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Article Excerpt
Vello Vensel (*)
The choice of a suitable exchange rate regime is the subject of numerous discussions in economic literature. Estonia has been successful in achieving economic stabilization and growth and steadily declining inflation. It has one of the highest per capita foreign direct investments in central and eastern Europe. Estonia also has one of the most liberalized economies among all transition countries. An essential element of the success of Estonian economic development is strict exchange rate control. Estonia has adopted a currency board that serves as a signal of commitment to prudent monetary policy and as a guarantee of sound money during the transition period. This paper discusses the experience of operating the currency board, some future prospects of the currency board arrangement, and the development of the banking system in Estonia. (JEL E5)
Introduction
A number of countries have established currency board arrangements in recent years. At present, Djibouti (since 1949), Brunei Darussalam (1967), Hong Kong (1983), Argentina (1991), Estonia (1992), Lithuania (1994), Bulgaria (1997), and Bosnia and Herzegovina (1997) maintain such a monetary system. The International Monetary Fund (IMF) staff has discussed the introduction of currency board arrangements with post-conflict Somalia and Liberia, and the pros and cons of a currency board for Russia have been discussed. The currency board arrangement has been a major element of a stabilization program, and a stable currency based on a currency board arrangement is a cornerstone of the success of Estonian economic reform. The currency board is highly credible and it seems to be an appropriate arrangement to be maintained up to the introduction of the euro, if it is supported by consistent policies.
Simulations proved the currency board arrangement to be the most suitable option for the small economy of Estonian [Sepp, 2001]. The expected long-term cost of exchange rate adjustments (for example, the reaction to the recent Russian crisis of 1998 or the Asian crisis of 1997 to 1998) in terms of a loss of credibility would be higher than the loss of output in the short run. Hochreiter [2001, p. 18] states it clearly when he says, "The main point is that replacing an established and credible (hard) peg with a new peg which would need to prove itself could be very costly for a small(er) open economy."
Currency boards are not a new phenomenon in economics. The currency board principle was established in the Bank Charter Act of 1844, where the Issue Department of the Bank of England acted as a currency board. For this reason, many of the British colonies in Africa, Asia, and the Caribbean used currency boards upon introduction of their own currencies. The first currency board was established in Mauritius in 1849. More than 70 such boards operated at one time. Among the best-known examples of territories that still have a currency board of some kind are Hong Kong and Argentina. A great deal has been written on the experience of the currency board arrangement in various countries. (1)
The orthodox currency board is not subordinate to a central bank, it only backs bank notes with foreign assets. Therefore, some observers do not consider present-day currency board arrangements to be real currency boards. However, since the main characteristic of a currency board is that it is always willing to exchange domestic currency for a foreign reserve currency at a fixed rate, it may be concluded that Estonia does have a currency board arrangement that conforms to present-day developments in money and central banking, as did the orthodox currency board in its own time.
The liberation of the central and eastern European countries (CEECs) from the socialist political and economic regime gave birth to financial and economic problems analogous to those caused by the liberation from colonial subjection. It was therefore natural for the idea of the currency board to be reborn in the 1990S. The aim of a currency board system is to achieve currency convertibility and a fixed exchange rate, thereby helping to stabilize the economy, bringing about structural change and integrating the country into the world economy as quickly as possible.
Estonia already has almost nine years of positive experience in applying a currency board system, which permits some generalizations about its positive and negative impact on the development of Estonia's s economic reforms. Given the spread of the currency board arrangement, the time seems right for drawing conclusions about its present performance. The currency board seems to be fulfilling its objectives. As Korhonen [1999, p. 6] states, "indeed, few would have expected in June 1992 that the Estonian currency board would still exist with its original exchange rate of eight kroons to one German mark seven years later." By choosing the external discipline of a currency board arrangement, the government has enhanced the credibility of its intentions to fight inflation, and policy makers operate within a relatively predictable internal monetary environment [Sorg, 1998; Sorg and Vensel, 2000].
This paper is organized as follows. The second section presents the necessity of a currency reform in Estonia in 1992 and the main characteristics and impact of the monetary system on the Estonian economy, and the third section discusses some future prospects of the Estonian currency board arrangement. The fourth section describes the development of the banking system, banking crises, and their resolution in the condition of the currency board arrangement, and the fifth section presents the conclusions.
Currency Reform in Estonia and Estonian Monetary System
The Necessity of a Currency Reform
Estonia was the first among the former Soviet republics to introduce its own currency, the Estonian kroon (EEK), in June 1992. The supporters and designers of the idea of a national monetary system hoped to achieve three main objectives: eliminate inflationary influences from the east, establish approximate macroeconomic balance of supply and demand, and conquer persistent cash crises. Hyperinflation had broken out due to the liberalization of prices and the disruption of Estonia's eastern trade at the beginning of 1992. This caused a sharp cash crisis and threatened to paralyze monetary circulation completely. Confidence in the inflationary ruble, also called the occupation ruble, was completely lost. This was stressed by a high dollarization ratio. So as the ability of a domestic currency to deliver basic functions of money were distorted in an environment of high inflation and excessive exchange rate volatility, economic agents substituted the domestic currency with the stable U.S. dollar.
For the Estonian authorities, this situation set up two conditions for a successful currency reform. First, the currency reform must be carried out as quickly as possible before multiple wage and inflation shocks would cause a social explosion and economic collapse. Second, the new currency must inspire confidence, though introduced under circumstances of deep economic crisis and lack of experience by the central bank in carrying out monetary policy. An early main goal of monetary reform was to control inflation.
Those who carry out a currency reform must take into account a temporary acceleration of inflation. Having eliminated the shortage of cash, it is necessary to create confidence in the new currency. This may be done by means of a currency board arrangement where the value of the new currency is fixed in terms of a major reserve currency. In Estonia, the exchange rate between the Estonian kroon and the German mark (DEM) was based on the prevailing market...
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