On the road to euro: how synchronized is Estonia with the euro zone?

• Author: Brixiova, Zuzana
• Position: Report

1. Introduction

   In 1992, shortly after regaining independence from the Soviet Union, Estonia left the ruble zone and established its own currency (Kroon), which helped gather support for difficult reforms associated with the transition to a market economy. Simultaneously, the country introduced currency board, pegged initially to the German mark and since 1999 to euro. Under this regime the monetary base became fully backed by the foreign exchange reserves of the Bank of Estonia, the Kroon was completely convertible, and all restrictions on capital account transactions were abolished. With the adoption of the currency board, Estonia gave up its exchange rate and monetary policy in order to enhance credibility of its monetary stance and reduce inflation. (5) The money supply became endogenous, consisting of exchanging domestic currency at a fixed exchange rate to the currency that forms the reserve (Sepp and Randveer, 2002).

   The currency board arrangement increased credibility by eliminating any possibility of discretionary monetary easing, since lending by the Bank of Estonia to the domestics banking sector or for government needs was prohibited except to banks experiencing systemic risks. Even in such situations, the lending could not exceed the accumulated excess foreign exchange reserves over the monetary base (Knobl, Sutt and Zavoico, 2002). By doing so, the board constrained the policy space to respond to future asymmetric shocks with respect to the euro area. It also limited the possibility for the central bank to provide liquidity to the banking sector in the event of a financial crisis to the amount of excess reserves over the monetary base. By joining the EU and the ERM II in June 2004 and aiming at an early euro adoption (at the prevailing exchange rate), Estonia has solidified its commitment to permanently fixed exchange rate regime. (6) In other words, Estonian policy makers viewed euro adoption--at the prevailing exchange rate -- as the most appropriate exit strategy from the currency board (Lattemae and Randveer, 2006).

   The currency board served the country well during the 1990s and in fact played a key role in successful stabilization efforts, with inflation falling from high double digits in 1993 to low single digits by the late 1990s. During the 2000s, however, the benefits of the currency board declined. Estonia was one of the fastest growing emerging market economies in the world during this period, and until 2005 also had low inflation. However, growth was unbalanced, driven by non-tradables (especially the real estate sector) and financed by large capital inflows, which in turn fuelled domestic credit expansion, mostly in foreign currency. The combination of complete convertibility of the capital account with the currency board facilitated these capital inflows, as the currency board constrained the Bank of Estonia's room to mitigate the inflows and curtail the growth of private sector credit. Eventually, the credit boom created systemic risks to the banking sector through heavy exposure to international funding. The inflexible monetary policy framework implied that exchange rate adjustments were not possible to counter the severe adverse external shock when the global financial crisis hit. These factors contributed to a severe recession that Estonia experienced in 2009 (Brixiova, Vartia and Worgotter, 2010). (7)

   Given the large share of the private sector credit denominated in foreign currency and the associated currency risk, the global financial and economic crisis has made euro adoption even more attractive and put it on top of the country's policy agenda (Bank of Estonia, 2009). The heightened currency risk during the crisis demonstrated that the currency board is not a substitute for joining the euro area. (8) The enhanced interest has been driven mostly by the desire to eliminate this risk, triggered by the speculation in the wake of the global crisis. Estonia was able to maintain an orderly financial system throughout the crisis largely due to good cross-border cooperation and provision of liquidity from the Nordic banks, which account for 95 percent of the Estonian banking market. (9)

   The objectives of the paper are threefold. First, using several empirical methods, the paper establishes that the alignment of Estonia's shocks with those of the euro area, one of the preconditions for joining currency area posited by the optimal currency area approach, is low. Second, drawing on the existing literature, the paper suggests that in a small open economy with strong trade linkages to the euro zone such as Estonia benefits of the fixed exchange rate regime on balance still outweigh the cost created by the lack of alignment. Moreover, the paper posits that the recent financial crisis has illustrated the advantages of common currency zone and increased the case for the euro adoption in Estonia, given its large share of foreign-denominated debt. Third, the paper briefly discusses policies that can help mitigate the cost of Estonia's incomplete business cycle synchronization with the euro zone.

   The paper is organized as follows. After this Introduction which provides a brief background on the Estonian monetary policy framework, Section 2 conducts empirical analysis on the degree of synchronization of Estonia's business cycles with those of the euro area. Section 3 posits that euro adoption would be beneficial for Estonia. Section 4 concludes. While this paper focuses on Estonia, its conclusions can apply to other countries with either a currency board or a fixed exchange rate regime and weak business cycle synchronization with the euro zone, such as the other two Baltic countries.

2. How Synchronized is Estonia with the Euro Zone?

   The interest among policy makers and researches in the cyclical alignment of the new EU members with the euro area started in the 1990s and picked up around the EU enlargement period. It has remained high since most of the new EU members still have the EMU accession ahead of them and was only heightened by the global financial and economic crisis. (10) The objective of this section is to reassess the business cycle synchronization between Estonia and the euro area, utilizing several empirical methods and recent data.

   It needs to be underscored that in the case of Estonia, the degree of synchronization with the euro zone does not affect anymore the country's decision whether to join the common currency area or not. This is because Estonia has been paying the price of abolishing independent monetary and exchange rate policies to counter adverse shocks since the introduction of the currency board in 1992. Hence joining EMU will not create a new challenge in this respect, as the challenge of coping with adverse shocks through alternative mechanisms already exists under the currency board. Still, Estonian policymakers need to be aware of the degree of cyclical alignment of their economy with the euro zone in order to determine to what extent such mechanisms should be employed. This becomes particularly important in the context of the post-crisis recovery, as there are concerns that Estonia's return to trend growth could take longer than in the EMU countries.

   2.1 Background Theory

   The empirical analysis below draws on the traditional optimal currency area (OCA) theory (Mundell, 1961 and others), which posits that symmetry of macroeconomic shocks is a key consideration for participation in a monetary union (or adopting fixed exchange rate). The traditional OCA analysis claims that membership in a currency union provides economic efficiency gains by relieving the member country of the macro economic instability risk, provided its business cycles are synchronized with those of the currency area. Asymmetric, country-specific shocks would weaken the case for a common currency/peg and increase the need for an independent monetary policy and a flexible exchange rate regime. Costs of pegs, and especially monetary unions, thus rise with diverging business cycles. (11) Business cycles may not be synchronized due to asymmetric shocks and/or differences in the transmission mechanisms of common shocks, but structural similarity reduces the impact of these factors.

   Even with asymmetric shocks in place, the exchange rate and monetary policy tools can be relinquished in countries with mobile labour (Mundell, 1961), a high degree of economic openness (McKinnon, 1963), and diversification in production and consumption (Kenen, 1969). Other factors that ease monetary integration include flexible wages and prices, financial integration, and counter-cyclical fiscal policy which is effective in stabilizing the economy. However, the original OCA work abstracted from important benefits of monetary integration/pegged to a strong currency, most notably enhanced credibility, but also lower transaction costs and increased political integration. The political aspect became relevant in, for example, Italy, where the euro adoption helped insulating financial markets from disruptive political events, such as collapses of governments and resignations (Fratzscher and Stracca, 2009).

   The backward looking OCA approach cannot address structural and other changes resulting from the monetary integration. Specifically, the OCA endogeneity hypothesis of Frankel and Rose (1998) argues that some of the OCA criteria, especially the synchronization of business cycles, will become more fulfilled once the country joins a monetary union. Austria is considered to be an example of a country which did not constitute an OCA (with Deutsche Mark) in 1980s, but now forms an OCA with the euro area. Hochreiter and Tavlas (2004) conclude for Austria that: "... the hard peg mattered because it mustered a domestic constituency in favor of change, providing the impetus for the domestic economy to become more flexible so that the peg could be sustained. The hard peg also furnished a disciplinary framework for sound...