15 years of currency board in Estonia

1. Ülo Kaasik 15 years of currency board in Estonia

2. Outline Currency Board Arrangement in Estonia • History • Framework and results • Recent developments and challenges

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

4. 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

5. 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

6. 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

7. What are the results?

8. Relatively quick stabilisation of the economy The introduction of the currency board was crucial in achieving disinflation During the last 8 years the average CPI has been 3.7 % CPI (1991-2007) 1991 -- 257% 1992 -- 1077%

9. The interest rates have converged to the interest rate level in euro-area countries

10. Fast capital inflow, through FDI and banking system

11. Very rapid income convergence Source: Eurostat

12. … and current account deficit

13. Pace have accelerated during last years • Double digit GDP growth • Rapid credit growth • Deepening CAD • Inflation well above Maastricht criterion

14. 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

15. CBA ensures high liquidity buffers

16. Flexible labour markets is crucial for economic adjustment

17. CBA cannot operate without conservative fiscal policy

18. Is inflation too high?

19. Lower level of convergence implies faster growth rate

20. 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

21. Apart from conjunctural price increases current inflation rate also reflects price convergence

22. 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 2005 2006 2007 Economy has started to cool down, 2007 Q2 growth was 7.6%

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

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

25. No big impact of financial turbulences

26. 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

27. 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