Eesti Pank Bank of Estonia 15 years of

Eesti Pank Bank of Estonia 15 years of currency board in Estonia Ülo Kaasik

Eesti Pank Bank of Estonia Outline Currency Board Arrangement in Estonia • History • Framework and results • Recent developments and challenges Ülo Kaasik CBA in Estonia 2

Eesti Pank Bank of Estonia Why choosing CBA? • Need for stabilising anchor in the beginning of 1990 s • Creating a simple and reliable monetary system, effective since 1992 • Small open economy with free capital mobility Ülo Kaasik CBA in Estonia 3

Eesti Pank Bank of Estonia Monetary system • Fixed exchange rate against euro (since 1999, formerly since 1992 equivalently against the DEM) • Full convertibility of Estonian kroon • Base money is fully backed by high quality foreign assets Ülo Kaasik CBA in Estonia 4

Eesti Pank Bank of Estonia Operational framework • Smooth liquidity management through unlimited EUR-EEK exchange with the central bank (forex window) • High liquidity buffers in the form of required reserves (reserve ratio currently 15%) • No domestic monetary policy interest rate: monetary stance is determined by European Central Bank monetary policy decisions Ülo Kaasik CBA in Estonia 5

Eesti Pank Bank of Estonia Other policies supporting CBA • Fiscal policy based on a balanced budget principle • Tax system – motivating, transparent, simple • Liberal trade and investment regime since 1991 • Flexible labour market • Strong banking system • Preparations for EU membership Ülo Kaasik CBA in Estonia 6

Eesti Pank Bank of Estonia What are the results? Ülo Kaasik CBA in Estonia 7

Eesti Pank Bank of Estonia Relatively quick stabilisation of the economy CPI (1991 -2007) 1991 -- 257% 1992 -- 1077% The introduction of the currency board was crucial in achieving disinflation During the last 8 years the average CPI has been 3. 7 % Ülo Kaasik CBA in Estonia 8

Eesti Pank Bank of Estonia The interest rates have converged to the interest rate level in euro-area countries Ülo Kaasik CBA in Estonia 9

Eesti Pank Bank of Estonia Fast capital inflow, through FDI and banking system Ülo Kaasik CBA in Estonia 10

Eesti Pank Bank of Estonia Very rapid income convergence Source: Eurostat Ülo Kaasik CBA in Estonia 11

Eesti Pank Bank of Estonia … and current account deficit Ülo Kaasik CBA in Estonia 12

Eesti Pank Bank of Estonia Pace have accelerated during last years • • Double digit GDP growth Rapid credit growth Deepening CAD Inflation well above Maastricht criterion Ülo Kaasik CBA in Estonia 13

Eesti Pank Bank of Estonia How to avoid overheating of the economy under CBA? Case of Estonia • Flexibility: in economic policies and markets • Reducing cost and price pressures of the government • Reminding conservative financial decisions • More reserves in the financial system • Close cooperation with supervisors and central banks of the host countries Ülo Kaasik CBA in Estonia 14

Eesti Pank Bank of Estonia CBA ensures high liquidity buffers Ülo Kaasik CBA in Estonia 15

Eesti Pank Bank of Estonia Flexible labour markets is crucial for economic adjustment Ülo Kaasik CBA in Estonia 16

Eesti Pank Bank of Estonia CBA cannot operate without conservative fiscal policy Ülo Kaasik CBA in Estonia 17

Eesti Pank Bank of Estonia Is inflation too high? Ülo Kaasik CBA in Estonia 18

Eesti Pank Bank of Estonia Lower level of convergence implies faster growth rate Ülo Kaasik CBA in Estonia 19

Eesti Pank Bank of Estonia Income and price levels tend to correlate i. e. converge together Price level and GDP per capita in PPS in European Union (except Luxembourg) Source: Eurostat Ülo Kaasik CBA in Estonia 20

Eesti Pank Bank of Estonia Apart from conjunctural price increases current inflation rate also reflects price convergence Ülo Kaasik CBA in Estonia 21

Eesti Pank Bank of Estonia Economy has started to cool down, 2007 Q 2 growth was 7. 6% difference GDP growth Estonia GDP growth euroarea 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Ülo Kaasik CBA in Estonia 2005 2006 2007 22

Eesti Pank Bank of Estonia Credit cycle has turned Credit growth in the non-financial sector 60% 50% 40% 30% 20% 10% 0% I II IIIIV I II IIIIV I II IIIIV 2001 2002 2003 2004 Credit growth y-o-y 2005 2006 2007 2008 • Monthly credit growth has not declined to a too low level – it remained around 2% during the whole summer 2009 Spring forecast 2007 Ülo Kaasik CBA in Estonia 23

Eesti Pank Bank of Estonia The external balance has not widened any further Current account (% of GDP) 0% -2% -4% -6% -8% -10% -12% -14% -16% -18% -20% I II III IV I II IIIIV I II III IV I II* III IV I II III IV 2000 2001 2002 2003 Current account 2004 2005 2006 2007 2008 2009 Spring forecast 2007 * Flash estimate Ülo Kaasik CBA in Estonia 24

Eesti Pank Bank of Estonia No big impact of financial turbulences Ülo Kaasik CBA in Estonia 25

Eesti Pank Bank of Estonia Euro adoption as the ultimate exit clause • Adoption of the euro as soon as possible, targeting 2011 • Central role of the government in reducing inflation: – Avoiding additional cost and price pressures – Managing regulated prices • No changes expected in the monetary environment due to euro adoption Ülo Kaasik CBA in Estonia 26

Eesti Pank Bank of Estonia Conclusions • CBA can be an effective corner stone for the economy • However, CBA cannot be successful without supportive economic policies • CBA offers the closest monetary environment to the euro area, preparing the economy for the euro adoption Ülo Kaasik CBA in Estonia 27