A tale of four different exchange rate experiences 21
A few weeks ago I compared Latvia's fixed exchange rate experience with Belarus' massive 2011 devaluation - this post looks at some of the same issues but with more comparators and this time from the west.
Once again the issue is: Does Latvia have something to learn from the exchange rate experiences of, in this case, Iceland, Sweden and the United Kingdom?
Those countries are of interest since they underwent rather different exchange rate developments during the financial crisis: Iceland's kronur was trading at around 85-90 ISK/EUR until it started sliding towards 130 ISK/EUR in spring 2008 and experiencing a massive devaluation in October 2008 when the price of the EUR went to 290. 3 December is the last day for which the ECB records a bilateral rate for Iceland since the country has introduced capital controls (ISK is not fully convertible). Iceland's central bank lists the exchange rate now (April 2012) as 167 ISK/EUR i.e. an overall devaluation of close to 50%.
The British pound traded around 0.675 GBP/EUR until in late 2007 when it started depreciating. It is now rather stable around 0.825 GBP/EUR, an increase in the price of EUR of 22% (or a depreciation of GBP of some 19%). OK very recently it has started appreciating again but this is outside the trade data I have here.
The Swedish krona traded around 9.3 SEK/EUR until it depreciated to around 11.25 SEK/EUR in early 2009 (a 17% depreciation) after which it slowly appreciated and is now at more or less the level it had in 2008, if not even a bit stronger.
And the Latvian lat stayed through tempestuous times (e.g. June 2009) within its +/- 1% band vis-à-vis the euro.
Four different currency developments but what can be said of the related impact on export performance? Figure 1 displays the development of competitiveness via the Real Effective Exchange Rate, i.e. a measure of the development in a country's costs or prices of production vis-à-vis those of a host of trading partners. If the curve slopes upwards a country's costs are moving faster than abroad and the country loses competitiveness and vice versa.
As can be seen, the massive devaluation in Iceland increased Icelandic competitiveness sharply, UK competitiveness increased somewhat via the more subdued GBP depreciation while Latvia initially lost competitiveness on a grand scale (due to the high inflation of 2005-07) but later regained significant lost ground via the ‘internal devaluation' from 2008 and onwards.
Figure 1: REER, 2005 = 100
Source: LV, SE, UK: Eurostat, ULC-based, 36 trading partners, IS: OECD data
Does a devaluation help exports via increased competitiveness? Any text book will say so and I surely agree - but the extent to which it does so is not God-given.
Figure 2 shows that Iceland's exports performed substantially better than in the other three countries. Even in that year of world recession, 2009, where most countries saw exports drop due to lower demand all over the world, Iceland was one of only four countries with an increase in exports in Europe (the others being what I think I can refer to as outliers without offending too many, namely Kosovo, Serbia and Azerbaijan).
Figure 2: Exports of goods and services, 2006 = 100
So, even a die-hard anti-devaluationist (?) must admit that devaluation works but then a similar die-hard pro-devaluationist would have to admit when looking at Figure 2 that Latvia's internal devaluation has worked as strongly as the depreciations of Sweden and the UK - or even better - since Latvian export performance has been somewhat stronger than in those two countries. Yes, I am perfectly aware that also other factors affect exports but Figure 2 just isn't consistent with an undercompetitive Latvia with an overvalued exchange rate; alas, the internal devaluation has demonstrated results.
This is of course a bit of back-of-the-envelope results but they do seem to suggest that exports are not all that price elastic and that a massive devaluation would be needed for really boosting exports. And a massive devaluation here, or rather currency collapse as I think it was in Iceland, could have taken down not just borrowers with foreign currency loans but a good chunk of the banking system; hardly an attractive choice.
A final point is the following: Exports seem to be losing steam in Iceland cf. Figure 3 and this also takes some of the steam out of the pro-devaluation argument*.
Figure 3: Exports of goods and services, 2008 = 100
* Some claim it is due to production capacity constraints in Iceland but this then argues against undertaking a devaluation in the first place. Some of it is most likely (also) due to rather high inflation which reduces some of the gained competitiveness.
** For those who might be interested in (much) more about Iceland's devaluation and its choice of economic policy in general during the crisis here is a link to the big conference of 27 October 2011 on Iceland.
Morten Hansen is Head of Economics Department, Stockholm School of Economics in Riga