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Adoption of the Euro and Its Effect on Inflation in Lithuania

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Adoption of the Euro and Its Effect on Inflation in Lithuania University of Amsterdam Faculty of Economics and Business International Economics and Globalization Master Thesis Alina Nikitionok (10604596) [email protected] Supervisor: Boe Thio ADOPTION OF THE EURO AND ITS EFFECT ON INFLATION IN LITHUANIA 14 September 2014 Table of Contents 1. Introduction ................................................................................................................................................... 3 2. Lithuania and the euro .................................................................................................................................. 5 2.1. Lithuania and Maastricht criteria ......................................................................................................... 5 2.2. Local attitude towards the adoption of euro ..................................................................................... 10 3. Literature overview ..................................................................................................................................... 17 3.1. Reasons why prices tend to increase during the currency changeover period .................................. 17 3.2. Existing empirical evidence ................................................................................................................ 21 4. Estimation of possible effect of currency changeover on inflation and prices in Lithuania .................... 23 4.1. The model .......................................................................................................................................... 23 4.2. The data ............................................................................................................................................. 25 4.3. The results .......................................................................................................................................... 28 5. Conclusions ................................................................................................................................................. 33 6. References ................................................................................................................................................... 35 7. Appendix ..................................................................................................................................................... 38 2 1. Introduction Lithuania is one of the European Union countries since 2004, so it is obliged to enter the Eurozone as soon as it fulfils the Maastricht criteria. The aim to enter the Eurozone and adopt the Euro was very strong until the global financial crisis hit in 2008. Lithuania initially set the target to adopt the Euro from 2007; however, the inflation was slightly higher than the allowed maximum. The year 2010 was set as another target year, but inflation, again, was too high. The most recent announcement of the Prime Minister of Lithuania set the year 2015 as a new target year and on 4th of June 2014 European Commission announced that Lithuania is ready to adopt the euro. The final decision will be made by the EU government in the second half of July 2014, but Lithuania is already preparing for the new currency. Now it looks reasonable and realistic as inflation is going down and other Maastricht criteria are not violated. When entering the European Union every member state is obliged to set a monetary guideline, i.e. a country should target the inflation or the exchange rate. Lithuania chose to adopt the European Exchange Rate Mechanism (ERM) in 2002 and pegged the national currency litas (LTL) to the euro at a fixed exchange rate (3,4528 LTL for one euro). The ERM is an exchange rate system in which the national currency is linked to the Euro and can be exchanged to the later on demand. To ensure this, the Central Bank (CB) must keep the euro/gold reserves to cover at least 100% of local currency in circulation. Moreover, the ERM limits the ability of the CB to regulate the interest rate and act as a lender of last resort for commercial banks. By now only two countries in the EU, Lithuania and Denmark, are following the ERM, but in the last decades Greece, Slovenia, Cyprus, Malta, Latvia, Estonia and Slovakia were part of ERM system as well1. As debates on entering the Eurozone are rising among political parties and society in Lithuania, this thesis will develop the following topic further. Some consider this step as a step towards closer economic and political integration, while others argue that 2015 is not a good year for the Euro adoption in Lithuania, as the economy is still weak and adopting a new currency can prolong the crisis. Moreover, the new currency is likely to boost the prices and this, in turn, will worsen Lithuania’s competitive position. Based on that, this thesis will analyse the effect of the adoption of the Euro in Lithuania on the country’s economy, more precisely - its effect on prices and inflation. The question of the new currency adoption in other EU countries was analysed by many authors2, and in all cases a significant positive relationship between the Euro adoption and the inflation growth was found. Due to the reason that other Eurozone countries experienced a price increase during the period of the Euro adoption, this topic is very relevant for Lithuania, since it is 1 Later all these countries entered the Eurozone. 2 For example see Lauri (2007), Folkertsma al al. (2002), Santos et al. (2002), Deutsche Bundesbank (2004), Ercolani and Dutta (2006), Eurostat. 3 entering the Eurozone in 2015. Furthermore, no other research on the currency changeover effect on prices for Lithuania has been done by other authors. The research question being developed in this master thesis is: what is the possible effect on inflation during the euro-changeover period in Lithuania? The methodology covers descriptive and graphical data analysis, literature study and regression analysis. Chapter 2 describes the progress made by Lithuania in fulfilling the Maastricht criteria and the local attitude towards the euro adoption. This chapter sets an important background necessary to fully understand the extent to which Lithuania is ready for the new currency and the main problems it can face after entering the Euro area. Chapter 3 covers relevant literature review. It answers the question of why prices tend to go up after the currency changeover and what studies were conducted on this topic for other countries. Finally, chapter 4 focuses on the model that was used to estimate the possible additional euro-related effect on inflation in Lithuania. It also describes the data used in the analysis and the estimated results. Some authors (e.g. see Karam at al., 2008) developed a model for the inflation targeting countries, but due to the reason that Lithuania is an ERM system country, this analysis would be difficult to adopt for the exchange-rate targeting. Therefore, in this master thesis the analysis conducted by Hüfner and Koske (2008) will be replicated to some extent. The authors developed an empirical model for Slovakia, which was an ERM country as well. Hüfner and Koske (2008) used data of twelve first-wave Euro area countries, which switched to the Euro on 1 January 2002, for the time period from July 1997 to July 2007. The authors disaggregated data in COICOP (Classification of Individual Consumption by Purpose) level 2, calculated the currency changeover effect on prices using the generalized least squares approach and, based on this, made the conclusions about the possible effect on the prices in the Slovak Republic. In the analysis for Lithuania, the time period was extended until July 2013 and all seventeen countries3, that entered the Eurozone during this period, were included. Moreover, data disaggregated in COICOP level 3 was used to obtain more observations and more accurate results. It was calculated that the euro related additional effect on Harmonised Index of Consumer Prices in Lithuania should be no higher that 0,34%4. 3 In the period from July 1997 until July 2013 seventeen EU countries adopted the Euro. Twelve first-wave Euro area countries were Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, Spain. In the time period from July 2002 to July 2013 five more countries entered the Eurozone: Cyprus, Estonia, Malta, Slovakia, Slovenia. 4 This is estimated effect for the time period starting from July 2014 and until July 2015. 4 2. Lithuania and the euro Consequences of the euro adoption are generally more positive than negative. However, the degree of the euro effect on the country’s economy depends on the economic situation of a particular country. Thus, it is important to understand the readiness of Lithuania to enter the Eurozone and evaluate the possible benefits and costs of this step. Chapter 2 provides more information about the current economic situation in Lithuania, expectations of the population and policymakers. Chapter 2.1 provides evidence that Lithuania’s economy complies with the Maastricht criteria and is ready for the new currency. This chapter is based on the European Commission’s Convergence report 2014. Chapter 2.2 describes how politicians see Lithuania’s future with the euro and what is the public opinion regarding the new currency; moreover, this chapter presents the Bank of Lithuania’s evaluation of the possible euro-related consequences for Lithuania’s economy. 2.1. Lithuania and the Maastricht criteria Lithuania entered the European Union in 2004. Since then
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