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The economic commentators reacted unanimously, when the speculations about the stock market crash in Estonia were fulfilled – we predicted this a long time ago. It would have been great, however, if the crash prediction were easily understandable and more precise. This article tries to take these faults into account and predict the devaluation of EEK, using, believe it or not, hamburgers.
Big Mac index was created to show the necessity of devaluation. Its main idea lies on the fact that the same baskets of goods should cost exactly the same amount of money in two countries.
It is hard to find a better suited good for comparison purposes than the Big Mac. Burger is mostly made on domestic ingredients and thus shows the valuation of domestic produce.
1 BM is 24EEK, 1$=13.64EEK (11.11). Thus the burger should cost $1.76 in USA. I think this price would cause buying panic in USA, because the price in reality is $2.53 or 34.5EEK. According to baskets, the exchange rate should be 9.49EEK=1USD, which is about 70% of the reality. According to the same logic, a DEM should cost only 5.56 EEK.
The aim of devaluation is to shift the exchange rate in the other direction, like 9EEK:1DEM (in Estonia rate is fixed at 8EEK:1DEM – comment). Thus according to this analysis there is no economic reasoning for devaluation.
Some might think of the Big Mac idea as something
ridiculous, whereas it does in fact have a strong theoretical and empirical background.
Many international investigations have shown that very much more complicated
analysis will reach remarkably similar conclusions. For example, J. Annaert found, that if americans
would have invested according to the BM index to undervalued currencies, they would
have earned on average 1.5% more annually without any extra risk (7.12.96
Economist).
Of course,
the analysis cannot be so single-sided. The BM index has 3 major shortcomings.
Firstly, it
does not take the tastes into account. Americans might like BM much more than
Estonians do, thus the BM should be more expensive in the USA. However, the
competition should be a lot stronger in USA as well, thus it is unreasonable to
suggest that McDonalds can rise prices as much as it wants to.
It becomes
apparent from the dynamical viewpoint that lately the BM cost only 21EEK or 60%
of its real value. This highlight the higher inflation in Estonia, the basket
of goods is getting rapidly more expensive. Kroon should become overvalued in
1-3 years, requiring a devaluation sooner or later. And on money markets sooner
is usually a lot cheaper option.
Reading the
FT on 12.12 seems that the right time is now. The short-term exchange rates do
not depend on goods, but on the money movements. No country can back its
deposits by foreign currency, thus now currency board is unbreakable. But
normally the breaking of the currency board is really expensive.
Stuart Bennet,
(Westdeutche Landesbanken) says in the FT that there has been considerable
political capital invested to EEK. To speculators it means:”Choose another
victim”. Thus the pressure on EEK has dropped to almost 0, meaning that Estonian
banks have no forward risks from devaluation, and the Estonian Bank has normal
rerves again.
One should
not overestimate the political damage that the devaluation makes. If EEK would
cost 9 DEM, the thing costing 120DEM before would still cost approx. 1000EEK
after devaluation. Economically it is a lot better to have a slightly weaker
currency that can be backed adequately, than to have a strong EEK that is about
to be devalued! The devaluation has helped countries to get over economic
standstills before, so it would be an ideal tool to finish current stock market
downturn.
Estonia is
competitive and there are no direct economic reasons for devaluation. However,
Estonia’s position is worsening and to avoid the crisis in the future,
governement should devalue straight away. I thin the Bank of Estonia will draw
similar conclusions from the FT article (one article in the Economist caused
stock markets to crash). We are in a similar situations with the kroon as with
the stock market in springs, when the brakes were not applied: everything is
going brilliantly, but towards a disaster.