The main objective of Eesti Pank as the central bank of the Republic of Estonia is to guarantee the stability of the national currency, the efficiency and reliability of the banking system. Since the 1992 monetary reform our monetary policy has been based on the fixed exchange rate against the German mark and the currency board system. The aim has been to achieve the stability of prices through a fixed external value of the kroon. This policy has proven successful. In 1996 the inflation rate continued to fall and the increase in prices slowed down, in particular in the second half of the year. The average annual inflation rate dropped to 23%, while in December 1996 consumer prices increased by only 14.8% as compared to December 1995. The slow-down of the price increase and lowering of inflation expectations in their turn are prerequisites for a sustained economic growth as can be seen from the experience of other countries in transition.
The success of the policy of the fixed exchange rate is based on the trust in the durability of the kroon of the general public and all those who are active in our economy. The trust or lack of it is in the monetary policy terms best characterised by the developments in the Estonian kroon interest rates which are approaching those of the German mark. We are satisfied with the general trend of interest rates which in 1996 indicated the persisting trust in the continuation of the chosen policy. The inter-bank money market was stable throughout the past year. Interests on the medium-term, four-five-year liabilities decreased considerably on the financial market, varying between 10 and 12% in case of the bonds issued by companies and local governments, and dropping to 12% by the end of the year in case of loans issued by commercial banks.
The currency board system gives the broadest possible guarantee for the external stability of the national currency. The issuing of money is restricted with the increase or decrease of Eesti Pank's foreign assets. The monetary policy environment based on such strict rules sets certain limits to the central bank's participation in the money market and thus increases the role of the banks' liquid assets in securing the smooth operation of the financial system. In order to allow the banking system to use domestic reserves in a more flexible manner, Eesti Pank changed the rules on reserve requirement calculation in 1996. Under the new requirement, the commercial banks' minimum reserve requirement with Eesti Pank has to meet the monthly average level. At the same time, it has to be emphasized that the smooth functioning of the financial system and credibility of the national currency is in the first place still guaranteed by the adequate foreign reserves and the free movement of capital.
The monetary policy based on a fixed exchange rate cannot succeed without the government's support in its budget policy. Although the government's fiscal policy continued to be relatively conservative in 1996, the overall deficit of the state budget, local budgets and off-budget funds increased. Therefore, special importance must be attached to the government-initiated legislative amendments, aimed at securing the balance of the state budget and hence the stability of prices. Those amendments are supposed to improve the coordination of the fiscal policy of the central government and the local governments already in 1997.
Strong and effective banking system is one of the main pillars of Estonia's successful monetary policy and market relations-based economic development. Trust in the commercial banks increases society's inclination to save and guarantees the channelling of domestic and foreign resources into productive investments. The effectiveness of the banking system as the main financial intermediary, its security and reliability depends on two matters. Firstly, the activity of the banks has to be regulated by laws with adequate precision and the legislative regulation has to be enforced. Secondly, decisions on loans and other business activity have to be made proceeding from good banking practice, without external interference. We proceeded from those principles in carrying out our regulatory and supervisory tasks also in 1996.
In working out the legislative framework, Eesti Pank proceeds from international and first of all, European Union standards. The application of those standards introduces into the Estonian banking legislation the basic principles of the legislation of the developed market economy, and thereby makes the banking system more secure and facilitates the further integration of the Estonian financial system into the financial system of the developed industrial countries. Improvement of the Law on Credit Institutions as well as the draft law on protecting bank deposits are aimed at the further harmonization of Estonian legislation with the respective legal acts of the European Union. The security fund provided for in the proposed law on deposit protection will considerably increase the public trust in the Estonian commercial banks, improve the efficiency of financial intermediation and reduce the danger of a crisis in the banking system.
The intermediation of financial resources from depositors into the business unavoidably makes banks dependent on the overall market situation of the economy. Like in other business spheres, taking risks is also an inseparable part of banking. Therefore, it must be stressed that supervision can never totally exclude the possibility of problems for the banks, although it is the task of supervision to minimize the costs to society resulting from those problems. In organizing banking supervision we believe that competition between commercial banks, based on the principles of market economy, equal opportunities and fixed rules, is the best way to increase the security and reliability of the banking system. Thus, the supervisory activities of Eesti Pank in 1996 were focussed on monitoring and improving the banks' risk management systems and internal audit units. The smooth functioning of both mechanisms will guarantee the correspondence of the banks' executive decisions with the good banking practice and existing legislation and the use of the most extensive information in the process of decision-making.
The efficiency of the Estonian banking system and its role in financing the economy increased considerably in 1996. This is characterised by the continuing increase in the volume of loans and deposits, and the decrease in the interest margin between loans and deposits. The continuation of the bank mergers was part of the structural changes taking place in the banking sector and aimed at the further consolidation of the system and growth of the private capital in the bank's ownership structure. The increasing competitiveness of the Estonian banks is confirmed by the continuing internationalization of their ownership and the expansion of the banks on foreign markets. The increase in the financial system's inner competitiveness and efficiency was facilitated in 1996 by the rapid development of the leasing companies and other financial intermediaries as well as the capital market, of which an important characteristic feature was the launch of the Tallinn Stock Exchange. The inner integration of the financial sector deepened, which sets new tasks before the banking supervision.
In 1997, Estonia marks the fifth anniversary of the reintroduction of the kroon. The development of the economic and monetary policy after the reintroduction of the kroon has in broad terms corresponded to the goals set five years ago. The Estonian economy has successfully emerged from the stabilization period and entered the stage of growth. The most important monetary policy result of the stabilization period has been the sudden halt of the increase in consumer prices under the influence of the fixed exchange rate and conservative fiscal policy. The continuation of the current policies will guarantee the slow-down of the price increase and decline in interest rates also in the future. However, the continuation of strong monetary policy and the policy of a balanced budget is impossible without the increasing competitiveness and productivity of the economy. The prerequisites for this are the openness of the economic system, the continuing increase in domestic savings and further integration into the economic system of the developed industrial countries through foreign trade as well as investments. Thus, regardless of all past achievements, Estonia more than ever needs the firmness of decision to fortify what has already been achieved and to continue radical economic reforms.
Vahur Kraft
President of Eesti Pank