ASPECTS OF THE SUSTAINABILITY OF ESTONIAN CURRENCY BOARD ARRANGEMENT Urmas Sepp Martti Randveer Tallinn 2002 Working Papers of Eesti Pank No 5, 2002

The main aim of the paper is to examine different aspects of the sustainability of Estonian CBA. For this purpose the paper gives an overview of CBA in general, describes the rationale for the choice of the CBA in Estonia and uses model simulations to assess its sustainability. It also analyses whether the preconditions for the successful performance of the CBA are in place in Estonia and discusses the compatibility of Estonian CBA to the EMU and ERM 2. The analysis in the paper shows that CBA is a suitable exchange rate regime for Estonia. It is argued that the preconditions for a well-functioning CBA - resilient financial sector, flexible wage and employment system and prudent fiscal policy - are in place. The sustainability of the CBA is also supported by model simulations, which show that shocks hitting Estonian economy do not cause convergence of the Estonian economy from the long-run path. Based on the above-mentioned results, the paper concludes that the currency board arrangement is the best exchange rate regime for Estonia before the full participation in the third stage of the EMU.

* The support from the PHARE ACE (grant P98-1027-R) is gratefully acknowledged.

Authors' e-mail addresses: usepp@epbe.ee, randveer@epbe.ee

The views expressed are those of the authors and do not necessarily represent the official views of Eesti Pank.

CONTENTS

Introduction

1. Currency Board Arrangement in Estonia

2. Features of CBA

2.1. Credibility

2.2. Adjustment Process

3. The Rationale for the Choice of CBA

3.1. Institutional Underdevelopment

3.2. Part of Stabilisation Package

4. Channels of Transmission

4.1. Interest Rate Channel

4.2. Exchange Rate Channel

4.2.1. Real Exchange Rate (REER)

4.2.2. Nominal Exchange Rate (USD)

4.3. Significance of Transmission Channels

5. Comparative Analysis: CBA vs Alternative Policy Rules in Estonia

5.1. Alternative Regimes

5.2. Historic Simulations

6. Sustainability of CBA

6.1. Simulation of External Shocks

6.2. Actual Performance of CBA

7. Case Study of the Speculative Attack: the Russian Crisis

7.1. Money Supply

7.2. Forward Market

7.3. Interest Rates

7.4. Consequences of Crises

8. Fiscal Policy Stance (1997-2000)

9. Flexibility of the Real Sector of the Estonian Economy

10. Compatibility of the Estonian CBA with the EMU and ERM 2

11. Legal and Institutional Aspects of Joining the EMU

12. Economic Problems Related to the EMU: The Conflict between Achieving Full Nominal and Real Convergence

Conclusions

References

Figures

Appendix 1. Measures taken by Eesti Pank aimed at improving the monetary policy operational framework in changing internal and external environment

Appendix 2. Nominal appreciation of Swedish krona

Appendix 3. Appreciation of NEER

Appendix 4. 1 percentage point increase of Euribor

Appendix 5. 1 percentage point increase of import prices

Appendix 6. Increase of exports (+1.5%)

Appendix 7. The short-term core equations of the model

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