The primary goal of Eesti Pank as a member of the European System of Central Banks is to guarantee price stability in Estonia, the key measure for achieving this being the strictly pegged exchange rate of the kroon to the euro. Thus, discussing last year's results I am going to first reflect on the Estonian price rise issues.

Monetary policy and inflation in 2007

The Estonian monetary policy framework and the stable exchange rate keep the inflation, i.e., the growth rate of consumer prices, stable in the medium term. Meanwhile, it should be emphasised that the so-called natural inflation in Estonia is slightly higher than in the European Union. The reason for this is very simple - in the world there is a certain link between the wealth and price level of a country. For instance, as at the end of the last year, the purchase power in Estonia amounted to 72% of the European Union average, but our price level reached an average of 64% compared to that of the European Union. Along with income growth prices are also rising gradually.

Inflation in Estonia exceeds the average of the European Union as long as the Estonian economic growth outpaces that of Europe. In general it is estimated that in the medium run the Estonian inflation may exceed the respective indicator for the euro area by an average of 1.5 to 2.5% per cent. This is feasible presuming that the euro area's price rise will remain at approximately 2%, which is the goal of the European Central Bank. When inflation in Europe accelerates, like in the first half of this year, also the difference between the euro area and Estonia will increase.

Meanwhile, the 2007 price rises in Estonia were also affected by several additional factors, including the rapid increase in domestic demand during recent years and rising prices in the global market. Still, loan growth started slowing and wage growth displayed first signs of deceleration at the end of last year's second quarter. Thus, the pressure on domestic prices by domestic demand, which had soared in previous years, started decreasing. At the same time, compared to the old Member States Estonia was more influenced by the price rise of food and fuel in the global market. Despite the waning domestic price pressure, at the beginning of 2008 the consumer price index exceeded 10% primarily due to the energy and food components.

Since the second quarter of this year, however, we have been witnessing clear signs of a deceleration in price rise. In the second half of 2008 we expect the Estonian price growth to gradually slow further. In 2009 and 2010 we estimate the inflation to drop to 5% and 3.5%, respectively. The inflation of 2010 may draw near the reference value of the Maastricht criterion, which is essential in terms of adopting the euro. However, this requires greater harmony between wages and productivity, i.e. the growth rate of wages must continue decelerating and the productivity of the economy as a whole must improve.

Primary fields of activity of the central bank

In order to guarantee the smooth functioning of the Estonian monetary policy and the pegged interest rate, the level of the banks' reserve requirement and the management of the foreign assets of Estonia are essential. The aim of the reserve requirement is to ensure a sufficient amount of liquid assets in the banking system and thus support the stable management of the banks' daily cash flows. Considering the insecurity that has overwhelmed the global financial markets, and the Estonian economic situation, in 2007 Eesti Pank maintained the reserve requirement rate unchanged at 15%. Banks had no difficulties with fulfilling it. By end-2007, the official foreign assets of Estonia, i.e., the assets backing the kroon, reached 33.7 billion kroons. In 2007, the rate of return on foreign asset investments was 4.2%, which slightly exceeded the forecast at the beginning of the year. The return was primarily influenced by the slightly different developments of interest rates in the US and in Europe.

The efficiency of monetary policy undoubtedly depends on the smooth operation of interbank settlement systems and cash circulation. I am pleased to confirm that in 2007 important settlement systems encountered no failures hindering the smooth operation of the settlement systems. Eesti Pank continued the preparations for acceding TARGET2, the new trans-European settlement system of the European System of Central Banks, and joined it on May 19, 2008. Via TARGET2 the central bank offers commercial banks operating in Estonia a fast and less expensive opportunity for settlements within the European Union. The interbank direct debit system was also launched. The new service enables customers to use direct debits also if the accounts of the payer and the payee are not held with the same bank. In 2007, there were no problems with meeting the cash demand and with cash circulation. As scheduled, Eesti Pank also launched the new 2- and 10-kroon banknotes with renewed security features into circulation.

Pursuant to law, in 2007 one of the main duties of Eesti Pank was to safeguard the stability of the financial system in cooperation with the Ministry of Finance and the Financial Supervision Authority operating by Eesti Pank. I can confirm that during the economic adjustment stage that began last year the banking system remained reliable and strong. After the hectic development of the previous years, the growth rate of bank loans started to decelerate in the second quarter of 2007 and has currently dropped to 15%. The capitalisation and liquidity of banks were and are good.

So far, the mayhem in global financial markets has not directly concerned Estonian banks, but indirectly the global events also influence the Estonian banking system. Thus, the climb of the interbank loan rate Euribor to 5.2-5.4% has also increased the loan servicing costs of Estonian companies and residents. The aggravation of risks in the operational environment of Scandinavian banks also compels them to adopt a more cautious credit policy, due to which the growth rate of loans may drop slightly faster than estimated and hinder borrowing in the future. Last week's events on Wall Street and the bankruptcy of Lehman Brothers also had a certain effect on the banking groups operating in Estonia. The financial crisis is also influencing the performance of the Tallinn Stock Exchange and the Estonian investment funds.

In 2007, the new capital calculation system, Basel II, was adopted. Estonian banks started using it as of January 1, 2008. In this respect, Eesti Pank updated the rules of prudential ratios, by which in 2008 housing loans in Estonia will be covered by 60% instead of the 35% weight allowed pursuant to Basel II. Thus, banks continuously need more capital to cover the housing loan risks than in Europe on average, which is consistent with Eesti Pank's conservative approach.
In 2007, also new reporting forms for banks were prepared. The new balance sheet and income statement schemes in accordance with international standards entered into force at the beginning of 2008.

Cooperation in the field of financial sector stability in the European Union deserves a special mention. One of the most important issues for Eesti Pank concerning the financial sector policies discussed in the European Union in 2007 was the arrangement of cross-border supervision in the single market of financial services and banking. The Estonian financial sector primarily consists of the subsidiaries and branches of the financial intermediaries of other Member States. Thus, Eesti Pank has supported the arrangement of supervisory activities that would enable to serve the financial stability interests of the country of location the most efficiently and ensure effective control over the operations of the whole group.

The measures adopted by Eesti Pank in order to avoid the risks deriving from a global economic crisis may be divided into two: crisis prevention and preparations for solving the crisis. For crisis prevention, Eesti Pank took steps to raise the capital and liquidity buffers of banks already in 2006 in order to improve the banks' resilience. Thus, in 2006 the central bank raised the banks' reserve requirement, i.e., their mandatory liquidity buffer to 15% of all their liabilities. This is considerably higher than the respective euro area indicator - 2%. Eesti Pank also increased the risk weights attributed to housing loans when calculating capital adequacy, due to which in 2007 the amount of banks' mandatory minimum capital rose by approximately a tenth. Currently the capital adequacy of Estonian banks is 18%, which exceeds the mandatory minimum value of the EU by more than twice. The main goal of preparing for crisis solution is cooperation within the European Union and with Nordic countries as well as national cooperation among different state authorities.

Shaping economic policy standpoints and making decisions and recommendations requires an effective system of monitoring and forecasting economic developments. Eesti Pank's analysis covers Estonia and the European Union as well as other major countries that influence global developments; it also includes the stress test of the Estonian banking system. Eesti Pank compiles the Estonian economic forecast every spring and autumn, publishing the current year's estimates concerning the economic developments and the prospect for the two next years. Eesti Pank presented all the results of the economic analysis at six economic policy statement press conferences and in print in two issues of Estonian Economy and Monetary Policy and two Financial Stability Reviews.

Naturally, the main duty of the central bank is to explain its economic policy standpoints and decisions to the Estonian citizens and their elected representatives. In this context our regular meetings with the members of the Riigikogu and the abovementioned publications - the annual report and the Estonian Economy and Monetary Policy and the Financial Stability Review - are essential. Since 2007 Eesti Pank added another informative publication, the Report on the Adoption of the Euro, to the existing ones, published semi-annually. Eesti Pank also comments on the major economic indicators every month and replied to 2,440 information queries in 2007.

Finally, let me introduce Eesti Pank's activities to improve the efficiency of organisation management. In 2007 Eesti Pank formulated its values, which are divided into four categories: competence, cooperation orientation, reliability and consideration. A regular study on management quality was also conducted, involving over 70% of the employees. The information system of management accounting was improved, the process management development committee was established and the rules for describing participation in processes were harmonised (to improve the process-based budget drafting). In 2007, the focus of risk management was on planning the business continuity of the bank's key processes.