IV MONEY AND CREDIT MARKETS

The first half of 1998 was a difficult time for banks to attract foreign capital. The continuously cautious attitude of the world towards Estonia's macroeconomic situation, foreign relations (Russia) and the banking system as well as pending bank mergers did not facilitate major increase in external finances. Thus, the domestic monetary environment became more stringent expressed in curbed loan volume growth rates and interest growth expectations in May-June. After a stabilization period which followed the end-1997 speculative pressures, the foreign exchange market activated again in July 1998. The increased volatility of the German mark - Estonian kroon spot and forward markets was caused both by the developments in the local market as well as by the financial instability in Russia.

MONETARY AGGREGATES

The suspended inflow of foreign capital and the slowdown of financial deepening have curbed the growth rate of monetary aggregates in 1998. The overexpansionist developments of 1997 were replaced by more moderate growth rates already in the fourth quarter and a slow decrease continued in the beginning of 1998. In mid second quarter the growth of monetary aggregates slowed down significantly and a further sudden drop in monetary aggregates in June was, among other factors, also caused by the exclusion of deposits in the bankrupt Eesti Maapank (Land Bank of Estonia).

Figure 4.1 demonstrates the growth of monetary aggregates against the same period a year ago. As demand deposits have grown only marginally in the first half of 1998, narrow money (cash in circulation demand deposits; residents, excl government) has grown just a couple of per cent over the year. Broad money, containing also time, savings and foreign currency deposits, has increased by 15% over a year. The financial situation of the general government has been relatively good in the first half-year. However, as most of the state budget surplus has been transferred to the Stabilization Reserve Fund, the broader monetary aggregate containing government deposits has also grown only moderately.

Significant changes have taken place in the structure of broad money (see Figure 4.2). Earlier this year increasing interest rates triggered the growth of time deposits and their share in broad money leaped from 16% in end-1997 to 21.5% in July 1998. The share of time deposits has been slowly growing over several years whereas an increase in the share of cash in circulation revealed in the second quarter of 1998 was a new development. Although a high cash demand characterizes each holiday season in June-July, its higher than regular level cannot be explained only by seasonality in the second half of the quarter. The increased cash demand in mid-June was also linked to negative information from the banking sector (see Background Information on page 49). It triggered temporarily foreign currency purchases in June as well. The 'dollarisation' characterized by greater preference of foreign currency deposits in the broader monetary aggregate, has more or less remained on the level it reached at the end of 1997, and was 15% in end-June.

LOANS

Limited external credit resources, tighter prudential ratios and merger-related temporary restrictions as well as banks' more conservative attitude towards macroeconomic developments have significantly restrained the credit flow into the economy (see Figure 4.3). The 1997 swift growth in borrowing was mainly based on the inflow of external capital. The rapid boost in credit volume against a much slower growth of residents' deposits has stopped by now.

The balance sheet of the banking sector reflects an about EEK 2.2 billion increase (11%) in the stock of loans in the first half-year (see Figure 4.4), annual growth rate is 35%. Corporate lending increased by EEK 1.9 billion (16.1%). Reduced borrowing outlooks have had a significant impact on the growth of loans to financial institutions and private persons. Total lending to financial institutions increased by EEK 273 million (8.9%). For private individuals borrowing has become more expensive and more complicated. The lending volume in this category increased by EEK 59 million (1.4%) over six months.

Bank loans to the non-bank sector constitute one component of actual borrowing by economic agents. Banks' investments into bonds of companies and financial institutions, in principle also credit, just like loans, increased by EEK 233 million (9.7%) in the first half-year. Over the last years larger companies have also been able to obtain external resources independently, and since 1998 via banks acting as intermediaries for direct lending. In 1997, bank subsidiaries (mainly leasing companies) have accelerated external borrowing as well, facilitated by the parent bank's guarantees.

MONEY AND FOREIGN EXCHANGE MARKETS

Banks' more conservative performance in setting their investment priorities was a positive trend in the first half of 1998. Banks' more cautious attitude towards developments and trends in external markets brought along an increase in the liquidity buffers. Additional liquidity requirements introduced by Eesti Pank in end-1997 had their impact as well. Inherent from growing internal liquidity buffers, the role of the inter-bank money market weakened.

The 1997 amendments in the reserve requirement and the introduction of additional liquidity requirements have raised in the structure of banks' liquid assets the share of reserve holdings at the central bank. Regardless of the relatively high reserve requirement, most of the banks did not seem to have any difficulties in meeting them (see Figure 4.5). Banks were also more active in using standing deposit facility in Eesti Pank[1] .

With adequate liquidity buffers, the role of the overnight market in smoothing shortages in short-term liquidity has significantly weakened. The highest ever turnover in the beginning of the year was followed by passive moods in the inter-bank overnight market in the second quarter. The volume of long-term transactions in the inter-bank money market was also quite small, especially in the second quarter.

In end-June foreign exchange spot market there was a major demand for foreign cash which could be linked with the temporary distrust towards the banking sector. The share of cash in foreign exchange transactions increased significantly, especially in the last days of June. Estonian kroons were mainly exchanged into German marks whereas higher spreads between purchase and sale rates than in case of other currencies (eg US dollar) were accepted. Such an increased purchase interest was still limited and regionally contained. The daily foreign exchange turnover between Eesti Pank and commercial banks maintained its regular level.

The foreign exchange forward transactions market was relatively stable in the beginning of the year and focused on routine transaction orders. In mid-June, mainly due to the insecure economic and political situation in Russia, a certain cautious speculative interest appeared. Price quotations of forward transactions increased. Comparing 1998 to October 1997, market participants have been more cautious this time. Price quotations were mostly provided for smaller quantities and prices increased rapidly against low transaction volumes. Nevertheless, in mid-August for a couple of weeks the volume of forward transactions exceeded the regular weekly turnover by 7-8 times but the number of transactions concluded remained far below the last ten days of October the year ago (see Figure 4.6). However, inadequate information does not allow to differentiate direct speculative pressure from traditional corporate hedging.

INTEREST RATES

The beginning-of-the-year drop in the prices of long-term money market instruments stabilized in the second quarter. It was mainly due to the stabilization of international financial markets in the first quarter. The situation changed when the external environment changed - in early July several banks raised quotations for periods exceeding one month, partially probably reflecting expectations related to a general interest rate level increase (see Figure 4.7). It was a decision mostly determined by the external pressure, supported by the growth in forward transaction prices (see Money and Foreign Exchange Markets). There is still no proof of the adequacy of interest rate quotations for the money market. It has been referred to by local banks as well, in the context of the low number of transactions.

As two price quoters for the inter-bank loan (TALIBOR) and deposit interest rates (TALIBID) - Eesti Hoiupank (Estonian Savings Bank) and Tallinna Pank - have disappeared in bank mergers, principles of inter-bank money market quotation were revised as of 1 September 1998. Apart from changing the number of banks, other amendments were made as well to eliminate some previous defaults and to make both TALIBOR and TALIBID function more efficiently as reference interest rates for pricing other instruments[2].

The interest rate level increase is also reflected in the deposit and credit markets (see Figure 4.8). The growing deposit interest rates (see Table 4.1) in the limited liquidity circumstances in the fourth quarter of 1997 affected mostly short-term deposits. Interest rates of long-term deposits rose by a couple of percentage points. In the first half of 1998, deposit rates decreased again but have remained higher than during the last couple of years. During the first half-year loan interest rates decreased for those customer groups who had suffered most by the interest increase in end-1997 (see Table 4.2) - for financial institutions and private individuals. The general interest level was somewhat above the 1997 summer level. Prices for long-term loans have recently risen as well. In the continuously insecure monetary environment, the price of credit in mid-term horizon is not likely to drop.

[1] Standing deposit facility is an opportunity provided for commercial banks to deposit their free reserves in Eesti Pank. If the monthly average balance on the correspondent account of a commercial bank exceeds the reserve requirement, Eesti Pank pays interest based on the discount rate of the Deutsche Bundesbank.
[2] Since 1 September 1998 TALIBOR and TALIBID are computed based on the quotations of the three largest commercial banks by balance sheet volume (Hansapank, Eesti Ühispank (Union Bank of Estonia) and Eesti Forekspank (Estonian Forexbank) instead of the previous five banks. From the list of quoted periods one week was eliminated and six months included as the six months interest rate is a more frequently used indicator in contracts. The restriction on the same period loan and interest rate margin was abolished. The quotation is now for EEK 10 million instead of EEK 1 million previously.