating exchange rate (as, e.g.
Ukraine last November)
 Option 4: Keep the peg but do all efforts to introduce
the euro as soon as possible, which implies significant
adjustment in government budget (expenditure cuts
and/or tax increases) and nominal wage cuts
18
Option 1: Try to survive as in the past without the
euro, use fiscal policy to dampen the economic and
social impacts of the crisis; rush for the euro only
after the crisis
 Very risky
 This policy would not restore confidence in Estonia,
capital flows may decline further
 Risk of contagion as well: If the most troubled county,
Latvia, will eventually not be able to keep its exchange
rate peg  risk of a domino effect, i.e. attack against
the Estonian kroon and chaos
19
Option 2: Devalue, but keep the peg
 Arguments in favor:
– Large and permanent correction is needed in the current
account, which requires a large correction in relative prices.
Without that, there will be no economic recovery for years.
It is easier via devaluation than through deflation.
– It is easier to manage an economy with a low level of
inflation than it is to manage an economy which has a
deflation
– There will be bankruptcies anyway, but devaluation is
quicker and perhaps less painful, than cuts in wages and
prices
– Better to do it voluntarily now than to be forced by the
market later
20
Option 2: Devalue, but keep the peg, cont’d
 Arguments against:
– Very risky: It would create a precedent and markets may expect
further devaluations as well
– It’s unclear how much a devaluation would actually needed
– A devaluation would bring bankruptcies earlier, while deflation
would give some time to adjust
– A devaluation may prompt Swedish banks to withdraw from
Estonia in the face of a concentrated defaults, which would
further undermine economic recovery
– A devaluation would further increase the debt/GDP ratio and
may result in credit agency downgrades to junk status
– Estonia has a very flexible economy and weathered the storm
during the Russian crisis in 1998 and may do so again
– May trigger devaluation in Latvia, Lithuania and Bulgaria, and
also could possibly impact countries with floating exchange rates
21
Option 3: Introduce a floating exchange
rate
 It would had been a good option around 2000 (i.e. well
after the Russian crisis and before the huge credit boom
started).
 Confer the success of the Czech Republic with the floating
exchange rate (high growth, low inflation, no FX loans;
the crisis have a mild effect so far, the central bank could
cut interest rates)
 For Estonia, move to a float at the time of the crisis would
risk excessive depreciation of the exchange rate, and
consequently, the dangers of a devaluation discussed in
the previous slide would come to play at a greater force
22
Option 4: Keep the peg but do all efforts to
introduce the euro as soon as possible
 Painful in the short run
 Risk of failure:
– What if the government will not meet the deficit
criterion of 3%?
– What if inflation will not fall as much to meet the
inflation criterion?
– Even if Estonia meets all backward looking criteria,
what if the EC and ECB will not regard the situation
sustainable?
(Note: the Maastricht Treaty requires that the
criteria should be met in a sustainable manner)
23
Option 4 (quick euro adoption), cont’d
 Even if Estonia may adopt the euro soon, there will be
significant risks and challenges for the medium and long
run
 The needed permanent decrease in the current account
deficit should be achieved by decreases in nominal
wages and prices  it may prove to be extremely
difficult
 The exchange rate may remain overvalued  risk of a
substantial slowdown in economic growth
 Note the case of Portugal: prosperous economic
catching-up before euro area entry in 1999, after that:
the slowest growth among euro area countries and the
catching-up process halted
24
The Human face of the crisis
(The title of this seminar)
 People in Estonia must understand that the economic
developments of the past few years were not
sustainable: high growth in GDP, wages, prices,
consumption, credits, housing prices, external
indebtedness
 There are various options regarding the exchange rate
system, which is the corner-stone of economic policy in
Estonia, but none of them are painless
 The most sensible option is to try to adopt the euro as
soon as possible, even is there are serious risks.
Otherwise: danger of an exchange rate collapse with
much severe effects.
25
Steps toward euro adoption

Key steps to foster euro adoption
– Government budget deficit must be under 3% of GDP
– Nominal wages must be cut substantially (reach a social consensus)
– Flexibility of the labor markets should be strengthened
– Economic restructuring should be fostered
– All these should be done in a sustainable manner

A short term tool to alleviate somewhat the pain: private debt
restructuring (e.g. in Hungary those how lost their job may receive a 2year period of quasi moratorium in debt service)

Even if euro is introduced, there will be longer term
consequences as well
– Tighter credit conditions, higher risk premium, high debt service 
larger share of income will be spent on it
– Lower GDP (and consumption, wages, etc.) level and growth in the
future
26