Academic journal article The European Journal of Comparative Economics

On the Road to Euro: How Synchronized Is Estonia with the Euro Zone?

Academic journal article The European Journal of Comparative Economics

On the Road to Euro: How Synchronized Is Estonia with the Euro Zone?

Article excerpt

1. Introduction

In 1992, shortly after regaining independence from the Soviet Union, Estonia left the ruble zone and established its own currency (Kroon), which helped gather support for difficult reforms associated with the transition to a market economy. Simultaneously, the country introduced currency board, pegged initially to the German mark and since 1999 to euro. Under this regime the monetary base became fully backed by the foreign exchange reserves of the Bank of Estonia, the Kroon was completely convertible, and all restrictions on capital account transactions were abolished. With the adoption of the currency board, Estonia gave up its exchange rate and monetary policy in order to enhance credibility of its monetary stance and reduce inflation. (5) The money supply became endogenous, consisting of exchanging domestic currency at a fixed exchange rate to the currency that forms the reserve (Sepp and Randveer, 2002).

The currency board arrangement increased credibility by eliminating any possibility of discretionary monetary easing, since lending by the Bank of Estonia to the domestics banking sector or for government needs was prohibited except to banks experiencing systemic risks. Even in such situations, the lending could not exceed the accumulated excess foreign exchange reserves over the monetary base (Knobl, Sutt and Zavoico, 2002). By doing so, the board constrained the policy space to respond to future asymmetric shocks with respect to the euro area. It also limited the possibility for the central bank to provide liquidity to the banking sector in the event of a financial crisis to the amount of excess reserves over the monetary base. By joining the EU and the ERM II in June 2004 and aiming at an early euro adoption (at the prevailing exchange rate), Estonia has solidified its commitment to permanently fixed exchange rate regime. (6) In other words, Estonian policy makers viewed euro adoption--at the prevailing exchange rate -- as the most appropriate exit strategy from the currency board (Lattemae and Randveer, 2006).

The currency board served the country well during the 1990s and in fact played a key role in successful stabilization efforts, with inflation falling from high double digits in 1993 to low single digits by the late 1990s. During the 2000s, however, the benefits of the currency board declined. Estonia was one of the fastest growing emerging market economies in the world during this period, and until 2005 also had low inflation. However, growth was unbalanced, driven by non-tradables (especially the real estate sector) and financed by large capital inflows, which in turn fuelled domestic credit expansion, mostly in foreign currency. The combination of complete convertibility of the capital account with the currency board facilitated these capital inflows, as the currency board constrained the Bank of Estonia's room to mitigate the inflows and curtail the growth of private sector credit. Eventually, the credit boom created systemic risks to the banking sector through heavy exposure to international funding. The inflexible monetary policy framework implied that exchange rate adjustments were not possible to counter the severe adverse external shock when the global financial crisis hit. These factors contributed to a severe recession that Estonia experienced in 2009 (Brixiova, Vartia and Worgotter, 2010). (7)

Given the large share of the private sector credit denominated in foreign currency and the associated currency risk, the global financial and economic crisis has made euro adoption even more attractive and put it on top of the country's policy agenda (Bank of Estonia, 2009). The heightened currency risk during the crisis demonstrated that the currency board is not a substitute for joining the euro area. (8) The enhanced interest has been driven mostly by the desire to eliminate this risk, triggered by the speculation in the wake of the global crisis. Estonia was able to maintain an orderly financial system throughout the crisis largely due to good cross-border cooperation and provision of liquidity from the Nordic banks, which account for 95 percent of the Estonian banking market. …

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