Academic journal article International Advances in Economic Research

Development of the Banking System under the Estonian Currency Board

Academic journal article International Advances in Economic Research

Development of the Banking System under the Estonian Currency Board

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. …

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