In 1997, all the Baltic states that gained de facto independence in August 1991 can look back at five years of the reintroduction of their national currencies and the independent monetary policy. In the monetary reforms and later monetary policy decisions of Estonia, Latvia and Lithuania both common features and differences can be traced which are reflected in the quantitative as well as qualitative development of the money market of those countries.
'PREHISTORY' OF THE NATIONAL CURRENCIES
Among the Baltic states the idea of the national currency was first suggested by Estonia in September 1987[2]. In the next two or three years the debates on monetary issues in the three Baltic states were directly linked with the striving for economic autonomy in that period. On the other hand, those debates were a sort of purely economic counterweight to the constipated and irresponsible monetary policy of the Gosbank SSSR (State Bank of the USSR) and the Soviet government. In 1985-1988, the Soviet Union's consolidated budget deficit increased from 1.8% of the GDP to 9.2%, and the internal debt increased from 18.2% of the GDP to 35.6%. In 1990 the latter amounted to 56.6% already. Loans to the government accounted for 72.4% of the assets of the Gosbank SSSR on 1 January 1991[3] .
In the conditions of deepening general deficit the ruble had in fact stopped being an economic regulator and its main function seemed to be rubber stamping the administrative decisions and describing them in terms of accounting. Rubles with differing value were being used and these had a different value in different transactions. The situation had reached such a point that the rubles in circulation were being backed by the government's hopeless internal debt (by the beginning of 1991 the central bank's loans to the government exceeded the amount of cash in circulation 3.4 times).
In this context the debates in the Baltics were logically connected with what was going on in the entire Soviet Union and, therefore, the ideas presented in the general key of perestroika and politically quite tame at first found the support of a number of reform-minded economists of Moscow like Vladimir Belkin, Pavel Medvedyev and others. The main suggestion was to introduce the so-called convertible ruble, by way of experiment, in the regions of the Soviet Union which wished to get the status of the Chinese-like special economic zones. However, gradually the idea of introducing the national currencies began to express the striving of the Baltic states for independent statehood on the basis of historical continuity.
Economic Autonomy and 'Local' Currency
The idea of the Baltic states' own currency was accepted on an official level in the spring and summer of 1989 by the economic autonomy concepts adopted by the supreme councils of Estonia, Latvia and Lithuania, in the following wording:
Estonia: 'The Estonian SSR will be responsible for banking and money circulation, including the introduction of its own currency and determining the procedures and rates of exchanging it into other currencies, including the common currency of the Soviet Union, the ruble. The aim of developing the economy of the Estonian SSR is to achieve free convertibility of the Estonian SSR currency against the currencies of foreign countries.'
Lithuania: 'In order to guarantee equivalency of the inter-republic economic relations, protect the interests of the economy and the population and to implement the economic autonomy of the republic, the Lithuanian SSR can introduce its own currency and credit system in accordance with the existing legislation. In that case, the monetary regulation of the economy, issuing of banknotes, control over securities and the exchange rate of the currency will be determined by the State Bank of the Lithuanian SSR.'
Latvia: 'The Latvian SSR has control over banking and the circulation of money, including the introduction of Latvia's own currency and determining its exchange rate against other currencies, including the ruble as the common currency of the Soviet Union.'[4]
As a logical sequel to those documents, the ideas of the 'local' currency were also included into the first banking laws of the Baltic states. Thus, for example, the Bank Law of the Estonian SSR adopted on 28 December 1989, specified one basic task of Eesti Pank (the Bank of Estonia) as guaranteeing the stability of the money circulation, the purchasing power of the money circulating on the territory of the Estonian SSR and determining the exchange rate of the national currency against the Soviet currency as well as the currencies of foreign countries. The Law of the Bank of Lithuania adopted on 13 February 1990, among other matters mentions a hypothetical Lithuanian money, the sole right of the Bank of Lithuania to issue it and its obligation to inform the public of the banknotes to be issued.
This concluded the first, somewhat idealized and heroic stage in the striving for the national currencies of the Baltic states. On one hand, the countries who wished to have their own currency did not even exist yet, on the other hand, out of naivete or for some other reason, it was believed that the launch of a two-tier monetary system was possible, with regional currencies being freely convertible into foreign currencies while the Soviet ruble was not.
In essence, the ideas put forward back then could only have materialized in the form of some kind of dollarisation, something that could not have been even dreamed of at that time. Also, the knowledge of the monetary matters was scarce in all three Baltic states. Looking for analogues to the economic autonomy idea of the late 1980s, some similarities can be seen in the theory of humane economic democracy (socialist market economy) suggested by Ota Šik, one of the leaders of the Prague Spring and later an economics professor at the St. Gallen School of Economics and Social Sciences.
The next stage in the process of the introduction of the Baltic currencies is connected with the so-called transition parliaments elected in 1990 and the first non-Soviet governments appointed by them. The secret aspirations to independence were replaced by the direct demand to restore independence and a logical component of this demand was the launch of an independent monetary system and the introduction of national currencies. The general public suggested all sorts of scenarios for the introduction of the national currencies which varied greatly in their practical application. Thus, the restoration of the 1940 currencies (based on the then exchange rates and gold reserves) was proposed, or adopting the currency of some foreign country (in Estonia the Finnish markka, for example).
As a result of debates in economic and political circles, in 1990-1991 the first official views were formed on how the future monetary reform was to be carried out. In Estonia, where these discussions made the best progress, two alternative monetary reform concepts were drawn up by the end of 1990, one supervised by the government adviser Bo Kragh and the other by the then President of Eesti Pank Rein Otsason[5]. Understandably, these carried the stamp of their time: Estonia, just like Latvia and Lithuania, was de facto still part of the Soviet Union. Therefore, in essence both concepts were planning the introduction of a parallel currency. Gradually, it was to develop into a 'better' currency than the Soviet ruble and acquire the dominating role on the market. However, this could only happen under certain political conditions, with Estonia having the status of a protectorate at least.
The convertibility and stability of the national currency seemed unattainable, at least for the time being. This view was directly expressed by Bo Kragh: 'Without giving away any secrets we can already now claim with 100-per-cent certainty that even many years after the monetary reform in Estonia the country will lack adequate hard currency and gold reserves (let alone economic power) to turn the Estonian kroon into an internationally convertible currency. Estonia is unable to secure the rate of the kroon against the US dollar, the German mark or other internationally convertible currencies, using its foreign currency or gold reserves.'[6]
Although these concepts were hardly of any use while carrying out the actual monetary reform in 1992, they did contain some positive elements. For example, putting an end to the public debate on choosing the 'right' way to carry out the monetary reform so that by the time the reform took place it was carried out under the guidance of Eesti Pank without much outside discussion.
Debates on the future monetary reform were going on also outside the Baltic states. As an example we could mention Estonian Ardo Hansson and Latvians Juris Viksninš and Arnis Vilks. Speaking at a symposium in Travemünde, Germany, immediately after the Baltic states restored their independence, the latter suggested four models of the monetary reform for the Baltics:
1. the so-called laissez-faire where the market itself is allowed to choose the most suitable from among various currencies circulating simultaneously;
2. the introduction of the classical national currencies (with a floating rate);
3. the introduction of the currency with a fixed exchange rate, supported by the central bank's currency interventions;
4. the Baltic Monetary Union [7].Out of these four alternative models, Arnis Vilks pragmatically preferred laissez-faire and the Baltic Monetary Union. The introduction of the classical national currencies in Vilks' and many others' view involved several serious drawbacks. Firstly, it could happen that once the young national governments gained access to the money presses, they would, under strong political pressure, start printing money with no cover in order to solve social or environmental problems. The second consideration was that the small money markets of the Baltic states could prove to be easily destabilised from the outside. And thirdly, Vilks pointed to the danger that potential investors would be confused about the new currencies which would become a stumble block for the inflow of foreign investments.
At the same symposium Ardo Hansson mentioned the currency board systems as one possible model of the future monetary system[8]. In the following months the same model, albeit in the classical exogenous form, was suggested also by Steave H. Hanke, Lars Jonung and Kurt Schuler[9] for Estonia and by Holger Schmieding for all three Baltic states[10]. The former proposed the Swedish krona for Estonia as the anchor currency and Sweden as the base of the currency board, while the latter suggested pegging the Baltic common currency to the ecu and the manager of the common currency, for example, to be Banque de France.
At the same time, in the first months following the restoration of independence none of the three Baltic states was ready to introduce its own national currency. As it turned out, there were more urgent problems to be solved and besides, the Baltics wished to take full advantage of the ruble inflation. Still, following the example of Estonia, Latvia and Lithuania too formed their three-member monetary reform committees. However, the reforms themselves had to wait. The need to speed up the reform emerged at the turn of the year when hyperinflation[11] and the undeclared blockade of the Russian central bank led to a deepening shortage of cash.
PARALLEL AND INTERIM CURRENCIES
In the monetary reforms of all three Baltic states the stage of the interim and permanent money could be distinguished. Usually this applies mainly to Latvia and Lithuania where the different stages - rublis and lats in Latvia and talonas and litas in Lithuania can also be nominally distinguished. But Estonia, too, had its interim money stage. In this case it was the so-called local Soviet ruble the purchasing power of which was considerably lower than in the rest of the Soviet Union due to the earlier legalization of the hidden inflation. The liberalization of prices that was begun in October 1990 (the majority of wage limitations had been liquidated by the local administration by the winter of the same year) led to the transition to the cheap ruble in the situation where prices and wages were still frozen elsewhere in the Soviet Union, including Latvia and Lithuania. In 1990, consumer prices in Estonia increased by 79%, and by 36% in the fourth quarter (against the fourth quarter of 1989 and the third quarter of 1990, respectively). In Latvia consumer prices increased by an average of 29% in 1990 and in Lithuania by only 9%. According to official statistics, the average increase in consumer prices in the Soviet Union in 1990 was 5.3% without the black market, and 6.8% including the black market.
In the conditions of overall galloping inflation, Estonia managed to maintain the advantage gained in 1990 against the other Baltic states until the monetary reform: by June 1992 consumer prices in Estonia had increased by an average of 35.5 times as compared to the end of 1989; in Latvia the increase was 19.2 times and in Lithuania 16.1 times (see Table 1). However, by the time Estonia restored its independence, prices and wages in Estonia were approximately two times higher than in the neighbouring regions.
The cheap local ruble on one hand proved to be a relatively efficient protection for the Estonian domestic market against the coverless rubles of the ruble zone, and on the other hand it brought Estonia's price structure closer to that of Western Europe. This created a relative plentitude of goods in Estonia for its 'local' rubles (as compared to the rest of the ruble zone, of course). The price of the success was the sacrificing of the earlier savings but at the old prices the 'sacrificed' rubles would not have bought anything anyway.
Strangely enough, the central authorities of the Soviet Union did not react to the 'act of sabotage' arranged against the ruble in Estonia. On the contrary, in the conditions where the surplus of the loans granted to the economy and the population in 1990 decreased by 6.8% in the entire Soviet Union, it increased 8.6% in Latvia, 17.7% in Lithuania and 37% in Estonia yet[12] .
At the same time such an unco-ordinated activity of Estonia, which did not find quick support by Latvia and Lithuania who perhaps did not wish to support it, led to a certain friction between the Baltic states. Thus, the Latvian Prime Minister Ivars Godmanis on several occasions made sharp statements claiming that the cheap rubles of Estonia were emptying the Latvian market.
In addition to striving for preventive inflation, another main monetary policy phenomenon in Estonia's economic policy of those years was the encouraging of dollarisation, thus creating an alternative foreign currency circulation and attracting foreign currency into Estonia. Relying mainly on the experience of Poland in the 1980s, the Estonian government worked out a so-called dollarisation programme at the beginning of 1991, which was not given an official status but which in the legal sense meant an open conflict with the official foreign currency regulations of the Soviet Union as well as the criminal code[13].
In March 1991, Eesti Pank started independently quoting the Soviet ruble, proceeding from the black market exchange rates. In essence, this meant local devaluation of the Soviet ruble. Brian van Arkadie and Mats Karlsson have called such practice equal to introducing a new 100 per cent backed currency[14]: 'An alternative strategy would be for the republics to legalise or even promote foreign currency use alongside the ruble. This has already happened spontaneously, especially in Estonia. This would be similar in effect to issuing a new national currency against 100 per cent backing in foreign exchange (with the important difference that with 100 per cent foreign exchange-backed currency, the issuing agency or currency board enjoys the interest to be earned from the foreign-exchange holdings).'
The inflation anticipating policy combined with encouraging dollarisation (although this cannot be called monetary policy in the real sense) facilitated considerably the subsequent introduction of the kroon - the bulk of the rubles had by that time been eaten up by inflation or exchanged into foreign currency or some material values (furniture, vodka, sugar, etc) in the hope of 'converting' them in the future.
It was these foreign currency savings that contributed to the quick growth in the foreign currency reserves of Eesti Pank after the monetary reform. Thus, for example, in June 1992 (the month of the monetary reform) the sums earned from the sale of convertible foreign currency accounted for 8.3% of the net income of an average Estonian family. In July and August the respective figure was 3.3 and 4.8%, respectively. In the three months before the monetary reform the figure had ranged from 1.7 to 2.6%[15].
Similar phenomena and developments took place in Latvia and Lithuania, but with a certain time delay (six to twelve months) in favour of Estonia, thanks to which Estonia managed to avoid the introduction of a parallel or interim currency.
In order to overcome the ever deepening shortage of cash (by that time hyperinflation had been triggered or was about to in the CIS countries, with consumer prices in Russia increasing 3.5 times in January 1992 alone) Lithuania introduced the coupon-like talonas as a parallel currency on 1 May 1992, and Latvia introduced the so-called Latvian ruble or rublis on 7 May 1992. The exchange rate of both was 1:1 against the Soviet ruble.
Estonia managed to avoid the introduction of this sort of parallel money mostly by coping with the cash shortage by using bank cheques and expanding the use of non-cash transactions, but also by delaying the payment of wages, pensions and social benefits. However, the proposals for introducing parallel money were also made in Estonia. Thus, the town of Tartu briefly issued its own 'city money' and less than two months before the monetary reform the government proposed that the future 1- or 2-kroon banknotes be introduced as a surrogate money for big-denomination rubles.
In Latvia the rublis and in Lithuania the talonas were at first circulating parallel with the Soviet ruble and various foreign currencies. The introduction of the rublis and the talonas, meant at first as a measure to overcome the shortage of cash by introducing an extra currency, later became the first stage of the gradual monetary reform of those two Baltic states.
After all rubles were exchanged into rublis without any restrictions on 7-15 July 1992, and the rubles on the bank accounts had been exchanged by 20 July, the rublis became the national currency of Latvia, albeit as an interim money. Lithuania replaced the rubles with its interim money, talonas, by 1 October. The dollarisation that in Estonia had quickly subsided after the monetary reform only began to gain momentum in Latvia and Lithuania after the introduction of the interim currencies.
The introduction of such new banknotes can only conditionally be termed as a monetary reform. The introduction of the surrogate money originally meant to be just an additional tender developed into the so-called evolutionary monetary reform after the exchange rate of the rublis and talonas began to increase against the Soviet ruble due to the lower inflation in Latvia and Lithuania (consumer prices increased 26.1 times in Russia in 1992; see Table 2). The exchange rate of the rublis and talonas against the convertible currencies depended on the ratio of demand and supply.
The introduction of the interim money which gradually distanced Latvia and Lithuania from the ruble zone allowed them to start carrying out their own monetary policy. In Latvia it became restrictive already in the autumn of 1992. In October the Bank of Latvia increased the refinancing rate to 120% although in the context of the real inflation it was negative at the time. This led to the stabilization of the exchange rate of the rublis against foreign currencies and from the beginning of 1993 the rublis even began to strengthen against foreign currencies (see Table 3).
However, by their nature the rublis and the talonas first and foremost served the purpose of a legal tender. This was underlined also by the low quality of the banknotes (bad colour quality and few security elements that made the banknotes easy to counterfeit). The attitude towards the rublis and the talonas as not quite the real money was at first transferred to the lats and the litas and it took some time before the attitudes changed. At the same time the impact of the interim money on the economies of Latvia and Lithuania and on the restructuring of the orientation to the foreign market was smaller than in Estonia where the permanent national currency the kroon had been introduced by that time, detaching Estonia completely from the ruble zone.
INTRODUCTION OF THE NATIONAL CURRENCY
The first Baltic country to introduce its own national currency was Estonia where the monetary reform began on 20 June 1992, exactly 44 years after the monetary reform of the German western zones that has become the classics of monetary reforms. Although the impact of the German monetary reform on the technical side of the Estonian reform was minimal, the 'philosophy' of the German reform played an important role in the 1992 Estonian reform.
As far as the economy was concerned it was the most suitable time for Estonia to carry out its monetary reform. The unavoidable explosive price hike of the imported raw materials and energy was already over. In terms of the price increases a certain stability had been achieved (in the second quarter of 1992 consumer prices increased 'only' 30% in Estonia). Furthermore, the Russian central bank had for the past six months been trying to forcibly stabilize the exchange rate of the ruble (the exchange rate had dropped from 230 rubles per one dollar in January to 110-115 rubles per one dollar in June) which also affected the rubles circulating in Estonia. It was also high time to leave the ruble zone because a new wave of inflation began in the autumn.
The denominational monetary reform (10 rubles equalled 1 kroon) removed the rubles from circulation. The kroon was pegged to the German mark under the currency board system, and proceeding from the original gold and foreign exchange reserves as well as the demand and supply of foreign currency, the exchange rate was set at 1 DEM for 8 kroons. The considerations that led Estonia to decide in favour of the currency board system in 1992 deserve a separate article. At first the collateral of the kroon was mainly made up of the pre-war gold deposits returned to Estonia by Western banks shortly before the monetary reform. A total of 11.3 tonnes of gold was received in 1992-1993 in either gold or in the form of monetary compensation. Latvia was returned seven tonnes of gold frozen in 1940 and Lithuania received six tonnes of gold.
On the outside, the replacement of the rublis with the lats was just a 200-time denomination. Namely, from 5 March to 18 October 1993, all rublis banknotes were gradually exchanged into lats. Technically, nothing happened on 5 March except that the Bank of Latvia issued a new 1,000-rublis denomination which was called 5 lats. This was also emphasized by the President of the Bank of Latvia Einars Repše: 'We will just introduce new, more carefully designed banknotes that carry the name that is closer to our hearts. The lats is just the same as the Latvian ruble, it only looks different.'[16]. To some extent the somewhat premature introduction of the first lats banknotes was due to the new 500-rublis banknotes that had proven too easy to counterfeit and had to be replaced.
There were some weak points too in the Latvian monetary reform. Due to the small size of the money market the floating exchange rate of the Latvian currency was very vulnerable to any kind of speculative actions. This became clearly evident shortly before the introduction of the lats when the exchange rate of the dollar on 22-25 February suddenly plunged from 170 rublis per dollar to 100-120 rublis per dollar. In Estonia this was enviously interpreted as the strengthening of the Latvian currency, the Latvian monetary reform was seen as a more 'correct' one and the extremely high exchange rate of the lats was considered the right choice. However, the Bank of Latvia saw in it the united front of the commercial banks to force people to hurry to sell their cheapening dollars to the banks. The commercial banks in their turn accused the Bank of Latvia of currency interventions. Obviously, the timing of the attack on the lats was bad. Luckily, the value of the rublis dropped again before 5 March, otherwise the lats would have began its life with a quick devaluation which would have been a serious psychological blow to the image of the new currency.
Thus, on the outside the two-stage monetary reform of Latvia repeated the 1920s reform. Back then the lats had replaced the Latvian ruble in 1922.
The Latvian monetary reform was over by February 1994 when the lats was informally and through the interventions of the central bank pegged to the IMF currency unit SDR at the rate 1 SDR = 0.7997 lats (see Table 4).
In Lithuania the transition from the talonas to the litas took place from 25 June to 1 August 1993. The transition was denominational in Lithuania as well, at the exchange rate of 100:1. From 1 April 1994, Lithuania pegged the floating litas to the US dollar under the currency board system at the exchange rate of 1 USD = 4 litas.
While in Estonia the fixed exchange rate against the German mark and the currency board system were just the means to bring stability into the monetary system and the economy as a whole, Lithuania's fixed exchange rate could be seen as a goal in itself since it was introduced only after the monetary reform when the inflation buffer had mostly been used up. Another peculiarity of the Lithuanian currency board system was that the right to change the litas-dollar peg was granted to the government who had to co-ordinate it with the Bank of Lithuania. Only the 20 July amendments to the law gave the right to change the peg to the central bank but on the condition of co-ordinating it with the government.
1 April 1994 can be seen as the end of Lithuania's evolutionary monetary reform although debates between the supporters and opponents of the currency board system continued and in 1997 a decision was made to gradually abandon the currency board.
As to monetary policy, Latvia adopted a tight monetary policy in the autumn of 1992, while Lithuania preferred a clearly expansionist monetary policy until April 1993.
Securing the Stability of the External Value of the Currency
All three Baltic states have based their monetary policy on securing the external value of the national currency. True, only Estonia made this decision from the very start, pegging the kroon to the German mark. The exchange rate of the kroon against the currencies of third countries is based on the exchange rate of the German mark. Latvia and Lithuania started with the floating exchange rate, allowing the market to determine the exchange rate of the rublis and the talonas as well as the lats and the litas. Hence the essential differences in the development of the nominal rate of the kroon, the rublis/lats and the talonas/litas.
Due to the fixed external value the kroon was over-devalued against the internal purchasing power, although the exchange rate of the kroon reflected the actual demand and supply on the hard currency market at that time. Over-devaluation gave the Estonian economy a possibility and time to adapt to the new situation. It guaranteed the competitiveness of domestic production resources in the longer run (this allows us to speak of evolutionary structural policy) while the 1:8 exchange rate at the same time also proved a strong protectionist barrier against the imports. Estonia passed the phase of the so-called floating rate on ruble basis before the monetary reform.
The currencies of Latvia and Lithuania were characterised by a considerable revaluation - in Latvia since January 1993 and in Lithuania since April 1993 (see Table 3) - which came to a halt only after the exchange rate was pegged to the SDR (in February 1994) and the dollar (in April 1994), respectively. The increasing nominal rate of the rublis/lats and talonas/litas undoubtedly slowed down inflation. This can be clearly seen in case of Lithuania where the transition from the earlier slack monetary policy to a strict one in April 1993 led to the sharp revaluation of the talonas in the conditions of the floating exchange rate and speedy reduction of the inflation rate.
At the same time the increase in the nominal rate had a strong negative impact on the exports of Latvia and Lithuania. Thus, Latvia's exports decreased from 204.6 million lats in the first quarter of 1993 to 120.9 million lats in the first quarter of 1994, or by 40.9% (see Table 5) which the revaluation of the lats expressed in the US dollars or German marks was unable to compensate for (in the dollar terms Latvia's exports was down 19% and in terms of the German mark the decline was 14%). In case of Lithuania too at least a quantitative connection between the 'floating' revaluation of the litas and the decline of Lithuanian exports can be observed: exports decreased from 2,663 million litas in the third quarter of 1993 to 1,668 million litas in the first quarter of 1994, or by 37%. Expressed in dollars and the German marks Lithuania's exports decreased by 33 and 31%, respectively, over that short period of time.
Just like the fixed exchange rate of the lats had stopped the decline in Latvia's exports, the decline in Lithuania's exports stopped after the exchange rate of the litas was fixed. No such decline in exports occurred in Estonia. On the contrary, from the first quarter of 1993 to the first quarter of 1994 exports increased by 88.3% in terms of kroons and by 79% in terms of dollars.
Fixed versus Floating Exchange Rate
Contrary to the common understanding, the lats of today can be seen as a classical currency with a fixed exchange rate secured by the central bank's currency interventions. The kroon and the litas, with their external values fixed against a stable anchor currency, fluctuate against the currencies of the third countries together with the anchor currencies, the German mark and the US dollar.
Professor Manfred Willms of Kiel University, for example, has classified currencies based on the currency board system as currencies with adapted fixed exchange rates (feste aber anpassungsfähige Wechselkurse) and thus equal to currencies of the European Monetary System[17] (see also Graph 1).
All three Baltic states have used liberal foreign exchange policy. An extreme example in this sense is Latvia where the money market for a long time was no different from the market of any other commodity. Lithuania, and particularly Estonia have tried to keep the foreign exchange market under control and in the post-monetary reform period the aim was to curb the dollarisation that dominated in the last months of the ruble period. In 1994, the Baltic states declared the convertibility of their currencies in accordance with Article 8 of the IMF.
Free convertibility of the kroon, the lats and the litas and the liberal foreign exchange policy of the Baltic states have secured full competitiveness on the foreign exchange markets of the Baltics. It reduced the margins between the buying and selling rates of the currencies to the minimum (particularly in Estonia) which testifies to the trust in the national currencies (see Table 6)[18].
MONEY SUPPLY AND DEVELOPMENT OF MONEY MARKETS
Restraining Policies of the Estonian and Lithuanian Central Banks
The peculiarities of the money supply in the Baltic states were first and foremost caused by the different monetary systems chosen by them, although the money supply in each country is affected by the general economic, political and macroeconomic development. In Estonia and Lithuania, where the monetary system is based on the currency board, the supply of the base money depends on the increase or decrease in the foreign exchange reserves (see Table 7 and Figure 1, Figure 2 and Figure 3).
At the same time the role of the central bank in the money supply has been relatively modest. To some extent the money supply can be affected through the reserve requirement of the commercial banks but so far the money supply has been influenced by the banking regulations. In Estonia, for example, the 10% level of the reserve requirement is in force since the end of 1992. In Lithuania the 12% level of reserve requirement was applied until the banking crisis at the beginning of 1996. In order to increase the liquidity of the banking system, the Bank of Lithuania then brought the reserve level temporarily down to 5%. Eesti Pank acted the same way during the banking crisis in the autumn and winter of 1992, abandoning the earlier plan to increase the level of reserve requirement gradually to 15%, and returning to 10% from the then 12% level. In Latvia, the level of reserve requirement has been 8%. The concrete practice of calculating the reserve requirement differs from country to country and has undergone changes from time to time. In Lithuania, for example, commercial banks have to keep their reserve requirement at the central bank in foreign currency.
The Bank of Latvia has all the classical possibilities of regulating the money supply at its disposal although these have been used relatively seldom. De facto the Bank of Latvia has rather been following the technology of the currency board, with all the issued cash backed by the foreign exchange reserves. An exception was made during the 1995 banking crisis when the net foreign assets of the Bank of Latvia decreased by 27.2% between January and July (the amount of the cash decreased with a three-month time delay, by 13.5% from April to October). From August to December 1996 the net foreign assets of the Bank of Latvia fully covered all the base money (see Table 7). Unlike the central banks of Estonia and Lithuania, the Bank of Latvia refinances the money market by granting loans to commercial banks, arranging credit auctions and carrying out open market operations.
Formally, the Bank of Latvia held the refinancing rate higher than inflation from December 1992 until the second half of 1996, which should mean that a stabilization policy based on curbing the money supply was applied (see Table 8). However, such a quantitative connection is mostly an illusion, particularly if we take into account the fact that for a long time the loan interests of the Latvian commercial banks were considerably higher than the central bank's refinancing rate. The case seems to be that the Bank of Latvia has been passively following the trends of the money market, taking a more active role only during the 1995 banking crisis and at the turn of 1996 and 1997.
The high interest rates of the Latvian money market must first and foremost be attributed to external factors, and specifically the direct influence of the Russian money market with its much higher interest rates in the form of the so-called money transit. This became particularly apparent in 1993-1995 when it contributed to the future banking crisis.
Experts from Latvia and foreign countries have admitted that the Latvian money market became more and more detached from the Latvian economy. According to Valerijs Praude, the Latvian monetary policy 'led to the distancing of the Latvian monetary system from the local industry'[19]. Imants Kirtovskis has said that the Latvian credit resources serviced the economy of other countries while 'changes in the money supply were not regulated by the monetary policy of the central bank but followed the logic of their own'[20]. The international consulting agency Roland Berger & Partner GmbH pointed out that 'Latvian interest rates were determined in Russia'[21].
The aptness of such claims was proven by the banking crisis in the spring and summer of 1995. On one hand, the leading commercial banks of Latvia had been operating largely as investment funds, with their loan portfolios made up of highly risky projects, considering the local inflation level. On the other hand, the borrowers in Latvia could not rely on the so-called inflation guarantee in paying back their loans because the annual interests of short-term loans were on an average two times higher than the consumer price index.
The 1995 banking crisis led to the moratorium on four out of the ten largest commercial banks in Latvia, with the total amount of frozen accounts from May to November reaching 135.0-155.1 million lats or 20.5-24.6% of the money supply M2 (see Figure 4). By December 1995 the money supply M2 had decreased by 170 million lats as compared to the pre-crisis period (April) or by 24.5%, and did not reach the pre-crisis level even by the beginning of 1997 (see Table 9). The Lithuanian banking crisis at the beginning of 1996, too, led to the decrease in the foreign currency reserves and the money supply, although in a smaller extent and for a shorter period than in Latvia.
Institutional Guidance of the Money Market
Unlike in Latvia where the central bank has tried to influence the money market through the means at its disposal, the activity of Eesti Pank has been focusing on the institutional development of the money market. In May 1993, Eesti Pank began issuing the 28-day certificates of deposit (CD) to support the commercial banks in depositing their free funds. In June 1993, the overnight inter-bank lending market was launched and already in 1994 its average monthly turnover reached 1.4 billion kroons. Although the first overnight transactions took place in Latvia in November 1993 (in Lithuania only at the end of 1996) the overnight market proper developed only in 1995 and interest rates were four or five times higher than in Estonia. Somewhat surprisingly, Estonia's interest rates of both CDs and overnight loans fell quickly to the level of the German mark interest rates (see Table 10).
In Latvia, the same function has been performed by the government bonds which due to their high interest rates (at the stable external value of the lats and the low risk level) led to the inflow of short-term money to Latvia and thus increased both the money supply and the instability of the Latvian money market.
The Estonian and Lithuanian money system in principle rules out the possibility of the central bank crediting the government while in Latvia the central bank lends also to the government. The lending was the most extensive during the 1995 budget crisis that coincided with the banking crisis when the share of government loans in the central bank assets increased from 2.6-4.6% in January-April to 10.2-12.2% in May-June.
Differences of the Money Markets
The major quantitative differences of the money markets of Estonia, Latvia and Lithuania can be seen in the considerable differences in the interest rates of the commercial banks and the different level of cash and foreign exchange on the market (see Table 11). As far as the level of interests is concerned, these should be more or less the same in all three countries. In reality, the differences are quite considerable in different countries although since the end of 1996 the levels have begun to move closer to one another. On one side we have Estonia where the relatively low interest rates are clearly below the consumer price index, and on the other side are Latvia and Lithuania with high and usually positive real interests (see Table 12 and Table 13).
Such a situation is somewhat contradictory, particularly if we compare Estonia and Latvia and take into account Latvia's somewhat lower inflation and the strong revaluation of the rublis/lats at the first time. The main reason is the stronger orientation towards the former Soviet Union of the Latvian and Lithuanian banking sector. In addition to this, the money markets of Latvia and Lithuania are more uneven as far as time is concerned and there are contradictions between the loans of different length.
Another sphere with major differences is the structure of the money supply. The differences concern the share of cash and foreign currency in the money supply and the share of time deposits in the total volume of deposits. The young economies of the Baltic states are characterised by the big share of cash in the money supply (see Table 9). In Estonia and Lithuania this derives from the currency board system which provides the so-called absolute guarantee for cash. Therefore, the even higher share of cash in the Latvian monetary system can be seen as something of a paradox, particularly in view of the high interest rates paid on lats deposits (see Table 12).
Thanks to high interest rates, the volume of time deposits is substantial only in Latvia. Thus, the share of time deposits in lats in the money supply M2D was usually 30-40% until the end of 1995 when the banking crisis was resolved. At the same time it was barely 10% in Estonia. In 1996, the share of lats time deposits dropped to 6-7% which is two times below the respective level of Estonia and Lithuania. In Lithuania the share of litas time deposits increased until the second half of 1994 and then began to fall. At the end of 1996, the share of time deposits in national currencies in the money supply M2D amounted to 14.4% in Estonia, 12.6% in Lithuania and 6.4% in Latvia.
As to the dollarisation of the money supply, here too we can see Estonia with the share of foreign currency deposits at around 10% of the money supply M2 on one side and Latvia and Lithuania with the 25-33% share on the other side. The big share of the foreign currency deposits in all three Baltic states can be attributed to the openness of their economies which in case of Latvia and Lithuania has been amplified by the lower trust in the national currencies and the banks. This mistrust has not been overcome even by the strong revaluation of the lats and the litas and considerably higher interest rates paid on deposits in the national currency as compared to deposits in foreign currency. In case of Estonia the administrative restrictions set on the foreign currency deposits immediately after the monetary reform may be affecting the behaviour of the population also later.
At the end of 1996, the amount of cash in circulation per capita was the equivalent of 235 US dollars in Estonia, 192 in Latvia and 128 in Lithuania, while the corresponding indicator characterizing the money supply M2 was 777, 456 and 378 dollars, respectively. The ratio of cash in circulation and the GDP was 9.2% in Estonia in 1995, 8.9% in Latvia and 8.0% in Lithuania; the ratio of the money supply M2 and the GDP was 25.0, 22.2 and 24.0%, respectively.
The monetary policy of Estonia, Latvia and Lithuania and the development of their money markets after the introduction of the national currencies can be estimated in many ways. The evaluation may also depend on whether one looks at the processes from within or from the outside. In any case, however, we have to keep in mind that the kroon, the lats and the litas are the so-called young currencies and that the Baltic states are just taking the first steps in their monetary policy. We must not forget that for half a century they lived in society where permanent money was almost unknown and monetary policy (if there was any in the Soviet Union) was the monopoly of Moscow.
Only time will give the final evaluation of the reforms and the choices made so far although five years is a long enough period for certain (statistical) trends and first results to become manifest. However, we should not ignore the general economic and political background of different countries (the budget deficit being allowed or not, inclination towards protectionism, the extent of subsidization, tax policy, etc).
Among the estimations given to the monetary reforms and policy of the Baltic states one can find those that praise Estonia that choose the currency board system and surprised the world in 1992. Others acknowledge the success of Latvia that preferred to start as the classical central bank and take all the risks involved. However, some four or five years ago the world's leading monetary experts had no faith in the Baltic states' ability to guarantee free convertibility of the national currencies from the very beginning, maintain the stability of their external value and quickly overcome hyperinflation. Moreover, the Baltic states considered free convertibility of the national currencies not to be the aim as it is usually done, but rather as a means to introduce stability into the monetary system and the economy as a whole.
Some aspects of the Baltic monetary reforms and the decisions of the first years will obviously find a place among the world 'monetary classics' in a few years' time. In case of Estonia this might be, for example, the choice of the German mark as the anchor currency for the kroon. As it was, a currency was chosen on which only a fraction of Estonia's foreign trade was based and which was clearly in the shadow of the Finnish markka, the Swedish krona and the US dollar during the pre-reform dollarisation period. On the international arena, the monetary reforms and policies of Estonia and Latvia have found more recognition so far, while the attitude towards the developments in Lithuania have been more reserved [22].
Kalev Kukk
[1] The author of the present article, Kalev Kukk, PhD (Econ), is Member of the Board of Eesti Pank.
[2] Siim Kallas, Tiit Made, Edgar
Savisaar and Mikk Titma - Ettepanek: kogu Eesti NSV täielikule
Isemajandamisele (Proposal: Full Economic Autonomy for the Estonian SSR). In the newspaper Edasi, 26 September 1987.
[3] See Narodnoye Khozyaistvo SSSR v 1990 g., pp 5-28.
[4] See Basics of Economic Autonomy of the Estonian SSR (Article 9), adopted on 18 May 1989;
Basics of Economic Autonomy of the Lithuanian SSR (Article 19),
adopted on 19 May 1989;
On the Economic Autonomy of the Latvian SSR (Article 11), adopted
on 27 July 1989.
[5] See The Concepts of Introduction of the National Currency. Tallinn, 1990.
[6] See The Concepts of Introduction of the National Currency, p 10. Tallinn, 1990.
[7] See A. Vilks - Zur Frage der Währungsordnung in den baltischen Staaten in the volume Die Wirtschaft der baltischen Staaten im Umbruch, pp 47-54. Verlag
Wissenschaft und Politik, Köln, 1992.
[8] A.H. Hansson - Währungsreform in Estland in the volume Die
Wirtschaft der baltischen Staaten im Umbruch, p
83. Verlag Wissenschaft und Politik, Köln, 1992.
[9] See S.H. Hanke, L. Jonung and K. Schuler - Monetary Reform for Free Estonia. A Currency Board Solution.
Baltimore-Stockholm, 1991.
[10] Hansaregion Baltikum. Bericht der Internationalen Studiengruppe, p 28. Eesti Komitee,
1992.
[11] In three months, from December 1991 to February 1992 consumer prices increased 4.2 times in Estonia, 3.7 times in Latvia and 3.4 times in Lithuania.
[12] See Narodnoye Khozyaistvo SSSR v 1990 g., p 30.
[13] See Dollari ees on kõik võrdsed (The Dollar Makes Everybody Equal, in the weekly Kaubaleht No 4, 1991) and Dollariseerumine: kas ka siin maksab Poola kogemus? (Dollarisation: Is It Based on the Polish Experience? in the weekly Äripäev, 20-26 February 1991) by Kalev Kukk.
[14] See B. van Arkadie and M. Karlsson - Economic Survey of the Baltic States, p 145. New York University Press, N.Y. 1992.
[15] See Eesti sotsiaalstatistikat, (Estonian Social Statistics), p 24. Tallinn, 1994.
[16] See the newspaper Diena, 2 March 1993.
[17] M. Willms - Internationale Währungspolitik, p 153. Verlag Franz Vahlen, München, 1995.
[18] A randomly chosen example of the difference in buying and selling rates of the kroon and the lats in a third country: on 14 May 1997, the difference between the selling and the buying
rate of the Estonian kroon at the Forex money exchanges at the Arlanda Airport in Stockholm was 7.1%, the difference between the selling and buying rate of the lats was 25% and the Lithuanian litas was not quoted. By way of comparison, the selling and buying rates of the German mark and Austrian shilling differed
2%, the Finnish markka 3%, the Polish zloty 8.2%, the Czech koruna 10.7%, the Russian ruble 28% and the Hungarian forint 31.2%.
[19] V. Praude - Monetary and Banking Reforms - Links with Industrial Restructuring, p 13. Riga, February 1995.
[20] See Business & The Baltics, 8 March 1995.
[21] See Wirtschaftsreport. Estland, Lettland und Litauen, p 9. Roland Berger & Partner, No 1, 1995.
[22] See S. Lainela and P. Sutela - The Baltic Economics in Transition. Bank of Finland, Helsinki, 1994;
K. Schrader and C.-F. Laaser - Die baltischen
Staaten auf dem Weg nach Europa. Institut für Weltwirtschaft,
Kieler Studien, 264. Tübingen, 1994;
K. Schrader and C.-F. Laaser - Der Transformationsprozeß in den baltischen Staaten: Ordnungspolitische Fortschritte und strukturelle
Anpassungsprozesse. Institut für Weltwirtschaft, Kieler
Arbeitspapiere No 783, January 1997.
F. Träumer - Währungsreformen in den Baltischen Ländern. Bulletin, Deutsche Bank Research, pp 13-20, Frankfurt am Main, 11.04.1994.