Combining the incompatibles : fixed exchange rate, liberalisation and financial development in Estonia

Abstract

Contrary to most experience, Estonia (as well as Latvia and Lithuania) has been able to combine, for a number of years, fixed exchange rates, financial liberalisation (prior to proper supervision) and large current account deficits without inviting speculation using large capital flows as vehicles.The standard argument is that this must be due to exceptionally sound fundamentals and great policy credibility.Without challenging this argument either generally or for the case of Estonia, Latvia and Lithuania, this paper offers a supplementary perspective.These countries did not aim at developing a full-scale national economy with a full set of financial and other markets, as they had the possibility of joining an institutionally, culturally and geographically close set of North-Western European markets.Such a strategy goes further than having the goal of "rejoining Europe" as the external policy anchor.Having well-developed domestic markets can in some cases be substituted by accessing near-by markets, thus leaving little leeway to potentially unstable capital flows.This option, however, is not open to all, and it also has its downside. Key words: capital flows, exchange rate systems, institutional development, financial liberalisation, Baltic countries