Eesti Pank Bank of Estonia 15 years of currency board in Estonia Ülo Kaasik.

Eesti PankBank of Estonia

15 years of currency board in Estonia

Ülo Kaasik

Ülo Kaasik CBA in Estonia 2


Outline

Currency Board Arrangement in Estonia• History

• Framework and results

• Recent developments and challenges



Why choosing CBA?

• Need for stabilising anchor in the beginning of 1990s

• Creating a simple and reliable monetary system, effective since 1992

• Small open economy with free capital mobility



Monetary system

• Fixed exchange rate against euro (since 1999, formerly since 1992 equivalently against the DEM)

• Full convertibility of Estonian kroon

• Base money is fully backed by high quality foreign assets



Operational framework

• Smooth liquidity management through unlimited EUR-EEK exchange with the central bank (forex window)

• High liquidity buffers in the form of required reserves (reserve ratio currently 15%)

• No domestic monetary policy interest rate: monetary stance is determined by European Central Bank monetary policy decisions



Other policies supporting CBA

• Fiscal policy based on a balanced budget principle

• Tax system – motivating, transparent, simple

• Liberal trade and investment regime since 1991

• Flexible labour market

• Strong banking system

• Preparations for EU membership



What are the results?



Relatively quick stabilisation of the economy

0%

20%

40%

60%

80%

100%

The introduction of the currency board was crucial in achieving disinflation

During the last 8 years the average CPI has been 3.7 %

CPI (1991-2007)

1991 -- 257%

1992 -- 1077%



A

A-

BBB+

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

3M EURIBOR (3M DEM LIBOR) 3M TALIBOR Sovereign Rating (Standard & Poor's)

The interest rates have converged to the interest rate level in euro-area countries



Fast capital inflow, through FDI and banking system

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

FDI stock, % of GDP

FDI inflow, % of GDP

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

domestic banks, total assets % of GDP

banks with foreign ownership, total assets % of GDP

net foreign assets of banks, % of GDP



Very rapid income convergence

0

2000

4000

6000

8000

10000

12000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

10

20

30

40

50

60

70

GDP per capita (EUR, nominal), left scale GDP vs EU-25 (%, PPP), right scale

Source: Eurostat



… and current account deficit

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

% o

f G

DP

goods balance services balanceincome balance current transfers balancetotal current account



Pace have accelerated during last years

• Double digit GDP growth

• Rapid credit growth

• Deepening CAD

• Inflation well above Maastricht criterion



How to avoid overheating of the economy under CBA? Case of Estonia

• Flexibility: in economic policies and markets

• Reducing cost and price pressures of the government

• Reminding conservative financial decisions

• More reserves in the financial system

• Close cooperation with supervisors and central banks of the host countries



CBA ensures high liquidity buffers

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

02/0

2/19

98

02/0

8/19

98

02/0

2/19

99

02/0

8/19

99

02/0

2/20

00

02/0

8/20

00

02/0

2/20

01

02/0

8/20

01

02/0

2/20

02

02/0

8/20

02

02/0

2/20

03

02/0

8/20

03

02/0

2/20

04

02/0

8/20

04

02/0

2/20

05

02/0

8/20

05

02/0

2/20

06

02/0

8/20

06

02/0

2/20

07

02/0

8/20

07

mln

EE

K reserve requirement

deposits in Bank of Estonia

market value of foreign assets liquidity portfolio



Flexible labour markets is crucial for economic adjustment

0%

5%

10%

15%

20%

25%

30%

35%

40%

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

nominal wage growth

real productivity growth



CBA cannot operate without conservative fiscal policy

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

General government deficit/surplus,% of GDP



Is inflation too high?



Lower level of convergence implies faster growth rate

0123456789

20 40 60 80 100 120GDP per capita in PPS (2000), EU25=100

Ave

rage

ann

ual r

eal G

DP

grow

th (

2001

-200

5),

%

LV EELT



Income and price levels tend to correlate i.e. converge together

Price level and GDP per capita in PPS in European Union (except Luxembourg)Source: Eurostat

R2 = 0,9101

0

20

40

60

80

100

120

140

0 20 40 60 80 100 120 140 160

gdp per capita

pri

ce

lev

el



Apart from conjunctural price increases current inflation rate also reflects price convergence

-2%

0%

2%

4%

6%

8%

10%

12%

2000 2001 2002 2003 2004 2005 2006 2007

CPI Services Manufactured goods excl fuel



Economy has started to cool down, 2007 Q2 growth was 7.6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

difference GDP growth Estonia GDP growth euroarea



Credit cycle has turned

• Monthly credit growth has not declined to a too low level – it remained around 2% during the whole summer

Credit growth in the non-financial sector

0%

10%

20%

30%

40%

50%

60%

I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV

2001 2002 2003 2004 2005 2006 2007 2008 2009

Credit growth y-o-y Spring forecast 2007



The external balance has not widened any further

-20%

-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

I II III IV I II III IV I II III IV I II IIIIV I II III IV I II III IV I II III IV I II* III IV I II IIIIV I II III IV

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Current account Spring forecast 2007

Current account (% of GDP)

* Flash estimate



No big impact of financial turbulences

0,0

0,1

0,2

0,3

0,4

0,5

0,6

0,7

0,8

31.1

0.0

6

14.1

1.0

6

28.1

1.0

6

12.1

2.0

6

26.1

2.0

6

09.0

1.0

7

23.0

1.0

7

06.0

2.0

7

20.0

2.0

7

06.0

3.0

7

20.0

3.0

7

03.0

4.0

7

17.0

4.0

7

01.0

5.0

7

15.0

5.0

7

29.0

5.0

7

12.0

6.0

7

26.0

6.0

7

10.0

7.0

7

24.0

7.0

7

07.0

8.0

7

21.0

8.0

7

04.0

9.0

7 -1

0

1

2

3

4

5

6

7

3M Talibor-Euribor (l.s) 6M Talibor-Euribor (l.s)3M Rigibor-Euribor (r.s) 6M Rigibor-Euribor (r.s)



Euro adoption as the ultimate exit clause

• Adoption of the euro as soon as possible, targeting 2011

• Central role of the government in reducing inflation:

– Avoiding additional cost and price pressures

– Managing regulated prices

• No changes expected in the monetary environment due to euro adoption



Conclusions• CBA can be an effective corner stone for the

economy

• However, CBA cannot be successful without supportive economic policies

• CBA offers the closest monetary environment to the euro area, preparing the economy for the euro adoption

Eesti Pank Bank of Estonia 15 years of currency board in Estonia Ülo Kaasik.

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