Märten Ross. Estonian experiences in the ERM II

"Panel on Country Experiences in the ERM (II)"
Comments on Estonia

Märten Ross, Bank of Estonia

Estonia joined the ERM II on June 28, 2004, less than two months after joining the EU on May 1. The entry was widely expected as there were several factors supporting an immediate move after accession into the EU itself. The following two years in the mechanism have been uneventful. This has cooled both the hopes and concerns observers voiced before joining the mechanism.

Background

The act of joining the ERM II so soon after the EU accession created very limited public debate or controversy. The primary reason for this was that Estonia had already had almost 12 years' experience with a strictly fixed exchange rate peg under the currency board arrangement.

In fact, Estonia opted for a strict currency peg immediately after the introduction of its independent currency in June 1992. Regarding the conduct of its monetary policy, it implied that the Bank of Estonia has already been intervening in the foreign exchange market for years at the mid-point of the fixing (15.6466 EEK per EUR since 1999) without even the buy-sell margin. If one adds in the facts that capital mobility had been totally liberalized by at least 1994 and banks heavily use cross-border financial flows to equilibrate the domestic money market, it is indeed the type of system that is as close to the currency union as an independent currency regime can possibly be.

It is also important to note that the fixed exchange rate served as a nominal anchor during previous crisis periods (e.g. the banking crisis in 1992 and the so-called Asian/Russian crisis of 1997-1998) as well as during the calmer years of the early 21st century. During this period it helped to successfully contain inflationary pressures. The inflation differential on average had been well in line with the theoretical assumptions on the price level convergence process between transition economies and more mature economic areas.

As a result, the public's expectations that the exchange rate could serve as an additional shock absorber were all but non-existent.

Therefore, it is not surprising that the public by and large had already had the perception of living with a de facto currency union in place. Joining the ERM II in that context was widely considered a mere formality, as it did not bring along any further exchange rate fixity. It is also not surprising that in this context the ERM II entry was widely understood to merely be an unavoidable step towards eventual euro area accession.

In addition, while trying to assess the impact of joining the ERM II on the Estonian economy one should underscore the importance of the entry into the EU itself on the economy. Therefore, it is difficult to separate the effect of one step or another on economic developments.

It is also important to stress that both the moment of joining and the following periods under the ERM II have been accompanied by very favourable conditions for capital flows into the catch-up countries, including the new member states. This makes specifying the effects of joining the mechanism even more complicated.

Lessons from the entry

Entry into the ERM II itself went very smoothly. One has to admit that 'good peer pressure' before joining was very helpful in assisting the authorities to steer economic policies towards prudent fiscal and financial sector strategies. This is so even if one recalls the other economic discussions among EU members at that time, as well as within the multilateral organizations, as being rather excessive anyway.

The discussions also appeared valuable in the sense that early on they clarified the differences in the economic experiences between the older and newer member states. From the Estonian perspective it was very helpful to realize the fact that the knowledge of the currency board and convergence process in general appeared to be more limited than expected. For example, the different historical experiences with exchange rate pegging made expectations about a possible regime shift after ERM II entry diametrically opposite to one another.

Some complications were connected to the communications part of the ERM II entry process.

Firstly, it appeared rather tricky not to violate the rules of avoiding any pre-commitment on the exchange rate under the currency board type monetary strategy setup without undermining the credibility of the peg itself. On the one hand, it was understandable that the rules of ERM II type multilateral negotiations start from the common understanding that the main objective of the negotiations - i.e. a central parity - is not prejudged by one or another party.

On the other hand, it is obvious that the success of any exchange-rate-based monetary strategy is dependent on the authorities' commitment to gear other economic policies to the rule of a pre-determined exchange rate fixing. Clear communication of this aim is a key point.

Any sign of hesitancy in that would have undermined the very core of the strategy itself. For example, if journalists asked the simple question - "What is your exchange rate strategy?" - The only obvious way to answer was to commit oneself to the long-term target of a fixed exchange rate. It would have been absurd to respond in any other way.

The only possible way out of the dilemma was to minimize public exposure of the issue prior to the ERM II negotiations. However, one has to admit that this kind of concealment is not in line with the broader principles of the good conduct of monetary policy.

Secondly, and partly resulting from the first complication, some elements of the public also questioned the rationale of the arrangement per se for currency board countries such as Estonia. This is not surprising as any argument for further exchange rate fixing within the ERM II compared to the present exchange rate system was apparently nonsensical. On the contrary, these commentators pointed out that it might lead to less certainty in and clarity of monetary policy strategy.

Indeed, one has to accept that compared to a unilateral commitment to a zero fluctuation band under the currency board, the +/- 15% fluctuation band of the ERM II had the potential to send a totally conflicting signal to the market concerning the authorities' potential moves on the exchange rate.

For a while, therefore, there was also discussion on the possibility of applying for a narrower fluctuation margin (e.g. in Denmark). However, even this arrangement would have had a potentially misleading signalling effect, as it would have still implied a regime shift. On the other hand, it is obvious that any commitment from the system's point of view would not have been easy to achieve anyhow.

Therefore, the 'least troublesome' approach of the general agreement (i.e. that would appear 'normal' to the public) to Estonia's unilateral commitment was chosen by both sides to minimize any possible misunderstanding of policy intentions. This was successful.

Life in the ERM II

The experience of living in the ERM II has, in a way, proven that it has not at least done any harm.

From the economic point of view, the two years under the ERM II have been characterized inter alia by strong growth, noticeable capital inflows and improvements in productivity. Overall, it appears that the supply side effects of the EU accession itself have been greater than expected (including easing trade flows and integration).

While inflation has been somewhat higher it is mostly attributable to external shocks and in any case has not exceeded the expected convergence "tolerance band" accompanying the improvements in productivity.

The exchange rate peg has remained highly credible as evidenced by the low interest rate margins. However, as the overall economic environment has remained very supportive, it is rather unclear what role (if any) the ERM II has in this credibility building.

Possibly its only effect is related to cementing the public's expectations about eventual euro area entry more concretely. This is ironic, as this element of entry was intentionally downplayed during the entry process itself.

From the technical point of view, life under the ERM II has been rather uneventful. For Estonia, it has made some external communications a bit easier. E.g. rating agencies and possibly some institutional investors have probably found it easier to frame our country analysis. The biggest change is probably the increased scrutiny in different formal European forums.

However, with some exceptions early after entry, the unilateral commitment to a strictly fixed peg under the currency board has clearly remained a more prominent policy commitment for the public than participation in the mechanism. Therefore, the credibility of the currency board per se has remained the focus point rather than the ERM II itself.

At the same time, it is clearly seen by the public as a 'de facto' waiting room for the upcoming currency union.

Märten Ross. Estonian experiences in the ERM II