In looking at the decade of the transition in East and Central Europe, even economists seldom focus sufficiently on the extent of the enormous decline in exports, output, and income, which has taken place in the countries of the old Comecon (or CMEA, as it was called in Europe). This collapse has been much sharper than the Great Depression of the 1930s in North America and Western Europe. While real output in the U.S. fell by about one-fourth in the 1929-1933 contraction, real GDP in most of the former Soviet Union has declined a lot more. For example, output in Russia itself fell by one-half in the 1989-1996 period and has not recovered very much since then. In Georgia, beset by civil war and hyperinflation, 1996 output was only 25% of the 1989 level, and statistics for Turkmenistan are not yet available.⁽¹⁾ To be sure, some of the decline in output was both to be expected and beneficial. The classical socialist system was based upon "physical success indicators" - on exceeding, but only slightly, the annual target quota. Now things have changed -- tons of potatoes produced no longer include rocks, a splash of water and all of the rotten ones, in order to maximize the weight indicator to make the kolkhoz chairman look like a good manager. Cows no longer giving milk can nowadays be culled from the herd. Also, petty cheating in the reporting of output statistics has probably declined - if anything, sales and production are likely to be understated for tax reasons.

The three Baltic countries were especially exposed to disaster in the early part of the transition decade. All of them exported about two-thirds of the "Gross Republic Product," according to Soviet statistics, and 95% of these shipments went to the rest of the USSR or the "brotherly socialist republics." This trade was based upon the poorer areas of the USSR providing subsidized or nearly free raw materials for Baltic industries, especially in Estonia and Latvia, and receiving finished products in return. The collapse of the Comecon trading system led to a fall in real output of about 50%. Today, ten years later, Baltic export destinations have been switched toward the west, mainly the EU, the UK, and the Scandinavian countries. Although exports to Russia today constitute less than 20% of the total, all three countries continue to be vulnerable to potential economic sanctions applied to raw materials, especially energy. The port cities of the region have all experienced some recovery in income levels in recent years, but Russia's planned efforts to bypass the Baltics as much as possible in foreign trade and to build a pipeline and port facilities near St. Petersburg are a matter of concern, particularly to Ventspils.

Among the countries of Central and East Europe, ten are currently considered candidates for formal accession negotiations by the European Commission. In only three of these ten - Poland, Slovenia, and Slovakia - does real GDP currently exceed the 1989 level. As Hans Pitlik concludes:

". . . It seems that both supply-side and demand-side responses to the policy changes as well as bad initial conditions contributed to the dramatic output losses during the early years of reform. Countries that initiated comprehensive reforms were able to return to positive growth rates. Delays in policy changes and the failure to continue with reforms after some minor initial steps appear to be the central causes for the ongoing bad performance in a number of transition economies."⁽²⁾
 

It is true, of course, that in much of eastern Europe there exists a substantial amount of what is called "shadow economy" activity, often estimated at 20-25% of GDP, which is not included in the official statistics. This includes illegal activities (smuggling and prostitution) but also barter and exchange of services. Moreover, some economic activities favored by many people in the Baltic area - recreational fishing and hunting, mushroom and berry picking, and the growing of vegetables and flowers on private plots - are completely outside the standard UN system of national income accounts, which makes these three countries appear to be much poorer. In much of Western Europe, on the other hand, most food is bought in stores or markets - and, mushrooms and berries cannot be collected from nature due to "Waldstarben" (forest death). Few people would go mushroom-hunting in the woods surrounding the Frankfurt airport.

The European Union's decision to open negotiations with Latvia and Lithuania was announced shortly after the Helsinki Summit in mid-December 1999. The EU macroeconomic indicators, often called the "Maastricht criteria," do not appear to present a serious problem to the three Baltic countries. Most of them have already been reached. The central government budget deficit came in at about 3% of GDP in all of them in 1999 (actually, 3.8% in Latvia, but there had been a rough balance in the budget in 1998). Foreign debt is well under 60% of GDP (only slightly more than 10% for Latvia) and inflation targets are being approached quite successfully. Latvia's exchange rate for the lats has certainly been more stable than the euro in 1999,⁽³⁾ and the other two countries operate currency board arrangements.

Moving Toward the EU and the Euro

The motivation for the Baltic states to join the EU is probably mainly political. Joining the EU "would cement Latvia's westward alliance, providing greater assurance against the risk of Russian intervention than there would otherwise be." Given that assumption, it is still important to assess the economic benefits and/or costs of membership - to ensure that appropriate policies can be followed, . . . "so as to maximize potential benefits and/or to minimize the costs." It is also important that the case for joining be "sold" to the public by being able ". . . to demonstrate significant economic benefits from joining . . . the political argument by itself may not be enough . . ."⁽⁴⁾

The Baltic states are likely to receive significant benefits from a formal integration with Europe through trade, financial, and fiscal channels. Access to a large market and growth in trade are likely to spur real growth. Interest rates are likely to decline significantly from present levels - the bank lending rate is 8.7% in Estonia, 14% in Latvia, and 13% in Lithuania, while corporate bonds in the Euro-11 area are at 6%. There are likely to be significant fiscal transfers, beginning with ISPA and SAPART projects already in 2000. However, there are also likely to be significant costs. As a recent IMF working Paper (WP/99/156) points out:

"... There will be demands for additional expenditure, largely on account of the required investments in the environment and infrastructure sectors, which could result in a notable increase in the share of public expenditure to GDP. To the extent that an expansionary effect on domestic demand ensues, spurring imports of consumer products and project-related investment goods, the current account position could be significantly affected. Lower interest rates which tend to boost domestic investment could compound an eventual widening of the external imbalance . . ."⁽⁵⁾
 

The primary focus of the Eurosystem is on price stability, and it is being stressed that accession will be a step-wise continuum. First, applicant countries are expected to implement important elements of the "acquis communautaire," a set of obligations deriving from treaties, legislation, and judicial rulings by the Court of Justice. In the financial field, central bank independence and integration in the ESCB is stressed. Upon accession, the candidates enter a second stage, joining the Economic and Monetary Union (EMU) in the status of "countries with a derogation." They will remain committed to adopting the euro eventually (no opt-out clause) and to this end to join ERM II.

In this connection, an interesting question has been raised recently by an IMF Discussion Paper (PDP/00/1):

". . . However, it still needs to be examined whether currency boards are compatible with participation in ERM II. During this phase, EMU countries are envisaged to establish central rates for their currencies against the euro, and to limit fluctuations of their exchange rates to a band of up to around the central rate. Participation in ERM II can be seen to fulfill several objectives: facilitating nominal convergence (meeting the Maastricht criteria); allowing a market test for exchange rate stability; helping to ensure that countries enter the euro zone at an appropriate exchange rate; and preparing central banks for operating within the euro zone."⁽⁶⁾
 

Billed as ". . . the most far-reaching change in the global monetary system since the Bretton Woods conference of 1944," the EMU will challenge American dominance in the financial markets by setting up a new entity of roughly equivalent size. However, a successful monetary union in Europe will benefit the United States and the rest of the world by extending the sphere of "democratic peace" to Central and Eastern Europe, ". . . where instability might otherwise require American resources and intervention." Phase I of preparations for the EMU took place from mid-1997 to the end of 1998, and featured the establishment of the European Central Bank and the European System of Central Banks. Phase II began on January 1, 1999, with an "irrevocable fixing of the conversion rates of national currencies to the euro" and the conversion of European Currency Units (ECUs) into euros on a one-to-one basis. The euro has been introduced only in a non-cash form, and has been used to establish the new TARGET payments system. Only 11 of the 15 member countries opted to join EMU, although Greece is in the process of trying to meet the criteria and is expected to expand "Euroland" of 1999-2000 to "Euro-12" on January 1, 2001. The changeover to the euro as the only monetary unit is expected to be completed by January 1, 2002, with the minting of coins and printing of notes, and national currencies will lose their legal tender status by July 1, 2002.⁽⁷⁾

The introduction of the euro should be a positive development for the single EU market as well as its trading partners. International price comparisons have already become more transparent, and considerable savings on transaction and hedging costs should be possible. The elimination of exchange rate exposure takes a significant risk out of both trade and investment across national boundaries. The adoption of the Maastricht criteria in the near future should lead to a convergence of inflation and interest rates to "Euroland" levels in the ten Central and Eastern Europe candidate countries and serves to reaffirm the importance of conservative fiscal and monetary policies. These criteria include:

(1) An average inflation rate for a year before joining that does not exceed the average price increase in the "three best performing member states" by more than 1.5%;

(2) Participation in the EMS exchange-rate mechanism and "observance of the normal fluctuation margins for at least the last two years;"

(3) An average nominal long-term interest rate on government bonds for a year that is not more than 2% above that of the "three best performing member states in terms of price stability;"

(4) Government budget deficit of 3% of GDP and government debt of 60% of GDP at most, with a small amount of discretion being available in determining the reference value;

(5) Some other criteria, including market integration, the current account, and the trend in unit labor costs and other price indices, will be considered, but no quantitative terms of reference are prescribed.⁽⁸⁾

Regarding monetary policy and exchange rates, many independent experts regard the prescriptions of the European Central Bank in Frankfurt in this area as quite inappropriate for the Baltic states. The ECB envisages a formal two-year transition period during which the exchange rates of the candidate countries would be allowed (required?) to float freely, "in order to reach an equilibrium level." For countries that have been employing currency board regimes de jure (Estonia and Lithuania) or even a very similar arrangement de facto (Latvia), this suggestion is tantamount to saying "let's deliberately destabilize exchange rates and challenge the credibility of the local central bank, and see what happens." Partly as a result of this misguided suggestion, the Lithuanian litas may be floated in 2001, getting rid of its successful (and politically painful!) six-year link to the U.S. dollar. During 1999, as the dollar appreciated and the euro fell (by some 20%), Lithuanian exporters lost and Estonian exporters won market share, with the Latvians in between. It may well be that the Lithuanians abandon the dollar and begin a peg to the euro just when it bottoms out and starts appreciating. Exiting from a currency board arrangement prematurely may be hazardous to your financial health.⁽⁹⁾

At the present time, EU law requires at least a two-year gap before the candidate country joins the monetary union. In a widely-cited report published by the European Commission (in charge of accession talks) in October, it was strongly implied that "attempts at too early adoption of the euro could be highly damaging." At an enlargement seminar held in November, the message was the same: "rush at your peril."⁽¹⁰⁾

There also exist the so-called "Copenhagen criteria," which are not easily quantifiable. These include stable institutions guaranteeing democracy, the rule of law, human rights, and respect for the protection of minorities. The existence of a market economy, capacity to compete and the ability to take on the obligations of membership are also prominently mentioned.

Baltic Monetary Policies

As all three Baltic countries left the ruble zone in 1992 (often contrary to the recommendations of foreign experts) and began to re-orient their economies toward the free market and the West, optimism abounded. Many felt that the only prerequisites for rapid growth and development were conservative macroeconomic policies - a balanced budget and a moderate rate of growth in the money stock - and that everything else could and should be left to private initiative. After all, Baltic living standards had been roughly similar to those in Scandinavia before the Soviet occupation and it was hoped that a healthy economy could be rebuilt in a few years. Estonia moved first to establish a rigorous currency board regime (8 EEK = 1 DM) - with no central bank loans to either the government or commercial banks - and to liberalize its foreign trade and payments. According to Norgaard and Johannsen, these policies

". . . carried a politically hazardous price, however, because it involved consigning a significantly larger share of its population to a life in poverty, accepting greater social inequalities than the other two countries and - particularly - destroyed a larger part of the economy than a less radical strategy would have done."⁽¹¹⁾
 

After rather brief periods of experimentation with temporary currencies in 1992 - the Talonas in Lithuania, which actually depreciated against the Russian ruble, and the Latvian ruble, which appreciated (to 8 Russian to 1 Latvian in the spring of 1993) - stable monetary regimes were established in both neighboring countries as well. Lithuania opted for a currency board in 1994 (1 USD = 4 litas), but is intending to move to a traditional currency peg to the euro in mid-2001 - although it may be advisable to phase out the link to the dollar gradually, perhaps over several years. Latvia re-introduced the lats in March 1993 at a conversion rate of 200 Latvian rubles ("repsisi") to one lats. The average exchange rate of the lats was $1.48 in 1993, but it appreciated to an average of nearly $1.90 for the year 1995, mainly due to the weakness of the U.S. dollar. In the 1993-94 period, the lats was the "strongest currency unit in the world," in the sense that it rose against the U.S. dollar by somewhat more than even the Japanese yen, which reached its all-time high early in 1995. In February 1994, the Bank of Latvia decided that the appreciation of the lats was becoming a negative influence on the export sector and pegged against the SDR basket at a rate of LVL 0.7997 = 1 SDR.⁽¹²⁾

A brief digression on the SDR seems to be in order, since the management of the Bank of Latvia intends to maintain this peg until switching to the euro, in 7-9 years time. The SDR is an international reserve asset created by the IMF in 1969 to supplement existing reserves of members, to serve as a unit of account in the Fund and to be used for IMF transactions and operations. At the outset, one SDR was defined as having the same gold content as a U.S. dollar - they were called "paper gold" in the media. In August 1971, after the first Nixon devaluation, the link to the USD was broken, and the dollar price rose to $1.10 (and about $1.20 after the second devaluation in 1973). A very complex weighting scheme involving 16 currencies was used in the 1970's, but since 1982, the SDR basket has included the currencies of the five member countries of the IMF "with the largest exports of goods and services during the preceding five-year period." The weights are adjusted every five years, and have been as follows:
 

Currency	1981-1985	1986-90	1991-95	1996-2000
U.S. dollar	42	42	40	39
Deutsche mark	19	19	21	21
Japanese yen	13	15	17	18
French franc	13	12	11	11
Pound sterling	13	12	11	11

 

On January 1, 1999, DM 0.446 was replaced by 0.2280 euro and the French franc at FF 0.813 was equated to 0.1239 euro. Thus, today a little more than 30% of the SDR - and, hence the Latvian lats - already tracks the euro.⁽¹³⁾ As has been pointed out by the Bank of Latvia in the press, about 44% of Latvia's trade is valued in dollars (39% of SDR basket) and 35% is in euros (32% of the basket). The Bank of Latvia continues to point out that stability and transparency in foreign exchange rate management are very important values, and that annual changes in valuation to reflect the precise trade weights for each foreign currency would be very destabilizing.

As can be seen from Table 2, the growth performance of all three states weathered the problems of structural adjustment and major bank failures in the early 1990's,⁽¹⁴⁾ and began to grow rapidly in the 1996-98 period. Then, the Russian crisis hit, and 1999 turned into a serious decline for Lithuania. Of perhaps greater importance is the steady decline in inflation, bringing price increases down to OECD levels. Table 1 tracks the growth of major monetary aggregates. Money holdings, measured in SDR's per capita, have shown a steady increase, but are still well below other EU candidate countries: Slovenia (around SDR3200), the Slovak Republic (at SDR1700), Hungary (SDR1500), Poland (SDR1200), and the Czech Republic (around SDR900) are all above Estonia's SDR837. A standard measure of monetization and financial sector development is also the currency ratio. In Estonia, this has fallen from 40% to 22% over the period shown; in Lithuania, it has remained constant at 30%, but in Latvia it has risen from 33% to 36%. Estonia shows the largest relative increase in M2, followed by Lithuania and Latvia. A certain lack of trust in the domestic currency, and perhaps local banks, is shown by the rise in foreign currency deposits in Lithuania, from 25% to 30% of M2. In Latvia, the percentage of deposits denominated in lats actually fell slightly - from 54.4% in 1998, to 51.8% in 1999.⁽¹⁵⁾ Perhaps the pronouncements of self-styled experts from the West, who register for a week at the most expensive hotel in Riga, and pronounce the lats as over-valued do resonate in the public's expectations (a couple of local newspapers have also been endorsing the devaluation prescription). Perhaps we can invite some advisers from the Ukraine and Belarus - they would certainly be cheaper.
 

Source: International Financial Statistics, April 2000.

Source: Bank of Finland, Baltic Economies, 26.5.2000

1. See Martha de Melo, Cevdet Denizer, and Alan Gelb, "Patterns of Transition from Plan to Market," World Bank Economic Review, September 1996, Holger C. Wolf, Transition Strategies: Choices and Outcomes, Princeton Studies in International Finance No. 85, June 1999, and Hans Pitlik, "Explaining Economic Performance During Transition: What Do We Know?" Intereconomics, January/February 2000, pp. 38-45.

2. Pitlik, op. cit., p. 45. See also A. Berg et al, The Evolution of Output in Transition Economies: Explaining the Differences, IMF Working Paper No. 73, May 1999.

3. Although euro weakness has had beneficial results for the EMU export sector - see Gunter Weinert, "Marked Economic Recovery in the EMU," Intereconomics, January/February 2000, pp. 46-52.

4. See Barry Lesser (ed.), Latvia and the European Union (Halifax, Canada: Dalhousie Univ. BEMTR, 1999), pp. 1-3.

5. Rene Weber and Gunther Taube, On the Fast Track to EU Accession: Macroeconomic Effects and Policy Challenges for Estonia, International Monetary Fund, November 1999, p. 35. See also Julian Berengaut et al, The Baltic Countries from Economic Stabilization to EU Accession, IMF Occasional Paper 173, 1998. For a discussion of the gains and losses in the EU itself, see Phedon Nicolaides, "The Economics of Enlarging the European Union: Policy Reform versus Transfers," Intereconomics, January/February 1999, pp. 3-9.

6. Anne-Marie Gulde, Juha Kahkonen, and Peter Keller, Pros and Cons of Currency Board Arrangements in the Lead-up to EU Accession and Participation in the Euro Zone, International Monetary Fund, 2000, p. 17.

7. See C. Randall Henning, Cooperating with Europe's Monetary Union, Institute for International Economics, May 1997, pp. 1-5.

8. Deutsche Bank Research, "EMU Watch: Eastern Europe and EMU," February 28, 2000. See also Inna Steinbuka, "The Alignments of Latvian Economy in the Context of European Integration," and Seija Lainela, "Baltic Accession to the European Union," both in Journal of Baltic Studies, Summer 2000, pp. 193-216.

9. Further discussion of the Lithuanian case is in Thomas Grennes, "The Development of Banking and Financial Markets in Independent Lithuania," Journal of Baltic Studies, Summer 2000, pp. 172-192.

10. "The ECB heads for turbulence," The Economist, January 29, 2000.

11. Ole Norgaard et al, The Baltic States after Independence, Second Edition, (Edward Elgar, 1999), p. 108. More economic analysis will be found in the Spring 1997 issue of the Journal of Baltic Studies, particularly in George J. Viksnins, "Monetary Policy in Latvia."

12. Ibid., pp. 130-131. It seems amazing that a book published in 1999 fails to mention the SDR, but cites a fellow Danish "expert" who believes that the lat is overvalued.

13. Further detail is available at http://www.imf.org/external/np/exr/facts/sdr.htm. There is a proposed amendment made in September 1997 to increase the global supply of SDRs from SDR 21.43 billion to SDR 42.87. This expansion needs to secure approval by 85% of the voting power; as of March 2000, a little less than 50% had been secured. The future role of the IMF as a development leader is beyond our scope here. An excellent summary is provided by Otto G. Mayer, "The IMF Debate," Intereconomics, March/April 2000, pp. 53-54.

14. See Alex Fleming, Lily Chu, and Marie-Renee Banker, The Baltics - Banking Crises Observed, Policy Research Paper 1647, The World Bank, 1996.

15. A formal analysis of this issue is in Vadims Sarajevs, Econometric Analysis of Currency Substitution: A Case of Latvia (Helsinki: BOFIT, No. 4, 2000).