UNIVERSITY OF MICHIGAN

Estonia: An Economy in Transition

Joanna Kopicka, Arman Parimbekov, Valerie Roth

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 $29,400[1]. 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 leaders[2]. 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 made[3]. 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 Union[4]. 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

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 value[7]. 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 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. 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 euro[9]. 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. [JK1]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.

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.