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Mr. Yuan Xiao, Mr. Robert M Burgess, and Ms. Stefania Fabrizio

Abstract

Large current account deficits in Estonia and Latvia, and the continued real appreciation of the exchange rate in Lithuania, have prompted concerns about the competitiveness of the Baltic economies, and called into question the sustainability of their current fixed exchange rate arrangements. Recent external performance, however, appears to be explained more by temporary or cyclical developments than by a deterioration in the underlying competitive position of the Baltic economies. This book assesses the competitive position of the Baltic countries and focuses, in particular, on the viability of the countries’ strategy of maintaining their fixed exchange rates on joining the European Union, participating in its exchange rate mechanism, and then adopting the euro at the earliest possible date.

Mr. Yuan Xiao, Mr. Robert M Burgess, and Ms. Stefania Fabrizio

Abstract

Concerns about the competitiveness of the Baltic economies have reemerged, as current account deficits have widened in Estonia and Latvia, and the real exchange rate has continued to appreciate in Lithuania. Annual current account deficits in Estonia and Latvia are currently running at about 14¾ and 8¾ percent of GDP, respectively (Figure 1).1 Current account deficits of this magnitude are clearly unsustainable over the medium to longer term. While foreign direct investment (FDI) inflows remain substantial, net external indebtedness has increased.2 In Estonia, this has been accompanied by persistently strong growth in wages over the last couple of years, in excess of productivity growth. Other indicators, however, including strong enterprise profitability, tend to mitigate concerns about competitiveness. In Lithuania, the current account deficit is 5¼ percent of GDP, and net external debt has fallen. But the litas has continued to appreciate following its repegging from the U.S. dollar to the euro in February 2002, raising concerns about the future competitiveness of Lithuania’s exports to countries outside the euro area.3 Inflation, however, has been low, which has helped to offset (but not fully eliminate) the appreciation in the nominal effective exchange rate.4 Wages also remain subdued, with real wages declining in 2001 and growing only moderately since then.

Mr. Yuan Xiao, Mr. Robert M Burgess, and Ms. Stefania Fabrizio

Abstract

This chapter assesses developments in the Baltic countries’ external competitiveness by reviewing a range of standard indicators. These include price-and cost-based measures of the real effective exchange rate (REER), recent wage developments, and more direct measures of export performance. As each of these indicators is an imperfect measure of competitiveness, caution must be exercised in interpreting developments in any single measure.

Mr. Yuan Xiao, Mr. Robert M Burgess, and Ms. Stefania Fabrizio

Abstract

Productivity is the main determinant of national living standards over the long run—or at least the determinant over which policymakers in most countries have indirect leverage.18 It refers to how well an economy uses the resources it has available by relating the quantity (and ideally quality) of inputs to outputs. It is generally accepted that productivity growth rates are strongly influenced by a country’s position relative to the global production frontier—that is, the potential for “catch-up” or “convergence.” That said, there is also ample evidence that there is much more to relative productivity performance than simply lags in the diffusion of a common set of technologies, including the establishment of macroeconomic stability and the timeliness and intensity of structural reform efforts.19 This section considers the recent productivity performance of the Baltics.

Mr. Yuan Xiao, Mr. Robert M Burgess, and Ms. Stefania Fabrizio

Abstract

Whether or not recent movements in real exchange rates are a cause for concern depends on whether they reflect underlying changes in equilibrium exchange rates. This chapter therefore considers a range of factors that typically affect equilibrium exchange rates in transition economies, and provides some quantitative assessments of the importance of these factors in the Baltics. The first section focuses on whether the productivity improvements discussed in Chapter 3 can explain the observed appreciation in real exchange rates in the Baltics. Some illustrative econometric estimates of equilibrium exchange rates in the Baltics are then presented. Alternative statistical methods to identify trend movements in real exchange rates are also considered and found to yield similar results, which are then compared against actual trade flows.

Mr. Yuan Xiao, Mr. Robert M Burgess, and Ms. Stefania Fabrizio

Abstract

Since 1999, real effective exchange rates in the Baltics have been quite stable compared to the strong real appreciations experienced earlier in the transition process. REER indicators based on measures of relative prices or costs that are more representative of the traded goods sector have been even more stable. A more direct assessment of competitiveness based on export performance is complicated by the importance of electronics subcontracting in Estonia and oil processing in Lithuania, which are important in terms of trade flows but much less so in terms of value added. Aside from this, exports have generally performed quite well despite the global slowdown.