MONETARY POLICY SURVEY

As mentioned above, the ultimate aim of Eesti Pank in carrying out its monetary policy is the stability of the national currency and continuous economic growth resulting from the effective operation of markets. The basic principles of the Estonian monetary system, adopted with this aim in mind, have remained the same since the 1992 monetary reform. It is sufficient to mention two key-words: the fixed exchange rate against the German mark, the full convertibility of the currency. The Estonian economic environment as well as the monetary system is characterised by minimal state interference and openness of the economy.

Choosing the fixed exchange rate as a means for achieving price stability is motivated - besides some economic policy principles - by the great importance of the external sector in the Estonian economy, the inevitable corrections made in the structure of prices in a market re-integrating into the world economy (i.e., the prices and wages would have to change often anyhow) and the endogenous character of the Estonian price formation. The increasingly effective functioning of market mechanisms is probably caused by the mobility of production factors resulting from the smallness of Estonia and its relatively varied economy.

The main means for safeguarding the fixed exchange rate in Estonia is the requirement enforced by legislation that the central bank money (cash and bank deposits in Eesti Pank) be fully covered by the gold and foreign exchange reserves of Eesti Pank. The parallels with a currency board that are frequently drawn when speaking about the post-reform monetary system of Estonia stem from this requirement.

Provisions that give the power to change the exchange rate and the whole monetary system only to the Parliament and the central bank being prohibited from crediting the central or local governments, are among other legislative measures taken to reinforce the monetary system.

Estonian monetary system sets rigid limits to the state's activities in the sphere of monetary policy and practically excludes any arbitrary steps. Eesti Pank sees its role in constant improvement of the monetary system, monitoring and preventing any possible dangers.

The year 1994 is a memorable one in the history of Estonian monetary policy for a number of notable decisions taken in order to increase the efficiency and trustworthiness of the monetary system.

In February all restrictions so far imposed on commercial banks' German mark open position were removed. Naturally, such a step is possible only in case the banking supervision shares the firm conviction that the fixed exchange rate shall be preserved. The aim of this decision was to further improve the capability of the financial system to absorb the excess liquidity existing in the economy. After the above restriction was removed, practically all the main preconditions had been created for the economy to cope with the liquidity management on its own and the state to give up such aspirations. The latter have proved to be especially expensive and ineffective in transition economies.

In March the Riigikogu revoked the law on foreign currency, removing the last restrictions on foreign exchange transactions and allowing resident individuals to open foreign currency accounts. In reality, the foreign exchange restrictions had not played an important role for some time before that: they had been abolished step-by-step and not been enforced very strictly. In summer 1994, Estonia together with the other Baltic countries accepted the obligation to refrain from imposing foreign exchange restrictions in accordance with Article VIII of the IMF Articles of Agreement.

In order to strengthen the trust in the Estonian kroon and diminish any devaluation possibilities, Eesti Pank commenced the sale of EEK/DEM forward contracts to commercial banks with the maturity of up to 7 years.

The participation of Eesti Pank in public discussions on monetary and economic policy has been of utmost importance. It has made it possible to reach a consensus regarding the issues of monetary system and of its further development. As a result of several discussions a firm standpoint supporting the independence of the central bank was formed. After an unexpectedly high level of inflation in March, Eesti Pank had to explain the reasons and mechanisms of inflation as well as to withstand the political pressure "to do something traditional in order to diminish the demand". The possibility cannot be crossed out that the parliamentary elections have influenced the discussions, especially towards the end of 1994. It can be said that a stable Estonian kroon has the general support of the nation at the present moment.

In accordance with the currency board principle, the liquidity management of the banking system is the responsibility of the banks themselves, i.e., of the market. When analysing the trends of 1994 we can see that this principle has been operating rather effectively. As an example, mention could be made of the substantial decrease imposed on the Hoiupank (Savings Bank) reserve requirement on 31 March, implemented with the aim of increasing the effectiveness of the banking system, as well as the decision to decrease the banks' general required reserves held with the Eesti Pank on 4 July. To some extent the forwarding to the banks of the Systemic Transformation Facility obtained from the IMF in October, and the autumn loan of Eesti Pank to the Sotsiaalpank, should be also considered in this context. In each case the amount of currency in circulation increased by a few hundred million kroons at a time. Theoretically, an abrupt increase of money supply could have caused liquidity shocks, but the monetary system managed to absorb the excess liquidity rather quickly - and also without the interference of the Eesti Pank. This is also evident from Figure 1 (see page 26), where one can see that there have been no simultaneous abrupt changes in opposite directions of the two characteristics (liquid monies and liquid monies+reserve requirement with Eesti Pank). Nor was there any abrupt increase of liquid monies only. All this attests to the monetary system functioning in accordance with the theoretical prerequisites set up earlier.

The interbank rates are an even more important indicator. In spite of the above mentioned events, the interbank market rates remained stable. To be more precise, the fact that they have fallen (after the market started to function) to more or less the same level as the German mark rates (see Figure 2, page 26) has to be considered significant. First of all, this reflects the enormous trust in the Estonian kroon in a short perspective and secondly, the sufficient effectiveness of the interbank overnight market in levelling the interest rate margins and liquidity differences between the banks.

As the interests of loans and deposits have been slowly but consistently decreasing throughout the year, we can assume that the trust in the Estonian kroon has strengthened in the long perspective as well (see Figure 3, page 26). While speaking of the Estonian monetary system and interest rates, mention should also be made of the fact that the Estonian kroon rates have so far been one of the most stable in the whole East and Central Europe.

Figure 1. Kroon liquidity of commercial banks (million kroons)

Figure 2. Money market rates in Estonia and Germany

Figure 3. Loan and deposit rates at Estonian commercial banks

Trust in the Estonian kroon is also reflected by the fact that starting from the beginning of the liberalisation of the procedures for opening foreign currency accounts in August 1993 up to the time all regulation in this sphere was terminated, and after that, the amounts held on of foreign currency accounts have been growing at a stable rate (see Figure 4, page 27). One reason for the stable increase of foreign currency accounts has been the growth in the foreign trade volumes and the resulting, need of exporters-importers to keep more and more foreign currencies with the aim of avoiding conversion costs. At the same time, there are no large and abrupt changes in the growth trend of the foreign currency accounts.

Evidently, the Estonian monetary system has had a favourable influence on the stabilisation of the inflation rate (especially in the second half of 1994) and the growth of foreign investments in Estonia.