Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008-09

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The paper traces the Baltics' adjustment strategy during the 2008-09 global financial crisis. The abrupt end to the externally-financed domestic demand boom triggered a severe output collapse, bringing per capita income levels back to 2005/06 levels. In response to this shock, the Baltics undertook an internal devaluation that relied on unprecedented fiscal and nominal wage adjustment, steps to preserve financial sector stability as well as complementary efforts to facilitate voluntary private debt restructuring. One-and-half years on, the strategy is making good progress but not yet complete. Confidence in the exchange rate was maintained, the banking system was supported by its parent banks, external imbalances and inflation have largely disappeared, competitiveness is improving, and fiscal deficits are gradually being brought back towards pre-crisis levels. However, amid record levels of unemployment, further reforms are needed to foster a return to more balanced growth, fiscal sustainability, and a healthier banking system.

The Baltic Republics and the Crisis of 2008–2011

“…22 Elections to the European Parliament were held in all three countries in 2009. Finally, while in Latvia and Lithuania, the crisis brought about a dramatic fall in tax revenues, then in Estonia the revenue shock was significantly smaller; this divergence has been attributed to better tax compliance and tax administration in Estonia (Purfield and Rosenberg 2010;Nakrosis et al 2012). …”

“…Of those cutbacks, 683 million came from investments, 2.28 billion from transfers and 177 million from operating costs. 20 Parex had at the time ca 20% of domestic banking market (Purfield and Rosenberg 2010). helped to avoid the spillover of the liquidity crisis to the other Baltic economies as well (Purfield and Rosenberg 2010). 21 The lack of domestic banks gave Estonian (and Lithuanian) government significantly more fiscal space as bailing out banks was essentially 'outsourced' to the Swedish central bank.…”

“…Lithuania than in Estonia (where the budget surpluses were accumulated into a rainyday fund, called stabilization fund in the organic budget law) (Purfield and Rosenberg 2010;Deroose et al 2010). 7 At the backdrop of such optimistic oblivion, the magnitude of the economic downturn certainly came as a surprise to the local policymakers.…”

“…Importantly, nominal exchange rate adjustment would have precluded joining the eurozone as an exit strategy from the crisis. Furthermore, given that a large proportion of loans in these countries had been denominated in euros, 8 external devaluation would have imposed large costs on significant parts of the population and reduced private sector net worth (and potentially led to a surge in loan defaults, with contagion effects to the rest of the economy) (see also Purfield and Rosenberg 2010;Raudla and Kattel 2011a). Kuokstis and Vilpisauskas (2010) note that among the local policy-makers and experts, the prevalent causal belief was that devaluation of the currency would have been "clearly wrong and potentially disastrous".…”

Implications of the liquidity crisis in the Baltic-Nordic region

“…According to Mai (2008) the same scenario was present in the Nordic countries during the banking crises of the 1990s. Unfortunately bankers in the region did not learn their lesson and the same happened in the Baltics again during the recent crisis (for the chronology of the crisis in the Baltics see, for example, Purfield & Rosenberg, 2010).…”