Estonian monetary arrangement and challenges ahead€¦ · Full convertibility i.e. no restrictions...

1EURO strateegiast: kas euroga või eurol?Andres Lipstok

Estonian monetary arrangement and challenges ahead

Märten Ross


Outline

1. Features of Estonian monetary arrangement

2. Economic performance

3. Characteristics of Estonian economy

4. Challenges for the future


1. Estonian Monetary Regime

Currency Board Arrangement, introduced in 1992.Fixed exchange rate: 1 € = 15,6466 EEK (before 1999 1 DEM

= 8 EEK)Full convertibility i.e. no restrictions on current and capital

account convertibility (since 1994)Base money is fully covered with foreign reserves and it is

issued only against respective change at foreign reservesEstonia joined EU on May 1, 2004 and the Exchange Rate

Mechanism II (ERM II) on June 28, 2004 with existingeuro/Estonian kroon exchange rate and with a unilateralcommitment to maintain Currency Board Arrangementand thereby the fixed exchange rate with no fluctuation band.


2. Performance of Estonian economy

2.1 Economic growth

2.2 Inflation

2.3 Interest rates

2.4 Exchange rate expectations


2.1 The dynamics of Estonian GDP per person by PPP compared to EU-25, 1995-2006

0,00

0,10

0,20

0,30

0,40

0,50

0,60

0,70

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Estonian GDP per capita by PPP, EU-25=100

Source: Eurostat

Estonian economy (measured as GDP by PPP per person) has experiencedthe fastest growth among the 25 EU member countries between 1996-2006


2.1 Annual growth of GDP and labourproductivity in Estonia, 1998-2005

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

1998 1999 2000 2001 2002 2003 2004 2005

Labour productivitygrowthGDP growth

Source: Statistics Estonia

Annual labour productivity growth in real terms have exceeded 6 percent between 1998-2005


2.2 Consumer price inflation (1991-2005)

0,0%

20,0%

40,0%

60,0%

80,0%

100,0%

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

The introduction of the currency board was crucial in achievingdisinflationDuring the last six years the average consumer price inflationhas been ca 3.5 %


2.3 Interest rates (1997-2006)

0%

2%

4%

6%

8%

10%

12%

14%

16%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006Long-term interest rates, housing loansLong-term interest rates, corporate loans6M EURIBOR

The interest rates have converged to the interest ratelevel in euro-area countries


2.4 Exchange rate expectations: euro/EEK forward differences

0 ,0

0 ,5

1 ,0

1 ,5

2 ,0

2 ,5

3 ,0

3 ,5

01.0

1

05.0

1

09.0

1

01.0

2

05.0

2

09.0

2

01.0

3

05.0

3

09.0

3

01.0

4

05.0

4

09.0

4

01.0

5

05.0

5

09.0

5

01.0

6

05.0

6

1 M 3 M 6 M 1 Y 2 Y 3 Y

There is strong confidence in the maintenance of the present nominalexchange rate


2.5 Unavoidable question: “How much is too much?” (1)

Variable Estonia, 2005 "Ranking", 2004 Sample

Current account deficit/GDP -10,5%

3rd largest current account deficit relative to GDP 95 countries

Net FDI position/GDP -77%

6th largest negative net FDI position relative to GDP 138 countries

Net investment position/GDP -99%

9th largest negative net investment position relative to GDP 138 countries

0%

20%

40%

60%

80%

100%

120%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

% o

f GDP

Net FDI/GDPNet investment position/GDP


2.6 Unavoidable question: “How much is too much?” (2)

0 .0

0 .5

1 .0

1 .5

2 .0

2 .5

3 .0

3 .5

4 .0

12.9

903

.00

06.0

009

.00

12.0

003

.01

06.0

109

.01

12.0

103

.02

06.0

209

.02

12.0

203

.03

06.0

309

.03

12.0

303

.04

06.0

409

.04

12.0

403

.05

06.0

509

.05

12.0

503

.06

bn E

UR

0 %

1 0 %

2 0 %

3 0 %

4 0 %

5 0 %

6 0 %

7 0 %other loans

hous ing loans and leas ing

debt / d is pos ab le inc om e

debt / G D P

Compared to “old” members debt to GDP is still twice lower (ca 60 % of GDP in EU-15 and ca 30 % of GDP in Estonia)


3. Characteristics of Estonian economy

3.1 Fiscal policy3.2 Flexibility of markets

- price-setting- labour market- entry and exit barriers for firms

3.3 The mobility of factors of production3.4 Openness and trade integration3.5 The similiarities of the structure of the economy between

Estonia and main trading partners3.6 Financial integration


3.1 Fiscal policy – strong policy discipline

-6-4-202468

10

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Pro

ject

ion

Goverment debt (% of GDP) Fiscal balance (% of GDP)

During the last five years the budget has been in surplus

The gross debt of the government has steadily decreased during the last ten years ( in 2006 gross governement debt is ca 4 % of GDP)

In 2006 the net debt of the government is positive (ca 6 % of GDP)


3.2 Flexibility of markets (I): price-setting - frequencyof price changes per year(1)

Number of price changes EURO AREA(2) EE>= 4 14 18 2 - 3 20 25

1 39 43<1 27 14

Median 1 1Notes: (1) Percent, re-scaled figures excluding non-responses - (2) Weighted average (GDP weights).

Price changes are more frequent in Estonia than in the euro area countries


3.2 Flexibility of markets (II): price-setting - speed of price adjustment after shock

Higher demand Lower demand Higher costs Lower costsEuro Arealess than one month 22 26 24 22one to three months 32 39 34 34more than three months 46 35 42 44

Higher demand Lower demand Higher costs Lower costsEstonialess than one month 63 66 51 52one to three months 20 19 24 26more than three months 17 14 24 22

Notes: Percent of firms.

The speed of price adjustment after shocks is higher in Estonia than in the euro area countries


3.2 Flexibility of markets (III): labour markets -institutional frameworkEmployment and unemployment rates in Estonia and European Union - 25, 2005Q3

Employment rate Unemployment rateEuropean Union - 25 64% 8%Estonia 65% 7%

Trade unions: The share of workers in trade unions (ca 10 %) is oneof the lowest in European UnionMinimum wage: The ratio of the minimum wage to the average wagein 2006 is ca 32 %Employment protection: The extent of employment protection isclose to the average in European Union countriesUnemployment insurance and benefits: Unemployment insuranceis somewhat and unemployment benefits significantly lower than theaverage in European Union countriesTaxation of labour: Relatively high in international comparison


3.2 Flexibility of markets (IV): labour markets - themeasures of effectiveness

The flexibility of wages: after the Russian crisis (1998-1999) thewages in the tradable sector exhibited both real and nominaldownward flexibility.The gross flows of workers (employment turnover): (ininternational comparison) very high in the first half of 90s; later theemployment turnover has decreased but remains relatively high.The mobility of workers between sectors: (in internationalcomparison) very high in the first half of 90s.The mismatch between the education of workers and thequalifications required: the self-reported measures of over- and undereducated workers is low in international comparison (e.g. theshare of over- and undereducated workers was 21 % and 13 % inEuropean Union and USA in 90s; in Estonia these ratios are 13 % and 3 %, respectively).


3.2 Flexibility of markets (V): the role of entry and exit of firms - decomposition of total factor productivity of all Estonian firms

Productivity Within-firm effect Between firms effect Net entry effectgrowth (%) (continuing firms) (continuing firms)

(% of TFP growth) (% of TFP growth) (% of TFP growth)2 years 20,6 43,2 35,4 21,43 years 22,0 45,0 19,7 35,35 years 36,6 51,3 11,6 37,2

High proportion of productivity growth (ca 40 %) due to thereallocation: creative destructionEntrants (exits) are above (below) the average productivity ofincumbent firms


3.3 The mobility of factors of productionHigh capital mobility Since 1994 there have been no restrictions on capital accountconvertibility. As a result the net capital inflows have on averageexceeded 10 % of GDP after the introduction of currency boardarrangement (1992)Limited but increasing labour mobility After the enlargement (May 2004) three “old” EU membercountries (United Kingdom, Sweden and Ireland) opened theirlabour markets; from May 2006 also Finland, Spain and Portugal followed. In other EU countries, restrictions will be phased outduring the next five years. As a result of the partial openening of EU labour markets ca 3 % of Estonian workforce is currentlyworking in other EU countries


3.4 Openness and trade integration

Estonian economy is characterised by very highdegree of openess

Exports/GDP – 84 % of GDP (2005)Imports/GDP – 90 % of GDP (2005)

Estonia’s main trading partners are from EuropeanUnion

Exports and imports to European Union – 77 % (2005)Exports and imports to eurozone – 43 % (2005)(share of transactions in euros ca 65 %)


3.5 The similarities of the structure of the economybetween Estonia and main trading partners

The structure of GDP and employment has rapidlyconverged to “old” EU member countries The structure of GDP and employment divided by 14 fieldsof economic activity is quite similar to main EU tradingpartnersHowever, there still remain differences in the structure ofvalue added and employment in manufacturing (and exports) – the share of labour-intensive industries is larger and the share of high-tech industries smaller in Estonia thanin “old” EU member countries.


3.6 Financial integration

2000 2001 2002 2003 2004 2005 2006 I# of commercial banks 7 7 7 7 9 13 14Asset share of foreign bank subsidiaries 91 91 90 89 89 89 89Asset share of foreign bank branches 6 6 8 10 9 10 10foreign ownership, % 84 85 87 86 90 93 93

Estonian banking sector is dominated by foreign banks; the largestof them are owned by Nordic banks

Foreign banks (via subsidiaries and branches) asset share is 99 % and foreign ownership is 93 %


4. Challenges – euro adoption


4.1 The rationale for the adoption of euro

The traditional arguments for adopting euro:- reduced transactions costs- reduced exchange rate risks- improved comparability of prices

The preconditions for the successful participation in euro-area:- 14 years of successful performance under a euro-based currency

board i.e. 14 years without independent discretionary monetary policy- Strong fiscal policy discipline- Relatively high flexibility in product and labour markets- High capital mobility and increasing labour mobility- High trade and financial integration- The resilience of the financial sector


4.2 A quick assessment of the fulfilment of Maastricht criteria in mid-2006

1. Government debt criterion: the criterion is fulfilled asgovernment gross debt is below 5 % of GDP

2. Government deficit criterion: the criterion is fulfilled asbudget is in surplus and is projected to remain in balance

3. Exchange rate stability criterion: the criterion is fulfilled

4. Interest criterion: the interest rates below the criterion buttechnical problems as there is no government debt

5. Inflation criterion: not fulfilled; the inflation is ca 1.5 pp higherthan the criterion


4.3 Problems with the fulfilment of the Maastricht inflation criterion (I): Balassa-Samuelson effect/positivecorrelation between price and income level

40

60

80

100

120

140

30 50 70 90 110 130 150

Relative income level

Rel

ativ

e pr

ice

leve

l


4.3 Problems with the fulfilment of the Maastricht inflation criterion (II): Balassa-Samuelson effect/positivecorrelation between price and income level

• Most of the studies indicate that the size of the Balassa-Samuelson effect for Estonia is 1-2 pp compared to EU-12 average

• There is a strong correlation between income and price levels in EU; also in long-run the changes in income levels are positivelycorrelated to the changes in the price levels

• However, the criterion (as interpreted in previous convergencereports) has been only 0,5-1 pp higher than the average inflationin the EU (partially due to the inclusion of non-euro area countries)

• The criterion also includes that the criterion must be fulfilled in a sustainable way. What it could mean in the previous context?


Concluding remarksEstonian economy has prerequisities for the successful participation

in the euro area:- Flexibility of prices and wages- High trade and financial integration with euro-area- Strong fiscal policy discipline- Strong competitive pressures in most of the sectors- Relatively long and successful experience under the euro-based

currency boardHowever, the successful economic development itself implies (via

Balassa-Samuelson effect) that the Estonian economy is likely toexperience an equilibrium real exchange rate appreciation (underfixed exchange rates positive inflation differential) whichcomplicates the strict interpretation of the Maastricht inflationcriterion.

Estonian monetary arrangement and challenges ahead€¦ · Full convertibility i.e. no restrictions...

Documents

Transcript of Estonian monetary arrangement and challenges ahead€¦ · Full convertibility i.e. no restrictions...