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.