(1) Author of this article Terry L. Ziacik received her MA in economics from the University of Notre Dame, Notre Dame, Indiana, in August, 1995, and she is currently enroled in the PhD program at Indiana University, Bloomington, Indiana, USA. This article was written during her internship with Eesti Pank (Bank of Estonia) in September, 1995. All views expressed are those of the author only and do not necessarily represent those of Eesti Pank.
Author would like to thank Tanel Ross for his helpful comments and suggestions, Mati Vihman for arranging intership with the Eesti Pank, and the International Office of the Eesti Pank for their hospitality and help.

On June 12, 1995, Estonia, Latvia, and Lithuania signed Europe Agreements with the European Union (EU) giving them associate status in the EU. The Baltic States have been pursuing these agreements for the past two years and have taken several steps in that time to assimilate into the European economic arena. They join a group of other European countries who share the same desire to develop their economies to a point where they too can participate in the European Union.

Europe Agreements (also known as Associate Agreements) are bilateral agreements between the EU and prospective members designed to serve as a link to full EU membership.(2)

(2) Much of the general information on the Europe Agreements was obtained from the Lexis/Nexis news service's Europe library in the RAPID press release sub-library.

These agreements offer guidance to prospective members on matters ranging from trade and economic and monetary integration to security, transportation, etc. In other words, it is a sort of road map to the EU touching on every issue that comes into play in the EU. The Agreement replaces any free trade agreement (FTA) in place prior to signing. Because the Agreements' stipulations often involve implementation of new policies and creation of new institutions - especially in the case of countries moving toward a market economy - a transition period is granted to allow ample time for the countries to make the appropriate changes. Estonia is set apart from the other Baltic, Central and Eastern European countries who have signed these agreements because it is the only country that has waived this transition period.(3)

(3) These countries are Estonia, Latvia, Lithuania, Poland, Hungary, the Czech Republic, Slovakia, and Romania. Malta, Cyprus, and Turkey have also signed Europe Agreements.

The EU is in Agreement with the Baltic States that it would be advantageous for all parties to include the Baltic States in the EU when they have met the necessary conditions. Reasons behind Estonia's desire to join the EU are numerous and go beyond pure economic issues; political and security matters are also motivating the move to integrate. First, membership would strengthen their economic and political ties with the west. Estonia has much to gain from being a part of the Single Market -- even more than from merely signing a FTA. As a member, Estonia will have a voice in EU decision-making and will, therefore, be able to protect its own interests. EU membership is even more desirable now that two of Estonia's close trading partners, Finland and Sweden are members.(4)

(4) In 1994, Finland was Estonia's second-largest trade partner in terms of exports from Estonia (17.8 %) and largest in terms of imports (29.9%). Sweden was Estonia's third-largest trade partner for exports (10.8%) and fourth-largest for imports (8.9%). (State Statistical Office of Estonia, 1995).

Associate Agreements and then full membership makes Estonian goods more accessible to western markets and provide assistance in areas such as investment promotion, industrial cooperation, and banking and financial sector reform. Associate membership would also provide Estonia with added assistance during the transition period, both psychologically and financially. The increased likelihood of membership gives the public a more positive attitude during the transition and strengthens Estonia's bond with Europe that was weakened by the annexation by the Soviet Union. Should Estonia join the EU, Estonia will be eligible for funding earmarked for its less-developed members.

To become a member, Estonia must formulate its policies - economic, monetary, environmental, etc. - as well as legislation - in concordance with EU regulations. One advantage of Estonia's transitory position is that so many new laws are needed that were nonexistent in the Soviet system; as legislation is passed, it can be written to conform with existing EU standards. It is easier and more efficient to initially implement coordinating policies than to go back and change them. In light of Estonia's intention to apply for full EU membership, this paper will examine Eesti Pank's (Bank of Estonia's) monetary policy and the process of modelling it after that of the EU. Monetary policy is often discussed in Europe today because the monetary portion of the EU's plan to form an Economic and Monetary Union (EMU) is not moving along as rapidly and free from controversy as hoped. In terms of monetary policy coordination, Estonia (and Latvia and Lithuania) likely has an advantage over the Central and Eastern European (CEE) States in that the timing of Estonia's reform was late enough to be able to follow the legal convergence criteria which were established only in 1991.

This article focuses on the monetary aspect of Estonia's move to join the EU and how it compares to progress made in the other Baltic States as well as in select CEE States that have signed Europe Agreements. This discussion will first briefly examine the state of monetary integration in Europe, the requirements for membership in the full monetary union, and, most importantly, why it is in Estonia's best interest to meet them. In order to assess progress, specific steps will be outlined that should be made in the reform process to promote a successful transition to a market economy. Additionally, Estonia's performance will be evaluated relative to the other states on the basis of these factors.(5)

(5) This is just a partial list and by no means includes every step necessary for a successful and stable reform. This list was constructed to focus on monetary policy issues with EU membership objectives in mind.

The analysis will begin with an examination of the reform process in Estonia and then proceed to the other countries. These countries were chosen because they are all making the transition from a command economy to a market economy. Latvia and Lithuania serve as good comparisons because they share a similar history with Estonia, especially in terms of gaining independence form the Soviet Union. However, reforms in each country have been different, resulting in varied levels of success. The other Central and Eastern European countries are in transit from previously independent regimes, but nevertheless share common ground with Estonia in the development of a market economy.

1. Monetary Policy in the European Union

The formation of the EMU is one of the EU's primary objectives. On the economic side, this includes a completely open Single Market with free movement of goods, services, labour, and capital which is more or less in place. The monetary component includes initially irrevocably fixing exchange rates that will eventually be replaced by a single currency, now called the ecu (6), and following unified monetary and exchange rate policies made by the European System of Central Banks (ESCB).(7)

(6) The name of the common currency is likely to change soon due to pressure from Germany

(7) The ESCB consists of the European Central Bank (ECB) and the central banks of the member countries. Prior to full monetary union, the European Monetary Institute (EMI) will be in place to encourage and aid in monetary policy coordination among member states. Once the third stage begins, the ECB will replace the EMI and set Community-wide monetary policy. For exchange rate policy, Article 109m of the Treaty on European Union states "Until the beginning of the third stage, each Member State shall treat its exchange-rate policy as a matter of common interest". Once stage three has begun, the member states that meet the convergence criteria will irrevocably fix their exchange rates and eventually use a single currency. Those members who do not meet the convergence criteria will continue to follow Article 109m and maintain policies that coincide with the interest of the other members. Exchange-rate policy vis-á-vis non-EU members will be set by the ESCB (European Community, 1992).

Plans to achieve EMU are outlined in the Treaty on European Union, commonly known as the Maastricht Treaty. These goals affect any country wishing to join the EU because its policies must conform to EU standards.

Presently, all EU members belong to the European Monetary System although the United Kingdom, Greece, Italy, Finland, and Sweden do not participate in the Exchange Rate Mechanism (ERM). In order for EU members to progress to the full monetary union, they must first meet four convergence criteria outlined in the Maastricht Treaty:

(8) These convergence criteria were obtained from the Treaty on European Union (Maastricht Treaty), Article 109j, Protocol on the Excessive Deficit Procedure, and Protocol on the Convergence Criteria Referred to in Article 109j of the Treaty Establishing the European Community.

The earliest start of full monetary union prescribed by the Maastricht Treaty is 1997 providing a majority of members meet all five criteria. However, because at this moment only three (Ireland, Germany, and Luxembourg) satisfy all requirements - five short of a majority the EU has decided the target date for full monetary integration is now the alternative listed in the Treaty, January 1, 1999 (Roth, 1995; Barber, 1995). On this date, all members meeting the criteria, comprising a majority or not, will irrevocably fix their exchange rates and enter into a monetary union. Those who do not meet the requirements will be in the "periphery", with a seat on the board perhaps, but with no vote in monetary matters.

The idea of a common currency for Europe is still much-debated. Although the costs and benefits of monetary unification have been analyzed extensively, evidence does not overwhelmingly favour unification on the basis of economic reasons alone. Many of the benefits that are assumed will accompany integration are either of small magnitude or do not affect all members equally (Gros and Thygesen, 1992). The economic cost that probably weighs heaviest on the minds of most is the loss of exchange rate adjustment as a policy instrument to cope with asymmetric shocks. Other costs include the loss of seigniorage revenues and one-time costs of changing from one currency to another.

Elimination of transaction costs is one of the more obvious benefits of monetary union. While they are not of such a great magnitude in and of themselves, they are quite noticeable and annoying especially to people who frequently travel between countries for tourism, business or other reasons. For the EU as a whole, transaction costs account for approximately 0.25 to 0.5 percent of GDP (13.0 to 17.9 billion ecu; Commission of the European Communities, 1990). Once a monetary union is in place, price discrimination would be reduced due to the increase in exchange rate certainty (Gros and Thygesen, 1992). Investment possibilities are improved through monetary unification because costs would be lower; a reduction in exchange rate fluctuations lower risk premiums (Viñals, 1994).

Although Estonia may not be an EU member by the time monetary union happens, it is important that Estonia be able to meet the criteria when membership is granted. Despite the great uncertainty surrounding the monetary union, it is likely to be implemented. The economically stronger members are the ones most likely to be in the core "in" group of the monetary union. Remaining outside would prohibit Estonia from voting, and this would clearly not be advantageous. Once a core monetary union is formed, entry requirements may become stricter; the core group may be doing so well in terms of inflation rates, for example, that it makes the limit stricter. There is already talk of imposing non-tariff trade barriers on those members not using the ecu who devalue against it (Roth, 1995). This should not pose a problem for Estonia as devaluation of the kroon can only take place with Parliamentary approval and does not look likely in the near future.

2. Policy Prerequisites for Transition to a Market Economy

The formation of monetary policy is a significant step for transition economies to take in the process of economic reform. In the planned economy system, monetary policy did not play an important role, and therefore, it must be built up from ground zero (Hansson, 1995). This requires certain institutions to be formed and policies to be implemented. The following list of requirements is by no means complete; it merely serves as a starting point, a framework with which to gain perspective on the state of reform across the former communist bloc. The discussion is limited to the Baltic States, Poland, and the Czech Republic because an analysis of the entire eastern bloc, while certainly interesting, is beyond the scope of this paper. By looking at these countries' reforms, a general idea can be formed of what kind of progress is being made in some of the non-former Soviet Union transition economies and how it compares with progress in Estonia.

First, the establishment of an independent central bank is essential for maintaining a stable monetary policy. The sooner this happens, the better for stabilization because the bank sets the country's monetary policy. Bank independence in the form of autonomy from the Government is essential for the smoothest possible running of the bank. In most cases, this is satisfied through limited if not prohibited lending to the Government and a Bank Board whose members are appointed by Parliament. In this way, the bank is free from political influence and can function with the best interests of the economy as a whole, rather than the ruling party, in mind.

The banking system must be reformed from the monobank system of planned economy days to a two-tiered system comprising commercial banks and one central bank compatible with the market economy system. In the old system, banks were rarely used by households, and most of their transactions were carried out in cash. A sound banking system is necessary to build the confidence of the public and encourage widespread use. To integrate into Western Europe, the banking system must be strong to be compatible with its western counterparts. This is also the first step in developing advanced, compatible financial markets.

To combat high inflation that accompanies economic transition, an appropriate nominal anchor around which to design monetary policy must be selected. This anchor promotes macroeconomic stabilization by providing authorities with some kind of a guideline. In transition economies, where many of the market principles are new to bank staff and government officials, having guidelines simplifies the reform process. While there are several components that could be used as a nominal anchor, the money supply and the exchange rate are commonly used. Estonia chose an exchange rate target. There is much debate as to whether money supply targeting or exchange rate targeting is better, and each Government must carefully assess its individual situation before choosing.(9)

(9) We will briefly outline the advantages and disadvantages of each method here. For a more thorough treatment, please see Ross and Ross (1995).

Money supply targeting is often favoured in situations where the country lacks the large supply of foreign reserves necessary to maintain a stable and credible exchange rate. However, often in these economies, money velocity is volatile making it difficult to maintain the desired money supply. Authorities do not always have sufficient instruments at their disposal to change the money supply in response to high volatility. This route to stabilization has not been overly successful in transition economies with the exception of Latvia and Slovenia (Sahay and Végh, 1995).

Exchange rate-based stability has shown more promising results in controlling high inflation. It is advantageous because its credibility is easily recognizable; the public can see for itself whether the exchange rate fluctuates or not. This credibility is also apparent to investors who provide the economy with capital necessary for growth and development. Because credibility can be achieved more easily, interest rates can be lower, thus attracting more investment, and the decline in output that usually accompanies a stabilization program is reduced. In order to successfully maintain an exchange rate target, a strong commitment to tight fiscal policy and capital mobility is necessary (Ross and Ross, 1995).

Currency convertibility, for both current and capital account, is an important part of the transition to a market economy although the timing and the degree of convertibility depend on the individual country's circumstances.(10)

(10) As we discuss each country, we will address currency convertibility in each country.

In order to freely trade with many countries, the currency must be able to be easily exchanged. Current account convertibility promotes competition by allowing more products in the market; domestic firms must streamline their production processes in order to compete with imports from more industrially advanced countries. Capital account convertibility is desirable for an emerging market because it promotes investment (Greene and Isard, 1991). Initially, currency account convertibility is more important for developing economies in terms of satisfying the IMF Articles of Agreement which stipulate that currencies must be convertible for current account transactions. Regarding Europe Agreements and EU membership, both are ultimately essential although countries are given time to achieve capital account convertibility.

It is widely thought that price stability should be the dominant goal of the central bank, and indeed this is reiterated by the Maastricht Treaty's strict inflation rate requirement. However, due to privatization and price liberalization that occurs within transition economies, this aim is rarely possible to achieve within the early years of reform. Nevertheless, most newly established (or reformed) central banks assert that both internal and external currency stability are their main goals although initially, external is often placed above internal.

A commitment to tight fiscal policy is also recommended. For transition economies, this is very important because deficits in these countries cannot be financed without causing inflation, which is already present due to price liberalization. Financial markets are either not developed enough to effectively sell bonds or there is insufficient credibility of the Government to successfully eliminate the deficit in this manner (Lainela and Sutela, 1994). The only alternatives to finance the deficit are increasing the money supply through money creation by the central bank or obtaining foreign assistance. Fiscal balance is also recommended because the Maastricht convergence criteria include strict requirements in this area. It is much easier to commit to fiscal balance at the onset of reform than to attempt to bring down large deficits after years of sustaining them, especially if the public is used to a certain spending pattern or tax level. The Delors Report, the forerunner to the Maastricht Treaty which outlines the plan for economic and monetary integration in Europe, does mention advantages of increased fiscal policy coordination among members.(11)

(11) Please see Lamfalussy (1989) for arguments for increased policy coordination and von Hagen and Fratianni (1994) for arguments against.

While a high degree of future fiscal policy harmonization is not definite, the closer Estonia's policy is to EU specifications, the easier time Estonia will have adjusting if coordination does occur.

Additionally, we include progress in meeting the convergence requirements for EMU membership because the countries we will examine have committed to the initial process of European unionization.

3. Progress in Estonia Thus Far

In the group of former Soviet Union States, Estonia is leading the group in monetary stabilization. Banking reform began in Estonia in 1988 with the establishment of Tartu Kommertspank (the Commercial Bank of Tartu), the first commercial bank in the Soviet Union. This was brought about as a result of problems with the Soviet banking reform that had started in the beginning of that year (Kallas and Sõrg, 1995). Eesti Pank (Bank of Estonia) was established January 1, 1990 and coexisted for two years with the Estonian branch of Gosbank, the Soviet central bank. The functioning of Eesti Pank was rather limited during this time. Eesti Pank had little influence over commercial banks during the coexistence period. It could not issue notes; instead it had to obtain them, sometimes with great difficulty, from Moscow. In the beginning of 1992, the Tallinn branch of Gosbank was liquidated and all its resources were turned over to Eesti Pank (Kallas and Sõrg, 1995).

Eesti Pank is completely autonomous from the Government although accountable to Riigikogu (Parliament) and is prohibited from lending to the Government. Consequently, the bank can make policy in the best interest of Estonia, free from political influence.

Currency introduction took place in Estonia as well as in the other Baltic States rather quickly to protect their economies from the effects of inflationary conditions in Russia. The ruble was replaced by the kroon over a three day period in which preregistered residents could exchange up to 1500 rubles at a rate of 10:1. For amounts of rubles exceeding this, the rate was 50:1. Rubles could only be exchanged within a ten day time frame. Deposits under 50,000 rubles were also converted at a 10:1 rate (Lainela and Sutela, 1994).

The currency reform is thought to have been a success thus far. The kroon was established as the sole legal tender in Estonia rather quickly. Current account convertibility has been a feature of the kroon from the beginning, and capital account transactions have been fully convertible since 1993. Prior to that, restrictions were limited - some were in place merely to monitor movement of capital in and out of the country (Ross and Ross, 1995). Foreign exchange reserves have been growing since the introduction of the currency board (Lainela and Sutela, 1994).

Two features in particular stand out in terms of bringing credibility and stability to the monetary system: the currency board and the Deutsche mark (DM) peg. The choice to implement a currency board in Estonia was based on a desire to build confidence in the kroon and was, consequently established concurrently with the kroon. A currency board is attractive to a developing economy because of its operational simplicity and its credibility. In Estonia, the currency board is part of the central bank. Money supply cannot be altered by open market operations, but is determined instead by the supply of gold and foreign reserves.

The credibility of the Estonian currency board system comes from three key features:

Full backing of circulating currency ensures that the money is valued world-wide. An irrevocably fixed exchange rate ensures that the kroon will retain its value in currency markets and not undergo any erratic fluctuations that could destabilize the economy. This can also help prevent speculative attacks.

Pegging to the Deutsche mark is another credibility-enhancing measure taken by Eesti Pank. When the decision to implement the currency board was made, an exchange rate anchor had to be selected. A basket anchor is attractive because risk associated with exchange rate fluctuation is spread among the currencies in the basket; the optimal basket should be composed of primary trading partners' currencies. The ecu would be an obvious option, especially considering Estonia's potential future EU membership. But pegging to a basket can get complicated. From the onset of the introduction of the kroon, the exchange rate was set at eight kroons per DM.

The DM was chosen over currencies of other major trading partners such as the Finnish markka or Swedish krona because of its strength in currency markets and its stable reputation. This increases the public's confidence in the kroon because the behaviour of the Deutsche mark is well-known. Combined with foreign trade liberalization, pegging to a credible foreign currency such as the DM facilitates the convergence of domestic prices with world prices in the tradable goods sector. More importantly, this will bring Estonian interest rates in line with those of Germany. It was a wise move for Estonia considering possible EU membership because the DM is the unofficial anchor currency in the Exchange Rate Mechanism (ERM). The decision to peg to the DM has been met with some criticism on the grounds that Estonia will encounter difficulties such as increased exchange rate risk, for example, should it choose to cease pegging to the DM (Hirvensalo, 1994). However, there should be no need to unpeg any time soon even if Estonia would do away with the currency board arrangement. Since Estonia is considering EU membership, keeping the DM peg is even more attractive because a fixed exchange rate is an integral part of the EMU. Maintaining this relationship will ensure that at least one convergence

The main priority of Eesti Pank right now is maintaining external stability via maintenance of a fixed exchange rate. Internal price stability is also important to Eesti Pank and is definitely a long-term goal. However, due to the price liberalization taking place, it is not a realistic immediate objective. Ensuring a stable exchange rate will decrease the likelihood of a speculative attack. The lack of price stability in Estonia can be attributed to several factors, the full examination of which is already the topic of several other papers.(12)

(12) See for example, Hansson (1995), Sahay and Végh (1995), and Ross (1994). Sections on this topic can also be found in Saavalainen (1995) and Lainela and Sutela (1994).

Briefly, these include large foreign exchange inflows that accompanied the currency board introduction, initial undervaluation of the currency, and the process of price liberalization (Lainela and Sutela, 1994).

3.1. Fiscal Policy in Estonia

Along with following strict monetary and exchange rate policies, Estonia follows a strict fiscal policy as well. Estonia's budget has been more or less balanced since 1992 - actually, Estonia has been running a small surplus for the past two years. A balanced budget is a high priority for Estonia. In 1992, along with the currency reform, authorities implemented policies aimed at reducing purchasing power and balancing the budget including a VAT increase from 10% to its present value of 18% and cuts in spending (IMF, 1994a). However, further tax reform is needed in the corporate sector where there still is much difficulty in collecting taxes. The success of maintaining fiscal equilibrium in Estonia (as well as in the other Baltic States) has been attributed to a sounder fiscal policy at the start of independence than in the other former Soviet or CEE States (Saavalainen, 1995).

3.2. Convergence

Assessing the Estonian economy now on the basis of the Maastricht convergence criteria, indicates that it is doing quite well compared to the EU Member States. Because it is pegged to the Deutsche mark, it has not undergone any devaluations. Estonia has been running a small surplus for the past few years, and domestic government debt does not yet exist. Long term interest rates are not yet applicable to Estonia because most lending is done in the short term. Inflation rates, although still quite high by European standards, are decreasing. Inflation rates are likely to stay somewhat higher than EU rates for a while due to discrepancies in Estonian and European price levels including wages. Out of the five convergence criteria, three are met now. However, it is still quite early to judge Estonia by these indicators as it is still in a transition stage and there are only a few years of data. Estonia is undergoing massive structural reform, and this surfaces in the statistics.

4. Baltic Comparison

Examining reform in Latvia and Lithuania is important in evaluating Estonia's progress because these two countries, of all undergoing transition, are the most similar to Estonia in many ways. They are similar in size, they share a common history of being unwillingly absorbed into the Soviet system. They regained independence roughly at the same time. And they are undergoing similar transitions to market economies. However, there are enough dissimilarities among the reform process in the three countries to provide an interesting comparison. An analysis of progress made in each state can aid the other former Soviet States in their reform processes; the varied routes taken by the Baltic States provide the others with different options that can be adapted to their individual economic situations.

Economic independence was granted to all three states in 1989 by the Soviet Union although Moscow still controlled their financial resources (Shen, 1994). Individual central banks were reestablished in each state in 1990 although they were not able to become fully-functioning until independence from the Soviet Union was achieved.

Individual reform processes in these states began at different times - a little less than a year lies between the date of the beginning of the first - Estonia - and the beginning of the last - Lithuania.(13)

(13) Reform dates here follow those given in Hansson (1995) and coincide with the beginning of the currency reform in each state.

The reforms themselves are different in nature. Broadening the scope from purely monetary to economic policy in general, differences in price liberalization and subsidy reduction among others are apparent. Structural differences also contribute to varying performance levels; Estonia, for example, is less dependent on outside energy supply than Lithuania or Latvia (Hansson, 1995). Geographic placement puts Estonia in a more favourable position due to the close proximity to its western trading partners. This is not only advantageous for trade-related reasons, but political ones as well; Estonians have been exposed to western thoughts and ideas for a longer period of time through media - Finnish television and radio - and tourism (Shen, 1994).

4.1. Latvia

The Bank of Latvia was established in July, 1990. Beginning in September, 1991, the bank engaged in commercial activities following the absorption of specialized former Soviet state banks. However, these branches were given separate balance sheets in May of 1992 to free the central bank from commercial activity (IMF, 1993a). Complete separation took place in 1993. The Bank of Latvia is autonomous from the Government. The Bank is permitted to finance the Government on a short-term basis, lending up to 1/12 of the revenues of the year's budget (Shen, 1994).

The Latvian ruble (LR) was introduced in May, 1992 after Latvia experienced a cash shortage; following Baltic independence, Moscow ceased supplying rubles to these states. There was not enough cash to pay workers or pensioners (IMF, 1993a). The LR was introduced in parallel to the Russian ruble (simply referred to as ruble). Latvian rubles, rubles, or any convertible currency could be used in transactions as long as all parties involved were in agreement until July, 1992, after which point rubles ceased to be legal tender.(14)

(14) The use of other currencies including rubles is still permitted in Latvia as long as prices are stated in lats (Lainela, 1994).

At that time, the Bank of Latvia implemented policies to increase the credibility of the LR: wage and cash payments were transacted in LR's; banks could exchange LR's for rubles without limit to reenforce the parallel relationship of the two currencies; and LR's could be converted into hard currencies. Over time, the LR's association with the ruble was diminished to protect the Latvian economy from problems in Russia (Shen, 1994). In 1992, Latvia brought its gold reserves back to the country and began to intervene in foreign exchange markets to stabilize the LR (IMF, 1993a). On June 28, 1993, the lats became the fully-functioning permanent new Latvian currency following a period of gradual introduction that began in March of that year. LR's could be exchanged for lats without restriction, thus strengthening the public's confidence in the new currency. Even now, the Bank of Latvia will buy back LR's (Bank of Latvia, 1994).

Initially, Latvia followed a floating exchange rate regime and allowed the lats to appreciate towards purchasing power parity. In this way, domestic prices would approach world prices without exacerbating inflation. In February, 1994, authorities "informally" pegged the lats to the SDR. The lats is a fully convertible currency in both current and capital transactions, and there are no exchange restrictions. The Latvian currency has had several periods of relative stability against hard currencies; the LR was fairly stable against the US dollar during the second half of 1992, and the lats has been relatively stable against the Deutsche mark since its introduction. The stability of the currency is due to intervention by the Bank of Latvia. It is difficult to assess the credibility of the SDR peg at this moment because it is so recent (Lainela and Sutela, 1994).

The primary objectives of the Bank of Latvia are to ensure exchange rate stability and to maintain low inflation (Bank of Latvia, 1994). Latvia exercises a tight monetary policy and has led the Baltic States in maintenance of low inflation in recent years. The Bank of Latvia follows a more traditional central banking arrangement; in principle, the bank has more monetary policy instruments at its disposal than Eesti Pank whose instruments are restricted by the currency board in operation. In practice, however, the financial markets of Latvia are too undeveloped to permit open market operations to take place. Excess reserves are large enough to bring question to the effect of minimum reserve requirements leaving quantitative restrictions and discount rates the primary monetary policy tools (Hansson and Sachs, 1994).

Latvia's fiscal position greatly improved upon leaving the Soviet Union due to the elimination of net transfers to the Soviet budget (Saavalainen, 1995). Like Estonia, since independence Latvia has exercised strict fiscal policy that has contributed substantially to reducing the monthly inflation rate by the end of 1993 (Lainela and Sutela, 1994). The Bank of Latvia does engage in lending to the Government. Latvia financed its deficit in 1994 primarily through the sale of treasury bills. The remainder was financed through credits issued by the Bank of Latvia (IMF, 1994b). Tax reform began somewhat later than in Estonia, and VAT increases were implemented incrementally over a year to the final rate of 18 per cent.

4.2. Lithuania

The Bank of Lithuania was established on February 13, 1990. Initially, as in Latvia, some of the former Soviet banks were part of the central bank, but these were separated in September, 1992. The Law on the Bank of Lithuania states that the central bank is independent of the Government, but in reality, it has less independence than the other Baltic central banks. In 1992, the bank was granted the power to set interest rate policies and placed in charge of foreign exchange reserves and Government securities (IMF, 1993b). However, that same year, due to policy differences, Parliament replaced the entire Board of the bank. The Bank of Lithuania is further linked with the Government by its role as the Government's banker. It can lend to the Government with approval by Parliament (Shen, 1994).

Lithuania's currency reform had a few more problems than that of Latvia or Estonia. The talonas, a temporary currency was introduced on May 1, 1992, to circulate in parallel with the ruble because Lithuania was experiencing a cash shortage of rubles. Rubles were withdrawn from circulation in September of that year because too many were entering the economy from former Soviet neighbours (Lainela and Sutela, 1994). Originally, Lithuania had wanted to move directly to the litas but was not ready when the large inflow of rubles began to happen. Unfortunately, an insufficient amount of talonas were produced and distributed. Allowing both talonas and rubles to circulate simultaneously led to Lithuania's economy being subject to the same adverse conditions as the Russian economy. On October 1, 1992, the talonas became the only legal currency, replacing the ruble completely. Despite replacement, the talonas' value declined along with the ruble's; consumers preferred convertible currencies with stable reputations to the new talonas (Shen, 1994). The political situation was unstable and often changing up until this time, weakening the public's faith in its currency or economy.

The litas was introduced in June 25, 1993 as the new legal tender of Lithuania. However, the ease with which it could be counterfeited weakened its credibility (Shen, 1994). Initially it was freely floating, but maintained a stable parity with the US dollar (about 3.9 to 1) since late 1993. In April, 1994, Lithuania entered a currency board arrangement pegging the litas to the dollar at a rate of 4 to 1 (IMF, 1994c). In contrast to the currency board arrangement in Estonia, initially both the base currency and exchange rate were determined by the Government (Pajula, 1994). The litas is fully convertible for current account transactions, but some restrictions are still in effect for capital transactions (Lainela and Sutela, 1994). Although the litas is pegged to the wrong currency for European integration, the fact that it is pegged illustrates Lithuania's ability to sustain a strict exchange rate regime. However, it must be kept in mind that this arrangement is only a little more than a year old thus caution should be used when making these kind of judgements.

Like its Baltic neighbours, the Bank of Lithuania has a stable currency and low inflation as its main goals. Lithuania is still lagging behind its Baltic neighbours in low inflation, although the gap is not so wide anymore. The majority of inflation in Lithuania occurred before monetary policy was tightened in 1993. One reason authorities decided to implement a currency board scheme was to increase the credibility of the new currency. This decision was influenced by the success of Estonia's currency board. The Bank of Lithuania was not in favour of this plan and felt that the lower inflation was indication enough that monetary policy was becoming stricter (Lainela and Sutela, 1994).

Even though central bank-deficit-financing regulations in Lithuania are the laxest in the Baltics, fiscal policy still remains tight. As in Latvia, its deficit situation was helped by removal of transfers to Moscow. In 1992, Lithuania had a small budget surplus and in 1993, a small deficit. The introduction of the currency board limited the amount of deficit financing the Government could obtain from the bank, and the 1994 deficit was consequently a bit larger but still within Maastricht limits. Currently, Lithuania's debt-to-GDP ratio is 15 per cent; this falls well within the limitations of Maastricht (Stoddard, 1995). As in the other Baltic States, cutting inflation is the biggest problem Lithuania will have in meeting convergence criteria, and Lithuania has the largest inflation in the Baltics. Instead the Lithuanian Government sold bonds to increase revenue. Lithuania is still in need of tax reform; there are significant problems, as in Estonia, with enterprises paying taxes on time leading to a reduction in Government revenue (Pajula, 1994).

4.3. Baltic Comparison

Looking at the reform processes in the Baltic States, we can say that Estonia's was the most disciplined in terms of strict policies and timing. The kroon was not only the first independent Baltic currency to be introduced, but also the only currency to be directly introduced without a coupon currency circulating in parallel to the ruble. The currency board arrangement in Estonia exhibits the most stability and credibility. Eesti Pank is a fully independent institution, and unlike Latvia and Lithuania, it cannot lend to the Government whatsoever. In other words, Eesti Pank is more likely than its Baltic counterparts to be able to pursue independent monetary policy in the future as well and will therefore be able to take steps necessary to coordinate policy with that of the EU without worrying about conflicts with Riigikogu (Parliament).

On the whole, the Baltic States have exhibited remarkable progress in their economic reforms considering their prior situation and the amount of time they have been reforming. But there is still room for improvement, especially in the financial sector. Unlike Estonia, Latvia and Lithuania do issue treasury bills to help finance the deficit. The Lithuanian inter-bank market is the least developed of the three (Lainela and Sutela, 1994).

Lainela and Sutela (1994) list two criteria that can serve as indicators of currency reform efficiency: market share and interest rate parity. The first measures the acceptance of the currency by the public as a unit of account, medium of exchange, and measure of value. This is indicated by the degree of use of the new currencies in each country. Estonia has the highest rating in this area; the kroon is the only legal tender. In both Latvia and Lithuania, hard currencies are used as well, although the extent of this is not precisely known. This represents ideological differences, however, in the case of Latvia where competing currencies is just another aspect of market competition (Lainela and Sutela, 1994).

The interest rate parity criterion refers to the ex ante real interest rate - the difference in interest rates of domestic- and dollar-denominated assets. In theory, the closer they are, the more similar should risks involved be. However, in practice, determining this measurement is not so straightforward because of a number of problems. First, the relatively late beginning of a strong reform effort in Lithuania causes an inconsistency among the three countries. Because the banking systems in these countries are so new, different commercial banks within a single country offer different risk levels to customers and, consequently offer varied interest rates. Determining a representative interest rate to use in the comparison can thus be problematic. In Estonia's case, foreign exchange deposits are still so rare that this measurement does not serve as a good indicator of Estonia's progress. Real interest rates were negative in this comparison, primarily due to low rates on domestic deposits (Lainela and Sutela, 1994).

5. The CEE States

Looking at the reform patterns and progress made in Central and Eastern European (CEE) States can be useful because these countries share similar difficulties of reform with Estonia and the Baltics; both groups previously had centrally planned economies and are trying to establish market economies. Precise reform beginning dates among the CEE States vary, but generally, serious reform toward a market economy began for most in the late eighties or 1990.

5.1. Poland

Banking reform activities began in Poland in 1989 with the break-up of the monobank National Bank of Poland (NBP). Commercial banking activities were delegated to nine state-owned commercial banks. The National Bank of Poland is relatively independent although a draft of monetary policy guidelines must be submitted annually to Parliament for approval (Ebrill, et al., 1994). The NBP does engage in deficit financing although the actual restrictions are a bit confusing. One article of the Banking Act provides for a limit of two per cent of projected budget expenditure while another article states that the amount is negotiable between thee bank President and Minister of Finance (Hochreiter, 1994).

Poland made a rapid move to establishing currency convertibility of the zloty in 1989 although tight capital controls are still in effect (Siklos and Ábel, 1995). The exchange rate regime followed by Poland is a crawling peg against a basket of currencies that has been in effect since October, 1991.(15)

(15) The basket consists of the following weights: 45% US dollar, 35% Deutsche mark, 10% British pound, 5% French franc, 5% Swiss franc. From January, 1990 until October, 1991, Poland employed a fixed exchange rate policy with the zloty pegged at various rates to the US dollar and then the afore-mentioned basket (Ebrill et al., 1994).

This emulates a fixed regime in practice, however, because the adjustments have been regular and preannounced. The crawling rate was set below the forecasted inflation differential with trading partners in order to keep inflation in check while maintaining competitiveness. In order to maintain credibility, Poland must exercise a tight monetary policy, controlling the money supply (Ebrill, et al., 1994).

The primary goal of the National Bank of Poland, as outlined in the Banking Law of 1989, is to strengthen the Polish currency (Ebrill, et al., 1994). However, price stability is undoubtedly important as well. Monetary and exchange rate policy have been successful in reducing inflation from 250 per cent in 1990 to close to 30 per cent annually in 1994. This low level of inflation has been attained even with large amounts of deficit financing to the Government by the central bank. The Polish inter-bank market is more developed than that of Estonia. Development in the Polish money market is attributed to increasing public awareness of profit potential, an improved payments system, the central bank's development of indirect monetary policy tools. Treasury bills have been in use since 1991, and the market for them is growing. There is a bond market in Poland to aid in deficit financing, but it is not yet well-received (Ebrill, et al., 1994).

Fiscal policy in Poland has undergone changes since the onset of reform in 1990. During the mid-eighties, Poland's budget was more or less balanced, but in 1989, Poland had a large deficit - 8 per cent of GDP - that was caused primarily by a reduction in tax revenues. The tax system needed to be overhauled to become more compatible with the needs of a market economy. Since 1989, an enterprise income tax, personal income tax and VAT have been created. Expenditure reduction has been occurring in Poland as well; the majority of producer and consumer subsidies have been eliminated (Ebrill, et al., 1994). Poland is one of the three CEE and Baltic States that have already submitted the actual application for EU membership (Hungary and Romania are the other two). While Poland has had a fiscal deficit for the past two years, it is just under the three-per-cent-of-GDP requirement.

5.2. Czech Republic(16)

(16) Prior to 1993, data refer to Czechoslovakia.

In January, 1990, Czechoslovakia established a two-tiered banking system, separating commercial from central banking activities (Baliño, Dhawan, and Sundararjan, 1994). The central bank initially did not have complete independence although it gradually increased. In 1992, the Czech National Bank (CNB) was given full autonomy.(17)

(17) That same year, the National Bank of Slovakia (NBS) was granted autonomy as well.

The CNB can lend up to five per cent of the previous year's budget revenues to the Government for a period not exceeding three months (Hochreiter, 1994).

The Czech Republic's currency, the koruna, is doing well as far as stability goes. It maintains a fixed exchange rate regime pegged to a basket consisting of the dollar and the Deutsche mark (35 and 65 per cent weighting respectively). A pegged exchange rate regime was chosen over a floating system from the beginning of reform for credibility-enhancing reasons. However, recent legislation has approved measures to make the koruna more convertible - allowing unlimited current account transaction convertibility and limited capital account transaction convertibility. Despite the koruna's nominal stability, real appreciation against both the dollar and the Deutsche mark has occurred affecting competitiveness. Increased convertibility is necessary for EU membership and will likely lead to eliminating the dollar portion of the basket and pegging strictly to the Deutsche mark (Boland, 1995). This is a wise move if EU membership is a serious objective, not only in terms of the exchange rate stability requirement for EMU membership, but also regarding lower inflationary pressures accompanying increased foreign exchange inflows.

The CNB outlines its primary goals as being maintenance of internal and external currency stability and follows a tight monetary policy in order to do so. This was especially necessary following the separation of Czechoslovakia in early 1993 because of the economic uncertainty that accompanies the separation of the Government, institutions, etc. Prior to 1993, the CNB engaged in direct monetary intervention, but gradually moved toward indirect policy tools including open market operations, refinancing, and reserve requirements for commercial banks (Czech National Bank, 1994).

Fiscal policy has been tight in the Czech Republic (formerly Czechoslovakia) from the beginning of reform. The 1990 budget under the new Government provided a small surplus - 0.5 per cent of GDP. Fiscal policy in 1991 remained tight although toward the end of the year, the budget was slightly in deficit (Aghevli, Borensztein, and van der Willigen, 1992).

In accordance with the Czech Republic's desire to belong to the EU, the Czech National Bank has been making a concerted effort to monitor and improve policy coordination with EU standards. Inflation is still too high for the Maastricht criterion although it is lower than in the Baltic States. Annual inflation increased from 11.1 per cent at the end of 1992 to 20.8 per cent at the end of 1993 (Czech National Bank, 1994). However, the break up of Czechoslovakia must be taken into account. Since then, it has dropped back to the precious level. The budget deficit requirement has been met since the reform began. Interest rates for the short term are coming down although they are still higher than the convergence rate. Long term interest rates really do not exist at this point in time.

5.3. Comparison with Estonia

The CEE States were generally in a better initial position than Estonia regarding economic reforms.(18)

(18) Although this paper focuses on Estonia, many of the comparisons apply to Latvia and Lithuania as well.

Due to dependence on Russia for energy, Estonia was subject to larger terms of trade shocks than the CEE States. Russia adopted world prices for energy in 1992 which had an adverse effect on Estonia because Estonia was not yet ready for the higher prices (Saavalainen, 1995). The small size of Estonia and its dependence on exports from Russia and former Soviet States made Estonia more vulnerable to the terms of trade deterioration (Hansson, 1995). Because Estonia had been part of the Soviet Union, it was unable to start any significant reforms before independence was reached.(19)

(19) Gorbachev did allow some banking reforms to take place as part of his Perestroika program.

In 1987, for example, Estonia wanted to introduce a separate currency but Moscow refused to allow it at that time. Some of the CEE States - Poland and Hungary - were able to begin market-economy reforms early on, before real transition took place. The CEE States already had national currencies and banking systems in place so there was no need to create an entire system of new institutions.(20)

(20) However, one could argue that this is not such a great advantage. While it is true that these countries did not have to spend valuable time developing new currencies and banking systems, the ones in place needed quite a bit of revision. The banking systems in these countries functioned on the same monobank principles as the Soviet system. Although establishing a new currency is risky in itself, one advantage starting fresh brings is that the public has no former bias against the currency from poor past performance.

One advantage Estonia had over its CEE counterparts, however, was its lack of foreign debt at the onset of reform. Russia had taken over all foreign debt of the former Soviet Republics, improving Estonia's financial position. The revenue-to-GDP ratio was lower in Estonia and therefore had more room for improvement in the form of tax reform. In Hungary and former Czechoslovakia, for example, tax rates were much higher than in Estonia at the beginning of reform (Saavalainen, 1995).

Looking at the budget deficit as a percentage of GDP, Estonia is performing better than many of its CEE counterparts. Estonia exhibits a surplus in 1993 and 1994, while deficits in the CEE States run as high as 11.4% (Bulgaria). Not all CEE States are doing poorly in this area, however; the Czech Republic, for example, has a surplus of 1% (Hansson, 1995). Fiscal policy remains tighter in Estonia in the face of banking crises; this is evident by comparing crisis remedies. Estonia recapitalized banks in a stricter fashion than did many CEE States (Saavalainen, 1995).

6. Concluding Remarks and Directions for Future Research

The economies we have examined above share some common characteristics in their moves toward a market economy. They have all expressed commitment to maintaining credibility, upholding a stable currency, and keeping inflation controlled (see Table 1). Estonia stands out among these countries with respect to clear-sightedness of its reform process. This is not to say it has been without problems; the banking crisis of 1992-1993, for example, did present some setbacks. But Estonia established a plan to attain stability in the beginning and has stuck to it. The immediate changeover from the ruble to the kroon conveyed the message to the public that Estonia was serious in its commitment to reform.

Comparing with the other Baltic States, Estonia does come out ahead as the strongest in reform techniques although Latvia does have better inflation performance. However, it is still too early to determine the effects the recent banking crisis in Latvia will have on the economy. As far as Poland and the Czech Republic go, Estonia seems to be holding its own. Due to differences in initial situations of the CEE States and Estonia, it is difficult to determine who was in the better position. In the CEE States, reforms were not contingent on gaining independence from an authoritarian Soviet Union. However, there is something to be said about the psychological effect of freedom on a public who has hardly had the opportunity to govern itself throughout history. Coming out of such a severe regime makes widespread public support more likely. This could explain the swiftness of Estonia to embrace the market.

Stability and credibility are closely linked and quite important in the scope of European monetary integration. The relationship between them is not unconditional; the more stable an economy (or an exchange rate, etc.) is, the more credible it will be to the public. And the higher the degree of credibility the authorities have with the public, the fewer the fluctuations taking place will be, resulting in greater stability. Theo Waigel, the German Minister of Finance, states that "it appears that the foreign exchange markets of today are exceedingly sensitive to even the smallest credibility gap in monetary as in fiscal policy ... strengthening the convergence process is thus the key to greater exchange rate stability and to the final stage of economic and monetary union" (1995). These statements reinforce the importance of credibility for the EU. Because Estonia would like to be a member one day soon, credibility is important for Estonia as well. Thus far, the choices Estonia has made are conducive to maintaining stability and credibility in the international foreign exchange market.

From a monetary policy point of view, Estonia seems to be heading in the right direction. Inflation and interest rates are a bit high, but Estonia does have several years to work on that before it becomes crucial. It is important, though, that Estonia really try to meet the convergence criteria from the beginning. Although there is much confusion and uncertainty within the EU about exactly how and when this transition will take place, there are enough political reasons behind it to ensure that somehow and someday, some type of EMU will be attained. Because Estonia is a small country just starting out in the wonderful world of market capitalism, it is integral to the well-being of the country that it get a foothold in the core group if at all possible. Right now, the penalties of remaining in the periphery beyond no voting rights are not known, but recent tensions within the EU indicate that there could be some. At any rate, it is definitely advantageous to be in with the economically strong states, and with Estonia's record so far, there is no reason to doubt this possibility.

One concern, however, that could be problematic is the issue of sovereignty. It is a very sensitive issue that is quite big at the moment in countries such as the UK. The concept of monetary union intensifies this because issues such as giving up national currencies and monetary policy tools are at hand. A national currency is very symbolic to a country, especially one whose currency is barely two years old. In Estonia's case, sovereignty can be even more sensitive because of its past history of foreign occupation. While public opinion is in general in favour of EU membership for various reasons, some, such as the Better Estonia/Estonian Citizen and Centre parties, are more cautious because of sovereignty questions (Baltic Observer, 1995).