Eesti Pank - Bank of Estonia

There were no significant changes in the monetary policy environment in 1995. Together with a relatively stable economic environment the stability of the currency contributed towards the continuing balancing of the economy. Even the short-term political instability caused by elections and change of Government did not decrease the kroons credibility.

The monetary policy framework has remained the same since the 1992 monetary reform and its principles have been fixed by legislation. The strict peg of the Estonian kroon to the German mark introduces the stability of international prices into the Estonian economy. Taking into account the small scale and the openness of the Estonian economy, the peg also stabilises the general domestic price level in the long term.

In order to guarantee the credibility of the fixed exchange rate, it is important that the central bank's currency issuing policy be in concordance with the economy's demand for money and discretion is avoided. According to the currency board principles, the central bank is prohibited from increasing the supply of base money (MO) unless it has sufficient foreign exchange reserves to cover this increase.

In the case of the currency board, the intervention of the central bank into the monetary system is limited to foreign exchange transactions initiated by commercial banks. These transactions comprise selling to or purchasing from commercial banks, Estonian kroons in accordance with market demand and using the fixed exchange rate (see Table 25 and Figure 12).

In the case of the currency board, an important part in economic stabilisation is played by the free movement of currency and a relatively rapid formation of a market-based balanced interest rate. This should diminish the long-term discrepancy of interest rates and the resulting danger of short-term speculative capital in- or outflows in the financial markets. The foreign currency regime has constantly been liberalised since the monetary reform. This process was nearly complete by the end of 1994 when Eesti Pank allowed the banks to maintain an unlimited German mark open position.

In general, the base money supply is related to money demand and the regulation mechanism functions through the balance of payments.

According to the theoretical prerequisites of the currency board and the fixed exchange rate policy, Eesti Pank has not set itself medium-term targets other than following the exchange rate and pegging the base money supply (MO) to the currency board mechanism. Thus, the wider money supply, liquidity of domestic money markets, interest rate levels and general volumes of credit are determined by the financial system or the real economy and are established in accordance with the laws of supply and demand. Thus, they are a reflection of the environment rather than a result of the direct monetary policy aims.

The stabilisation process diminished the need for the forward transactions that were commenced by Eesti Pank in 1994 with the aim of enhancing the credibility of the Estonian monetary system. Restrictions on transactions were imposed at the end of 1994 and no new transactions were commited since March 1995.

As to external factors, a decisive role in developing the monetary policy environment was played by the following:

1) large capital inflows that had already started in 1993, continued, although they slowed down and changed in nature to some extent. Over the last two years the inflow of short-term and bank capital has increased and the share of state guaranteed loans has decreased;
2) the results of Estonian monetary policy were influenced by the great changes of the major foreign currency exchange rates, of which the most important was the fall of the USD exchange rate against the German mark over the first half of the year and the only partial revival during the second half. The strengthening of the German mark and thus also the Estonian kroon balanced the price development although it also caused temporary strains in the export sector;
3) the Estonian monetary policy environment was also influenced by the steps taken by the Deutsche Bundesbank designed to lower the DEM short-term interest rate. These steps affected the interest rates on the Estonian money markets.

In the environment of a fixed exchange rate policy, money supply based on the currency board policies and free movement of capital, Estonian kroon interest rates do not have an independent role in monetary policy, but are formed in accordance with the demand and supply on the money markets. The interest rate level is in such a case formed by the interest rates of base currency dominating the Estonian kroon. If money markets perform faultlessly, the difference between the domestic interest rate level and that of the German mark reflects the estimates of economic agents regarding different risks - primarily the possibility of exchange rate changes and credit risk.

As the Deutsche Bundesbank lowered its base interest rates three times in 1995 and the general condition of the money market was stable, the Estonian kroon short-term interest rates followed the direction of German mark interest rates with a relatively small margin and fell over the entire year (see Figure 13).

Long-term assets do not have an active market yet. The interest rate on customers' deposits taken by banks and loans made to them can include an abnormally high loan risk assessment. The relationship between the kroon interest rate and that of the German mark was not very clear in 1995. However, the level of the German mark interest rate was approximated to some extent (see Figure 14) although the yield curve for the kroon was still steep.

The growth rate of money supply is not a direct monetary policy target for Eesti Pank. However, the bank needs to follow this indicator in order to obtain information about the liquidity developments in the economy. When interpreting money supply as an indicator, it is important to consider the possibility that the velocity of currency turnover may vary greatly in transition economies.

The nominal growth of monetary aggregates also increased in 1995, although the growth was slower compared to the two previous years. Due to the structural changes in the money aggregates, wide indicators grew more rapidly (see Figure 15). The velocity of cash circulation accelerated.

Whereas 1994 was characterised by a steep fall in the money demand growth rate compared to the respective months of 1993, in the first quarter of 1995 the decline came to a halt and differences within a year become somewhat smaller. Money demand increased to some extent in the second and third quarter, but by the end of the year it fell close to the level of the beginning of the year (see Figure 16).

In the structure of the widest money aggregate M2 the processes characteristic to previous years (especially to those of 1994) continued (see Figure 17). Compared to the average of 1994, the share of cash in circulation and demand kroon deposits diminished in M2 while that of foreign currency deposits increased and time deposits remained practically the same. The decrease of the cash share first of all characterises the development of the banking sector regarding non-cash payments, but also indicates the banks are becoming better accustomed to placing savings.

In contrast to previous periods when the increase in the money supply corresponded to the increase in net foreign assets in the banking system, the share of domestic credit increased in 1995. The growth rate of loan offers from domestic banks remained rather high all through the year, constantly increasing from its low point at the beginning of the year (see Figure 18). The relatively higher increase in the loan portfolio compared to the growth of the money supply can be related to the increase in the share of banks' long-term loan resources. In addition, stabilised economic conditions added to the growth of credit supply, promoting the credibility and lowering the interest rate level. The latter, in turn, enhanced the growth of demand for credits.

The liquidity reserves of commercial banks held with Eesti Pank changed in accordance with the money supply trends. The average balances of commercial bank accounts with Eesti Pank (excluding of course the liquid foreign reserves and other liquid assets important to banks) fell to the lowest level in the second quarter. Over the next months banks maintained considerably higher liquidity reserves on their accounts. This can partly be explained by seasonal influences (see Figure 19, Page 38).

The efficiency of Estonian monetary policy and the monetary system can be assessed from two aspects. The inflation rate has continued to decrease where the price level has not yet reached the so-called long-term equilibrium and is thus out of the range of stabilisation policy. At the same time however, one has to be realistic about the dangers to the economy that arise from the so far rather high statistical inflation and the incorrect inflation expectations as well as difficulties in adapting to disinflation.

In conclusion, the currency board has fulfilled its 1995 obligations. Favourable grounds for the further stabilisation of monetary policy conditions have been created. Proceeding with the present policies is also an important prerequisite for the establishment of further credibility.

Monetary Policy