ESTONIAN INTEREST RATES: UP OR DOWN?

Estonia’s financial markets are among the most developed in the post-communist world. This is apparent in the low interest rates now charged by Estonian banks: The 3-month Talibid interest rate was, as of mid-April, down to 4.33 percent. By contrast, interest rates on bank credits in Poland and Hungary are in the double digits, while most interest rates in Russia are above 30 percent. In fact, Estonia’s interest rates are already at the levels required for EU countries seeking to join the Economic and Monetary Union. According to the Maastricht criteria for EMU membership, long-term interest rates can not be more than two percentage points above those of the three best-performing EU countries. Estonian analysts, however, disagree about the course of interest-rate trends this year.

Estonian interest rates have been on a downward trend for the past couple of years. Short-term interest rates on kroon-denominated loans ended 1998 at 16.7 percent. They fell steadily in the first half of 1999, picked up in the third quarter, but then decreased quickly in the fourth quarter, ending the year at 8.7 percent. Due to Estonia’s currency board monetary system, the central bank does not set interest rates. Instead, market liquidity and international trends influence rates in Estonia. But analysts are divided about the importance of the various determinant of Estonia’s interest rates, and consequently disagree about what will happen to Estonian interest rates in 2000 and beyond.

Due to the currency board and the small size of Estonia’s money market, short-term interest rates respond rapidly to changes in capital flows. According to the central bank, the higher interest rates anticipated in Western Europe and the United States this year will push up Estonian money market rates. Therefore, the Bank expects no further falls in interest rates in the near term (Central Europe Business Daily, April 7). According to local analysts, short-term lending rates in Estonia are influenced by European Central Bank (ECB) moves, while longer-term rates are more affected by developments on the U.S. market.

On the other hand, the Estonian Market Research Institute is predicting that interest rates will fall in 2000, albeit at a slower pace than last year (Central Europe Business Daily, April 12). The Institute argues that rates will be pushed down by greater financial liquidity and by competition between domestic banks. Estonia’s largest bank, Hansapank, recently issued a 2.5 billion kroon (US$150 million) bond, further increasing domestic liquidity. There has been no interest recently on the swap market in lending the kroon, which means that there has been no need to borrow it. Bridging the Bank’s and Institute’s views, some local analysts have suggested that while interest rates on hard currency loans may rise as the ECB raises rates, rates on kroon-denominated loans should remain steady due to growth in market liquidity. But even a high level of liquidity may not result in declining interest rates. Mid-April’s low rate (4.33 percent) on three-month Talibid borrowing suggests that interest rates may not have much room to fall farther.

LATVIA’S CURRENT ACCOUNT DEFICIT GIVES CAUSE FOR CONCERN.