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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 1990s • 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 1992 -- 1077% The introduction of the currency board was crucial in achieving disinflation 20 00 100% During the last 8 years the average CPI has been 3.7 % CPI (1991-2007) 80% 1991 -- 257% 60% 40% 20% 20 06 20 07 (4 ) 20 05 20 04 20 03 20 02 20 01 19 99 19 98 19 97 19 96 19 95 19 94 19 93 0% 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 20% 18% A 16% 14% A- 12% 10% 8% BBB+ 6% 4% 2% 0% 1996 1997 1998 1999 2000 3M EURIBOR (3M DEM LIBOR) 2001 2002 3M TALIBOR 2003 2004 2005 2006 2007 Sovereign Rating (Standard & Poor's) Ülo Kaasik CBA in Estonia 9 Eesti Pank Bank of Estonia Fast capital inflow, through FDI and banking system 90% 140% domestic banks, total assets % of GDP FDI stock, % of GDP 80% 120% FDI inflow, % of GDP 70% banks with foreign ownership, total assets % of GDP 100% net foreign assets of banks, % of GDP 80% 60% 60% 50% 40% 40% 20% 30% 0% 20% -20% 10% -40% Ülo Kaasik CBA in Estonia 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 -60% 1994 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 0% 10 Eesti Pank Bank of Estonia Very rapid income convergence 70 10000 60 8000 50 6000 40 4000 30 2000 20 0 10 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 12000 GDP per capita (EUR, nominal), left scale Source: Eurostat GDP vs EU-25 (%, PPP), right scale Ülo Kaasik CBA in Estonia 11 Eesti Pank Bank of Estonia 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% goods balance income balance total current account 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 -30% 1993 % of GDP … and current account deficit services balance current transfers balance 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 45,000 reserve requirement 40,000 deposits in Bank of Estonia market value of foreign assets liquidity portfolio 35,000 30,000 25,000 20,000 15,000 10,000 5,000 Ülo Kaasik CBA in Estonia 02/08/2007 02/02/2007 02/08/2006 02/02/2006 02/08/2005 02/02/2005 02/08/2004 02/02/2004 02/08/2003 02/02/2003 02/08/2002 02/02/2002 02/08/2001 02/02/2001 02/08/2000 02/02/2000 02/08/1999 02/02/1999 02/08/1998 0 02/02/1998 mln EEK CBA ensures high liquidity buffers 15 Eesti Pank Bank of Estonia Flexible labour markets is crucial for economic adjustment 40% nominal wage growth 35% real productivity growth 30% 25% 20% 15% 10% 5% Ülo Kaasik CBA in Estonia 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 0% 16 Eesti Pank Bank of Estonia CBA cannot operate without conservative fiscal policy 5% 4% General government deficit/surplus, % of GDP 3% 2% 1% 0% -1% -2% -3% -4% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 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 Average annual real GDP growth (2001-2005), % Lower level of convergence implies faster growth rate 9 8 7 6 5 4 3 2 1 0 LV LT 20 EE 40 60 80 100 GDP per capita in PPS (2000), EU25=100 Ülo Kaasik CBA in Estonia 120 19 Eesti Pank Bank of Estonia Income and price levels tend to correlate i.e. converge together R2 = 0,9101 140 120 price level 100 80 60 40 20 0 0 20 40 60 80 100 120 140 160 gdp per capita 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 CPI Services Manufactured goods excl fuel 12% 10% 8% 6% 4% 2% 0% -2% 2000 2001 2002 2003 2004 2005 Ülo Kaasik CBA in Estonia 2006 2007 21 Eesti Pank Bank of Estonia Economy has started to cool down, 2007 Q2 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 I II IIIIV I II IIIIV I II IIIIV 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 III IV I II III IV I II IIIIV I II III IV I II III IV I II III IV I II* III IV I II IIIIV 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 3M Talibor-Euribor (l.s) 3M Rigibor-Euribor (r.s) 04.09.07 21.08.07 07.08.07 24.07.07 10.07.07 26.06.07 -1 12.06.07 0,0 29.05.07 0 15.05.07 0,1 01.05.07 1 17.04.07 0,2 03.04.07 2 20.03.07 0,3 06.03.07 3 20.02.07 0,4 06.02.07 4 23.01.07 0,5 09.01.07 5 26.12.06 0,6 12.12.06 6 28.11.06 0,7 14.11.06 7 31.10.06 0,8 6M Talibor-Euribor (l.s) 6M Rigibor-Euribor (r.s) 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