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Monetary policy and EMU enlargement: issues regarding ERM II and adoption of the euro in Estonia.

Official Position on Membership in ERM II and the Euro Adoption

Estonian authorities have declared that Estonia seeks to join the European Economic and Monetary Union as soon as possible, with the goal of being technically prepared to adopt the euro in mid-2006. The Estonian government and the central bank intend to seek participation in the ERM II exchange rate mechanism soon after joining the EU, in accordance with all relevant multilateral procedures and within the established framework. The intention of the authorities is to participate in ERM II with the standard fluctuation band and to maintain unilaterally the currency board arrangement (CBA). The latter implies that the Estonian authorities will unilaterally guarantee a zero percent fluctuation margin of the Estonian kroon. As the authorities intend to be prepared to adopt the euro in mid-2006, the length of the stay in ERM II would be as short as possible.

What is the Rationale for Early Entry into ERM II?

The main motive for early entry of Estonia into ERM II is to reap the benefits of the monetary union as soon as possible. The latter include: (1) the maintenance of a strong policy discipline; (2) an increase of the economic and financial integration of the Estonian economy with the euro area; (3) a reduction of transaction costs; and (4) a decrease in the interest rates via an elimination of the exchange rate risk premium. All of these in turn should intensify trade, foster economic growth, and real convergence.

Usually, premature participation in ERM II is deemed to entail potential costs in other areas, such as short-term costs of fiscal consolidation and the cost of giving up independent monetary policy and flexible exchange rates as stabilization tools. Those costs are practically non-existent in the case of Estonia, as the ERM II and later full participation in the euro area do not call for major adjustments in Estonia's macroeconomic policies.

Fiscal discipline has been strongly entrenched in the political culture of Estonia. During the last 12 years, Estonia has maintained one of the most prudent fiscal policies among the acceeding countries (see Figure 1 and 2). Throughout this period, the budget deficit has exceeded the Maastricht 3 percent limit only once, in 1999 (due to economic adjustments after the Asian and Russian crises that coincided with the election cycle). The general government budget has recorded a surplus since 2001 (+2.6 percent in 2003) and is expected to be in balance in the coming years. As a result, the government debt is the lowest among new member countries (5.8 percent of GDP in 2002). (1) Debt level will remain low in the medium term, as the authorities intend to pursue a balanced budget policy also in the future. Therefore, joining the monetary union does not entail any significant change for fiscal policy.


As compared to the present situation, the costs related to the possible loss of independent monetary policy are non-existent, as Estonia has operated a successful currency board vis-avis the euro (German mark) for almost 12 years and therefore, has not been able to pursue an independent discretionary monetary policy. The currency board with its limited discretion is usually perceived to be the closest monetary regime to a full monetary union. Thus, Estonia has been practically in a quasi-monetary union with the euro area core countries for almost a dozen years now. Participation in ERM II and entrance into the euro area are, therefore, steps that do not entail giving up monetary independence but eliminating the remaining transaction costs and risk premiums. Thus, adjustment and transmission mechanisms that are currently in place will remain largely unaltered after the entrance.

What is the Rationale for the Maintenance of the CBA?

The rationale for the maintenance of the CBA (implying the absence of an independent discretionary monetary policy) until the adoption of the euro is based on the high degree of nominal convergence and exchange rate stability, the flexibility of the markets, and the strong integration of the Estonian economy to the euro area countries.

Exchange Rate Stability and Nominal Convergence

The nominal exchange rate of the Estonian kroon has been kept unchanged for the last 12 years. During that period, the incidence of speculative attacks has been rare (1997, 1998). The stability of the exchange rate has been strongly entrenched, evidenced by the fact that the public has not seriously questioned the current monetary regime (and the level of the nominal exchange rate). Also, the market participants expect the nominal exchange rate to remain at the current level for the next two years.

The currency board arrangement has created a nominal anchor for stable inflation and interest rates in Estonia (see Figure 3). Inflation in Estonia has decreased to single-digit levels since 1998 and is currently below the EMU average (annual CPI was 1.3 percent in 2003). However, the core inflation (overall CPI with energy, food, alcohol, and tobacco excluded) has, however, stayed about 1 percentage point higher than the core inflation in the EMU since mid-2002. Similarly to inflation, there has been a steady decline in interest rates--the long-run interest rates of bank loans amount to 5-6 percent. The remaining spreads over euro area interest rates are about 50 bases points for money market rates and about 50-100 bases points for real sector lending rates at the end of 2003. (2)


Trade and Financial Integration of the Estonian Economy into Euro Area Countries

Estonia is a highly open economy, with total exports and imports (including services) accounting for about 180 percent of GDP. It has close trade relations with the EU, accounting for approximately 80 percent of Estonia's foreign trade. The Estonian economy is most closely connected to the economies of Finland and Sweden. These connections are visible in both trade and investments, as Finland and Sweden account for 41 percent of exports and 67 percent of foreign direct investments to Estonia.

Similarly to trade links, strong financial links should also reduce the exposure to asymmetric shocks, as they should smooth the impact of asymmetric shocks by cross-border flows of capital and by convergence of financial structures [Mongelli, 2002]. The EU, especially the Nordic countries, plays an important role as a source of FDI inflows, as well as in the Estonian financial sector. Swedish and Finnish investors own 67 percent of FDI stock and 86 percent of the Estonian banking sector, whereas the rest of the EU accounts for an additional 18 percent of FDI.

Comparable economic structures decrease the danger of asymmetric economic shocks and increase the similarity of shocks within a monetary union [Tavlas, 1994]. The structure of the Estonian economy (both in terms of value added and employment) disaggregated into three main sectors, has practically converged to the economic structure of the present EU. On a more disaggregated level, some differences remain.

Frenkel and Nickel [2002] have estimated the correlation of supply and demand shocks between the current E(M)U members and CEEC (Central and Eastern European Countries) countries. Among the CEEC countries, Hungary, Slovenia, the Czech Republic, and Estonia showed higher correlation of supply shocks with the EMU than the other acceeding countries. Fidrmuc and Korhonen [2001] used a similar approach and found that the correlation of supply shocks of some acceeding countries (including Estonia) with the EMU is already similar to the supply shocks correlation of some current EMU members.

However, the economic symmetries in Estonia should be higher vis-a-vis the Nordic countries than vis-a-vis the larger EMU members, as trade and investment links are stronger with this region. Indeed, some studies show that the Estonian business cycle is closely synchronized with Finland's business cycle [Danilov, 2003; Kaasik et al., 2003]. Therefore, possible economic asymmetries in Estonia vis-a-vis the euro area as a whole depend also on possible asymmetries between the Nordic countries (especially Finland) and the other EMU economies. Thus, the business cycle synchronization between Estonia and the EMU core members might remain smaller than in central European countries, as the synchronization of the business cycle of the Nordic countries with the euro area is not very high.

The Flezibility of the Real Sector

The need for nominal exchange rate adjustments is lower if wages and prices are flexible (especially downwards). It should be stressed that in spite of relatively weak economic ties with Germany in the early and mid-1990s, when the currency board was introduced, Estonia's growth and export performance has been favourable. As this has occurred under a rigidly fixed exchange rate regime, the latter indirectly points to the flexibility of the real sector to cope with asymmetric shocks without the need for a more flexible exchange rate policy.

This is reconfirmed by the fact that incidences of exchange rate pressures have been rare throughout these years, save for only some contagion episodes during the Asian and Russian crises in 1997-98. While the Estonian economy experienced considerable output volatility in 1998-99, the subsequent quick recovery from a strong external shock is a sign that the currency board provides fast and credible signals for the economy to react to changes in the global environment. As a result, the periods of restructuring have been fairly short. Most studies have concluded that in international comparisons, the Estonian labor market appears to be relatively flexible and has been able to absorb asymmetric shocks by adjusting labor costs and employment levels to new market conditions (see Figure 4). (3)


The structure of Estonian employment has changed considerably during the 1990s. The labor force has been mobile across sectors and job tenure has been rather short. Labor flows among sectors in Estonia have been large compared to OECD countries, as well as the other acceeding countries [Faggio and Konings, 1999; Haltivanger, Vodopivec, and Gross, 1999; Eamets, 2001]. Firing restrictions are comparable to those of an average EU country in terms of their strictness (according to the OECD index). (4) Yet, geographical mobility of the labor force has been lower (reflected by high and persistent regional unemployment).

The institutional framework underpins labor market flexibility. Wages are mostly bargained at the individual firm level. At the country level, for example, the contracts do not include a direct increase in wages but concentrate on minimum wages, unemployment benefits, and other basic questions of incomes policy. Ex-ante indexation has no role in the Estonian wage setting system. Under these conditions, wages in Estonia have demonstrated downward real (in the tradable sector even nominal) flexibility during the adverse shock of the Russian crisis in 1998-99.

The means-tested character of the social safety net has also supported the flexibility of the labor market by curbing the negative impact of unemployment benefits (until 2003 the replacement ratio was less than 10 percent of the average gross salary). A mandatory unemployment insurance scheme was introduced in 2002, which has made unemployment benefits more comparable to the average in the EU, in terms of the amount and duration of benefits (50 percent of the previous pay during the first 100 days and 40 percent of the previous pay during the next 80 days). However, the share of unemployed persons who are eligible to receive the higher unemployment benefits has been around 20 percent.

Policy Challenges of the Adoption of the Euro--Current Account Deficit

In spite of the high degree of exchange rate stability, nominal convergence, integration with euro-area countries and the flexibility of the economy, there are challenges related to the adoption of the euro. They are mainly related to current account sustainability.

The recent sharp deterioration in the current account deficit (from 6 percent of GDP in 2001 to 12.6 percent of GDP in 2003) has posed questions about its excessiveness and sustainability. The possible excessiveness of the current account deficit is commonly analyzed as a reflection of real sector competitiveness or relative price developments. The main aim is to benchmark the current account deficit against some economic fundamentals or actual REER (Real Effective Exchange Rate) against fundamental REER.

Several studies have tried to assess the sustainability of the current account deficit in Estonia [Haas et al., 2003; Burgess et al., 2003]. The general conclusion from these studies is that some amount of a current account deficit may be justified in the medium-term, as long as competitive developments continue to be favorable. The estimates for an equilibrium current account deficit in Estonia range around 5-8 percent of GDP. For example, the IMF has estimated that a non-excessive current account deficit, which is sustainable and solvent in the medium-term, is around 7.5 percent of GDP, whereas a longer-run equilibrium current account deficit is estimated to be around 5 percent of GDP in the Baltic countries [Haas et al., 2003]. Those results are also in line with the Bank of Estonia's assessments.

The widening of the current account deficit in 2002-03 could be attributed to several factors. The standard explanations for the increase in the current account deficit have been the incidence of "one-off" investments (these are investments to purchase rail cars and locomotives for leasing to the Russian railroads), intensified inflow of foreign capital due to confirmed EU accession, as well as weaker global economic activity combined with sustained domestic demand. However, in the context of entry into ERM II and the adoption of the euro, the issue of the possible misalignment of the real exchange rate also requires careful examination.

In general, the dynamics of different REERs has been relatively stable since the mid-1990s, with one rather strong incident of appreciation (about 12-16 percent) during the Russian crisis in 1998 due to the nominal appreciation of the EEK/RUR exchange rate (see Figure 5). The sharp appreciation of the REER in 1998 was followed by gradual depreciation of REERs during 1999-2000.


It should be noted that changes in the real exchange rate of the Estonian kroon from the mid-1990s have crucially depended on the price-cost index--the ULC-based, PPI-based REER and terms of trade have exhibited neither strong depreciation nor appreciation. The CPI, GDP deflator, and internal REER have shown various degrees of trend appreciation. The differences in the longer-run dynamics of various REER indices stem from the fact that domestic inflation in non-tradable goods and services has been much higher than in the tradable sector. Therefore, the indices that include a significant share of non-tradable goods and services exhibit a stronger appreciation that the indices with a lower share of non-tradable goods and services.

The relative stability of REER developments in recent years reflects the fact that a considerable share of Estonia's exports is directed towards the EU. Moderately appreciating trends in the CPI-based REERs in recent years can, therefore, be connected to the Balassa-Samuelson effect rather than to the loss of competitiveness. Trend real appreciation due to the Balassa-Samuelson effect has been estimated at 1.5--2 percent annually. Other factors that contributed to strong real appreciation in the early years of transition have, to varying degrees, dissipated [Burgess et al., 2003].

Due to difficulties in interpreting the REER indices, an equilibrium REER concept is sometimes used to assess possible exchange rate misalignments. The equilibrium REER concept presumes that there exists an equilibrium real exchange rate, which refers to REER that would prevail if the economy would be simultaneously in internal and external balance. This concept indicates that exchange rates can get seriously misaligned with economic fundamentals, thereby creating substantial macroeconomic imbalances. Moreover, misalignments can be a consequence of inappropriate macroeconomic policies and thus indicate the necessity of a shift in monetary or fiscal policy. Therefore, several studies have attempted to estimate the equilibrium level of the real exchange rate of the Estonian kroon.

Although the Estonian REERs have to some extent appreciated over the last decade, relevant literature has not found much evidence of misalignment of the Estonian kroon (see Table 1 for the summary of the results of different studies). The equilibrium REER estimates obtained from the different approaches indicate that the initial position in 1992 ranges from a 15 percent undervaluation to a small overvaluation of the kroon, depending on the model used. The initial undervaluation, found in several models, turned into a temporary 5-10 percent overvaluation in 1998 (due to adjustments related to both the Russian crisis as well as to contagion effects). The deviation in 1998 was short-lived. At the end of the estimation period, the actual real exchange rate was found to be close to the equilibrium rate in most studies.


Most assessments, based on a broad range of indicators, suggest no clear evidence of exchange rate misalignment that would call into question the underlying competitiveness of the Estonian economy. According to most calculations, the actual real exchange rate has not deviated significantly from its estimated equilibrium value throughout the period and is currently close to the equilibrium exchange rate.

In addition, the estimates of trade elasticity vis-a-vis the exchange rate in those studies indicate that the impact of the REER or NEER (Nominal Effective Exchange Rate) on trade flows is limited. This result seems to be robust across different methods and specifications of the models employed, implying a secondary role for the exchange rate in achieving a sustainable position of external balance. The latter is also reflected by the fact that the dynamics of REER and the current account are rather different, which suggests that trade flows have been determined primarily by income or supply factors rather than by movements in relative prices.

The weak relationship between the current account deficit and the real exchange rate is also evident by the dynamics of the components of tthe current account deficit. In 2003, the deficit of the income balance (6 percent of GDP) explained nearly half of the current account deficit. The size of the deficit of the income balance depends on the stock of foreign investments in Estonia and the profitability of foreign-owned firms, (5) the latter is loosely related to the level of the real exchange rate. The deficit of the trade and service balance (7.9 percent of GDP in 2003) was, to a large extent, explained by "one-off" investments. In 2003, these investments amounted to 3.2 percent of GDP. Once again, the relationship between these investments and the level of the real exchange rate is practically non-existent.


Estonian authorities seek to apply for ERM II membership soon after EU accession. The intention of the authorities is to participate in the ERM II with the standard fluctuation band and to unilaterally maintain the currency board arrangement. The latter implies that the Estonian authorities will unilaterally guarantee a zero percent fluctuation margin of the Estonian kroon. As the authorities intend to be prepared to adopt the euro in mid-2006, the length of the stay in ERM II will be as short as possible.

The early entry into ERM II is appropriate as the perceived costs--short-term costs of fiscal consolidation and the cost of giving up an independent monetary policy and flexible exchange rates as stabilization tools--are practically non-existent in Estonia. The rationale for the maintenance of the currency board arrangement and the early adoption of the euro is based on the high level of exchange rate stability and nominal convergence, the relatively high flexibility of the economy, and integration with the euro area. The high current account deficit in Estonia is not related to the loss of competitiveness but reflects the incidence of "one-off"' investments and an intensified inflow of foreign capital due to confirmed EU accession.
REER Misalignment in Estonia--Results of Different Studies

Author(s)                 Period    Misalignment at the  Method
                                     End of the Period

Hinnosaar et al. [2003]  1995-2003         None          BEER
IMF [2003]               1994-2002          -5%          BEER
Coudert/Couharde [2002]  1993-2001         None          FEER
Smidkova et al. [2002]   1996-2001          10%          FRER
Randveer/Rll [2002]      1994-2000         None          BEER
Filipozzi [2000]         1994-1999          5%           BEER
Begg et al. [1999]       1990-1997         None          B-S, Panel

Note: Column 3 refers to the undervaluation or
the overevalutation of the Estonian kroon.


(1) As the general government's financial assets amount to 9 percent of GDP, the net financial position of the general government is positive.

(2) In 2003, Estonia fulfilled the Maastricht inflation, budget deficit, and public debt criteria. As the government has not issued debt in kroons, the fulfilment of the interest rate criterion cannot be assessed. However, as mentioned, the remaining spreads with the euro area interest rates are 50-100 bases points for the real sector lending rates.

(3) Trends in the Estonian labor market since the early 1990s have been similar to those in the other acceeding countries. Hidden unemployment, a typical feature of centrally planned economies, became transparent and was accompanied by declining employment during the transitional recession. The new equilibrium seems to be characterized by high unemployment (about i0 percent in 2003) and a low labor force participation rate (about 64 percent in 2003 among 15-74 year olds). It means that unemployment is still to a large extent, a structural rather than cyclical problem in Estonia, i.e. it is related to skill mismatching, low capital-to-labor ratio, and a high level of regional unemployment.

(4) The OECD index may overestimate the fact that in Estonia these restrictions are set by law instead of being included in the collective bargaining contracts at the industry and enterprise level.

(5) As most of the profits of foreign-owned firms are reinvested, they are simultaneously recorded in the current account and financial account of the balance of payments.


Burgess, R.; Fabrizio, S.; Xiao, Y. "Competitiveness in the Baltics in the Run-Up to EU Accession," IMF Country Report, No. 03/144, April 2003.

Danilov, T. "The Synchronization of the Business Cycles of Estonia and Eurpean Union," Working Papers of Eesti Pank, No. 2, 2003 (in Estonian).

Eamets, R. " Reallocation of Labor During Transition Dis-Equilibrium and Policy Issues: The Case of Estonia," Tartu University, Ph.D. Thesis, 2001.

Faggio, G.; Konings, J. "Gross Job Flows and Firm Growth in Transition Countries: Evidence Using Firm Level Data on Five Countries," CEPR Discussion Paper No. 2261, 1999.

Frenkel, M.; Nickel, C. "How Symmetric Are the Shocks and the Shock Adjustment Dynamics Between the Euro Area and Central and Eastern European Countries?" IMF WP No. 02/222, 2002.

Fidrmuc, J.; Korhonen, I. "Similarity of Supply and Demand Shocks Between the Euro Area and the CEECs," Bank of Finland Institute for Economies in Transition, Discussion Paper No. 14, 2001.

Haas, R.; Schipke, A.; Stavrev, E.; Rasmussen, T.; Maliszewski, W. "Republic of Estonia: Selected Issues and Statistical Appendix," IMF Country Report, No. 03/331, October 2003.

Haltivanger, J.; Vodopivec, C.; Gross, M. "Worker and Job Flows in a Transition Economy: An Analysis of Estonia," World Bank, Policy Research Working Paper No. 2082, 1999.

Kaasik, U.; Luikmel, P.; Randveer, M. "The Relationship Between the Business Cycle of Estonia and Its Main Trading Partners," Working Papers of Eesti Pank No. 6, 2003 (in Estonian).

Mongelli, F. "New Views on the Optimum Currency Area Theory: What is EMU telling us?" ECB Working Paper No. 138, 2002.

Tavlas, G. "The Theory of Monetary Integration," Open Economies Review, 5/2, 1994, pp. 211-30.


* Bank of Estonia--Estonia
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Title Annotation:Economic and Monetary Union and Enterprise Resource Management
Author:Lattemae, Raoul; Randveer, Martti
Publication:Atlantic Economic Journal
Geographic Code:4EXES
Date:Dec 1, 2004
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