Estonian Financial and Monetary System

Aare Jârvan (*)

Restructuring of Estonian financial and monetary system took its real path at the first half of 1992, shortly after this country had regained full political independence from the Soviet Union (FSU). By this time the previous economic system had been repeatedly showing signs of collapse. State-made trade relations mostly with the FSU, were gone, whereas the market-driven integration was yet suppressed with the West and hard to reestablish in the East; inter-enterprise arrears were surging, four-digit annualized inflation was rampant for several months, around 8% of Estonian GDP was frozen by the insolvent Moscow's Vneshekonombank - the only bank our exporters were allowed to use up to the end of 80ies. In these circumstances the emerging market economy called for a radical approach in reforming the inadequate financial and monetary system.

Almost three years have lapsed since that time. Today, Estonian monetary system has proved to be the best choice we might have made and the rapidly developing banking industry already seems to meet all general requirements our real economy may have.

Institutional framework

Central bank

Eesti Pank (founded in 1919) was re-established on 1 January 1990.

According to the Law of the Central Bank of Estonia Eesti Pank "is responsible for maintaining the stability of the legal tender" and "carries out control over all credit institutions within the Republic of Estonia". In addition, Eesti Pank provides payment and settlement services to credit institutions, but does not act as the fiscal agent in the Government's domestic operations. As to the Government economic policies: "Eesti Pank supports, as per its mandate, the economic policies of the Government of the Republic of Estonia when these policies do not contradict its mandate of securing the stability of the currency and its other mandates as set forth in the present law".

The Law states explicitly that "Eesti Pank is independent from all governmental agencies. Eesti Pank reports only to the Parliament; it is not subordinated to the Government of the Republic of Estonia nor to any other institution of executive state power".

The President of Eesti Pank, the Chairman and members of the Board of Eesti Pank, all having their terms of office for five years, can be dismissed only if found guilty by a court of law.

Banking system

Estonian banking system consists of 19 commercial banks, one investment bank (Estonian Investment Bank), plus one branch and several representative offices of foreign banks. The fourth largest bank is the only one under full state ownership besides which the state has retained the majority votes in one other bank. Both these banks will undergo privatization in the coming months. Foreign participation in Estonian banks is steadily increasing.

All Estonian banks are allowed to operate internationally relying on their correspondent banks abroad for payment services. The alternative FSU payments facility provided by the central bank has been loosing its last importance to direct interbank operations.

Financial system

Besides banks there are also loan and savings co-operatives, investment funds and some hedge funds in the Estonian financial market. Compared to the banking sector, their share in the market is smaller, yet the rate of growth is higher. Insurance companies have also grown fast in the course of the previous year.

Estonian securities market is still in its early stages of development. The number of registered emissions is constantly increasing, but there is no permanent quotation of prices yet. Local administrations, successful large enterprises and private investment funds are the main issuers.

Since autumn 1994 Estonian Central Depository for Securities has been operating making it possible to hold securities electronically, in a machine-readable form. In a very short time electronic securities have won popularity due to the fact that they are easy to handle. New issues are effected, almost without exception, electronically.

A decision has been made to establish the Tallinn Stock Exchange which should start to pursue its activities at the beginning of 1996. The Stock Exchange will be fully electronical and will form, together with the Central Depository for Securities, the core of the future Estonian securities market.

Monetary policy and money market

Estonian monetary system is based on currency board like arrangements. To secure the credibility of the system the Parliament has ruled that the central bank is to maintain sufficient reserves to back at least 100% of base money by its convertible currency and gold. The Parliament has also approved the prohibition of direct or indirect fiscal lending and the prohibition of devaluing the national currency by the central bank.

Adding to the above said the absence of any restrictions on current and capital account transactions, one can see almost no room left for discretionary monetary policy in Estonia. The biggest concern for the Government and central bank is to develop and ensure the proper institutional framework for the market.

The exchange rate peg at 1 D-mark to 8 Estonian kroons has been held since the monetary reform took place in June 1992. Eesti Pank experienced a fourfold increase in its foreign reserves during the first year and a half.

International integration has permitted the interbank rates to follow closely the respective D-mark rates. As to the liquidity management of the economy, one of the most stable interbank interest levels among the CEE countries allows us to keep relaying solely on microeconomic decisions made in the banking sector.

The CPI inflation is down from 953% in 1992 to an estimated 26% in 1995. A still high real appreciation of kroon should mostly be attributed to a relatively high productivity growth in the tradeables sector whereas the non-tradeables sector has its common supply constraints.

Financial policy

Estonia was successful in establishing fiscal equilibrium right from the beginning. In principle, there can be no current expenditures in excess of current revenues. (In addition to that, the Government was decisive enough to adopt less distortive income and corporate tax rates at 26% flat). Other Government fund rising activities for public investment programs as well as for intermediating long-term funding to the banking sector are strictly limited and require a separate case-by-case approval by the Parliament. Main foreign creditors for the Government are international and national financial organizations often having special arrangements to support the transition process of this economy. The outstanding foreign debt is now around 6% of GDP.

The remarkably high (6-7% of GDP) current account deficit reflects the massive inflow of private capital and can be mostly attributed to the import of the much-needed capital goods. Estonia is ranking third among the CEE countries in foreign investments per capita. A special Foreign Investment Agency was set up recently to assist in these markets.

Estonian financial system which is still rather bank-centered is gradually becoming able to attract - besides the more expensive and scarce domestic resources - foreign funding without state mediation. The growing number of foreign financial institutions establishing here will hopefully accelerate this process.

Due to the absence of any benchmark instruments, long term interest rates refer to bank loans only. Over five-year interest is around 10-12% whereas shorter rates are above 16%.


The relatively rapid stabilization of the growth trend is, without doubt, at least partly due to the monetary and fiscal framework established in Estonia. It is vital that the lack of state discretion in these fields could be easily compensated by the "right" economic decisions made in the private sector in average. Therefore the Government and the central bank are to assist in creating and developing a proper institutional setup, in acknowledging the current economic situation and prospectives by the public, etc.

Today, it is hard to imagine any imminent threats to the Estonian monetary and fiscal system serious enough to jeopardize it - or to compel the authorities to change the basic rules of the system. Our vision has been to leave the above described cornerstones unchanged until being accepted to the EU membership, since the EU will ask all members to hold firm to the same principles anyway.


(*) Eesti Pank/Bank of Estonia. Head of Central Bank Policy Department. Estonia pst 13, Tallinn EE0100 - Eesti/Estonia.