Annual Report 1993. Estonian Monetary Policy in 1993

THE PATH CHOSEN IN 1992 HAS BEEN FOLLOWED

There were no major changes in the monetary policy of Estonia in 1993. The main aim was the same as in the previous year, namely, to create a stable financial environment and general trust in the financial system. That had been seriously damaged due to the high inflation rate and banking crisis in the beginning of 1990. Stability was also necessary in order to secure the development of a banking system which would correspond to the demands of a market economy.

To achieve these aims, it was decided to pursue the path chosen earlier. Thus, the activities of Eesti Pank in the area of monetary policy continued within the strict system introduced by monetary reform in 1992. The exchange rate of the Estonian kroon remained rigidly pegged to the German mark and the money supply was limited by the increase of the foreign exchange reserves of Eesti Pank. Other factors influencing the money market (e.g., interest rates, credit volumes of banks and currency flows) were left to be determined by the market. Since 1992 Eesti Pank has actively participated in the market only when solving the banking crisis and when guaranteeing the liquidity of one bank.

1993 was marked by growing trust in the domestic currency which in its turn helped to stabilise the Estonian economy and to lay the basis for returning to economic growth.

PRINCIPLES OF THE ESTONIAN MONETARY SYSTEM

Since 1992 Estonia has followed a simple monetary policy which at the same time is based on trustworthy principles. The guidelines of such a policy, which tend to bring to mind a currency board system, are easily followed by the public and, taking into account the general lack of stability, have proved remarkably credible.

Compared to wide-spread central bank practices, the main characteristic of the Estonian monetary system is the strict legal restriction of domestic currency emission, limited with the foreign convertible currency reserves of the central bank, so that the supply of base money (i.e., kroons issued and banks' deposits with Eesti Pank) does not exceed the foreign convertible currency assets of the central bank. The main pillar of the Estonian monetary policy is the decision to peg the kroon to the German mark, with Eesti Pank having no right to devalue the kroon without an appropriate Parliament decision. The fact that changing the exchange rate of the kroon needs a Parliament decision lessens the possibility that exchange rate policy might become an object of short term economic or political pressure.

For further credibility a strict credit policy has been pursued. Eesti Pank is prohibited by law to credit the central or local governments. Also, intervention in banks' activities is limited by emergency liquidity assistance, in which case Eesti Pank still has to maintain full foreign reserve backing for any issue carried out.

Eesti Pank has refrained from creating a common re-financing possibility for commercial banks. Instead, all possible measures have been taken to promote the rapid development of the interbank money market.

The main aim of the system is, through a fixed exchange rate and the mechanism of money supply, to bring into the economy a certain nominal framework and automatic control mechanisms. These controls should put constant pressure on economic subjects and, on the other hand, through an open economy, offer sufficiently rapid and adequate information for maintaining a healthy price formation, which in turn helps to avoid inflation and encourage competition.

In the system in force today, where the increase of the money supply in Estonia is mainly connected to foreign currency movement across the borders as well as to the public's preference to either keep kroons or an alternative currency, the financial sector itself can be more flexible in following possibilities for economic development and thus stabilise the financial system according to prevailing conditions. In order to enforce the self-regulation mechanism banks are allowed to keep an unlimited German mark open position. This has been possible due to the full backing of the Estonian kroon and the lack of pressure to change the system in the long run.

With the introduction of the present automatic system and with pegging the kroon, Eesti Pank gave up a number of possibilities for active participation in carrying out monetary policy. Due to these technical peculiarities Eesti Pank does not need to intervene in the foreign exchange market with the aim of stabilising the exchange rate of the kroon, for example, and neither does Eesti Pank participate in directing the short term interest rates on the interbank market.

At the same time it should be noted over and over again that, differing from the common activities of a central bank, the Estonian monetary system offers greater guarantees for the maintenance of the fixed exchange rate of the kroon - and that due to the full backing of the issued currency. With such a system the central bank need not worry about the decrease of foreign exchange reserves for it is theoretically ready to respond to any outflow of currency from Estonia, however great it might be (or exchange it to another currency) and thus it can not be subjected to speculative attacks.

RESULTS OF THE MONETARY SYSTEM

The system described above together with resolute actions taken during the recent acute banking crisis have given remarkable results in creating a stable financial environment in 1993.

The exchange rate of the kroon remained fixed to the German mark, which naturally caused changes in the external value of the kroon according to developments on the international currency markets: during the first half of the year the kroon was rather stable, during the second half its value in relation to the more important foreign currencies started to decrease to some extent, as did that of the German mark.

Although the domestic rise of prices exceeded inflation in Germany (the country of the basic currency for Estonia), this has not been a good enough reason for giving up the chosen system. The different movement of the domestic and external value of the kroon can be accounted for by the inevitable changes connected with opening the economy under the conditions of a fixed exchange rate and a more rapid increase of productivity.

Along with inflation the interest rates on deposits and on credits that banks offered decreased throughout the year. Although this could be explained, to some extent, with changes in credit policies carried out by banks, the decrease was mainly due to the diminishing of risks. The decrease was constant and reached 25.4% by December 1993. In comparison with the 51.7% of December 1992 this figure is remarkably lower (for loans with a maturity of over five years the interest rate reached 9.6 in December 1993).

The interests paid on deposits also decreased constantly, causing a situation, especially during the second half of the year, where alternative investment possibilities started to attract interest.

In addition to the above, the interbank overnight market which started to grow extremely rapidly during the last months of 1993 as well as the decreasing interest margin of the Eesti Pank 28-day certificates of deposit compared to the short term interest rates of the German mark, testify to the high credibility of the Estonian kroon in the near perspective. The low interest rates can be partly explained by the extremely high liquidity of banks, which resulted from the strict solution to the banking crisis as well as from the conservative credit and investment policies of banks.