Märten Ross*

Successful launch of single currency will remove one of the major uncertainties regarding the political and economic developments of European Union over short and medium term. That will facilitate, among other things, also 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 them far from being solved. Moreover, after immediate concerns related to the introduction of single currency are solved, the other and at least as demanding issues arise.

The following article describes the position of Estonia as one of the candidate countries to the European Union. The first part gives an overview of the monetary system and economic developments in Estonia over the recent years. The second part focuses on different economic linkages between Estonia and the European Union with special emphasis on the potential impact of 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. Monetary Policy Framework¹

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

• fixed exchange rate policy against German mark (1DEM=8EEK) and, consequently, from January 1999 also to euro and the rest of EMU currencies

• restriction on central banks liabilities not to exceed reserves in high-rated foreign assets or gold

• unlimited current and capital account convertibility.

The fixed exchange rate policy, especially the adoption of the currency board approach, 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 the liquidity in the system is the standing facility provided by Eesti Pank in foreign exchange market² and the reserve requirement, which has to be met on monthly average basis³ .

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

1. 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 to the further restructuring and development of the economy. It should be noted, however, that fixed exchange rate regime was one component of the general economic policy framework aimed at macroeconomic stabilisation. Other policies such as liberal external trade regime and fiscal discipline, have been equally important.

The monetary reform in 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 and then continuous downward trend over the following years (see chart 1). Considering the rapid economic growth accompanied by fast capital inflow 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 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 on the money market, 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 Asian and Russian crisis 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 on changes in capital flows and speculative pressures as the central bank does not provide additional financing and the banks’ limits close in a short time. The interest rates as automatic stabilisers have proven their efficiency in stabilising the financial system’s external imbalances in the turbulent external environment both at the end of 1997 and in 1998.

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, the balance sheet growth has extensively been based on debt creating foreign capital inflow financing the very high domestic credit growth. The constrictive international environment after the Asian and Russian crises has been heavily reflected in the financial sector growth rates and behavior since the beginning of 1998. The financial system responded as expected -- the increasing interest rate and decreasing price of financial assets were part of the process to balance external pressures. However, lack of experience in the environment of retarded growth or falling markets, which were amplified by 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 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, 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 reaching its peak of 12 % of GDP in 1997. With the 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. Private sector accounts for most of the deficit and the level of foreign borrowing of 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 is 18 percent of GDP and the net external debt of the public sector is 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 into the rapidly growing economy is considered to make Estonia's economic development less secure and considerably dependent on foreign capital fluctuations.

The unstable external environment since the end of 1997 has determined several development trends in Estonia's economy, including the decline in the growth rate of GDP, but has neither destabilized 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 compensating 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 falling and the fast slowdown in credit and money growth has stopped. Nevertheless, the economic growth will most probably remain modest in 1999 compared to the previous years, depending among other things also on the export demand in Europe. Higher real interest rates and tensions in the labour market caused by Russian oriented export decline will be the challenges for the real sector in the near future.

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 multifold rise in prices of securities raised a question as to whether the economic growth achieved is sustainable and in compliance with the economic potential in mid-term perspective and more proactive objectives to achieve macroeconomic balance were added.

As mentioned above, the currency board system rules out the possibility to pursue 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 growing domestic credit fuelled by debt capital inflow via the financial sector. The changes included widening the reserve requirement base to net foreign liabilities and financial guarantees of commercial banks and introducing the temporary additional liquidity requirement together with the 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 the banking group.

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 potential economic recession or other contingencies and potential future structural problems (e.g. pension reform), and the Fund would also have a macroeconomic effect by reducing aggregate demand and current account deficit. To achieve the latter effect, most of the Fund’s resources were invested abroad. This line of policy was continued also during the first half of 1998. However, the slowdown of economic growth and effects of Russian crisis to the real economy have 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.

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

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

While the fixing to German mark is still in force de jure, as it is stipulated in Estonian legislation, since the 1st of January, 1999 Estonian currency is fixed to euro both de facto and de jure. Decree No 39 from 31.12.1998 by the president of Bank of Estonia stipulates that exchange rate of Estonian kroon is fixed to euro at EUR 1 = EEK 15.6466, and equivalent to the fixing of kroon to German mark at DM1 = EEK 8.

Therefore, Estonian monetary conditions have been and will continue to be directly influenced by three factors: (a) interest rate movements in euro area, (b) implied country risk, i.e., the general risk level of financial investments made into Estonian economy and (c) by the strength of euro on 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 coming bigger the transmission mechanisms of monetary and exchange rate policy should be even better understood by market participants.

It is also important, that as European Central Bank is committed to ensure 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 EMU. If euro area inflation and interest rates are stable, then there will be a positive impact for Estonian monetary conditions via two channels. First and foremost, our underlying interest rate level remains stable, thus reducing the possibility of unpredictable movements of short and medium term capital. Secondly, as interest rate stability will reduce the likelihood of sharp exchange rate movements between the major currencies, our external terms of trade will remain, ceteris paribus, intact.

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 euro zone alone for around 40%. Exports to European Union increased by 29% during the first 11 months in 1998 compared to 19% in overall export growth. The main export articles to European Union are machinery and equipment that account for 40% of Estonia’s exports to EU, followed by textiles and timber with 18% and 15%, respectively.

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

Being 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 bigger 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 euro will increase capital mobility. For example borrowing cost 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 to Central and East European countries could increase as a result of search for higher yields. However, that will bring forward also 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 will deepen and widen gradually, and their economies and, consequently, financing needs, increase.

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

Several effects may increase FDI flows from European Union and euro zone to applicant countries. In general, 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 European Union may serve as an incentive for enterprises to seek actively for merger and investment opportunities and that could, theoretically, benefit also Estonia. Finally, even in case of economic slowdown and rising interest rates, companies from European Union may search for competitive investments in CEE countries, including Estonia. However, the very same factors that might increase the FDI flows to Estonia can act also in opposite direction. Increasing competitiveness and price transparency may increase the investment opportunities also 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: general sentiment on financial markets towards emerging economies, and Estonian domestic policies. In general, we predict FDI financing amounting to around two thirds or more from current account deficit over medium term.

There are three main factors that will influence Estonian banking system over medium term as a result of the introduction of the euro. Firstly, as the access to euro financial markets will increase 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.

In more general terms, the evolution of the whole 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 early 90’s whereby the Soviet legislation was of no use while new, coherent legal framework, proper for market economy, was to emerge yet. In these circumstances, European acquis communitaire provided for a natural legal source for the institutionalisation of market economy and creation respective administrative capacity. Among other areas, this was the case regarding free movement of capital, basic principles of monetary policy and financial services, where Estonian legislation is in line with relevant acquis.

The main general policy choice for Estonia is to continue the preparations for the accession to 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 market oriented and stable legislative framework, stability-oriented macroeconomic policies and openness both in foreign trade and regime of capital movements. In terms of the accession vocabulary, these principles are enshrined in Copenhagen criteria for the European Union membership: the rule of law, the existence of functioning market economy and ability to cope with competitive pressures on the Single Market.

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

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

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

Main strategy pillar, that have earned already considerable credibility, e.g. currency board and fixed exchange rate will remain the cornerstones for Estonian monetary policy over medium term. That is at least well after the accession to European Union, and, possibly, even after the accession within the new exchange rate mechanism between the euro zone and new member sates.

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

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

The above described policy mix 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 next four years. Increasing domestic saving, brought forward by budget surplus and will gradually diminish current account deficit from some 9% in 1998 to 3.5% from GDP in 2003. Nevertheless, it is important to underline that Estonian economic development will continue to rely on foreign financing over medium term, i.e., we do not expect current account turning into surplus soon.