Rein Minka. Presentation at the business seminar in Lisbon

Presentation by Mr Rein Minka, Deputy Governor of Eesti Pank

Estonian Business Seminar in Lisbon
November 28, 2005

His Excellency Mr President, distinguished speakers, Ladies and Gentlemen,

First, please allow me to thank the previous speaker for the introduction to the recent trends in the Estonian economy. I would also like to thank the organizers of this Business Seminar for giving me the opportunity to share some thoughts about the Estonian financial system and our preparations for full membership in the euro area.

Main characteristics of the Estonian financial system

From the financial markets' point of view, Estonia and our neighbouring Baltic countries have always looked towards Europe. We have always belonged to the Scandinavian area of economic interest. Estonia's stable macroeconomic position, improving investment environment, transparent and flat tax regime, and liberal policies towards trade and capital movement have promoted foreign investors' interest in our business environment and financial sector. Today, foreigners own almost 100 per cent of our commercial banks and their subsidiaries.

The integration of our financial markets has been essential to the development of the Estonian economy. The three main characteristics of our financial system are:

a)  Firstly, the high level of integration of our financial markets with the European, or more specifically, the Scandinavian markets.
Today, the Scandinavian and Baltic financial markets are very closely integrated. Banks dominate the financial system; the strategic owners of our banking sector are mainly Swedish and Finnish financial groups. Their interest in the Estonian market can primarily be explained by the profits the banks make and although competition has lowered the margins during last few years, the non-interest income is still solid, while liquidity and capital adequacy ratios have remained very satisfactory by international standards.
b)  Secondly, consolidated financial sector supervision.
Financial sector supervision is consistent with the best international practices and the importance of cooperation between regional supervisory bodies cannot be overemphasized.
c)   Finally, the stable macroeconomic environment coupled with membership in the European Union has been very important. A rapidly growing economy and positive expectations towards future income growth have fuelled optimism towards the financial sector and supported the demand for credit.

Interest rates on longer-term projects have decreased almost to the levels of most "older" member states of the European Union.

Why do we consider a quick accession to the EMU necessary?

The Estonian economic model has been at the centre of international interest and discussions as a model of a small open economy with a fixed exchange rate. It has proved the currency board to be a splendid interim arrangement for achieving a stable exchange rate, decreasing inflationary expectations and maintaining a responsible fiscal policy. The importance of external targets like EU membership, or now, the expected euro area membership as common policy goals has been striking.

A similar macroeconomic framework and fixed exchange rate vis-à-vis the euro have forced Estonia to keep its product and labour markets flexible. The fixed exchange rate policy and full current and capital account convertibility are very similar to the current rules of the euro area. Full capital account convertibility, meaning no restrictions to the foreign investors in Estonia, has supported the reorganization and integration of our economic system so as to be more competitive and suitable in the European context. The flexibility of the product and labour markets has been necessary to ensure the adequate functioning of the fixed exchange rate policy.

As the exchange rate of our local currency, the kroon, has been pegged to the euro and its markets have adapted to its functioning flexibly, it is natural for Estonia to soon change kroons into euros and make full membership in the euro area an exit strategy from the currency board arrangement. The changeover to the euro will take no toll on policy-making - we do not need to surrender or completely change our main policies such as the exchange rate, interest rate, or fiscal policies. We have already made all the necessary changes to be politically ready when the moment arrives. That is why Estonia wants the changeover to happen as quickly as possible.

We have always kept our long-term macroeconomic policy goals in check, and when one thinks of the limited number of political instruments available to Estonian policy-makers, the results speak for themselves. Estonia is not expected to have any major difficulties in meeting most of the Maastricht criteria. The budget has been either in balance or in surplus for the last 5 years and will be in surplus again in 2005. The central government has not borrowed from the international markets since 2001 and is not borrowing from the local market, so the debt level is low and decreasing, holding steady at 5.5 per cent of GDP this year. The exchange rate has been fixed for 13 years, and interest rates, as I have already said, have decreased to the levels seen in most euro area countries.

Clear and simple economic rules have supported the stabilisation of inflation and the convergence of price and income levels towards the EU average. The somewhat worrying pick-up in the inflation rate in 2005 has been mainly caused by external factors - meaning, the increase in the prices of fuel and its related products. However, core inflation reflecting domestic price pressures has been stable for the last 2 years. It is natural that the Bank of Estonia is observing the inflation behaviour very closely, although we do not regard temporary political changes that influence the inflation level well, as these may decrease the credibility of Estonian policy-making principles.

Practical preparations for the changeover

The message I want to stress here is that apart from inflation, Estonia will be technically ready for the changeover in summer 2006, by which we will have participated in the Exchange Rate Mechanism II for two years and completed all the legal and practical preparations for the changeover.

Estonia is a small country, just half the size of Portugal, and thus we expect fewer logistical problems than most of the current euro area members had to face. This is also a reason why we consider the so-called big bang scenario - meaning no transition periods for settlements, accounting, or other reasons - and a minimum parallel circulation period for the two currencies as sufficient.

Until we actually qualify for full membership in the European Monetary Union, Estonia will continue to follow sound economic policy-making rules. On this positive note I would like to finish this short overview. Thank you very much for listening.

Rein Minka. Presentation at the business seminar in Lisbon