Eesti Pank - Bank of Estonia

I suppose that my speech may contribute to the general discussion from the perspective of a small open economy with a fixed exchange rate.

Firstly, Estonia's currency board arrangement excludes the possibility of targeting a specific rate of inflation. Price level development depends mainly on the speed of real convergence. Of course, inflation also depends on exogeneous factors such as the inflation rate in Europe or tax situations like the harmonization of excise taxes with EU levels.

Secondly, Estonia's economy is already integrated into the European and particularly in the Scandinavian markets. The absence of any restrictions on trade and the free movement of capital have resulted in close trade links, foreign investment inflow and a strong, foreign controlled financial sector in particular. That integration and openness have assured us that the currency board arrangement is not only a transitory phenomenon, but will also foster gains in future efficiency and is the main pillar of continuing real convergence.

Thirdly, inflation performance over the last decade has been encouraging. Yearly inflation is now firmly established in the low single digits: 3.5% in 1999 and 4.5% in 2000. Real exchange rate appreciation has slowed and labor productivity growth over the last five years has exceeded the cumulative rate of inflation by two times. All in all, the adherence to a fixed rate has also paid off in terms of monetary stability.

Let me turn to the main challenges of the future. First, I would like to emphasize that our main challenge of the future is the continuation of our present policy stance. In that case relatively high real growth rates will cause nominal convergence that will do no harm to our external competitiveness.

Estonia's main challenge on the macroeconomic level is to maintain fiscal discipline. Essentially that means adherence to the principles of a balanced budget over the entire business cycle. On the other hand, the initial cost of future reforms related to EU integration may put some moderate pressure on that.

The second challenge for us is to maintain the strength of our banking and financial system. A strong financial sector is the key to avoiding an excessive growth of credit and domestic demand, as well as the consequent increase of tyhe current account deficit.

The healthy financing pattern now in place is essential to guaranteeing the sustainability of our current account position, which in the present investment cycle is naturally showing a deficit.

However, these policies should be supported by structural policies. We already have a competitive, functioning market economy in place that in itself is a certain guarantee against real exchange rate overheating. Nevertheless, several tasks remain that should be dealt with.

Firstly, we should maintain and improve the flexibility of our product and labor markets. In that respect, the government has several active policy plans in place for training and re-training but we are preparing a more comprehensive policy study that will also re-examine the fundamentals determinants of labor supply and demand.

As for the markets for goods and services, the main task is to complete the ongoing privatization of these infrastructure and utilities that are still in governmental or municipal ownership. That will increase the transparency of prices and reduces the number of goods where they still have direct or indirect influence.

Finally, we will of course maintain the openness of our economy. The resulting FDI inflows and further transfer of new technologies and managerial know-how will form the backbone of the real convergence on the corporate level.

Should these short and medium term tasks materialize, we expect real convergence to continue. The real growth rates are expected to be at or over 5% in the medium term. Export-led growth should be assisted by a high investment level, and we expect the accompanying current account deficit to remain at an easily sustainable level. In addition, we also expect the real exchange rate to appreciate moderately. Finally, we trust that headline inflation will remain approximately 2 percentage points above euro area inflation over the short and medium term.

Session I/4 - Price Dynamics in Accession Countries: Future Challenges