Märten Ross. Challenges of Monetary Accession: the Case of Estonia




Background paper for Euro-50 meeting in Brussels, 10/07/2002(1)
Märten Ross
Bank of Estonia

(1) Special thanks to Reet Reedik from the Bank of Estonia for valuable comments and assistance in preparing the paper.


After regaining its independence Estonia started the transition from a planned to a market economy in a quite unfavorable position. Enormous structural rigidities of the Soviet economy compared to somewhat more liberal regimes of eg Poland and Hungary were notable. This caused deeper initial restructuring and arguably also bigger social adjustment than in many other transition economies. Statistically, this is captured by official growth data of early 90ies (Figure 1). In addition, being a newly independent country, Estonia had to rebuild its most basic elements of credibility from nothing.

Following a clear rule-based monetary policy has been one central ingredient of the transition strategy in this 'environment of change'. Estonia started with DEM-based currency board arrangement immediately after the introduction of an independent legal tender and has followed this strategy ever since. Although many other elements of economic restructuring carried probably also a big part of the burden, the monetary strategy has been probably the single most important factor in anchoring the functioning of the market economy and supporting stable framework for reallocation of resources and building up new private and public sector institutions (Table 1). Dynamics and flexibility of the labor force has been high, especially in 1992-1994 when the average yearly hiring and separation rates reached well above 20%.

Leaving aside the transitional recession immediately after the 1992 currency reform lasting till 1995, the average growth rate of the Estonian economy has exceeded 5 percent (in the years 1995-2001). GDP per capita in constant prices has increased by about 40 percent, nominal wages 2.4 times and real wages by a third over the same period. Productivity growth in manufacturing over the last five years has exceeded two times the cumulative rate of REER. Even with the current slowdown in Estonia's subcontracting industry direct exports have maintained their positive and quite stable growth rate (~10% y-o-y).

Experiences of transition under currency board - overview

It is of course difficult to compare different periods of transition along the same parameters. However, there are clearly some general conclusions from these 10 years that are relevant for analyzing optimality of different scenarios towards the European Economic and Monetary Union (EMU).

The first conclusion is clearly of no surprise: exchange rate stability has brought about decisive and successful stabilization of inflation. This is, of course, not too surprising given the openness of Estonian economy as well as its early adoption of liberal trade and capital mobility regimes. Even more importantly, both inflation and real effective exchange rate have generally followed a fairly stable path over these difficult years. Taking into account convergence-related growth in price levels the stabilization towards the trend equilibrium has been comparatively fast even after stronger misalignments, like for example resulting from the devaluation of the Russian ruble (see Figure 2).

Secondly, contrary to many other experiences with exchange rate targets, Estonian currency board has preserved even in difficult times high level of credibility in the eyes of financial markets and more importantly -- in the society. In particular, after the "testing periods" of Asian and Russian crisis of 1997 and 1998, the credibility has remained solid.

Thirdly, while Estonian economy experienced considerable output volatility in 1998-1999, the subsequent quick recovery from a strong external shock is a sign that the currency board provides fast and credible signals for the economy to react on changes in global environment. As a result, the periods of restructuring have been fairly short and reallocation of resources has happened efficiently. Specifically, by stabilizing external prices, it has provided at least some anchor not only for inflation but also for unavoidable and massive changes in the price structure. This leads us to a conclusion, that in addition to a macroeconomic stabilization, credible fixed exchange rate regime provides the economy also microeconomic advantages and assists its flexibility. This, by definition, reduces the merits of exchange rate as a tool for adjustment.

In conclusion, Estonian experience has shown that with sufficient credibility and relevant policy support in the fiscal and structural front (eg financial sector strength), fixed exchange rate arrangement can deliver the effects expected from it in theory

Linking past with future - from currency board to monetary union?

Keeping the above in mind, it is not surprising that the currency board framework has built up considerable legitimacy among Estonian electorate. Therefore, it is rational to assume, that voters require very thorough and understandable reasoning to change the system that has proven its efficiency.

The only obvious alternative that seems to be accepted by the public today is to join a stable monetary union -- EMU. At some point the public acceptance of single currency seemed to be even stronger than joining the European Union itself.

This approach is understandable. Currency board brings a fixed exchange rate strategy almost as close to a currency union as one can imagine. By imitating the same transmission mechanisms and the basis for economic policy-making, the credible currency union with the base-currency area is rather a "crown-jewel" and less a major change in formal policy principles. By definition, if a currency union is credible, it provides any unilateral peg the additional credibility that can not by definition be delivered by it independently.

Definitely, there is a threat that in this context the public misunderstands some critical elements. Most importantly, currency union, contrary to unilateral commitments, is by definition a "team-project" that could theoretically influence some economic policy discussions - ie restrain independent policy-making even beyond monetary policy framework. However, compared to the currency board situation, objective argumentation should not be very different.

From economic point of view there would be only few technical differences for the economic agents on monetary front. The interest and exchange rate policies change only to the extent there are inefficiency margins today due to independent currency system (Figure 3). Transmission mechanism works to large extent similarly under credible currency board and within the monetary union. There are definitely some changes due to presumably deeper integration of real economy and financial markets. However, this does not change basic paradigm the firms and individuals have been working recent 10 years.

It is therefore not surprising that when combining politics and economics the only serious strategy towards the EMU is the one that leads directly from currency board towards eurozone. It is logical to assume that baseline scenario for Estonia, which is least shocking for the economy, is to continue with the unilateral currency board commitment until the EMU accession and to join the single currency with the present parity.

However, the above argumentation should not in any way give a false signal that the accession is not facing potential threats even under the currency board. Broadly speaking, these could be separated into two.

Firstly, there are, like under any other currency regime, question marks about how well the macroeconomic stability is preserved in the accession process. Potentially, accession could bring about changes in the structure and volumes of capital flows or in resource allocation of the economy in general that could lead either to outright overheating or at least to an uneasy mix of policies. Secondly, even if the logic of baseline scenario is definitely a strong one, there are questions about its fitness into "the club rules" that can not be overlooked.

Challenges of accession - "economy" (2)

(2) For the sake of honesty, one should stress that not all challenges are strictly speaking EMU-accession related, but are more broadly linked to EU. However, considering the limits of this article and present close time-schedules of these processes, the separation is not necessary.

Economic challenges of monetary accession are two-fold.

Firstly, there are doubts that higher credibility and possibly also some sort of accession-related speculations could induce too high level of both private and public investment, that by definition should be partially financed by capital inflows. Leaving aside credibility related issues of the accompanying current account deficit, there is acute threat of resource misallocation and/or excessive price pressures and maybe also resulting speculative pressures on financial markets. Arguably, if materialized, this could hamper the prospects for fast real convergence.

Secondly, there are doubts, whether Estonian good track record of fiscal discipline could be preserved during the accession, possibly hurting the basis of efficient functioning of the currency board or even the smooth functioning of economy in the monetary union. This threat could be generated by excessive financing needs of accession related projects if other expenses are not correspondingly restrained. Or if accession related "herd behavior" of the financial markets makes the temptation of higher borrowing so overwhelming that the political establishment gives in to the pressure.

Both of these risks could potentially have detrimental effect on the baseline scenario. This could happen predominantly because its basic argument - the assumption that long-preserved exchange rate parity provides also equilibrium exchange rate for the entrance to the monetary union - becomes considerably weaker in the public debate. However, even if these threats should be taken seriously during the policy discussions, they are definitely not sufficient to ex ante challenge present base-line scenario.

Firstly, Estonian economy and monetary system has already faced restructuring pressures over the transition period. And one should not forget that Estonian trade and capital flows have been fully liberalized already for nearly 10 years. The shocks have been massive both in terms of capital and trade flows as well as prices. One example is interest rates where the largest share of EU accession effect is already priced in. Also, much of the legislation is already or will be harmonized well before monetary union.

In this light it is quite difficult to envisage that the future periods would by definition generate bigger threats to stability or per se induce less conservative macromanagement on fiscal side. If the rigid monetary framework has managed to stabilize economy thus far, there are no reasons to believe it would do less so either within the EU or even within the EMU. Therefore, although both of these challenges should be taken seriously, there are no arguments why they should work against otherwise logical move from currency board towards the EMU. Additionally, several of above-mentioned risks are actually better coped within currency union and not outside of it.

Challenges of accession - "rules of the club"

One of the aspects that public tends to forget in the EMU discussion is the fact that this is a complex and multidimensional project, where generally accepted rules of the Treaties are the only noticeable anchors of stability. Thereby, preserving the stabilizing factor of these rules is fully in the strategic interests of the accession countries. Therefore, if it could harm the credibility of the EMU then starting to fine-tune some aspects of the rules are not automatically in the interests of accession countries. Even if it is probably right to note that the present rules were designed for different development stage of the EMU and are less relevant for transitions countries' specific situation .(3)

This is not to say that Estonia does not potentially face these problems. The main challenge concentrates on Maastricht criteria of price and exchange rate stability, or in other words on requirement to preserve real exchange rate stability during the measurement period.

There are different academic arguments why the transition economies should face the equilibrating real exchange rate appreciation during the transition. True, there are theoretical discussions why, how fast and how much exactly. But even if we do not agree to which level (Vienna? Andalusia? Helsinki?) and when (5, 10 or 20 years?) we should expect this convergence to happen then for simplicity one should plainly restate the statistics, that there is considerable room for potential price level convergence over the coming years (Figure 4).

As exchange rate has been fixed to Euro, Estonian experience is similar to the results delivered in many theoretical works. Over the last couple of years the inflation differential has fluctuated around an average of 2% level compared to Eurozone (Figure 5) while growth differential has reached on average about 3,5% level.

Hoping for further real convergence, there is quite difficult to project any dramatic decline in this trend level over the next years. Clearly, this situation should be fundamentally distinguished from the situation where the inflation differential is generated directly by nominal or policy shocks. And importantly, there is seemingly strong evidence that under transparent currency board strategy this process has not even caused strong nominal rigidities in the economy that is otherwise referred to as a cause for concern. Furthermore, this process is something that could happen to anyone even within the EMU.

This puts us into the situation, where fulfilling the criteria could be difficult even if the reasons behind it are rather signs of strength and not weakness. True, considering the differential, the criteria could be met either by luck (the cycle happens to be on the downside) or by creative policies. However, it is questionable whether either creativity in this field or delaying the accession by being overly restrictive is more credibility enhancing for the EMU or for the accession process than taking good arguments into mind.

(3) Relevant example for Estonia is clearly the requirement to join ERM-II and again start proving the exchange rate stability after preserving euro-based currency board under full capital mobility for over 10 years. Even if there are good reasons for that also objectively, purely stability argument of avoiding questionable exceptions in unnecessary details is in common interest.

Alternative scenarios?

Any analysis of Estonian EMU accession scenarios is not fully honest if it avoids the question of euroisation. The temptation to look for shortcuts from the system as close to the monetary union as currency board is understandably overwhelming.

However, to start with, one should specify that the discussion is often blurred by very different variations of the topic. Most critically, totally unilateral and at least to some extent mutually agreed adoption of euro are often not separated. However, this is usually of critical importance.

Thus far, the waves of discussion over unilateral euroisation have come and gone without much wider consequence. This is not particularly surprising as the most essential requirement for more permanent support for such a move - domestic currency instability - has been waning in hand with strengthening credibility of currency board arrangement. At the same time, potential negative consequences of both political and practical nature (ie EU enlargement negotiations, unavoidable practical mess of such a major change, seigniorage loss etc) have continued to outweigh any remaining potential positive expectations (eg partially higher price transparency vis-?-vis the Eurozone).

Indeed, it is obvious that the usual argument for such a move, ie regenerating lost credibility of monetary authorities, is highly misplaced after 10 years of currency board and during credible EMU accession process. And there is no way, how unilateral euroisation could change anything in objective factors of economic agents' balance sheets (eg debt burden, competitiveness etc).

This is not to say that analyzing any such kind of a move is not sensible for Estonia at some future point of time. But most notably, presumption for this should be some developments that are related either to the emergence of some sort of bilateral support for it from EU side or strongly deteriorating outlook of "ordinary exit to EMU". In both cases the outcome could theoretically be also welfare enhancing even compared to euro-based currency board. Presently, there are no signs of any of these prerequisites to be a matter of practical relevance.

To sum up

The main conclusion of the above analysis is that the long-term strategy of targeting exchange rate via currency board arrangement gives us a clue also about optimal way of Estonia's convergence towards the monetary union. The present approach has built up both economic and political logic that prefers direct and fairly quick approach towards the EMU. Other tactical plans that stress either higher nominal flexibility or/and delaying the accession require clearly "something new" to happen in order to deliver better results.



Figures and Tables


Figure 1: Real GDP growth in selected transition economies
Source: IMF ,WEO database





Figure 2: CPI (12 month index ) and REER (base index 1995=100)





Figure 3: Interest rates in Estonia and Eurozone





Figure 4: Real and nominal convergence (Austria = 100)
Source: European Comparison Programme, Eurostat, OECD, 1996 and Bank of Estonia estimates





Figure 5: Annual CPI growth in Estonia and Eurozone




Table 1. Employed by economic activity (% of total)




Agriculture, hunting and forestry



Mining, electricity, water supply









Wholesale and retail trade



Hotels and restaurants



Transport, storage and communication



Financial intermediaries, real estate, renting



Public administration and defence






Health and social work