2011 inflation in Estonia not to be blamed on euro

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A common explanation for Estonia's high inflation during the past year has been the euro adoption. The connection is undoubtedly easy to draw but if this were indeed the case, Estonia would at least be in a somewhat worse position compared to Latvia and Lithuania that have not yet joined the currency union.

Estonia has been a member of the euro zone for more than a year now. The switch itself was pulled off with unexpected smoothness, as the task was conveniently placed on the shoulders of merchants who were made responsible for exchanging the kroons to euros. A year later, people finally seem to have got used to the new exchange rate, and convert prices increasingly less often back to kroons to put the EUR prices in perspective. The phenomenon was a common sight in the first months in 2011, especially among older people whose unseparable companions in their daily grocery shoppings were euro-calculators. So although the fuzz has slowly started to fade, what stings with an extreme sharpness is the highly perceptible increase in prices that has accompanied Estonians throughout the year 2011.

In several months in 2011, the recorded inflation in Estonia was highest in the euro zone. In the light of wage inflation lagging behind and unemployment levels still elevated, working-age population keeps leaving for abroad, mostly to Finland, but also to UK and Australia. The census is currently still ongoing, but the results will likely resemble the ones of Latvia – still hopefully not as bad as Latvia's 13% decrease in population in 10 years. So by no means are Estonians satisfied with the situation and the most popular among the scapegoats to be blamed for rising prices is of course the euro. However, this is nothing but a misconseption. The high inflation has indeed coincided with the same year the joint currency was adopted, but its effect on the price rise can only be regarded as marginal. The other two Baltic countries, Latvia and Lithuania (both with their own currencies, but both also pegged to EUR) have not witnessed easier pressure from inflation compared to Estonia, as the comparative indicators illustrate. Would you not expect it to be otherwise if the euro indeed was the main reason for Estonia's recent painful price rise?

To prevent merchants operating in Estonia of profiting from the currency change, in 2010 many went along with joining the EU-initiated fair pricing agreement having themselves publically listed on the campaign's website. When it came to converting prices to EUR, the merchants were to round prices down or else face sanctions by the consumer watchdog. Still, as the move was of voluntary nature, many did not jump the bandwagon and of this everyone can name some examples – including a drastic occasion where the machine coffee in news2biz headquarters experienced a whopping 56-percent price increase overnight! So there is no wonder consumers may feel cheated when reading headlines such as "Prices in Estonia once again highest in euro zone" – didn't they promise the euro would not raise prices?

Although Estonia's record high inflation is a documented fact, when it comes to the Baltics, however, prices have recently increased the most in Latvia instead, while both Estonia and Lithuania have basically moved at the same rate for the past 6 years. The graph below illustrates it nicely – compared to the pre-boom-and-recession 2005 average, prices in both Estonia and Lithuania had risen approximately 35 percent by the end of 2011, while Latvia had gone through about a 45 percent increase.

What also strikes when looking at the graph is that the overall trend of the prices in all three countries has all along been very similar. The reason being of course their open, export-oriented economy and great exposure to the external environment – raw material and fuel prices on world markets have very strong influence on the cost of local end products. It is quite natural, then, that food and transport prices were among the ones to increase the most – e.g., both more than 8 percent in 2011 in Lithuania's case. As to Latvia's higher inflation, one important reason is its recent tax hikes, which has always been a standard solution when it comes to balancing the state budget. VAT, for instance, has gone up from 18 to 22 percent – the highest in the Baltics and naturally contributing directly to inflation. At the same time, Lithuania and Estonia have been somewhat more conservative in raising the VAT – from 18 to 21 and 20, respectively.

Finally, the official statistical assessments only confirm the argument. Although the influence of the euro is hard to evaluate, neither the consumer watchdog nor statistical office reported any direct and significant impact on prices by the euro in the first months of 2011. Eurostat even provides some numbers to illustrate the significance of the impact – a mere 0.2-0.3 percent from December 2010 to March 2011 of the total CPI of 1.5 percent in the said period. This is also said to be comparable with the experience of other countries that have recently changed to the euro.

The positive effect of the euro on the Estonian economy – encouraged FDI due to currency risk decrease – that was argued as the most important benefit by euro supporters, can indeed be confirmed a year later. Although there were not any huge foreign investments last year that can be linked to euro (e.g., the acquisition of Silmet by US Molycorp based entirely on market developments and was bound to happen regardless of the euro), there were plenty of SMEs investing in Estonia in 2011. Some of them have cited EUR as one of the reasons for their decision to expand to Estonia. The currency being an advantage to Estonia was also recently confirmed by the CEO of Kärcher, German cleaning equipment manufacturer, in an interview to news2biz LATVIA.

It remains to be seen just how many large investments euro will lure into Estonia (especially in the light of the recent controversial step by Swedbank – moving more than EUR 750m of profits out of Estonia), but at least the entrance of smaller firms can already be counted as a positive effect of the euro – market fragmentation. So the most popular (and populist) claim attributing the price rise in Estonia to the joint currency is groundless, for in that case Estonia would at least be in a somewhat tighter position compared to the rest of the Baltics that are yet expecting to adopt the euro in the coming years and are, together with Estonia, all very dependent on the movements on the world markets.