On Nominal and Real Convergence: the Case of Estonia

Background Material

Vienna Seminar on Accession Process
Price Dynamics in Accession Countries
December 15, 2000
Vienna, Austria

On Nominal and Real Convergence: the Case of Estonia
(Some Additional Aspects on Convergence of Price Level and Structure)

General observations on nominal and real convergence

  1. Real convergence.
    For the applicant countries the economic rationale of the European integration for applicant countries lies in the assumption that over medium term the reform process results over medium term in real growth rates above those of the present member states. Thus, the gap between per capita income in present and future member states diminishes as higher productivity growth results in higher real income, i.e., the real convergence occurs. Several factors explain the speed of the real convergence. Initial income level, propensity to invest during the reform process, expenditures for education and other investment in human capital, and development of institutions are among the most common explanations.
  2. Real and nominal convergence.
    The real convergence will result in nominal convergence - higher income will gradually raise the domestic price level. The nominal convergence is explained by different rates of productivity growth in open and sheltered sector of economy, by changes in consumer preferences as real incomes increase and to a certain extent by the improvement in terms of trade as the value added component of export production increases. The resulting increase of prices of nontradables over the price of tradables puts gradual upward pressure on the overall price level. The speed of nominal convergence slows as income gap shrinks i.e. the nominal convergence is non-linear.
  3. Realization of nominal convergence.
    In nominal terms the convergence will result in either higher domestic price level or in appreciating exchange rate or in both. In case of fixed exchange rate the nominal convergence will inevitably cause the higher (albeit decreasing) rate of domestic inflation than in the anchor currency country. The inflation behavior in the applicant countries can be attributed to three major determinants; however these processes are interrelated and may overlap in time:    the liberalization of prices of tradable goods and non-essential services,
       the initial correction of administered prices of energy, communication, utilities and other services provided by public sector,
       gradual convergence of general price level towards medium and long term equilibrium that is determined by the speed of real convergence.

Evidence on price level convergence in Estonia

  1. For Estonia, in terms of price level convergence the last decade should be divided into two periods, as underlying processes have been rather different before and after 1995.    Early stabilization period (1992-1995) involved higher inflation and rapid real appreciation of real exchange rate. The prices of tradabale & nontradable goods increased approximately 3,7 and 9 times respectively during this period.
       During Q2 1996 - Q2 2000 the price increases of tradable and nontradable goods were 15% and 50%, respectively.
    The yearly headline inflation has been on constantly declining trend and has by now firmly reached low single digits.
  2. Until 1996 both liberalization and stabilization process were the driving forces of inflation - the former caused the sudden and rapid increase of price level while the latter lead to the gradual decrease of inflation rate. Although the coexistence of these two processes makes evaluation of the disinflation process difficult, it has sometimes been considered too slow, specially bearing in mind that the developments took place under the currency board arrangement. However, the extent of initial distortions of nominal and relative prices as well as initial terms of trade shock was probably much deeper in Estonia than in many other applicant countries. That may have caused higher appreciation of the national currency during the first years of economic restructuring.
  3. The price and real exchange rate movements starting from 1996 can be clearly associated with real convergence issues. For example, during Q2 1996-Q2 2000 the labor productivity in the manufacturing sector rose almost 40% while the REER was appreciating against industrial countries only by 20%, and the CPI increase was 28% cumulatively. Thus, after overcoming initial substantial changes in price level and structure the developments in REER were similar to those of CEEC5. This fact describes Estonia's bigger initial distortions in the price level and structure than in CEEC5 group and that also explains higher appreciation real exchange rate in Estonia compared to that in CEEC5.

The economic policy, currency board and convergence

Currency board and convergence

  1. While real convergence is primarily determined by supply side policies, the government demand side policies might nevertheless attempt to influence relative prices and target either explicitly or implicitly certain level of real exchange rate. The private sector behavior may have the same consequences, e.g., the rapid inflow of (short term) capital via financial system may result in temporary excessive real exchange rate appreciation.
  2. The demand side policy mix to avoid excessive and short-term appreciation depends very much on particular circumstances and currency board is one option among the many. One advantage of the currency board is the application of strict limitations on demand side policies. The authorities are fully deprived of monetary policy measures and fiscal deficit can not be financed by central bank. In addition, the absence of the fully fledged lender of last resort facility and solely market-determined interest rates provide the financial system and banks with relatively strict framework that may encourage the observance of more conservative lending and borrowing practices.
  3. The clear policy framework may provide more predictable link between real convergence and inflation developments over medium term. The speed of nominal convergence may depend more directly on the present and expected pace of real convergence, i.e., on the perception of continuing economic reforms and increasing competitiveness. In addition, currency board provides transparent signals for various prices and, thus, fosters the restructuring both between and inside various sectors of the economy. That may be relatively important given the rapid development of economic structure in applicant countries and still ongoing identification of comparative advantages.
  4. The corollary of the above argumentation is that by definition, the direct or indirect inflation targeting is impossible and not meaningful under the currency board (in theory, for completely open economy currency board resembles inflation targeting via exchange rate targeting). Price level developments should be looked at in the context of all main macroeconomic variables that characterize internal and external stability of the economy. In the medium term, this means that one of crucial future challenges beyond enhancing competitiveness is to maintain macroeconomic stability for avoiding real exchange rate misalignments.

Supporting policies

  1. However, the efficient functioning of currency board is impossible without supporting supply side policies that should warrant the necessary flexibility of product and labor markets to withstand external shocks and to correct internal imbalances. In short, the two main compulsory characteristics of successful economy under the currency board are    flexibility for resource reallocation and relative price changes both in product and labor markets, and
       Existence of sufficient cushion of liquidity and capital in the financial system to withstand temporary squeeze and losses. That requirement is relevant on government level (thence the need for a balanced or surplus budget), for financial sector and for corporate sector.
  2. The main supporting factor of Estonia's flexibility is its openness both in economic and institutional terms. Regarding the latter, the virtual absence of barriers for foreign trade and free movement of capital have de facto integrated Estonia into European markets to a large extent already. Estonian companies have been exposed to foreign competition. On the capital account, the most remarkable development has been the inflow of direct investments (on the average 6-7% of GDP in 1994-2000) due to the openness of and the need for our companies to restructure in face of European competition. FDI has provided Estonian enterprises with both financing and, even more importantly, with transfer of technology, managerial know-how and corporate culture in general. An additional impetus for restructuring is the de facto absence of government subsidies to industry. More broadly, the functioning bankruptcy procedure and relatively well defined ownership rights provide sound basis for functioning market economy.
  3. Estonian banking sector has passed two major rounds of institutional and balance sheet restructuring and is now fully privately owned and sound. It provides the customers with a wide array of banking and non-banking financial services from traditional deposit taking to leasing and personal investment. Four major Estonian banks, accounting for over 90 per cent of the market, have either strong foreign strategic investors or are branches or subsidiaries of reputable Scandinavian institutions.

Main policy challenges

  1. The main challenge for Estonian authorities is to maintain the momentum for continuing economic growth and real convergence. That will depend on both the macroeconomic and financial policies as well as on the further restructuring of the economy. Gradual nominal convergence will not hamper Estonia's competitiveness, should the authorities manage these policies properly.

Medium term macroeconomic scenario

  1. The economic objectives will be pursued in the context of the currency board arrangement. As demonstrated by the improvement in current account position (almost by half compared to 1997) after Emerging Markets crisis in 1997-1998 and solid export growth to western markets, the current exchange rate peg is appropriate. Hence, we intend to maintain the present framework until Estonia becomes a full participant in the EU and EMU.
  2. The sustainable growth target over the medium term is around 5% or even higher. The growth relies on export of goods and services and further investments to maintain the pace of real convergence. Corresponding nominal convergence will continue and the inflation rate will remain slightly above that of the euro area average (around 2 percentage points or slightly more).
  3. The economic restructuring process is the main factor behind high investment demand (about 27-28% of GDP), exceeding domestic savings rate (21-22% of GDP). Therefore the current account is expected to remain in deficit in coming years due to the quickening pace of recovery in domestic demand. As a result of prudent fiscal policy, strengthened private savings and fast export growth, the current account deficit will remain at sustainable levels over the medium term. The current account deficit will be financed primarily by non-debt creating and/or long-term capital flows.

Structural reforms

  1. Given the strict rule-based monetary framework, real sector flexibility is continuously essential for the general convergence process. Major structural reforms will be implemented in the public sector, agriculture, energy sector, transport and telecommunications, and environment. Two key priorities in this regard are the pension reform program and privatization of the energy complex. In addition, the authorities intend to    Increase the transparency of the structure of our public finances,
       start the public administration reform, including by increasing the transparency of public employment and remuneration,
       complete the privatization of infrastructure enterprises on national and municipal level,
       strengthen financial sector regulation and move cautiously toward consolidating financial sector supervision under one independent authority, and
       continue the reform of the public health care system.
    These efforts are needed to further improve productivity and maintain export competitiveness.

Maintaining competitiveness

  1. The appreciation of the real exchange rate is the reflection of real convergence and, thus, should not indicate the loss in competitiveness per se. Indeed, nominal convergence caused by real convergence may not decrease competitiveness, provided that macroeconomic stability is maintained. Thus, care should be taken to avoid excessive real exchange rate appreciation as a result of to optimistic expectations, expansionary official or private foreign borrowing or rapid inflows of short-term capital.
  2. Macroeconomic stability is the sine qua non for maintaining the competitiveness of the economy. Special emphasis must be put on fiscal credibility and maintaining the sustainability of current account deficit and its financing. The principle of balanced budget over the business cycle is also consistent with the harmonization of fiscal policy with EU requirements under the Growth and Stability Pact.
  3. Equally important is further restructuring and privatization. In particular, the latter will increase the transparency, efficiency and competition in sheltered sector of the economy, thereby promoting more flexible price formation of infrastructure and other essential services.
  4. The competitiveness was and will be based on the transfer of technology connected to FDI inflows. These foreign-origin capital formations will promote structural changes and stimulated reorientation to European markets. The Estonian way to manage competitiveness is to be attractive for FDI inflows. Recognizing the importance of foreign direct investments, the government will continue equal treatment of foreign investors and domestic investors and further support the business climate.
  5. To gain the full benefits from the inflow of FDI the government has to address the possible supply side rigidities of the labor market. The primary task in handling competitive and qualified labor deficit lies in the development of advanced training and re-training of the young and adults. To achieve this goal, the reorganization of the vocational training system has started already and the reform is carried out in three phases until 2005. The mechanisms will be developed to involve employers in the process of developing and financing of vocational and advanced training of employees.

Figure 1. Productivity and real wage in Estonian manufacturing sector 1996-2000

Figure 2. Real effective exchange rate and export indeces in Estonia 1996-2000.

Figure 3. Real wage and unemployment rate in Estonia 1996-2000.

Figure 4. Monthly CPI in Estonia 07/92-12/95 (chain indeces).

Figure 5. Monthly CPI in Estonia 1996-2000 (chain indeces).

Figure 6. Real effective exchange rate (REER) index of the kroon (I quarter 1996 =100)

Figure 7. REER, real export and productivity indeces in Estonia 1996-2000 (I/1996=1).

Figure 8. FDI inflows to Estonia in 1994-2000.

On Nominal and Real Convergence: the Case of Estonia)