Chapter 2. Assessing Competitiveness
- Yuan Xiao, Robert Burgess, and Stefania Fabrizio
- Published Date:
- July 2004
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.
A. Real Effective Exchange Rate Indicators
REERs are the most frequently used indicators of external competitiveness and can be calculated with reference to a variety of alternative price and cost indices. This section reports REERs based on three such indices—Consumer Price Index (CPI), Producer Price Index (PPI), and Unit Labor Cost (ULC), the main advantages and disadvantages of which are summarized in Box 3.7 Movements in these indices require careful interpretation, as they may reflect equilibrium phenomena rather than changes in competitiveness. Some appreciation of CPI-based REERs, for example, would be consistent with the convergence of living standards and productivity in the Baltics on advanced economy levels, while PPIand ULC-based measures, which are more representative of the traded goods sector, could be expected to remain more stable. This has generally been the case in the Baltics, except where specific factors unrelated to competitiveness, such as the impact of oil prices on producer prices in Lithuania, have been at play.
Box 3Real Exchange Rate Indicators of Competitiveness
The CPI-based measure is widely available, facilitating comparisons with other countries. It is also a broad-based indicator, including both goods and services. The main drawbacks are that such indices include a large number of nontraded goods and services, and exclude intermediate goods, which are an important component of traded goods; and the representative basket will vary across countries. In transition countries, the CPI can also be significantly affected by price liberalization and adjustments of administered prices.
The PPI-based measure retains the disadvantage that the basket varies across countries. However, the items in each basket are typically more representative of traded goods, including traded intermediate goods. But the PPI-based measure may not be a good measure of competitiveness as companies can price to market by squeezing profits in the short run.1
The ULC-based measure is often thought to be the most appropriate for use as a competitiveness measure because labor costs are an important component of production costs. But the measure misses some important aspects of actual production costs; a fall in unit labor costs that results from the substitution of capital for labor, for example, need not necessarily signal an improvement in underlying competitiveness. The measurement of productivity that underlies the ULC-based measure is difficult in practice, especially when used as a basis for cross-country comparisons, and typically is highly sensitive to variations in the economic cycle.
The usefulness of REER measures is generally assessed according to their ability to explain actual trade flows. Marsh and Tokarick (1994), for example, find that for a range of advanced countries, trade flows are most closely correlated with ULC-based REER measures.1 Corporate profitability is also difficult to compare across countries. In a recent survey, however, Citron and Walton (2002) ranked 23 countries by the profitability of their private nonfinancial corporate sectors in 2000/01. Estonia ranked fifth and Latvia eighteenth. The study did not include Lithuania.
- The REER for Estonia has moved within a very narrow band throughout this period, reflecting the close conformity between Estonia’s peg to the euro and the structure of its trade flows: almost half of Estonia’s exports over this period were directed toward the euro area (and Denmark, whose currency is tightly linked to the euro through the ERM II) (Figure 3).9 The depreciation of the euro against the dollar through the end of 2000, and its more recent appreciation, thus had only a modest impact on Estonia’s REER.
- Lithuania’s trade with the euro area (and Denmark) is lower, but still significant, accounting for over one-third of all exports. The appreciation of the dollar against the euro therefore led into an appreciation of Lithuania’s effective exchange rate through its link to the dollar, with the appreciation only partly offset in real effective terms by Lithuania’s low inflation rates. The recent appreciation of the euro against the dollar has had a similar effect following the repegging of the litas from the dollar to the euro in February 2002. As a result, Lithuania’s REER has risen by about 20 percent since early 1999. While the overall appreciation of Lithuania’s REER has exceeded that of its Baltic neighbors, it has been broadly comparable to that in other countries acceding to the EU (Figure 4).
- In the case of Latvia, the REER peaked in late 2000, as the dollar reached a new peak against the euro, but has since depreciated in response to both a fall in inflation in Latvia and, more recently, the depreciation of the dollar against the SDR and the euro.10
Figure 2.Effective Exchange Rates
Source: IMF staff estimates.
Figure 3.Trade Shares
Source: IMF, Direction of Trade Statistics.
PPI-based measures of the real exchange rate have depreciated modestly in Estonia and Latvia since the beginning of 1999, in line with the lower share of nontraded goods in the PPI than in the CPI (Figure 5). In Lithuania, however, the PPI-based REER has appreciated by over 30 percent since the beginning of 1999. This reflects the importance of the oil-processing trade in Lithuania, as a result of which the PPI is heavily biased toward oil products and sensitive to changes in international oil prices.11 To the extent that the price of exported processed oil products also moves in step with changes in international oil prices, the sharp appreciation of the PPI-based REER should not, therefore, be interpreted as a decline in competitiveness. The PPI-based exchange rate excluding oil prices by contrast has appreciated by a little over 10 percent since the beginning of 1999—less than the corresponding appreciation in the CPI-based measure.
Figure 5.Real Effective Exchange Rates, CPI- and PPI-Based
Source: IMF staff estimates.
Note: CPI is Consumer Price Index; PPI is Producer Price Index.
ULC-based REERs have moved more or less in line with the equivalent CPI-based measures in Estonia and Latvia, but by significantly less than the CPI-based measure in Lithuania (Figure 6). The growth of manufacturing wages has been particularly strong in Estonia in recent years (although lower than average wage growth in other sectors of the economy) but has generally been matched by equally strong growth of productivity. Both wage and productivity growth have been more moderate in Latvia. In Lithuania, the strong recovery following the post-Russia crisis recession coincided with an acceleration in the process of labor shedding, leading to exceptionally high increases in measured productivity. Manufacturing wages have risen only modestly since 2000, and the resulting fall in unit labor costs has fully offset the continued appreciation of Lithuania’s nominal exchange rate.
Figure 6.Unit Labor Cost-Based Real Effective Exchange Rates
Source: IMF staff estimates.
Note: CIS is Commonwealth of Independent States; ULC is Unit Labor Cost; CPI is Consumer Price Index.
More recent data covering the whole economy suggest that wage growth in Estonia remains high and, arguably, excessive. Wages have grown at an annual rate of over 10 percent a year since 1999, well in excess of whole-economy productivity growth.12 Recent wage increases in Latvia have been much more moderate when measured in euros, but this is entirely a reflection of the depreciation of the lats against the euro (wages measured in domestic currency increased at an annual rate of over 10 percent in the first half of 2003). Wage growth in Lithuania has rebounded somewhat since 2001, but remains relatively moderate (Figure 7).
Figure 7.Wage Growth
Sources: Country authorities and IMF staff estimates.
The level of labor costs in the Baltics remains well below the accession average and considerably below the EU average (Figure 8).13 In 2000, hourly labor costs in industry were 2.91, 2.65, and 2.28 euros in Estonia, Lithuania, and Latvia, respectively, compared to an average of 3.70 euros in the Czech Republic, Hungary, Poland, and the Slovak Republic, and 22.70 euros in the EU. Labor costs tend to be somewhat higher in the service sector, although a similar pattern emerges with respect to hourly costs compared to other accession countries and the EU. The main exception is in financial services, where hourly wage costs in Estonia of 6.66 euros are marginally above the average of 6.40 euros in the other central and eastern European accession countries (excluding Slovenia). However, while these differences reflect the cost of labor in each country, they do not take into account differences in labor productivity among countries. Adjusting for this suggests that “unit labor costs” in industry and services were somewhat higher in the Baltics in 2000 than in the Czech Republic, Hungary, and the Slovak Republic, but lower than in Poland.
Figure 8.Wage Costs in Acceding Countries
Sources: Eurostat and IMF staff estimates.
1 Calculated as ratio of average labor costs per employee to GDP per employee.
B. Export Performance
A more direct measure of competitiveness is given by export performance. Export growth has recently accelerated in all three Baltic countries, driven primarily by a recovery in exports to non-Commonwealth of Independent States (CIS) countries (Figure 9). Prior to that, exports to the EU were relatively weak, but this weakness was partly offset by renewed growth of export to CIS countries, supported by a depreciating REER against these countries and the growth of demand in the CIS countries.14 The relative weakness of Baltic exports to the EU during 2000–01 was largely a reflection of the weakness in EU demand. Abstracting from this, however, the Baltics have been relatively successful in maintaining—and, in some cases, increasing—their share of the EU market (Tables 1 and 2).15 Estonia and Lithuania have performed exceptionally well in this regard. Latvia’s market share has risen more moderately, but, excluding the wood sector—which suffered because of a difficult market environment—Latvia has also performed well. The pattern of overall export performance is partly explained by the commodity composition of trade:
Figure 9.Export Growth
Sources: Direction of Trade Statistics and IMF staff estimates.
Note: CIS is Commonwealth of Independent States.
|Total, excluding machinery and electrical equipment|
|Total, excluding wood|
|Total, excluding machinery, electrical equipment, and oil|
|Oil and mineral products||2.2||–5.6||1.3||13.6||8.8||104.2||6.0||7.1|
|Wood and articles of wood||17.3||5.0||52.0||7.7||8.4||1.7||1.2||–4.1|
|Textiles and textile articles||13.8||6.5||18.2||8.7||33.0||10.5||5.5||–6.3|
|Base metals and articles of base metal||8.4||10.9||8.7||48.6||3.8||1.1||7.3||–0.4|
|Machinery and electrical equipment||34.7||37.0||3.3||4.3||10.1||9.0||27.3||3.6|
|Miscellaneous manufactured articles||7.9||20.0||7.2||16.8||6.2||39.1||2.3||2.2|
Share in total exports to the EU, 1997–2001 average.
1997–2001 annual average.
Share in total exports to the EU, 1997–2001 average.
1997–2001 annual average.
- In Estonia, the sharp increase in market penetration in 2000 is largely a reflection of the assembly subcontracting operations of Scandinavian telecommunications companies. This accounts for the bulk of the 125 percent rise in Estonia’s exports in machinery and electrical products to the EU in 2000, resulting in an increase in total exports to the EU by 38.5 percent. It also led to a similar increase in imports, and the resulting share in total value added in the economy of this sector is thus relatively low. The collapse in the global telecommunications sector in mid-2001 by the same token resulted in a fall in Estonia’s market share. If machinery and electrical products are excluded, both the increase of Estonia’s market share over recent years and the reduction in share since mid-2001 have been more moderate.
- The more moderate increase in Latvia’s EU market share is partly explained by the concentration of exports on wood and wood products, which account for about 50 percent of goods exports. There has been a general decline in EU demand for wood, with global wood exports to the EU declining by 4.1 percent between 1997 and 2001. Wood prices have also been quite sluggish, declining by 0.9 percent between 1997 and 2001.16
- Lithuania’s export base is more diversified than those of Estonia and Latvia, with oil, textiles, machinery, and equipment all contributing significantly to export growth. Much of the large increase in Lithuania’s market share in 2001, however, relates to the oil sector, and in particular the resolution of supply difficulties at the country’s main oil refinery.17 As with the electronics processing sector in Estonia, this also led to an increase in imports with only a minor impact on national value added.