The Estonian Monetary System and the Euro

The successful launch of the single currency will remove one of the major uncertainties regarding the political and economic developments of the European Union over the short and medium terms. It will also facilitate, among other things, the forthcoming enlargement of the Union. However, one should bear in mind that the enlargement as such is a function of several variables, some of which have problems that are far from being solved. Moreover, after immediate concerns related to the introduction of the single currency are resolved, other equally demanding issues will arise.

The following article describes the position of Estonia as one of the candidate countries for the European Union. The first part gives an overview of the monetary system and economic developments in Estonia over recent years. The second part focuses on different economic linkages between Estonia and the European Union with a special emphasis on the potential impact of the euro and considerations about the necessary preconditions for full realisation of the opportunities created by the single currency.

1. Monetary and economic developments 1995-1998

1.1 Monetary policy framework

Estonia implemented the currency board principle simultaneously with the introduction of its national currency in June 1992 and that principle constitutes the basis for the whole Estonian monetary system. The cornerstones of the system comprise:

   a fixed exchange rate policy against the German mark (1 DEM=8 EEK) and, consequently, from January 1999 also against the euro and the rest of the EMU currencies;
   a restriction on the central bank's liabilities not to exceed reserves in highly-rated foreign assets or gold;
   unlimited current and capital account convertibility.

The fixed exchange rate policy, and especially the adoption of the currency board system, imposes clear constraints on the use of other interim targets of monetary policy. Eesti Pank does not participate actively in the interbank money market and it does not initiate daily open market operations. Ordinary central bank refinancing facilities are non-existent. Consequently, the most important channel stabilising liquidity in the system is the standing facility provided by Eesti Pank in the foreign exchange market, and the reserve requirement, which has to be met on an average monthly basis.

In ensuring a stable liquidity system, the principal role has to be fulfilled first and foremost by the financial intermediaries themselves. However, the Bank of Estonia facilitates this stability through improvements in the system structure and the introduction of supervisory standards. The developments that occurred during the turmoil in the international financial markets during the past few years have shown that high capitalization and adequate reserves have been vital for the financial sector to cope with external shocks. Measures taken in monetary policy and prudential regulation over the last two years have been directed at enhancing liquidity buffers and the capitalization of banks.

1.2 Main developments in 1995-1998

Fixing the kroon to the German mark and the implementation of the currency board system to make the peg credible provided a solid nominal anchor for the further restructuring and development of the economy. It should be noted, however, that the fixed exchange rate regime was but one component of the general economic policy framework aimed at macroeconomic stabilisation. Other policies such as a liberal external trade regime and fiscal discipline, have been equally important (table 1).

The monetary reform of 1992 and the introduction of the currency board brought about a fast initial reduction of inflation from more than 1000 percent to below 100 percent, followed by acontinuous downward trend over the following years (see chart 1). Considering the rapid economic growth accompanied by the fast inflow of capital and price convergence peculiarities of the transition period, the level of inflation in Estonia has so far been acceptable, being at the same time adequate enough to encompass the inevitable transformation of the pricing structure. Considering the initial undervaluation and high productivity growth in the tradables sector, the appreciation of the real exchange rate is strongly overstated by statistical phenomena and has not been a major threat to international competitiveness.

Due to the great mobility of capital the interest rates of the Estonian kroon have no independent role in the monetary policy framework and depend on the supply-demand situation in the money market, and in the longer perspective, on the interest rates of the kroon's base currency. Until autumn 1997 there was a continuous trend of convergence in the Estonian money market with German interest rates, especially in the short-term instruments. The external financing constraints and the general rise in risk assessments of emerging markets after the Asian and Russian crises had an effect on the interest rate level in Estonia as well (see chart 2). In the currency board system the short-term interest rates react quickly to changes in capital flows and speculative pressures as the central bank does not provide additional financing and the bank's limits close in a short period of time. Using interest rates as automatic stabilisers proved to bet efficient in stabilising the financial system's external imbalances in the turbulent external environment both at the end of 1997 and in 1998.

The financial sector (commercial banks and their financial subsidiaries in particular) has been the fastest growing sector of the economy for several years. The consolidated balance sheet of the banking sector has grown more than seven times since 1992. Since 1996, together with improved access to external credit facilities, balance sheet growth has been extensively based on debt creating foreign capital inflow financing the very high domestic growth in credit. The constrictive international environment after the Asian and Russian crises has been heavily reflected in the growth rates and behavior of the financial sector since the beginning of 1998. The financial system responded as expected - the increasing of interest rate and decreasing price of financial assets were part of the process of balancing external pressures. However, lack of experience in the environment of retarded growth or falling markets, which was amplified by a worsening external environment, tighter competition, inadequate market transparency and weak control over executive management, pinpointed mistakes in financial institutions asset-liability management and in selecting long-term strategies. This has lead to further consolidation in the banking sector as well as the bankruptcies of smaller banks and the dramatic rise of the share of foreign strategic ownership. Within the strict currency board regime which restricts crediting by the central bank and the small and potentially volatile money market, the participation of foreign banks and strategic alliances in the local banking system will provide protection against liquidity risks in the financial sector.

One of the major concerns over the past years has been the very large current account deficit, which reached its peak of 12 % of GDP in 1997. With an investment ratio of around 30 percent of GDP the deficit is in many ways a natural consequence of the restructuring needs of the economy. However, when in 1996 the financing of the deficit shifted from foreign direct investment towards debt creating capital flows; it raised, of course, the question of vulnerability. In 1998 the nature of the capital flows changed once more and the share of debt creating flows decreased. The current account deficit diminished as well. The private sector accounts for most of the deficit and the level of foreign borrowing in the public sector, which is considered dangerous in financing the current account deficit, has been rather low in Estonia. According to the international investment position in September 1998 the outstanding net external debt of the Estonian economy was 18 percent of GDP and the net external debt of the public sector was 2.7 percent of GDP. Despite this, the potential vulnerability of the financial sector as one of the major facilitators of capital inflow and the danger of over-investing in the rapidly growing economy is considered to be making Estonia's economic development less secure and considerably dependent on foreign capital fluctuations.

The unstable external environment that has existed since the end of 1997 has influenced several developmental trends in Estonia's economy, including the decline in the growth rate of GDP, but has neither destabilized the restructuring of the economy nor the financial system. There are signs that the economic situation may have already started to stabilise: export growth to the west has continued to compensate for the collapse of the Russian market; the overall liquidity situation of the banking system has improved after the recent inflows of share capital and refunding operations; interest rates have started to fall and the rapid slowdown in credit and money growth has stopped. Nevertheless, economic growth will most probably remain modest in 1999 compared to previous years depending on, among other things, the demand for exports in Europe. Higher real interest rates and tensions in the labour market caused by the decline in Russian-oriented exports decline will be the challenges for the real sector in the near future.

1.3 General economic policy implications

After the initial stage of liberalization, the main target of economic policy in Estonia has been to improve the institutional structure of the economy. In 1997 the substantial current account deficit, sharp increase in domestic credit and a multi-fold rise in the prices of securities raised a question as to whether the economic growth achieved is sustainable and in compliance with the economic potential in the mid-term perspective. AS a result, more proactive objectives to achieve macroeconomic balance were added.

As mentioned above, the currency board system rules out the possibility of pursuing a discretionary monetary policy and the system relies on interest rates and capital flows as automatic stabilizers. One of the main goals of Eesti Pank has been to increase the credibility and risk tolerance of the banking sector. Measures taken in monetary policy have been aimed at strengthening the liquidity buffers of the banks through higher reserve holdings at the central bank. During the period of vast capital inflow and signs of overheating in 1997 and slow adjustment at the beginning of 1998, the measures taken were also aimed at curbing the vast growth in domestic credit fuelled by debt capital inflow via the financial sector. The changes included widening the reserve requirement base to net foreign liabilities and the financial guarantees of commercial banks as well as introducing the temporary additional liquidity requirement together with a rise in the daily minimum reserve requirement at the central bank. Complimentary measures in prudential standards have also helped to increase the capitalization of banks and raise the efficiency of supervision through the implementation of consolidated reporting of banking groups.

In view of the large current account deficit, recently, the objective of the fiscal policy has been to increase public sector savings. In the fall of 1997 the Government made a major decision to achieve a budget surplus and transfer it to the Stabilisation Reserve Fund. Thus, the state would be better prepared for a potential economic recession or other contingencies and potential future structural problems (e.g., pension reform). The Fund would also have a macroeconomic effect by reducing aggregate demand and the current account deficit. To achieve the latter effect, most of the Fund's resources were invested abroad. This line of policy was also continued during the first half of 1998. However, the slowdown in economic growth and the effects of the Russian crisis on the real economy put some pressure on the state budget and by the end of 1998 the targeted surplus was not achieved. The Fund's resources currently amount to around 3.5 percent of GDP.

2. Potential impact of the euro

Estonia has an extremely large direct and indirect exposure to economic developments in the European Union and the euro zone. Therefore, the introduction of the euro in Estonia creates, as it does for the European Union itself, new opportunities and risks. Below, some of the issues will be discussed in more detail.

Direct monetary links

From a strictly monetary policy point of view, Estonia has been, as described above, a de facto member of what is now called the euro zone for six years already. By introducing the currency board and fixing the exchange rate of Estonian kroon to the German mark in 1992, Estonia has opted for a nominal external anchor and, thus, has been mimicking European monetary policy to a great extent.

While the peg to the German mark is still in force de jure, as is stipulated in Estonian legislation (as of the 1st of January, 1999), Estonian currency is fixed to the euro both de facto and de jure. Decree No 39 dated from 31.12.1998 by the President of the Bank of Estonia stipulates that the exchange rate of the Estonian kroon is fixed to the euro at EUR 1 = EEK 15.6466, and is equivalent to the fixing of the kroon to the German mark at DM 1 = EEK 8.

Therefore, Estonian monetary conditions have been and will continue to be directly influenced by three factors: (a) interest rate movements in the euro area, (b) implied country risk; i.e., the general risk level of financial investments made into the Estonian economy and (c) by the strength of the euro in the global foreign exchange markets.

Enhanced currency stability among European countries improves the effectiveness of our present currency board-based monetary policy framework. As the base-currency area is growing larger the transmission mechanisms of monetary and exchange rate policy should be even better understood by market participants.

It is also important that as the European Central Bank is committed to ensuring low and stable inflation in the euro area; the potential volatility of interest rates and capital flows could be lower as well. This commitment is likely to reduce possible fluctuations of the euro against foreign currencies in the beginning of the third phase of the EMU. If euro area inflation and interest rates are stable, then there will be a positive impact on Estonian monetary conditions via two channels. First and foremost, our underlying interest rate level will remain stable, thus reducing the possibility of unpredictable movements of short and medium term capital. Secondly, as interest rate stability reduces the likelihood of sharp exchange rate movements between the major currencies, our external terms of trade will remain, ceteris paribus, intact.

Trade link

The European Union is by far the largest export partner for Estonia, with the Union as a whole accounting for 68% of Estonia's total exports as of December 1998, and the euro zone alone for around 40%. Exports to the EU increased by 29% during the first 11 months of 1998 compared to 19% in overall export growth. The main export articles to the EU are machinery and equipment, which account for 40% of Estonia's EU exports, followed by textiles and timber at 18% and 15%, respectively.

Economic convergence, adherence to fiscal discipline and low inflation will likely boost European output over the medium term, thereby creating additional demand for, inter alia, Estonian exports to the European Union and euro zone. However, Estonian exporters are likely to face increasing competition both inside and outside the EU and euro area as increasing price transparency will broaden the set of available choices for both households and enterprises.

Financial link

Being an extremely open economy, Estonian economic development depends heavily on the availability of foreign investments, both in the form of direct and financial investments. Estonia's high current account deficit, that is the surplus of domestic investments over domestic savings, should be financed by the rest of the world. Estonia will certainly benefit from the larger and more transparent financial markets created by the single currency in Europe.

By stabilising interest rates and creating a larger and more liquid capital market, the introduction of the euro will increase capital mobility. For example, borrowing costs could be reduced both for issuers in the euro area as well as for issuers in other instruments in euro units. That might broaden the access of Estonian banks and enterprises to European capital markets and, thus, increase the amount of available financing. Additionally, fixed-income and equity investments in Central and East European countries could increase as a result of the search for higher yields. However, that will also bring forward well-known risks related to financial investments: their relatively short-term nature and, therefore, potential volatility. In addition, the likelihood of speculative attacks on CEE currencies is likely to increase as their markets gradually deepen and widen, while their economies and, consequently, financing needs, increase.

Foreign direct investment link

In general, Estonia has thus far been relatively successful in attracting foreign direct investments, the major bulk of which come from the European Union and euro area. The most dramatic change in ownership structure has recently taken place in the financial sector with the two largest banks in Estonia having strategic investors and the forth-largest bank being a branch of MeritaNordbanken.

Several effects may increase FDI flows from the European Union and euro zone to applicant countries. In general, a more stable economic environment, moderate inflation and low interest rates increase the propensity to invest, and that will create spill-over effects for applicant countries. Secondly, increasing competition within the European Union may serve as an incentive for enterprises to actively seek merger and investment opportunities that could, theoretically, also benefit Estonia. Finally, even in the case of an economic slowdown and rising interest rates, companies from the European Union may search for competitive investments in CEE countries, including Estonia. However, the very same factors that might increase FDI flows to Estonia can also act in the opposite direction. Increasing competitiveness and price transparency may also increase the investment opportunities inside the euro zone, thereby drawing away potential investments from applicant countries.

The extent of the possible positive effect transmitted via financial channels depends mainly on two factors: the general sentiment of the financial markets towards emerging economies and Estonian domestic policies. In general, we predict FDI financing amounting to around two thirds or more of the current account deficit over the medium term.

Effect on the banking system

There are three main factors that will influence the Estonian banking system over the medium term as a result of the introduction of the euro. Firstly, as access to euro-financial markets increases over time, the number of domestic enterprises searching for direct financing will increase. As a result, the customer base of domestic banks will change. Secondly, European banks will most probably enter local markets more actively both by providing more debt financing and capital. The latter has already happened in Estonia. And thirdly, both these developments may change the customer base of local banks even more towards retail banking and SME financing; i.e., into areas where they have particular knowledge in local markets.

Legal framework

In more general terms, the evolution of the entire Estonian legislative framework has been guided by European legislation. One has to bear in mind that after 50 years of central planning and socialism, a judicial vacuum occurred in the early 90's whereby Soviet legislation was of no use while a new, coherent legal framework, proper for a market economy, was yet to emerge. In these circumstances, the European acquis communitaire provided for a natural legal source for the institutionalisation of a market economy and creation of a respective administrative capacity. Among other areas, this was the case regarding the free movement of capital and the basic principles of monetary policy and financial services, where Estonian legislation is in line with relevant acquis.

2.1 How to make use of these opportunities?

Principles

The main choice of general policy for Estonia is to continue its preparations for accession to the European Union. There are three main areas in which the accession procedure will support the use of the benefits provided by the single currency.

In short, the continuous accession effort will underline Estonia's commitment to a market oriented and stable legislative framework, stability-oriented macroeconomic policies and openness both in foreign trade and the regime of capital movements. In terms of accession vocabulary, these principles are enshrined in the Copenhagen criteria for European Union membership: the rule of law, the existence of a functioning market economy and the ability to cope with the competitive pressures of the Single Market.

Focusing now on the issues more directly related to the monetary policy framework, the situation in the above mentioned three main areas is the following:

Legislation

Legislation regarding the monetary policy framework, including the clauses stipulating central bank independence, is in broad compliance with the relevant acquis. Secondly, the free movement of capital, regarding both direct investments and financial investments, and regarding the entire spectrum of maturities, will and remains the cornerstone of Estonian economic policy. It is the most important point, particularly in the context of a fixed exchange rate and the currency board. The free movement of capital flows will have an immediate effect on interest rates, thus signalling the possible need for a change in policy stance. Finally, in general, capital movements between countries and regions reflect different returns and, therefore, can considerably augment the availability of financial resources in the accession countries.

Medium term strategy - main principles

The main aim of Estonian macroeconomic policy over the medium term should be a gradual convergence of the economy towards the economies of the European Union and euro zone; i.e., a gradual rise of both real and nominal income closer to the levels in the European Union. The keyword here is gradualism; i.e., sharp nominal corrections of, say, wages, and, consequently, prices should be unconditionally avoided. The the opposite scenario would cause massive unemployment, a fiscal deficit, and a dramatic deterioration of Estonia's competitiveness as well as a serious crisis in its balance of payments.

The main pillar of strategy, which has already earned considerable credibility; e.g., the currency board and fixed exchange rate, will remain the cornerstones of Estonian monetary policy over the medium term. That is at least until well after the accession to the European Union, and, possibly, even after the accession within the new exchange rate mechanism between the euro zone and the new member states.

Certainly, more exact scenarios about the convergence of the monetary framework from the currency board to the single currency are needed in coming years to enhance the credibility of the process in the eyes of the wider public.

To maintain stable economic development, a strict fiscal policy aimed at a budget surplus is an important prerequisite for any successful medium-term strategy. The impact of a fiscal surplus is twofold. Firstly, given the relatively large current account deficit, a fiscal surplus provides a certain cushion in case of sudden changes in investors' sentiment. In addition, by creating surpluses the public sector compensates for the private sector's lack of savings. Secondly, a fiscal surplus is an imperative to finance structural changes yet to come, most notably the pension reform.

The policy mix described above should maintain the economy on a sustainable growth path with both real GDP growth and inflation remaining in the range of 5% to 6% on average. Therefore, nominal income would rise under that scenario by some 10% on average over the next four years. Increasing domestic savings brought about by budget surpluses will gradually diminish the current account deficit from some 9% in 1998 to 3.5% of GDP in 2003. Nevertheless, it is important to note that Estonian economic development will continue to rely on foreign financing over the medium term; i.e., we do not expect the current account to turn into a surplus soon.