Year 1992 was a watershed both for Estonia and Sweden regarding respective country’s currency policy. At the same time as Sweden let its currency krona float freely Estonia reintroduced its currency kroon and pegged it to what was perhaps the most stable currency in the world, the Deutsch Mark, Dag Kirsebom, the co-author of "Hard Landing - The fairy tale of the rise and fall of the Estonian economy” writes.
In a historical perspective year 1992 is the start of a successful currency policy in both Estonia and Sweden, although with completely opposite prerequisites. Now in the year 2009 the time has come for Estonia to close the circle.
Jacob Palmstierna is perhaps the most well known banking guru in Sweden. He was CEO of SEB during the loan bubble in Sweden in the 1980s and Chairman of the Board of Nordea during the restructuring of the banking sector in the 1990s. Mr Palmstierna has recently published his memoirs; Jacobs Stege (Jacob’s Ladder). In his book Mr Palmstierna uses the term “treason” to describe the atmosphere in Sweden towards people like the right-wing politician Ian Wachtmeister who questioned the peg prior to the free floating of the krona in November 1992. This again is of course very similar to Estonia today and the aggressive and very emotional response you encounter if you dare to question the peg of the kroon.
Another person very much involved during both the bubble and the crash was Bengt Dennis, the Governor of the Swedish Central Bank from 1982 until 1993. In history books Mr Dennis is most famously known for raising the overnight interest rate to 500% in a desperate attempt to defend the Swedish peg in September 1992. It is estimated that the failed attempt to defend the peg cost Sweden 500 billion SEK. Today Mr Dennis is a consultant to the Latvian government, whom he has strongly advised to devalue the LAT. You don’t have to be Freud to see this as a late admission from Mr Dennis’ side that it was a mistake to defend the Swedish peg so strongly in the autumn of 1992. Some people now ridicule Mr Dennis for his advice to the Latvian government calling him “Mr 500%”. But I see this the other way, someone who is ready to learn from his mistakes should be credited for that and rather have higher credibility. Again compare to the Swedish commercial banks who not only didn’t learn from their mistakes in Sweden in the 1980s but more or less managed to “copy and paste” their mistakes in Estonia 15-20 years later.
In 1992 Estonia pegged its currency to the D-Mark at the rate of 1 D-Mark = 8 EEK. When the EUR was introduced the peg was so to say just forwarded, and since it was close to 2 D-Mark per EUR the exchange rate became 15,6466 kroon per EUR. In other words Estonia has had a fixed exchange rate towards the stable currencies of D-Mark and EUR for 17 years, a fantastic achievement for a small country that was a communist state occupied by the Soviet Union just some 20 years ago. But as any ageing Hollywood- or Sportstar can tell you; you can’t live on old merits forever. The great accomplishments made during the first 10 years of the second republic have now to a large extent been ruined. In the 1990s Estonia had a plan for long-term success. Lately everything has been only focused on short-term winnings, with the fantasy goal of joining the EUR in 2011 as the last example.
It is to a large degree the politicians of Estonia who have undermined the stability of the kroon-peg with their policies and unrealistic statements during last five years, especially guilty is the coalition government of the Reform- and Center party that Estonia had a few years ago during the most crazy period of the bubble economy. Anyone remember the naïve promise to join the EUR in 2007? But still today when discussing with most Estonians they don’t want to accept this fact. If you question the exchange rate many Estonians look at you as if you are crazy, almost like if you would question the value of pi (3,14159265…). Maybe this attitude is not so strange when you take into consideration repeated comments from Estonian officials that a devaluation is “impossible”. The argument is based on the facts that Estonia has a currency board where all kroons are fully guaranteed by foreign exchange reserves and that Eesti Pank has no right to devalue the exchange rate of the kroon according to the law. In other words currency speculators such as George Soros are not able to speculate against the kroon. However it is important to remember that the currency speculators in Europe in the beginning of the 1990s, who brought down among others the British pound, the Finnish marka and the Swedish krona, were only using imbalances that already existed.
So even if you can’t speculate against the kroon it doesn’t mean the underlying imbalances have disappeared. One example of this is that the market has a much higher interest rate on EEK compared to EUR. In this manner the market indirectly demonstrates it’s suspicion regarding the value of the kroon. If it really would be “impossible” to devalue the kroon the interest rates would otherwise be exactly the same for EEK and EUR. Examples of imbalances in the Estonian economy are a GDP growth of minus 15% and unemployment of 15% (last figure according to Eurostat). When will the “impossible” devaluation become possible? Unemployment of 20%? 25%? 30%? I don’t know the answer, but my guess is that the pain threshold is an unemployment somewhere between 20 and 25%. And this level I think will be reached in the autumn, or latest in the winter.
Swedish banks are heavily exposed to the Baltic countries. Sweden as a country is very dependent on the wellbeing of its banks. The international currency market is immediate and relentless when punishing a country with problems by lowering the value of its floating currency. So when Swedish banks have problems in the Baltic countries the Swedish krona looses value against for example EUR. It is now the feeling of being like Alice in Wonderland occurs. As the kroon is pegged against the EUR it actually strengthens in value against the Swedish krona when the economic situation in Estonia worsens!
The most absurd scenario of all will be if Latvia devalues but Estonia manages to keep its peg to the EUR. Then Estonia will be in an even worse economic situation but simultaneously the kroon will strengthen further against the krona. Sweden is one of Estonia’s most important trade partners, export to Sweden is very important for Estonia. Comments by the Estonian government, Eesti Pank and economic professors in Tartu that a devaluation is meaningless because “Estonia anyways doesn’t export anything” and “we anyways can’t increase our exports during a global recession” is utter nonsense. The importance of the EEK/SEK exchange rate can be witnessed on a daily basis by both myself and other Estonian companies trying to sell our products and services to Sweden.
Only six months ago it was seen as common knowledge that Baltic devaluations were bad for Swedish banks and therefore also for Sweden as a country. This as many people in the Baltic countries have taken loans in EUR and these loans will be bigger in local currencies after a devaluation which in turn will lead to bigger credit losses for the banks. Between the lines in the Swedish debate the opinion among most economists at the same time seems to be that for the Baltic countries themselves the best strategy would be to devalue in order to kickstart their economies. In other words it has been Sweden pushing the Baltic countries not to devalue. This might very well be true, but I think Sweden didn’t need to push the Baltic countries very much. Playing along with Estonian, Latvian and Lithuanian national pride has probably been a much more simple and efficient strategy.
During last couple of months representatives of the Swedish banks have changed their analysis somewhat. Now they say that today’s austerity policy in the Baltic countries, so called internal devaluation via deflation, will end up with the same total level of credit losses for the banks. Only difference being that a “normal” devaluation would speed up the process, the credit losses would come sooner. I am getting more and more convinced that the analyses by the Swedish banks have been and still are wrong. I don’t think this is a zero-sum game where profits for Sweden mean losses for Estonia, and vice versa. On the contrary I think Estonia and Sweden sit in the same boat. A substantial devaluation, or even better a freely floating kroon, will give the Estonian economy a much needed boost where after the economy can turn upwards again. And a growing economy, unlike a collapsing economy, will consist of people and companies with better abilities to service their old loan obligations.
I completely agree with Estonians that the best possible combination is a strong economy and a strong currency. One good example is Switzerland where the economy and the currency in parallel have become stronger and stronger since WWII. But unfortunately this combination doesn’t exist here in Estonia anymore due to mistakes already made. There is one combination even worse than having a weak economy and a weak currency, and that is having a strong currency together with a weak economy. In other words exactly what Estonia has today.
One year ago I and Claudio Zucchelli published our book “Hard Landing – The fairy tale of the rise and fall of the Estonian economy”. The main point of our book was that the similarities between the loan bubble in Sweden in the late 1980s and the loan bubble in Estonia a few years ago were amazing, even the same banks were involved. Other examples of similarities were an interest rate that was lower than inflation, irresponsibly optimistic politicians and real estate valuations that had lost all contact with reality. Finally we described how the economy in Sweden crashed in the beginning of the 1990s, indicating for all readers what scenario was in store for Estonia.
During the year that has passed since we published our book most of the elements in the Swedish crash have also occurred in Estonia. It is astonishing how history can repeat itself so exactly. There is now only one major step left for the resemblance to be complete – that Estonia lets its currency float freely. I have a hard time seeing one single good argument against such a development. And for Estonia in 2009, as for Sweden in 1992, applies that the costs for defending a pegged and substantially overvalued currency just increases the longer you wait.