Estonian Kroon: According to Big Mac index the exchange rate should be 5.56EEK:1DEM
Hamburgers support Estonian Kroon
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 consider these faults 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 all countries.
It is hard to find a better-suited good for comparison purposes than the Big Mac. Burger is mostly made from domestic ingredients and thus shows the valuation of domestic produce.
DEM costs 5.56 kroons.
One Big Mac costs 24EEK in Estonia, 1$=13.64EEK (11.11.97). Thus, the burger should cost $1.76 in USA. I think this price would cause a buying panic in USA, because the price in reality is $2.53 or 34.5EEK. Accordingly, the exchange rate should be 9.49EEK=1USD, which is about 70% of the reality. Thus, 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 Big Mac 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. It does not consider the tastes. Americans might like BM much more than Estonians do and 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.
However, the devaluation could come soon anyway
It becomes apparent from the dynamical viewpoint that half a year ago the Big Mac cost only 21EEK or 60% of its USA value. This highlights the higher inflation rate in Estonia, the basket of goods is getting rapidly more expensive. Accordingly, Kroon should become overvalued in 2-3 years (an appreciation of 10 percentage points every half-year), requiring a devaluation eventually. In addition, on money markets sooner is usually a lot cheaper option, because an expectation of devaluation could cause panic.
Reading the FT on 12.12 seems that the right time might as well be 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, no 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 zero. Estonian banks have no forward risks from devaluation, and the Estonian Bank has normal reserves again. This means that devaluation will not be extraordinarily expensive for domestic banks.
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.
One should devalue straight away
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, government should devalue straight away. I think the Bank of Estonia could draw similar conclusions from the FT article (one article in the Economist caused stock markets to crash). We are in a similar situation with the kroon as with the stock market in springs, when the brakes were not applied: everything was going brilliantly, but towards a disaster.
This article was written for the Eesti Paevaleht by Keith Siilats (http://www.ieg.ee/keith) sometime in November, 1997. Obviously, with the benefit of historic hindsight, some of the suggestions at the end are useless.