Four years have passed since the monetary reform. The basic characteristics of the Estonian kroon from the beginning of 1993 to the beginning of 1996, as far as these are suitable for comparison, have been given in table 1. We have deliberately not chosen the moment of the monetary reform as a point of departure but a time when the first period of regulation is over and we have a comparable data base.

General Observations

The amount of base money (M0), which according to the Law on the Security for Estonian Kroon has to be fully covered by the gold and foreign exchange reserve of Eesti Pank, has increased 2.5 times over the past three years. The respective reserves backing the kroon (KV) has increased by almost the same degree - 2.3 times. The relative slowdown of the increase of the reserves backing the kroon and its unevenness have mainly been caused by the fact that the impact of the return of Eesti Pank's gold and foreign exchange that had been deposited abroad and of changing into kroons the foreign currency in circulation and savings before the monetary reform has come to an end, and the official exchange rate of the kroon (pegged to the German mark) against other currencies has changed. The latter can be seen from the table depicting the exchange rate of the kroon against the US dollar.

The figures for the broad money supply (M1, M2D, M2) which are derived from the activity of the banks in accepting deposits and lending have grown faster than the base money. This is a normal consequence in the development of the banking sector which has a greater impact in the given period of development and stabilization. A significant fact is that in the second half of the given period broad money supply has been more or less synchronous with the changes in the price indices.

Foreign currency deposits in Estonian commercial banks and their depositing of money into foreign banks (which through conversion affect the demand and supply of the kroon) have changed in harmony with the broad money supply if we look at the period as a whole, but mostly on account of the more rapid growth in the second half of the period. There are several reasons for this - the abolition of restrictions on transactions with foreign currency, acceleration of the growth of foreign trade and other forms of foreign relations combined with the need to keep more money in foreign currency and in some cases also doubts about the stability and reliability of the kroon that have been spread from time to time. As we know, money is very sensitive to any kind of economic, political and other impacts.

The consumer price index, the producer price index, the exchange rate and the purchasing power of the currency as well as the demand and supply of money are closely intertwined. It is not always clear which is the cause and which is the result. If we proceed from classical theories the data given in the table raise various questions. The most conspicuous among them is the great difference between the domestic purchasing power of the kroon and its real rate, and the relative stability of the official rate pegged to the German mark.

Changes in the Purchasing Power

The main aim of the present article is to look at the functioning and effect of the Estonian monetary system in purely practical terms, so that it would bring a transition economy closer to a market economy. We have to begin with the fixed exchange rate, or the kroon's peg to the German mark. The 1:8 rate fixed by the monetary reform still applies. The purchasing power of the kroon abroad at the beginning of this year, considering the inflation in the developed countries, was approximately 90% of the purchasing power in early 1993. On the domestic market, however, the purchasing power of the kroon has dropped to 27.5% due to price increases. The decline in the purchasing power on the domestic market has been compensated by the increase in incomes. The increase in incomes (the nominal wage has more than tripled) has created for kroon-owners a nearly three times bigger potential for purchases on the foreign markets.

The real rate of the kroon, which actually indicates the purchasing power of foreign currency on the Estonian market, has increased over the given period. The purchasing power of the owners of foreign currency, including Estonian exporters, has declined on the domestic market as a result. This has been mainly caused by the stability of the official exchange rate on the one hand, and the significant difference of the rates of inflation of different countries on the other hand. For developed countries where inflation is considerably lower than in Estonia the price increases on our domestic market mean that the kroon becomes more expensive, a development that will continue until the level of domestic prices reaches more or less the level of international prices. In other transition countries where the inflation rate is close to that of Estonia the result can be the opposite, depending on what has happened in the given period. Despite the increase in the real rate of the kroon, the real purchasing power of the kroon for owners of foreign currency is still approximately 1.5 times higher as compared to the international price level, due to our low domestic prices.

The Devalued Exchange Rate of the Kroon Has Provided Us with the Time Necessary for the Restructuring of the Economy

On numerous occasions there has been criticism about our monetary system. The criticism has come from wage earners and pensioners, as well as from those whose income depends on export. Even foreign investors have said that the realisation of investments in Estonia has become more expensive. For tourists, particularly shopping tourists, the conditions have become less favourable than before. From the table 1 and the above explanations we can see that the situation has indeed changed. No doubt it will continue to change in the same direction also in the futures - at least until the level of prices in Estonia has come close to the level of international prices. In case of an open economy this is an unavoidable process. The application of restrictions here can backfire and usually leads to an unreasonable (undesired) result. The given situation should be analysed and valued from the point of stimuli which contribute to the economic development, or in other words, from the point of economy's internal pressure mechanism that objectively leads to a normal economy, since ignoring objective rules never yields the best result.

As we have said before, and we will repeat it here, for a small country like Estonia the engine of development is export in all its forms. In practice it also covers transit trade and transport, all kinds of mediation, tourism, etc. The advantages programmed into the kroon during the monetary reform (being under-valued) will decrease in the course of the international levelling of prices and will finally disappear. So far this mechanism has made the transition process easier and enabled us to enter the world market with low-quality products, lower prices, and to be less demanding when choosing trade partners. The provided time reserve that still lasts for us has to be used for preparing and completing qualitative changes.

The toughening of conditions, particularly the increase of the real rate of the kroon, forces (read: stimulates) us to adapt our economy more to the requirements of the world market. The complaints of foreign investors about the less favourable conditions, too, will make them adapt to higher demands in Estonia. And besides, these complaints have little ground since the foreign investors have realised their investments mostly through importing equipment in the past as well as now. In the new conditions they will have to put more emphasis on the modernization of the equipment and technology. Shopping tourism, on the other hand, is mostly characteristic of developing countries. If we wish to escape this status we must set our aim at replacing shopping tourism with real tourism.

While analyzing all these problems, particularly when it is done on an emotional level, the aspect of guaranteeing the real increase of wages and pensions is often left aside. The increase of the real wage and income is based on the increase of productivity, which in turn depends on the existence of the market, production technology, costs, and various other factors.

The current level of wages and pensions has been more or less acceptable due to the low domestic prices. Since the index of the purchasing power of the currency is the inverse value of the price index, it has no separate meaning for these issues. As we said above, the purchasing power of our average nominal wage (because of the fixed rate of the kroon) has nearly tripled over the given period whereas the real wage has increased only by a few dozen per cent on the domestic market.

To reach a higher level of development much has to be done still. The most important aspect here is that rearrangements in the economy should be in harmony with the nearing of domestic prices to the world market prices. Here we keep in mind all aspects of this process, beginning from ownership relations and ending with the technological solutions necessary for increasing productivity and better adaptation to market demands. It would probably be an exaggeration to say that the decisive factor here is the ability of the kroon to guarantee us the necessary time reserve for completing these changes. However, in a transition economy for which classical money theories do not apply in full, the comparative analysis of domestic purchasing power of the currency, its real and official rates deserves serious attention. All those aspects characterize the purchasing power of the currency through different forms of economic relations. Until a certain moment of time these can be supportive of one another, that is, have a positive combined effect. However, from a certain moment, for example from the beginning of a rapid increase in the real rate, they can begin to work against one another.

Due to the novelty of the problem there does not exist the necessary database for a more thorough analysis and evaluation of these processes, let alone for theoretical generalizations. The evaluation is made even more complicated by the difference in the direction and size of the impact of industrial and transition countries on the combined index. The critical point is thus different in every concrete case. However, we can be certain of one thing - the quicker we can rearrange the structure of our economy, so that it would meet the needs of the world market, the less danger there is in the conflict of the different parameters of the purchasing power of the kroon.

So far, the kroon has acted as an important factor of stability in the economy, which is very important for balancing the instability caused by extensive transition processes. The future depends largely on how the economic development will be able to support the kroon. The cause and the result will change places, although the stability of the kroon in promoting foreign relations has not been the only, albeit important, reason for Estonia's progress. In a normal economy the strength of the money is determined by the strength of the economy. At the moment we must try to make the most of the possibilities that can be found in the Estonian monetary system.

Raimund Hagelberg