Vahur Kraft. Presentation on currency boards

Helsinki Seminar on the Accession Process
Helsinki, 10-12 November 1999

Panel: Monetary & Exchange Rate Strategies
Subject: Currency Boards
Vahur Kraft
Governor, Eesti Pank

[Why a fixed exchange rate & the CB]

For transition economies the choice of monetary policy sets the basic conditions for the transition from their earliest stage. Monetary stability is one of the most important preconditions for successful reforms in other areas of economic policy. Looking back to the early 90s today, the dominating features of that period were high inflation, an inherited ineffectual allocation of resources and a major gap in the productivity between developed countries and transition economies. Therefore, we believe that monetary policy choices for economies in transition must be focused on long-term goals in order to achieve convergence with the developed world rather than on short-term effects for cushioning temporary fluctuations.

This is particularly true for very small open economies. Due to the small size of domestic market and high capital mobility during most of the 90s, the possibilities of influencing monetary developments are rather limited. Looking for a way of handling this, most CEE countries have experienced some sort of nominal anchor-based monetary rules during most of the 90s. That is to say that central Europe has been predominantly a domain of direct or indirect exchange rate targeting. Estonia's choice of the CB reflected the search for high credibility and transparency of its monetary policy as well as a firm ground for economic reforms. The choice of the CB versus a conventional peg proved to be appropriate for us during the international financial markets' turbulence in 1997-1998, as the CB offers a more efficient defense against external shocks than a conventional peg does.

Once again, after looking back at almost 8 years of using the CB in Estonia, we have to ask if the preferences have changed. In the early 90s, the main aim of the CB was to create an exchange rate-based stabilization policy. Today, particularly after weathering the recent turmoil in Asia and Russia, the central issue for monetary policy strategy is a smooth nominal and real convergence of the economy towards EU levels. According to our point of view, the CB is continually operational even though our objectives have changed over time.

[Basic features & Performance so far]

The re-emergence of CBs after WW II was never really in a pure orthodox form; i.e., they were currency board-like systems rather than pure CBs. This is also true for Estonia, even though the Estonian CB is more orthodox than the Argentinean or Hong Kong versions. These examples also indicate that CBs are not only suitable for developing economies but others as well.

The Estonian CB relies on some of the classical CB principles such as the full backing of the domestic liabilities of the central bank, prohibiting the financing of government deficits and the non-existence of discretionary monetary policy tools. To make this system work efficiently, it is presumed that it is open in terms of capital movement and integrated into the international financial markets. The latter point means that broader liquidity management is not restricted to domestic markets only. That is to say that openness is a precondition for CBs to be effective and hence CBs favor integration into international financial markets in general and European markets in particular. In this respect, CBs are in full compliance with the trend of further integration of financial markets within Europe. This topic will be covered in more detail in our second presentation, which deals with Financial Structures.

Estonian monetary policy has always been solely focused on maintaining monetary stability. Under a CB-type rigid fixing of the exchange rate, interest rates are determined by the markets, particularly for a small open economy. Under these circumstances – openness, the free movement of capital and a small domestic money market – a discretionary monetary policy for smoothing out interest rate fluctuations would be a rather complex issue. Therefore, by giving up monetary autonomy under the CB we have received monetary stability in return. The monetary policy measures of the ECB influence the Estonian monetary environment over the peg to the DM, which in actuality is a de facto peg to the EUR. The tightening or loosening of the monetary environment by the ECB does not contradict the trends of domestic monetary conditions, because close to 70% of Estonia's foreign trade is with the EU. This means that the possibility of being in a fundamentally different phase of the economic cycle than the EU is not likely to occur. In other words, the conditions for optimization of the currency sphere are increasingly being fulfilled for Estonia.

The track record of the Estonian CB on inflation trends is in accordance with the expected behavior of CBs in general: annual CPI inflation for 1999 will be about 4%, which is lower than in many CEE countries and hence does not imply the need for inflation targeting, at least for today. Inflation under CBs can be described as 'inflation targeting via exchange rate targeting', as price developments for a very small open economy are predominantly externally determined. CBs continually provide clear signals about the policy intentions of their respective authorities. While ensuring monetary independence from the government, CBs facilitate an adjustment of expectations and promote wage and price discipline, thereby lessening potential inflation biases. Still, that does not mean that price levels and structural convergence are over; or in other words, in the coming years there will be a slightly higher rate of inflation in Estonia than in the Eurozone.


Inflation and interest rates. Estonia's higher price increases as well as changes in the structure of relative prices have been part of the country's economic development in the course of which the price structure has gradually been approaching that of the more developed countries. The main source of real convergence is the diminishing difference in productivity between Estonia and these countries. Long-term interest rates remain higher than those in the Eurozone due to the market's perception of mainly credit risk differentials. As an indicator of the CB credibility, interest rate differentials between our domestic currency and its anchor currency have always been low (100-200bp.), except under the pressures of October-November 1997 and in autumn 1998 after the Russian crisis.

The rates of real economic growth since 1995 have been acceptable for a catch-up economy, peaking at 10% in 1997, except for early 1999 when a short recession occurred as a result of two years of international turbulence and overall sluggish growth in Europe. Over the first full economic cycle in 1994-1999, economic activity showed considerable volatility. This has, to a large extent, been caused by the smallness and openness of the Estonian economy. At the same time, the choice of monetary policy again proved its viability as it passed the test during the turbulence in the international markets and economy, and will have return to a growth path by the end of 1999. It is worth mentioning that during the adjustment period over the last two years, external balance improved remarkably, while net foreign debt even fell and is today ~10% of GDP. However, the price for this adjustment was that fiscal balance worsened: ~4% of GDP is expected for 1999. Due to the automatic stabilisers characteristic to CBs, the adjustment processes are perhaps more rapid than under conventional pegs, which may also explain the relatively high level of volatility in economic activity in recent years. This, however, is exactly what is needed during the accession and after joining the single currency area.

Copenhagen criteria. According to the opinion of the European Commission, we have a functioning market economy and will be capable of coping with the competitive pressures within the European Union in the medium term. In achieving this, the currency board-based monetary policy has played a significant role in terms of a particularly real convergence of the economy. We strongly believe that the CB promotes the convergence of our economy towards EU standards. We also believe that this is in full accordance with the plurality of approaches stated by the ECB regarding exchange rate and monetary policy arrangements in the pre-accession period. It also leaves room for any necessary institutional changes needed for complying with the monetary policy operational framework of the Eurozone before joining the EMU.

[Compliance with the acquis]

In recent years, Estonia has made considerable progress in adopting the acquis. Regarding to EMU's acquis, the basic features are fulfilled; i.e., legislation is generally in accordance with the ideology of stage III of the EMU.

This holds for the prohibition of direct financing of the public sector or government entities and of privileged access to financial institutions by the public sector. The same is true regarding the independence of the central bank. As for fiscal policy, under the CB it is the main instrument for achieving macroeconomic stability. This means that maintaining fiscal balance over the medium term serves a twofold purpose – as under the CB, ensuring the integrity of the currency board means the avoidance of an excessive budget deficit is in line with the EMU's acquis requirements. On exchange rate issues, no problems are foreseen. Due to the fixed exchange rate and the CB in force since 1992, Estonia already fulfills the requirements of the ERM II today, as a currency board arrangement can be interpreted as an ERM II with a 0% fluctuation band. That is, in principle, our system is in compliance with the ERM II, as it involves a fixed exchange rate and automatic unlimited interventions on the forex market. In our view, the CB relies on similar basics as the ERM II does. In addition, it is generally in accordance with the treatment of exchange rate policy as a matter of common concern.

On the free movement of payments and capital, all restrictions on current account payments and transfers were eliminated in 1994. Capital account transactions have been liberalized, as that is one of the preconditions for the efficient functioning of the CB. Any unresolved problems still remaining are of minor importance. The building of a new interbank payments' system, which will be in compliance with EU requirements, is in progress.

Tasks remaining for the pre-accession period include some improvements in legislation and addressing some of the abovementioned issues in a more detailed way. To wind up, according to the Estonian position on the adoption of the EMU's acquis, upon accession to the European Union Estonia is prepared to accept the acquis with respect to the economic and monetary union to the required extent.

To summarize, we have reached the following conclusions:

   Estonia has been closely related to the EU for seven years already, due to its tight trade relations with the EU countries, currency peg to the euro and a very open economic environment.
   Macroeconomic policy of this period has been targeted at ensuring the efficient performance of the fixed exchange rate regime.
   And lastly, it is worth stressing that in our view, in line with the ECB's statement on the plurality of approaches, the currency board system provides us with a relevant monetary policy framework for the pre-accession phase to the EU.
Vahur Kraft. Presentation on currency boards