On the sustainability of Estonia's monetary system

Märten Ross
Deputy Governor of Eesti Pank

The stability of the monetary system is one of the fundamentals of an efficient economy. Although business risks will never disappear (nor should they), the state is able to simplify the future decisions of businesses and households by offering them a predictable financial environment.

It is always a challenge to ensure financial stability in a country with a small and open economy. Things are more complex because of the inevitable volatility resulting from the small size of markets and the fact that in a crisis situation, Estonia lacks the advantage of being able to use the economies of scale characteristic of larger systems.

The sustainability of the Estonian monetary system rests on three cornerstones. At its centre is the fixed exchange rate together with the restrictions of the currency board arrangement as well as euro area membership in the future. The success of the monetary policy also relies on conservative fiscal policy and on financial-sector policy, which is based on close integration with Nordic banks.

Rule-based monetary system

The main pillar of the Estonian monetary system and its sustainability is the so-called currency board arrangement. Its two underlying principles are the fixed exchange rate of the kroon to the euro and a firm limitation on money issuance in the form of the central bank's foreign reserves. Such a monetary system sends the strongest possible signal to the economy that businesses and households can rely on monetary stability relatively similar to that provided by the euro.

Naturally, it also means that the economy itself must adjust to shocks, whether by changing prices or regulating the production level. Such a "burden" is not a shortcoming of the system itself nor is it placing businesses in a less favourable situation compared to countries where the exchange rate must fluctuate in order to compensate for the inflexibility of businesses and, more generally, the markets.

The main objective of this kind of monetary system is to keep the long-term inflation rate close to the inflation of the euro area. In the previous years' boom environment, which was characterised by the rapid growth of domestic demand and external prices (e.g., food and energy), the attainment of this objective was perhaps one of the toughest challenges in our monetary history. Nevertheless, inflation expectations remained in relatively good check even at the peak of the growth cycle, and major risks resulting from large inflation inertia were avoided.

One question that has been raised over the years is whether the fixed monetary system is not limiting the Estonian economy excessively. Last year attempts were made to understand if larger exchange rate freedom has benefited or harmed smaller economies. There is no single answer to this question, since the outcome of the analysis depends on the specific situation in given countries.

It is now fairly clear that the existence of such a firm monetary system as the currency board arrangement has helped the Estonian economy to quickly adjust to external imbalances. Those who expected to see the opposite apparently overlooked the relatively well-known fact that monetary stability also plays an important role in shaping future expectations. In turn, expectations tend to determine how quickly and flexibly the economy responds to problems. Lack of clarity would probably have only extended the time it took for businesses to respond to contracting demand in global markets and needlessly prolonged economic adjustment.

The long-term use of the currency board arrangement also means that when Estonia joins the euro area, there will be no significant changes in the monetary policy environment for the country's economy. Moreover, years of experience with a pegged exchange rate have also been a benefit because, in principle, we are already living in the single currency area.

Sustainable budget policy

In order to be credible, the monetary system must also receive support from conservative fiscal policy. Otherwise it would be fairly difficult to avoid the erosion of confidence in money. Although technically there is no direct link between these two aspects, not many hope to keep the state from printing money in a situation where the budget starts slipping into deficit. Therefore it is not surprising that fiscal policy has almost everywhere in the world come under particular scrutiny in the current global crisis as a potential future risk to the monetary system.

Estonia is well positioned in this regard. By international comparison, Estonia has been relatively conservative in its fiscal policy through various economic cycles and governments since regaining independence. Budgets were in balance during the economic restructuring of the 1990s and budget controls were also largely intact in the aftermath of the so-called Asian and Russian economic crises at the beginning of this century.

In the rapid growth period of the recent decade, the consolidated state budget had a moderate surplus. As a result, public debt was insignificant at the beginning of the current downturn phase, accounting for only about 5% of GDP. The public financial position was reinforced not only by the low debt burden, but also by financial buffers accumulated over the years. It should be noted that these reserves were kept outside the Estonian economy and the financial system to ensure that they would function as proper insurance in case Estonia suffered a severe economic shock.

Considering that Estonia's liquid financial assets exceeded its debt, it can be said that the country's financial situation was fairly unusual (at least outside the oil producing countries).

What was the basis for such prudence? Contrary to popular belief, it was not legal restrictions that were restraining the budget deficit. Although the base documents that determine the whole structure of the Estonian budget underline the need for a balanced budget, these have not outlawed borrowing. Therefore, in terms of national economy, constitutional restrictions have not prevented the governments from increasing the deficit.

Instead, the determining factor behind our fiscal sustainability has been responsible economic policies that, over the years, have taught us that a balanced budget is a useful policy guideline both for politicians and for the society in general.

It is truly remarkable that public support for a balanced budget and low public debt has remained strong even in the toughest of times. Surveys commissioned by Eesti Pank during the most recent economic downturn have shown that one must avoid living beyond one's means. Such support would not have existed had the measures recently taken to ensure the sustainability of the budgetary position been unsuccessful. The benefit of the prudent financial situation has been particularly evident in the financial crisis that hit the world in the last few years. In our liberal economy, low public debt has guarded us against abrupt changes in the sentiment of the global financial markets. Moreover, our reserves have been the guarantee that the state would be able to survive brief liquidity problems if tax receipts were to decline sharply.

Irrespective of major uncertainty with regard to this region's economic development, we have steered clear of the crisis situations that have hit several other countries in financing public sector expenditure.

The biggest mistake we could now make is to start resting on laurels. There are still some concerns about Estonia's fiscal sustainability. Therefore, the priority for the next few years is to restore the pre-crisis situation, i.e., to bring the budget back into balance or into moderate surplus. This is also how we can restore the reserves we have been utilising.

According to current forecasts, this will not happen if all we do is hope that growth will resume. Since economic expansion is likely to remain modest over the next few years, it is inevitable that we must adjust revenues or cut costs that increased even more during the crisis to maintain a budget balance.

Another thing to be noted about fiscal sustainability is that the ongoing ageing of the population is going to gradually exert additional pressure on our economy.

Financial sector strength

After the eruption of the global financial crisis, foreign observers have been most concerned about the Estonian banking sector. This is attributable to the level of debt created during the credit boom in the middle of this decade. There was reason to fear that changed economic conditions would inevitably lead to large loan losses in our banking sector, and the state was expected to assume liabilities and cover the costs of deposit insurance.

This fear was partly justified. In spite of tougher restrictions imposed on banks and repeated alert calls, credit growth in 2006-2007 was clearly excessive and asset prices were higher than justified by their fundamental indicators. On the other hand, one should not forget the specific structure of our banking sector. Unlike many other emerging economies, our financial system was almost entirely and fully integrated into Scandinavian banking groups even before Estonia's accession to the EU. This was why the banks operating in Estonia had the financial capacity to go along with the borrowing spree. But it also meant that there was little point in assessing the financial strength of the banks only in light of the situation in Estonia. An important aspect was that the Nordic countries were relatively unexposed to the global financial crisis and their financial position was relatively strong. Moreover, their domestic loan losses have remained smaller than anticipated and no-one has put their solvency in doubt. As an additional security, banks operating in Estonia must meet higher capital and liquidity requirements.

Thus, the crisis has made it clear that closer integration into the EU has been the right approach in making the Estonian monetary system more sustainable.

But this market situation raises also new issues. Banking sector supervision cannot be limited to monitoring and regulating the home market alone. Co-operation between international supervisors and regulators is also a precondition for the efficient functioning of this kind of financial system. Thus, the sustainability of our monetary system is greatly influenced by the current development of the European single financial market.


The strong resilience of the Estonian monetary system to the global crisis is based on its capacity to withstand major shocks. In this respect, financial policy, fiscal prudence and the integrated banking system have been supplementing each other. Although the peak of the crisis has passed, we must keep reinforcing this resilience. One possibility is accession to the single currency system, but, in addition, we must restore budget surpluses and ensure efficient financial supervision to support financial integration all over Europe.

Published date: 
Published in: 
In Estonian Ministry of Foreign Affairs Yearbook 2010