General Tendencies

The rate of inflation dropped considerably in 1996 and greater stability of the economy further increased the credibility of the monetary system. Monetary policy was characterised by the continuation of tendencies of the previous years. Long-term interest rates declined and the increasing demand for loans persisted. At the same time, the structure of monetary aggregates continued to change.

Of external factors, the monetary policy environment was influenced by the continuing decline in the interest rates of the German mark as well as by the slight decrease in the external value of the kroon against certain foreign currencies which are important from the point of foreign economic relations.

Structure of the Monetary System

Since the monetary reform of 1992, Estonia's monetary policy has been based on the fixed exchange rate policy supported by the currency board system.

The currency board system means a particular fixed exchange rate policy based on strict legislative restrictions on the implementation of monetary policy. These concern first of all curtailing the issuing of money by the increase in the foreign currency reserves and formal rules on changing the national currency's exchange rate against the base currency. On the everyday level of implementing monetary policy the currency board framework means that in regulating the liquidity of the money market the main emphasis is on the movement of capital between domestic and foreign markets initiated by the market agents and the resulting foreign exchange purchase and sale transactions between commercial banks and the central bank. The aim is to guarantee the conformity of the implementation of monetary policy with the existing rules and thereby increase the credibility of the national currency.

Historically, the set-up of the currency board was accompanied by the creation of a separate monetary authority the activity of which was limited solely to changing the national currency notes into foreign currencies. However, in countries relying on the currency board system the everyday activity of such separate institutions has come close to the usual functioning of a central bank or else, currency board is simply introduced via certain legal restrictions to the functioning of the prior existing central banks.

The currency board system of Estonia is based on the second option. On the one hand, the Law of the Central Bank of Republic of Estonia lays down the foundations for the functioning of the central bank, giving it the same degree of independence and rights in carrying out monetary policy as the central banks of developed countries. On the other hand, the Law on the Security for Estonian Kroon sets relatively strict rules to the central bank. Thus, for example, the base money issued by Eesti Pank (notes and coins in circulation and the deposits of commercial banks in the central bank) has to be fully backed by the foreign currency or gold reserves. Neither can the central bank change the Estonian kroon's peg to the German mark as it was set during the monetary reform.

Like any other fixed exchange rate policy, the currency board system is aimed at the stabilization of the purchasing power of the national currency through the fixed peg and this way reaching the final goal of monetary policy -- low level of inflation. Presuming that the base currency is stable, the fixed exchange rate converges, through international economic relationship, the prices of the so-called open sector of the economy which indirectly affect the development of the price structure of the entire economy. At the same time, the fixed exchange rate regulates the overall activity of the economy in correspondence with the competitiveness of the economy and prevents the implementation of overly expansionist or depressive monetary policy.

Peculiarities of the Currency Board

The use of a currency board-based monetary system has attracted growing attention in the 1990s. Hong Kong and some other small countries who have used this system for decades have been joined by Argentina, Estonia and Lithuania.

The strong points of the currency board system are its simplicity and transparency and its relative ease of implementation. Therefore, the currency board system has been adopted by countries where the credibility of monetary policy has been severely harmed by the previous unsuitable economic policy. On the other hand, the currency board system is a relatively simple system for small countries with unavoidably open economies and who wish to get closer to a bigger economic region with a more stable currency.

The main weakness of the currency board system is its low flexibility in certain situations. For example, while regulating the short-term liquidity of the money market relying on the interest arbitrage and international capital flows alone can turn out to be inadequate due to the discords deriving from the risks of the payment system. This can have a negative effect on the efficiency of financial intermediation.

However, the possible shortcomings of the currency board can be overcome without causing major damage to the foundations and advantages of this monetary system. In practically all countries using the currency board system the central banks apply some means of improving the everyday functioning of the money market, aimed at adapting this monetary system to the requirements of the developed financial markets without changing the principles of the currency board.

The central bank can interfere to the extent by which the external reserves at its disposal exceed the minimum determined by the currency board. Naturally, the use of such a buffer for regulating liquidity has to be clearly defined and rest on definite rules in order not to harm the general credibility of the currency board framework. On the other hand, the commercial banks' own liquidity buffers in the central bank (reserve requirement, for example) have been strengthened or the possibilities of the banks to exchange their liquidity reserves kept in foreign currency into the national currency at the central bank (swaps, etc.) have been improved.

Due to the above, the regulations of the currency board have been successfully combined with the flexibility expected from a modern-day central bank. Through the stability of the money market this development in its turn increases the credibility of the monetary policy and contributes to achieving the final goal, the stability of the national currency. Due to those changes the impact the currency board has on the money market is not much different from the impact of the so-called ordinary central bank.


Interest Rate Level

In the conditions of the fixed exchange rate and capital mobility, interest rates of the money market are first and foremost affected by the decisions of the central bank of the country of the base currency. Thus, in Estonia the changes in interest rates have been determined by the monetary policy decision of the Deutsche Bundesbank. As a result of the interest rate arbitrage the differences in interest rates on the Estonian and German money market first of all reflect changes in the market estimates on the exchange rate and credit risks.

Thus, it is only natural that on the inter-bank money market the short-term kroon interest rates have closely followed the trend of the rates of the German mark. In 1996 interest rates in Estonia were affected by the Bundesbank's decision in April on changing the discount rate and the short-term interest rates were even more affected by the lowering of the repo rate at the beginning of the third quarter. At the beginning of 1996 Estonian interest rates were also affected by the lowering of interest rates by the Bundesbank at the end of 1995 (see Figure 15).

Figure 15. Interest rates on the Estonian and German money market, between 1994 and 1996 (%)

The considerable decrease in the interest rates on the Estonian overnight money market in July and August was besides the external factors also affected by the changes in the monetary policy operational framework made by Eesti Pank. The new situation led to the temporary decline in the volume of overnight lending transactions and brought interest rates even below the interest level of the German mark. However, the sharp fall proved to be specific to the adaptation period and by September the previous margin between Estonian and German interest rates had been restored.

In the last months of the year a certain level of instability could be detected in the interest rates of the overnight market. As the overall liquidity of the monetary system remained at an acceptable level, the fluctuations of the average interest rates on the overnight market could be attributed to risk evaluations on the microeconomic level. This argumentation is supported by the fact that only a few banks had problems with meeting the reserve requirement at the end of the year and they thus had to borrow more from the overnight market. The sharp increase in the demand of some banks brought about a temporary rapid increase in the average interest rate.

Despite the similarities of the interest rates of the Estonian kroon and its anchor currency on the short-term money market, there are still noticeable differences in the interest levels of long-term assets and liabilities. Like in 1994 and 1995, a certain decline in the long-term kroon interest rates could be noticed in 1996 as well as their approach to the interest level of the German mark. On the long-term market, interest rates were first and foremost affected by the considerable inflow of long-term foreign capital meant for credits and continuously high loan risk rating (see Figure 16).

Figure 16. Deposit and loan interest rates in Estonia and Germany, between 1994 and 1996 (%)

Monetary and Credit Aggregates

Last year was characterised by the continuing remarkable increase of the monetary and particularly credit aggregates which was mainly based on the capital inflow and the development of financial intermediation. The only exception was the considerable slow-down in the growth rate of cash in circulation.

In the development of broader monetary aggregates the processes that had emerged in 1995 persisted, characterised by the continuing decline in the share of cash and the increase in deposits by private persons. Broader aggregates increased at practically the same rate as in 1995 while the 12-month growth rate of cash demand slowed throughout the last year: at the beginning of 1996 the total amount of cash in circulation was approximately 28% larger than in the same period of 1995 but by the end of December this figure had declined to 12% (see Figure 17).

Figure 17. Estonian monetary aggregates, between 1993 and 1996 (EEK mn)

In the structure of the broad monetary aggregate M2, the share of time deposits increased considerably throughout the last year. Due to the gradually declining share of cash transactions, the share of demand deposits increased by the end of the year. The share of foreign currency deposits remained on the level of 1995 (10%) throughout the past year. The changes in the structure of monetary aggregates can be explained by changes in the liquidity preferences of economic agents and the growing credibility of the banking sector (see Figure 18).

Figure 18. Structure of monetary aggregate M2, between 1994 and 1996 (%)

Mainly due to the constant slow-down in the growth rate of cash the increase of base money was also moderate in 1996. Only in the last months of the year a slight seasonal increase was recorded.

Besides the structural changes of the broader monetary aggregate the monetary environment of 1996 was also characterised by the considerably quicker increase in the volume of loans as compared to the increase in deposits. Besides the savings by residents, the banks financed their loan supply from foreign long-term credit resources which are gaining an ever more important role in the lending activities. In the bank liabilities, the share of resources received from foreign credit institutions increased to 7.7% at the end of 1996 (see Figure 19).

Figure 19. Increase in the volume of monetary and loan aggregates, between 1994 and 1996 (compared to the respective period of previous year, %)

The relatively rapid growth of the credit supply was also facilitated by the changes in commercial banks’ asset management which increased the share of loan portfolios in the balance sheets. At the same time this meant a simultaneous decline in the share of foreign reserves which could be noticed particularly clearly at the beginning of the year. On the one hand, these changes in the structure of the banks' balance sheets indicate increasing credibility in the development of the local market and the solvency of the residents, but on the other hand it means the concentration of potential additional risks in the banking and in the Estonian monetary system as a whole.

Another explanation to the extensive development of the domestic credit can be found from the changes in the structure of the loans. In the loan portfolios, the rapid absolute and relative growth of the share of credits granted to financial institutions continued. A large part of these financial institutions is made up of the banks' own subsidiaries involved mostly in the leasing activities. The loan demand of private persons increased as well, mostly thanks to the fall of interest rates and extended maturities of lending (see Figure 20).

Figure 20. Loans to residents and fixed income securities, between 1994 and 1996. Structure by customers (%)

Exchange Rate

Throughout the post-monetary reform period the Estonian kroon has been pegged to the German mark. The impact of the monetary policy based on the fixed exchange rate on the Estonian economy depends thus directly on the changes in the exchange rate of the German mark against other foreign currencies important for the Estonian economy.

In 1996 the German mark weakened somewhat against those currencies. As a result, the exchange rate of the Estonian kroon was slightly weaker in 1996 than it had been in 1995. However, the changes were relatively minor as compared to the sharp fluctuations of 1995. By the second half of 1996 the external value of the kroon stabilized mainly on the level of the second half of 1994 (see Figure 21).

Figure 21. Exchange rate of the Estonian kroon against the currencies used in foreign trade, between 1993 and 1996 (base index, January 1993 = 1)


The peculiarities of the currency board system and the initial stage of development of the banking sector allowed Eesti Pank to maintain a relatively homogeneous operational framework of monetary policy for nearly four years after the 1992 monetary reform. Among the developments during this period the most important were the introduction of the limited use of reserve requirement and the central bank certificates of deposits (CD).

In connection with the above we have to keep in mind that, due to the policy of the fixed exchange rate, the aim of Eesti Pank's monetary policy has never been to control the increase in the money supply, e.g. through securities’ issues, reserve requirement or some other instrument. The issuing of CDs was begun in the spring of 1993 first of all in order to develop the market, although the repurchasing transactions allowed to use them also as a liquidity buffer for the base money. The observation of reserve requirement was required until the summer of 1996 and thus their use in smoothing liquidity shortages was complicated. The use of reserves for everyday transactions was permitted at a relatively high penalty interests, to a limited extent and during a limited period of time.

In the second half of 1995, Eesti Pank began to draft bigger changes in the existing operational framework of monetary policy. Despite the relative success in Estonia (see Figure 15) of the functioning of the currency board liquidity management principles -- free movement of capital and interest arbitrage -- there were signs of increasing financial risks of the payment system deriving from the expansion of the financial sector.

The transfers had become increasingly dependent on the inter-bank money market. The need to optimize costs forced the banks to economize more on the non-interest buffers of the base money. The customers became more and more exacting about the quality of the payment services. Instances when it was not possible to guarantee that all payments involved in a clearing be transferred on the same banking day became more frequent (see Table 32. Some indicators characterizing the monetary policy operational framework). As we can see from the experience of other countries relying on the currency board system dependence on the international capital flows alone is not always adequate in case of a more developed financial sector for achieving monetary balance and cannot thus fully replace the liquidity management activity of the central bank.

Table 32. Some indicators characterizing the monetary policy operational framework (monthly average of a period, excl. 6. and 9.)



20.06.92 -

05.04.94 -

01.07.94 -

01.07.96 -



Deductibility of vault cash in meeting the reserve

Including vault cash in the reserve
requirement was not allowed

up to 50%

up to 40%



Share of vault cash in meeting the reserve







Banks' foreign exchange transactions with
Eesti Pank / monthly average foreign exchange
reserves of Eesti Pank







Supply of Eesti Pank certificates of deposits (CD)
(EEK mn)

up to EEK 30 mn
twice a month

EEK 30 mn
once a week

EEK 30 mn
twice a month

EEK 30 mn
once a month



Use of CDs through repo transactions and re-selling
before maturity (EEK mn)







Biggest monthly use of CDs through repo
transactions and re-selling before maturity (EEK mn)







Use of reserve requirement for penalty interest rates
(EEK mn)

no comparable data





Share of inter-bank market overnight loans in all
payments, settled via Clearing Division of Eesti Pank







Payments eliminated from final settlement
(number of cases)

no comparable data




(1) Excluded are the banks to whom special temporary reserve requirement was established.

For the sake of greater credibility and transparency of monetary policy ,discretional instruments were left aside while planning the changes and attention was focussed on the reserve requirement and the possibility of creating standing facilities. In the second half of 1996 the constant maintaining of reserve requirement was replaced by the obligation of keeping the balance of the deposits in Eesti Pank at the required monthly average level. Thanks to this change, the banks now have a considerably larger base money buffer at their disposal for everyday transfers and for the use on the inter-bank money market. In order to discipline the banks' liquidity management, however, it is still mandatory to maintain a 20% daily reserve and these balances can only be used at a penalty interest rate. At the same time the share of cash in reserve requirement was also lowered by 20% as the former level did not stimulate the banks to optimize their cash surpluses (see Figure 22).

Figure 22. Balances of banks' accounts with Eesti Pank in 1996 (EEK mn)

In order to allow the interest arbitrage to fulfil its role as the money market liquidity regulator more successfully, from July 1996 Eesti Pank abolished the difference between the buying and the selling exchange rates in transactions involving the Estonian kroon and the German mark. The relatively small difference between the exchange rates used before still prevented efficient short-term interest arbitrage because of the costs of the transactions involved.

As an additional stimulus for the stabilization of the banks' base money demand, Eesti Pank for the first time introduced the standing deposit facility for the banks in the second half of 1996. In order to avoid market distortions and to increase the credibility of the currency board the interest rate paid on the banks’ excess reserves is lower than the interest rate on the Estonian money market and linked with the discount rate of the Deutsche Bundesbank.

Changes in the rules of maintaining reserve requirement reduced the dependence of the banks on the relatively unstable inter-bank money market and lowered the systemic risk related with it. As the costs of the foreign exchange market have decreased, the volume of transactions has increased considerably and thus we can presume that the efficiency of the interest arbitrage as the money market liquidity regulator will increase in the future (see Table 32).

Eesti Pank sees its further options for improving the monetary policy framework in improving the access to information of the money market agents, expanding the possibilities of standing borrowing facilities and improving the technical setup of the reserve requirement.