14 September 2014
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) aalina.n@gmail.com Supervisor: Boe Thio
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 it is obliged to fulfil the Maastricht criteria and enter the Eurozone. The Maastricht Treaty (1992) mentions five main fiscal and monetary policy variables to be fulfilled in order to adopt the Euro:
1. Member States should avoid excessive government deficits: the budget deficit should not be higher than 3% of the national income.
2. Government debt should not exceed 60% of the national income.
3. Prices should be stable: inflation (Harmonised Index of Consumer Prices) should not be more than 1,5% higher than the unweighted arithmetic average inflation of three EU countries with the lowest inflation rates.
4. The exchange rate should be stable, i.e. do not fluctuate more than 15% from an unchanged central rate.
5. Interest rates on the 10-year government bonds should be no more than 2% higher than the unweighted arithmetic average of the similar bond yields in three EU countries with the lowest HICP inflation.
A country is considered a potential candidate to enter the Euro area if all the Maastricht criteria are not violated or if some of the economic variables are approaching the allowed threshold and reached a level that comes close to the reference value. In case of Lithuania, it is important to understand which of the criteria were the main barriers to enter the Eurozone earlier. This section discusses the progress made by Lithuania in fulfilling the Maastricht criteria and the economic variables which were the main obstacles to adopt the euro in previous years.
1. Budget deficit
The deficit of the general government in Lithuania was severely affected by the economic crisis that hit Europe. In 2007 the deficit was at the level of 1% of GDP, but by 2009 it rose to 9,4% of GDP. According to the European Commission’s Convergence Report 2014, consolidation measures adopted during the crisis period reduced the budget deficit to 5,5% of GDP in 2011. The consolidation measures were mostly related to the expenditure side of the national budget. They included cuts in public sector wages and a wage freeze, temporary cuts in pensions and cuts of selected social benefits. On the revenue side, the standard VAT was increased from 18% to 21% (European Commission, 2014). In 2012 the Lithuania’s general government deficit reached 3,2%, thus, it got closer to the 3% maximum allowed by the Maastricht Treaty. The main reason for that was better tax administration, an expenditure restraint and a solid economic growth. In 2013 the budget deficit decreased to 2,2%, which is a way below the allowed maximum5. Figure 1 represents the dynamics of the Lithuania’s general government deficit since Lithuania entered the European Union in 2004:
Figure 1: Lithuania’s general government deficit (% of GDP). Source: made by the author using the data from the Eurostat database.
In the year 2014 further expenditure restraints are being implemented, mainly through partial wage freeze in the public sector. On the revenue side, excise duties on tobacco and alcohol are increasing. Moreover, the Lithuanian government is putting more efforts to tax collection,
5 According to the Maastricht treaty the allowed budget deficit maximum is 3% of GDP. In the year 2013 the Euro
area‘s average budget deficit was 3% of Eurozone‘s GDP, and the European Union‘s average government deficit was 3,3% of union‘s GDP. -9,4 -7,2 -5,5 -3,2 -2,2 -10,0 -9,0 -8,0 -7,0 -6,0 -5,0 -4,0 -3,0 -2,0 -1,0 0,0 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 G en er al g ov er nm en t d ef ic it ( % o f G DP ). 6
especially VAT (European Commission, 2014). According to the European Commission, these measures should lower the general government deficit to 2,1% of GDP in 2014 and to 1,6% of GDP in 2015. The Lithuanian government predicts slightly more optimistic results6 with 0,1% of GDP surplus in 2016.
2. Government debt
The Lithuanian government debt-to-GDP ratio still remains well below the allowed 60% maximum and even more below the Euro area average (see Figure 2), however it has been increasing substantially since 2008. The government consolidated gross debt started to grow in the year 2008 due to high government deficit and high interest on new debt incurred during the crisis (European Commission, 2014). In 2012 the debt-to-GDP ratio reached its maximum at 40,5% even though the Lithuanian government was able to reduce it to 39,4% in 2013.
Figure 2: Government consolidated gross debt (% of GDP). Source: made by the author using the data from the Eurostat database.
The main reason for this decline was not a decrease in the gross debt, but higher GDP growth. Figure 3 shows that the government debt in Lithuania actually increased from 13333,1 million euro in 2012 to 13644,5 million in 2013. This gives 2,33% of annual increase. High interest rates on previous lending were the main reason for the debt increment. The real GDP growth in 2013 was 3,3%, thus, real GDP rose more than the government debt. This led to a decrease of debt-to GDP ratio in 2013.
6 In the Lithuanian Convergence report 2014 the general government deficit is foreseen to decrease to 1,9% of GDP in
2014 and to 0,9% of GDP in 2015. 19,3 18,3 17,9 16,8 15,5 29,3 37,8 38,3 40,5 39,4 92,6 0,0 10,0 20,0 30,0 40,0 50,0 60,0 70,0 80,0 90,0 100,0 De bt -t o-G DP ra tio (%) Lithuania
Euro area (18 countries)
7
Figure 3: Government consolidated gross debt in Lithuania (mln. euro). Source: made by the author using the data from the Eurostat database.
3. HICP inflation
Before the year 2014 inflation was the main obstacle for Lithuania on the way of entering the Euro area. In early 2012, the 12-month average inflation rate in Lithuania was above the reference value. However, since then, average inflation was moving downwards and reached 0,6% in April 2014. The corresponding reference value was 1,7%, i.e. average HICP inflation in Lithuania was 1,1% below the allowed maximum. The European Commission’s projection of the 12-month average inflation in Lithuania predicts it will remain below the reference value in the upcoming months (see the blue dot in Figure 4). Figure 4 represents the progress made by Lithuania in fulfilling the inflation criterion.
Figure 4: Comparison of the 12-month moving average HICP inflation in Lithuania and the reference HICP value (%). Source: European Commission Convergence Report, 2014. Note: The dot in December 2014 show the
projected reference value and 12-month average inflation in the country
13.333,1 13.644,5 0,0 2.000,0 4.000,0 6.000,0 8.000,0 10.000,0 12.000,0 14.000,0 16.000,0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 G ov ern me nt c on so lid at ed g ro ss d eb t (ml n. e uro ). 8
4. Exchange rate
Lithuania is participating in the European Exchange Rate Mechanism system since 2002. Since then, Lithuanian national currency litas has been pegged to the euro at the fixed rate of 3,4528 LTL/EUR and there has been no deviation from the central rate. This condition ensures that the Maastricht criterion regarding the exchange rate fluctuation is not violated.
5. Interest rates
Secondary market yield on a single benchmark government bond with the average maturity of around 9 months is used for the convergence comparison of the long-term interest rate in Lithuania.
The 12-month moving average of the long-term interest rate in Lithuania reached its peak at about 14% at the end of 2009. It declined in early 2011 and since then remained rather stable and below the reference value (see Figure 5). In April 2014 the long-term interest rate reference value was 6,2%. At the same time, the long-term interest rate of the Lithuanian benchmark bond, which is used for the assessment, was 3,6%, thus, the long-term interest rate in Lithuania was 2.6% below the reference value (European commission, 2014).
Figure 5: 12-month moving average of long-term interest rate in Lithuania versus the reference long-term interest rate value (%).Source: European Commission Convergence Report, 2014
Despite five major quantitative Maastricht criteria, there are some additional conditions in order to enter the Eurozone. One of those additional conditions is a legal framework which ensures the central bank’s independence, describes monetary and fiscal policy in a country-candidate and does not contradict with the Treaty on the Functioning of the European Union (TFEU). According
to European Commission’s Convergence Report 2014, the Lithuanian Law and the Lithuanian Constitution are fully compatible with the European Union’s legislation.
Among additional conditions there is also competitiveness, described by the development of the balance of payments; labour, product and financial markets integration in the European Union. While imports of Lithuania are still much higher than exports and competitiveness is pretty low, Lithuania has achieved significant progress in market liberalization and trade integration within the Single Market. As it is mentioned in the Convergence Report (2014): “The Lithuanian economy is well integrated into the euro area through trade and investment linkage”, moreover, the trade openness of Lithuania is substantially above the Eurozone average and amounted to 84% in 2012 (European commission, 2014).
Despite the fact that Lithuania will be not violating the Maastricht criteria by the time of entering the Eurozone, some of the criteria may be violated in the short- and medium-term after the adoption of the Euro. It is difficult to predict the reference values of the Maastricht criteria and evaluate Lithuania’s position with respect to them in the future, but inflation is likely to increase at least in the first quarter of 2015. This tendency was noticed in other Euro area countries in the period just after the Euro changeover (e.g. see Folkertsma et al., 2002; Santos et al., 2002; Deutsche Bundesbank, 2002; Deutsche Bundesbank, 2004; Mastrobuoni, 2004; Ercolani and Dutta, 2006; European commission, 2007; European commission, 2008; Eurostat, 2009; Eurostat, 2011). The absence of national monetary policy power can force the local government to use procyclical fiscal policy if economy will be struggling. This will lead to increase of the governmental spending, which, in turn, will increase government’s deficit and public debt.
The International Monetary Fund (2014) recommends to use not procyclical but rather countercyclical fiscal policy in Lithuania. This will help to built fiscal buffers during the good times and use them to cover the deficit in the time of an economic downturn. Moreover, the IMF suggests establishing macro-prudential powers to mitigate the risk of the financial system in Lithuania and restructure the public and private debt.
2.2. Local attitude towards the adoption of euro
The opinion of different groups and institutions is important once one wants to understand the extent to which the local government, households and businesses are ready for a new currency. Moreover, this discussion can put some light on the problems which can already be noticed or can arise in the future due to entering the common currency area.
This chapter focuses on the attitude towards the introduction of the euro in Lithuania. The opinions vary: some politicians are in favour of this step, while others do not support this decision. The Bank of Lithuania estimated that benefits from the euro adoption will be long lasting and
exceed the costs invested in this step, however, the Lithuanian economy can face some difficulties without being able to use national monetary policy tools. Moreover, the population is concerned about increase in prices as it can force them to lower consumption while wages remain unchanged. The opinion of different social groups and institutions in Lithuania is discussed further in more details.
Political attitude towards the euro
In May 2014 Lithuania faced the presidential elections, thus, many candidates and other politicians had an opportunity to express their opinion about the adoption of the euro in 2015. The political opinion is diversified, but the majority of members in the Seimas of the Republic of Lithuania (Lithuanian parliament) were voting in favour of the euro adoption.
Prime Minister of Lithuania Algirdas Butkevičius supports Lithuania’s accession to the Eurozone. Moreover, the independent candidate and the current president of Lithuania, Dalia Grybauskaitė, expressed her opinion that adoption of the euro is very beneficial to the country’s economy. The currency changeover will motivate trade with other euro area countries. It is also a stimulus for investments and for an increase in exports. Dalia Grybauskaite believes that euro is very beneficial for the population as well. Businesses and consumers will get access to lower interest rates and they will be able to save on currency exchange. All together, the benefits of the euro adoption will put Lithuania’s economy on a more stable path and will increase the competitiveness of the country.
However, another candidate Valdemaras Tomaševskis7 is afraid of the crisis in the Eurozone, which especially severely hit the southern European countries. He mentioned that 2015 is not the best time for Lithuania to adopt the euro and support weak Eurozone member states. He also mentioned that ten other European Union countries have not yet adopted the euro; moreover, countries like the United Kingdom, Denmark and Sweden do not enter the Eurozone deliberately.
Some politicians in Lithuania supported the idea of a public referendum to get the opinion of the citizens on the question of the euro adoption. However, this idea was not implemented, as the organisation of the referendum is a very costly procedure and the results are only of recommendable character. Moreover, Lithuania is obliged to adopt the euro since it ratified the Treaty of Accession to the European Union, so referendum has no power in this case. Prime Minister A. Butkevičius speaks against the referendum, while other politicians, such as leader of the Labour Party V. Uspaskichas and President D. Grybauskaitė, are still interested in it, as this is a good way to inform the public about all administrative changes before and after the adoption of the euro.
7 Valdemaras Tomaševskis is the leader of the political party „Electoral Action of Poles in Lithuania“ and a current
Member of the European Parliament
11
The Ministry of Finance, along with Minister of Finance Rimantas Šadžius, has an official opinion that entering the Eurozone will bring more positive than negative outcomes to the country. Not entering the Euro area can make Lithuania less attractive for foreign investments, as Lithuania’s closest neighbours, Estonia and Latvia, have already adopted the euro, and investors prefer these countries, because they can face fewer barriers due to the common currency. Avoiding the euro adoption can also lead to lower export growth rates, and, together with lower investments, this can increase unemployment. Moreover, being outside the Eurozone potentially means having lower international rating, as country’s risk is higher. This leads to higher borrowing interest rates and increases country’s debt. Higher debt can lead to some social restrictions and cuts of wages, pensions and other social benefits. All in all, Lithuania can lose its competitiveness and international confidence.
In spite the fact, that only less than half of the population in Lithuania is in favour of a new currency (Eurobarometer, 2014), the Ministry of Finance believes that the main fear of the population is the growing prices, so the best way to ensure people that prices will not raise due to the adoption of the euro, is strict price monitoring and fines for those companies that wrongly converted prices to the euro.
Bank of Lithuania and IMF evaluation of the possible costs and benefits after the euro changeover
In 2013 the Central Bank of the Republic of Lithuania, or the Bank of Lithuania (hereinafter LCB), made a cost-benefit analysis of the possible consequences of the euro adoption for Lithuania’s economy and concluded that the positive effect from the euro adoption will be long-lasting and will exceed the short-term expenditures and additional financial contributions.
The medium-term benefits for Lithuania are related to the decline in currency exchange and credit risks, as Lithuania is believed to become a more stable country due to the adoption of the euro and its international credit rating can increase. The LCB’s analysis was made in 2013, but some changes can be already noticed: in August 2014 Standard & Poor’s rating for Lithuania increased from BBB to A-, however, Fitch rating remained the same. Moreover, households and businesses will be able to save on currency exchange expenditures.
Another advantage of the euro adoption is a decline in interest rates. This can happen both due to the fact that interest rates for transactions in litas will be changed to lower interest rates for transactions in euro, and that interest rates for transactions in euro can also decrease. But the main gain from the adoption of the euro is related to the medium-term increase in exports. This will bring sufficient revenues which will exceed the short-term cost of the euro adoption.
The LCB also estimated that Lithuania could have saved the amount of 0,59 - 0,79 percent of GDP had it adopted the euro in year 2007. Moreover, by adding the amount that Lithuania could have saved on the interest rates, this number can almost be doubled. Considering that the possible increase in prices is the main concern of the Lithuanian population, the LCB estimated that prices can rise by additional 0,2 – 0,3 percent in the first months of 2015 due to the currency change-over. These estimations are based on the results obtained while analysing the situation after the euro adoption in Estonia and other Eurozone countries since 20078.
According to the IMF Country Report (2014) entering the Eurozone will boost economic integration, foster trade and foreign direct investments, and strengthen policy frameworks in Lithuania. Moreover, local commercial banks will get access to European Central Bank’s liquidity; this will put downwards risk premiums and contribute to increase of financial stability. However, to achieve this, the Lithuanian government should concentrate more on countercyclical fiscal policy, raise the quality of public spending, develop better tax administration, encourage productive
investments and execute structural reforms. This, in turn, will help to raise economic efficiency and deal with asymmetric economic shocks inside the currency union. Moreover, the Bank of Lithuania should establish macro-prudential powers which will be also beneficial as common monetary policy tools cannot always address local issues properly (IMF, 2014).
Public opinion about the euro
The public opinion about the consequences of the euro adoption at the national level is diverse. 47% of the population think that the after-effect will be negative; however, 41% believe that euro can bring more positive outcomes to Lithuania’s economy. It follows hence, that most Lithuanians are rather against (48%) than in favour of (46%) the introduction of the euro. This can be related to the main fear of the population: 75% of locals think that the introduction of the euro will increase prices. Moreover, 70% of Lithuanians think that the currency changeover period will be used by companies and other institutions to abuse and cheat on prices (Eurobarometer, 2014).
In Lithuania people are also afraid that the new currency can cause some personal inconvenience and the euro adoption will mean that Lithuania will lose most of its national identity and it will lose control over its economic policy. On the other hand, most of the Eurobarometer survey’s (2014) respondents think that introduction of the euro will make them feel more European. That is more, it will become more convenient to travel and shop in other Euro area countries.
In Lithuania the majority of the citizens (65%) think that a country can choose whether or not to adopt the euro (Eurobarometer, 2014). This points to the fact, that the population is not well informed about European Union and Eurozone policy. However 50% of the local citizens think that
8 The analysis was conducted by the Eurostat
13
they are quite well or very well informed regarding the euro. According to the Eurobarometer survey (2014) 48% of Lithuanians would trust the information on the changeover of the euro provided by the local Central Bank and 42% would trust European institutions. People in Lithuania think that dual display of prices in shops during the currency changeover period is most essential. Also dual display of the commodity prices and TV advertising is very important.
Statistics Lithuania provides some data on consumer expectations and prediction regarding prices. Figure 6 summarises consumers’ opinion on changes in prices:
Figure 6: Consumer opinion: forecast of changes in prices in Lithuania for upcoming 12 months (% of respondents). Source: Made by the author using Statistics Lithuania database
One can notice that since December 2013, when first thoughts about introduction of the euro in Lithuania appeared, more consumers have been expecting rapid increase in prices in the following 12-months period. In May 2014 even 42 percent of respondents thought that increase in prices would be higher next year. This can be explained by the fact, that Lithuania is going to adopt the euro from January 2015 and local citizens relate this event with higher inflation.
Public information and consumer protection
The National Changeover Plan (2013) is the main document on practical preparation for the euro introduction, and the main institutions responsible for the adoption of the euro are the Government of the Republic of Lithuania and the Bank of Lithuania. The aim of the Plan is “to envisage the key principles, scenario, time periods for the changeover from the litas to the euro” and “to ensure the protection of consumer interests, a smooth changeover and public information” (National Changeover Plan, 2013). To ensure this, the Bank of Lithuania together with the Seimas
26 42 43 35 21 13 0 5 10 15 20 25 30 35 40 45 50 % o f re sp on de nt s
Faster price increase Same price increase Slower price increase Prices remain the same Prices decrease
prepared and issued a law on the Adoption of the Euro which indicates conversion of litas into euro, cash changeover and withdrawal of litas from circulation, dual display of prices, fines in case of the violations, etc.
According to the Plan, all pensions, wages and social benefits will be rounded to the last euro cent and the final price of goods is advised to be rounded down to the benefit of the customer. Moreover, in order to avoid unreasonable increase in prices and consumer rights violations after the introduction of the euro, Statistics Lithuania will monitor retail price changes in litas and euro and will inform the public about them. The State Consumer Rights Protection Authority will investigate complaints of customers and detect the cases of violation of consumer rights. The Bank of Lithuania will also act actively in the detection of the violations of consumer rights in financial markets. Economic entities, which unjustifiably raise prices or abuse the euro adoption, will be fined and included in the publicly available blacklist.
To ensure consumer protection and inform population about the new prices, the period of mandatory dual display of prices is introduced. To prepare the public for the euro changeover, a special toll-free hot call line began functioning. By calling this line citizens can get all information regarding the preparation and the procedure about the currency changeover. Moreover, a big information campaign is being held. It involves public authorities, mass media and other information channels and provides information about mandatory dual display in prices, conversion of litas into euro and other legal matters.
However, in spite of the fact that the legal basis for the euro adoption has been prepared, prices in Lithuania started to rise in March and April of 2014 (see Figure 7). In the beginning of 2014 it was not clear yet whether or not Lithuania adopt euro in 2015, but all talks and preparation gave a stimulus for retails to increase prices while no sanctions against them could be implemented. On 17 April 2014 the law on the euro adoption in Lithuania was issued. It prohibited raising prices without reasonable grounds and in June 2014 no increase in prices was noticed.
Figure 7: Monthly rate of change of Lithuania’s HICP. Source: made by the author using Eurostat database
The National Changeover Plan also has some “holes”. First of all, it is only advisory, and not mandatory to round retail prices down to the benefit of the consumer. Secondly, all levies and fines in euro “may be established by public authorities under their own legal acts”, but the
digression from ones in litas should minimal. Higher levies and fines can increase uncertainty and change retailers’ expectations, which may lead to increase in prices.
All in all, most politicians support Lithuania’s accession to the Eurozone. The Ministry of Finance and the Bank of Lithuania believe that this step will bring more benefits than drawbacks to the country’s economy. However, local citizens do not trust businesses and are afraid that retailers can abuse on prices. In order to solve the distrust of the public problem, the big information
campaign started. Moreover, governmental institutions prepared the legal basis to protect consumer rights. 0,4 0,3 -0,3 -0,2 -0,1 0,0 0,1 0,2 0,3 0,4 0,5 16
3. Literature overview
As wages in Lithuania count among lowest in the European Union, local citizens are very concerned about the increase in prices. High inflation after the euro adoption can lower the consumption by Lithuanians and worsen the quality of life. This is the main fear of the Lithuanian population, especially because many studies (Folkertsma et al., 2002; Santos et al., 2002; Deutsche Bundesbank, 2002; Deutsche Bundesbank, 2004; Mastrobuoni, 2004; Ercolani and Dutta, 2006; European commission, 2007; European commission, 2008; Eurostat, 2009; Eurostat, 2011) agree that adoption of the euro did lead to some increase in prices in other Euro area countries. A small rise in prices is usually noticed just after the currency changeover, however not all economic sectors are affected to the same extent. Therefore, it is important to understand why prices increase after the adoption of the new currency and which sectors are the most sensitive to this price change. Chapter 3.1. discusses reasons why prices tend to increase after the adoption of a new currency and distinguishes between short-, medium-, and long-term explanations for euro-related effects on prices.
Politicians and governmental institutions in Lithuania try to manage people’s expectations regarding the prices in the beginning of 2015. Prices have already been taken under legal control, but despite this, euro-related price increase is likely to be noticed. This conclusion is based on the analyses conducted for other Euro area countries, which are discussed in more details in chapter 3.2.
3.1. Reasons why prices tend to increase during the currency changeover period
There are a lot of explanations, why prices go up during the currency changeover period. Since prices in the old currency are converted to the new currency using the fixed exchange rate, this should have no effect on the price level. However, consumers and producers tend to associate a new currency with higher prices. Figure 8 summarises the reasons why prices tend to increase:
Figure 8: Possible reasons for the price increase during the currency changeover period. Source: Made by the author
The most noticeable price increase appears to happen immediately after the adoption of the new currency. This is also called the “immediate price level effect” (Hüfner and Koske, 2008). The most common explanations for this short-run price increase include menu costs which are related to the administrative costs of price changes from the local currency to the Euro within a firm (retail sector needs to convert prices, change labels, catalogues, etc.) (Lauri, 2007; Hüfner and Koske, 2008), and the “attractive price” argument which comes out of marketing decisions, as retailers tend to round prices to a more attractive level. Although the rounding effect should in theory be symmetric, retailers tend to round prices upwards (Lauri, 2007; Hüfner and Koske, 2008).
However, some other sort-term explanations of a price increase after the adoption of a common currency exist as well. For example, the theory of money illusion, proposed by Diamond et al. in 1997. The theory emphasizes the evaluation of nominal and real value of money by consumers. Due to currency changeover a consumer may choose more expensive goods just because the nominal price became smaller as a result of the smaller denomination of the older currency. So, with real income unchanged, a consumer tends to buy slightly more expensive goods and services, as their nominal numerical value is lower than it was. By doing so, we can notice the negative substitution effect, which can boost the consumer price index (Lauri, 2007). For example, in the Netherlands after the currency changeover in January 2002 sales in the supermarkets
Inflation
Price transparency and market structure Theory of money illusion Cyclical economic changes Rational inattention Balassa-Samuelson hypothesis Menu costs Attractive prices Prospect theory 18increased by around 10%. Consumers may have failed to evaluate the new prices in euro, because their nominal numerical value became smaller than it was. However, this effect was not observed in the non-food sector, where goods are more expensive. Higher expenses force consumers to evaluate new prices more accurately and they are more cautious about the changes (Folkertsma et al., 2002).
After the introduction of a new currency, a consumer needs to process the information of the new prices, i.e. mentally convert the new price to the old one and compare them. Since it creates some costs (e.g. it is time-consuming), a consumer processes the information only if benefits are large enough. Thus, a consumer tends not to notice price difference of the low-price goods, since benefits of noticing the difference are lower than the costs invested to notice this difference. This is called rational inattention (Lauri, 2007). Sellers can take this situation as an opportunity to increase price for low-price frequently-purchased items. As frequently-purchased items are likely to be included in HICP this will boost inflation (Lauri, 2007).
The Prospect theory (Kahneman and Tversky, 1979) is the fifth explanation of the price increase. It can be assigned to short- and medium-term effect on prices. This theory was mentioned by Lauri (2007) while discussing the possible effect on prices in Malta after the introduction of the Euro. The Prospect theory describes the way people make choices and evaluate losses and gains in an environment under certain risk. People tend to memorise losses better than gains of the same magnitude, moreover, people memorize prices of the frequently-purchased items faster, as they face them more often. It is called the “learning process”. For example, food, beverages and catering services are considered to be low-priced items with a high purchase frequency. Given the relatively low prices of such consumer items, only small weights are assigned to these goods in the HICP weightings, whereas, given their frequency of purchase, increase in prices of these items is more easily memorised. People’s memory is important in formation of the perceived price development, thus, price increase of low-priced frequently-purchased goods will have higher effect on perceived inflation than on HICP. Based on this, people tend to over-estimate the increase in prices and real inflation. Prospect theory tries to explain what people choose in real life, rather than their optimal decisions, so it is important to distinguish between consumer price indices and perceived inflation. Moreover, this theory focuses more on what people notice and memorize in real life. It tries to describe that people’s feelings about the increase in prices can be misleading and this is not actually reflected in the HICP to the same extent.
Price transparency and market structure can also affect prices in the medium-run (Lauri, 2007; Hüfner and Koske, 2008). It was observed that consumers might face difficulties in evaluating prices expressed in euro. This fact decreases price transparency and increases uncertainty, which, in turn, can lead to lower competition in the market. As economic theory suggests, the higher the competition in the market is the lower the prices are, because it is more
difficult to compete and producers tend to attract more customers by lowering the price, so when the competition is low sellers tend to set higher prices. For example, Dziuda and Mastrobuoni (2008) analyse the relation between imperfect information and price increase. They found that in countries with lower price transparency prices for cheaper goods increase after the currency changeover. However, Hüfner and Koske (2008) argue that the level of competition in the non-Eurozone countries is higher, and this, in turn, can help to contain price increase.
Cyclical economic changes can also affect the price level in the medium- and long-term. The latter refers to higher inflation during economic downturn, thus, when a currency changeover coincides with negative economic development, it can lead to higher prices.
The Balassa-Samuelson hypothesis (Balassa, 1964; Samuelson, 1964) can describe a long-run price increase after entering the Eurozone. The hypothesis describes the differences in price levels and inflation rates between emerging and advanced economies. In its dynamic form it states that productivity in the tradable sector grows faster than in the non-tradable sector. Wages in the tradable sector should go up and this effect will spill over to the non-tradable sector, thereby raising prices of non-tradable goods. According to Hüfner and Koske (2008), if the productivity differential between tradable and non-tradable sectors in a growing economy is higher than the one of the Euro area, prices in emerging growing economies should rise faster than in the Euro area. Caporale, Ciferri and Girardi (2008) using the generalized purchasing power parity approach estimated that the hypothesis holds for all Baltic economies. Moreover, Égert (2003) conducted an analysis for Estonia and estimated that a potential long-run impact on prices in Estonia is 1%-2% due to the Balassa-Samuelson effect. As Lithuania is one of the Baltic States, the latter provides the evidence that the Balassa-Samuelson effect is relevant for the Republic of Lithuania and is directly related to possibly higher inflation. According to the IMF (2014) the long-run Balassa-Samuelson additional effect on inflation in Lithuania is 1,1 percentage points annually and 73% of the observed inflation differential with the Euro area inflation can be explained by the Balassa-Samuelson hypothesis. Euro adoption in 2015 in Lithuania will be the stimulus for further Lithuania’s integration with the European Single Market. This should lead to the increase in trade with other Euro area countries, which, in turn, will boost prices in the tradable sector. As Lithuania is subject to the Balassa Samuelson hypothesis, productivity differential between tradable and non-tradable sectors in Lithuania is high and differs a lot from the one of the Euro area countries. Thus, entering the Eurozone can result in the higher inflation in the long-run due to the Balassa-Samuelson effect in Lithuania.
3.2. Existing empirical evidence
Some other studies were conducted based on the factual information on changes in prices after the adoption of the euro. Most of the studies are consistent in the evaluation of the euro-related immediate additional effect on prices, and this additional price increase in most of the cases is limited by 0,3 percent. Table 1 summarizes the results of the other researches:
Table 1: The euro-changeover additional impact on inflation.
Study Country of interest
Year of the adoption of the euro Sample period Estimated additional impact on prices (%) Folkertsma et al.
(2002) Netherlands Jan 2002 Jan 2002
0,5 – 0,9 for retail prices and 0,2 – 0,4 for Dutch CPI Santos et al. (2002) Portugal Jan 2002 Jan 2002 – Mar
2002 0,24
Deutsche
Bundesbank (2002) Germany Jan 2002 Jan 2002 At most 0,2
Deutsche
Bundesbank (2004) Germany Jan 2002 Jan 2001 – Jan 2002 At most 0,3 Mastrobuoni (2004) Euro area members Jan 2002 1990 - 2003 0,17 – 0,299
Ercolani and Dutta
(2006) Euro area members Jan 2003
Dec 2001 – Jan
2002 -0,1 – 0,8
10
European
commission (2007) Slovenia Jan 2007
Dec 2006 – Feb
2007 At most 0,3 European
commission (2008) Cyprus and Malta Jan 2008
Dec 2007 – Jan
2008 0,2 – 0,3
Eurostat (2009) Slovakia Jan 2009 Dec 2008 – Feb
2009 At most 0,3 Eurostat (2011) Estonia Jan 2011 Dec 2012 – Mar
2011 0,2 – 0,3
All the studies mentioned in Table 1 find that overall effect on changes in prices is positive and statistically significant. For example, Folkertsma, van Renselaar and Stokman (2002) conducted
9 The range refers to those Eurozone countries where the unadjusted currency changeover impact is statistically
different from zero at 10% significance level (Spain, France, Italy)
10 The range refers to those Eurozone countries where the unadjusted currency changeover impact is statistically
different from zero at 10% significance level (Belgium, Finland, Germany, Greece, Luxembourg, Netherlands, Portugal, Spain)
21
the survey and the analysis on price changes in the Netherlands after the adoption of the euro in January 2002. They concluded, that additional impact on the consumer price index is around 0,2 – 0,4 percent. Prices in the Netherland increased mostly due to the rounding to attractive prices and passing on the costs of the currency changeover to the consumer. Authors also concluded that the biggest increase in prices was in the catering sector and in small firms with less than 5 employees. Increase in these categories is higher because smaller shops and catering business face less competition.
Analysis conducted by Santos, Evagelista, Nascimento and Coimbra (2002) for Portugal also proves relatively small currency changeover effect on consumer prices. This small price increase is mostly related to the rounding effect and menu costs, which provide the “natural” opportunity for price changes. Moreover, a conclusion made by Deutsche Bundesbank (2002) is similar to one of Santos et al.: changeover to euro did not play a major role in price increase in Germany. In the monthly reports Deutsche Bundesbank states that, at most, a 0,3% contribution to the annual inflation rate for January 2002 can be explained by the introduction of the euro banknotes and coins. On the other hand, prices increased more in the service sector. This can mostly be explained by higher taxes on tobacco, alcohol and insurance.
To summarize, it is proved that adoption of the euro has a significant additional effect on inflation, but this effect is small and usually it is no higher than 0,3%. Most of the explanations of the increase in prices after the currency changeover are related to the immediate change in prices. Moreover, most reasons for price increase are connected to the psychological explanation of the mindset of the consumer. The theory of money illusion, the prospect theory, the rational inattention, the “attractive” pricing, etc. try to explain how consumers make decisions in the everyday life, their choices and attitude to prices.
4. Estimation of possible effect of currency changeover on inflation and prices in Lithuania
Lithuania’s consumers and businesses are really concerned about inflation after the introduction of the Euro on 1 January 2015. Those worries have reasonable evidence: other Euro area countries faced an increase in prices during the currency changeover period. In this chapter the analysis will be conducted in order to estimate the possible additional euro-related impact on inflation in Lithuania. Chapter 4.1. discusses the model specifications, while the data collection and data arrangement processes are explained further in chapter 4.2. and, finally, the results of the analysis are presented in chapter 4.3.
4.1. The model
The analyses mentioned in chapter 3.2. were conducted after the currency changeover and they were based on the available information on prices. However, some authors try to predict the possible price increase before the actual adoption of the euro. The article of Hüfner and Koske (2008) is used as background for the analysis conducted for Lithuania. Hüfner and Koske (2008) analysed the possible effect of the currency changeover on inflation and interest rates in the Slovak Republic. This article was published in July 2008, while Slovakia entered the Eurozone in 2009. The authors discussed the short-term and medium-term increase in prices; they reviewed empirical evidence on the price level effect of the currency changeover in existing Euro area member countries and estimated the possible effect in the Slovak Republic.
Hüfner and Koske (2008) used the data of Harmonised Index of Consumer Prices (HICP) disaggregated at COICOP level 2 in the period from July 1997 to July 2007 on the first twelve Euro area countries. They assumed that the currency changeover period lasts from July of the year just before the adoption of the Euro until July of the year of the currency changeover. This July-July focus allows to capture changes in the price setting behaviour which occurred due to the preparation for the adoption of the Euro and changes in the price setting behaviour which did not take place immediately (for example, legislation can require to hold prices stable at the period of the changeover, but later retailers can still adjust prices due to menu-costs or “attractive price” reasons).
The authors estimated the following system of equations:
𝜋𝜋𝑖𝑖𝑖𝑖𝑖𝑖 = 𝛼𝛼𝑖𝑖𝑖𝑖𝜋𝜋𝑖𝑖𝑖𝑖𝑖𝑖−1+ 𝛽𝛽𝑖𝑖𝑖𝑖𝜋𝜋𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖𝑖𝑖+ 𝛾𝛾𝑖𝑖𝑖𝑖𝐺𝐺𝐺𝐺𝐺𝐺𝑖𝑖𝑖𝑖+ 𝛿𝛿𝑖𝑖𝑖𝑖𝐷𝐷𝑖𝑖𝑖𝑖+𝜀𝜀𝑖𝑖𝑖𝑖𝑖𝑖 (1)
where i is a subscript for a country and j is a subscript for a sector, πijt is the change in the price index between July year t-1 and July year t, πNEURjt is the unweighted average of the respective variables in the United Kingdom, Sweden and Denmark, GAP is the average output gap of year t-1 and t , and D is a dummy variable equal to one if it is the year of the currency changeover in the country. The data on the United Kingdom, Sweden and Denmark is included to account for other
exogenous events (exogenous shocks to inflation) that might have triggered price increases (weather conditions, diseases, etc.). The system of equations (1) was estimated by Hüfner and Koske using the generalized least squares approach.
Using estimated coefficients on variable D for other Eurozone countries and employing the weights of the different sectors in the aggregated HICP, the average expected price increase for the Slovak Republic was calculated11. Authors concluded that while prices in some sectors can rise significantly, the impact on the aggregated HICP is relatively small, and that the currency changeover in Slovakia could increase inflation by additional 0,34%.
Following Hüfner and Koske (2008), in order to estimate the possible immediate effect on prices in Lithuania, sectors with the significant price increase for the Euro area countries should be identified, so the system of equations (1) will be processed in order to estimate the price increase due to the Euro adoption in other Eurozone countries and then the results will be applied to Lithuania. The analysis for Lithuania includes the same variables, but GAP refers not to the average output gap between year t-1 and t, but to the actual output GAP in year t. This should not change the results, but make them easier to apply and interpret. Moreover, the time period is extended to July 2013 and five more Eurozone countries are included (Cyprus, Malta, Slovakia, Slovenia and Estonia). The coefficients on the Euro adoption period categorical variable in Lithuania are assumed to be the same across countries (so that δij = δj for all i). This is necessary to estimate the
coefficients on an average changeover effect by sector.
The system of equations (1) is estimated using the generalized least squares (GLS) method. GLS corrects for the heteroskedasticity and autocorrelation between error terms. In the analysis described in this paper heteroskedasticity can arise due to the differences in variance of error terms between different countries and during different time periods. Autocorrelation is likely to arise due to the reason that most of the variables included in the equation are highly dependent on their own past and future values. As GLS model assigns weights for observations depending on the size of the variance of their errors and the magnitude of error correlation across time, the problem of heteroskedasticity and autocorrelation is solved. This gives more effective results as the true standard error of the GLS estimator is larger, because the model weights the observations in terms of the size of their variance, and in terms of whether their errors are correlated or not: the larger is the variance of an error of a particular observation or the larger is the correlation between error terms, the smaller is their contribution to the covariance of dependent and independent variables’ calculation. Thus, GLS modelling transforms heteroskedastic and autocorrelated errors to the homoskedastic and uncorrelated ones. Moreover, estimated GLS regression parameters are unbiased and consistent, like OLS estimators.
11 Authors assumed, that coefficient δ varies between sectors, but is the same for every country. 24
Panel data are used in the analysis. This gives more control over omitted variables as it is possible to include state and time fixed effects. The state fixed effect is included by creating a dummy variable for every specific country. This controls for the omitted variables that are specific for each country, but are constant over time (cultural, geographical, historical differences). By including time trend (a dummy variable for the year) in the analysis, time fixed effects are estimated. They control for the omitted variables that are common to all entities but vary over time (global economic situation, weather conditions in the region).
In order to get the full picture of the possible currency changeover effect on prices, four different approaches can be implemented:
1. GLS regression including time and state fixed effects 2. GLS regression including only time fixed effect 3. GLS regression including only country fixed effect 4. GLS regression with no fixed effects
All four approaches will be used in further calculations. This will allow to compare the results and notice the differences between them. The differences may arise because of the impact of time and state fixed effects which control for omitted country- and time-related variables. The outcomes of the approaches will be discussed in more details in chapter 4.3. and the arguments on the best approach will be provided. Thus, the most relevant and proper approach will be used for the results interpretation.
Finally, sectors with the significant price increase will be identified and the total expected inflation increase will be estimated using weights of the different sectors in the aggregated HICP of Lithuania. The total increase of HICP is expected to be small (up to 0,5 %), but the increase of prices of frequently-purchased goods and services is expected to be higher.
4.2. The data
The analysis conducted by Hüfner and Koske (2008) and discussed in the first part of chapter 4.1. can be easily applied to Lithuania, since Slovakia was also one of the ERM system countries12. In this section, the data used for the analysis are described in more details providing definitions and intuition why these particular variables should be included. Table 2 summarises the main variables used in the model:
12 The full analysis conducted by Hüfner and Koske is wider. First, they estimated the average effect on inflation for
every sector using the equation (1). In the second step of their analysis, authors estimated the additional effect of the currency changeover for every country separately, but this step will be not replicated in this thesis.
25
Table 2: Summary of the variables used in the analysis. Source: made by the author using the analysis of Hüfner and Koske (2008).
Variable Definition
πijt The change in the price index between July year t-1 and July year t in the country i sector j.
πijt−1 The lag of the price index
πNEURjt
The unweighted average of the respective variables in the United Kingdom, Sweden and
Denmark at year t sector j. GAPit The output gap of country i at year t.
Di A dummy variable equal to one if it is the year of the currency changeover in the country i.
The analysis for Lithuania will include first seventeen Eurozone countries. The annual change in prices between July year t-1 and July year t will be covered for the period from July 1997 to July 2013. The July-July focus is kept in order to catch the difference in the inflation due to the currency changeover. If year t is the year of introduction of the new currency in a country, the currency changeover period is assumed to start in July year t-1 and end at July year t. Thus, the analysis includes panel data of seventeen countries with seventeen years per each country
The data on harmonized indices of consumer prices (HICPs) of all current Eurozone countries except for Latvia are taken from the Eurostat database. Latvia is not included in the analysis because it entered the Eurozone only on 1 January 2014, so there is not enough data available up till now. Harmonized indices of consumer prices are designed for international comparisons of consumer price inflation and they are calculated on the base of the Laspeyres index, i.e. current prices are measured in the relation to those of the base year 2005.
The data needed for the analysis are disaggregated at COICOP level 313. This gives a more detailed picture and puts some light on prices of the narrower sectors of consumption, such as bread, meat, wine, tobacco, etc. Disaggregation at COICOP level 2 will combine bread, meat, fish and other food in one category “Food”; it will combine spirits, wine and beer in one category “Alcoholic beverages” and so on. So disaggregation at level 3 is more accurate, can provide more detailed results and give a larger data sample.
However, not all of the sectors are representative for evaluating changes in the inflation due to the currency changeover, so some modifications of the data set are needed. In some sectors governmental interventions are substantial. Because of the governmental price administration or ownership, health, transport services, postal services, electricity, gas and other fuels, and education categories are excluded from the analysis (Hüfner and Koske, 2008). Thus, the analysis covers 76 different categories (sectors) of goods and services per country (see Appendix 1).
13 COICOP level 1 includes groups, level 2 includes subgroups, level 3 includes categories. 26
The second modification for the data is made due to taxation, which may occur during the currency changeover period. Tax or excise increase or some changes in tax legislation also influence prices during adoption of the new currency period, so corresponding sector and country should be dropped from the sample. Table 3 shows a country (or countries) and a sector it was excluded for:
Table 3: Countries excluded from the analysis due to changes of the taxation in the particular sector. Source: Hüfner and Koske (2008), European Commission’s reports on the Taxation trends in the European Union
COICOP Excluded country(ies)
Bread and cereals Belgium
Spirits Spain, Estonia
Wine Spain, Estonia
Beer Spain, Estonia
Tobacco France, Germany, Spain, Estonia
Actual rentals for housing Netherlands
Cultural services Belgium
Books Slovakia
Accommodation services Cyprus
Insurance connected with the dwelling Germany
Insurance connected with health Germany
Insurance connected with transport Germany
Other insurance Germany
To control for the changes in the economy of each country, such as changes in labour or production costs, the output gap of each country is included. The output gap shows the difference between actual GDP and the efficient output, which can be achieved if recourses are allocated in their most efficient way. As suggested by the economy theory, a positive output gap can lead to inflation, so its inclusion is important since it captures changes other than the currency changeover that may influence prices.
The average inflation of the United Kingdom, Sweden and Denmark (πNEUR) is included to account for other exogenous events (exogenous shocks to inflation) that might have triggered price increases, such as weather conditions, diseases, world economic crises, etc. Figure 8 shows that variable πNEURjt mostly follow the same trend as the inflation in the European Union and inflation in the Eurozone. Including this variable in the analysis eliminates the common inflation trend which is interdependent on the world economic situation. This lets focus only on the differences which were encouraged only by internal Eurozone changes.
Figure 8: Annual rate of change of HICP. Source: made by the author using Eurostat database
4.3. The results
The analysis was conducted using strictly balanced panel data for all sectors in STATA14. Four different GLS method approaches15 were implemented to obtain the estimations. It was assumed, that the approach which includesboth state and time dummies should give more effective results as this controls for all country- and time-specific omitted variables. However, in equation (1) variable 𝜋𝜋𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖𝑖𝑖 has already been included and this variable should control for some external shocks which vary over time. On the other hand, correlation between time dummies and 𝜋𝜋𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖𝑖𝑖 is small, but it still exists for some sectors and years. Moreover, variable D, which is equal to one if the currency changeover took place, is collinear with the time dummies for particular countries and particular years. Although STATA drops all collinear variables, the risk of multicollinearity still exists. This, in turn, can lead to less consistent estimates. Thus, results of the approaches which include time fixed effects may be biased and inconsistent.
Including only state fixed effects seems to be more reasonable. However, Hüfner and Koske did not include them in their analysis in 2008. This, probably, can be explained by the fact, that variable 𝐺𝐺𝐺𝐺𝐺𝐺𝑖𝑖𝑖𝑖 is included in the equation (1). Variable 𝐺𝐺𝐺𝐺𝐺𝐺𝑖𝑖𝑖𝑖 controls for some economic changes that are specific for each country, but it cannot capture all country-specific omitted characteristics. What is more, there is no correlation between country-specific dummy variables and the output gap. Despite the fact, that the differences in the results of these last two approaches are
14 For some countries data for some sectors is not available for one or several years. In this case, STATA drops this year
for all countries included. Thus, using unbalanced panel data can give different results for some sectors.
15 Different approaches were presented in chapter 4.1.
-1 0 1 2 3 4 5 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 HI CP (% ) Euro area πNEUR 28
very small, it seems reasonable to choose the approach which includes state fixed effects to be the main model for the interpretation of the results.
All in all, approaches with time fixed effects make difference only if the additional inflation is estimated using all significant price changes. Here results are distorted: additional estimated effect on inflation is unnaturally small or even negative, which means decrease in HICP after the adoption of the euro. These results are not likely to occur in the real situation. Moreover, they are inconsistent with other studies conducted by other authors. However, the choice of the approach does not involve a big difference in the results if the additional inflation is estimated using only the significant price increase.
In order to estimate a possible price increase due to the adoption of the euro in Lithuania, sectors with significant changes in prices are identified for other Eurozone countries using the system of equations (1) and country-specific dummy variables (state fixed effects). Table 4 shows the estimated significant coefficients on D variable, i.e. the estimated additional effect on prices for a particular sector due to the currency changeover. Table 5 also presents the level of significance for each of the estimates.
Table 4: Sectors with significant changeover-related price changes. Source: authors estimates
Sector Coefficient (price
change in %) Significant at
Fruit 4,943 5%
Gardens, plants and flowers 2,950 1%
Cleaning, repair and hire of clothing 2,815 1%
Oils and fats 2,592 10%
Recreational and sporting services 2,536 1%
Footwear 2,039 5%
Wine 1,882 5%
Motor cars 1,591 5%
Restaurants, cafés and the like 1,577 1%
Bread and cereals 1,344 5%
Meat -1,983 1%
Equipment for the reception, recording and reproduction of
sound and picture -2,135 1%
Photographic and cinematographic equipment and optical
instruments -2,455 5%
Jewellery, clocks and watches -2,477 5%
Prices on meat, audio, video and photographic equipment, and jewellery decreased in the euro area during the period of the euro adoption. This can be explained by lower barriers to trade due to the common currency: producers and importers can save on currency exchange and other administrative fees. This decreases the cost of production and import, thus, prices go down.
Surprisingly, prices on fruit during the euro changeover period in other Eurozone countries increased the most, by about 5%. The same results were found, for instance, by Folkertsma et al. (2002). Bread and cereals, fruit, oils and fats belong to the food category in COICOP classification. Food is a low-price frequently-purchased good, so retailers can take this food characteristic to slightly increase prices. Due to the rational inattention and money illusion arguments, consumers tend not to notice the difference between prices in old currency and prices in euro.
Cleaning, repair and hire of clothing, recreational and sporting services, restaurants, cafés and the like are all service sectors. According to the Balassa-Samuelson hypothesis, after the adoption of the new currency, productivity in the service sector (non-tradable goods) tends to increase faster. This, in turn, increases wages and labour cost. As service production costs become higher, prices are moving upwards. These results are consistent with other studies on this issue which also identify significant euro-related price increase in these sectors (e.g. see Folkertsma et al., 2002; Deutsche Bundesbank, 2002; Ercolani and Dutta, 2006).
Due to the adoption of the euro prices on footwear, gardens, plants and flowers, wine and motor cars also increased significantly in other euro area member states. Moreover, footwear and flower sectors are also related to labour intensive production so the price increase in these sectors can by partly described by the Balassa-Samuelson effect.
The estimates presented in Table 4 are, however, the averages among all countries included in the analysis. Thus, for different countries the effect is likely to have been different. For example, Hüfner and Koske (2008) estimated, that the cash changeover in Spain and France led to prices increases in 20% of all sectors, while in Finland euro-changeover affected prices in only 6% of all sectors.
Hüfner and Koske (2008) also found more sectors with the significant price increase, but they had fewer observations: authors included less countries and their time period was shorter. What is more, Hüfner and Koske did not find any significant change in the food sector. All other price increases are in line with the results obtained by Hüfner and Koske. The authors estimated the significant price increase in sectors such as: Footwear including repair; Recreational and cultural services; Catering services; Other recreational items and equipment, gardens and pets; Purchase of vehicles; Alcoholic beverages. Estimated additional euro-related inflation in these sectors is consistent with the results of this thesis. However, Table 4 provides more detailed results: there is the significant price increase in Gardens, plants and flowers which is a part of Other recreational items and equipment, gardens and pets; in Recreational and sporting services which is a part of Recreational and cultural services; in Footwear which is a part of Footwear including repair; in Wine which is a part of Alcoholic beverages; in Motor cars which is a part of Purchase of vehicles; and in Restaurants, cafés and the like which is a part of Catering services.
