The Estonian Currency Board

Basic Information about Estonian Economy

Today Estonia is a small but prosperous country. In March 1991 most of the population of Estonia voted in favour of independence in a referendum. Then on 19 August 1991 hardliner Communists in Moscow attempted a coup. On 20 August Estonia declared its independence. The coup was defeated and Russia recognized Estonian independence on 6 September 1991.Communism was then dismantled in Estonia and replaced with a market economy. In the early years of the 21st century the economy grew rapidly Estonia, a 2004 European Union entrant, has a modern market-based economy and one of the higher per capita income levels in Central Europe and the Baltic region. Estonia's successive governments have pursued a free market, pro-business economic agenda and have wavered little in their commitment to pro-market reforms. The current government has followed sound fiscal policies that have resulted in balanced budgets and low public debt. The economy benefits from strong electronics and telecommunications sectors and strong trade ties with Finland, Sweden, Russia, and Germany. Tallinn's priority has been to sustain high growth rates - on average 8% per year from 2003 to 2007. Estonia's economy fell sharply into recession in mid-2008, primarily as a result of an investment and consumption slump following the bursting of the real estate market bubble. Estonia has rebounded well from the economic crisis. GDP contracted 14.3% in 2009, but the Estonian economy now has the highest GDP growth rate in Europe, largely thanks to a boom in exports and increased foreign investment

Estonian economy in 90s

On June 1992 Estonia become the first country that emerged from the Soviet union to abandon the Russian ruble and introduce its own national currency. The relative success of subsequent stabilization and reform program including the realization of rapid real growth, has often been attributed largely to Estonias early embrace of the currency board mechanism. Not only was the introduction of national currency linked to the explicit national goal of achieving economic independence from Russia but at the same, the Bank of Estonia already wanted to construct solid basics of further economic growth. Immediately after re-gaining independence Estonia started pursuing a policy of transition from central planning to market economy. This had to be achieved against the background of an initial position of Estonian economy that was much more difficult than that of the Eastern and Central European countries at the starts of their reform efforts. The system shock when Soviet central planning collapsed was very large, with widespread disruptions in trade and financial links that led to shortages of goods and raw materials. Economic circumstances grew more dire in early 1992 as the hyperinflation in Russia began. The trade shock caused by changes of prices of goods which were exported from Russia to Estonia resulted in dramatic decrease of real incomes. This time foreign experts( Jeffrey Sachs, Ardo Hansson) arrived in Tallinn. With the Argentinian experience with a currency board in the background, Sachs proposed to Kallas that Estonia adopt a currency board in the background. The final decision to take the CBA route was taken by the Bank of Estonia and MRC in late April shortly after the departure of experts mission.

Currency Board
In short definition currency board is a monetary authority that makes decisions about the valuation of a nation's currency, specifically whether to peg the exchange rate of the local currency to a foreign currency, an equal amount of which is held in reserves. The currency board then allows for the unlimited exchange of the local, pegged currency for the foreign currency. A currency board can only earn the interest that is gained on the foreign reserves themselves, so those rates tend to mimic the prevailing rates in the foreign currency. The currency board chosen by the Bank of the Estonia put strict constraints on economic policy. Under the CBA, base money could only be created against convertible foreign currency. There was, therefore no scope for discretionary monetary policy. There was

there was also to be no central bank credit to Government or enterprise and lending to banks could occur only under exceptional circumstances when the soundness of the entire banking sector was at risk and then only within strict limits of excess foreign exchange cover of base money. The CBA also provided a framework of fiscal policy and budget deficit needed to roughly balances. It was also recognizes that to ensure a high degree of confidence in the reform, restrictions on conversion would need to be minimal. Accordingly, it was agreed to introduce the kroon with broad current account convertibility and limited capital account convertibility. The introduction of the kroon went relatively smoothly, the only significant miscalculation being the underestimation of the demand for the new notes over the first weekend of its introduction. This was most likely due to high accumulation of foreign currency (mainly us. Dollars) and stored them under martresses than officials had expected. The result was that new currency become generally accepted as the new and exclusive medium of exchange in Estonia within a week of its introduction. Connection between the introduction of the CBA and economic stabilization is clear thanks to tight ,anti-inflationary and fiscal policy. For instance monthly inflation declined from an average of about 80% in early 1992 to only 3.3 % in December 1992. There is no doubt that Estonian currency helped to achieve rapid political and economic break with its soviet past and the Croon quickly become a symbol of this quest for independence. This enabled the Estonian authorities to present often contentious and painful adjustment measures, especially keeping the budget balanced shutting down insolvent banks, and pusinh forward privatization policy.

Micha Janowcz Sebastian Paliwoda