MONETARY POLICY

ESTONIA'S MONETARY POLICY FRAMEWORK AND CURRENT EXPERIENCE

Since the 1992 monetary reform Estonia’s monetary system has been based on the fixed exchange rate of the kroon against the German mark and on the currency board arrangement. The kroon is freely convertible and Eesti Pank has no right to devalue the kroon without the resolution of Riigikogu (the Parliament). The balance sheet liabilities of Eesti Pank are fully backed by net foreign assets (see Figure 4.1). The law prohibits Eesti Pank to credit directly or indirectly the central and local governments.

The fixed exchange rate policy, especially the currency board arrangement sets explicit constraints on the use of other interim targets of monetary policy. Considering the high mobility of capital, the interest rates of the Estonian kroon do not play an independent monetary policy role and they develop in compliance with money market demand and supply, in the longer perspective - in compliance with the kroon’s base currency interest rates. The key role in ensuring the stability of the liquidity system remains with financial intermediaries. However, Eesti Pank helps to improve the system structure and sets supervisory standards.

Fixing the exchange rate of the kroon against the German mark and introduction of the supportive currency board system provided a nominal anchor for the restructuring and development of the Estonian economy. The implications were soon seen in the stabilising price level and decreasing interest rates. Nevertheless, in the price convergence process one should consider several short-term factors, originating both from transition specificities and external impacts, which temporarily drive the price convergence from its long-term trend.

The fixed exchange rate of the kroon has successfully performed as a nominal anchor for open sector prices. By December 1998, the inflation in the open sector had decreased to 2.5% whereas the overall consumer price increase was 4.2% compared to 1997 (see Inflation, pp 30-32). Decreasing external demand and the appreciation of the Estonian kroon against the Finnish markka, Russian rouble and to some extent against the US dollar as well had a downward impact on the prices of exports and imports. Although most of the prices in Estonia were liberalised already in 1992, administered prices constitute about one fifth in the consumer basket; hence, the price convergence depends on administrative measures as well. Wages and prices in the sheltered sector have also been subject to influences from efficiency-boosted wage increase in the open sector. Nevertheless, the price level and structure convergence with the rest of the world will remain a driving force for Estonia’s price increase in future as well.

The fixed exchange rate of the Estonian kroon against the German mark sets the basis for interest rate convergence as well. Although due to a higher inflation level and a larger risk margin, the interest rate level in Estonia has generally been higher than in Germany, interest rates in Estonia, especially the short-term rates were continuously converging with German interest rates until autumn 1997. The Asian crisis-initiated instability on global markets interfered with this trend. Crises in Asia and Russia restrained emerging markets-oriented capital flows and tested several countries against foreign investor confidence and speculative attacks. Most of the emerging markets were hit by increases in the interest level and risk assessment. Due to the currency board-based monetary system and small volume of the money market, short-term interest rates in Estonia respond rapidly to changing foreign capital flows and speculative attacks against the kroon as the central bank does not intervene directly in liquidity and interest rate level in the money market. Both in end-1997 and in August 1998 the currency board arrangement proved its resistance capability in the unstable economic environment.

Regardless the efficiency of interest rates as automatic stabilisers in balancing the financial system liquidity, the currency board-based monetary system requires a relatively high real sector flexibility to achieve general efficient adjustment of the economy. The rapid economic growth and extreme growth of monetary and credit aggregates in 1997 was followed by some stabilisation in early 1998 and a tightening economic environment beginning from the second half of the year. Both the external demand and the credit supply based on generous external financing, habitual for previous periods, decreased. The rise in nominal interest rates due to limited loan resources accompanied by more rapid than expected decline in inflation lead to higher real interest rates. Beside the challenges it brings along for adjustment of the real sector, it should also help to increase domestic saving contributing to the improvement of investments-savings ratio and external balance.

The maintenance of the current monetary framework, that of the currency board arrangement and the kroon-peg to the German mark, is well in harmony with the objective of internal price stability. The adherence to the above principles facilitates also the institutional convergence of Estonia’s economic environment to the EMU single currency system.

EUROPEAN SINGLE CURRENCY AND ESTONIAN MONETARY SYSTEM

In connection with the beginning of the third stage of the EMU on 1 January 1999, currencies of 11 countries, including the Estonian kroon’s base currency - the German mark, were irrevocably tied with each other and a single currency was introduced - the euro. On 31 December 1998, Eesti Pank set the rate of the Estonian kroon (EEK) against the euro: 1 EUR = 15,6466 EEK. This rate is equivalent to the official exchange rate of the Estonian kroon against the German mark 1 DEM = 8 EEK.

The introduction of the euro does not bring along any direct changes for Estonia in the exchange rate and monetary policy. The price-stability-oriented monetary policy implemented by the European Central Bank (ECB) does not differ essentially from the monetary policy pursued by the Deutsche Bundesbank. The introduction of the euro involved only a few formal and technical changes in the operational framework of Estonia’s monetary system (see Operational Framework of Monetary Policy, pp 49-51). However, as the exchange rate of the Estonian kroon is now fixed with a currency involving a much broader economic area than the German mark did, it would undoubtedly have its implications on Estonia’s business and financial sector.

The introduction of the EMU will dramatically change the performance environment of European as well as Estonian banks. The introduction of the single currency renders the EMU participants’ financial systems more open and efficient. According to Eesti Pank it should significantly enhance Estonian financial and real sector’s integration into the European monetary and capital markets. In the long run it should facilitate access to international capital markets containing borrowing costs for issuers of euro-denominated instruments and increasing the interest of euro area investors in CEE Countries offering higher profitability.

As trade with EU countries constitutes about two thirds of Estonia’s gross trade, the higher price and exchange rate stability in this area would reduce Estonian companies’ foreign exchange risks and exchange costs and contribute to less fluctuations in export and import prices. Definitely the single currency will make prices in various euro-zone and euro-related areas more transparent and will enhance competition.

OPERATIONAL FRAMEWORK OF MONETARY POLICY

Developments over the last two years in Estonia’s monetary system confirm the assumption that in small economies like Estonia flexibility and adjustability as well as high capitalisation of the financial sector, availability of reserves and balanced positions create a necessary precondition for an effective response to potential external shocks. Therefore the changes in the operational framework of monetary policy as well as in banks' prudential ratios were aimed at enhancing financial stability and increasing the liquidity buffers of the system. The above steps constituted part of the Memorandum of Economic Policies prepared jointly by Eesti Pank, the Government of the Republic and the International Monetary Fund for the second half of 1997 and for 1998. In mid-term the Memorandum focused on sustainable economic growth and reduction of risks arising from over-accelerated economic growth and deepening current account deficit. In short-term the priority remained with restoring the foreign investor confidence in Estonia’s economic viability in the context where the Asian crisis has spread also to other emerging markets and ensuring the smooth performance of the fixed exchange rate and currency board arrangement.

In the first half of 1998, Estonia’s economy faced problems similar to the previous half-year - unchanged current account deficit, continuous investment boom, slightly unstable price convergence process and insecure external environment. Changes in the monetary policy framework introduced in 1998 were a logical sequence to restrictive monetary policy decisions made in autumn 1997. As a supplementary measure to increase banks’ liquidity buffers and curb credit growth, Eesti Pank expanded the reserve requirement base by the amount equivalent to banks’ guarantees to financial institutions and non-resident credit institutions. Due to the decreasing cash demand and the need to increase settlement system liquidity buffers, on 19 June Eesti Pank reduced the allowed cash component in meeting the reserve requirement from 30 to 20%.

The additional liquidity requirement introduced during the liquidity crisis in end-1997 filled a dual purpose: to increase domestic liquidity buffers and restrain domestic credit growth by removing part of the bank’s resources as reserve requirement. The objective was to prevent banks from expanding their loan portfolios at the expense of liquidity buffers in the deteriorating financial environment. As the expansive macroeconomic developments were significantly retarded in the second half of 1998 - the real growth of economy decreased, inflation rate fell, current account deficit shrank faster than anticipated, credit growth slowed down - the direct restrictive function of the additional liquidity requirement has somewhat lost its importance. However, its role as a liquidity buffer and in securing financial stability in the unstable external environment is still significant.

The start of the third stage of EMU and the parallel use of euro area national currencies and the euro beginning from 1 January 1999 brought along a few amendments to the normative documents of Eesti Pank. New procedures for the purchase and sale of foreign currency between Eesti Pank and credit institutions operating in Estonia entered into force in 1999. A significant change is that purchase-sale transactions with the euro and the Estonian kroon and the national currencies of the euro area countries and the Estonian kroon are now concluded between Eesti Pank and commercial banks without a price spread. The list of currencies with which Eesti Pank concludes unlimited purchase-sale transactions involves all national currencies of the euro area countries. As of 1 January, Eesti Pank pays ECB deposit interest rate replacing the previous discount rate of the Deutsche Bundesbank on the monthly average balance on accounts of credit institutions with the central bank exceeding the monthly minimum requirement. The accounting procedure for the open forex position was amended as well. Taking into account the equality between the euro and national currencies of the euro area countries, the volume restriction on DEM/EEK joint positions was replaced on 1 January with the volume restriction on the joint position of the Estonian kroon, the euro and national currencies of the euro area countries. Their open joint position cannot exceed 15% of the net own funds of the credit institution (see Table 4.1).

MONETARY DEVELOPMENTS

External Capital Flows

The small size of Estonia’s economy and the currency board-based monetary system make the domestic monetary environment largely dependent on foreign capital movements. The wave of financial crises that set off in 1997 in Asia, continued in August 1998 with the crisis in Russia and then spread to Latin America, has inhibited the emerging markets-oriented capital flows and raised the cost of foreign capital for these countries (see World Economy and Financial Markets in 1998, pp 11-20). The cautious anticipation of the after-effects of the Asian crisis characterised the first half of the year whereas the distrust towards all emerging markets intensified drastically after the crisis in Russia. Since October attitudes have differentiated - the Russian crisis has had more implications on Latin American countries and less on European transition Economies[1] .

Despite unfavourable trends in the external environment, Estonia witnessed no capital outflow in 1998. However, capital inflow was substantially curbed. In 1997, net capital inflow amounted to 11 billion kroons, while initial estimates for 1998 indicated about 7 billion kroons. The years 1996-1997 were dominated by the inflow of capital accompanied by rapid economic growth and increasing money supply, declining interest rate level and concurrent price growth of financial assets. In 1998, the growth of money supply and central bank reserves stopped, the interest rate level rose and prices on the financial assets market fell. On the whole, the 1998 development trends can be described as an adaptation of money demand to the cutback in external funding. For the structure of capital flows it meant a significant shift from debt instruments towards direct investments, except refinancing of the banks’ short-term liabilities.

During the first half of the year, the role of the banking sector in attracting foreign capital was extremely modest. Beginning from the third quarter the inflow of foreign capital in the form of foreign direct investment into the banking sector as well as the share issues and foreign loans increased. From the perspective of financing the economy as such, the banks’ objective in incorporating external funds was other than in 1997. Whereas in 1997 external funds were primarily used to finance domestic credit growth, in 1998 foreign capital was mostly used either to refinance prior liabilities or to increase reserves. Thus, the capital inflow was not reflected in credit or monetary aggregates. Foreign borrowing by the banking sector slowed down abruptly already at the beginning of 1998, but involvement of external funds through the banks’ subsidiaries (mostly leasing companies) against the parent bank guarantees continued during the first half-year as well. It was also reflected in the expanding leasing volumes in the first half of 1998, which witnessed considerable slowdown in the second half-year. Independent foreign borrowing was difficult for real sector enterprises throughout 1998 and in many cases the focus was on selling full or partial ownership to foreign investors. The largest borrowers were infrastructure companies.

Monetary Aggregates

Decreasing capital inflow, deceleration of the growth rate of the real economy and financial disintermediation curbed significantly the growth rate of monetary aggregates in 1998. The over-expansive developments of 1997 had been replaced by a more moderate growth already in the fourth quarter and the adjustment continued in early 1998. As of summer, the growth of money supply slowed down abruptly. Apart from external environment and real sector developments the deposits of the bankrupt Eesti Maapank (Land Bank of Estonia) fell out of money supply in June and those of ERA Pank under moratorium and of bankrupt EVEA Pank in October. The sharp downfall in the growth of money starting in the second quarter of 1998 stabilised by the fourth quarter.

Due to shrinking demand deposits, the narrow money supply decreased by 3.2% over the year. The broader money supply increased by 6.9% a year[2] . Because of the budget deficit, transfers to the Stabilisation Reserve Fund and losses caused by the bankruptcy of some banks, the broader monetary aggregate that contains government deposits grew by only 1.4% (see Figure 4.2).

Significant changes took place in the structure of broader money supply in 1998 (see Figure 4.3). The share of demand deposits in broader money supply decreased from 44 to 39% a year. An increase in the deposit interest rate level had a positive impact on time deposits, their share growing from 16% in end-1997 to 23% by end-1998. As end-of-year the share of foreign currency deposits did not change and was 16% in December. In October 1997, unstable money and stock markets as well as speculations against the kroon’s credibility had brought along an escalated growth of foreign currency deposits. In the second half of 1998, an increase in their share was partly the result of the structural shifts, magnified against the background of modest growth of deposit volumes in general. However, in the category of private individuals, a stable increase of the share of foreign currency deposits was notable throughout the year: from 12% of the previous year to 19% by end-1998 of all deposits held by private individuals. In the category of enterprises, the share of foreign currency deposits has always been bigger and less stable, depending greatly on their foreign business activities.

The distrust in the banking sector following the closure of several problematic banks, brought along a short-term cash demand both for kroons and foreign currencies among private individuals, reflecting the sensitivity of time deposits to banking problems. Despite that, if compared to end 1997, the cash demand decreased in 1998. There was also some migration of customers’ savings between the banks, triggered by a change in the evaluation of the banks’ credibility.

Liquidity and Money Market

Liquidity

During the last one and a half year, the importance of liquidity buffers held with Eesti Pank has increased considerably in the structure of the banks' liquid assets (see Figure 4.4), mainly due to the extension of the reserve requirement basis and the additional liquidity requirement enforced in November 1997. Banks’ more cautious attitude towards the continuous instability in international financial markets also promoted increasing reserve requirement and liquidity buffers in the first half of 1998.

In the second half of 1998, liquidity position of the banking sector was affected on the resources side by unusually modest foreign capital inflow and decelerating growth of monetary aggregates that had begun already in spring. From August to November the share of liquid assets in the banks’ balance sheets decreased under the impact of the harsh monetary environment and concomitant effects of the Russian crisis. Nonetheless, the banks’ liquidity buffers were in the second half of 1998 on the average bigger than they had been during the liquidity crisis in October 1997. During the first three quarters of 1998 banks used the standing deposit facility but in the fourth quarter the monthly average balance of banks’ accounts in Eesti Pank decreased, remaining for the first time for a longer period below the additional liquidity requirement (see Figure 4.5).

The liquidity of the banks improved considerably in November. It was associated with the consolidation process in the banking sector, better capitalisation of major banks and engagement of external funds. As of January 1999, the monthly average balance of banks’ accounts in Eesti Pank has started to increase and by end-February it exceeded the additional liquidity requirement by 100 million kroons.

Money Market

Due to adequate liquidity buffers, the role of the inter-bank overnight market in balancing short-term cash flows diminished significantly. High turnover at the beginning of the year was followed by a passive inter-bank market beginning from the second quarter. The consolidation process in the banking sector, transaction limits and a more cautious attitude to the turbulent monetary environment can explain moderate volumes of the overnight market in the second half of 1998 as compared to the two previous half-years. During the second half of 1998, the volume of the inter-bank overnight market amounted only to 11% of the volume of the second half of 1997 and 12% of the first half of 1998. In the second half-year, market agents placed their free liquid assets mostly in demand deposits with foreign banks, foreign bonds and fixed income instruments.

In 1998, similar to previous periods, the banks did not practically trade with longer than three-month funds[3] . The turnover of 3-6months money market instruments was only 1% of the turnover of up to three-months' instruments and showed a downward trend over the year. There was virtually no trade in longer-term instruments. In the first half-year, transactions between resident credit institutions dominated in the market, but in the second half-year lending by resident credit institutions to non-resident credit institutions gained volume (see Figure 4.6).

Forward Market

The foreign currency forward market was relatively calm in early-1998 and focused mainly on ordinary transactions. In mid-June the unstable economic policy situation in Russia promoted a cautious speculative interest. During the second half-year the foreign currency forward market experienced a substantial rise in price quotations. This can be related to the crisis in Russia and scarcity of free resources in the banking sector.

Unlike in October 1997, the rise in quotations was not followed by a notable increase in trading volumes. In the third quarter, the volume of DEM-EEK forward transactions undertaken by the banks amounted to 7.8 billion kroons which was less than the record-braking 9.5 billion kroons in November 1997. On one hand, position taking was restrained by the availability of bank funds and transaction limits; on the other hand, a huge bid-offer spread in foreign currencies and high interest levels made speculations expensive. Because of the consolidation process in the banking sector and involvement of foreign capital, short positions of foreign banks in the Estonian kroon started to decrease on the forward market from November and consequently also price quotations for forward and swap transactions. By the end of December the total open net forex position of the Estonian banks had increased from 1.9 billion kroons of the end-1997 to 3.6 billion kroons. It was mostly due to a decrease in the banks’ forward trading and an increase in the positive open forex position in the banks’ balance sheet (see Figure 4.7).

Credits

In 1998, the growth of credit volumes and equivalent debt instruments[4] directed by the banks into the economy slowed down. In 1997, the rapid growth of credit was mainly based on foreign capital inflow through the financial sector. In 1998, the foreign capital inflow diminished and its nature changed (see External Capital Flows, p 51-52). The rapid growth of credit volumes compared to residents’ deposits stopped in 1998 (see Figure 4.8) and credit supply became more based on domestic resources. Apart from changes in the foreign capital inflow, a modest deposit increase and deterioration of the macroeconomic environment accompanying the financial crisis in Russia also restrained the credit volume growth. Nevertheless, the worsening of the external environment in the second half-year was followed not only by an interest rate increase in the credit market but banks started also to restrict more the credit availability to individuals and private enterprises, becoming more conservative in evaluating customer eligibility.

According to the consolidated balance sheet of the banks the annual growth rate of loans to residents fell to 15.4%, the annual growth including residents’ debt instruments fell to 14.3% by the end of the year. Lending became relatively more restrictive for private individuals - borrowing became more expensive and difficult for them. The volume of private individuals’ credit increased by 65.6 million kroons a year, ie by only 1.6%. Banks’ lending to residential private enterprises increased by 1.9 billion kroons, ie by 15.7% in a year and banks’ lending to local financial institutions more than one billion kroons, ie by 33.3%. The credit growth rate of private individuals and private enterprises revealed a downward trend throughout 1998, stabilising slightly in the fourth quarter. The lending to financial institutions showed relatively slow growth over the year and increased only in the fourth quarter (see Figure 4.9).

Compared to 1997, lending in 1998 decreased in all customers' categories. Reduced credit supply by credit institutions and harsher borrowing terms for domestic private enterprises requires their flexibility and adaptability to survive in the changing environment.

Interest Rates

Money Market Interest Rates

Prices of the long-term money market instruments stabilised in the second quarter after a fall at the beginning of the year. The situation changed due to tightening external environment - in early July most of the banks raised quotations for longer than one month instruments, partially reflecting the general anticipation in an interest rate level increase. Nevertheless, it was still a decision induced upon by the external pressure, explicit, on one hand, in a price increase in forward transactions prior to the interest rate increase (see Liquidity and Money Market, pp 53-56) and on the other hand, in the lack of interest among local market participants.

Since two price quoting agents (Eesti Hoiupank/Estonian Savings Bank and Tallinna Pank) participating in the formation of inter-bank loan interest rates (TALIBOR) and deposit interest rates (TALIBID) merged and disappeared from the market, quotation principles for inter-bank money market interest rates were amended from 1 September 1998. Eesti Pank started to calculate TALIBOR and TALIBID on the basis of quotations from three banks (Hansapank, Eesti Ühispank/Union Bank of Estonia and Eesti Forekspank/Estonian Forexbank) for one, three and six month period. One-week quotations of TALIBOR and TALIBID as well as constraints on the spread between loan and deposit interest rates were abolished. The sum within which quoting banks were obliged to accept deposits and extend credit with their quotation, was increased from 1 million kroons to 10 million kroons. TALIBOR and TALIBID were still fixed once a week, every Wednesday at 11 am[5] .

In the second quarter, among external factors, the Russian crisis had the strongest impact on the Estonian money market through the initial pressure from the forward market. The devaluation of the rouble in August escalated a speculative pressure on the Estonian kroon on the swap market which, in turn, lead to an abrupt rise of the Estonian inter-bank loan (TALIBOR) and deposit (TALIBID) interest rates (see Figure 4.10). Despite the following fast decline in the turnover of the swap market that started in mid-September, money market interest rates continued to climb due to the greater risk margins, demand for operating capital in the real sector and scarcity of liquid funds. In line with the developments in the money market, the banks raised time deposit interest rates for private individuals in late October. They also raised short-term kroon loans interest rates (see Figure 4.11).

The increase in money market interest rates stopped only in November. It was related to the stabilisation of swap interest rates and decrease of roll-overs in the corporate bonds sector: due to high interest rate levels enterprises started to buy back commercial papers in November. Since in November-December major banks did not channel any notable funds collected from share issues or received from foreign loans to the money market, in December money market interest rates did not exhibit any essential decrease. The fall of the money market interest rates that started in January 1999 was mainly related to the decline in the turnover and interest rates in the forward market.

Long-term Interest Rates

Due to the uncertain monetary environment, limited liquidity conditions and negative external factors, interest rate level on resident loans and deposits were in 1998 slightly higher than in 1997. Only in the first months of the year, a slight downward trend characterised short-term interest rates, which had abruptly grown in end-1997.

Loan interest rates were relatively volatile; however some upward trend was noticeable throughout the year, especially in long-term loans. Relatively strong fluctuations in the loan interest rates can be explained by considerable shifts in customer groups and also by a more conservative credit assessment of customers, which partly substituted the curbing of lending volume growth by means of higher interest rates. Fluctuations of interest rates on kroon loans were mitigated by somewhat lower and more stable interest rate level on foreign currency loans. The weighted average interest rate on foreign currency and kroon loans issued to residential private enterprises and private individuals increased to 14.7% by the end of the year (see Figure 4.12).

Corporate and private deposit interest rates were less susceptible than loan interest rates and increased slightly. The rise was caused by the tightened liquidity conditions and by the need to encourage domestic saving in order to allow the growth rate of deposits to catch up with the growth rate of credit. The interest rate increase affected mainly kroon deposits; foreign currency deposit interest rates showed a downward trend till November. In summer, resident deposit interest rates decreased slightly, remaining still above the level of the two previous years. The liquidity constraints in the second half-year brought along an upturn again (see Figure 4.13).

[1] As fundamental indicators of more developed transition economies in Europe were better, their debt burden relatively smaller, volume of portfolio investments in these countries smaller and the economic policy of the region assumed to be relatively adequate, they were less affected by the autumn disturbances on financial markets. Currencies of Central European countries were devalued by 4-10% between 17 August and 17 September but then quickly recovered their former level.
[2] For analytical purposes deposits of non-residents and the government sector have been excluded in calculating monetary aggregates in the current publication and hence the terms narrow money and broad money used differ from aggregates M1 and M2 officially published by Eesti Pank.
[3] In 1998, the peak of the inter-bank money market turnover was in February with the turnover of up to three-months’ instruments reaching 7 billion kroons and that of 3-6months' instruments - 100 million kroons.
[4] Banks' credit to non-banking sector does not reflect fully the actual borrowing by economic agents. Banks' investments into the corporate and financial institutions' fixed income securities are also a credit, similar to lending.
[5] A major change was introduced in the quotation rules on 8 February 1999. According to these rules Eesti Pank started to fix TALIBOR and TALIBID at 11 on every business day. In addition to the above-mentioned three banks Merita Bank Plc and Svenska Handelsbanken were included among the quoting banks. TALIBOR and TALIBID are hence quoted as an arithmetic mean, excluding the highest and lowest quotation. Quoted time periods were supplemented with two, nine and twelve month's quotations. The obligation for the banks to extend credits or accept deposits with their quotations was abolished.