Currency Boards: Survival of the Fittest

Ivan Tchakarov, Nomura, London.
This article appeared in the April 2009 issue of Current Economics with permission of the author.

Key Concepts: Currency Boards | Exchange Rates |
Key Economies: Bulgaria | Estonia | Latvia | Lithuania |

When a country runs a currency board, it keeps enough foreign currency in reserve to exchange its entire supply of national money at a fixed rate – one of the strictest ways to control an exchange rate. That fixed rate helps provide price stability and reduce the costs of import and export operations, which play a particularly large role for small countries such as the Baltics (Latvia1, Lithuania and Estonia) and Bulgaria. These currency arrangements were instrumental in providing a stable economic environment for growth, and the four countries posted impressive growth rates in recent years based on cheap credit, strong capital inflows and EU membership.

However, while the recent bout of unwinding risk aversion may have temporarily halted the decline in most EMEA (Europe, the Middle East and Africa) currencies, their slide in the post-Lehman Brothers (a failed Wall Street bank) period has accentuated the dilemmas faced by currency boards. A key issue in an environment of slumping global demand is the loss of competitiveness implied by the rigid pegs. Therefore, the challenging external environment poses a familiar dilemma to policymakers – devalue the currency in the hope of reviving exports (or at least limit spending on imports) or experience a painful income contraction to improve net exports and reduce external financing requirements. In an ideal world, the trade-off may lend itself to the obvious conclusion of letting the currencies go and avoiding unpleasant cuts in wages, but the benefits of this solution look increasingly small against the background of slumping global demand and substantial household and corporate foreign indebtedness. As a result, the policy dilemma looks less acute: while going off the currency board would set in motion adverse balance sheet effects that are bound to aggravate severely the already bleak economic fundamentals, keeping the currency board would help preserve the hard-won gains of the currency pegs and prevent mass private sector defaults. Financial support from multilateral institutions should provide a useful additional anchor for the currency boards should they come under duress.

Risks, however, are tilted to the downside and country differences underscore the importance of policy actions. Bulgaria has the most overvalued currency, in our view, but possesses ample fiscal buffers to manage the crisis. In contrast, the Baltics’ less prudent fiscal policies leave little policy room to support the currency boards with the concomitant political pressures to abandon the pegs.

Figure 1: SEER-implied current account imbalances Figure 2: FX SEER-implied overvaluations
Eastern Europe current account deficits Overvaluations in Eastern European currencies
Source: CEIC and Nomura Global Economics Source: Nomura Global Economics

Degree of Overvaluation

In our 2009 Global FX Outlook, we introduced the Stock Equilibrium Exchange Rate (SEER) Model to estimate the medium-term fair value of the exchange rates in emerging markets2. There we argued that one limitation of this approach was its backward-looking way of viewing fair values. Although we introduced a methodology to deal with this constraint, we believe the best way to use this model, especially in an environment of sharp turnarounds in key macroeconomic variables, is to compute a forward-looking SEER by using our own 2009 forecasts for GDP and the current account. This is particularly relevant in the case of CB countries, where we believe the growth rates and current accounts deficits are set to contract sharply in 2009.

The methodology allows us to compute equilibrium levels of the current account, i.e., those that are consistent with stabilising the net foreign asset position of these countries. Bulgaria’s equilibrium current account deficit is 7.8% of GDP, followed by 3.3%, 2.9% and 1.1% deficits in Estonia, Lithuania and Latvia, respectively (Figure 1, above). These levels imply substantial differences with actual 2008 current account deficits in all countries, pointing to large overvaluation gaps. The exchange rate misalignment is particularly pronounced in 2008, with Bulgaria’s lev exhibiting the largest degree of overvaluation of 40% relative to long-run equilibrium and smaller, yet still sizable, overvaluations in the case of Lithuania’s litas, Latvia’s lat and Estonia’s kroon (Figure 2, above). However, when set against our forecast 2009 current account deficits, which will decline substantially in line with slumping domestic demand, the overvaluations look much less impressive. Given our methodological preference to call currencies that fall within the (-5,+5) estimated valuation range as broadly in equilibrium owing to the uncertainties in estimating fair value models, we find that the Bulgarian lev is the only currency that is expensive on a forwardlooking basis. The kroon and litas fall comfortably within our preferred margin of error and the lat is just about borderline.

Figure 3: Balassa-Samuelson effect in Bulgaria and Estonia Figure 4: Balassa-Samuelson effect in Latvia and Lithuania
Real effective exchange rate in Bulgaria and Estonia Real effective exchange rate in Latvia and Lithuania
Source: CEIC and Nomura Global Economics Source: CEIC and Nomura Global Economics

Degree of competitiveness

Loss of competitiveness is the overriding economic concern related to CBs, and pegs in general. Quite often, sharp and sustained increases of the real effective exchange rate (REER) are misleadingly interpreted as evidence of an associated loss of competitiveness. However, such a temporal evolution of the REER is not, per se, an indication that an economy is lagging behind, as it might simply reflect the fact that the productivity differential against trading partners is rising as well (the Balassa-Samuelson effect). To investigate this further, we construct trade-weighted productivity differential indices for the CB countries over the period of fast growth (2000-2008) and compare them with the REER to analyse the significance of the Balassa-Samuelson effect.

The results suggest that for most countries, REER increases were closely matched by favourable productivity increases until mid-2005. Interestingly, there was a significant surge in productivity that actually outstripped REER after that period, casting doubts on the thesis that the currency board countries have been losing competitive edge. Bulgaria is the only exception in that productivity increases have failed to maintain balance with the REER from mid-2005. This generally encouraging picture, however, started to dim in 2008 when the Baltics experienced an appreciable decline in productivity differentials, lending more credibility to the view that the currency board economies may have overplayed their productivity advantages.

Another way to assess competitiveness levels is to look at the evolution of productivity-adjusted real wages. The concept is easy to understand when described with a simple example. If real wages of workers in an economy rose by 10% within a year, this might be interpreted as a 10% loss of competitiveness relative to peer countries; however, if this were complemented by a 10% increase in workers’ productivity, then productivity-adjusted real wages would be zero, pointing to no loss of competitive edge. The results indicate that productivity-adjusted real wages in the currency board countries mostly hovered around zero until end-2005, although there was significant volatility around it (Figure 5, below). However, the most virulent phase of the credit boom during 2006-07 contributed to a substantial rise in real wages that was not accompanied by a corresponding improvement in productivity. This was particularly evident in the case of Latvia, which experienced real wage increases of up to 25% during that period. Although real wages have subsequently declined in all countries, reaching into negative territory in Latvia and Estonia, these, by and large, have been associated with even larger drops in productivity, thus generally keeping productivity-adjusted real wages well above zero. Lithuania is the only country that has managed to keep its productivity-adjusted real wage under control, with Estonia following closely, and Bulgaria and Latvia still exhibiting high productivity-adjusted wage increases.

Figure 5: Productivity-adjusted real wages
Real wages in Eastern Europe adjusted for productivity
Source: CEIC and Nomura Global Economics  

Degree of Protective Buffers Although according to our analyses Bulgaria is the country with the most overvalued currency and the most pressing competitiveness issues, ironically, it also possesses the strongest buffers to withstand attacks against the lev and to navigate the crisis (Figure 6, below). Its foreign reserves cover comfortably the most liquid monetary liabilities, M1, while in the Baltics the coverage is generally only half as large. Despite its large current account deficit, Bulgaria exhibits a very robust foreign reserve coverage of imports, which has never fallen below 5.4 during the past eight years. The Baltics fare much worse on this basis as well. In addition, foreign reserves account for almost 40% of GDP in Bulgaria and only about 15-20% in the Baltics.

However, the most important protective buffer working in Bulgaria’s favour is its very healthy fiscal position, which the Bulgarian government has maintained adamantly during the boom years. While running 5% of GDP fiscal surplus already looks quite impressive, Bulgaria has effectively saved portions of the surpluses into its fiscal reserve account, which has been impressively built up to about 13% GDP in 2008. In contrast, the Baltics, with the notable exception of Estonia, have run much more profligate fiscal policies in the upswing, leaving them with little room to undertake counter-cyclical policy in the downswing. The latter is also constrained by the desire not to breach the 3% of GDP Maastricht limit on fiscal deficits.

Figure 6: Foreign reserves and fiscal buffers
Fiscal positions in Eastern Europe
Source: CEIC and Nomura Global Economics  

Maintaining currency boards necessarily means painful economic adjustments to curb nominal incomes in an effort to reduce external imbalances and large external financing requirements. The alternative of moving to a more flexible currency regime, in our view, will offer such countries few benefits owing to their limited ability to stimulate exports in a depressed global environment or to engineer a real depreciation via devaluation because of the high exchange rate pass-through. Rather, this would speed up household and corporate defaults owing to their large foreign currency exposure and certainly exacerbate the downfall. At least clinging to the currency board offers the tangible prospect of preserving financial stability and improving private sector rollover rates.

1 Latvia is, strictly speaking, not a currency board country, although it runs a hard fixed exchange rate policy.
2 Bulgaria and the Baltics were not included in the valuation estimation.

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