Journal Issue

The Operation of the Estonian Currency Board

International Monetary Fund. Research Dept.
Published Date:
January 1993
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ON JUNE 20, 1992, Estonia left the ruble area and introduced its own national currency, the kroon. In doing so, Estonia not only became the first of the countries of the former Soviet Union (FSU) to introduce an independent currency but also joined a small number of countries operating a currency board.

The currency board was once a common arrangement to effect monetary stability in the colonial territories of European powers; it is now comparatively rare.1 A currency board was reintroduced in Hong Kong in 1983 to forestall a general crisis of confidence in that economy and its currency.2 This arrangement provides a convenient foil to the Estonian system.

Currency boards can vary from the relatively pure system like that of Hong Kong, where there is no central bank, to more hybrid schemes that retain limited central bank functions. They are relatively simple institutions to set up and run—an important consideration in countries where expertise in central banking is limited. Provided the rules of the game are followed, a currency board can also be considerably more robust than a conventional central bank arrangement, although this benefit brings with it certain costs in terms of the loss of policy flexibility. Finally, currency boards provide a convenient way of garnering seigniorage.

I. Operating Principles

Under a currency board arrangement, the board agrees to supply or redeem local currency bank notes and, if applicable, reserve deposits of commercial banks held with the currency board for another currency— normally a widely traded currency—at an established exchange rate and without limitation. It will exchange local currency on no other terms. In particular, local currency bank notes will not be exchanged for local currency claims on other institutions. The decision to set up a currency board involves four main issues: (i) what liabilities to back, (ii) how much backing to provide, (iii) what to back the liabilities with and what currency to peg to, and (iv) who should have access to the board.

The simplest arrangement is to back only bank notes, as in Hong Kong, where the currency board has no role in commercial bank clearing operations. This is the purest arrangement. In Estonia, on the other hand, it was decided to maintain the existing regime of reserve deposits. This was done partly because there was no effective system of interbank clearing outside the central bank, but also to ensure that banks held precautionary balances, over and above till money, against unexpected outflows. Such deposits, by virtue of being the liabilities of the Bank of Estonia and interchangeable with cash, would have to be backed in the same way as cash. The Estonian system is therefore a hybrid.

To instill confidence that it can honor the pledge of convertibility, the currency board should start with foreign exchange reserves sufficient to back a substantial proportion of the outstanding value of the relevant liabilities at the chosen exchange rate. Where confidence is lacking, this proportion needs to be 100 percent. The Hong Kong system began with full backing with the Office of the Exchange Fund at the linked exchange rate, and Estonia was fortunate enough to start with 90 percent backing by virtue of the Bank of England’s restitution of prewar gold (with full backing later, following the reclamation of further gold).

The choice of the currency to which to peg will depend, among other things, on the character of the currency (strong or weak) as well as on prospective trading relationships. In Estonia, consideration was initially given to linking to the European currency unit (ECU). Such a link would not have been as transparent as a link with a single well–known currency, however, and would have greatly complicated the task of reserve management and conditions of exchange. While the Finnish mark or Swedish krona might have recommended themselves from the point of view of trade, the deutsche mark was ultimately chosen because of its strength and respectability. As for the exchange rate of the kroon, this was set close to the equivalent prevailing market rate for the ruble at the time of the reform, taking into account conversion terms.

The final question concerns who has direct access to the currency board. In Hong Kong, only the banks with note–issuing authority have the right to convert cash into foreign exchange. Individuals and enterprises must rely on arbitrage and the competitiveness of the banking system to ensure that the rates offered them are equivalent. In Estonia, in order to demonstrate to the general public that the guaranteed exchange was genuine, it was felt appropriate for the Bank of Estonia to provide a window through which it would convert bank notes into deutsche marks and vice versa to all comers. The Bank found that it was a net seller of deutsche marks through this window and that its customers tended to be banks. This may reflect the fact that this was the only channel through which the Bank provided deutsche mark bank notes. All other transactions were settled via account.

II. Institutional Arrangements

To maintain the integrity of the currency board it must be prohibited from general discretionary lending. This is not to preclude occasional intervention to offset exceptional fluctuations in liquidity or to provide temporary assistance to a commercial bank, but this activity should be confined to those resources available to the authorities that are in excess of the requirements of the currency board.

Balance Sheet

For this reason, the Bank of Estonia was divided into two departments: the Issue Department and the Banking Department. The Issue Department’s balance sheet is endogenous to the economy at large—it is not controlled by the authorities. The Banking Department, on the other hand, represents the exogenous, or policy, side of the central bank, and as such it is important to distinguish these activities from those of the Issue Department.

The Issue Department operates the currency board. Its liabilities are those that qualify for the guarantee of exchange—bank notes and deposits in kroon placed with the Bank of Estonia. Its assets are the foreign exchange sufficient to match its liabilities. Seigniorage, in the form of interest earned, is passed, as it accrues, to the Banking Department.

The Banking Department holds excess foreign exchange reserves (balances surplus to the Issue Department) and is responsible for any residual central banking functions—in particular, in connection with payments arrangements with the former Soviet Union. If the need arises, the Banking Department will provide loans to the banking system for emergencies. All other outstanding commercial banking operations that used to be undertaken by the former central bank were transferred to the Northern Estonian Bank.

This division of responsibilities serves to ensure that, whatever assistance the Bank of Estonia chooses to give to the banking system, it cannot exceed its surplus foreign exchange reserves and therefore cannot compromise the currency board, provided the authorities play by the rules of the game. These rules require the Banking Department to “purchase” the kroon resources that it proposes to lend from the Issue Department, in exchange for its surplus foreign exchange reserves.3

Relations with the FSU

Ideally, financial transactions with other states of the FSU would have been left to the commercial banks of the respective countries to settle among themselves, but at the time of the monetary reform, the Russian authorities did not want any ruble transactions to take place on Estonian soil. As a result, they requested that all transactions be settled at the level of the two countries’ central banks, and for this purpose the central bank of each country opened an account with the other. The account of the Central Bank of Russia with the Bank of Estonia was credited with EEK 50 million, while the Bank of Estonia’s account with the Bank of Russia registered a credit of Rub 500 million. At the time of the currency reform, these were equivalent amounts.

The kroon balances were clearly a liability of the Bank of Estonia, but they were not automatically exchangeable into foreign exchange, being linked explicitly to the settlement of trade between the two countries. Reflecting this distinct status, these liabilities were not incorporated into the Issue Department’s balance sheet but featured instead in that of the Banking Department, which, with the restitution of gold, was soon more than able to back these claims.4 As these kroon balances were run down, mostly to pay the costs of the Russian Army still in Estonia, the kroons showed up instead as cash liabilities of the Issue Department, and equivalent sums in foreign exchange were thereby transferred from the Banking Department to the Issue Department. Since this is a process that, if repeated, would rapidly exhaust the Banking Department’s excess hard currency reserves, the Bank of Estonia is hoping to devolve responsibility for stonia–Russia financial settlements to the commercial banking sector.5

Savings Bank

A special problem surrounded the Savings Bank, home of the majority of personal savings in Estonia and whose accounts had been frozen since January 1, 1992. This bank effectively had no assets, since the proceeds of all deposits were traditionally remitted to Moscow, and their reclamation was caught up in the general negotiations between Russia and Estonia concerning debts. With the high rate of inflation experienced in early 1992, however, the real value of these balances had, by the time of the monetary reform, shrunk substantially. Since the cost in terms of reserve backing was relatively small (EEK 230 million, or about $20 million), it was decided to guarantee the conversion of these Savings Bank liabilities into cash. This meant that the Savings Bank was effectively 100 percent capitalized, and the Issue Department accordingly treated the liabilities of the Savings Bank as its own when drawing up its balance sheet.

The advantage of this treatment of the Savings Bank was twofold. First, some testing of the new system was expected and the backing of Savings Bank deposits meant that panic withdrawals could be met without closing its doors. Second, it meant that the economy had a reserve of liquidity that it could draw upon if citizens could be persuaded to exchange the guarantee attached to a Savings Bank deposit for an interest–bearing, but unguaranteed, deposit with a commercial bank.6 In the event, the feared withdrawals failed to materialize.

III. Policy Implications

The operation of a currency board entails a number of restrictions for the conduct of fiscal and monetary policy.

Government Finances

One of the primary conditions of a currency board is that the central bank, or currency board, cannot lend to the government. If this were to happen in Estonia, the currency board would find its kroon liabilities backed by domestic claims, typically also kroon denominated, and this would rapidly undermine the viability of the peg.

Since the government cannot obtain financing from the central bank, domestic financing, if needed, must be obtained instead from the commercial banks. Given the difficulties faced by banks in Estonia, where there were few resources to lend even to the private sector, it was appropriate to marry the currency reform with a commitment by the government to balance the budget in 1992. This commitment was met.

A balanced budget is not a necessary corollary of a currency board, but a government must realize that any borrowing it undertakes will crowd out borrowing by the private sector, except insofar as it obtains additional foreign finance. The success of the Hong Kong system is not unrelated to the fact that the government traditionally runs a surplus.

Open Market Operations

Under a currency board, both the level of interest rates and the yield curve are genuinely market determined. In this sense, a currency board deprives the authorities of the degree of freedom that is retained, by sterilizing foreign exchange intervention, under an exchange rate peg. A currency board can, in essence, be viewed as a pegged exchange rate system under which open market operations, and thereby sterilization, are prohibited. This implies the complete loss of control over interest rates.

By forgoing the ability to control interest rates, however, the authorities gain a more robust exchange rate. This is because attempts to control interest rates through open market operations typically leak quickly into changes in reserves. Under a currency board, open market operations are not permitted, and this process of reserve hemorrhage is thereby ruled out.

Along with control over interest rates by means of open market operations, control through administrative action is also ruled out. Any attempt by the government to control interest rates administratively would lead to the early collapse of the system, since it interferes with the mechanism through which banks bring equilibrium to the distribution of monetary assets and liabilities. If interest rates are set too low, for example, banks would be subject to excess withdrawals—leading ultimately to their collapse. For this reason, the Bank of Estonia makes no attempt to influence interest rates, either through open market operations, which are explicitly ruled out, or through administrative guidance regarding their level or spread. A corollary is the absence of any official “discount rate” or other statement of preferred interest rates.7

Lender of Last Resort

The inability to influence interest rates also limits the Bank of Estonia’s role as guarantor of the banking system. The scale of assistance that may be given to a weak bank must be confined to the excess foreign exchange reserves held by the Banking Department. Such assistance would normally be available only on a case–by–case basis. Thus, with the finite resources available, the central bank cannot act as “lender of last resort.” It cannot underwrite the banking system.

In Estonia, the very tight monetary conditions entailed by the currency board combined with banks’ weak balance sheets to render several banks illiquid at the end of 1992, a development that is discussed below. The pressure to lend to these banks proved difficult to resist, although the amounts involved were within the resources of the Banking Department. While the limited provision of liquidity may be within the scope of the Bank of Estonia, however, the overall task of dealing with insolvency is a fiscal responsibility, as was recognized in the bank rescue operation of early 1993. More liberal lending, such as might have occurred in the absence of the currency board, could have delayed but not averted collapse.

Scope for Devaluation or Revaluation

Although, in principle, an exchange rate fixed through a currency board could be adjusted—upwards or downwards—this rarely occurs under stricter currency board regimes. In Hong Kong, there has been periodic discussion over the possibility of realigning the Hong Kong dollar, but always the proposal has been rejected.8 The view taken is that once the certainty of the exchange rate is removed, the resilience of the exchange rate would be compromised. In addition, market interest rates would become more variable, reflecting speculation about the prospects for a future realignment.

In Estonia, the rise in the price level observed since the currency reform has obviously implied a progressive appreciation of the real exchange rate. This perceived loss of competitiveness has led some to expect that the kroon will have to be devalued at some future point. It is important for the authorities to discourage this assumption, since such expectations have the adverse effect of propping up the long end of the interest rate yield curve.

Exchange Controls

One of the advantages of a currency board is that its robustness usually permits a very liberal structure of exchange arrangements. In fact, it works most effectively under liberal conditions—the Hong Kong arrangements are probably among the most liberal in the world. However, there may still be a case for interim capital controls if the banking system, before restructuring, lacks viability and the full confidence of the public. For this reason, the Estonian currency board was set up with a system of capital controls. This system required the repatriation and conversion of foreign exchange earnings with authorized commercial banks and precluded the purchase of foreign exchange with kroon for anything other than current transactions.9 This was designed to prevent the transfer of funds abroad, in the event of a bank run, thereby protecting the liquidity of the banking system as a whole, except to the extent that the public withdrew kroon cash from banks.

The same principle applied to personal transactions, where purchases of foreign exchange required proof of travel or another current account need. As confidence in the kroon grew, however, the Bank of Estonia ceased to enforce these rules for individuals, although they remain in force for enterprises and institutions. Some liberalization, even in this area, was necessary, however, as enterprises that needed to turn around their funds relatively quickly found themselves hit by commissions both ways. Accordingly, enterprises that could prove a subsequent import requirement within two days were freed from the surrender requirement. Meanwhile, enterprises that could demonstrate the need for working balances abroad could apply for a license to hold overseas accounts, for which the surrender requirement was waived. As confidence in the banking system recovers, it would be appropriate for the remaining capital controls to be relaxed in due course.

IV. Implications for Foreign Exchange Market

While the currency board may fix the rate of exchange between cash and foreign currency, there may still be an active foreign exchange market—although rate movements will rarely be of any magnitude. Under a Hong Kong–type arrangement, where the exchange rate is for notes only, the principal role for the market is to allow banks to trade each other’s deposits for foreign exchange. In the same way as the gold standard allowed for small deviations in exchange rates—the so–called “gold points"—beyond which it became profitable to ship gold and arbitrage the deviations, so under a currency board small deviations from the currency board rate can occur in the foreign exchange market (for bank deposits). If pressure exists on the currency, for whatever reason, the deviation from the currency board rate will never be large, because the incipient arbitrage (drawing down bank deposits in exchange for notes, which can be exchanged at a favorable rate for hard currency) would induce banks to raise interest rates to the level required to abort the arbitrage.

In Estonia, these deviations will typically be negligible for deutsche mark transactions. This is because the Estonian currency board guarantees the exchange not just of bank notes but also of the deposits of commercial banks held with the central bank. Thus, a bank wishing to purchase deutsche marks can present the central bank with a check drawn on another bank’s account with the central bank. For other currencies, on the other hand, this guarantee does not hold, but the arbitrage process will instead operate through the cross rates.

This consideration has prompted calls from the commercial banks for the central bank to guarantee exchange for other currencies too. It is not the job of the currency board to operate as a clearinghouse for foreign exchange transactions. However, recognition that banks running up against legal requirements concerning their “open positions” may be required to convert currencies other than the deutsche mark into kroon at short notice has led the Bank of Estonia to agree to convert other currencies for marginal transactions required by the “open position” regulations.

In the absence of an active interbank market in foreign exchange, competition considerations argued for the retention of the less efficient auction market, which meets only periodically. Although enterprises are obliged to sell foreign exchange to commercial banks, they are entitled to ask such banks to sell foreign exchange in the auction market if they feel they are not being offered a sufficiently competitive rate. However, the deadline for surrender is proving too tight for the auction market to perform this competitive check on the banking system. Instead, the auction market continues to perform its traditional role as a forum for trading rubles, chiefly for dollars but now also for deutsche marks and kroon. Because of the lack of competition, enterprises have complained about the cost of buying and selling foreign exchange in dealing with the commercial banks. For this reason, the Bank of Estonia has limited the maximum spread, including commission, that banks may establish between the buying and selling prices of foreign exchange.

V. Implications for Program Design

The existence of the currency board arrangement in Estonia has necessitated some changes to the usual IMF performance criteria. In particular, the fact that the currency board’s balance sheet is effectively determined by the demand for cash means that the reserves employed to back the note issue are not under the control of the authorities. It therefore makes no sense to set targets for such reserve holdings, as is customary in IMF programs, since the authorities cannot control the public’s demand for cash. Targets can, however, be retained for those reserves that are surplus to the requirements of the currency board—those of the Banking Department—since they are under the direct control of the authorities. Since the exchange rate is preserved through the operation of the currency board and by virtue of the reserves of the Issue Department, these surplus reserves have no further role as regards conventional balance of payments considerations. Under a currency board, pressures that normally give rise to balance of payments problems and the loss of reserves give rise instead to pressures within the domestic banking system and rising interest rates. These excess reserves thereby serve instead as a means for supporting the banking system should the need arise.

Clearly, it would be appropriate for these reserves, which are finite and not easily supplemented, to be used in a parsimonious and prudent manner. It therefore makes sense to set targets for these surplus reserves: in other words, to target total reserves less the currency board cover.10 Accordingly, the present stand–by arrangement with the IMF employs (minimum) targets for such reserves. Since these reserves are to be used, in exceptional circumstances, for the purposes of supporting banks, a reserve target of this type also doubles as a ceiling on the net domestic assets of the central bank. Therefore, no separate performance criterion is needed for net domestic assets. On the other hand, the requirement that government borrowing be kept to a minimum in the initial stages of the Estonian currency board arrangement leads naturally to a ceiling on net government borrowing from the banking system.

VI. Performance to Date

Notwithstanding the generally difficult economic conditions faced by Estonia over the past year, the performance of the kroon has so far surpassed expectations.


The first stage of Estonia’s currency reform involved the conversion of ruble balances, in the form of both cash and deposits, into kroon. To avoid the conversion of unauthorized quantities of rubles, individuals wishing to convert rubles were required to register, with proof of residency, before the day of the reform. Those who did so were permitted to convert up to 1,500 rubles (about $12) in cash into kroon at the conversion rate of 10 rubles to 1 kroon. Cash balances in excess of this amount could be converted at the less favorable rate of 50 rubles per kroon. Household deposit accounts with the Savings Bank were converted at the same rate as that for cash, with no upper limit. Cash balances held by enterprises and banks were collected by the Bank of Estonia and converted without limit at 10 rubles per kroon.11 All rubles on account, as well as ruble borrowings, with domestic banks were redenominated into kroon at this rate without limit.12 Ruble correspondent balances with other states of the FSU were set aside under the aegis of the Bank of Estonia for subsequent settlement on terms that remain to be negotiated. Thus converted, the exchange rate for the kroon was set at EEK 8 per deutsche mark, equal to the equivalent prevailing market rate for the ruble (Rub 80 per deutsche mark). This was considered a very competitive level from which to launch the kroon.

Balance Sheet

At the time the currency board was set up, the agreed conversion terms for outstanding rubles resulted in the currency board assuming kroon liabilities that were somewhat greater than the reserves available, although it was realized at the time that the deficiency would be made up. On June 20, 1992, kroon liabilities, including provision for the liabilities of the Savings Bank, amounted to EEK 754 million, whereas foreign exchange reserves (gold from the Bank of England) amounted to only EEK 685 million. This small deficiency was duly made up on July 8 by the timely arrival of some $31 million from Sweden in lieu of prewar gold, and by July 17 the excess reserves held by the Banking Department stood at EEK 121 million (about $10 million). This surplus position was supplemented later in July by the first tranche of prewar gold owed to Estonia by the Bank for International Settlements (BIS). The second tranche of the BIS gold (deposited in the New York Federal Reserve and the subject of litigation) was not released until the end of September, by which time the surplus position of the Banking Department stood at the equivalent of about $40 million.

Figure 1.Bank of Estonia, Asseu of Issue and Banking Departments

Sources: Bank of Estonia and IMF staff estimates. Note that the Bank of Estonia’s assets do not include those with FSU or other miscellaneous pre–reform assets.

The evolution of these excess reserves can be gauged from Figure 1, which shows how reserves have grown, both those accruing to the Issue Department and those to the Banking Department. Issue Department reserves were, as noted, insufficient to cover liabilities at the outset, so the balance sheet includes a temporary item denoted “capital” representing negative net worth. This is quickly eliminated as additional gold was restituted; thereafter the Issue Department is fully capitalized. The surplus foreign exchange then shows up in the Banking Department. In addition, the Banking Department features lending: initially advances of kroon bank notes to banks dating from the currency reform; later loans to troubled banks.13 The nature of the operation of the Banking Department means that the totality of reserves and loans should be broadly constant (apart from the restitution of gold) but that the mix between the two should reflect the use of reserves to finance lending. As can be seen, significant reserve use occurred during the September—October 1992 period and again during January—February 1993. Nonetheless it can be seen that as of end–March 1993, notwithstanding the loans made by the Banking Department, reserves remained substantially in excess of currency board liabilities.

Table 1.Monetary Aggregates in Estonia(EEK millions)
Broad money (M3)3,1933,2333,8533,6283,4883,709
Currency outside banks2377231,0411,0461,1601,269
Demand deposits7671,6461,6801,7241,6991,838
Time deposits278145248221237227
Foreign currency deposits1,911719884637391374
Domestic Credit
Claims on government (net)a–174–157–275–53–118–161
Claims on state enterprises428589644580599597
Claims on private sector1,1451,0779861,1311,1601,247
Sources: Bank of Estonia and IMF staff estimates.

Includes EEK 300 million bond issue for bank recapitalization from January 1993 onward.

Sources: Bank of Estonia and IMF staff estimates.

Includes EEK 300 million bond issue for bank recapitalization from January 1993 onward.

Turning to the currency board (Issue Department) balance sheet. Figure 2 shows that the opening liabilities were almost equally divided between kroon notes, Savings Bank deposits, and commercial bank reserve deposits. As time passed, however, virtually all the growth in liabilities was in kroon note issue, which rose 322 percent in the first nine months of the arrangement. Beyond the monetary base, however, broad money growth was negligible (Table 1). By end–March 1993, kroon cash balances outside banks represented some 34 percent of broad money,

Figure 2.Bank of Estonia, Liabilities of Issue Department

Sources: Bank of Estonia and IMF staff estimates.

compared with only 7 percent at end–June 1992. Within broad money, however, the growth of kroon bank deposits was more pronounced, 98 percent over the nine months ending March 1993, reflecting considerable switching out of foreign currency deposits. But the prevalent distrust of the banking system had nonetheless contributed to pronounced liquidity preference, thus limiting the growth of broad money.

Involvement of Foreign Banks

Several banks in Finland and Sweden now quote exchange rates for kroon, with Finnish banks holding kroon deposits in Estonia for this purpose. The respectability of the kroon was enhanced on December 1, 1992, when the Bank of Finland announced it would henceforth quote rates for the kroon for information purposes. Thus far, one small American bank—the Baltic American Bank—has set up business in Estonia and on December 3 a large Finnish bank, Yhdyspankki, opened a representative office in Tallinn.

Domestic Banking System

Because, in part, of the constraint placed on the Bank of Estonia in its ability to provide liquidity to the banking system, the latent insolvency of a number of banks was rapidly translated into illiquidity. In November 1992 three banks, for which there was an ever–growing queue of unpaid checks drawn on their accounts, were subject to moratoria on the authority of the Bank of Estonia. Two of these banks, Union Baltic Bank and the Northern Estonian Bank (itself a spin–off from the pre–reform central bank), suffered from the freezing of foreign exchange deposits in Moscow (about $80 million) at the beginning of 1992. All three banks suffered additionally from a portfolio of doubtful loans. In the case of Tartu Kommertspank, these loans reflected imprudent lending since the monetary reform as much as they did problems inherited from the past. In response to this apparent culpability, the authorities decided at the end of December to liquidate Tartu Kommertspank. The other two banks were merged into a new bank. Recapitalization involved a contribution of EEK 100 million from the Bank of Estonia and a bond issue of EEK 300 million by the government. When the new bank opened its doors in February 1993, there were immediate withdrawals of some EEK 75 million, requiring more loans from the Bank of Estonia. These withdrawals then ceased, however, and the bank was able to operate normally.

After the successful restructuring, market interest rates dropped sharply and the spread between loan and deposit rates narrowed.14

Inflation and Competitiveness

As Figure 3 shows, inflation since the currency reform has been slower than in the neighboring Baltic states, where more conventional monetary arrangements are followed and the exchange rate is allowed to float. Inflation has nonetheless been higher than expected.15 Average wages, in dollar terms, moved up sharply following the currency reform and are now significantly higher than those in Lithuania (also Figure 3). Following the marked appreciation of the Latvian ruble at the end of 1992, however, the margin of Estonian dollar wages over those in Latvia mostly disappeared by early 1993. Notwithstanding the apparent loss of Estonian competitiveness since the currency reform, trade with the industrialized countries of the West expanded vigorously in the second half of 1992, reflecting the very competitive starting position of the exchange rate.

VII. The Medium Term

Over the medium term, it is reasonable to expect the Estonian economy to grow. As it grows, the requirements for liquidity will also grow. This does not mean, however, that Estonia must run a current account surplus indefinitely to generate the money growth that would otherwise be supplied domestically.16 This is because liquidity can be supplied through the capital account as well as through the current account. For Hong Kong, one of the principal financial centers of the Pacific rim, capital is very mobile and the economy is thus always assured a sufficiency of cash to service the economy. For Estonia, by contrast, capital will not be nearly so mobile, and the first years of the arrangement are likely to be characterized by a fairly severe financial squeeze as the price level is forced to adjust to the note issue rather than the other way around.

Figure 3.The Baltic Stares: Prices, Exchange Rates, and Wages

Sources: Estonian, Latvian, and Lithuanian authorities and IMF staff estimates.

However, it is only the growth of base money that is constrained by the rules of the currency board, and cash is only one component of the money supply. Since the cash–to–money ratio is currently very high in Estonia, there is plenty of room for the money multiplier to generate growth in broad money, as the cash–to—broad money ratio declines, which should occur as the banking system recovers its health and confidence is restored. In the short term, while the capital account can be expected to be less fluid than that of Hong Kong, this multiplier process might be the primary manner in which broad money will grow.

In the medium term, however, the capital account should be the main channel through which base money will grow. This process should be facilitated by the entry of foreign banks into the domestic banking system. Under the British colonial currency boards, for example, the existence of a branch banking network undoubtedly helped channel the required inflows and outflows of liquidity.

Initially interest rates on kroon–denominated assets can be expected to remain considerably higher than those prevailing on equivalent deutsche mark assets because of (i) expectations of a future realignment and (ii) the problems, and thereby riskiness, of the Estonian banking system. As it becomes clear to market participants that the authorities will not countenance a realignment, and as the banking system is overhauled and recapitalized, market interest rates in Estonia should steadily decline. Eventually, if the supply of liquidity through the capital account proves adequate, interest rates should converge toward those of the deutsche mark.

While interest rates may converge toward those of Germany, there is no reason to expect inflation to do so. Initially, the divergence may be large, reflecting the supercompetitive level of the exchange rate at the time of the currency reform. Some upward move in the real exchange rate from this level is bound to occur and is clearly reflected in recent monthly price increases in Estonia.

Quite apart from this initial rise in prices, inflation in Estonia might be expected to remain above that in Germany even over the medium term. This is because a developing economy such as that of Estonia, starting from a very low level of productivity owing to its inherited Soviet industrial capital base, may be expected to enjoy much faster productivity growth in manufacturing and other export–oriented industries than that of more mature economies, like Germany. The rising incomes that are thus generated will translate into a rise in the Estonian real exchange rate over the medium term. With a fixed nominal exchange rate, this suggests that inflation will be comparatively high in Estonia. This factor helps explain why inflation in Hong Kong, for example, is consistently higher than that in the United States, despite the peg of the Hong Kong dollar to the U.S. dollar. To the extent that a higher rate of inflation is caused in this way, there is no reason why it should impugn the viability of the peg.


Adam Bennett, a Senior Economist in the Policy Development and Review Department, holds degrees from Cambridge University and the London School of Economics. He was formerly an Economic Advisor to the U.K. Treasury. The author would like to thank Charles Adams, David Burton, Adaibert KnObl, Susan Schadler, Basil Zavoico. and Tapia Saavalainen for valuable comments.

For an analytical discussion of currency hoards. see Osband and Villaneuva (1993). See also Hanke and Schuler (1991a) for a proposal for currency boards in Eastern Europe. For a description of the last example of a currency board in a neighboring region (Northwest Russia in 1918–19), see Spring–Rice (1919) and Hanke and Schuler (1991b).

For an analysis of the Hong Kong system, see Greenwood (1984a).

Contrary to usual central banking arrangements, reserves held by the Issue Department should not be diversified but held entirely in the currency to which the kroon is pegged, lest exchange rate changes undermine the backing. Reserves held with the Banking Department. on the other hand, can be handled in a more conventional manner and diversified.

Nor did the ruble balance, which featured in the balance sheet of the Banking Department, qualify as reserve backing.

To this end, commercial banks in Estonia are now permitted to hold correspondent accounts with commercial banks in Russia.

In fact, Savings Bank accounts also earned interest, but the interest payable was low (some 3–4 percent a year) compared with that available from the banks during the latter half of 1992 (some 20 percent).

No interest is payable on bankers’ deposits with the Bank of Estonia.

See, for example, Greenwood (1984b).

This conversion had to be completed the day following repatriation for domestic accounts and within 30 days for overseas accounts.

Insofar as the correspondent accounts of foreign central banks with the Bank of Estonia remain operational. there is a strong case for setting the target with respect to reserves less currency board cover and less kroon correspondent liabilities. This would avoid misleading variations in “surplus” reserves.

Ruble cash balances collected by the Estonian authorities in this manner are to be returned to Russia in due course, on terms that remain to be agreed.

Further details of the reform, with the associated decrees and other legislation, can be obtained from the report of the Bank of Estonia (1992).

The interest rate on these loans varied, from a maximum of 10 percent to zero, and were never punitive. The maturity was generally of one year. Some of these loans to banks have turned out to be covert loans to government agencies, with the National Grain Board featuring prominently.

By the end of 1992. interest rates for loans were about 70 percent a year, while time deposit rates were 20 percent. After the bank rescue, loan rates declined to some 40 percent. For the first time since the currency reform, loans to the business sector began to rise, and by more than inflation, so that there was a real increase in the stock of credit.

It should be cautioned that the initial price increases partly reflected the liberalization of previously administered prices as well as distortions in the composition of the price indices that resulted from the monetary reform in June.

In the first nine months following the introduction of the currency board. Estonia nonetheless did run a current account surplus.

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