Economic integration and exchange rate arrangements in the post-soviet period. The Baltic states in comparative perspective.

• Author: Ljungberg, Jonas

1. Introduction

   Which have been the consequences of the euro for integration and economic performance in the Baltic Sea region? This paper addresses that question through a comparative examination of six countries of which four today are in the euro, and two are not. The four in the euro are Finland, a member from the start, and Estonia, Latvia, and Lithuania, who joined the euro in 2011, 2014 and 2015, respectively. However, to qualify for the Economic and Monetary Union (EMU) the Baltic countries were in currency boards with pegs of their respective currencies to the euro from the early 2000s, and to other "hard" currencies before that, why they broadly have shared the conditions of a member country from early on. (1) The two outside the euro are Poland and Sweden. Another country with ports on the Baltic Sea is Russia, but being outside the EU and the single market it does not fit in the comparison. In those respects Germany would fit in, but as a much larger country, than the six compared, the question of integration looks a bit different. Denmark also has a long coast to the Baltic Sea and is of comparable size but would complicate the comparison by formally being outside the EMU though in actual practice pegging her krone to the euro. Thus the paper zooms in on two "old" countries, Sweden and Finland, with the latter in the euro, and four "new", Estonia, Lithuania, Latvia, and Poland, with the three first in the euro. (2)

   The core argument of the paper is based on effective exchange rates, both nominal and real. The Bank for International Settlements (BIS) provide time series back to 1994, but they do not include exchange rates with countries in the former Soviet Union, except Russia, which make them less feasible for the present analysis. Therefore, new series on effective exchange rates have been consistently constructed for all six countries 1995-2016, based on exchange rates and trade with their 20 largest trade partners. For the "new" countries this includes accounting on exchange rates retrieved from central banks of former Soviet republics, for example the Belarus ruble which was not published until February 2019. More about the data when they enter in the discussion.

   The next section contains a short discussion of exchange rates, economic growth and convergence; section three provides an overview of economic growth in the Baltic Sea region over the past quarter century; section four examines exports and integration in the region; section five examines the role of exchange rates for competitiveness and in the global financial crisis; section six assesses the long-term consequences of the austerity policy in the Baltic countries, in turn a consequence of the pegs to the euro; section seven concludes.

2. Convergence and exchange rates

   The role of exchange rates for catch-up and convergence in Europe over the 20th century has not been negligible (Ljungberg and Ogren 2017). A consensus has emerged that an early leave from the Gold Standard in the 1930s was crucial for a recovery from the Great Depression (Temin 1989; Eichengreen 1992; Crafts and Fearon 2013). The abandonment of gold and the fixed exchange rates were also one of the ingredients in the catch-up by the Scandinavian countries during the interwar period. Moreover, in the postwar period the Mediterranean countries could catch-up, buttressed by depreciating currencies (Ljungberg and Ogren 2017). It has also been pointed out that successful catch-up by developing countries have benefitted from weak currencies (Rodrik 2008). However, there is a common presumption that a country's drawing on the exchange rate is a sin and should be condemned as "beggar thy neighbour policy." Yet, arguably it is only in the view of a zero-sum game that a depreciating currency lays the cost on foreign countries. By allowing for a more expansionary economy, it will rather enhance a growth that spills over also on trading partners (Eichengreen and Sachs 1986). The long-term growth of western Europe can be interpreted in these terms. Countries that began a process of catch-up became gradually more integrated with other European countries, and typically the poorer countries had lower price and wage levels. With the integration follows a levelling of prices and wages, and consequently inflation rates tend to be higher in catching-up countries. Even if productivity growth is faster in the catch-up countries, the gain in competitiveness is eroded by the higher inflation. Hence, the depreciation in the postwar period up to the 1990s of weaker currencies such as the Italian lira, Spanish peseta, Portuguese escudo, Greek drachma and also of the Irish punt and Finnish markka, sustained the catch-up of these countries and contributed to the growth of the European economy (Ljungberg and Ogren 2017). It might seem unfounded to talk about depreciation in the postwar period, since apart from the big European devaluation in 1949, one of the pillars of the Bretton Woods system until 1971 was the "pegged but adjustable" exchange rates and there were only a limited number of "adjustments" (Eichengreen 2008). However, there is a difference between a peg to an anchor, and the effective exchange rate a country encounters vis a vis its trading partners. In the later 1960s most of the mentioned currencies depreciated, and they did even more so during the following decades with the exchange rate arrangements under the "Snake" and then the European Monetary System (Gros and Thygesen 1992; Eichengreen 2008).

   However, in the 1980s the concerns about the external balance problems, which had been central in the earlier discussions about European economic and monetary integration, were superseded by the idea about "the advantage of tying one's hands", that is, of fixed exchange rates irrespective of the structural differences between countries. This idea was based on the principle of rational expectations with the belief in a rule based economic policy, with fixed exchange rates as one of its pillars. (3) After the collapse of the Soviet Union, these neoliberal ideas exerted a weighty influence on the transition to market economies in the former planned economies, one case in point being the adoption of currency boards in the Baltic countries (Hanke et al 1992; Feldmann and Kuokstis 2017). This was the beginning of a monetary policy with fixed exchange rates that eventually led to the adoption of the euro. On the other hand Poland, the largest of the central and east European countries, has kept its zloty floating. Similarly Finland and Sweden have chosen different arrangements, Finland being among the twelve original countries in the euro while Sweden has retained its floating krona, after a referendum in 2003. Hence the question whether these different monetary arrangements have had any significant impact on integration and economic performance in the Baltic Sea region is indeed relevant.

3. Growth and integration in the Baltic Sea region

   The Iron Curtain divided the Baltic Sea region just as it divided continental Europe. Neighbouring countries took, or were enforced to, different paths of development. This is not the least highlighted by the gap in income levels between East and West after the collapse of the Soviet empire. Hence, in 1995 Poland was at one third of the per capita income level of Sweden, while Estonia, Latvia and Lithuania were at just about one fourth of the Swedish income level (Ameco 2018). Although far to the east, economically and politically westward Finland had been close to the Swedish level before the crisis of the early 1990s, but that crisis lowered Finland's income per capita with some 12 per cent compared to a loss of "only" 6 per cent for Sweden--widening a gap which however should be almost closed in 2008, on the eve of the next crisis.

   The regional divide is even more clear in a somewhat longer perspective and while the post-war period saw a convergence of income levels in the West, countries under Soviet dominion lagged behind. According to the data in Maddison (2007), Poland in 1950 had been clearly above the Mediterranean countries Greece, Portugal and Spain, at about two thirds of the income level of Finland and at 36 per cent of the Swedish level. (4) At that point in time Sweden had, along with Denmark, achieved about the same level as the United Kingdom, and in Europe these three countries were only behind Switzerland (Maddison 2007). However, in the mid-1990s countries in western Europe had converged to a broadly similar level and only Greece, Portugal, Spain and Ireland were still somewhat behind but in a process of catch-up. And with the fall of the Iron Curtain also eastern countries began to catch-up.

   Seen over the period 1995-2016, it is clear that the Baltic states and Poland have made a successful catch-up in GDP per capita terms. Adjusted for differences in price levels (PPPs), they have climbed from less than one third, and just above one third for Poland, to more than a half of the Swedish level. One should recall that this was not due to a particularly poor performance of the Swedish economy. On the contrary, over this period the annual growth rate of Sweden was double that of the Eurozone as a whole, 2 per cent a year against 1 per cent, as can be seen in table 1. (5)

   The take-home of the table is, first, that the three Baltic countries as well as Poland have made an impressive catch-up, and not surprisingly "Baltic Tigers" became a nick-name in the mid-2000s. But the table also highlights, secondly, that there is a difference in growth rates before and after the global financial crisis. The difference is rather moderate for Poland, but down to one fifth for Latvia and clearly significant also for Estonia and Lithuania. Thirdly, the slow-down in growth is also significant for Finland, Sweden, and the Eurozone as a whole. However, while Finland and the Eurozone turned into negative growth from 2008 to 2016, the Swedish figures...