Advantages and Disadvantages of Fixed Exchange Rate in the Baltic States

Advantages and Disadvantages of Fixed Exchange Rate in the Baltic States

Fixed exchange rate is exchange rate regime of country under which central bank or government fixes the exchange rate to another country’s currency or the price of commodity, for example gold. The main objectives of fixed exchange rate are to keep currency value of country within narrow bands and maintain low inflation level. Based on theory country should choose the mechanism of currency based on several criteria such as size of national economy, trading partners, openness of its economy, inflation level, flexibility of inside prices, development level of the country, etc…
In the last two decades all Baltic countries have been maintaining fixed exchange rate regime. At the moment Baltic countries have fixed their national currencies to the euro. Supposedly, fixed exchange rate in Baltic countries is more suited than a floating one, because of small markets and sizes of their economies. In this paper we would like to discuss fixed exchange rate advantages and disadvantages in Baltic countries.

Trade partners. Country chooses the anchor currency regarding trading partners of country, their influence on inside prices and economy, when exchange rates fluctuate. Issue of inflation may arise to trading country if exchange rate or anchor is chosen inadequately. For instance, if local currency loses the value, the import may increase the price of importable goods and increase the inflation. As a consequence, one of the primary reasons, why Baltic countries pegged their national currencies to the euro was the objective to protect their foreign trade from risk arising from uncertainty of future exchange rates fluctuations. Baltic countries have fixed national currencies to euro and at the same time trade with countries of euro zone and European Union. Lithuania’s trade with EU countries makes approximately two thirds of all foreign trade and only one third is related with import from Russia. Trade with European Union countries of Latvia and Estonia consist even more, 70 – 80% of all foreign trade. Given such trade structure, it is beneficial for Baltic countries to fix their national currencies to euro. In such way countries may avoid undesirable price shock caused by fluctuation in currency. Lithuania has a lower trade share with EU because it imports more oil from Russia, which is refined in Orlen Lietuva plant. After that, its production mainly as petrol is exported to other two Baltic states.

Coincidence of business cycles. If economic cycles of Baltic countries and economic growth in euro zone countries are out of sync, then fixed exchange rate is not useful for Baltic countries. For instance, if economic decreases in euro zone countries and economic rises in Baltic countries simultaneously, than ECB may reduce interest rate and stimulate economy in euro zone. It is obvious that such action would make damage to Baltic countries (if economy rises) because of rising inflation. I evaluated business cycles comparing real GDP and inflation rate of Baltic countries with ones of Euro zone countries. If the economics development and business cycles of Baltic countries coincide with euro zone countries than we will make the suggestion that fixed exchange rate and monetary policy is beneficial to Baltic countries too. Comparing annual inflation rate of Baltic countries with one of Euro zone countries (appendix) I noticed that inflation in Baltic and Euro zone countries was similar in year 2002 – 2004. Over next 3 years inflation in Baltic countries rose while there was decline in the Euro zone countries. In 2009 I noticed drop of inflation in both regions. If we analyzed GDP of both regions (Appendix) we would see that economic growth in euro zone countries was half as much as growth in Baltic states. In period 2005 – 2007 I saw sudden economical growth in Baltic countries while economic growth was not such sharp in Euro zone countries. Over last two years GDP dropped in both regions. Now we can understand why ECB kept constant base rate over period 2003 – 2005. We can realize that such monetary policy was more suitable to developed countries without sharply increasing inside economic and inflation.
Generally speaking, I can say that business cycles were more or less similar in both regions. Next, fixed exchange rate and monetary policy of ECB was beneficial for Baltic countries at the beginning of period 2002-2009, while inflation level was not high. However, over last two years inflation and GDP changed a lot. Monetary policy of ECB was directed to more developed euro zone countries, whose issue of economical growth and inflation was not as strong. It is evident that monetary policy was not as beneficial as earlier to Baltic countries over last two years. It is evident that base rate was too small to govern lending in Baltic countries.

Managing inflation and prices stability. It should be stressed, that one of the primary reasons, why fixed exchange rate is chosen is to keep quantity of money stable in the economy. As a result of this policy, the stability of general prices level in the economy may be easily maintained. However, reality shows us a little bit different view. The problem of high inflation was prominent during almost the whole comparatively long time period since restoration of independence in the Baltic states in 1990. Despite of fixed currency exchange rate, inflation was mostly higher in the Baltics then in their anchor currency zone. The only exception is Russian economic crisis, when, due to dramatically dropped demand from Russian market for products from the Baltic states, prices in the domestic Baltic markets also had to stabilize. For example, there was even some periods of deflation in Lithuania.
When a country maintains fixed exchange rate, fiscal policy and discipline becomes even more important for the prices stability and the economy as the whole. Fiscal policy remains as only one instrument for managing inflation as fixed exchange rate regime does not allow conducting another measure for managing inflation and prices stability -- monetary policy. As fixed exchange rate helps to keep the quantity of money in the economy relatively stable, fiscal policy becomes even more effective than under floating exchange rate. Fiscal policy should be used to offset or mitigate not favorable influences caused by anchor currency monetary policy. For example, when interest rate set by ECB is too low to keep low inflation level in the Baltics states, they can try to offset this effect by reducing public spending.
Unfortunately, despite of rising inflation, governments of the Baltics states were increasing its spending over various areas, pensions and other types of social payouts were notably risen during the period of 2006-2008. This kind of economic policy did not allow collecting budget surpluses during the fast economic growth period and worsened the situation afterwards when economic hardship came. Too high inflation did not allow Lithuania to adopt euro in beginning of 2007. On the other hand, differently from Lithuania and Latvia, Estonia was an exception with a surplus budget, which later allowed to soften the consequences of economic crisis.

Absence of independent monetary policy. Theoretically, one of the main disadvantages of fixed exchange rate is absence of independent monetary policy. The major part of monetary policy is usually conducted by anchor currency central bank. In the case of the Baltics it is European Central Bank (ECB). For example, as Lithuanian litas is pegged to the Euro, the majority of monetary policy decisions of ECB also has to be adopted by Lithuanian central bank for Lithuanian currency. The same measure applies for other two Baltic states.
Somebody may ask, what would happen, if any Baltic state would decide to start conducting its own monetary policy and keep fixed exchange rate at the same time? For example, Latvian Central Bank decides to set different benchmark interest rates from ECB. Theorically, if it happens, so-called one side bet opportunity arises, and, if both, anchor and fixed currencies can be freely tradable in interbank market, market participants can borrow currency with lower interest rate, then buy currency with higher interest rate and gain interest from it. As exchange rate is fixed, there is no risk exchange rate fluctiations which may cause losses for the investor. However, for this assumption to be true, we have to ingore several factors of reality, including difference between lending and borrowing (-bid and –bor) and probability of anchored currency devaluation.
Because of aforementioned restrictions, national central bank cannot adequately react to every arising economic issue in the country. For example, during 2006-2008 year period, crediting for housing, consumption and other purposes had been expanding at a very fast pace, which later caused overheating of national economies of the Baltic states and pulled all of them into a deep recession. Inflation reached double digit numbers in all three Baltic states during the year 2008. If Baltic states had independent monetary policy, they would have avoided this kind of economic crisis and mitigated its socioeconomic outcomes, such as rapidly rising unemployment or decreasing consumption. ECB benchmark interest rates were obviously too low for Baltic states during the period of 2006-2007 and did not mitigate the boom of crediting. For instance, other post communist EU members in central Europe such as Poland or Czech Republic, whose who have independent monetary policy and maintain floating exchange rate regime for their currencies, did not face so high inflation and a terrible economic crash after that. Independent, adequate and countercyclical monetary policies allowed these countries to sustain more stable economic growth and avoid heavy economic cycles fluctuations.

Threat of devaluation. Theoretically, as mentioned above, as fixed exchange rate is maintained, benchmark interest rates for anchor and pegged currencies should stay the same. Otherwise, we face the opportunity of one side bet. On the other hand, we can see in reality, that interest rates in the interbank market for anchor and pegged currencies are not the same, difference between them varies over time. For example, in summer of 2009 speculations about devaluation of Latvian lats were widespread among market participants. Interbank interest rate for Latvian lats rose sharply. 12 months Rigibor rose above 20% in some days, while interbank interest rates for the Euro stayed just above 1%.
Threat of devaluation of national currency and abnormally high interbank interest rates negatively affects the whole economy. As a result, domestic competitiveness drops, it becomes much harder to get a loan with good conditions for both businesses and private persons, probabilities of defaults increases sharply.

To conclude, we would like to stress that Baltic countries pegged their national currencies to euro before joining the EU in order to reach better integration of their economies into single EU market. On the one side, Baltic countries benefit from fixed exchange rate because economic cycles of two regions more or less were similar, Baltic states traded with euro zone countries and fixed exchange rate in many cases helped to manage inflation and price stability. Another reason for choosing fixed exchange rate regime could have been a small size of all three Baltic economies and high level of their openness. On the other hand, Baltic countries lost their independent monetary policy and as result Baltic countries’ economies were harmed over period 2006-2008 (high inflation period) and a deep recession which came afterwards and was much deeper than in other EU countries. Also, there was arisen a threat of devaluation of national currencies which heavily deteriorated confidence worldwide of Baltic states economies.