A tale of four different exchange rate experiences 21

Foto: Andrejs Terentjevs, F64
Morten Hansen 24.aprīlis 2012 12:19

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

Source: IMF

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

Source: IMF

* 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


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Uldis Rutkaste Morten, thanks for this article! I found it interesting and thought provoking. Just a small remark from my side.

I think Iceland is indeed an interesting example, but at the same time Iceland is also an outlier when it comes to export performance during the past crisis. You pointed out already that Iceland was one of the very few countries (at least if compared to other European economies) that managed to sustain and even increase exports during 2009.

I can agree that devaluation helped somewhat to Icelandic short-term export performance. But then there is a question why we did not see similar developments in other countries that experienced large depreciations. I think the following chart may provide some insight on why this was so:

Namely, close to 80% of Icelandic merchandise exports consists of marine products and products of power intensive plants. So, my hypothesis would be like this. Given that Iceland is largely exporter of natural resources (fish and cheap geothermal electricity), the share of domestic value added in the total value added of their export basket is large enough. Consequently, they likely were less hit by a surge in (imported) input costs because of currency depreciation, in its way increasing the positive effects of devaluation on exports. Given the very high concentration of just few product groups in their export basket, asymmetries in external demand may also have played its role (e.g., product or market distribution effects). One way or another, it seems that the Icelandic export performance was shaped by these two narrow product groups over the past crisis. The rest of Icelandic export basket seems has followed the trends observed in many other countries.
 +3  Radius_box_plus Radius_box_minus 2 ATBILDES  ATBILDĒT  24.aprīlis 2012 14:00
Plus_opinionNasing spešal! Thanks, it just confirms an argument that whatever form of devaluation is used (either internal devaluation or currency devaluation), the result is the same for exporters. Question is still about impact to other economic measures.
 +1  Radius_box_plus Radius_box_minus 1 ATBILDE  ATBILDĒT  24.aprīlis 2012 16:19
Econ Stāsts katram, kas kaut ko saprot no šīs lietas, ir viens - nepareiza monetārā politika ar jau sākotnēji skaidru iznākumu.

Latvijas eksporta kapacitāte drīz vien arī mazināsies, jo dabas resursu, tas ir - koku un kūdras - vešanas iespējas nav bezgalīgas. Koka ciršana un izvešana nav rūpniecība, tāpat kā kailcirtes nav skaistākie dabas skati uz Zemes :) Devalvēšanās par 17% tādām attīstītām valstīm kā Zviedrija nav maz.

Dažreiz nekas cits nepaliek kā tikai pateikt - tā bija kļūda, šis ir viens no tiem gadījumiem. Un tas sliktākais - to tagad ar visu Latvijas Māstrihtas kritēriju ņemšanos apliecina arī ECB, un tas ir ļoti slikts signāls potenciālajiem investoriem (ne koku cirtējiem, tos mēs paši mākam cirst).
 -2  Radius_box_plus Radius_box_minus 7 ATBILDES  ATBILDĒT  24.aprīlis 2012 12:41

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