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


While the currency board served Estonia well during transition in the 1990s, it has limited its ability to counter the impact of the global financial crisis and heightened the currency risks. The euro adoption has thus become a top policy priority again. However, this paper finds that even after almost two decades of hard peg with the core of the euro zone shocks affecting Estonia are relatively weakly synchronized with those of the zone, contributing to large output volatility. Nevertheless, the case for euro adoption by Estonia holds, since the costs of the loss of independent monetary policy were paid, and - as the global financial crisis demonstrated - the currency board is no substitute for the common currency. To reduce future output volatility, Estonia should move to counter-cyclical fiscal policies, maintain labor and product market flexibility, and adopt policies stimulating rise in the knowledge and high-tech content of its production.

JEL classification: E32; F42; C53

Keywords: shock synchronization; structural VAR; euro adoption; financial crisis; Estonia

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 (Knöbl, 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 (Lättemäe 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. …

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