MONETARY POLICY

MONETARY POLICY FRAMEWORK AND CURRENT EXPERIENCE

Since the 1992 monetary reform, monetary policy in Estonia has been based on the Estonian kroon's fixed exchange rate to the German mark and the currency board system. The kroon is freely convertible and Eesti Pank has no right to change the exchange rate without Riigikogu (the Parliament) resolution. The law also forbids Eesti Pank to grant credit to the central government and local governments.

The currency board system means that all Estonian kroons issued by Eesti Pank have to be fully backed by foreign exchange reserves. As the currency board has not been separated from the central bank, the above requirement implies that the foreign exchange reserve cover is required not only for base money (cash and credit institutions' deposits with Eesti Pank) but also for all Eesti Pank's liabilities and guarantees provided. This requirement enables the central bank to maintain the fixed exchange rate even in unstable situations, incl to repel potential speculative attacks against the Estonian kroon. Figure 4.1 illustrates foreign exchange reserve cover for Eesti Pank's balance sheet liabilities.

The fixed exchange rate policy, especially the adoption of the currency board approach, imposes clear constraints on the use of other interim targets of monetary policy. Due to the great mobility of capital, the interest rates of the Estonian kroon have no independent role in the monetary policy framework and depend on the supply-demand situation on the money market, in the longer perspective, on the interest rates of the kroon's base currency - German mark. In ensuring a stable liquidity system, the principal role has to be fulfilled, first and foremost, by financial intermediaries themselves whereas Eesti Pank shall facilitate it through improvements of the system structure and introduction of supervisory standards.

The pegging of the kroon to the German mark and the introduction of the currency board system to support it, provided a solid nominal anchor to the further restructuring and development of the economy. Its effects were seen soon after the monetary reform in the stabilizing price level and decreasing interest rates.

In view of the above strategic targets of monetary policy and considering the rapid economic growth and peculiarities of the transition period, the level of inflation in Estonia has so far been acceptable, being at the same time adequate enough to encompass the inevitable transformation of the pricing structure (see Estonian Economy, Inflation). Due to the reliable monetary policy, full convertibility of the kroon and a liberal foreign exchange regulation, Estonia has managed to sustain a relatively low interest rate level among transition economies even after the adjustments made in the last months of 1997. Smooth achievement of the monetary targets presupposes, in addition to the implementation of the currency board system, also congruity between other components of the economic policy (see Estonian Economy, Public Sector).

Evaluating the performance of the Estonian monetary system in the context of price stability and overall stability of the financial system, two specific features emerged in 1997. In addition to conventional factors that influence the rate of inflation during the transition, the disinflation process was slowed down among other factors by the weakening of the kroon's anchor currency - German mark - against US dollar in the first half-year. It had a considerable impact on import and export prices because Estonia's foreign trade is largely based on dollar accounting. The decision to use a fixed exchange rate and German mark as the base currency has long-term strategic implications and therefore such temporary effects are inevitable.

On the other hand - the currency board system proved its resilience and efficacy in a more critical situation in the autumn of 1997 when the overall confidence of the international financial markets in the emerging markets diminished. One of the main goals of the currency board is to ensure that the central bank is willing to fulfill its promise of maintaining the pegged exchange rate and is well prepared for that task because the currency board provides automatically for adequate reserves, should the situation destabilize. Due to the built-in self-regulation mechanism, the system, then, does not depend entirely on the capability of making adequate political decisions.

OPERATIONAL FRAMEWORK OF MONETARY POLICY

Structure of the Central Bank's Monetary Policy Framework

The nature of the currency board imposes constraints on the operational framework of the monetary system and interventions by the central bank. At the same time these constraints act like an automatic protection mechanism for the system, helping, for example, to offset external attacks against the exchange rate.

The main weakness of the currency board system is said to be its rigidity, lack of sufficient flexibility necessary for quick and effective reaction to short-term liquidity problems on the money market. Within traditional currency board systems the choice of 'active' monetary policy instruments (open market operations) and their implementation scope is determined by the size of the foreign exchange reserves exceeding the minimum provisionary requirement of the currency board. Several countries that have adopted the currency board approach have now embarked on a course towards greater flexibility and, in doing so, have weakened the strict criteria of the currency board applied to credit institutions in daily management of liquidity issues.

The strict currency board system enhances the role of credit institutions in achieving financial stability. Under these circumstances liquidity management is essentially effected through foreign reserves of credit institutions. Thus Eesti Pank's monetary policy is almost entirely enacted on the foreign exchange market, offering the banks unlimited conversion options with an unvaried exchange rate. The scope and expediency of the use of other instruments has so far been relatively limited. In order to facilitate short-term interest arbitrage, the spread was eliminated in the Estonian kroon and German mark transactions between Eesti Pank and domestic credit institutions. Together with the progress in international integration, the reduction of transaction costs has helped to increase foreign exchange - in December 1997 the monthly foreign exchange turnover was 14 times higher than in June 1996 (see Figure 4.2).

However, focus on international capital flows due to some technical aspects is not always an adequate solution expected to ensure short-term equilibrium of the liquidity system. International experience has shown that in order to lower the sensitivity of the financial sector to the risks related to the above strategy, it is expedient to strengthen domestic liquidity buffers.

Required reserves kept at the central bank is one of the main options for depositing domestic liquidity buffers. Essential improvements of the operational framework of the monetary policy were undertaken by Eesti Pank in mid 1996. Up to 1996 the use of required reserves was strictly limited, while beginning with July 1996, credit institutions had to comply with the reserve requirement on the monthly averaging principle which provided them with a much more flexible buffer for their day-to-day liquidity management and helped to stabilize the inter-bank money market interest rates.

Eesti Pank pays credit institutions an interest on the account balance above the minimum required reserve level. This interest rate is directly related to the discount rate of the Deutsche Bundesbank. The main aim of the so-called standing facility is to foster the increase of domestic liquidity reserves. Interest payment on the amount exceeding the reserve requirement also allows to offset to some extent revenue earning advantages of financial intermediaries who are not subject to the reserve requirement and to diminish market distortions in the evolution of deposit and loan interest rates. If in these circumstances the lowest possible interest rate is the so-called standing deposit facility rate, then the highest rate on the domestic inter-bank market is theoretically shaped by the penalty interest rate applied by Eesti Pank to punish credit institutions for non-compliance with the reserve requirement.

Domestic inter-bank money market is alongside with the required reserves and excess reserves with the central bank another important liquidity buffer. However, its importance in Estonia's liquidity system has steadily declined. In view of the great volatility of the inter-bank overnight market and its dependence on the overall liquidity position of the market, it is too risky for the banking sector to rely solely on this buffer when planning its financial flows. However, the inter-bank market has proved appropriate in situations where cash flow cycles of different credit institutions vary.

Certificates of deposit (CD) issued by Eesti Pank since 1993, initially meant to increase the efficiency of the inter-bank money market, are now mostly used to smooth out seasonal fluctuation in cash issues in order to abate money market distortions. As credit institutions prefer other liquidity control instruments (mostly foreign reserves) due to market conditions, their interest in Eesti Pank's CDs has so far been rather modest.

Within the strict currency board regime which restricts crediting by the central bank, participation of foreign banks and strategic alliances in the local banking system would provide protection against liquidity risks in the financial sector. Main advantages of financial institutions with a foreign participation or international co-operation as compared to those based on domestic capital is their ability to isolate themselves from the local market risks.

Measures to Strengthen the Liquidity System

In 1997, a number of risks accompanying rapid economic growth surfaced in the macroeconomic environment, led to the need to adjust the monetary policy framework.

An important remedy applied by Eesti Pank in the banking sector, aimed at diminishing the structural deviations caused by the regulation of foreign capital inflow, was to expand as of 1 July the accounting basis of the credit institutions' reserve requirement by the amount borrowed by banks from foreign credit institutions surpassing the amount deposited with these institutions. As the result of this step the size of foreign reserves of credit institutions grew to some extent (see Figure 4.3), but at the same time the ratio of the loan portfolio within the asset structure continued to grow as well, backed by the extensive amounts of incorporated foreign capital (see Financial Sector, Non-resident Liabilities).

This was followed by new steps taken by Eesti Pank in autumn in order to restrict monetary conditions. As a temporary measure with the purpose of enhancing liquidity buffers and supporting reduction of credit growth, Eesti Pank enforced from 1 November a provisional additional liquidity requirement with Eesti Pank, which by the end of 1997 amounted to 3% of the reserve requirement base[1] .

In order to stabilize the banks' intra-month kroon liquidity and to minimize potential settlement risks, Eesti Pank raised from 1 November the daily minimum reserve requirement from 2 to 4% of the reserve requirement base. Simultaneously a penalty interest rate for non-compliance with the reserve requirement increased to 20% (see Table 4.1).

To alleviate to some extent the discriminating impact of the above measures on credit institutions, the central bank changed concurrently standing deposit facility conditions. Interest paid on the deposit account balance exceeding the level of the average monthly minimum reserve requirement and the additional liquidity requirement together was raised to the level of the Deutsche Bundesbank's discount rate (2.5% at the end of 1997).

Further Measures to Improve the Operational Framework of the Monetary Policy

The development of the economy and the financial system, as well as new trends on the international arena in connection with the formation of the European Monetary Union (EMU) will impose new demands on the operational framework of the Estonian monetary policy. Adaptation would help to maintain and improve the functioning of the monetary system. Eesti Pank sees as one of its most important task for the coming years a thorough analysis of the performance and efficiency of the operational framework of the monetary policy and implementation of necessary changes.

A precondition for the improvement of the main directions within the monetary policy framework is the sustainability of the currency board-based monetary policy and relations with the EMU. As a main medium for the improvement of the system Eesti Pank considers (inter alia also in connection with the introduction of a new real time gross settlement system, see Payment and Settlement System) further development of standing facilities as well as technical modernization of reserve requirement and additional liquidity requirement calculation and conformity control.

MONETARY POLICY INDICATORS

Monetary Aggregates

The growth rate of monetary aggregates, with the exception of the cash demand in the economy, was relatively high throughout 1997 (see Figures 4.4 and 4.5). This was supported, on one hand, by considerably high growth indicators of the economy and solid budgetary status of the public sector, and on the other hand, by an on-going financial deepening and foreign capital inflow.

In the structure of broader monetary aggregates, one could notice that processes which had emerged in recent years persevered, implying that financial intermediation in the economy continued to deepen. Although the base money coefficient exhibited a declining trend in the second half-year, this primarily reflected the enforcement of monetary policy decisions targeting the balance of accounts maintained by credit institutions at Eesti Pank (broadening of the reserve requirement base, accounting baseline, implementation of the additional liquidity requirement) and not so much changes in the liquidity preferences or financial behaviour of the economic agents.

The instability that prevailed on financial markets in October-November effected new tendencies in the cash demand. On one hand, it was reflected in a clearly decelerating growth rate of monetary aggregates, although a higher interest rate fostered, first and foremost, the increase of the share of term deposits. On the other hand, the share of residents' foreign currency deposits in the broad money supply rose. Throughout the greater part of the year it had sustained a 10-12% level, but in October it climbed to 14% (see Figure 4.6). Favouring of foreign currency deposits by economic agents was a reasonable reaction to the uncertainties on the money and stock markets in the second half of October and growing speculations about the credibility of the Estonian kroon. Under the currency board systems 'dollarization' as such poses no immediate threat to the stability of the currency.

Loans

1997 was characterized by the further acceleration of investments made by credit institutions into domestic loan facilities and equivalent debt instruments and sustained at a higher level than residents' deposits growth rate (see Figure 4.7). Intensive borrowing was prompted by both the falling interest rates and optimistic future projections based on the rapid growth of economy. At the same time changes in the banks' asset management strategies and lending procedures that facilitated the intensification of the borrowing activities continued. Due to favourable conditions on international money and capital markets until the second half-year, credit institutions and a few other institutions enjoyed wider opportunities for a more intense utilization of foreign capital in order to meet credit demand.

The growth in the credit volume reached its peak at the end of the third quarter when the yearly growth rate was 95% (see Figure 4.8). This extremely rapid expansion of the credit volume began to subside to some extent only during the last months of the year. Settling of internal tension triggered by the unbalanced development of the credit market as well as gradual deterioration of the external environment caused lending rates to rise which, in turn, had an adverse impact on credit demand and forced credit institutions to explicitly restrict the expansion of their loan portfolios.

Money and Foreign Exchange Market

The capacity and depth of the Estonian money market is relatively limited. At the same time the overall integration of our banking system with international money and capital markets has been growing. This fact in conjunction with the changes in Estonia's monetary policy framework undertaken in the last two years has contributed to the gradual reduction of the importance of the domestic inter-bank money market in the banks' liquidity management.

While expansive development of credit institutions was based mostly on external funding (see Financial Sector, Figure 3.6), the development of the money market in 1997 was ever so more unstable. In view of the small total asset volume of Estonian credit institutions on the international scale, each of the subsequent foreign sources used meant a substantial liquidity increase for them. Competition and profitability expectations created a desire to reckon with the expected funds already before their arrival which augmented the short-run mismatch between terms of assets and liabilities, testifying to the inevitable structural risks arising from such a strategy.

Due to measures applied by Eesti Pank for the strengthening of credit institutions' liquidity buffers, the role of funds kept at Eesti Pank has increased in the banks' liquidity control. They were permitted to comply with the reserve requirement on the monthly averaging principle which allows them to do it in accordance with the cyclic nature of their cash flows. Credit institutions' reserves with Eesti Pank remained high throughout the year. Despite the introduction of more stringent liquidity restrictions in autumn, which curbed the growth of credit institutions, balances of all major banks at Eesti Pank increased due to the steps taken by Eesti Pank (see Figure 4.9). This was not disrupted even when funds were withdrawn from the Estonian monetary system and transferred to the Stabilization Reserve Fund in the framework of the government budgetary policy.

On the foreign exchange market the year 1997 was noticeable for the growing interest in taking speculative positions both on forward and spot markets. The greater volume of the market during the year as compared to previous periods was generally related to the market's own development and the usual interest of economic agents to provide for their foreign exchange risks. Nevertheless, in September and October forward transactions showed a sharp increase which cannot be explained by the above arguments.

Although also during the spring months trading on the forward market was more active, speculations with foreign exchange culminated dramatically towards the end of October. This reflected above all growing uncertainty among foreign investors with regard to the sustainability of the fixed exchange rate policy of the Estonian kroon, caused both by deepening uncertainty towards the currencies of emerging markets, in general, as well as doubts about the economic situation in Estonia, in particular. The volume of forward transactions stabilized in early November and thereafter displayed a steady falling tendency.

The German mark-Estonian kroon forward transactions made by the credit institutions increased in the last 10 days of October by more than EEK 4 billion and for the first time the banks' open net positions to the German mark became negative. This sharp increase in positions was depleted relatively quickly because, although DEM-EEK position does not need additional capital due to the current currency regulation system, potential speculations by the market players were curbed by the internal risk exposure thresholds of the investors and also by the local banking sector. It was also important that because of the currency board system, local banks could not automatically apply to the central bank and obtain finances for the speculation-driven pressure. The rising interest rate level on the markets and increased cost of forward transactions together with the stabilization of the overall situation, restrained the market players from taking speculative positions.

Interest Rates

The interest rate level of the Estonian kroon remained relatively stable at the short-term inter-bank money market until the autumn of 1997, with only a minimum variance from the German mark money market interests. The latter, in view of the pegging of the exchange rate, act as a natural determinant of the interest rate level in Estonia.

With the intensification of tension in the financial system, the situation on the money market started to change dramatically towards the end of the third quarter (see Figure 4.10). Although the unbalanced growth of credit institutions had caused some instability in interest rates already in the spring, short-term interest rates started to climb up gradually in September. In October, perceiving fundamental changes and further deterioration of the external environment - both factors failing to support current development strategies - also long-term interest rates rose quickly.

Similar trends that had first shaped interest rates on the money market were with some time shift observed also on the credit and deposit markets. In general, these interests could be characterized by a steady fall in 1997, but since October an increase in the interest on loans and deposits was noticed (see Figure 4.11). By the end of the year interest rates had, in general, reached the early 1995 level. The interest rates on short-term (up to 3 months) kroon loans increased the most, those of long-term loans rose less. Interest rates on kroon deposits increased for all customer categories and maturity terms.

Although the situation in some parts of the financial system became more stable in the last months of the year, the interest rate level remained high throughout the year's end, indicating no tendency to fall. First and foremost, it showed the inertial nature of the adjustment process in our economy. On the other hand, this signalled the on-going uncertainty on the international capital markets and their attitude towards emerging markets' debt instruments.

[1] After the implementation of Eesti Pank's monetary policy instruments the monthly minimum reserve requirement increased by EEK 215 million. In December, it averaged EEK 2, 011 million, meaning that together with the additional liquidity requirement banks were obliged to keep at Eesti Pank, based on the monthly averaging principle, EEK 2, 812 million (see Figure 4.9).