OPERATIONAL FRAMEWORK REFORM OF THE MONETARY POLICY
(background information for the Supervisory Board of Eesti Pank meeting on 25 April 2000)

	I Reform of the operational framework of the monetary policy
	II Operational framework reform of the monetary policy
	III The impact of the reform on the monetary environment
	IV Conclusion

I Reform of the operational framework of the monetary policy:

Objectives and stages

1. Definition of the operational framework of a monetary policy. According to international practice [1] the operational framework of a monetary policy involves
   1. In broader terms:

    Monetary policy objectives in general (including intermediate and ultimate targets, setup of monetary policy instruments as a means of achieving these targets, etc.),

    Central bank independence and policy transparency issues;

    General legal framework and guiding legal instruments (including banking practices and unwritten standards).

2. In narrower terms:

    Liquidity system and constraints stemming from financial stability objectives.

The following framework reform strategy is based on the continuation of the currency board arrangement (CBA) in Estonia until joining the Economic and Monetary Union (EMU). Hence, the reform will review the operational framework of the monetary policy in narrow terms, i.e. the operational framework design for liquidity management purposes

2. The currency board arrangement is based on stringent rules and efficient markets. As a classical orthodox-type currency board set-up does not involve open market operations to influence the money supply and interest rates, the monetary policy objectives are accomplished through the smooth operation of standing facilities. Efficient financial markets will ensure an adequate supply of resources to meet demand, leading to the stabilization of interest rates, the latter being one of the key factors in the currency board based macroeconomic stabilization process. Under a rule-based monetary system such as a currency board, the major emphasise is on the fluent functioning of the operational framework.
   
3. The latest view is also emphasized in the Strategic Development Plan of Eesti Pank. Paragraph 3 of the document "The main tasks of Eesti Pank during 1999-2001" states the following: "To ensure the efficiency of rule-based monetary policy transmission Eesti Pank will pursue an adequate operational framework of the monetary policy and aim for the better exchange of information with market participants". Thereby, the efficient functioning of the operational framework of the monetary policy ensures the efficient functioning of the whole monetary system.
   
4. During the last two decades international financial markets have undergone vast and rapid changes. Asian and Russian financial turmoil have contributed to the impetus towards globalization and further integration: the largest monetary union - the Economic and Monetary Union - was founded. Both domestic economic and monetary policies have to keep pace with global trends. Commensurate with the trend towards the globalization of financial markets, the free movement of capital gathers even more weight - in this light a more flexible and less distorting operational framework of the monetary policy is the key contributor to the development of efficient financial markets.
   
5. The medium term goal of Estonia is joining the European Economic and Monetary Union, as stated in Estonia's negotiation position. Despite the fact that the exact time of accession to the EMU is unknown, it is necessary today to take steps to support the convergence of the monetary system with European standards while simultaneously maintaining monetary stability during the transition phase. Thus, the monetary policy reform has two clear objectives: contemporary improvement of the liquidity management system in the short-term and the long-term perspective of pursuing operational convergence with the Eurosystem.
   
6. The hereby presented monetary policy framework reform should not be viewed separately from the previous policy decisions of the central bank aiming at the stability of the monetary environment, the latter being a necessary precondition for price stability. The current framework reform is a logical continuation of the policies started in 1999 to lessen the somewhat distorting impact of the present framework on market structures as well as to promote the integration of Estonian banks into European markets. The Bank of Estonia’s decision to remunerate the required reserves of commercial banks as of July 1, 1999 should be viewed in this light. Taking into account the ultimate objective of joining the EMU, the following concept of the operational framework reform of the monetary policy includes both short and long-term views.

[1] The definition used here relies on that of the CCBS.

The goals of the reform

7. The reform on the monetary policy's operational framework has two distinct objectives:

1. A critical review of the efficiency of monetary policy instruments and rules to ensure the smooth functioning of the fixed exchange rate mechanism under the currency board arrangement in the short-to-medium term;
2. The longer term goal of converging the monetary policy operational environment towards that of the Eurosystem.

The time-frame of the operational framework reform is somewhat complicated due to uncertainty about the exact time of the accession to the EMU. This stems from the stepwise accession to the EMU and divides the reform at least into two stages: (1) pre-accession period and (2) post-accession period for a country with derogation (i.e. as a member of the EMU but not a member of the Euro zone). Hence, the preparations for full convergence into the EMU framework have to be divided between two (or even three, if joining the Euro zone is taken as a final goal) periods; during the first period this means improvement of the existing currency board arrangement.

8. The exchange rate regime as a main determinant for operational framework reform in the short term. In light of the definition of an operational framework mentioned above, the exchange rate regime is the main determinant of the liquidity system. As opposed to the discretionary monetary framework, the monetary systems relying purely on rules and markets – like a currency board – the liquidity system is treated as a central complex ensuring the functioning of the system, including the maintainance of a fixed exchange rate. Therefore the intermediate goals and monetary policy strategy are unavoidably different from that of the discretionary monetary arrangement. For example, the intermediate objective of the CBA is the exchange rate as opposed to the money supply target and/or direct inflation target used by other systems. As the ultimate goal is the same – price stability – it can be said that the CBA targets price stability via exchange rate stability.
   
9. EMU aspects today. The operational framework reform of the monetary policy relies on the principle of acceptable plurality of exchange rate regimes during the pre-accession period. This means that the main characteristics of the CBA will remain unchanged during the pre-accession period. This also means no changes in the legislation of the monetary framework regarding aspects of the exchange rate. The last statement is also supported by the ECB's statement on the suitability of the CBA (on a case-by-case basis) within the ERMII as a unilateral commitment[2]. Additionally, it is clear by now that the immediate implementation of the monetary framework of the Eurosystem in applicant countries is not realistic due to different stages of development and available monetary policy choices; early implementation can also cause serious drawbacks in the course of normal development.
10. The need for critical evaluation of the existing operational framework of the monetary policy in the short term. The last thorough evaluation of the operational framework took place in 1996. The core of the 1996 reform was the monthly averaging of required reserves' calculation. In addition, the spread for buying/selling forex to commercial banks was abolished, remuneration of banks' excess reserves with the central bank was linked to the Bundesbank discount rate, a penalty rate for not meeting the reserve requirement was implemented, etc. Since 1996 the financial system has undergone several changes including international testing during the financial markets' turbulence of 1997-1998. It can be said that the framework has worked well and proved to be sustainable in difficult circumstances. Still, bearing in mind the changes in the financial markets, the operational framework needs to be re-assessed and improved, when and where necessary.

[2] “…Thus such countries may participate in ERM2 with a CBA as a unilateral commitment augmenting the discipline within ERM2.” (ECB press conference from April 13, 2000).

The efficiency of changes in the operational framework in 1996-1999

11. As a classic currency board mechanism does not support open market operations to influence the money supply and interest rates, the ultimate goal of a monetary policy has to be accomplished through the smooth functioning of the rest of the operational framework. In Estonia the monetary policy framework's major emphasis has been on the standing facilities (forex window and deposit facility) and required reserves' system. The development of the standing facilities during 1996 -1999 can be qualified as a response to the turbulence in the internal and external macroeconomic environments. Even though the external shocks demanded ad hoc policy decisions to address the structural imbalances in the economy, Eesti Pank stressed the importance of keeping long-term policy objectives in mind, including the efficiency of the monetary system. In table 1 the chronology of monetary policy decisions over the last 3 years is presented, along with the impact of these steps on the monetary environment.

Table 1. Measures taken by the Eesti Pank aimed to improve the operational framework of the monetary policy in changing the internal and external environments.

Measure	Date	Underlying causes	Impact on markets
Standing facility of buying/selling foreign currency to commercial baks ("forex window")
Abolished the spread in EEK/DEM (since 1.01.99. EEK/EUR and other EMU currencies) transactions between BOE and domestic credit institutions.	1.07.96	Promoted the effective functioning of the forex market and facilitated short-term interest arbitrage.	Bigger banks have established an effective infrastructure for such "broader liquidity management" as well as strengthened their foreign liquidity buffers.   Transactions between Eesti Pank and commercial banks have been simplified.   The role of the domestic inter-bank forex market has gradually been weakened.   Lowered interest rate margin between the Estonian kroon and the Euro due to missing capital controls.   For liquidity management purposes the "forex window" could not be viewed as an alternative to required reserves in the very short term (T+0).
Reserve requirement
Introduced the monthly averaging principle in meeting the reserve requirement.	1.07.96	Provided banks a more flexible buffer for short-term liquidity management in order to limit liquidity risks and stabilized the inter-bank money market interest rates.	The use of the daily minimum requirement by banks decreased substantially.   Assessment of the impact of introducing averaging on interest rate stability is complicated because of significant structural changes in the banking sector over the past 3 years. However, the interest level has been steady in stable times.
Lowered the cash deductible in meeting the reserve requirement.	1.07.96 (40%) 1.07.97 (30%) 19.06.98 (20%)	Actual cash demand decreased (structural reasons).    Increased liquidity buffers.    Decrease of security risks of cash holdings.	In 1996-1997 banks took the cash deductibility ratio in their cash holdings into account.   In 1998 the impact of the decrease of the cash component was insignificant.
Added net liabilities of credit institutions vis-à-vis foreign banks" to the reserve requirement calculation base.	1.07.97	Diminished structural deviations caused by the massive inflow of foreign capital.   Eliminated the "unjustified advantages" of credit supply based on foreign capital inflow.    Limited credit expansion.    Increased liquidity buffers.	Strong signal to banks about the risks of foreign liabilities based credit expansion.    Banks circumvented the requirement in various ways (over-reporting cycle, over-channeling capital inflow via other parts of the banking groups).    The size of foreign reserves of banks grew; at the same time the quality of foreign assets remained ambiguous.
Increased the penalty interest rate for non-compliance with the reserve requirement to 20%.	1.11.97	Ensured the meeting of the reserve requirement in a situation where the market interest rates tend to grow higher than the penalty interest rate set by the Eesti Pank.	Created a "ceiling" for money market interest rates.    The penalty interest rate has been too high and rigid during stable times.
Raised the daily minimum reserve requirement to 4% of the reserve base.	1.11.97	Forced the banks to keep intra-day kroon liquidity reserves due to instability stemming from the Asian crisis.    Provided Eesti Pank with some flexibility in the case of potential liquidity crises.	Because of the relatively high (monthly averaged) reserve requirement the daily requirement did not play any important role, particularly for larger banks.
Extended the reserve requirement base: including financial guarantees into the reserve base.	1.08.98	Avoided circumventing of ‘net liabilities against foreign banks’ clause in reserve requirements over channeling the capital inflow via other parts of financial groups.    For strengthening the liquidity buffers of the monetary system.	The volume of effective reserve requirement increased significantly.    Rapid adjustment of banks: the amount of banks’ guarantees to financial institutions and non-resident credit institutions diminished.
Remuneration of required reserves.	1.07.99	Decreased distortions of the financial market by reducing the negative impact of the uncompensated reserve requirement.    Decreased the advantages of other financial market players (not subject to the reserve requirement) over credit institutions.    Attempted to reducing liquidity buffers, while reforming the operational framework in a more market-oriented direction.	Decrease in structural deviations.    Signaling effect: continuation of restrictive monetary policy in the conditions of expansive fiscal policy.    Partial compensation for the restrictive monetary policy.
Additional liquidity requirement (ALR)
Established the liquidity requirement.	1.11.97	Prevented banks from expanding their loan portfolios at the expense of liquidity buffers in the deteriorating financial environment.    Enhanced financial stability.    Restricted credit expansion.	Considerable growth of banks’ deposits held with the Eesti Pank.    Most banks did not face any trouble meeting the requirement after its introduction.    Strong positive signal in the middle of the Asian financial crisis.
Maintained the liquidity requirement.	1998	Maintained adequate liquidity buffers and secured financial stability (precautionary measures in order to avoid the contagious effects of the Russian financial crisis).
	1999	Continued restrictive monetary policy in the conditions of the expansive fiscal policy.   Maintained adequate liquidity buffers for potential Y2K problems.
Penalty for non-compliance with additional liquidity requirement.	1.11.97	Ensured the meeting of the ALR targets.	Overwhelmingly accurate meeting of ALR.    Case by case penalty rule may cause moral hazard.    Liquidity buffer at Eesti Pank is practically inoperative (due to harsh penalty measures), thereby hindering smooth liquidity management.
Standing deposit facility
Established standing deposit facility.	1.07.96	Increased banks’ incentives to maintain liquidity in domestic currency.	Assessment of the impact on reserve demand ambiguous.    The instrument has supported the smooth functioning of the liquidity management.
Certificates of deposits of BOE
Central bank CD auctions.	19.03.93	Increased the efficiency of inter-bank money markets.    Smooth seasonal fluctuations in the cash demand cycles.    The creation of an instrument based on domestic eligible security was meant to encourage a domestic inter-bank market (via providing potential collateral).	Does not function during turbulent times (if market rates are significantly higher than the yield offered by the central bank).    Is a divergence from the orthodox currency board as it changes the money supply; hence, the volumes have been kept very small and the yield capped; its role diminished in line with the deepening of financial intermediation.

12. Major changes in both internal and external environments and the development of the financial system have produced a need for a re-assessment of the operational framework. First and foremost, the problematic area is the build-up of a required reserves' system in respect of its various functions (liquidity function, restrictive function, etc.). Additionally, the central bank's CD auctions have lost their initial meaning due to their very small amounts and an interest caps. Under this design, the auctions failed during turbulent times (due to a much lower yield compared to market rates) and represented an alternative form of investment for banks during stable times. Hence, they have lost their usefulness in the monetary policy framework.

The environment & timing of the reform

13. Monetary environment. Relying on the experience of the last three years, it can be stated that the present build-up of the monetary policy's operational framework has supported the credibility of the Estonian monetary system, reinforced the capitalization and liquidity of commercial banks and created a favorable environment for real and nominal convergence towards the EU levels. The monetary environment has significantly improved after the Asian and Russian crises, which in turn gave a chance for starting the operational framework reform. Additionally, growing integration into international markets and the rapid development of real-time settlement systems has also supported the timing of the reform.
14. Accession to the EMU as a background for the timing of the reform. The reform will be divided into at least two stages. According to information available at present, the accession to the EU and the EMU cannot take place before January 1, 2003; however, later dates are possible. Consequently, the first stage of the reform, which is mainly targeted at further improvement of the smooth functioning of the CBA, must be accomplished no later than 2001.
15. The CBA by itself sets the limits for available monetary policy tools. Rapid development and the further globalization of financial markets induce further combination of CBA principles with modern liquidity management practices. For the CBA this means ensuring the smooth functioning of the standing facilities in a broad sense, as discretionary means are not normally used for achieving monetary policy goals. Under standing facilities in broad terms we mean a standing facility for buying/selling forex deposit facilities and a required reserves system[3]. Hence, the first stage of the reform involves:

    Improvement of the liquidity system over a further development of the standing facilities; first and foremost this covers required reserves’ system;

    Re-assessment of the operational framework in other respects.

16. One of the central issues of the reform is the optimal level of required reserves. In principle it is possible to derive the so-called 'optimal level for Estonia in an international context' using international comparisons; however, this approach remains highly conditional due to the big differences between different countries in respect to size, exchange rate regime, openness of the economy, etc. With taking into account that the long-term goal is the harmonization of the operational framework with that of the EMU, the level of required reserves should be lowered to 2% as the final target. On the other hand, as the required reserves' system is one of the key components of the Estonian CBA, immediate unification with the EMU framework is not realistic. Therefore it is appropriate to treat the issue of optimal level of required reserves in the form of gradual lowering of it over time with the aim to reach the same level and structure of required reserves as in the EMU. The central bank strongly believes that lowering the liquidity buffers before joining the EMU is not acceptable. This last statement stems from the specific features of the CBA.
17. To summarize, during the pre-accession period to the EMU it is necessary to start reforming the operational framework towards the EMU standards. At the same time further improvement of the CBA is necessary for ensuring price stability in the medium term. In the longer view, operational convergence towards the EMU framework starts with the standing facilities; the implementation of open market operations before joining the EU and the EMU is not likely.

[3] This approach differs in some extent from that of the ECB where monetary policy instruments are divided into three families: open market operations, standing facilities and reserve requirements. In this paper standing facilities also cover reserve requirements in the broader meaning of the term.

II Operational framework reform of the monetary policy

18. For reasons of clarity and in line with the abovementioned objectives of the operational efficiency and operational convergence, the reform is divided into two different phases. Table 1 describes both the first and second phase of the reform and presents the main changes necessary to the operational framework in the short-to-medium term. Even some of the monetary policy instruments not existing under the current framework such as the marginal lending facility have been reviewed.

Table 1. Enhancements to the monetary policy instruments

19. The first phase of the operational framework reform takes us to the second half of 2001 and will be followed by the second phase lasting till Estonia joins the EMU. The division of the reform into two phases is justified by the difficulties in predicting both the exact speed of the economic-political integration process into the EMU over the medium term and the pattern of the Estonian economic cycle. A relatively high level of reserves at the central bank would be justified during the first phase of the reform to ensure adequate coverage of settlement buffers when the new payment systems start operating. This leaves the banks ample time to set up and test their cross-border liquidity management systems.
20. The first phase of the operational framework reform involves:

1. Unification of the additional liquidity requirement under the reserve requirement;
2. In line with the integration of the Estonian banking system into the European markets, the liquidity buffers of the monetary system in the sense of the reserve requirement will take into account both the banks’ domestic and foreign reserves: (a) the main part of the reserve requirement still has to be met by holding Estonian kroon deposits with the central bank, (b) the remainder of the reserve requirement, to be seen as a temporary measure until Estonia joins the EMU, could also be met by holding eligible fixed income securities of investment grade or higher and nominated in the anchor currency;
3. Discontinuation of the central bank CD auctions after the introduction of the new required reserves’ system. Later, along with the new settlement systems, there will be new alternatives for liquidity management;
4. Before the full implementation of the reform on January 1, 2001, the reserve base will be reviewed according to the needs of the reform.

21. The second phase of the reform (2001+) includes complete harmonization of the Estonian minimum reserve system with that of the ECB, including unification of the reserve calculation base and reserve requirement level of 2%. In addition, a real-time intra-day repository facility will be introduced for payment system purposes, and a standardized marginal lending facility backed by eligible assets will be set up, if necessary.
    
22. The first phase of the reform will foresee a partial meeting of the reserve requirement with foreign assets (fixed income securities). One crucial criterion for the eligibility of foreign securities is that they should be close substitutes for kroon deposits held with the central bank; this means they should be liquid instruments and of high rating. The second precondition for the substitution criterion is efficient functioning of the forex window; the latter will largely determine the speed of cross-border flows. The efficiency of the forex window will improve with the launch of the real-time gross settlement system. At least during the first phase of the reform foreign assets are not perfect substitutes for reserve deposits due to technical restrictions imposed by the present stage of settlement systems (operating on a t+2 basis).
23. The real-time gross settlement system will be operational from the second half of 2001. The operational framework reform does not foresee any changes in the operations of the forex window during 2000 as the reserve deposits will provide ample liquidity buffers for the settlement systems. During the second phase of the reform, when the reserve deposits levels will be lowered, the intra-day liquidity facility and/or the forex window will be introduced. It is likely that both options will be necessary as introducing an intra-day reposotory facility also means an operational convergence towards the Eurosystem. Research on the optimum liquidity facility design will be carried out in co-operation with the commercial banks.
    
24. One of the main objectives of the reform is to minimize market distortions stemming from the required reserves system itself, while simultaneously sustaining adequate liquidity buffers. Hence, the planned reform of the required reserves system will involve a gradual lowering of the required reserves to be met by holding kroon balances with the central bank and a respective increase in the eligible liquid foreign assets holdings. The overall level of required reserves will remain the same. This arrangement leaves the liquidity position of the banking sector largely unchanged (it is supposed that highly-rated liquid foreign assets are almost perfect substitutes for the reserve deposits held with the central bank). The restrictive effect of such an 'Argentinean type' liquidity requirement remains somewhat ambiguous, as both the motives for holding foreign assets and the quality of foreign assets vary remarkably across banks. In principle there is no difference where the liquidity reserves of the monetary system are kept - in the form of high quality securities or in central bank deposits, provided the liquidity transfer mechanism works perfectly. The reforms' impact on the money supply and credit growth is somewhat difficult to predict; the summary of theoretical foundations and analysis is presented below. The sterilization effect of this type of reserve instrument is directly proportional to the credit quality of the eligible assets. The quality of eligible assets is crucial from both the liquidity and sterilization points of view; it is obvious that a lessening of quality will undermine the effectiveness of the minimum reserve system.
25. The expected implications of the operational framework reform of the monetary policy on the liquidity system are the following:

1. The reform will decrease market distortions and increase efficiency of financial intermediation. In that respect meeting reserve requirements with tradable foreign assets is more effective than the remuneration of reserve deposits with the central bank as the central bank cannot pay market rates due to the necessity of covering its own risks;
2. An intra-day liquidity management instrument will be set up for payment system purposes. In the long run this will provide an operational basis for operational convergence towards the Eurosystem monetary policy framework;
3. As a result of the reform the required reserves’ liquidity and restrictive function will become more distinct, though a wider set of instruments will be available for managing capital flows;
4. The reform will ease the harmonization of the required reserve system with that of the Eurosystem by lowering the reserve deposit level in domestic currency. That part of the reserve requirement to be fulfilled by eligible foreign assets should be seen as a temporary measure, the overall aim of which is not to compromise the integrity of the currency board before joining the EMU;
5. The reform will support integration into the European financial markets, a necessary precondition for the successful operation of the currency board.

26. Possible problems stemming from the operational framework reform of the monetary policy are two-fold:

1. Direct impact on the liquidity system;
2. Indirect impact on the monetary environment

The main problems in the course of the reform could be associated with the smaller banks which are not in the same position as the larger institutions to benefit from the additional flexibility offered through the modernized operational framework. In particular, larger banks already have ample experience and have made investments to develop cross-border liquidity management capabilities. The smaller banks lack profound experience in investing in international capital markets partly due to economies of scale and a lack of comprehensive infrastructure. These issues have to be taken into consideration while designing the technical solutions. The other source of potential problems can be associated with additional expenses for the central bank as a by-product of the reform; these issues will be covered below.

27. In conclusion, the operational framework reform will provide for more efficient and flexible use of the standing facilities (as the main instruments of the currency board framework) and will expectedly squeeze the interest margin between the Estonian kroon and Euro interest rates through diminishing market distortions. In addition, the reform will possibly have a stabilizing effect on short-term interest rates as domestic banks would be in a position to employ their foreign liquidity buffers on very short notice to cover unexpected Estonian kroon liquidity outflows from the payments system. The latter will reduce the systemic risk in the RTGS where the timing of payments is of critical importance. In the longer run, this reform will enhance the operational convergence towards the Euro zone monetary framework.

III The impact of the reform on the monetary environment
at the macroeconomic level

28. In addition to the effect on banks’ liquidity management, the impact on the monetary environment has to be considered. The discussion below is divided into two sub-problems:

1. The monetary policy signal of the reform as a part of general economic policy;
2. The impact of the reform on the monetary environment, including central bank expenditures.

Expected impact on the monetary environment

29. The role of a monetary policy in a small open economy. Recent developments and experience over last 8 years have stressed the positive contribution of the currency board arrangement to economic growth, but to some extent at the expense of higher volatility of economic activity. The past financial and currency crises have proved to the international community that currency board mechanisms are credible policy alternatives for small open economies, provided there is a sound balance between fiscal and monetary discipline. During recent years currency boards have gained more international recognition. Research performed by the IMF has shown that countries following currency boards have been successful not only in reducing budget deficits and beating inflationary expectations in the stabilization phase, but have also outperformed many other countries following other exchange rate regimes in achieving sustainable growth (see Figure below).

30. The main causes of volatility of economic activity in Estonia are its openness to external shocks and the limited possibilities to smooth out the effects of external shocks through the active use of monetary policy instruments (for example: limited possibilities for sterilizing capital inflow and for minimizing the effect of direct price shocks, etc.). On the other hand, automatic stabilizers under the currency board arrangement imply a fast adjustment in the real sector and thus provide a quick reaction to the changing macroeconomic environment. Moreover, because of their smaller domestic markets all small open economies have less room for setting independent monetary policy irrespective of the exchange rate regime.
31. Implications for the monetary policy operational framework. Under the currency board arrangement the operational framework as far as a pure liquidity management system is concerned should function independently from the economic cycle; i.e. it should function in neither pro-cyclical nor contra-cyclical manner. Due to the limited set of policy instruments under the currency board arrangement, it is sometimes difficult to distinguish the economic and monetary policy objectives from the goals of effective liquidity management and financial stability. To illustrate, the changes (or the status quo) in the required reserves system in 1997 at the turn of the economic cycle and during the 1999 economic downturn have served the purpose of reaching an adequate balance in the economic policy. Thus, in practice, it has been difficult to separate the reserve requirements' restrictive and liquidity functions.
32. As a result of convergence of the Estonian monetary policy framework towards that of the Eurosystem, the level of the minimum reserves requirement will be gradually lowered. Whereas the restrictive and liquidity functions of the minimum reserve system have been the matter of reserve requirement level, the capital inflow sterilization issues have been first and foremost related to the composition of the reserve base. For example the introduction of financial guarantees and net credit position of the resident banking sector vis-à-vis the foreign banks in the reserve base have served the aim of dampening excessive capital inflows inflating the macroeconomic environment. Thus, the sterilization issue has to also be analyzed through the reserve requirement base.
33. The impact of the reform on the monetary environment is related to the monetary policy signals (reduction of required reserves in the prevailing economic stance can be associated with monetary policy relaxation) and possible direct monetary expansion. In the foregone analysis it has been assumed that the additional resources freed from the reduction of minimum reserves will be channeled in full by the banks to the domestic credit market and not invested abroad[4]. In the broader economic context, the reform will depend on the concrete economic situation prevailing at that time. In short-term the reform can result in a one-time effect on monetary expansion and credit growth. Assuming a growing money demand under the currency board system, even the long-term effect on the monetary environment should be neutral.
    
34. The restrictive function of the reserve requirement in the short and long-term perspective. It has been mentioned that the reform foresees that in the future part of the minimum reserves could be fulfilled with eligible foreign assets. Reduction of the reserve requirement in terms of required Estonian kroon deposits with the central bank will form the basis for a possible one-time monetary expansion (given that sufficient effective demand for credit is there). However, the short and long-term effects of partial meeting of minimum reserves with foreign assets are different. The short-term effect depends on the banks’ reaction in asset management after the reform; the long-term effect is associated with the sterilizing effect of minimum reserves.
35. A classical multiplier model has been used to assess the possible short-term effect of the minimum reserves’ system reform on credit growth. The results are in a sense partial as money supply and credit markets are just parts of the general macroeconomic framework. At its best the model can be used to assess the possible short-term effect on the monetary environment. The medium-term impact from the reduction of the reserve requirement will depend on the phase of the economic cycle. However, it is not possible today to fix any exact reserve requirement reduction plan with the aim of bringing the requirement down to the Eurosystem level of 2%.
36.  In today’s economic situation credit growth stands at a fairly modest 15% y-o-y [5]. Other economic indicators do not point to any short-term risks of overheating or growing imbalances. In addition, short-term interest rates in the Euro zone are following a rising trend that should help to combat excessive demand in the short-term. Thus, the reduction of required reserve deposits by 3% implies a respective credit growth maximum by 6% with an underlying pessimistic assumption that all resources freed from the minimum reserves will be invested in Estonia. Even though credit growth remains well under the 1996 level (not to mention the 1997 credit boom), under this marginal scenario, the results indicate that considering the present economic growth phase the fast reduction of reserve requirements and liquidity buffers can have destabilizing effects on macroeconomic stability.
37. In general, the medium to long-term effect of the operational framework reform of the monetary policy on the monetary environment will be neutral and will support a further declining of the interest rate margin. As a by-product the base money volatility will be reduced, which is expected to have some stabilizing impact on broad money as well.

[4] This assumption is relevant, as the aim is to identify the maximum effect on credit growth. It is clear that in reality this assumption will not be realized in full.
[5] As of early April, 2000.

The expected impact of the reform on central bank profits

38. The second important area of the consequences of the reform is its impact on profits of the central bank. Relying on the profits allocation strategy of Eesti Pank, approved by the Board of Eesti Pank, it is critical to avoid the substantial decrease of excess currency board coverage before joining the EMU. In other words, in the course of the reform it is important to take into account the restrictions stemming from the nature of the CBA while considering the expenses of upholding the operational framework. Additionally, it is important to stress that the maintenance of excess reserves is vital for maintaining the credibility of the monetary system under the CBA.
39. Relying on previous considerations, the cost of upholding the monetary policy operational framework is more important for a CBA-based monetary system than under a conventional central bank. Or in other words, under the CBA the independence of the central bank, and its financial independence in particular, is more important for ensuring transparency of monetary policy measures and lowering inflationary expectations.
    
40. In the context of operational framework reform this means assessing all the costs associated with the operational framework, including the remuneration of minimum reserves and other services offered by the central bank. Here a pragmatic view on these issues is preferred, i.e. even though monetary policy is a public good, under the CBA it is necessary to pursue such framework changes, which ensure the maintenance of sufficient excess reserves. This approach is well in accordance with the strategy of profit allocation of Eesti Pank, approved by the Board of Eesti Pank in 1999.
41. The main determinant of changes in Eesti Pank profits is the margin between the yield of foreign reserves and minimum reserves remuneration rate, not the build-up or composition of the reserves as such. Or in a more detailed way, in line with decreasing domestic currency reserve deposits in the central bank both the income base of the central bank (i.e. monetary base) and the costs of remuneration of reserve deposits will decrease simultaneously. In conclusion, the reform of the operational framework is in accordance with the strategy of profit allocation of the central bank, approved in 1999; the expenditures that accompany the reform do not undermine the financial credibility of the currency board in the medium term.

IV Conclusion

42. In conclusion, the monetary policy reform strategy foresees:

1. (The reform will be carried out in two stages: the first phase will last for a year starting on July 1, 2000; the second phase will start on July 1, 2001, and last until joining the EMU.
2. At the end of the first phase of the reform 50% of the reserve requirement can be met by holding eligible foreign securities; reduction of the required reserves deposits will be accomplished during the year in two stages, but no later than July 1, 2001. The required level for eligible foreign assets will be increased at the same time and at the same ratio respectively. Monthly averaging for reserve requirement calculations will hold steady. During the first phase of the reform the required deposits at the central bank will be remunerated according to the present system.
3. The second phase will include the harmonization of the operational framework with that of the Eurosystem in the medium term. It will also include convergence into the Eurosystem required reserve system and the introduction of intra-day liquidity instruments (intra-day repository). It will end with the finalization of preparations for the full implementation of the Eurosystem operational framework.
4. The first phase of the reform will start with the unification of the reserve requirement and additional liquidity requirement at the current (liquidity) levels. The auctions of Eesti Pank's Certificates of Deposits will be discontinued as of May 20, 2000.
5. Before full implementation of the minimum reserves’ reform the required reserves’ base and list of eligible assets will be specified.