The National Currency of Estonia — The Estonian Kroon

In introducing the kroon, Estonia adopted the currency board system. In this system, the state issues national currency only in the amount covered by its gold or hard currency reserves. At the same time, the national currency may be exchanged at a fixed rate with a chosen hard currency (the Estonian kroon is tied to the Deutsche Mark). The currency board system is arguably the most simple, credible and pressure-resistant way to introduce a national currency in undeveloped monetary conditions. Estonia’s decision to leave the rouble zone in June 1992 and introduce its own currency – the kroon – provided the foundation for the stabilisation and restructuring of the economy.

The reintroduction of a national currency in Estonia was first discussed as early as 1987, when it would have given Estonia a measure of economic independence within the Soviet Union. The kroon also had historical significance since an earlier version of the kroon had served as the Estonian currency until the Soviet occupation of 1940. Preparations for the monetary reform were initiated after Estonia regained independence in 1991, and the kroon was introduced in June 1992. At that time the economic situation in Estonia was very different from that of today. Poor production and distribution led to a tremendous shortage of goods, a number of basic products were rationed, and certain shops and restaurants only accepted hard currency.

The choice to follow the currency board system was based on Estonia’s foreign exchange reserves and Estonian gold which was deposited in the foreign banks before World War II and then recovered after the restoration of independence, as well as the skills, education and experience of those in the banking sector. The Bank of Estonia, the state bank, pegged the kroon to the Deutsche Mark at the rate of 8 kroons to 1 Deutsche Mark (1 DEM = 8 EEK). This rate was based on the market rate between the rouble and the Deutsche Mark at the time of the kroon’s introduction. Although Estonia sought to introduce an exchange rate that reflected market realities, the precise rate between the kroon and the Deutsche Mark was not nearly as important as the determination to keep to the chosen rate, based on the principles of the currency board system. The kroon’s 8:1 peg to the Deutsche Mark can be changed only by Estonia’s Parliament.

The aim of a currency board system is to maintain currency convertibility and a fixed exchange rate and thereby help to stabilise the economy, bring about structural change and integrate the country into the world economy as quickly as possible. One important advantage of the currency board system is that it cannot be influenced by any political power. Since the introduction of the national currency, the Bank of Estonia has guaranteed the exchange value of all kroon notes and kroon-denominated central bank deposits of the domestic banking system. This is backed with Estonian gold reserves.

Estonia has decided that in order to maintain the strict adherence to the principles of the currency board, the central bank could not be permitted to engage in crediting the Estonian economy and lending to commercial banks. The Bank of Estonia was therefore split into two departments. The Issue Department functions along the principles of the currency board, and the Banking Department is responsible for other central banking functions. The Issue Department holds enough foreign exchange to back all of its kroon liabilities, while any excess foreign exchange which it accumulates is transferred to the Banking Department.

Because the Estonian banking system was underdeveloped and did not have the full confidence of the public at the time the currency board system was introduced, a strict system of capital controls was set up to support it. These restrictions have been eased as the central bank has gained operating experience. Legislation dropping the last few regulations (concerning the opening of foreign currency accounts by Estonian private citizens) was adopted in May 1993.

One prerequisite for the successful operation of a currency board system is that the country’s central bank is not able to lend to the government. The Bank of Estonia is therefore prohibited from doing this; if the Government needs domestic financing, it must borrow from the commercial banking system. In addition, the central bank, as a matter of policy, does not engage in open market operations. Interest rate levels and the yield curve in Estonia are therefore genuinely market-determined.

The Bank of Estonia has enjoyed strong public and parliamentary support. Before the kroon’s introduction, it was widely expected that the new currency would not be able to serve as the country’s sole legal tender, and parallel circulation of hard currencies was envisaged. This, however, has not occurred. Similarly, many feared that the introduction of the kroon would bring about an outflow of foreign reserves. Instead, there has been a net inflow. In June 1993, parliament passed without opposition the the Bank of Estonia Act, guaranteeing the independence of the central bank and securing for it a position of considerable influence in the country’s financial system.

When Estonia experienced a crisis in its banking system in late 1992 and early 1993, the Bank of Estonia chose to let several banks with weak balance sheets fail rather than grant them emergency loans, and the country’s financial system successfully weathered the storm. The Bank’s handling of the crisis has considerably strengthened the financial discipline of Estonian commercial banks and demonstrated the central bank’s ability to operate within the limitations imposed by the system of the currency board.

Estonia has also established control over credit creation by implementing balanced general government budgets starting from the year 1992, and by eliminating all central bank credit to enterprises. The process of decontrolling prices was almost complete by the time the kroon was introduced and the tax-based incomes policy implemented after the monetary reform helped contain any continuing pressures from wage raises.

The Estonian authorities have simultaneously liberalised external trade and payments arrangements and introduced bold structural reforms, including the privatisation of large enterprises and the implementation of an effective bankruptcy law in September 1992. Due to these measures, Estonia’s average monthly inflation rate fell to below 2 percent by mid 1993, and the exchange rate stability inherent in the Deutsche Mark peg contributed to a sharp reorientation of trade from the former Soviet Union to developed economies of the West. The burgeoning private sector and growth of exports to western industrial countries encouraged inward investment and permitted a modest recovery in output beginning in mid 1993.

The progress of economic reform and the rapid success of the Estonian kroon give grounds for optimism that these problems will be solved and Estonia’s goal of full integration with Europe will be realised.