Eesti Pank Annual Report 2016

EESTI PANK ANNUAL REPORT 2016

2017 © Eesti Pank, 2017

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Print ISSN 1406-1414 Online ISSN 2382-8811 Layout: Urmas Raidma Printed by Folger Art CONTENTS

FOREWORD BY THE GOVERNOR OF EESTI PANK...... 4

THE SUPERVISORY BOARD OF EESTI PANK...... 8

ACTIVITIES OF EESTI PANK IN 2016...... 14

PARTICIPATION IN MONETARY POLICY DECISION-MAKING IN THE EUROSYSTEM AND IN IMPLEMENTING DECISIONS...... 14 Monetary policy decisions...... 14 Implementing monetary policy decisions in the euro area and Estonia...... 18 Eesti Pank’s monetary policy operations...... 19 ENSURING FINANCIAL STABILITY...... 21 Macroprudential policy...... 21 Financial sector policy...... 24 Crisis management...... 25 MANAGING CURRENCY CIRCULATION...... 26 The role of Eesti Pank...... 26 Availability of cash...... 26 Payment systems...... 31 STATISTICS FOR THE ESTONIAN FINANCIAL AND EXTERNAL SECTORS...... 35 Development of new areas of statistics...... 35 Focus on optimising the burden of reporting...... 36 Domestic cooperation...... 37 Publication of statistics...... 37 Development of the new reporting gateway...... 37 ECONOMIC ANALYSIS AND CONSULTATION...... 39 Economic analysis and monitoring at Eesti Pank...... 39 Economic forecasts...... 40 Economic research...... 41 Advisory functions...... 42 INTERNATIONAL COOPERATION AND PUBLIC COMMUNICATIONS...... 45 International cooperation...... 45 Public relations...... 45 FINANCIAL ASSET MANAGEMENT...... 48 Reserve management...... 48 ACCOUNTABILITY, GOVERNANCE AND ORGANISATION, AND HUMAN RESOURCES POLICY...... 51 Central bank accountability...... 51 Governance and organisation...... 52 Eesti Pank employees, training and development...... 53

ANNUAL ACCOUNTS OF EESTI PANK for the financial year ended 31 December 2016.....56

APPENDIXES...... 90

APPENDIX 1. THE RESPONSIBILITIES OF THE SUPERVISORY BOARD OF EESTI PANK...... 90 APPENDIX 2. DECISIONS OF THE SUPERVISORY BOARD OF EESTI PANK IN 2016.....91 APPENDIX 3. DECREES OF THE GOVERNOR OF EESTI PANK IN 2016...... 93 APPENDIX 4. PUBLICATIONS OF EESTI PANK IN 2016...... 95 Eesti Pank Annual Report 2016 4

FOREWORD BY THE GOVERNOR OF EESTI PANK The economy grew modestly in Estonia and in Europe in 2016. Achieving faster growth over the long term and improving living standards will require shared efforts. This means central banks supporting the economy by ensuring low and stable inflation, companies taking risks and investing, parliaments and governments passing painful economic reforms, and citizens voting wisely in elections.

The outlook for Europe is more optimistic

The European and global economies fared better last year than in 2015. There was an increase in the second half of last year in economic activity around the globe and growth is expected to strengthen further, though not to the levels it reached before the crisis. Growth in the euro area also continued its recovery in 2016, though it is still held back by the lack of structural reform. The European Central Bank forecast finds that growth in the economy will be 1.6-1.8% in 2016 and the next three years.

There are still several risks to economic activity. Any acceleration in growth in 2017 will be limited by the uncertainty caused by the upcoming elections in several euro area countries. It is probable that in the years ahead the risks in the outlook for the global trade environment will be defined by the uncertainty stemming from Brexit and the policies of the new US government.

The monetary policy of the central banks of the euro area is certain to play a part in the recovery of the euro area economy, as it has helped hold interest rates low and so has helped support the economy. Although inflation has been held close to zero for the past two years by low energy prices primarily, it picked up to 1.1% in the euro area towards the end of 2016 and continued to rise at the start of 2017.

At the start of last year, the Governing Council of the European Central Bank1 found inflation to be too low for the economy to run smoothly, but by the end of 2016 the state of the economy had become a little more optimistic and those changes during the year were reflected in the monetary policy decisions of the Governing Council.

In reaction to inflation being too low at the start of 2016, the terms of the short-term and long-term monetary policy loans made by central banks to commercial banks were made more favourable and the cost to the banks of keeping deposits at the central banks was raised. The monetary policy asset purchase programme was also increased in size from 60 billion euros to 80 billion euros a month.

1 The monetary policy of the euro area is set by the Governing Council of the European Central Bank, which consists of the members of the bank’s Executive Board and the governors of the national central banks of the euro area. Eesti Pank Annual Report 2016 5

As the economy was developing more strongly by the end of 2016, it was decided in December to reduce the size of the asset purchases back to 60 billion euros a month. It is planned that asset purchases will continue until at least the end of 2017, and longer if necessary, until there are clear signs that inflation is moving consistently towards the euro area target of a little below 2% a year over the medium term.

The combination of quite strong growth indicators and low interest rates camouflages some fairly major risks for companies, individuals and central banks, as asset prices may rise so far in some markets that bubbles could start to appear. Asset purchases also increase the risks that Eesti Pank faces, and so we need to continue increasing our reserves to reduce that risk.

The dangers of stimulating the national economy

The Estonian economy grew in 2016 at one of its slowest rates since the crisis. This was mainly because of problems in some branches of the economy, notably oil shale production, energy, agriculture and real estate activities, and economic difficulties in some important trading partners. An increase in the rate of growth was evident in the second half of the year, and the situation improved in most sectors. Confidence indicators for the private sector show greater optimism about the near future and the increase in output volumes indicates that companies will be looking to recruit additional staff. The problem though is the shortage of suitable labour, which has caused the number of vacancies to rise steadily in recent years, and the effect on growth in the economy of the shortage of labour is becoming ever more apparent.

There remain some contradictions in the Estonian economy, as growth has been slow but demand for employees has been high, leading wages to rise rapidly. These circumstances give rise to worries about poor productivity, as wages cannot keep growing faster than the whole economy indefinitely. If the circumstances do not change, companies would sooner or later suffer a blow to their competitiveness. Were this to happen, wage growth would slow or wages could even fall, and unemployment could start to rise. Eesti Pank considers that the most likely scenario is that the burst of economic growth driven by rising employment after the crisis is coming to an end, and wage rises will start to depend more and more on increased productivity, giving grounds for some optimism.

If the economy is somewhat out of balance, government fiscal policy becomes even more important. Eesti Pank considers that it would not currently be the wisest policy for the government to use a structural deficit in the state budget to stimulate demand. By placing additional orders with companies that focus on the domestic market, the government would push the labour market even further out of balance, and this would make life harder for businesses overall and would place a brake on economic growth in Estonia in the longer term.

Pressure on wage costs has already increased, as taxes started to rise again in autumn 2016. Driven mainly by higher energy prices and rises in excise, inflation climbed above 2%, having been negative for two years. The slower growth in purchasing power that resulted from the rise in inflation will increase the pressure on wage demands from employees, and labour shortages will give them a stronger position in wage negotiations. The key issue for further development in the economy is how much companies want and are able to reorga- nise their production to meet the ever higher wage demands of employees. Eesti Pank Annual Report 2016 6

What matters to Europe matters to Estonia

Estonia is a member of the European Union, which means that the work of the public sector is connected to Europe. The same is true of Eesti Pank, as a large part of our work comes from the shared duties of the central banks of the euro area, especially in shaping and implementing monetary policy. It is not possible to delineate and define precisely what of our work is uniquely for the benefit of the Estonian economy and what for the euro area. Several tasks that were earlier done for the good of Estonia are now done for the whole euro area. In rough terms more than one third of the working time of Eesti Pank staff is taken up by the work of the euro area, which could be translated as 86 of the 236 Eesti Pank employees working on euro area tasks.

The amount of work for the euro area has increased substantially since Estonia joined the single currency, and it is a notable achievement that the number of staff at Eesti Pank has not risen in consequence. Eesti Pank is the smallest central bank in the euro area, and we aim to do our work well and efficiently. As head of Eesti Pank I consider efficiency to be a priority, as it helps the central bank keep the trust of the people of Estonia.

Meeting our joint responsibilities asks a lot of us as the smallest central bank in the euro area, but it is vital work and allows us to make proposals that draw on Estonia’s experi- ences and knowledge when decisions are taken that affect the whole of the euro area. The principle that all the countries sit around the table to take decisions jointly applies in other European Union matters as well.

Several activities in 2017 will arise from Estonia’s membership of the European Union, and Eesti Pank started preparations for this in the preceding years. Eesti Pank will release the new fifty-euro second series banknote in April and will host the external meeting of the Governing Council of the European Central Bank in June, and Estonia will join the TAR- GET2-Securities securities settlement system during the year, and will assume the presidency of the European Union in the second half of the year.

Eesti Pank’s second main task after monetary policy in the euro area is maintaining the stability of the Estonian financial system, as strongly functioning banks are vitally important for a successful economy. After three years of work, Eesti Pank has finished putting together the tool kit needed for macroprudential supervision. The central bank earlier introduced requirements for issuing housing loans to help prevent damaging real estate bubbles appearing in the economy. We also introduced additional countercyclical capital buffer requirements, which reduce the risks to the banks of excessively fast credit growth. In 2016 we raised the level of capital required from Swedbank and SEB, because the Esto- nian economy and financial system would be seriously threatened were difficulties to emerge at such important banks for the financial system. In the years ahead we will continue to assess risks regularly, standing ready if necessary to use the tools developed to steer the conditions prevailing in the market.

It is the job of the central bank to furnish the country with cash through commercial banks, and the quality and the supply of cash in Estonia in 2016 were good. In the summer Eesti Pank presented the design and security features of the new fifty-euro note, which enters into circulation in April 2017. Looking at cash circulation more broadly, it is good to see that access to cash has improved in rural areas. In response to an interpellation by Riigikogu members in autumn 2014, I proposed six ways that access to cash could be improved, and I particularly emphasised the benefits of cashback from tills in shops. I am glad to see that there are now 380 shops across the country from which cash can be withdrawn, and Eesti Pank Annual Report 2016 7

this may be improved further by a bank that has changed its ownership and has a new business plan.

In our work with payments and settlements, the TARGET2-Eesti system for large payments that is managed by Eesti Pank functioned well. Eesti Pank continued preparations together with the Estonian Central Securities Depository to join in September 2017 the pan-Euro- pean securities settlement platform TARGET2-Securities, which will harmonise securities trading across Europe. Throughout last year we did many of the other tasks of a central bank by providing timely and high quality statistics, investing the state’s foreign reserves, and advising the government on economic policy issues.

As Governor of Eesti Pank it falls to me to make sure that the bank is ready to face any unpleasant surprises. The joint work of the central banks of the euro area to stimulate economic activity through low-cost credit to commercial banks and large-scale asset purchases have increased the size of Eesti Pank’s balance sheet, and with it the financial risks we face. Although the buffers that Eesti Pank has against these risks have increased in recent years, they are still smaller than those of most other central banks in the Eurosystem. For this reason I am pleased that the Supervisory Board of Eesti Pank decided to transfer 23.55 million euros of the 31.4 million euros of profit for 2016 to the central bank reserves, and 7.85 million euros to the state budget.

Conclusion

A lot has been said in recent years about growth in the Estonian economy being modest. I should point out though that the Estonian economy and financial sector have many strengths. In searching for new sources of growth we must be able to recognise and maintain our strong suits, which certainly include sound public finances and a well-capitalised banking sector. I believe that there is more room for development in some parts of Esto- nian economic policy, but in others it may be wiser to step lightly, as change for change’s sake is not needed, but rather changes should be made in order to improve the quality of life in Estonia.

Ardo Hansson Governor Eesti Pank Annual Report 2016 8

THE SUPERVISORY BOARD OF EESTI PANK Eesti Pank is the central bank of the Republic of Estonia and is a member of the European System of Central Banks. Legislators in both Estonia and the European Union have given the central bank extensive powers and defined its obligation to manage national monetary systems, maintain price stability, help design and execute the single monetary policy of the Eurosystem, safeguard and manage the official national foreign reserves, operate payment systems without fault, and help preserve the stability of financial systems. All this makes it very important that Eesti Pank be well managed, efficient and effective, and that it carry out its duty to report to Estonian citizens and their elected representatives.

Under § 8 of the Eesti Pank Act, the Supervisory Board of Eesti Pank exercises supervision over all the activities of the central bank. The Governor and Deputy Governors inform the Supervisory Board members on a regular basis about Eesti Pank’s activities and budget and about the Estonian economy and monetary policy and the financial sector.

Specific questions that come under the competence of the Eesti Pank Supervisory Board are covered in detail in Appendix 1.

The members of the Supervisory Board of Eesti Pank

The Supervisory Board consists of a Chair and seven members. The Chair of the Super- visory Board is appointed to office for a term of five years by the Riigikogu at the proposal of the President of the Republic. Photograph: Eesti Pank

Members of the Supervisory Board of Eesti Pank. Seated: Kaie Kerem, Chair Mart Laar and Liina Tõnisson. Standing: Jaanus Tamkivi, Kalev Kallo, Enn Listra, Urmas Varblane and Rein Minka. Eesti Pank Annual Report 2016 9

The Chair organises the work of the Supervisory Board, chairs its meetings, ensures that its decisions are enacted, represents the Board, and responds to interpellations from the Riigikogu concerning the Supervisory Board’s activities.

The current members of the Supervisory Board were appointed by the Riigikogu on 25 February 2014 when the mandate of the previous Board ended. The members appointed were Kalev Kallo, Kaie Kerem, Enn Listra, Rein Minka, Jaanus Tamkivi, Liina Tõnisson and Urmas Varblane.

The Riigikogu appointed Mart Laar as Chair of the Supervisory Board from 13 June 2013.

The authority of the current Supervisory Board of Eesti Pank runs for five years until February 2019.

Mart Laar’s mandate as Chair runs until 12 June 2018.

The framework for the supervision work of the Supervisory Board of Eesti Pank Under § 6 of the Eesti Pank Act, the Supervisory Board of Eesti Pank is responsible for the supervision of Eesti Pank. General supervision over the operations of the central bank is one of the most important roles that the Supervisory Board plays for Estonian society. The aims of supervision The Supervisory Board uses the results of its supervision to assess the activities of the bank in a range of areas, levels and subjects. At the most general level the Board looks at whether the bank’s vision is in line with what is expected by domestic and international public interested parties, whether the chosen development strategy and the actions under that strategy are taking the bank closer to where it wants to be in future, and whether the strategic goals can be achieved with the way work is planned. At a more detailed level, the Board assesses how appropriate the work plans approved by the bank are, and whether the planned resources, financial, staff or otherwise, are sufficient for the plans to be executed. The Board also looks at how well the work of the Executive Board adheres to the principles of good management, and whether and how the Executive Board follows the principles of effectiveness, efficiency and economy. At an operational level the Board looks at individual decisions taken by the Executive Board and requests explanations where necessary of the choices behind those decisions. The Supervisory Board pays particularly close attention to the decisions that the Executive Board takes based on the results of the internal and external audits, and in doing so it supports the independence of the internal audit. The resources for supervision The Supervisory Board collects and analyses information for its supervision work firstly from the bank itself, and also from parties outside the bank. The Board reviews the strategy, vision and mission of the bank once a year, so not every time there is a change. The role of the Board in handling these documents is limited to advising, consulting and giving opinions. The Executive Board regularly advises the Supervisory Board of its work in implementing plans of work, executing the budget and running procurements. The reports also cover development of staff and management, including training, the realisation of risks, and the personal contributions of members of the Executive Board. The internal audit department also reports regularly on its activities to the Supervisory Board. The reports from the internal audit contain reviews of audits carried out at regular intervals and their results and the auditors also inform the Supervisory Board of the recommendations they have made and of how those recommendations have been followed. The Board gets further information on the management practices of the bank from regular surveys of management quality and satisfaction. If any failings are discovered or suspected, the Board can use the annual work plan of the internal audit to order detailed reports from the internal audit on matters that are of interest. The Supervisory Board can also order audits or surveys Eesti Pank Annual Report 2016 10

from outside the bank if the internal audit does not have sufficient resources to investigate everything that is of interest to the Board, as the annual work plan of the internal audit also has to include audits ordered by the European System of Central Banks and by the Executive Board. The results of supervision The Supervisory Board collates the results of its supervision in the annual report of the bank. After the annual report of the bank has been approved by the Supervisory Board, the Chair of the Board presents the report to the Riigikogu. The report by the Board contains assessments of the bank’s activities on a broad scale. Alongside these assessments, the Board can also make observations in its chapter of the report on the information that it analysed. If opportunities for development are identified, the Board may add a text giving its own recommendations to the Executive Board of the bank.

The work of the Supervisory Board of Eesti Pank in 2016

The Supervisory Board had nine regular meetings in 2016 and it also held seven seminars as an additional forum for its work.

Supervision of the Executive Board of Eesti Pank The Supervisory Board heard a review of Eesti Pank’s financial results for 2015 and approved the annual report proposed by the Governor for 2015. The Chair of the Board presented the approved report to the Riigikogu

The Board also reviewed the profit distribution strategy of Eesti Pank and decided to continue with the same strategy of transferring up to 25% of the profit to the state budget each year until the Eesti Pank figures for ‘Capital and reserves’, ‘Revaluation accounts’ and ‘Pro- visions’ are at the same proportion of the figures for the Eurosystem as the Eesti Pank participation in the paid-in capital of the European Central Bank, which is 0.2739 per cent. As a result, Eesti Pank decided to transfer 25% of its profit for 2015, or 7,526,995 euros, to the state budget.

The Board considered the strategy of Eesti Pank on one occasion. The Supervisory Board and the Executive Board found that a new strategy document needs to be drawn up in 2017. The Executive Board has commendably taken the recommendations of the audit of the strategic planning process very seriously, with the result that the strategic planning process has become more meaningful and systematic.

The Board heard the Executive Board’s reports for 2015 and the first half of 2016, and gave recognition for the quality of the reporting and the innovative approach to drawing up reports.

At the last meeting of the year, the Governor of the bank presented the draft budget for 2017 to the Board, from which it was clear that the Presidency of the European Union, the external meeting of the Governing Council of the European Central Bank, and the minting of commemorative and collector coins for the centenary of the Republic of Estonia will create large one-off expenses. The Board was satisfied with the draft of the budget.

Following the public procurement run by the internal audit department, and in coordination with and with the approval of the European Central Bank and the European Commission, the Supervisory Board of Eesti Pank decided to appoint KPMG Baltics OÜ as auditor of the financial section of the annual report of Eesti Pank for the years 2016-2020.

The Board heard risk management reports on two occasions and returned the regular presentation of risk management reports to the working schedule of the Supervisory Board. Eesti Pank Annual Report 2016 11

Internal audit The Supervisory Board updated the work schedule of the internal audit department in 2016 and approved a new work schedule for 2017, and heard reports on the work of the internal audit department. The Board had two regular meetings with the head of the internal audit department.

Recommendations made as part of the audit had again all been carried out by the end of the year. The Board thanked the internal audit at its meeting and acknowledged the good and successful work done in this by the Governor, the Executive Board and the depart- ments of the bank for the second year in a row.

The Supervisory Board confirmed the new statutes of the internal audit department.

Participation in decision-making in the Eurosystem and implementation of decisions In its meetings the Board received regular retrospective reviews of the work of the Euro- pean System of Central Banks, covering how single monetary policy is set, the operation of single banking supervision, and the work of the European Systemic Risk Board. The Executive Board presented the Eesti Pank forecasts that were prepared as part of the joint broad macroeconomic projection exercise (BMPE) forecast produced with the European Central Bank and the other central banks of the Eurosystem.

Currency circulation The Board heard a seminar on the work of the Cash and Infrastructure Department, visited the department and heard there about its work with cash processing and storage.

Financial stability Meetings of the Supervisory Board heard presentations of the Financial Stability Reviews, the Financing of the Economy review, the review of the financial behaviour and consumption habits of households, and the Labour Market Review.

Consultation and cooperation on questions of economic policy The Board held two seminars in 2016 on the work of the Fiscal Council, at which the annual report of the Fiscal Council was presented, as were reviews of its work and its opinions on the state budget that was being drafted. It was noted that, given the current position of the economic cycle, the government should set more demanding targets for the structural position for 2017-2020 than the minimum required by the State Budget Act. It was further noted that the government’s presentation of the draft budget to the Riigikogu without waiting for the opinion of the Fiscal Council was not correct and did not follow the spirit of the law, or the best practice of the euro area. The Fiscal Council has proposed to the Min- istry of Finance that changes be initiated in the State Budget Act to prevent such a situation arising in future.

The Supervisory Board of Eesti Pank declared itself satisfied with the work of the Fiscal Council during the year.

The Executive Board presented a review to the Supervisory Board of its work at the IMF and the Bank for International Settlements, and of its work with the Nordic, Latvian and Lithuanian central banks. Eesti Pank Annual Report 2016 12

Organisation A seminar was held where the Supervisory Board heard proposals on personnel and staffing issues.

The Board approved the new guidelines for the professional behaviour of members of the Supervisory Board of Eesti Pank.

At its seminar it clarified the division of its work and the responsibilities of its members.

It proposed support for the issue as part of the Eesti Mõtteloo (History of Estonian Thought) series of three collections of works dedicated to outstanding economists of their time such as Ragnar Nurkse, Otto Strandman, Johanna Sild-Rebane or Rudolf Jalakas, to mark the centenary of the Republic of Estonia.

Appointments to office The Board nominated Deputy Governor Ülo Kaasik for a second five-year term of office from 8 July 2016 and Deputy Governor Madis Müller from 1 September 2016. Eesti Pank Executive Board member contracts were used for the first time in the appointment of the Deputy Governors. A presentation from the Governor on the restrictions on the position of Deputy Governor and the term of office was heard, and the topic will be revisited in 2017.

The Supervisory Board nominated Rein Minka as member of the supervisory board of the Financial Supervision Authority from 1 October 2016.

Collector coins At the proposal of the Executive Board, the Supervisory Board approved the clarified principles for minting different types of coin.

The Board decided to support the idea proposed by the advisory committee considering ideas for commemorative coins and collector coins of starting a series of coins dedicated to the Hanseatic towns of Estonia, and approved the nominal values and designs for the gold and silver coins dedicated to Tallinn.

The Board approved the joint issue by the Baltic states of a two-euro coin with a special design on the national side relating to the approaching centenary of the Baltic states.

The Board took note of the programme for issuing collector and commemorative coins together with the proposals of the Executive Board for minting coins.

Assessment of the management of Eesti Pank in 2016

The Eesti Pank Supervisory Board notes from the explanations it has received and from the reports in international media that Eesti Pank has had a constructive influence on the decision-making process in the European System of Central Banks that has earned public recognition and attention.

The bank managed to achieve the goals it was aiming for in its strategic work.

The bank had work plans in place in 2016 and they were managed well. All the main tasks planned were executed successfully. The Executive Board exercised constant supervision over how the plans were executed and updated them if necessary, and the same was done with procurement plans and the budget.

The incomplete execution of the budget has been a running theme in the bank’s operations since the independence of the central bank was re-established. The management of Eesti Pank Annual Report 2016 13

the bank assess the budget and cost items other than fixed costs each year starting anew. The incomplete execution of the budget is rather a consequence of how the budget for the bank is drawn up and of the working culture and to a large extent because of savings that have been made.

This means that not spending all of the budget is a sign of savings, while the Executive Board of the bank met all of the criteria demanded of the budget, and so the bank operated economically in terms of the resources it used in 2016. Like the budget as a whole, the procurement plan was not executed in full, but this was because of the responsible behaviour of the bank’s managers in delaying or cancelling procurements when market conditions were unfavourable, rather than because tasks were simply left undone or there was delib- erately excessive planning of procurements.

Several members of the Supervisory Board commended the Economics and Research Department for having research articles published in international journals of good standing, for the quality of the economic forecasts produced, and for work in advising the Executive Board and involvement in economic policy issues, including fruitful meetings with top business leaders. Eesti Pank Annual Report 2016 14

ACTIVITIES OF EESTI PANK IN 2016

PARTICIPATION IN MONETARY POLICY DECI- SION-MAKING IN THE EUROSYSTEM AND IN IMPLEMENTING DECISIONS

Monetary policy decisions The Governing The monetary policy goal of the Eurosystem, which is the European Central Bank and the Council of the central banks of the 19 members of the euro area, is to maintain price stability in the euro European area, which is defined by the Governing Council of the European Central Bank as inflation Central Bank in the euro area1 of below, but close to, 2% over the medium term. Inflation in the euro finds that inflation pressures area stayed low throughout 2016, averaging 0.2% for the year, though it increased to 1.1% are still too low toward the end of the year (see Figure 1). Inflation was mainly restrained by low energy for the economy prices. Core inflation2 was affected by subdued economic activity and low energy prices to run smoothly. and averaged only 0.9% for the year. The December 2016 forecast by experts from the Eurosystem found that inflation will remain low in the euro area for some time yet, but will rise to 1.7% in 2019.

Figure 1. Inﬂation and core inﬂation in the euro area, % The Governing Council of the European Cen-

inﬂation tral Bank finds that inflation pressures are still core inﬂation too low for the economy to run smoothly. For 4.5 this reason it was considered necessary to 4.0 lower interest rates further and expand the 3.5 non-standard measures (see Table 1) to meet 3.0 the goal of price stability and support the 2.5 functioning of the monetary policy transmis- 2.0 sion channels. 1.5

1.0 In March the Governing Council cut the

0.5 interest rate on the main refinancing oper-

0.0 ations by 5 basis points to 0.00% and the 3 -0.5 interest rate on the lending facility by 5 basis -1.0 points to 0.25% (see Figure 2). The interest 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6

0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 4 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 rate on the deposit facility was lowered by a 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 further 10 basis points to -0.40%. The Gov- Source: Eurostat erning Council continues to expect that the central bank interest rates will remain at their current levels or lower for a long time and certainly for longer than the duration of the asset purchase programme5.

1 Inflation in the euro area is measured with the harmonised index of consumer prices (HICP). 2 Core inflation shows the change in price of the consumer basket without the effect of energy, food, alcohol and tobacco. 3 The marginal lending facility as a standing facility allows credit institutions in the euro area to access overnight funds from the central bank at fixed interest rates in exchange for collateral. The interest rates on such overnight loans are higher than the equivalent rates in the market and so credit institutions use the standing facility only as a last resort for accessing funds. Access to the lending facility is only limited by the amount of collateral put up, so the interest rate on it usually sets the upper bound on money market interest rates. 4 The standing deposit facility allows euro area credit institutions to open overnight deposits at central banks at fixed interest rates. The interest rates on such overnight deposits are lower than market interest rates and so overnight deposits are opened in the Eurosystem only if the depositors cannot find better interest rates for their available funds elsewhere in the markets. 5 The expanded asset purchase programme (APP) has four parts: covered bonds (CBPP3), asset backed securities (ABSPP), public sector securities (PSPP), and the corporate bond (CSPP) portfolio. Eesti Pank Annual Report 2016 15 Photograph: European Central Bank Central European Photograph:

The external meeting of the Governing Council of the European Central Bank in Malta in 2015. The Governing Council is the main decision making body of the European Central Bank, and it comprises the Governors of the 19 national central banks of the euro area countries, and the six members of the Executive Board of the European Central Bank. One of the main responsibilities of the Governing Council is setting monetary policy for the euro area, which includes Estonia. The Governor of Eesti Pank is involved in setting euro area monetary policy, as he has an equal vote at the Governing Council alongside those of all the other central bank governors from the euro area. Once a year the Governing Council holds its monetary policy meeting in one of the euro area countries, and in summer 2017 this meeting will be hosted by Eesti Pank.

In March it was decided to increase the monthly purchases under the asset purchase programmes from 60 billion euros to 80 billion euros starting from April, and it was stated that the purchase programme is intended to run until March 2017, or longer if necessary. The issuer and issue share limits on the purchases of the securities issued by eligible international organisations and multilateral development banks were raised from 33% to 50%. It was also decided to start purchasing corporate bonds from June to strengthen further the role of the purchase programme in improving the funding capacity of the real economy. The Eurosystem can purchase bonds denominated in euros of all euro area companies except banks with maturities of six months to 30 years that have ratings of at least BBB- or equivalent and meet the Eurosystem collateral requirements. Purchases can be made on the primary or the secondary market, except for purchases of bonds of publicly owned companies, which can only be bought on the secondary market because of the ban on monetary financing of government. The Eurosystem can buy up to 70% of a new issue, or 33% for public sector companies, like under the purchase programme for public sector bonds.

It was also decided at the meeting in March that the Eurosystem would offer long-term targeted lending to the commercial banks on even better terms from June. Loans to credit institutions are a cheap source of funding that allows banks in turn to ease lending conditions for companies and households and increase the credit supply. From June 2016 to March 2017 banks can apply once a quarter for a four-year loan at the interest rate on the main refinancing operations of the European Central Bank, if that loan is intended for onward lending to companies and households, though not through housing loans. If the Eesti Pank Annual Report 2016 16

lending portfolio of a bank to the private sector increases between February 2016 and Jan- uary 2018, the loans granted by the central bank will have a discount interest rate that will depend on the amount borrowed, and in the best case will be the deposit facility rate of the European Central Bank at the moment of the transaction. The asset pur- The Governing Council of the European Central Bank decided in December to continue chase programme the monthly purchases under the asset purchase programme beyond March 2017, but to is intended to run change the amount purchased monthly from 80 billion euros to 60 billion euros from April until the end of to December 2017 in response to the improvement in economic development. The asset 2017, but if necessary it will con- purchase programme is intended to run until the end of 2017, but if necessary it will continue until a lasting tinue until a lasting correction in inflation is apparent that is in line with the price stability correction in infla- goal of the European Central Bank. If the outlook deteriorates or if financing conditions are tion is apparent. no longer appropriate for further steps towards a lasting adjustment of inflation developments, the Governing Council stands ready to increase the size of the asset purchase programme or to extend its duration.

When new asset purchases are made, the principal paid off for securities that have reached maturity is reinvested within the asset purchase framework. The Governing Council approved some other changes to the details of the asset purchase programme to keep it running effectively. From January 2017 it will also be permitted to buy public-sector bonds that have at least a year to maturity, where the previous limit was at least two years, and debt instruments that have a yield to maturity that is lower at the moment of purchase than the interest rate on the standing deposit facility of the European Central Bank, which is currently -0.40%.

The impact expected from the various monetary policy measures will be felt in the economy of the euro area in the medium term. The supply of credit to businesses and households is improving as demand for credit has started to increase and conditions to ease, while

The operation of monetary policy in the euro area when interest rates are low Under normal conditions the central bank steers inflation, macroeconomic development and general financing conditions through short-term monetary policy interest rates. Central banks have cut interest rates steadily since the global economic and financial crisis, and rates in the euro area have reached a level where cutting them further would have very little or even no effect on the recovery of the economy. For this reason the European Central Bank has made increasing use of non-standard measures like asset purchases and targeted lending to achieve its price stability goal. The European Central Bank and other leading central banks around the world are also releasing information on the possible track of monetary policy so as to guide market expectations for interest rates and inflation. The Eurosystem has used this forward guidance for both the expected level of interest rates and the expected duration of the asset purchase programme. The Eurosystem uses the asset purchases to direct money to the banking and finance system. Increased demand for assets raises their price and this then helps bring down interest rates to a substantial degree, making it cheaper for companies and households to borrow from the banks. The banks might for example use such loans to create asset- backed securities that qualify for the asset purchase programme. The banks can also access the credit they need more cheaply through the targeted lending measures of the central bank. The Eurosystem buys assets from various investors, who can use the money they receive to invest further as they choose. The reorganisation of portfolios also increases the demand more broadly for financial assets in markets not directly covered by the asset purchase programme, and this reduces costs for companies looking for funds in capital markets. Economic agents have more options for consumption and investment, and this in turn encourages economic growth and job creation. This will raise inflation over the medium term back to close to 2%. Eesti Pank Annual Report 2016 17

interest rates have fallen for the whole of the euro area and the differences between interest rates for different countries have narrowed. Banks have noted that the situation should improve further in the credit market in 2017, especially for companies6. It should however be noted that interest rates remaining low could lead to additional risks to financial stability.

Table 1. The Eurosystem’s monetary policy framework in 2016

The standard monetary policy framework Deadline Frequency Change in 2016 Open market operations Interest rate lowered by 5 basis points on 16 March Main refinancing operations (MRO) One week Weekly from 0.05% to 0.00% Long-term refinancing operations (LTRO) 3 months Quarterly Fine-tuning operations (FTO) As necessary As necessary Structural operations As necessary As necessary Standing facilities Interest rate lowered by 10 basis points on 16 March Deposit facility (DF) Overnight Daily from –0.30% to –0.40% Interest rate lowered by 5 basis points on 16 March Marginal lending facility (MLF) Overnight Daily from 0.30% to 0.25% Reserve requirement Minimum reserve requirement (MRR) Daily Daily Excess reserves As necessary As necessary Non-standard measures Deadline Frequency Developments in 2016 Fixed rate tender procedures with full allotment From October 2008 Permanent (FRFA) The European Central Bank extended its currency Currency swap agreements with leading non-euro No specified term As necessary exchange agreement with the Chinese central bank area central banks for three more years Purchases ended, The Securities Markets Programme (SMP) and the covered securities Covered Bond Purchase Programmes (CBPP and are being held to CBPP2) maturity The second TLTRO series was announced on 10 March, with four operations from June 2016 to March Targeted longer-term refinancing operations 2017. The conditions were made simpler and more 2-4 years Quarterly (TLTRO) favourable. The final interest rate is between the base interest rate and the deposit facility rate (inclusive), and depends on the amount of new lending*. It was decided in March: (a) to increase the monthly purchases under the asset purchase programme from 60 billion euros to 80 billion from 1 April; (b) to start purchases of investment-grade euro- The expanded asset purchase programme (APP), denominated bonds issued by non-bank corporations which covers the third purchase programme established in the euro area from 8 June. for covered bonds (CBPP3), the asset backed It was decided in December: (a) to continue Until the end of 2017 securities purchase programme (ABSPP), public Permanent purchases under the asset purchase programme until or longer if necessary sector securities purchase programme (PSPP), at least the end of December 2017 at the monthly and the corporate bond purchase programme pace of 60 billion euros from April 2017; (b) to lower (CSPP), which was added in 2016 the maturity range for eligible securities from two years to one year; (c) to purchase securities with a yield to maturity below the interest rate on the ECB’s deposit facility at the moment of purchase where necessary. Bonds purchased under the corporate bond purchase programme started to be lent out from Lending out the securities purchased under the 18 July. From 8 December it became possible to From 2 April 2015 As necessary asset purchase programmes lend out all the securities in the purchase programme against cash, rather than just against securities as previously.

* The more is taken in new loans, the better the interest rate is.

6 ECB Bank Lending Survey, October 2016. Eesti Pank Annual Report 2016 18

Implementing monetary policy decisions in the euro area and Estonia

Monetary policy decisions are implemented through the monetary policy operations of the Eurosystem and the parts of the standard framework other than monetary policy interest rates did not change in 2016, though some non-standard measures were extended and expanded (see Table 1).

At the end of 2016, The main tool used in the monetary policy of the Eurosystem was the asset purchase pro- 1.5 trillion euros of gramme, which was expanded in 2016 by the addition of the corporate sector purchase assets had been programme for corporate bonds under which six central banks of the euro area, those of bought in total Germany, Belgium, France, Spain, Italy and Finland, buy corporate bonds7. under the expanded asset purchase At the end of 2016, 1.5 trillion euros8 of assets had been bought in total under the expanded programme. asset purchase programme, with the purchases divided as follows:

• Covered bond purchase programme 3 (CBPP3) – 203.5 billion euros; • Asset-backed securities purchase programme (ABSPP) – 22.8 billion euros; • Corporate sector purchase programme (CSPP) – 51.1 billion euros; • Public sector asset purchase programme (PSPP) – 1.3 trillion euros.

The consolidated balance sheet of the Eurosystem was worth 3.7 trillion euros, which was 84% larger than in autumn 2014.

There were three operations under the second series of targeted long-term refinancing operations (TLTRO II) in 2016, in June, September and December, and a total of 507 billion euros was lent in them. The outstanding amount of all the TLTRO operations was 545 billion euros on 31 December 2016. The total outstanding amount of the targeted lending under the first series of loans (TLTRO I) shrank to 39 billion euros as loans were repaid early. The further expansion of the asset purchase programmes meant that TLTROs became less attractive and less important. Figure 2. Monetary policy and money market interest The amounts borrowed were also reduced a rates in the Eurosystem, % lot in the weekly main refinancing operations main reﬁnancing rate lending facility interest rate within the standard framework and by three- 3-month EURIBOR month refinancing operations. The average deposit facility interest rate 2.5 volume of the weekly operations at the start

2.0 of 2016 was 67 billion euros, but at the end of the year it was 36 billion euros. Reduced 1.5 demand for monetary policy loans is a con- 1.0 sequence of the expanded asset purchase programme and the accompanying increase 0.5 in liquidity. Excess liquidity in the euro area, 0.0 which is amounts held at central banks in

-0.5 excess of required reserves, rose by 540 billion euros over the year to reach 1.2 trillion -1.0 6 6 6 6 5 5 5 5 4 4 4 4 3 3 3 3 2 2 2 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 euros by the end of December. 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 ...... 0 7 4 1 0 7 4 1 0 7 4 1 0 7 4 1 0 7 4 1 0 7 4 1 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 A consequence of the use of non-standard

Source: European Central Bank measures was that the EONIA index for unse- cured interbank overnight lending reached

7 The principle of division of market regions applies and Estonian bonds are bought by the Finnish central bank. See the section on Eesti Pank's monetary policy operations. 8 Volume at amortised acquisition cost. Eesti Pank Annual Report 2016 19

historically low levels at just a fraction above Figure 3. Changes in the volume of Eurosystem monetary policy the deposit facility rate. The yield on sover- operations, 2013-2016 (billion euros) expanded asset purchase programme SMP CBPP long-term refinancing operations eign bonds has fallen at the same time and main refinancing operations fine-tuning operations the yield curve has become flatter. One factor deposit facility current accounts 2,500 reducing the effectiveness of the measures in 2016 was the new Basel III regulatory require- 2,000 ments, though these are very important for 1,500 ensuring the stability of the banking system. 1,000

The Eurosystem will see a structural liquidity 500 surplus during the coming years as a conse- 0 quence of the non-standard measures, par- -500 ticularly the expanded asset purchase programme. A structural liquidity surplus means -1,000 that inflows of funds are larger than the -1,500 reserve requirement of the central bank. 07.2014 07.2013 07.2015 07.2016 01.2014 01.2013 01.2015 01.2016 10.2014 10.2013 10.2015 10.2016 04.2014 04.2013 04.2015 04.2016 Figure 3 shows the changes in the volume of the Eurosystem’s monetary policy operations. Source: European Central Bank

Eesti Pank’s monetary policy operations

The Estonian monetary policy counterparties did not use the lending facilities of the standard monetary policy framework of the Eurosystem, including the marginal lending facility, in 2016. The main reason for the low take-up was that the bank groups use centralised liquidity management and the local banks had sufficient liquidity buffers, meaning that local banks are not very dependent on the liquidity supplied by the central bank. Some Estonian counterparties took part in the second round of targeted long-term refinancing operations (TLTRO-II), borrowing quite modestly. At the end of 2016, Eesti Pank’s portfolio of monetary policy loans stood at 86 million euros. Various marketable assets were given as collateral and also for the first time credit claims (see Figure 4)9. In Estonia, eligible credit claims are loans to the central or local government and loans to companies with an Figure 4. Collateral assets, million euros

ECAI (external credit assessment institutions) marketable assets non-marketable assets rating. 250 The use of credit claims as collateral was made easier by the decision of Eesti Pank to 200 reduce the minimum size required for credit claims at the moment of mobilisation from 150 two million euros to half a million euros. The requirement to submit the original loan documents with the claim was also lifted. These 100 steps made it easier than before for the banks in Estonia to use credit claims as col- 50 lateral, and that simplification made participation in long-term targeted lending opera- 0 tions more attractive. end 2015 March June September December

Source: European Central Bank Bonds purchased under the covered bond purchase programme (CBPP2) and the secu-

9 Credit claims have been acceptable as collateral in the Eurosystem since 2007. Eesti Pank Annual Report 2016 20

rities market programme (SMP) are held to maturity by Eesti Pank. Eesti Pank does not participate in the asset-backed securities purchase programme (ABSPP), the third covered bond purchase programme (CBPP3), or the corporate sector purchase programme (CSPP) but it shares the risks in solidarity with the other members of the Eurosystem in accordance with the capital key, which gives Eesti Pank 0.2739% of the exposure. The risks are also shared for the securities markets programme (SMP). In 2016 Eesti Pank Eesti Pank participated in the public sector purchase programme (PSPP), buying various bought some two assets in the proportion of the capital key. As Estonia has not issued any sovereign bonds, billion euros of it is mainly the bonds of European institutions, where the risks are shared, that are bought bonds in total under as substitute purchases. During the year a total of 1.1 billion euros of bonds were pur- the asset purchase programme. chased, and the cumulative value of purchases on the balance sheet was 3.2 billion euros at the end of 2016. More detailed information on the purchases is published on the Eesti Pank website10.

From June 2015 to May 2016, Eesti Pank had a special exemption allowing it to buy the bonds of the state-owned transmission system operator Elering. From June 2016 the central banks of the euro area have been able to buy corporate bonds as part of the asset purchase programme. In the Estonian case this means that the bonds of AS Elering can no longer be purchased as part of the public sector purchase programme, though together with the bonds of Eesti Energia they qualify for purchase under the new corporate sector purchase programme, which Eesti Pank does not participate in. Since June the Finnish central bank has bought bonds issued by Elering and Eesti Energia. The financial risks of the Elering bonds that Eesti Pank bought earlier as an exception are borne by Eesti Pank alone.

10 http://www.eestipank.ee/en/monetary-policy/eesti-pank-holdings-under-pspp-programme. Eesti Pank Annual Report 2016 21

ENSURING FINANCIAL STABILITY

Macroprudential policy

Macroprudential policy covers systemic risk analysis and assessment, and the deploy- ment of measures to ensure financial stability. The objective of macroprudential policy is to increase the resilience of the financial system and to reduce the build up of systemic risks that threaten financial stability. If a systemic risk realises and the whole financial system or parts of it experience difficulties, it seriously disrupts the supply of financial services and has a negative impact on the real economy.

Systemic risk analysis and assessment Eesti Pank publishes its analysis of financial stability and assessment of risks twice a year in the Financial Stability Review. The majority of financial intermediation in Estonia operates through banks, so the review concentrates on assessing the financial positions and risks of banks and their customers, particularly companies and households.

Special topics analysed by Eesti Pank in the review in 2016 were possible changes in the business models of banks caused by changes in their operating environment; the impact on the credit market of the loan guarantees given by the state guarantee fund KredEx; the structure of the investment portfolio of the mandatory pension funds; and the rapid growth in real estate funds and in savings and loan associations, and the associated potential risks.

In 2016 Eesti Pank considered the possible risks to financial stability to be small, like in the previous year. The risks are being held down by the high level of capital in the banking sector and the good financial position of households in Estonia.

The risks to the financial sector in Estonia are small Eesti Pank finds that most of the risks to the operation of the financial sector in Estonia are low. Although there are several risks, there are three main risks that deserve attention. One of these risks is a continuing decline in the profitability of Estonian companies due to the fall in income caused by the weak external demand and to rapid wage growth, and a consequent deterioration in their ability to pay. The Estonian business sector has increased its equity in recent years however and its financial position is now better than it was before the last financial crisis. For this reason the decline in corporate profitability has not led to a significant increase in overdue loans, but a continued reduction in profitability could worsen the ability of companies to repay their loans. A second risk is that real estate prices in the Nordic countries, especially Sweden, have been rising rapidly for several years, with backing from increased lending. The indebtedness of Nordic households is high, which makes the economy vulnerable to any potential shock. Most of the banks operating in Estonia, with some 90% of the banking sector’s assets, are subsidiaries or branches of large Nordic banking groups. The parent banks largely fund themselves with bonds, and the terms for those bonds can change quickly. This could probably affect the liquidity of the largest banks in Estonia, and indirectly the credit supply. Another risk is that a decline in economic activity in Sweden could reduce the income from exports of Estonian companies and their ability to pay, and that could then affect the banks operating in Estonia. A further risk is that the vulnerability of Estonian banks may be increased by a possible rise in the rate of growth of Estonian real estate prices and loans. Growth in household incomes has been rapid, and if this continues it could lead to overly optimistic expectations for the future and could boost demand for real estate. With interest rates remaining low, this could lead to excessively fast credit growth, and if the state of the economy worsens, this could then lead to a major increase in loan losses. Eesti Pank Annual Report 2016 22

Macroprudential measures In 2016 the three- In 2016 the three-year long process of introducing a base of macroprudential tools was year long process of completed. The measures that have been set require banks to hold larger capital buffers introducing a base and to adhere to requirements when granting housing loans (see Table 1). In the years of macroprudential ahead Eesti Pank will continue with its regular risk assessment and the measures that have tools was completed. been introduced will be adjusted to reflect the outcome of that, or new measures will be introduced if appropriate.

Table 2. Macroprudential measures introduced by Eesti Pank (as at 31.12.2016)

Measure Rate From Systemic risk buffer 1% 1 August 2016 Other systemically important institutions buffer 2% 1 August 2016 Countercyclical buffer 0% 1 January 2016 Requirements for issuing housing loans* loan-to-value (LTV) 85%** debt service-to-income (DSTI) 50% 1 March 2015 maximum maturity 30 years

* The limits may be breached by 15% of the volume of mortgages issued each quarter ** The limit is up to 90% for loans guaranteed by KredEx

The macroprudential policy decisions that Eesti Pank took in 2016 concerned the capital buffers of the banks. From 1 January 2016 all the banks have to meet the countercyclical buffer requirement. The aim of this buffer is that banks should build up additional capital at times when credit is growing fast so that they can then use it to cover possible loan losses during a later cyclical downturn. The higher capital requirements set during times of rapid growth can also help to slow the growth in credit and restrain rises in asset prices. Eesti Pank introduced a 0% buffer rate for the banks at the start of the year and decided in the subsequent three quarters to maintain that rate unchanged as the debt level of companies and households remained stable and the lending activity of the banks was moderate. Eesti Pank assesses the need for the countercyclical buffer once a quarter. Like it did in Eesti Pank decided to reduce the rate of the systemic risk buffer introduced in August 2015, Eesti Pank 2014, lowering it from 1 August 2016 from 2% to 1%. The buffer rate was lowered because named two banks a separate buffer requirement for systemically important institutions was introduced to as systemically reduce the structural vulnerability that stems from the high level of concentration in the important credit institutions in banking sector. All the banks still have to meet the systemic risk buffer requirement, as 2016, these being before. The buffer helps to strengthen the resilience of the banks to the risks that arise Swedbank AS and because the Estonian economy is small and open. Were the external environment to dete- AS SEB Pank. riorate unexpectedly, it could lead to a rapid and broad reduction in the ability of companies and households to repay their loans. The systemic risks in Estonia are compounded by various structural factors, notably the high proportion of exports and investment, the relatively high level of debt of the non-financial sector in relation to incomes, and the com- paratively modest level of household financial assets.

To ensure a level playing field for all banks operating in the Estonian market, and to be certain the systemic risk buffer would be effective, Eesti Pank requested the authorities of other European Union member states to apply equivalent capital requirements to the Esto- nian exposures of branches and cross-border service providers. The European Systemic Risk Board (ESRB) issued a recommendation on this to the macroprudential authorities of the European Union (ESRB/2016/4). Eesti Pank Annual Report 2016 23

Like it did in 2015, Eesti Pank named two banks as systemically important credit institutions in 2016, these being Swedbank AS and AS SEB Pank, and it introduced a 2% additional buffer requirement for them from 1 August 2016. This buffer is intended to reduce the negative impacts that possible financial problems at a bank with large market share could cause for the functioning of the financial system and for the development of the economy. Eesti Pank analyses changes in market share each year and can change the list of systemically important banks and the buffer rates that apply to them accordingly.

International cooperation in macroprudential policy Under the European Single Supervisory Mechanism (SSM), the macroprudential authorities in the participating member states share responsibility for macroprudential policy with the European Central Bank. The prime responsibility remains with the member state, but the European Central Bank assesses the measures applied, and if necessary can introduce stricter requirements for the banks. The measures taken by countries in 2016 were mainly connected to the introduction of countercyclical capital buffers and capital buffers for systemically important banks. Together with national macroprudential authorities the European Central Bank continued working on developing methodologies which can help in assessing systemic risks and measures taken to reduce risks. To give the public more information about this work, the European Central Bank started to publish a regular bulletin describing the methods used to analyse the risks and the measures taken to reduce risks in the countries participating in the SSM.

Risks to financial stability at the European Union level are assessed and recommendations and warnings about financial stability are issued by the European Systemic Risk Board (ESRB) where appropriate. The ESRB considered that the risks to financial stability in Europe remained at a high level at the end of 2016. With interest rates low, the search for yield continued in financial markets, and greater risks were taken in consequence. At the same time, political uncertainty increased in the USA and some European countries and so did vulnerability in emerging markets. For these reasons the ESRB saw an increased risk that market participants would change their behaviour and the prices of financial assets would fall significantly. The banking sectors of some European countries continued to stand out for their unresolved problems, which included low profitability and a large share of bad loans. The ESRB issued several recommendations and warnings in 2016, for which the anal- The ESRB saw risks ysis and preparations had started in the previous year. In September the ESRB warned in the Estonian eight countries that they faced risks from developments in their local real estate mar- real estate market, kets. The ESRB also saw risks in the Estonian real estate market, though it found that the though it found that the macroprudential macroprudential measures taken by Eesti Pank, particularly the requirements on issuing measures taken housing loans, were appropriate and sufficient. Working with the European Central Bank, by Eesti Pank, the ESRB concluded its analysis of the impact of low interest rates on financial stability, particularly the and in November it published a report on that together with policy recommendations. It requirements on further recommended for the first time that other countries should reciprocate the expo- issuing housing sure-based measures taken by other EU member states, such as the additional require- loans, were appropriate and ments introduced by the Belgian central bank for Belgian residential real estate loans. As sufficient. the Estonian banks had no credit positions related to residential real estate in Belgium, Eesti Pank decided not to apply the additional requirements. The ESRB also issued an additional recommendation to reciprocate the systemic risk buffer requirement introduced by Eesti Pank. Eesti Pank Annual Report 2016 24

Macroprudential policy cooperation in the Nordic and Baltic regions continued in the informal high-level Nordic-Baltic Macroprudential Forum (NBMF), which brings together heads of central banks and supervisory authorities. A major part of the work of the NBMF consisted of presentation of the risk assessments of participating countries and sharing of experience of implementing macroprudential policy. There was also a discussion in 2016 of methodologies for setting the appropriate rate of the countercyclical buffer, and on how to organise the announcement of measures and mutual recognition of them.

Financial sector policy

The most important change in financial sector supervision in recent years has been the creation of the Banking Union in the European Union. This is intended to strengthen the supervision of banks operating in the euro area and to resolve effectively problems that arise in the banking sector. The first pillar of the Banking Union, the Single Supervisory Mechanism, started to operate in 2014. A year later the Single Resolution Mechanism was launched, and the Single Resolution Fund was created as a part of this. Within this it was necessary to find a solution for cases where the Single Resolution Fund did not have enough funds available. To achieve this the member states signed a transitional agreement for a common backstop that runs until 2024, and looking forward have started to develop the permanent guarantee measures that will be in place after the transition period.

Discussions on the development of the third pillar of the Banking Union, a European deposit insurance scheme, continued. Eesti Pank’s position is that this is necessary for the effective functioning of the Banking Union. The relatively high risks in the banking sectors in some member states of the European Union make it harder to reach an agreement. To reduce these risks, the European Commission proposed various changes to European Union Directives and Regulations concerning banking in November 2016.

The European Commission has brought together several policy issues affecting the financial sector in the Capital Markets Union initiative, which is a programme of 33 different measures that are planned to be introduced by 2019. This should help to improve and diversify the sources of financing for companies. Last year saw the first steps taken, the most important of which were the European Union’s Securitisation Regulation and the Prospectus Regulation, and the creation of the framework for covered bonds. During the drafting of an Estonian law for covered bonds, Eesti Pank recommended that the implementation of domestic regulation should be harmonised with the development of the framework at the European level.

Eesti Pank made In summer 2016 the United Kingdom held a referendum in which it voted to leave the Euro- proposals to pean Union. Eesti Pank was involved in setting the Estonian positions for the exit negotia- the European tions with the United Kingdom and for the future of the European Union. Eesti Pank finds Commission for how that the United Kingdom’s exit from the European Union will only have a small impact on the organisation financial stability in Estonia, and it will have a gradual impact over a fairly long period. of work in macroprudential The reason for this is that the direct relations between the financial systems of Estonia supervision could and the United Kingdom are small, so the main channels of influence will be indirect ones be extended in the like increased uncertainty in international financial markets and possible problems in the European Union and Swedish financial sector. The size of the actual impact is largely unknown as it will depend the implementation of on the agreement that finally emerges from the exit negotiations. measures improved. The European Commission carried out public consultation in 2016 on how to improve the functioning of macroprudential supervision in the European Union and how to clarify the choices for implementing measures. Eesti Pank supported the position that micro Eesti Pank Annual Report 2016 25

and macroprudential supervision should be kept separate, so supervision of the individual banks and the whole banking system should be implemented separately. Measures against systemic risk can currently be introduced by both macro and micro supervision institutions, and this makes it harder for market participants to understand what systemic risks are being assessed in a country and which measures are introduced to minimise the risks.

The current European Union procedure for introducing macroprudential supervisory measures contains many inappropriate restrictions. This could mean that necessary measures remain untaken at a time when they are needed. The Eesti Pank opinion contained proposals for the elimination or easing of several restrictions such as the elimination or raising of the current upper limit on the other important institutions buffer requirement. Eesti Pank also supported the harmonisation of macroprudential supervisory measures to make them more meaningful and effective and to reduce the administrative burden of them.

Crisis management

A cooperation agreement was drawn up jointly with the other Nordic and Baltic central banks with the intention of creating a framework for ensuring financial stability and providing emergency liquidity. This is necessary with banking groups with cross-border operations, as such work requires coordinated action by the central banks. The agreement sets out the principles for cooperation and for sharing information, and the grounds for providing emergency liquidity to a bank. Eesti Pank can provide liquidity to banks for monetary policy operations or as Emergency Liquidity Assistance. The principles of the agreement say that the responsibility for providing Emergency Liquidity Assistance falls on the central bank in whose jurisdiction the licence was issued to the bank. The decision to pro- A cooperation vide or not to provide liquidity assistance is made individually and independently by each agreement was central bank. The new agreement will replace the cooperation agreements signed in 2006 drawn up jointly with the other between the central banks of Estonia, Latvia, Lithuania and Sweden on managing finan- Nordic and Baltic cial crises. central banks Domestically Eesti Pank advised the Financial Supervision Authority in its assessment of with the intention of creating a the recovery and resolution plans that the banks draw up annually to guard against insol- framework for vency. These plans are required by the Financial Crisis Prevention and Resolution Act, ensuring financial which regulates the actions of banks. Eesti Pank assesses the measures and steps that stability and pro each bank expects to take to recover liquidity if it were to fall into difficulties because of a viding emergency liquidity shortage. It is important for Eesti Pank that the banks operating in Estonia be suf- liquidity. ficiently able to access liquidity from the central bank and that they have sufficient suitable collateral for transactions with the central bank.

The Riigikogu passed changes to the Guarantee Fund Act at the end of 2015 to harmonise it with the Directive on Deposit Guarantee Schemes of the European Union. As a consequence of this, the Ministry of Finance drafted a regulation, and Eesti Pank advised on the process. The requirements for the banks for informing depositors about the size of the deposit guaranteed and for regular reporting to the guarantee fund were introduced in the amended form. The new procedure uses the risk-based contributions calculation method for funding the deposit guarantee fund, and from 2016 the payment made into the deposit guarantee fund by each bank has started to depend on the risk profile of the bank as well as on the volume of its deposits. Eesti Pank Annual Report 2016 26

MANAGING CURRENCY CIRCULATION

The role of Eesti Pank

Eesti Pank ensures there is sufficient good-quality cash in circulation in Estonia. As the central bank of a euro area country, Eesti Pank is responsible for satisfying the demand for euro banknotes and coins in Estonia and for managing and maintaining the security of the cash stocks needed for circulation. Eesti Pank also helps payment systems function efficiently, acts as overseer for payment systems, and is involved in developing the payment environment.

Availability of cash

The availability of cash is backed up by the network of bank offices and automated teller machines (ATMs), which is extended further by the option of withdrawing cash through the tills of shops. Although services such as the bank bus and the postal bank have disap- peared, cashback withdrawals can be made from around 380 shops across Estonia.

In 2016 Eesti Pank The takeover of one competitor with small market share has led service provision in cash issued 1 billion handling services to be concentrated with one company. Credit institutions are updating euros to credit their ATMs by replacing cash-in machines with cash recycling machines (CRM). These institutions and 0.84 billion euros changes have reduced the quantity of cash sorted by Eesti Pank as well. The reduc- were returned tion in that quantity means that monitoring the quality of cash in circulation has become to Eesti Pank. even more important, and attention needs to be focused on overseeing the cash handling equipment used by companies providing cash processing services.

In 2016, 23.1 million banknotes were issued by Eesti Pank. The most commonly issued note continues to be the 50-euro note. The widespread use of the 50-euro notes arises because it is the most commonly used in ATMs and it is used both for making payments and for saving.

The issuance of 100-euro and 200-euro notes was higher than in 2015, while the issuance of small denomination notes of five, ten and twenty euros has declined as cash recycling machines have become more common and changes have occurred in the cash handling service sector. More 20-euro and 100-euro notes were again returned to Eesti Pank than were issued. The dynamics of cash issued and returned are shown in Figure 5. It is apparent from the figure that though Figure 5. Banknotes issued and returned the amounts of cash being issued and being returned have shrunk, net issuance has been banknotes issued, million (left scale) banknotes returned, million (left scale) net issuance, million (right scale) increasing since 2014. 50 12 In 2016 Eesti Pank issued 1 billion euros to 45 10 credit institutions and 0.84 billion euros were 40 returned to Eesti Pank (see Table 3). Although 35 8 the number of banknotes issued and returned 30 has fallen over the years, the value of cash 25 6 circulating in Estonia was up on 2015. Since

20 the euro was introduced, the net total of euro 4 cash issued by Eesti Pank has increased to 15 1.26 billion euros, of which 1.22 billion euros 10 2 was in banknotes and 45.1 million euros in 5 coins. Figure 8 shows the dynamics of the 0 0 2011 2012 2013 2014 2015 2016 issue and return of coins. A reduction year Eesti Pank Annual Report 2016 27

Table 3. Cash flows between Eesti Pank and credit institutions

Total amount (EUR billion) Number (million)

Year Issued by Received by Issued by Eesti Pank Received by Eesti Pank Eesti Pank Eesti Pank banknotes coins banknotes coins 2011 1.67 1.05 45.5 124.5 35.3 22.3 2012 1.44 1.32 43.8 35.9 43.3 5.0 2013 1.47 1.33 42.0 34.2 41.1 5.9 2014 1.30 1.21 38.1 30.0 37.3 5.6 2015 1.19 1.05 35.2 26.8 31.8 4.4 2016 1.00 0.84 23.1 23.9 18.7 0.7 by year in the amount of coins both issued Figure 6. Coins issued and returned and returned is evident from the figure. The coins issued, million net number of coins issued has been stable coins returned, million net issuance, million in recent years at between 22 and 25 million 140 coins. The most common coins issued by volume were one and two-cent coins, which 120 people often pile up as low-value coins after they have entered circulation. 100

Banknotes returned to Eesti Pank by credit 80 institutions are sorted by fully automated 60 sorting machines, the authenticity of all the notes is checked using parameters that only 40 the central bank knows, and worn, dirty, torn or stained banknotes are removed from cir- 20 culation. Banknotes that are suitable for cir- 0 culation are packaged and returned back into 2011 2012 2013 2014 2015 2016 circulation. A total of 18.8 million banknotes were processed, which is slightly less than half as many as in the previous year. Around 5.8% of the banknotes processed, meaning The number of some 1.1 million notes, were sorted as unfit for circulation, indicating that the quality of counterfeits banknotes in circulation is good. In 2016, experts from Eesti Pank analysed 9553 damaged discovered in banknotes and 662 coins, which were also removed from circulation. Estonia has been one of the lowest If there is a suspicion that a banknote is counterfeit, the Police and Border Guard Board in the euro area must be informed, so they can start an investigation. Banknotes that have been sent to over the years. the police as suspected counterfeits are examined by experts from the Estonian Forensic Science Institute, whose analysis confirms or rejects the authenticity of the banknote. This process led to the discovery of 518 counterfeit euro banknotes in Estonia in 2016. The number of counterfeits discovered was greatly affected by three cases, two of which found large quantities of counterfeit 50-euro notes, and one of which found 500-euro notes. There were 71 counterfeit euro coins discovered in Estonia. The number of counterfeits discovered in Estonia has been one of the lowest in the euro area over the years.

Estonian kroons returned as cash Eesti Pank will always exchange kroons for euros, and in 2016 this was done on 2508 occasions as kroons in cash worth about 557,473 euros were exchanged. Some part of the kroons cash that was in circulation has been permanently lost over the years or has Eesti Pank Annual Report 2016 28

been destroyed, and the amounts exchanged are smaller each year, but the facility for exchanging kroons for euros remains open.

Table 4. Unreturned kroons by nominal value of notes and coins

Banknotes Coins

Nominal Number of unreturned Value of unreturned notes in Nominal Number of Value of unreturned value notes EUR and EEK* value unreturned coins coins in EUR and EEK*

18 409 335 € 637 817 € 500 576 087 5 1 995 935 288 043 500 EEK 9 979 675 EEK 9 852 249 € 3 088 074 € 100 1 541 542 1 48 317 858 154 154 200 EEK 48 317 858 EEK 1 374 113 € 1 086 515 € 50 430 004 0,5 34 000 543 21 500 200 EEK 17 000 272 EEK 3 832 708 € 1 080 668 € 25 2 398 754 0,2 84 543 862 59 968 850 EEK 16 908 772 EEK 2 527 608 € 727 056 € 10 3 954 847 0,1 113 759 581 39 548 470 EEK 11 375 958 EEK 1 510 041 € 121 500 € 5 4 725 402 0,05 38 021 181 23 627 010 EEK 1 901 059 EEK 1 344 686 € 6 741 630 € 2 10 519 884 Total 320 638 960 21 039 768 EEK 105 483 594 EEK 289 966 € 1 4 536 986 4 536 986 EEK 39 140 707 € Total 28 683 506 612 418 984 EEK

*Unreturned kroons are converted into euros at the exchange rate of 1:15.6466.

Tens of millions of euros-worth of kroons are still unreturned Although there is no limit on how long kroons can be exchanged for euros for in the Eesti Pank museum shop, not all of the kroons in circulation will return to the central bank. The Estonian kroon has an important place in the nation’s history, and so a lot of people have kept coins and notes as souvenirs. Some notes will have been destroyed over time as well. Fewer and fewer kroons have been exchanged for euros over time. At the end of 2016 there were still more than 45 million euros-worth of kroons unreturned (see table 4). As it is very probable that not all kroons will be exchanged for euros, Eesti Pank devised a methodology by which the unreturned kroons were transferred to the income of the central bank. The Eesti Pank Executive Board decided that the obligation to exchange the kroons in circulation with a value of 45.1 million euros would be transferred to income and a targeted provision of 29.6 million euros would be set up. Future exchanges of kroons for euros will be funded from the provision. Other central banks in the euro area have made similar provisions, and Eesti Pank used the experience of the central banks of Ireland, Spain and Austria in deciding the size of the provision.

New banknotes and coins Preparations continued in 2016 for the introduction of the 50-euro banknotes of the second series, which will enter into circulation from 4 April 2017. A total of 6.2 billion banknotes were produced in the euro area in 2016, of which 73% were the new 50-euro notes of the second series. Eesti Pank allowed suppliers of cash handling devices and companies adopting such devices to borrow samples of the new 50-euro notes for testing purposes, and organised tests of cash handling devices. Stocks of banknotes and coins were replenished in 2016 to cover the structural demand for cash and meet the volumes needed. Eesti Pank Annual Report 2016 29 Photograph: Eesti Pank

Fully-automated machines are used for sorting banknotes in the euro area, and two of them are at Eesti Pank. This machine has been in use since 2010 and is able to sort around 30 banknotes per second. The machine is able to count the banknotes and check their authenticity, remove and destroy notes that are unfit for circulation, and package up the ones that are fit.

Banknotes All the central banks of the euro area are involved in the production of euro banknotes every year. In the third quarter of 2016, the Oberthur printing works in France concluded its work of filling the production obligations of Eesti Pank. The production obligation for 2016 of 14.6 million 50-euro banknotes of the second series will be met by the J.Enschede Preparations printing works in the Netherlands, and it is planned that this production will be com- continued in 2016 pleted in the first quarter of 2017. The new banknotes will be pooled with the stocks of the for the introduction Eurosystem. In 2017 Eesti Pank fulfilled its production obligation by joining with seven other of the 50-euro euro area central banks in a Joint European Tender11 to print the quota of second series banknotes of the second series, fifty-euro notes set by the Governing Council of the European Central Bank. The winner of which will enter the joint tender was the Bundesdruckerei printing works in Berlin, where the production into circulation volumes will be produced to meet the 2017 production allocation. from 4 April 2017.

The issuance of 500-euro banknotes will be discontinued The Governing Council of the European Central Bank plans to stop issuing 500-euro banknotes at the end of 2018. This means that from 2019, 500-euro banknotes will no longer be issued into circulation. In that same year, 2019, the 100-euro and 200-euro banknotes of the second series, with enhanced security features, will enter into circulation. All the other denominations of euros, from five euros to 200 euros, will remain in circulation, and the 500-euro banknote will continue to be legal tender and will keep its value.

11 The Joint European Tender is a shared format for procuring the banknote quotas for the central banks of eight countries – Cyprus, Estonia, Finland, Luxembourg, Malta, the Netherlands, Slovakia and Slovenia. Eesti Pank Annual Report 2016 30

Eesti Pank has a tradition of showcasing and presenting new collector coins and coin sets, which commemorate people, events or objects that are important for Estonia. The collector coins and coin sets are usually presented in the museum of Eesti Pank. The coin set dedicated to the 25th anniversary of Estonia regaining its independence was presented in the Valge Saal (White Hall) of Toompea castle on 20 August.

Circulation coins At the start of the year a two-euro commemorative coin with a special design was issued to mark the 100th anniversary of the birth of Paul Keres. A total of 0.5 million of the two-euro coins were minted, of which 5000 had a high-quality finish. The stocks of one, two, five and twenty-cent coins were replenished in 2016. The Eesti Pank procurement for minting the coins was won by the Mint of Finland. The 9 million one-cent coins, the 4 million two-cent coins, the 4.55 million five-cent coins and the 3.25 million twenty-cent coins minted with the issuance year 2017 will enter into circulation in the first quarter of 2017. Photograph: Erik Peinar

Eesti Pank usually issues a coin folder together with its collector coins, and these commemorate people, events or objects that are important for Estonia. The collector coins and the coin folders are usually presented in the museum of Eesti Pank. The coin set dedicated to the 25th anniversary of the return of independence to Estonia was presented in the Valge Saal (White Hall) of Toompea castle on 20 August.

Collector coins and numismatic products Several projects for collector coins and other collector products were in process in 2016. A ten-euro silver collector coin dedicated to Jaan Poska was issued on 22 January, and 4000 of the coins were minted in the Lithuanian Mint. The blue, black and white design was created by Mall Nukke. A second silver coin, designed by Martin Pärn and dedicated to the Olympic Games in Rio de Janeiro, was issued in 2016, and it was again the Lithua- nian Mint that minted 5000 of the coins. Eesti Pank Annual Report 2016 31

What is the difference between a collector coin and a commemorative coin? The commemorative coin is a normal circulation coin with a special design. The special designs are related to an important local or European event. Each euro area member may issue two two-euro coins with a special design into circulation each year, unless a joint commemorative coin has been issued. The countries of the euro area may also issue one joint commemorative coin once a year. Commemorative coins are valid as legal tender throughout the euro area. Collector coins are mostly made of precious metals and commemorate important events or people for the issuing country. Collector coins are only legal tender in the country of issuance, but they are not intended for circulation and their selling price usually exceeds their nominal value. Anyone, whether a private individual, an institution, a company or an organisation, may submit proposals to Eesti Pank for coins that could be minted. The proposals are considered by an advisory committee, whose recommendations are used by the Executive Board of Eesti Pank in its decisions on coins. Collector coins issued by Eesti Pank and other numismatic products and publications and collector’s items can be bought from the museum shop of Eesti Pank. The museum shop is also where Estonian kroons can be exchanged for euros, and worn or damaged cash can be submitted to expert analysis for exchange. Eesti Pank and Eesti Post together run the online shop, which was refurbished in 2016 and is now more convenient to use for buying Eesti Pank products.

Eesti Pank together with the August 20th Club issued a coin set to mark the 25th anniversary of Estonia regaining its independence. The coin set contains eight BU (Brilliant Uncirculated) quality circulation euro coins minted by the Mint of Finland and presented in a coin set designed by Vladimir Taiger. A total of 20,000 of the coin sets were printed and put together in Poland.

A joint project with the Estonian National Museum was a presentation booklet for the ten-kroon note, with a dedication to Jakob Hurt as the founder of the Estonian National Museum. In all, 3000 of the booklets were produced.

Preparations were made for the minting of the silver and gold collector coins dedicated to the Hanseatic town of Tallinn to be released in February 2017. The coins are dedicated to the Hanseatic town of Tallinn to mark its historical importance for trade and economic connections. Both the silver and the gold coins were designed by Riho Luuse and 5000 silver coins and 2000 gold ones were minted. A contract for the minting was signed with the Portuguese Mint.

Payment systems

Payment systems managed by Eesti Pank Eesti Pank manages the TARGET2-Eesti payment system and participates in developing the securities settlement platform TARGET2-Securities.

The year 2016 was one of stability for TARGET2-Eesti as there were no changes in the functionality of the system or in the set of participants, which are 13 credit institutions operating in Estonia and the Estonian Central Securities Depository. Even so, Eesti Pank had reason to convene the National User Group of representatives of the participants on several occasions to discuss the Vision2020 project of the Eurosystem, which had appeared on the agenda in 2015 and can be split into three divisions: Eesti Pank Annual Report 2016 32

What is TARGET2 TARGET2 is the system that allows euro payments to be made in real time. All payments are processed individually on a single technical platform. TARGET2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the leading system in Europe for processing the large-scale payments that are used by the national central banks and the commercial banks. The system is owned and operated by the Eurosystem, which is the European Central Bank and the national central banks of the euro area. For financial stability in the euro area to be ensured it is necessary that the payment systems function efficiently and smoothly, and this makes TARGET2 one of the main elements in the financial integration of the European Union. In short it permits the free movement of money across borders and supports the implementation of the single monetary policy of the European Central Bank. Around 1800 banks are direct participants in TARGET2. As there are other ways of accessing it, TARGET2 can be used by more than 55,000 banks and their clients around the world.

• harmonisation of the technological solutions for the TARGET2 payment system and the TARGET2-Securities (T2S) securities settlement platform, both run by the Eurosystem – division of the technical platform, use of harmonised messaging standards, and single access for users of TARGET2 and T2S services;

• instant payments – the settlement service for instant payments provided by the Eurosystem to all TARGET2 participants; the infrastructure provided can allow participants to construct completely new payment solutions based on it;

• development of a new system for collateral management – a system covering all the central banks in the Eurosystem for providing services relating to monetary policy collateral to all the market participants and central banks.

Estonian market participants also made their own contributions to the discussions of Vision2020. The development of the project will be decided on by the Governing Council of the European Central Bank in 2017.

There were also less welcome events in 2016 as cyber criminals succeeded in stealing millions of dollars from several banks around the world. As the interbank payment systems handle vital processes, they need protection at both the global and the local level, and so the Eurosystem as operator of TARGET2 and the providers of network services initiated additional measures to guard against cyber threats.

In 2015 the pan-European T2S securities settlement platform was launched, which will harmonise securities settlement across Europe. To disperse the risks arising from the large number of participants and the technical complexity, entry to the platform is being managed in waves. By the end of 2016, 12 depositories operating in Europe had joined T2S and the platform was settling about half of the volume of transactions that it is planned to be handling once all the waves have joined. Another nine depositories and the central banks providing them with cash settlement will join in 2017. The Estonian depository will join in the final wave in September 2017 as part of the Baltic depository being set up, and Eesti Pank will join at the same time. Eesti Pank Annual Report 2016 33

Oversight Eesti Pank monitors and assesses the risks to the important payment and settlement systems in Estonia and gives advice to system managers for improving the work of the systems and reducing risks.

At the beginning of the year Eesti Pank completed its assessment of the risks to the card payment system. The bank finds that the communications standards used are appropriate for the functioning of the system, and the business and operational risks are well managed. It remains necessary to minimise legal risks, and the conditions for joining the system need improving. The procedures to be followed if a bank participating in the system becomes insolvent also need to be developed, and issues around the finality of settlement need to be clarified. Eesti Pank made recommendations to both Nets Estonia and the banks participating in the system on how to contain risks in these areas. The execution of the Eesti Pank recommendations is planned for 2017.

The Estonian payment environment in numbers and the main events in 2016

Number (thousand Turnover (million Main developments Main actions by Eesti Pank payments per day) euros per day) in the market The first banks started to issue The overseer assessed the card payment Card payments 760 13 contactless payment cards system operated by Nets Estonia Domestic payments in At the proposal of Estonian market participants and Eesti Pank, another window for 121 143 the STEP2 system payments was added to the system, speeding up transfers in the morning Payments in the Vision2020: joining of TARGET2 and T2S, instant payments, 3.6 380 TARGET2-Eesti system a system for managing pooled collateral Payment transactions Payment institutions increased their client base, raising the number 13 1.8 of payment institutions and turnover of transactions 1. Preparations for joining T2S Securities transactions 0.13 0.442 (ECSD) 2. Preparations for creating a 2. The overseer monitored compliance with the recom- pan-Baltic depository mendations arising from the assessment in 2015

The risks from securities settlement arise from three major development projects being launched simultaneously in autumn 2017. Preparations are proceeding in parallel for the unification of the Baltic depositories in one as the Nasdaq CSD, the adoption of new securities settlement systems, and accession to the TARGET2-Securities settlement platform. The central banks of the three Baltic states started to assess the risks of the systems being created. The central banks as overseers of the securities settlement systems will start to participate in supervision of the unified depository, working with the competent authorities in Latvia, Lithuania and Estonia. Eesti Pank also monitored how the recommendations for improvements to the currently operating settlement system were met. The majority of the recommendations were fulfilled, but those where implementation is related to the technical standards of the Central Securities Depositories Regulation (CSDR) coming into force were directed to the Nasdaq CSD.

The STEP2 system used for the settlement of the interbank retail payments of Estonian bank clients functioned without major incident in 2016. Eesti Pank found that most of the risks in the system were satisfactorily minimised. One point of concern is that payments Eesti Pank Annual Report 2016 34

can be unwound and liquidity risk arises from this, and there are also risks from indirect membership. The system was assessed in 2016 under the leadership of the European Central Bank, which is the principal overseer for STEP2, and recommendations were made to the system operator for how to minimise risks.

Contribution to the development of the payment market From November Eesti Pank contributes to the functioning and the development of the Estonian payment 2016, clients have market, facilitating cooperation between parties in payment intermediation and partici- been able to receive pating in designing and implementing financial sector policies and regulation. payments to their accounts from The banks settle both domestic and cross-border retail payments in euros in the pan-Eu- other banks earlier ropean STEP2 system. Eesti Pank and the banks operating in Estonia together proposed in the mornings in 2015 to the STEP2 operator that an additional time window for sending payments could of working days. be made possible, and this was achieved in 2016. Most of the banks operating in Estonia are by now using this time window, with the result that 15% of early morning transactions reach the client’s account more quickly (see Figure 7).

To develop the payments market, Eesti Pank monitored and analysed the Estonian payments market in 2016 and advised public and private sector institutions on payments topics. Eesti Pank organised payments forums in Figure 7. Cumulative number of retail payments by settlement day 2016 covering Estonian and pan-European

ESTA (until February 2014) topics to give information to market partic- STEP2 (December 2016) ipants and keep them abreast of what was STEP2 (until November 2016) 100% new and what was happening in the pay- 90% ments market. Topics discussed included 80% legislative issues, developments at the Euro- 70% pean Retail Payments Board, reviews of the 60% payments market in Estonia, and instant pay- 50% ments. A first review was also given of the 40% contactless cards that started to be issued in 30% Estonia in 2016 and that allow faster payment

20% of up to ten euros for goods and services.

10% Eesti Pank participated in the work of pan-Eu- 0% 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 ropean working groups where attention was 0 3 0 3 0 3 0 3 0 3 0 3 0 3 0 3 0 : : : : : : : : : : : : : : : : : : 3 : 0 : 3 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 9 9 8

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 particularly focused on instant payments, * The introduction in November 2016 of an additional settlement option increased the share of cross-border e-invoices, contactless pay- payments sent early in the morning from 19% to 34%, making it equal to the volume handled at the start of the day by ESTA, the discontinued settlement system that was operated by Eesti Pank. ments, mobile payments and legislative issues. Eesti Pank Annual Report 2016 35

STATISTICS FOR THE ESTONIAN FINANCIAL AND EXTERNAL SECTORS Eesti Pank’s main duty in statistics is to produce and disseminate the financial sector and balance of payments statistics that are needed for the bank to execute its responsibilities. High quality, reliable, timely and consistent statistical data are the starting point for analysis of the Estonian economy and the financial sector, they are used in forecasting, and they are needed by the European Central Bank, Eurostat, the OECD, the IMF and other international bodies as an input for the statistical work of the European Union, the economic and monetary union and other international bodies. Eesti Pank is involved in developing statistical methods for international organisations and in maintaining the single reg- ister and database of the European System of Central Banks. Statistics were compiled and published on time in 2016, and were transmitted to international organisations on time too, and Eesti Pank completed all the statistical activities required under the national statistical programme and did not depart from the release calendar.

Development of new areas of statistics

Since Estonia joined the euro area, the driver of development in financial sector statistics has primarily been the statistical regulations and guidelines of the European Central Bank, and significant resources and international cooperation have been poured into developing them. The focus in financial sector statistics in recent years has mainly been on non-bank entities and on increasing the level of detail in statistics. The concentration on developing insurance and pension fund statistics meant that 2016 was no exception to this trend. The European Central Bank approved a regulation in May calling for detailed loan-based data from credit institutions to be collected from September 2018 in an AnaCredit database being created at the European Central Bank. The goal of this is to facilitate analysis that would support financial stability, but it will require large amounts of preparation by central banks and by credit institutions. To make the work go as smoothly as possible, a working group has been engaged since spring 2016 under the leadership of Eesti Pank and with participation from credit institutions and the Financial Supervision Authority.

Access to detailed statistics on securities is needed for identifying the risks from cross- border and domestic financial interconnection and the scale of those risks. For this reason the single securities database of the European Central Bank is being used more and more in compiling statistics and for various non-statistical aims. On top of its regular transmis- sions of data, Eesti Pank contributed to managing the quality of securities statistics and to developing the work processes that that required. A change to the regulation on securities holding statistics that will come into force in September 2018 will expand the list of banking groups reporting and notably increase the level of detail of the reports. Work has started at Eesti Pank to commence collection of data on the most important banking groups in Estonia.

Statistics focus on granular data Reliable, usable and internationally comparable statistics are the foundation of evidence-based economic and monetary policy. History has often shown us that crises always occur there where we were not watching carefully enough and where we did not quantify what was happening. This was confirmed again in the financial crisis of 2008, which the toolboxes of analysts and policymakers did not equip them to predict, even though they had large numbers of statistical time series. The classical time series were unfortunately not much use. The figures were too general and it was not possible to see from them the strength and depth of the financial links between countries and economic sectors. Eesti Pank Annual Report 2016 36

To eliminate such blind spots, the statistical system of the European Central Bank has focused its attention in recent years on granular data that give a detailed picture of individual events. This has seen the creation of the Centralised Securities Database, where information is constantly collected on issues of tradeable securities, issuers and prices so that analysis can be taken up to a new level. A second parallel database, the Securities Holdings Statistics Database, is under development and will start to collect detailed information on securities holders and the securities in their portfolios. Connecting these two databases will make it possible to assess risks arising from how the position of issuers and securities prices affect the welfare of economic sectors they have invested in across the whole euro area. The AnaCredit database of detailed information on lending, which will go live in 2018, will also contain granular data and give a picture of who owes how much debt to whom and how those debts are secured. Initially, loans from credit institutions to the business sector will be taken under observation. It will be possible to combine and use all three databases together in the analysis process. In a globalised and rapidly changing financial world, statistics must keep pace with innovations. Granular data have been called the oil of the 21st century, and they are the key to understanding better the processes, links and chains between countries, economic sectors, and large financial institutions, in a modern world where finance concerns more than just banks.

Focus on optimising the burden of reporting

At the same time that the level of detail has been increased in data collection, both the Euro- pean Central Bank and Eesti Pank have sought ways to reduce the burden of reporting. Insurance statistics were compiled for the financial sector statistics using the reporting of financial supervision. Another new approach is the exchange of insurance statistics with the Lithuanian central bank, which saves the Estonian and Lithuanian branches of insurers having to submit separate statistical reports.

To ease the burden of reporting in the banking sector, the European Central Bank started developing a European Reporting Framework (ERF). The principle behind this is to collect from the euro area countries all the statistics and banking sector data needed for banking supervision in an integrated and harmonised way.

Figure 8. External sector, ﬁnancial sector and securities statistics Ways of reducing the reporting burden for sent to international organisations businesses are also being sought in the ECB Eurostat external sector statistics. In 2016 Eesti Pank other (OECD, IMF and the World Bank) joined the Aruandlus 3.0 project on reporting, 2.0 in which reports, the figures in them and the 1.8 data exchange channels are analysed jointly 1.6 with Statistics Estonia and the Tax and Cus- 1.4 toms Board. The project aims to make it 1.2 possible for personal and economic data 1.0 that are important for the functioning of the 0.8 state to move automatically in the simplest million indicators million 0.6 possible way.

0.4 Figure 8 shows the volumes of statistical 0.2 data sent to international organisations. The 0.0 reduction in data volumes in 2016 does not 2008 2009 2010 2011 2012 2013 2014 2015 2016 indicate a reduction in the demand for data, but rather an improvement in the efficiency of Eesti Pank Annual Report 2016 37

international cooperation. Earlier, entire time series were sent in full for the agreed datasets for particular periods, but from 2016 Eesti Pank sends the data for the reporting period in full, but only sends the adjusted data for earlier periods when they have actually changed.

Domestic cooperation

The quality and compatibility of statistics is ensured by good cooperation between the two institutions producing statistics, Statistics Estonia and Eesti Pank. Drafting of a new joint memorandum on cooperation started in 2016 to set out more precisely the areas of cooperation and the principles for it so as to raise the efficiency of statistical work, improve cooperation on methodologies, and avoid work being repeated. The memorandum will be signed in 2017.

Publication of statistics

Several moves were made in 2016 to improve the accessibility of the statistics published on the Eesti Pank website and to extend them into new areas. External sector statistics started to be released at 08.00 rather than 12.00, which was appreciated by journalists. Several new indicators were added to the public database, including the effective exchange rate index and the consolidated figures from the Household Finance and Consumption Survey. At the same time efforts were made to increase access to statistics and improve their ease of use and make the information supplied more relevant. An updated version of the meta database was published in the second quarter with new functionality that Figure 9. Use of statistics from the Eesti Pank website for allows users to find the definitions and meth- different sectors ﬁnancial sector statistics and the ﬁnancial account odological information they are searching for external sector statistics key economic indicators and household survey results more easily than before. The publication cal- 600,000 endar for statistics was also updated and the functionality for downloading statistics was 500,000 improved. 400,000 The increasing need for statistics is confirmed by the year on year increase in the 300,000 number of visitors using the statistics sec- clicks of number tion of the Eesti Pank website (see Figure 9). 200,000 The number of hits on the Estonian language pages has remained the same over the years, 100,000 but the number of hits on the English site has 0 multiplied many times over in the past four 2012 2013 2014 2015 2016 years for both financial sector and external sector statistics.

Development of the new reporting gateway

To help it cope with the new statistical demands, the additional transmission of international data and the shorter release deadlines, Eesti Pank continues to work on improving the capacity of its IT solutions for processing and exchanging data. Work continued in 2016 on the development of a new portal for data reporting. An international procurement was run successfully at the start of the year, and a contract was signed with the winner in June. Development work was on schedule at the end of 2016, giving reason to expect that the portal will be ready for launch at the start of 2018. The project to develop the new Eesti Pank Annual Report 2016 38

portal has been driven by the need to consolidate the statistics from Eesti Pank’s statistical reporting and the supervisory reporting of the Financial Supervision Authority, provide modern ways of submitting data, make data collection and processing more efficient, and minimise staffing risks and other risks. Collage: Eesti Pank

Although the first international statistical standards were only issued in 1947, the consolidated balance sheets of the banks and the national balance of payments were first compiled in the 1930s. These statistics remain important for the financial sector and external sector statistics of Eesti Pank today. Eesti Pank Annual Report 2016 39

ECONOMIC ANALYSIS AND CONSULTATION

Economic analysis and monitoring at Eesti Pank

Economic monitoring and analysis by Eesti Pank is used in the preparation of monetary policy decisions in the Eurosystem and to support financial stability, and in the bank’s role as an advisor to the government. Research work is reflected in the regular publications of the bank.

The lending review published in February found the ability of the banks operating in Estonia to supply credit and the competition in the corporate loan market to be good. However, the financial behaviour of companies and households remains cautious and debt has grown moderately. Given the relatively low level of GDP in Estonia, the debt levels of Estonian households and companies are relatively high in comparison to those of other countries in the European Union. In recent years Estonia has become more similar to other countries in this sense12. The Competitiveness Report published in March considered price competitiveness from The the effective exchange rate, the change in the global market share of the Estonian exporting competitiveness sector, and ways of differentiating between price-based and non-price competitiveness. of Estonian Competition has become tighter in several branches of manufacturing and services since manufacturing and services is similar the crisis of 2009. Weak demand for imports from Estonia’s main trading partners has to that of other reduced the market share of Estonian exports in recent years to some extent. Despite countries in Central this, the competitiveness of Estonian manufacturing and services is similar to that of other and Eastern Europe. countries in Central and Eastern Europe.

A separate chapter of the review looked at domestic competitiveness, which was observed through an analysis of markups and the negotiating strength of employees. It found that a significant share of short-term profit is shared with employees, which shows that employees have a relatively good negotiating position in the Estonia labour market even given the minor role played by trades unions. The Labour Market Review that was published in April and October noted that wage growth Comparison of was exceeding productivity growth, and that employment was rising, though more slowly the labour market even as the economy was growing little. Wage pressures are partly explained by the sub- indicators with other analysis stantially weaker performance of labour-intensive sectors than the average. Comparison indicates that the of the labour market indicators with other analysis indicates that the Estonian economy is Estonian economy still able to keep up with increasing external demand. is still able to keep up with increasing Additional topics were also covered in the Labour Market Review. The spring issue of the external demand. review considered the labour supply over the long term in terms of the average retirement age and the general health of the population, and the autumn issue discussed possible changes in the distribution of revenues and the gender pay gap.

The publication Estonian Economy and Monetary Policy started coming out four times a year rather than twice, and covered not just economic conditions in Estonia but also developments in the global and euro area economies. Each issue contained several additional topics, and two issues contained the latest forecast for the Estonian economy.

The findings of these reports were used in meetings of the Eesti Pank management and experts with the Riigikogu and the government, and with the International Monetary Fund, the European Commission and international ratings agencies.

12 For more on monitoring and analysis of the financial sector, see the section "Ensuring Financial Stability". Eesti Pank Annual Report 2016 40

Alongside these reports, Eesti Pank published its regular commentaries and press releases on the Estonian economy and continued with public lectures presenting the results of its economic analysis. The results of monitoring and analysis were also made public in articles and presentations, and in the Eesti Pank blog.

Economic forecasts

Eesti Pank prepared two forecasts in 2016 as part of the joint broad macroeconomic projection exercise (BMPE) forecast produced with the European Central Bank and the other central banks of the Eurosystem. The first was published in June in the Estonian Economy and Monetary Policy, and the second in December.

In the joint forecasting process, the central bank of each euro area country analyses the outlook for its own economy, and a forecast for the euro area as a whole is compiled from the reports of all the individual member states. The euro area forecast is an important input for the monetary policy decisions taken by the Governing Council of the European Central Bank. To ensure consistency, the forecasts use shared assumptions for growth in the world economy, commodity prices, interest rates and exchange rates. The forecasts are coordinated by the monetary policy committee of the European Central Bank, which is the umbrella for the working groups on forecasting, state finances and the development of forecasting models. Experts from Eesti Pank participate in the monetary policy committee and in its working groups. In autumn 2016 the monetary policy committee decided to extend the forecast horizon, and from December the forecasts of the Eurosystem cover the current year and three years ahead. Photograph: Eesti Pank

Rasmus Kattai, an economist at Eesti Pank, presenting the economic forecast for 2017-2019. The regular economic analyses and forecasts produced at Eesti Pank are usually presented to the public in press conferences. Twice a year, in June and December, the management of Eesti Pank presents the publication Estonian Economy and Monetary Policy with the forecast for the Estonian economy for the current year and the next three calendar years. Eesti Pank Annual Report 2016 41

Economic forecasting at Eesti Pank uses econometric models, which are regularly updated using the results of the economic analysis carried out by the bank. As a rule, several boxes of background information are included with the forecast to show the workings of transfer mechanisms for impacts from the external environment and the important links with it.

Growth has been notably slower in the past couple of years in Estonia than previously. The main focus of the additional topics analysed in the economic forecasts of Eesti Pank in 2016 was on explaining how specific features of the past couple of years will affect economic growth in the near future. Topics included the changed structure of Estonian exports and the competitiveness of the exporting sector, the connections between labour costs and GDP growth, and the potential for growth in a broader sense. There were also reviews of how the saving behaviour of households has changed, the use of transfers from the budget of the European Union, and the external and domestic factors that have affected consumer price inflation.

A few days later a public lecture is given on the same subject. Of key importance for the prospects of faster growth in the economy is an improvement in the competitiveness of companies. Analysis has shown that competitiveness did not deteriorate in 2016 in the general figures and the opinion of exporters, despite the rapid growth in labour costs. This could indicate an improvement in the non-price competitiveness of companies and their products, which is also shown by the better export performance of goods which contain more value added created in Estonia. Growth in foreign demand should support the supply side of the economy. Domestic Eesti Pank finds demand has made a larger contribution to economic growth in the past couple of years, that less production but investment activity has been worryingly low. Eesti Pank finds that less production capacity than expected has been capacity than expected has been added in the past three years, and this has pushed added in the past potential growth below 2.5%. However, monitoring data show that the utilisation rate for three years, and production capacity in Estonia is lower than elsewhere in the European Union, while labour this has pushed market participation continues to increase. Furthermore, the work ability reform will bring potential growth people to the labour market after some time, and they will help ease the labour shortages below 2.5%. in low wage jobs, where the lack of workers is most severe. These factors support the prospects for faster growth. The household savings rate has been found to have risen so far that a sharp change in consumption habits can be avoided.

Overall, the Eesti Pank winter forecast found that real GDP growth in Estonia in 2017–2019 will be between 2.5% and 3.0%.

On top of their work in preparing the Eurosystem forecasts, experts from Eesti Pank also participate in the forecasting working groups of the European Commission and of the Organisation for Economic Cooperation and Development (OECD). Both organisations produce economic forecasts for Estonia, and Eesti Pank is able to give its opinion on the Estonian economy.

Economic research

In line with the strategic research plan, eleven research projects were completed by the monetary policy and research department in 2016 on monetary policy, the financial sector and the real economy, and development of the macroeconomic and banking modelling system. The results of the research work by Eesti Pank economists and visiting researchers was published in Eesti Pank working papers and occasional papers (see Appendix 4). Arti- cles based on the research are also published in academic journals and in publications Eesti Pank Annual Report 2016 42

and working papers of the European Central Bank. Economists of the research division and visiting researchers together wrote 27 research papers in 2016, of which 20 were published during the year. A further five pieces of research were written for the working paper series of the European Central Bank, and four of them were published in 2016 (see Tables 5 and 6). The results of research work were also presented at international scien- tific conferences.

Researchers continued working with Estonian and foreign partners in 2016, participating in the ESCB’s Wage Dynamics Network, and the Household Finance and Consumption Network run by the central banks of the euro area. Three experts from abroad came to work at the bank in 2016 as part of the visiting researcher programme, as did one Esto- nia-based guest researcher. Open seminars were organised again, with 14 guest lecturers speaking at the bank. Professor Michael Burda of Humboldt University gave a presentation on the threat of European disintegration as part of the series of lectures dedicated to Pro- fessor Ragnar Nurkse. The Eesti Pank research awards for 2016 went to Tarvo Vaarmets, Kristjan Liivamägi and Tõnn Talpsepp for their work on behavioural finance, and Marianna Rõbinskaja for her research into factor modelling in forecasting Estonian gross domestic product. Under an agreement on cooperation between the University of Tartu and Eesti Pank, staff from the bank gave courses in the university on macroeconomics and time series econometrics.

Table 5. Research by Eesti Pank employees for the European Central Bank

Working Papers of the European Central Bank 2016 Author Title Published in Export characteristics and output Urška Čede, Bogdan Chiriacescu, Péter Harasztosi, Tibor Lalinsky and ECB Working Paper volatility: comparative firm-level Jaanika Meriküll Series, No. 1902 evidence for CEE countries How competitiveness shocks affect ECB Working Paper Karsten Staehr ja Robert Vermeulen macroeconomic performance across No. 1940 euro area countries Occasional Papers of the European Central Bank 2016 Author Title Published in Pierre Lafourcade, Andrea Gerali, Jan Brůha, Dirk Bursian, Ginters Buss, Vesna Corbo, Markus Haavio, Christina Håkanson, Tibor Hledik, Gábor Labour market modelling in the ECB Occasional Paper, Katay, Dmitry Kulikov, Matija Lozej, Brian Micallef, Dimitris Papageorgiou, light of the financial crisis No 175 Juuso Vanhala and Marin Zeleznik Matteo Ciccarelli, Chiara Osbat, Elena Bobeica, Marek Jarocinski, Caroline Jardet, Caterina Mendicino, Alessandro Notarpietro, Arnoud Stevens, Sergio Santoro, Matthias Mohr, Marco Gross, Styliani Christodouloupulous, Low inflation in the euro area: ECB Occasional Papers, Björn van Roye, Simon Savsek, Elke Hahn, Eliza Lis, Mario Porqueddu, causes and consequences No 181 Jana Jonckheere, Mihail Yanchev, Davor Kunovac, Jakub Matějů, Jesper Pedersen, Jan-Oliver Menz, Dmitry Kulikov et al.

Advisory functions

Under the Eesti Pank Act, Eesti Pank advises the government on economic policy issues. Eesti Pank gives advice primarily on balanced economic development and the stability of the Estonian financial sector, and on relations between the financial and non-financial sectors. In recent years, topics around the further development of the institutional framework of the European Economic and Monetary Union (EMU) have been added to this.

Eesti Pank’s opinion on the EMU looking forwards is that it is particularly important to adhere to the agreed rules. Eesti Pank finds that it is not appropriate in the near term to create new institutions and give increased responsibility for economic policy to the European Union level. Making the structural reforms that are needed to increase Eesti Pank Annual Report 2016 43

Table 6. Selected research articles published by Eesti Pank employees in 2016

Author Title Published in Collection Labor Migration, EU Enlargement, Labor Market Transitions During the Great Andanika Meriküll and the Great Recession (Eds. Martin Kahanec and Recession in Estonia Klaus F. Zimmermann). Springer, 2016

Juan Carlos Cuestas, Alessandra Cepparulo Financial Development, Institutions and Applied Economics, published online, and Maurizio Intartaglia Poverty Alleviation: An Empirical Analysis 9 December 2016

Juan Carlos Cuestas, Yang Chen and Paulo Convergence in Corporate Statutory Tax International Journal of Finance and Economics, Regis Rates in the Asian and Pacific Economies Vol. 21, pp. 266-278

On the relationship between exchange rates Annals of Economics and Finance, Vol. 17-2, Juan Carlos Cuestas and Paulo José Regis and external imbalances: Should we learn pp. 255-280 from East and South-East Asia?

Juan Carlos Cuestas and Maurizio Do institutions alleviate poverty? New Economics Bulletin, 2016, Vol. 36, Issue 1, Intartaglia Empirical Evidence pp. 145-154

Testing for long memory in the presence Studies in Nonlinear Dynamics and Econometrics, Juan Carlos Cuestas and Luis A. Gil-Alana of non-linear deterministic trends with 2016, Vol. 20, Issue 1, pp. 57-74 Chebyshev polynomials

Inflation convergence in Central and Eastern Juan Carlos Cuestas, Luis A. Gil-Alana and Scottish Journal of Political Economy, 2016, Europe vs the Eurozone: non-linearities and Karl Taylor Vol. 63, pp. 519-538 long memory

Juan Carlos Cuestas, Simeon Coleman and Investigating the oil price-exchange rate Economic Issues, Vol 21, Part 2 Estefanía Mourell nexus: evidence from Africa 1970-2004

Economics and Business Letters, Vol. 124, Juan Carlos Cuestas and Karsten Staehr Introduction pp. 129-130

Applied Economic Letters, published online 26 April Juan Carlos Cuestas and Luis A. Gil-Alana Unemployment rate cycles in Europe 2016, in print in 2017 (Vol 24, 2017, Issue 2, pp. 136–139)

The impact of supply shocks on Juan Carlos Cuestas Economics and Business Letters, Vol. 5, No. 4 (2016) unemployment in Spain

Sectoral change and productivity growth Andres Kuusk, Karsten Staehr and Uku Economic Change and Restructuring, 2016, Vol. 49, during boom, bust and recovery in Central Varblane Issue 134, pp. 1-23 and Eastern Europe

How did household indebtedness hamper Journal of Comparative Economics, Vol. 44 (3), Merike Kukk consumption during the recession? pp. 764−786 Evidence from micro data

To be or not to be in the rouble zone. Nataland Levenko and Karsten Staehr CESifo Forum, Vol. 17, No 4 (Winter), pp. 34–42 Lessons from the Baltic states

Public finances and fiscal policy in the Baltic Research in Economics and Business: Central and Karsten Staehr States 1991-2015 Eastern Europe, 2016, Vol. 8, No. 1, pp. 26-41

On the long-run neutrality of demand Economics Letters, 2016, Vol. 139, February, Wenjuan Chen and Aleksei Netšunajev shocks pp. 57–60

Structural vector autoregressions with Econometrics and Statistics, 2016, published online Helmut Lütkepohl and Aleksei Netšunajev heteroskedasticity: A review of different 16.11.2016 volatility models

Journal of Macroeconomics, published online 6 Uncertainty and Employment Dynamics in Aleksei Netšunajev and Katharina Glass December 2016, in print in 2017 the euro area and the US (Vol. 51, March 2017, pp. 48–62)

Deep Habits and Exchange Rate Centre for Applied Macroeconomic Analysis (CAMA) Punnoose Andcob and Lenno Uusküla Pass-through Working Paper, No 17/2016, April

Monetary transmission mechanism Journal of Macroeconomics, Vol. 50, December Lenno Uusküla with firm turnover 2016, pp. 1-18 Eesti Pank Annual Report 2016 44

competitiveness and productivity should be the responsibility of individual countries. New initiatives to boost competitiveness and productivity should aim to direct the free movement of labour in labour markets to the most productive economic activities.

Eesti Pank considers that the no bail-out principle that each country is responsible for its own debts must continue to be followed as before. The increased risk of moral hazard makes Eesti Pank sceptical about the creation of a euro area budget or other form of joint financing in the current economic policy environment, even if it is intended to fund structural reform or smooth the economic cycle.

An important part is played in creating an environment in Europe that is favourable to long- term economic growth by the Banking Union and by the Capital Markets Union. Rolling out these programmes and keeping to the agreements that have been signed for them will not only strengthen the financial sector but also help in integrating the economies of the member states more closely and with economic stability more broadly13.

There was a livelier debate than usual over the budget policy for the next few years in terms of the balanced development of the Estonian economy. One of the aims of the new coalition government that came to power at the end of the year is to reinvigorate the economy. The government will cut income tax for the low paid, increase social benefits and direct support in some other areas, and will produce a multi-year national investment programme, using increased external capital to fund it if necessary. In order to spark up the economy, the government has said it will abandon the requirement for the general government budget to be in structural balance every year, and will permit a deficit of up to 0.5% of GDP. Eesti Pank finds that increasing general government spending and allowing a structural budget deficit is not at present an appropriate way to boost economic growth in the short term. Despite weak Growth in the Estonian economy has been restrained in recent years not by a lack of growth in the domestic demand, but by weak opportunities for exports and problems in individual capi- economy, the main tal-intensive sectors like transport and oil shale. Despite weak growth in the economy, the indicators for the main indicators for the labour market suggest that the domestic economy does not need labour market suggest that the any demand stimulus from fiscal policy, as the employment rate is high, unemployment domestic economy is at historical lows, wage growth exceeds productivity growth, and businesses expect does not need any increasing labour shortages and a rising number of vacancies. If additional resources are demand stimulus funnelled towards lifting domestic growth which is already growing strongly anyway, it may from fiscal policy. hinder the normalisation of growth in labour costs and weaken long-term competitiveness. Furthermore, the ageing of the population over the long-term will put pressure on pension and healthcare spending.

Economic policy questions were discussed more widely at regular meetings with the Min- istry of Finance and the Ministry of Economic Affairs and Communications. The Prime Min- ister’s office and the President of the Republic are also represented at those meetings. Questions of ensuring financial stability are discussed in a joint commission by Eesti Pank, the Ministry of Finance and the Financial Supervision Authority.

13 For more on the development of the legal rulebook for the financial sector, see the section on ensuring financial stability. Eesti Pank Annual Report 2016 45

INTERNATIONAL COOPERATION AND PUBLIC COMMUNICATIONS

International cooperation

Eesti Pank and the other euro area central banks take their key decisions jointly in the Governing Council of the European Central Bank. As a result, working with the European Central Bank accounts for the largest part of Eesti Pank’s international relations. This is followed by work with the Single Supervisory Mechanism (SSM) and the International Monetary Fund (IMF). Eesti Pank works together with the Ministry of Finance in the European Union’s Economic and Financial Affairs Council (ECOFIN) and its substructures. More information on other European Union and international institutions that Eesti Pank works with can be found on the Eesti Pank website14. Table 7 shows Eesti Pank’s participation in international bodies in more detail.

The main issues for Eesti Pank at the European Union level in 2016 were the monetary policy decisions described earlier, macroprudential supervision, and other measures to strengthen financial stability in the European Union. As a representative of the Republic of Estonia at the IMF, Eesti Pank was able to contribute to debates about supporting global economic growth and improving financial security networks.

The IMF gave more priority in 2016 than previously to the distribution of the benefits of growth to all, alongside its focus on balanced economic growth. To this end, the IMF initiated discussions with member states on improving the international monetary system, within which Eesti Pank participated in updating the institutional view on the liberalisation and management of international capital flows. The IMF wants to develop new lending programmes to strengthen global financial security networks by helping countries cope better with liquidity crises.

Also important for Estonia in 2016 was the increase of 149.7 million SDRs15 in Estonia’s quota at the IMF to 243.6 million SDRs. In addition, full-scale economic policy consultations under Article IV of the IMF’s Articles of Agreement were held as part of the surveillance by the IMF in Estonia. The IMF commended Estonia’s economic policy and reform programmes, but it underlined that preserving the capacity for growth requires Estonia to find ways of furthering competitiveness and of letting productivity growth catch up to wage growth.

Public relations

The public relations work of Eesti Pank supports the central bank in its primary role of maintaining price stability in the euro area and in achieving its other strategic goals (statistics on the public relations of the bank are presented in Table 8). The better society understands the actions of the central bank, the more successfully Eesti Pank can do its work. Public support for the central bank’s monetary policy is a great help in maintaining stable and sustain- able economic growth in Estonia and the euro area and in achieving financial stability. For this reason Eesti Pank regularly publishes information, spokespeople from the bank make presentations in meetings and conferences, and blog posts, articles and commentaries are written on topical issues. Eesti Pank also transmits its messages through Twitter.

There was media interest throughout 2016 in the economic commentaries of Eesti Pank, particularly those on the labour market, the outlook for economic growth, and inflation. In the middle of the year the focus fell on how Brexit impacted the development of the Estonian economy, and on the state of banking in Estonia and Europe. At the end of the year the question of balancing the state budget took precedence.

14 http://www.eestipank.ee/en/eesti-pank/international-cooperation. 15 Special Drawing Rights (SDR) are the IMF’s units of account, which were created in 1969 to create an artificial reserve currency that countries could also use for payments between themselves. Eesti Pank Annual Report 2016 46

Table 7. Eesti Pank’s participation in the work of international organisations and institutions*

European System of Central Banks Governing Council of the European Central Bank Ardo Hansson General Council of the European Central Bank Ardo Hansson Supervisory Board of the European Central Bank Madis Müller Public Relations Committee Katrin Kask, Viljar Rääsk Budget Committee Kairi Rätsepp, Helga Käärik Financial Stability Committee Jaak Tõrs Information Technology Committee Ahti Roosa, Jarmo Inkinen Committee on Controlling Helga Käärik, Kairi Rätsepp Payment and Settlement Systems Committee Mihkel Nõmmela, Kaire Torsus Organisational Development Committee Kairi Rätsepp, Helga Käärik Banknote Committee Rait Roosve, Margot Luukas Human Resources Conference Kadi Kapral, Riina Padar-Leppiman Accounting and Monetary Income Committee Liivi Teder, Kairi Rätsepp Monetary Policy Committee Martti Randveer, Peeter Luikmel International Relations Committee Raoul Lättemäe, Anu Randveer Risk Management Committee Kaari Kumari, Rain Nõmmik Internal Auditors Committee Henn Oit, Janno Kase Statistics Committee Jaanus Kroon, Ain Paas Market Operations Committee Janno Luurmees, Toivo Kuus Legal Committee Kadi Kapral, Marek Feldman Market infrastructure high level group Madis Müller SWIFT and CLS oversight high level group Kaire Torsus, Airi Uiboaid TARGET2-Securities Board Mihkel Nõmmela Council of the European Union Informal Council of Economics and Finance Ministers Ardo Hansson Economic and Financial Committee (EFC) Madis Müller, Raoul Lättemäe Euro Coin Sub-Committee (ECSC) Inga Sokk, Meelis Mettus European Commission European Commission and the European Central Bank statistics forum Jaanus Kroon Committee on Monetary, Financial and Balance of Payments Statistics Jaanus Kroon Organisation for Economic Cooperation and Development Economic Policy Committee Martti Randveer, Ilmar Lepik Financial Markets Committee Jana Kask International Monetary Fund (IMF) Board of Governors Ardo Hansson Nordic-Baltic Monetary and Financial Committee (NBMFC) Madis Müller, Raoul Lättemäe The European Systemic Risk Board (ESRB) General Board Ardo Hansson Advisory Technical Committee Jana Kask European Banking Authority (EBA) Board of Supervisors Jaak Tõrs, Indrek Saapar Bank for International Settlements Board of Governors Ardo Hansson Irving Fisher Committee on Central Bank Statistics Jaanus Kroon

* Only those committees and forums that had meetings and discussions in 2016 are listed in the table. Eesti Pank Annual Report 2016 47 Photograph: Eesti Pank

The central banks of the Eurosystem are responsible for maintaining the integrity of euro banknotes by improving their security features. The issuance of new notes is always preceded by the comprehensive distribution of public information. In 2017 the new fifty-euro note will be introduced. Anybody can easily check the authenticity of the banknotes as looking at them against the light reveals a transparent portrait window and watermark, feeling the note makes evident the raised lines on them, and tilting them makes changes in the emerald green number, the hologram and the portrait window become visible. The new fifty-euro note was first presented to the Estonian media at Eesti Pank in July.

Notes and coins were of interest to the public throughout the year, especially collector and commemorative coins, the issuance of the new fifty-euro note, the termination of printing of the 500- euro note under the second series, the concept of the cash-free society, and various payment issues. Pubic information requests to Eesti Pank most commonly concern the same topics, as people are interested in new coins or in exchanging kroons for euros, but there were also requests for various statistics and questions about the Eesti Pank economic forecast.

The role of the Eesti Pank museum is to maintain and cherish the history of Eesti Pank and Estonian money as a part of the Estonian cultural heritage. The permanent exhibition at the museum, its publications, and its educational work are all intended to inform the public of the central bank’s role and functions in society. Various public lectures were held at the museum in 2016, along with various family events like the family day for Independence Day, the night of museums, and the financially smart family day organised with the Financial Supervision Authority. Seminars were also held for teachers, and various educational programmes and excursions were run for adults and school groups. The Eesti Pank travelling exhibition on the history of money was presented in schools, libraries and museums across Estonia.

Table 8. Public relations in figures

Press releases 148 Comments by spokespeople 180 Articles and blog posts 35 Oral and written responses to enquiries 2231 Website hits 518 000 Museum visitors 20 707 References to Eesti Pank in the media 4432 Eesti Pank Annual Report 2016 48

FINANCIAL ASSET MANAGEMENT

Reserve management

The Eesti Pank reserves underpin confidence in the monetary system of the euro area, guarantee the bank freedom of action, and ensure that it has sufficient capital to cover any possible losses.

The goal of investment of the reserves is to earn a moderate level of stable income while ensuring that the assets are preserved over the long term. The investments are mainly made in the liquid money and capital markets of advanced countries.

The risk level accepted by Eesti Pank and the expected return are reflected by the benchmark portfolio, which is used for measuring the performance and risks of investments. The Executive Board of Eesti Pank sets the risk level of the benchmark portfolio, basing it on the situation in global financial markets. The benchmark portfolio is reviewed and adjusted to match the agreed risk level at least once a quarter. Figure 10. The structure of Eesti Pank’s investment assets (million euros) The structure of investment assets

other, 2 At the end of 2016, Eesti Pank’s portfolio of investment assets stood at 371 million euros reserves in domestic currency (see Figure 10), with a further 9 million euros (eurobonds), 66 shares, 100 of gold. The size of the Eesti Pank reserves is restricted and limited by an agreement between the euro area central banks and the European Central Bank on net financial assets. If the investment outlook is favourable, Eesti Pank can increase its portfolio of investment assets within agreed limits.

At the end of 2016 Eesti Pank’s invested reserves were in bonds of euro area countries, with 66 million euros of investment bonds in foreign currency, 202 there at the end of the year. The foreign currency reserve of investments outside the euro Figure 11. Return on investment assets and area stood at 302 million euros in 2016. The returns from the money markets largest part of the foreign currency reserve investment assets was the 102 million euros held in US Treasury money market 8% Notes and bonds. The equity portfolio increased further during the year to 100 mil- 7% lion euros. Eesti Pank continues to hold 8250 6% troy ounces, or 256.6 kg, of gold.

5% Return on investments 4% During the year a total of 14.4 million euros

3% was earned from investments meaning the return on invested assets was 3.16%, which 2% was significantly higher than the return from

1% money markets (see Figure 11). The portfolios of both equity and bonds made a positive 0% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 contribution to the results. Eesti Pank Annual Report 2016 49

The key phrase in financial markets in 2016 was ‘political risk’, and there were two main events during the year that caused fluctuations in financial markets and affected the prices of various financial assets. The first of these came in June when the United Kingdom voted to leave the European Union, and the second was in November when Donald Trump was elected President of the USA. The unexpected results of both the British referendum and the US presidential election caused a negative reaction in the markets at first as the prices of riskier asset classes, including shares, fell. Neither event had long-term consequences, as share prices started to rise and equity markets were positive in 2016 as a whole in advanced economies, which is where Eesti Pank invests part of its reserves.

Although the uncertainty around the US administration's economic policy and Brexit remains, equities have been helped to rise by other factors. The main factor is the slow but steady improvement in economic activity, mainly in the USA but also in other advanced economies, where the monetary policy of central banks remains accommodative and favourable to investment. In the end, equity indexes were up around 7.5% in advanced economies, and with the appreciation of the US dollar against the euro by around 3%, the effect on the Eesti Pank investment portfolio was significantly positive.

The Eesti Pank bond portfolio made a more modest, but still positive, contribution to the profitability of the reserves. While the yield on euro area bonds was very good the return from the sovereign bonds of the USA, Canada, Australia and the United Kingdom was close to zero. An improving economy and rising inflation usually indicate higher base interest rates, which have a negative effect on bond prices. Given that, Eesti Pank has reduced its investment in sovereign bonds from outside the euro area. The case of the euro area was a little different, with very low inflation and the continuing large-scale asset purchase programme, which in itself supported rises in the prices of sovereign bonds in 2016. Photograph: Andres Treial Andres Photograph:

Triin Kriisa, a portfolio manager at Eesti Pank. The Eesti Pank investment division handles the day to day investment of the bank’s financial assets by buying and selling various securities in international financial markets. Four portfolio managers work in the division and they follow the news and market movements in real time and decide from that which securities to buy and sell, when and at what price. This is done within strict parameters set by the Eesti Pank Executive Board, and the bank’s assets are invested at reasonable risk levels. Eesti Pank Annual Report 2016 50

Active investment generated excess return of 0.5 million euros over the benchmark portfolio in 2016. The contribution of external managers to active investment was slightly negative this year, but still very positive over the long term. At the end of the year Eesti Pank was using two external managers, PIMCO, which Eesti Pank has used since 2005, and Informed Portfolio Management, used since 2007. The external asset management programme is based on overlay mandates and the managers express the majority of strate- gies through derivative instruments.

Provision of asset management services Full asset management services were provided to the Guarantee Fund, whose investment portfolio amounted to 217 million euros at the end of 2016. The Guarantee Fund is a legal entity under public law that secures under the conditions and extent set in law the funds of depositors, investors, mandatory pension holders, and holders of insurance contracts signed with insurers for mandatory pensions.

Risk management at Eesti Pank Eesti Pank has a risk management system that covers all the processes of the bank and allows various risks to be tackled in a single framework. Risk management aims to reduce the damaging effect that unforeseen events can have on the bank’s work to achieve its goals. This requires integrated planning, budgeting and management reporting processes. Reporting and analysis of risks show that risks coming from the external environment have increased. Eesti Pank contributes to risk management for the whole of the euro area through the committees and management bodies of the European System of Central Banks. Contingency plans for services are used to reduce the impact of any possible inter- ruption to processes the bank considers critical and to ensure the continuity of activity. The external auditors regularly assess the risk management of the bank. Eesti Pank’s reserves are exposed to various risks such as market risk, credit risk and liquidity risk. Risks are managed on a daily basis, with various risk limits set on investments and precautionary measures employed like the four-eyes principle and a segregation of duties between decision-making and oversight functions. The general risk tolerance of Eesti Pank is set by the benchmark portfolio of bonds and equity indexes from advanced economies. The structure of the benchmark portfolio and its parameters are decided by the Executive Board of Eesti Pank. The biggest change in 2016 was that the bonds of the United Kingdom were removed from the benchmark portfolio. The main risk measure is Value at Risk (VaR), but other risk measures like Expected Shortfall are also used. On top of the risks from reserve management, the assets of Eesti Pank are subject to risks from monetary policy operations as all lending operations have to be covered with collateral. Under Article 33 of the Statute of the European System of Central Banks and of the European Central Bank, the income and expenses of monetary policy operations are divided between the central banks of the euro area using the capital key1. No major changes were made last year in the risk framework for collateral for monetary policy, though the risks of the Eurosystem were increased substantially by the various asset purchase programmes above all.

1 Under Article 29 of the Statute of the European System of Central Banks and of the European Central Bank, the central banks of the member states subscribe the capital of the European Central Bank in the proportions given by the capital key. The capital key is calculated by looking equally at each country's share of the European Union's population and GDP and the weightings are adjusted every five years or whenever a country joins the European Union. As the nine European Union member states that are outside the euro area do not have a right to the distributed profit and loss of the European Central Bank under the capital key, Eesti Pank's share of the risks of the European Central Bank has been 0.2739% since 1 January 2015. Eesti Pank Annual Report 2016 51

ACCOUNTABILITY, GOVERNANCE AND ORGAN- ISATION, AND HUMAN RESOURCES POLICY

Central bank accountability

The independence of the central bank is an indispensable part of a monetary system that aims to maintain price stability. At the same time, a modern democratic society requires every public institution to report on its activities. Central bank accountability and independence are two counterbalancing principles.

Work with the Riigikogu On top of the Governor’s annual presentation to the Riigikogu, the central bank has regular meetings with members of the parliament and provides explanations and comments to questions posed by Riigikogu members.

The Eesti Pank Executive Board met with members of the Riigikogu on the following occasions in 2016:

• 9 February – Eesti Pank Deputy Governor Ülo Kaasik and Head of the Eco- nomics and Research Department Martti Randveer discussed the reserve capital of the central bank with the Finance Committee of the Riigikogu;

• 2 May – Eesti Pank Governor Ardo Hansson presented the Eesti Pank annual report to the Finance Committee of the Riigikogu;

• 5 May – Eesti Pank Governor Ardo Hansson presented the Eesti Pank annual report to the Riigikogu;

• 3 June – Eesti Pank Governor Ardo Hansson responded to interpellations by the Riigikogu on the bond purchase programmes of the central banks of the euro area;

• 2 September – Eesti Pank Governor Ardo Hansson spoke at the parliamentary hearings of the European Union Affairs Committee of the Riigikogu on the future of the European Union following the results of the referendum in the United Kingdom;

• 21 November – Eesti Pank Governor Ardo Hansson and Deputy Governor Ülo Kaasik met members of the Finance Committee of the Riigikogu;

• 23 November – Eesti Pank Governor Ardo Hansson gave a review of the work of the central bank to the EKRE party.

Why does Eesti Pank want to increase its reserve capital? In November 2015 Eesti Pank sent a proposal to the leaders of the Riigikogu requesting a decision on whether Eesti Pank could increase its reserve capital. The step was taken under the Eesti Pank Act, because once reserve capital becomes equal to statutory capital, the Riigikogu has to decide whether or not to continue increasing the reserve capital. Eesti Pank considered it needed an increase in its capital buffers, which are the statutory capital, reserve capital and other capital buffers, because the use of extraordinary monetary policy measures has increased the balance sheets of the central banks in the Eurosystem substantially, and the risks of central banks, including Eesti Pank, have increased in recent years. The central bank needs to have sufficient capital buffers to cope with the possible risks to ensure its financial and institutional independence, as is required by the treaties of the European Union. Eesti Pank Annual Report 2016 52

The strategy for the division of profits approved by the Eesti Pank Supervisory Board supports the move in the direc- tion of increased capital and it sets a long-term goal of increasing the capital buffers to the average level of the central banks of the euro area, in proportion to the size of the subscription of the central banks to the European Central Bank. It is necessary to catch up to the average level of the euro area as a major part of the risks from the joint monetary policy are divided between the euro area central banks in accordance with their participation in the European Central Bank. Eesti Pank’s capital buffer is currently one of the smallest among the central banks in the euro area. It is best to increase the capital buffers through reserve capital because unlike for other capital buffers, there are restrictions in the law on what the reserve capital can be used for. So increased reserve capital means that there is a more secure base for Eesti Pank’s capital overall. Following this reasoning, the Riigikogu decided on 12 April 2016 that Eesti Pank should continue to increase its reserve capital from the earlier 100 million euros to 300 million euros.

Governance and organisation

The Executive Board of Eesti Pank The activities of the central bank are led and managed by the Executive Board, which consists of the Governor and Deputy Governors, and in 2016 the Governor was Ardo Hansson and the Deputy Governors were Ülo Kaasik and Madis Müller. The Governor of Eesti Pank is, by virtue of office, the Chairman of the Executive Board, who has exclusive authority over banking policy, organisation of the bank’s responsibilities to the European System of Central Banks, and general management of Eesti Pank’s activities, among other things. On 29 March the Eesti Pank Supervisory Board approved the proposal of the Governor Ardo Hansson for Ülo Kaasik and Madis Müller to continue as Deputy Governors for another five years. The Supervisory Board held a secret ballot on the proposal and the result was unanimous.

Development of the management system and work organisation of Eesti Pank Eesti Pank reviewed its strategy in 2016 as changes every year in the operating environment mean that the strategy needs to be adjusted accordingly. It is planned that a new strategy document will be drawn up for 2017.

The professional behaviour guidelines and the compliance framework were updated. The new guidelines are clearer for employees and so are easier to follow. These documents were harmonised with the equivalent guidelines of the European Central Bank. The changes were needed because questions had arisen when the compliance guidelines were introduced at the European Central Bank. A compliance working plan based on the compliance framework was approved together with the list of employees from whom the risk manager requested a detailed declaration of economic interests. No breach of the rules was discovered in the data submitted to the risk manager.

The principles for development and training of Eesti Pank staff were updated and human resources software with a functionality that supports professional development interviews was installed.

Eesti Pank was one of 22 financial institutions inspected in 2016 by the Labour Inspec- torate. The inspection by occupational health inspectors at Eesti Pank did not find any non-conformities. As it is in most other financial institutions in Estonia, the working environment at the central bank is designed for work and is constantly being worked on. An innovation in 2016 was the health week held jointly by Eesti Pank and the Financial Super- vision Authority, during which increased attention was focused on occupational health and Eesti Pank Annual Report 2016 53

Figure 13. Eesti Pank Organisation Chart as at 31.12.2015 Eesti Pank Organisation Chart as at 31.12.2016

Supervisory Board Chair Mart Laar

Internal Audit Department

Governor Ardo Hansson

Deputy Governor Deputy Governor Ülo Kaasik Madis Müller

Economics and International and Financial Research Public Relations Markets Department Department Department

Statistics Administration Financial Stability Department Department

Information Cash and Technology Infrastructure Department Department

Payment and Financial Settlement Systems Department Department

on promoting a healthy lifestyle. A step counting competition ‘Get Walking’ was organised and healthy recipes were shared. The bank’s Culture Club and Sports Club were involved in organising the event so that the messages about health would reach as many employees as possible.

Eesti Pank employees, training and development

Employees Eesti Pank is the smallest central bank in the European Union by number of employees. The bank aims to ensure that skilled and enthusiastic specialists work at the central bank given the competition pressure from the labour market and changes in how support services are organised in the public sector.

At the end of 2016 there were 236 people working at Eesti Pank, or 254 if those on suspended contracts are included. The total staff turnover in 2016 was 4.7%, which is about the same as in the previous year. Eesti Pank Annual Report 2016 54

There were 18 employees with suspended contracts, eight of them on maternity leave. Inter-institutional rotation saw two employees working at the Government Office of Estonia in 2016, one at the European Union representation in Estonia, one at the International Mon- etary Fund, and five at the European Central Bank. The contract of one employee was suspended for higher education studies.

On average, there were 231.8 full-time equivalent employees at Eesti Pank in 2016, and 232.1 in 2015. Staff costs were 5% higher in 2016 than in 2015.

The average age of Eesti Pank employees in 2016 was 44.9 and they had worked for Eesti Pank for an average of 12.3 years, and 135 people had more than 10 years of experience. Women account for 59% of the Eesti Pank staff, and 41% are men, while 52% of staff have a Master’s degree and 7.5% a doctorate.

At the end of 2016, 38 employees of the bank were studying for Master’s or Doctor’s degrees in various universities.

The salaries of the Governor of Eesti Pank and the Deputy Governors are set by the Super- visory Board. From 1 July 2016 Governor Ardo Hansson received a salary of 9350 euros a month, and Deputy Governors Madis Müller and Ülo Kaasik received salaries of 7600 euros a month. In total the members of the Executive Board of Eesti Pank were paid salary of 306,127 euros in 2016.

The average monthly salary at Eesti Pank, including holiday pay and additional pay for working overtime, at night, during holidays and during national holidays, was 2288 euros in 2016, up from 2187 euros in 2015. This figure covers everyone from the top managers to the service staff, but the largest group of the bank’s employees are professional specialists.

The remuneration policy of the bank aims to support the recruitment and retention of enthusiastic staff with the necessary qualifications, and to pay employees in the organisation fairly and competitively in the labour market. The general comparison group for employee compensation is the median in the financial sector in Tallinn and Harjumaa.

The salary of the members of the Supervisory Board of Eesti Pank is set by the law governing senior civil servants. The Chair of the Supervisory Board received 1850.94 a month in salary and other members of the Board received 1322.10 a month.

Training and development work In 2016, 94% of the bank’s staff attended training courses and the average per employee was 4.3 days of training. The average cost of training per employee was 625.2 euros and 1.6% of human resources spending in 2016 was invested in staff development.

Eesti Pank’s main partner in training in 2016 was the European Central Bank and the central banks of various other countries, together with the IMF Institute and the Joint Vienna Institute, and the US Federal Reserve.

The thorough management training that ended in early 2016 was followed by regular discussions with junior managers and heads of department in co-vision groups that share their experience and knowledge to find solutions to problems that arise at work. Twice a year the bank runs an induction programme for new employees to introduce new staff to each other, develop a sense of team spirit and explain the various activities of Eesti Pank, and 15 new employees attended this programme in 2016. Eesti Pank Annual Report 2016 55 Photograph: Eesti Pank

A management training meeting. To maintain the high level of professional skills in its staff and to help them keep on top of all the demands they face, Eesti Pank places great emphasis on training. The main priority in training for central bank staff in 2016 was additional professional training, and 94% of all employees attended various training courses in 2016.

The Eesti Pank Executive Board approved Figure 12. Staff turnover at Eesti Pank, 2010-2016 the updated principles for employee devel- left at own initiative, % opment and training and for interns in 2016. left at own initiative retired, % total turnover, % Giving work experience to interns helps to 10 9.3 identify possible future members of staff for 9 8.2 the bank, explain the goals and activities of 8 7.3 the central bank, and develop cooperation 7 6.1 with universities and other educational insti- 6 tutions. Eesti Pank takes as interns univer- 5 4.7 5 4.7 4.7 sity students who have completed higher 4.2 4.3 4 3.5 education and want to use the experience of 3.7 3.4 3.4 3 3 practical work to consolidate and deepen the 2.2 2.5 2 2.1 knowledge and skills they have gained from 2 1.7 their studies. An average of 10 students per 1 year do an internship at Eesti Pank. 0 2010 2011 2012 2013 2014 2015 2016 An innovation in 2016 was job shadowing as nine employees took the chance to shadow a colleague at work during the job shadowing month organised in November. Those who took part found the project to be highly beneficial. Eesti Pank Annual Report 2016 56

ANNUAL ACCOUNTS OF EESTI PANK for the financial year ended 31 December 2016

THE FINANCIAL POSITION OF EESTI PANK

Capital and reserves

Eesti Pank’s capital as at 31 December 2016 stood at EUR 437 million. More detailed information on Eesti Pank’s capital can be found under Item 29 “Capital and Reserves”, in the notes on the Balance Sheet.

Provisions for foreign exchange, interest rate, credit and gold price risks

Following from risk assessments, Eesti Pank increased its provisions for foreign exchange, interest rate, credit and gold price risks. The size of the provisions and the continuing need for them is reassessed each year, with various factors considered. The risk assessment is based on a calculation of the value at risk of risk-bearing assets, which takes into account the size of risk-bearing assets, the extent of risks that have realised during the year and the forecast for the year to come. As at 31 December 2015 the provisions made to cover foreign exchange, interest rate, credit and gold price risks were EUR 30 million. The bank transferred EUR 7.5 million to provisions in 2016 and as a result risk provisions increased to EUR 37.5 million. See also Item 27 “Provisions”, in the notes on the Balance Sheet.

Provisions for the obligation to exchange Estonian kroons for euros

It is highly probable that not all the kroons that were issued will be exchanged for euros in the future, as some will have been destroyed and some retained as souvenirs. For this reason the obligation to exchange the kroons issued into circulation with a value of EUR 45.1 million was transferred from the Balance Sheet to income in 2016 and a special purpose provision of EUR 29.6 million was set up. Future exchanges of kroons for euros will be funded from the provision. The net effect on profit of transferring the exchange obligation to income was EUR 15.5 million.

Revaluation accounts

Unrealised profit from gold, foreign currency and securities is not recorded as income in the Profit and Loss Account and is transferred directly from the revaluation accounts to the liabilities side of the Eesti Pank Balance Sheet. Assets on these accounts can be used to absorb any impact in the future from unfavourable developments in prices or exchange rates, and so such financial buffers can help strengthen the resilience of the bank to underlying risks. The total value of the revaluation accounts for gold, currency and securities was EUR 19.0 million at the end of December 2016 and EUR 10.5 million at the end of 2015. For more details, see the notes on accounting principles and Item 28 “Revaluation accounts”, in the notes on the Balance Sheet. Eesti Pank Annual Report 2016 57

Financial results for 2016

Eesti Pank’s net profit in 2016 was EUR 31.4 million, and it was EUR 30.1 million in 2015.

Net interest income rose to EUR 16.8 million in 2016 from EUR 14.9 million in 2015. A large part of the investment income in 2016 came from the equity portfolio, while the bond portfolio also had a positive return. Higher share prices were aided by an increase in economic activity in the advanced countries, particularly the USA. The dollar strengthened against the euro during the year, increasing the income from shares further. The yield on the bond portfolio was affected by the asset purchase programme of the euro area, a consequence of which was a rise in the prices of the government bonds of euro area countries. The income was close to zero on the sovereign bonds of other countries, which were the USA, Canada, Australia and the United Kingdom.

The net return on Eurosystem transactions came not only from the yield on the monetary policy debt securities portfolio but also from income on the excess reserves of credit institutions, while the income from the distribution of monetary income from the Eurosystem increased income by EUR 11.0 million and the distribution of profit of the European Central Bank by EUR 3.4 million.

The obligation to exchange the kroons issued into circulation with a value of EUR 45.1 million was transferred to income and a special purpose provision of EUR 29.6 million was set up. The sum of EUR 1.1 million for the obligation to exchange kroon and euro collector coins that have been sold in previous periods was also transferred to income. This came from a change in the accounting principles. For more details see Item 35 “Other income and expenses”, in the notes on the Profit and Loss Account.

The operating expenses of Eesti Pank, including depreciation, increased from EUR 17.0 million in 2015 to EUR 17.7 million in 2016. The largest expenses were on staff costs, information and communications technology, and cash processing. Eesti Pank Annual Report 2016 58

APPROVAL OF THE ANNUAL ACCOUNTS FOR THE FINANCIAL YEAR ENDED 31 DECEMBER 2016 BY THE EXECUTIVE BOARD OF EESTI PANK The Executive Board recognises its responsibility for the Annual Accounts of Eesti Pank for the financial year ended 31 December 2016.

The Annual Accounts of Eesti Pank have been drawn up in accordance with rules that are based on Article 26.4 of the Statute of the European System of Central Banks and of the European Central Bank1. The parts of the Annual Accounts that are not regulated by ECB guidelines have been drawn up in accordance with the accounting principles generally accepted in Estonia. The Annual Accounts give a true and fair view of the assets and liabilities, equity and financial performance of Eesti Pank.

The preparation of the Annual Accounts in conformity with the above requirements requires the Executive Board to provide estimates of the determinants affecting the assets and liabilities of Eesti Pank as at the accounting date and income and expenses during the accounting period. These estimates are based on the information available about Eesti Pank, its intentions and risks as at the date of preparation of the Annual Accounts. The final outcome of the economic transactions reflected in the Annual Accounts may differ from the estimates of the Executive Board.

On 16 March 2017, all the members of the Executive Board of Eesti Pank on that day signed the Annual Accounts.

Ardo Hansson Governor of Eesti Pank, Chairman of the Executive Board

Ülo Kaasik Deputy Governor of Eesti Pank, Member of the Executive Board

Madis Müller Deputy Governor of Eesti Pank, Member of the Executive Board

1 Decision of the ECB of 3 November 2016 on the legal framework for accounting and financial reporting in the Euro- pean System of Central Banks (recast)(ECB/2016/34), OJ L 347, 20.12.2016, p. 3. Eesti Pank Annual Report 2016 59

BALANCE SHEET AS AT 31 DECEMBER 2016 AND 2015

thousand EUR

Item 31/12/2016 31/12/2015

ASSETS

Gold and gold receivables 1 9 059 8 029

Claims on non-euro area residents denominated in foreign currency 323 076 371 690

Receivables from the IMF 2 94 642 97 051

Balances with banks, security investments and other external assets 3 228 434 274 639

Claims on euro area residents denominated in foreign currency 4 102 104 83 391

Claims on non-euro area residents denominated in euro 5 11 949 1 451 Lending to euro area credit institutions related to monetary policy 6 86 000 75 000 operations denominated in euro Other claims on euro area credit institutions denominated in euro 7 4 873 2 203

Securities of euro area residents denominated in euro 3 398 564 1 495 315

Securities held for monetary policy purposes 8 3 339 318 1 384 577

Other securities 9 59 246 110 738

Intra-Eurosystem claims 2 757 818 4 646 766

Participating interest in the European Central Bank 10 88 853 88 853

Claims equivalent to the transfer of foreign reserves 11 111 730 111 730 Net claims related to the allocation of euro banknotes within the 12 1 619 515 1 671 822 Eurosystem Other claims within the Eurosystem (net) 13 937 720 2 774 361

Other assets 67 485 53 813

Tangible fixed assets 14 17 304 18 097

Other financial assets 15 234 234

Off-balance-sheet instruments revaluation differences 16 91 613

Accruals and prepaid expenses 17 32 629 20 256

Sundry 18 17 227 14 613

TOTAL ASSETS 6 760 928 6 737 658

The notes on pages 62-87 form an integral part of the Annual Accounts. Eesti Pank Annual Report 2016 60

thousand EUR

Item 31/12/2016 31/12/2015

LIABILITIES

Banknotes in circulation 19 2 838 064 2 730 241 Liabilities to euro area credit institutions related to monetary policy 3 192 216 3 331 414 operations denominated in euro Current accounts (including cover for the minimum reserve system) 20 3 192 216 3 331 414

Liabilities to other euro area residents denominated in euro 21 18 207 11 954

General government 7 117 0

Other liabilities 11 090 11 954

Liabilities to non-euro area residents denominated in euro 22 5 207 20

Liabilities to non-euro area residents denominated in foreign currency 23 15 758 0

Counterpart of the special drawing rights allocated by the IMF 24 78 981 78 869

Other liabilities 58 036 100 238

Off-balance-sheet instruments revaluation differences 16 7 553 7 470

Accruals and income collected in advance 25 5 202 3 757

Sundry 26 45 281 89 011

Provisions 27 67 122 30 000

Revaluation accounts 28 19 039 10 500

Capital and reserves 29 436 895 414 314

Capital 222 581 200 000

Reserves 214 314 214 314

Profit for the year 31 403 30 108 TOTAL LIABILITIES 6 760 928 6 737 658

The notes on pages 62-87 form an integral part of the Annual Accounts. Eesti Pank Annual Report 2016 61

PROFIT AND LOSS ACCOUNT FOR 2016 AND 2015

thousand EUR

Item 2016 2015

Interest income 45 686 42 659

Interest expenses -28 916 -27 793

Net interest income 30 16 770 14 866

Realised gain arising from financial operations 10 278 24 546

Write-downs on financial assets -2 809 -3 362

Provisions for foreign exchange rate, interest rate and credit risks -7 500 -4 000

Net result of financial operations, write-downs and risk provisions 31 -31 17 184

Fees and commissions income 106 117

Fees and commissions expenses -60 -125

Net income from fees and commissions 32 46 -8

Income from equity shares and participating interests 33 3 488 2 852

Net result of pooling of monetary income 34 10 951 11 183

Other income 47 533 1 055

Other expenses -29 622 0

Other income and expenses 35 17 911 1 055

Total net income 49 135 47 132

Staff costs 36 -9 090 -8 635

Administrative expenses 37 -5 090 -4 886

Depreciation of tangible fixed assets 14 -1 860 -2 069

Banknote production services 38 -430 -518

Other operating expenses 39 -1 262 -916

Operating expenses -17 732 -17 024

Profit for the year 31 403 30 108

The notes on pages 62-87 form an integral part of the Annual Accounts. Eesti Pank Annual Report 2016 62

NOTES ON THE ANNUAL ACCOUNTS OF EESTI PANK

ACCOUNTING POLICIES USED IN THE ANNUAL ACCOUNTS

General Principles The Annual Accounts of Eesti Pank (occasionally also “the bank”) have been drawn up in accordance with the rules based on Article 26.4 of the Statute of the European System of Central Banks and of the European Central Bank2. The parts of the Annual Accounts that are not regulated by ECB guidelines have been drawn up in accordance with the accounting principles generally accepted in Estonia.

The preparation of the Annual Accounts requires the Executive Board to provide estimates of the determinants affecting the assets and liabilities of Eesti Pank and income and expenses during the accounting period as at the balance sheet date. These estimates are based on the information available about Eesti Pank and its intentions and risks as at the date of preparation of the Annual Accounts.

No Cash Flow Statement is presented as it does not provide significant relevant information to the readers of the Annual Accounts of Eesti Pank, given the bank’s role as the central bank.

The Annual Accounts have been prepared in thousands of euro unless indicated otherwise.

The Balance Sheet items are grouped by residency (euro area, non-euro area) and currency (euro, other currency). The assets and liabilities related to monetary policy are recorded on separate rows.

The Annual Accounts have been prepared on the historical cost basis, except in cases explained in the following accounting principles.

Assets and liabilities Assets and liabilities are recognised in the Balance Sheet when it is probable that any associated future economic benefit will flow to or from Eesti Pank; almost all of the risks and rewards related to assets and liabilities have been transferred; and the cost or value of an asset or a liability and the resulting gains or losses can be measured reliably.

Financial assets and liabilities A financial asset is any asset that is cash, or a contractual right to receive cash or any other financial assets from another entity, or a contractual right to exchange financial assets with another entity under conditions that are potentially favourable. A financial liability is any liability that is a legal obligation to deliver cash or any other financial assets to another entity or to exchange financial assets with another entity under conditions that are potentially unfavourable.

Financial assets are initially recorded at their acquisition cost, which is the fair value of the amount paid for the financial asset in question. Financial liabilities are initially recorded at their acquisition cost, which is the fair value of the amount received for the financial liability in question. Subsequent measurement of financial assets and liabilities is based on the market value, the acquisition cost or the amortised cost depending on the type of the asset or liability. Market value is the amount for which an asset could be exchanged, or a liability settled between knowledgeable, disinterested and willing parties in an arm’s length transaction. Financial assets recorded at market value are revalued on every balance sheet date.

2 Decision of the ECB of 3 November 2016 on the legal framework for accounting and financial reporting in the Euro- pean System of Central Banks (recast)(ECB/2016/34), OJ L 347, 20.12.2016, p. 3. Eesti Pank Annual Report 2016 63

Financial assets recorded at adjusted acquisition cost are written down if the recoverable amount of an asset is likely to be smaller than its carrying amount. The impairment of significant financial assets is measured for each object separately. The impairment of financial assets that are not individually significant and that are not expected to be impaired is measured for all assets together. Write-downs of financial assets are recorded as an expense of the accounting period in the Profit and Loss Account.

Recording of transactions in foreign currency With the exception of spot transactions in securities, transactions in financial instruments denominated in foreign currency are recorded in off-balance-sheet accounts on the trade date. On the settlement date, off-balance-sheet entries are reversed and transactions are recorded on the Balance Sheet. The purchase and sale of foreign currency affect the net foreign currency position on the trade date; realised results arising from sales are also calculated on the trade date. The interest accrued on financial instruments denominated in foreign currency and the premiums or discounts are calculated and recorded on a daily basis. These amounts also affect the foreign currency position on a daily basis.

Assets and liabilities denominated in foreign currencies are converted into euro at the exchange rate of the European Central Bank prevailing on the balance sheet date. Income and expenses are converted at the exchange rate of the European Central Bank prevailing on the recording date. The revaluation of on-balance-sheet and off-balance-sheet instruments and of foreign exchange assets and liabilities is performed on a currency-by-currency basis.

The special drawing right (SDR) of the International Monetary Fund (IMF) is defined in terms of a basket of currencies. To revalue Eesti Pank’s holdings of SDRs, the value of the SDR was calculated as the weighted sum of the exchange rates of five currencies (the US dollar, the euro, the Japanese yen, the pound sterling and from 1 October 2016 the Chinese ren- minbi) converted into euro as at 31 December 2016.

The exchange rates applied on 31 December 2016 and 2015 were as follows:

31/12/2016 31/12/2015

USD 1.0541 1.0887

GBP 0.85618 0.73395

JPY 123.4 131.07

CNY 7.3202 -

SDR 0.78456 0.78567

Gold Gold is valued at the market price prevailing at the year-end. No distinction is made between the price and currency revaluation differences for gold. Instead, a single gold valuation is accounted for on the basis of the price in euros per fine ounce of gold, which, for the year ending 31 December 2016, was derived from the exchange rate of the euro against the US dollar on 30 December 2016.

Securities

Securities held for monetary policy purposes Securities held for monetary policy purposes are accounted for at amortised cost subject to impairment. Eesti Pank Annual Report 2016 64

Other securities Marketable securities (other than those classified as securities held for monetary policy purposes) and similar assets are valued either at the mid-market prices or on the basis of the relevant yield curve prevailing on the balance sheet date, on a security-by-security basis. For the year ending 31 December 2016, mid-market prices on 30 December 2016 were used.

Income recognition Income and expenses are recorded in the Profit and Loss Account during the accounting period on an accrual basis regardless of when cash was received or paid. Realised gains and losses arising from the sale of foreign exchange, gold and securities are taken to the Profit and Loss Account. Such realised gains and losses are calculated by reference to the average cost of the asset concerned.

Unrealised gains are not taken to the Profit and Loss Account, but are recognised on the Balance Sheet under “Revaluation accounts”.

Unrealised losses are recorded in the Profit and Loss Account under “Write-downs on financial assets” if, at the year-end, they exceed previous revaluation gains registered in the corresponding revaluation account. Unrealised losses on any one currency or security or on gold are not netted against unrealised gains on other currencies or securities or gold. In the event of an unrealised loss on any currency or security or on gold at the year-end, the average cost of that item is reduced to the year-end exchange rate or market price.

Premiums or discounts arising on purchased securities are recorded as part of interest income and are amortised on a daily basis over the remaining life of the securities.

Under an agreement of the Accounting and Monetary Income Committee of the European System of Central Banks from April 2016, the interest income and expenses from monetary policy operations are presented on a net basis for each balance sheet item or sub- item. This change does not affect net profit for 2015. The consequence is that for this Profit and Loss Account, the corresponding data from the Profit and Loss Account for 2015 have been adjusted as follows:

thousand EUR

Initial 2015 Adjustment Adjusted 2015

Interest income 49 844 -7 185 42 659

Interest expenses -34 978 7 185 -27 793

Net interest income 14 866 0 14 866

thousand EUR

Initial 2015 Adjustment Adjusted 2015

Intra-Eurosystem interest income 20 273 -7 185 13 088

Bonds held for monetary policy purposes 0 9 141 9 141

Monetary policy operations 18 921 -16 326 2 595

TARGET2 733 0 733

Allocation of banknotes within the Eurosystem 571 0 571

Transfer of foreign currency reserves 48 0 48

Intra-Eurosystem interest expenses -7 185 7 185 0

Monetary policy operations -7 108 7 108 0

Minimum reserve requirements -77 77 0 Eesti Pank Annual Report 2016 65

Reverse transactions Repurchase transactions (sale/repurchase transactions) are recorded as collateralised loans taken at their fair value, i.e. securities are recorded as assets on the Balance Sheet and the repurchase sum as a liability.

Reverse repurchase transactions (purchase/resale transactions) are recorded as collateralised loans granted. Securities used as collateral for reverse repurchase transactions are not recorded on the Balance Sheet of Eesti Pank.

Investments in shares Investment in shares is recorded at market value if it can be assessed reliably. The assessment of the market value of shares is not reliable if they are not actively traded and there are no alternative methods for assessing their value reliably. In this case shares are recorded at their acquisition cost subject to impairment. Profits and losses on the sale of shares are recorded in the Profit and Loss Account after all conditions of sale have been fulfilled. Div- idend income is recorded as income for the period.

Fixed assets Fixed assets are assets with a useful life of over a year and an acquisition cost in excess of EUR 3200. Fixed assets are recorded at their acquisition cost, which is the purchase price and other expenditure directly related to bringing assets to the location and condition necessary for their intended use. Land, buildings, utility systems of buildings, IT hardware, software, and other assets with long-term useful lives are recorded as fixed assets on the Balance Sheet. Prepayments for fixed assets are also recorded as fixed assets.

Land and objects of art and culture are not depreciable assets. Other fixed assets are depreci- ated on a straight-line basis over the estimated useful lives of the assets at the following rates

2016

Land and buildings 3%

Utility systems of buildings 10%

Hardware 20%

Software, motor vehicles 15–50%

Other fixed assets 7–20%

The need to differentiate between software depreciation rates arose due to the introduction of application software with high acquisition cost and varying useful life.

Subsequent expenditure incurred for items of fixed assets is recognised as fixed assets when it is probable that Eesti Pank will derive future expected benefits from the asset and the cost of the asset can be measured reliably. Current maintenance and repair costs are recognised as expenses for the period.

Provisions for foreign exchange rate, interest rate, credit and gold price risks Given the nature of the operations of a central bank, Eesti Pank may set up provisions on the balance sheet for foreign exchange rate, interest rate, credit and gold price risks. The management of the bank decides on the size and use of the provisions, using a reasonable estimate of the bank’s exposure.

Claims and liabilities to the Financial Supervision Authority The Balance Sheet of Eesti Pank contains a claim on the Financial Supervision Authority in relation to services provided by Eesti Pank and acquisition of current assets, and a liability to the Financial Supervision Authority in relation to its current account held with Eesti Pank. Eesti Pank Annual Report 2016 66

Off-balance-sheet instruments Currency instruments, namely foreign exchange forward instruments, forward legs of foreign exchange swaps and other currency instruments involving an exchange of one currency for another at a future date, are included in the net foreign currency position for the purpose of calculating foreign exchange gains and losses.

Interest rate instruments are revalued on an item-by-item basis. Daily changes in the var- iation margin of open interest rate futures contracts are recorded in the Profit and Loss Account. The valuation of option transactions and of interest rate swaps is based on generally accepted valuation methods, using observable market prices and rates and the discount factors from the settlement dates to the valuation date.

Contingent liabilities Contingent liabilities are recorded in the Notes on the Annual Accounts and include com- mitments, guarantees and other liabilities which may, under certain conditions, become liabilities in the future, though the probability of their realisation is considered lower by the management of the bank than the probability of their non-realisation.

Post-balance-sheet events Assets and liabilities are adjusted for events that occur between the balance sheet date and the date of compilation of the Annual Accounts but are related to transactions during the accounting period or earlier periods or materially affect the condition of assets and liabilities on the balance sheet date. Important post-balance-sheet events that do not affect the condition of assets and liabilities on the balance sheet date are disclosed in the Notes.

Banknotes in circulation The European Central Bank and the euro area national central banks, which together comprise the Eurosystem, issue euro banknotes3. The total value of euro banknotes in circulation is allocated to the Eurosystem central banks on the last working day of each month in accordance with the banknote allocation key4.

The European Central Bank has been allocated a share of 8% of the total value of euro banknotes in circulation, and the remaining 92% has been allocated to the Eurosystem central banks according to their weightings in the capital key of the ECB. Eesti Pank’s share of the total of banknotes allocated to the Eurosystem central banks is disclosed in the balance sheet under the liability item “Banknotes in circulation”.

The difference between the value of euro banknotes allocated to each Eurosystem central bank in accordance with the banknote allocation key and the value of euro banknotes that it actually puts into circulation also gives rise to remunerated intra-Eurosystem balances. These claims or liabilities, which bear interest5, are disclosed under the sub-item “Intra-Eu- rosystem balances: net claims/liabilities related to the allocation of euro banknotes within the Eurosystem” (see “Intra-Eurosystem balances” in the notes on accounting policies).

From the cash changeover year until five years following the cash changeover year6 the intra-Eurosystem balances arising from the allocation of euro banknotes are adjusted in

3 Decision of the ECB of 13 December 2010 on the issue of euro banknotes (recast) (ECB/2010/29), OJ L 35, 9.2.2011, p. 26. 4 Banknote allocation key – the percentages that result from taking the ECB’s share in the total euro banknote issue and applying the subscribed capital key to the NCBs’ share of that total. 5 Decision of the ECB of 3 November 2016 on the allocation of monetary income of the national central banks of Member States whose currency is the euro (recast) (ECB/2016/36), OJ L 347, 20.12.2016, p. 26. 6 The year of changeover to the euro is the year when euro banknotes become the legal tender of a Member State. Eesti Pank Annual Report 2016 67

order to avoid significant changes from previous years in the relative income positions of the Eurosystem central banks. The adjustments are effected by taking into account the differences between the average value of banknotes in circulation of each Eurosystem central bank in the reference period7 and the average value of the banknotes that would have been allocated to them during that period under the ECB’s capital key. The adjustments are reduced in annual stages until the first day of the sixth year after the cash changeover year when income on banknotes is allocated fully in proportion to the Eurosystem central bank’s paid-up shares in the ECB’s capital. The interest income and expenses on these balances are cleared through the accounts of the ECB and disclosed under “Net interest income”.

Collector coins From 2016 the nominal value of collector coins that have been issued is no longer recorded as a liability in the Balance Sheet as the probability of the coins being bought back is very small and their value as precious metal exceeds their nominal value. Income from the sale of collector coins is recorded in the Profit and Loss Account as it is incurred. A change in the accounting principles meant that the nominal value of the kroon and euro collector coins issued was recorded as income and the liability in the Balance Sheet was reduced (see Item 35 “Other income and expenses”).

Interim profit distribution of the ECB The Governing Council of the ECB has decided that the seigniorage income of the ECB, which arises from the 8% share of euro banknotes allocated to the ECB, and the ECB’s income arising from securities purchased under the Securities Markets Programme (SMP), the third covered bond purchase programme (CBPP3) and the asset-backed securities purchase programme (ABSPP) shall be due in full to the Eurosystem central banks in the same financial year it accrues. Unless otherwise decided by the Governing Council, the European Central Bank distributes this income in January of the following year in the form of an interim distribution of profit8. It is distributed in full, unless the European Cen- tral Bank’s net profit for the year is less than its income earned. The distributed profit may be reduced if the Governing Council decides to make transfers to the provision for foreign exchange rate, interest rate, credit and gold price risks. The Governing Council may also decide to charge costs incurred by the European Central Bank in connection with the issue and handling of euro banknotes against income earned on euro banknotes in circulation.

The amount distributed to the Eurosystem central banks is disclosed in the Profit and Loss Account under “Income from equity shares and participating interests”.

Intra-Eurosystem balances Intra-Eurosystem claims arising from Eesti Pank’s participating interest in the ECB are reported under “Participating interest in the European Central Bank”.

Intra-Eurosystem balances arising from the transfer of foreign reserve assets to the ECB by NCBs joining the Eurosystem are denominated in euro and reported under “Claims equivalent to the transfer of foreign reserves”.

Intra-Eurosystem balances arising from the allocation of euro banknotes within the Eurosystem are included as a net single asset or liability under “Net claims/liabilities related

7 The period is 24 months long and starts 30 months before the day that the euro banknotes become the legal tender of the country in question. For Eesti Pank the period was from July 2008 to June 2010. 8 Decision of the ECB of 15 December 2014 on the interim distribution of the income of the European Central Bank (recast) (ECB/2014/57), OJ L 53, 25.2.2015, p. 24. Eesti Pank Annual Report 2016 68

to the allocation of euro banknotes within the Eurosystem” (see “Banknotes in circulation” in the notes on accounting policies).

Intra-Eurosystem balances result primarily from cross-border payments in the European Union which are settled in central bank money in euro. These transactions are for the most part initiated by private entities, meaning credit institutions, corporations and individuals. These transactions are settled in TARGET29 and give rise to bilateral balances in the TARGET2 accounts of EU central banks. These bilateral balances are netted out and then assigned to the ECB on a daily basis, leaving each national central bank with only a single net bilateral position towards the ECB. Intra-Eurosystem balances of euro area NCBs towards the ECB arising from TARGET2, and other intra-Eurosystem balances denominated in euro such as interim profit distributions to NCBs or monetary income results are presented in the Balance Sheet as a single net asset or liability position and disclosed under “Other claims within the Eurosystem (net)” or “Other liabilities within the Eurosystem (net)”.

9 The Trans-European Automated Real-time Gross Settlement Express Transfer system Eesti Pank Annual Report 2016 69

NOTES ON THE BALANCE SHEET

ITEM 1 – GOLD AND GOLD RECEIVABLES

Changes in the value of Eesti Pank’s gold reserves are as follows:

31/12/2016 31/12/2015

Gold (ounces) 8 250.171 8 250.171

Ounce market value (EUR) 1 098.046 973.225

Revaluation (thousand EUR) 1 871 842

Market value (thousand EUR) 9 059 8 029

ITEM 2 – RECEIVABLES FROM THE IMF

Receivables from the IMF are the SDR account in the IMF and the reserve position in the IMF.

thousand EUR

31/12/2016 31/12/2015

SDR account in the IMF 31 389 78 976

Reserve position in the IMF 63 253 18 075

Participation in the IMF 310 635 119 518

IMF No.1 account -247 382 -101 443

Total 94 642 97 051

The SDR account in the IMF An SDR account is generated for each IMF Member State for conducting loan transactions and various other related operations. The SDR account is used to record the SDRs distributed to support the foreign reserves of IMF Member States and to increase global liquidity (see Item 24 “Counterpart of the Special Drawing Rights Allocated by the IMF”).

Reserve position in the IMF Eesti Pank represents the Republic of Estonia in the IMF. A quota has been established for each IMF member determining its participation (subscription) and voting power in the IMF. Participation in the IMF is recorded under assets on the Balance Sheet and is equal to the country’s quota.

On 10 February 2016 Eesti Pank transferred EUR 47,005,407 to the IMF to receive SDR 37,425,000, which accounts for 25% of the quota increase of the Republic of Estonia. At the same time Eesti Pank credited the IMF’s No.1 account at Eesti Pank with EUR 141,016,221, equivalent to SDR 112,275,000 or 75% of the quota increase of the Republic of Estonia. At the end of 2016 the quota of the Republic of Estonia in the International Mon- etary Fund was SDR 243.6 million.

The reserve position in the IMF comprises the net amount of the quota and the IMF No.1 account. The reserve position increased in 2016 as the Republic of Estonia paid in SDR 37,425,000 as 25% of its quota increase. The size of the reserve position is affected by participation of the Republic of Estonia in the IMF’s Financial Transactions Plan (FTP) with SDR 5 million in 2016, which was SDR 7 million in 2015. Estonia has participated in the IMF’s FTP since 2012. Eesti Pank Annual Report 2016 70

ITEM 3 – BALANCES WITH BANKS, SECURITY INVESTMENTS AND OTHER EXTERNAL ASSETS

Item 3 reflects bank balances in foreign currency with credit institutions outside the euro area, term deposits and reverse repurchase agreements denominated in US dollars, and security investments denominated in United States, Canadian and Australian dollars and British pounds of non-euro area residents. Eesti Pank’s foreign reserves were invested mainly in government bonds of the United States, Australia, Canada and the United Kingdom.

thousand EUR

31/12/2016 31/12/2015

Securities 200 483 263 137

Reverse repurchase transactions 15 576 0

Fixed-term deposits 10 246 10 655

Current accounts 2 129 847

Total 228 434 247 639

thousand EUR

31/12/2016 31/12/2015

USD 128 400 151 959

CAD 51 169 47 562

AUD 48 484 50 304

GBP 241 24 773

JPY 76 33

CNH 34 0

NZD 24 3

CHF 2 2

DKK 2 2

SEK 1 1

NOK 1 0

Total 228 434 274 639

ITEM 4 – CLAIMS ON EURO AREA RESIDENTS DENOMINATED IN FOREIGN CURRENCY

Item 4 reflects bank balances in foreign currency with credit institutions in the euro area and investments in equities denominated in US dollars of euro area residents.

thousand EUR

31/12/2016 31/12/2015

Equities 100 490 73 175

Current accounts 1 614 4 530

Fixed-term deposits 0 5 686

Total 102 104 83 391 Eesti Pank Annual Report 2016 71

thousand EUR

31/12/2016 31/12/2015

USD 101 624 82 498

AUD 207 220

SEK 206 62

CAD 195 308

CHF 9 9

JPY 7 -17

NZD 0 4

GBP -144 307

Total 102 104 83 391

ITEM 5 – CLAIMS ON NON-EURO AREA RESIDENTS DENOMINATED IN EURO

Item 5 reflects bank balances in euros with credit institutions outside the euro area, reverse repurchase agreements denominated in euros, and security investments denominated in euros of non-euro area residents.

thousand EUR

31/12/2016 31/12/2015

Securities 6 609 1 315

Reverse repurchase transactions 5 190 0

Current accounts 150 136

Total 11 949 1 451

ITEM 6 – LENDING TO EURO AREA CREDIT INSTITUTIONS RELATED TO MONETARY POLICY OPERATIONS DENOMINATED IN EURO

The total Eurosystem holding of monetary policy assets amounts to EUR 595,873 million, of which Eesti Pank holds EUR 86 million (EUR 75 million in 2015) of longer-term refinancing transactions with maturities of 48 months. Under Article 32.4 of the Statute of the ESCB, any risks from monetary policy operations, if they were to materialise, are shared in full by the Eurosystem central banks in proportion to the prevailing ECB capital key shares. Eesti Pank’s share in the capital key is 0.27390%.

Losses can only materialise if both the counterparty fails and the recovery of funds received from the resolution of the collateral provided by the counterparty is not sufficient. Risk sharing has been excluded by the Governing Council of the ECB for specific collateral which can be accepted by NCBs at their own discretion.

In March 2016 the Governing Council introduced a new series of four targeted longer-term refinancing operations (TLTRO II). These operations have a four-year maturity, with a pos- sibility of repayment after two years. The applicable interest rate for TLTRO II operations depends on the individual lending benchmark of the respective counterparty between the date of allotment and January 2018. The actual rate will be set in 2018 and will be between the main refinancing operation’s rate and the deposit facility rate at the time of the allotment. Given that the actual rate will only be known in 2018 and a reliable estimate is not possible at this juncture, the deposit facility rate has been used for calculating the TLTRO II interest for 2016, as this is deemed a prudent approach. Eesti Pank Annual Report 2016 72

ITEM 7 – OTHER CLAIMS ON EURO AREA CREDIT INSTITUTIONS DENOMINATED IN EURO

Item 7 reflects the balances with banks of euro area credit institutions denominated in euro.

ITEM 8 – SECURITIES HELD FOR MONETARY POLICY PURPOSES

Item 8 reflects securities acquired by Eesti Pank within the scope of the purchase programmes for covered bonds10, the Securities Markets Programme11 and the public sector asset purchase programme12.

The Securities Market Programme was ended on 6 September 2012. The second covered bond purchase programme was ended on 31 October 2012.

Securities purchased under all the purchase programmes are valued on an amortised cost basis subject to impairment (see “Securities” in the notes on accounting policies). The amortised cost and market value13 of securities, which are not recorded in the Balance Sheet or Profit and Loss Account and are presented only for the purposes of comparison, are:

thousand EUR

31/12/2016 31/12/2015

Amortised cost Market value Amortised cost Market value

Public sector asset purchase programme 3 217 270 3 227 803 1 228 386 1 230 620

Bonds of institutions 3 155 618 3 165 692 1 181 305 1 183 501

Elering 61 652 62 111 47 081 47 119

Securities Markets Programme 108 568 119 545 142 716 158 627 Second covered bond purchase programme 13 480 14 647 13 475 14 808

Total 3 339 318 3 361 995 1 384 577 1 404 056

The decrease in the amortised cost of the securities held under the Securities Market Pro- gramme was due to redemptions.

In 2016 the expanded asset purchase programme (APP) of the Eurosystem14, which covers the third covered bond purchase programme (CBPP3)15, the asset-backed securities purchase programme (ABSPP)16, and the public sector purchase programme (PSPP)17, were supplemented with the corporate sector purchase programme (CSPP)18 as a fourth component.

10 Decision ECB/2011/17 of 3 November 2011 on the implementation of the second covered bond purchase programme, OJ L 297, 16.11.2011, p. 70. 11 Decision ECB/2010/5 of 14 May 2010 establishing a securities markets programme, OJ L 124, 20.05.2010, p. 8. 12 Decision ECB/2015/10 of 4 March 2015 on a secondary markets public sector asset purchase programme, OJ L 121, 14.5.2015, p. 20, as amended. 13 Market values are approximate and are derived from quoted market values. If no market quotation is available, the market value is calculated using the internal models of the Eurosystem. 14 For more on the asset purchase programmes, see the ECB website https://www.ecb.europa.eu/mopo/implement/ omt/html/index.en.html 15 Decision ECB/2014/40 of 15 October 2014 on the implementation of the third covered bond purchase programme, OJ L 335, 22.11.2014, p. 22. 16 Decision ECB/2014/45 of 19 November 2014 on the implementation of the asset-backed securities purchase programme, OJ L 1, 6.1.2015, p, 4, as amended. 17 Under this programme, the ECB and the national central banks may purchase, in the secondary market, euro-denominated securities issued by euro area central, regional or local governments, recognised agencies located in the euro area and international organisations and multilateral development banks located in the euro area. 18 Under this programme, the national central banks may purchase investment-grade euro-denominated bonds issued by non-bank corporations established in the euro area. Eesti Pank Annual Report 2016 73

From April 2016 until March 2017, the combined monthly APP purchases by the national central banks and the ECB increased from EUR 60 billion to EUR 80 billion on average. In December 2016, the Governing Council decided to continue the net APP purchases after March 2017 at a monthly pace of EUR 60 billion until at least the end of December 2017. If necessary this can be extended, in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim of keeping the inflation rate below but close to 2% over the medium term. If the outlook becomes less favourable in the meantime, or if financial conditions become inconsistent with further progress towards a sustained adjustment of the path of inflation, the Governing Council intends to increase the size or duration of the programme. The net purchases will be made alongside reinvestments of the principal payments from maturing securities purchased under the APP.

The European Central Bank gave Eesti Pank exceptional permission to buy bonds issued by the transmission system operator Elering as an alternative under the asset purchase programme. The Governing Council of the European Central Bank made an exception because unlike the other national central banks of the euro area, Eesti Pank is not able to buy bonds issued by its own government from the secondary market. At the end of 2016, the bonds issued by Elering stood at EUR 62 million on Eesti Pank’s Balance Sheet.

The total Eurosystem central banks’ holding of Securities Market Programme securities amounts to EUR 94,803 million, of which Eesti Pank holds EUR 109 million. The total Eurosystem central banks’ holding of securities under the covered bond purchase programmes amounts to EUR 186,965 million. The total holding of bonds of European institutions purchased under the public sector purchase programme amounts to EUR 139,639 million, of which Eesti Pank holds EUR 3,156 million. Under Article 32.4 of the Statute of the ESCB, any risks from holdings of securities under the Securities Markets Programme or the covered bond purchase programmes or the public sector asset purchase programme other than government bonds, if they were to materialise, are shared in full by the Eurosystem central banks in proportion to the prevailing ECB capital key shares.

The Governing Council of the ECB assesses on a regular basis the financial risks associated with the securities held under these programmes. Annual impairment tests are conducted on the basis of the estimated recoverable amounts as at the year end. No impairment was found in the value of these securities in 2016 and the Governing Council decided that all the future cash flows can be expected to materialise.

ITEM 9 – OTHER SECURITIES

Item 9 reflects investments in securities denominated in euro by euro area residents.

ITEM 10 – PARTICIPATING INTEREST IN THE ECB

Item 10 reflects the participating interest of Eesti Pank in the European Central Bank (ECB). Article 28 of the Statute of the European System of Central Banks (ESCB) states that the national central banks of the ESCB are the sole subscribers of the capital of the ECB. Sub- scriptions depend on the capital key weighting, which is set out in Article 29 of the ESCB Statute, and which is adjusted every five years.

The subscribed and paid up capital contributions of the national central banks are as follows: Eesti Pank Annual Report 2016 74

Subscribed Paid-in Capital key from capital as of capital as of 1/01/2015 1/01/2015 1/01/2015

% € €

Nationale Bank van België / Banque Nationale de Belgique 2.4778 268 222 025 268 222 025

Deutsche Bundesbank 17.9 973 1 948 208 997 1 948 208 997

Eesti Pank 0.1928 20 870 614 20 870 614

Central Bank of Ireland 1.1607 125 645 857 125 645 857

Bank of Greece 2.0332 220 094 044 220 094 044

Banco de España 8.8409 957 028 050 957 028 050

Banque de France 14.1792 1 534 899 402 1 534 899 402

Banca d’Italia 12.3108 1 332 644 970 1 332 644 970

Central Bank of Cyprus 0.1513 16 378 236 16 378 236

Latvijas Banka 0.2821 30 537 345 30 537 345

Lietuvos bankas 0.4132 44 728 929 44 728 929

Banque centrale du Luxembourg 0.2030 21 974 764 21 974 764

Central Bank of Malta 0.0648 7 014 605 7 014 605

De Nederlandsche Bank 4.0035 433 379 158 433 379 158

Oesterreichische Nationalbank 1.9631 212 505 714 212 505 714

Banco de Portugal 1.7434 188 723 173 188 723 173

Banka Slovenije 0.3455 37 400 399 37 400 399

Národná banka Slovenska 0.7725 83 623 180 83 623 180

Suomen Pankki – Finlands Bank 1.2564 136 005 389 136 005 389

Subtotal – euro area national central banks 70.3915 7 619 884 851 7 619 884 851

Българска народна банка (Bulgarian National Bank) 0.8590 92 986 811 3 487 005 Česká národní banka 1.6075 174 011 989 6 525 450

Danmarks Nationalbank 1.4873 161 000 330 6 037 512

Hrvatska narodna banka 0.6023 65 199 018 2 444 963

Magyar Nemzeti Bank 1.3798 149 363 448 5 601 129

Narodowy Bank Polski 5.1230 554 565 112 20 796 192

Banca Naţională a României 2.6024 281 709 984 10 564 124

Sveriges Riksbank 2.2729 246 041 586 9 226 559

Bank of England 13.6743 1 480 243 942 55 509 148

Subtotal – non-euro area national central banks 29.6085 3 205 122 218 120 192 083

Total* 100.0000 10 825 007 070 7 740 076 935

* Owing to rounding, the total may not correspond to the sum of all figures shown.

When Estonia joined the euro area, Article 48.2 of the ESCB’s Statute started to apply to Eesti Pank, requiring the central bank to pay a part of the reserves, revaluation accounts and risk provisions of the ECB in proportion to its share in the subscribed capital of the ECB. This item reflects the total amount paid for the reserves, revaluation accounts and the risk provisions of the ECB of EUR 67,982,624. Eesti Pank Annual Report 2016 75

ITEM 11 – CLAIMS EQUIVALENT TO THE TRANSFER OF FOREIGN RESERVES

Item 11 reflects claims of Eesti Pank arising from the transfers of foreign reserve assets to the ECB when Eesti Pank joined the Eurosystem. These foreign reserves were 85% in Jap- anese yen and 15% in gold. The claims are denominated in euro at a value fixed at the time of their transfer. The interest payable on claims translated from foreign currency is calculated daily at the latest available marginal rate for the Eurosystem’s main refinancing operations, adjusted to reflect a zero return on the gold component.

ITEM 12 – NET CLAIMS RELATED TO THE ALLOCATION OF EURO BANKNOTES WITHIN THE EUROSYSTEM

Item 12 reflects Eesti Pank’s claims towards the Eurosystem relating to the allocation of euro banknotes within the Eurosystem (see “Banknotes in circulation” and “Intra-Eurosystem balances” in the notes on accounting policies)19. The remuneration of these claims is calculated daily at the latest available marginal interest rate used by the Eurosystem in its tenders for main refinancing operations.

ITEM 13 – OTHER CLAIMS WITHIN THE EUROSYSTEM (NET)

Item 13 reflects net claims arising from the TARGET2 balance, the amount due to the difference arising from the monetary income pooled from and allocated to the Eurosystem central banks, and the amount due to the ECB’s interim profit distribution.

thousand EUR

31/12/2016 31/12/2015

TARGET2 924 122 2 760 954

Monetary income reallocation 10 951 11 183

Interim profit distribution of the ECB 2 647 2 224

Total 937 720 2 774 361

The remuneration of the TARGET2 balance is calculated daily at the latest available marginal interest rate used by the Eurosystem in its tenders for main refinancing operations. The decrease in the TARGET2 balance in 2016 is mainly due to the increase in the volume of the public sector purchase programme (see Item 8 “Securities held for monetary policy purposes”).

Claims on the ECB in connection with the reallocation of monetary income come from the difference between the amounts collected and allocated by the Eurosystem NCBs (see item 34 “Net result of pooling of monetary income”).

This item also covers amounts payable by the ECB to euro area central banks in the form of an interim distribution of profit (see “Interim profit distribution of the ECB” in the notes on accounting policies). At the decision of the Governing Council of the ECB, the ECB distributed its income of EUR 966 million in 2016 between the national central banks of the euro area (see item 33 “Income from equity shares and participating interests”).

19 In accordance with the accounting methods chosen by the Eurosystem for euro banknotes, 8% of the total value of euro banknotes in circulation is allocated to the ECB on a monthly basis. The other 92% of the euro banknotes in circulation are allocated to the national central banks on a monthly basis, and the NCBs reflect their percentages of the euro banknotes in their balance sheets in proportion to their paid-up contributions to the ECB capital. In accordance with these accounting methods, the difference between the value of euro banknotes allocated to a national central bank and the amount of euro banknotes issued into circulation is recorded under “Intra-Eurosystem net claims/liabilities related to the allocation of euro banknotes within the Eurosystem”. Eesti Pank Annual Report 2016 76

ITEM 14 – TANGIBLE FIXED ASSETS

thousand EUR

Acquisition cost Buildings Hardware Software Inventory Motor vehicles Total

Balance at the end of 2015 27 758 3 583 3 613 5 698 31 40 683

Acquisitions 96 264 66 127 0 553

Disposals 0 0 0 -28 0 -28

Balance at the end of 2016 27 854 3 847 3 679 5 797 31 41 208

Accumulated depreciation

Balance at the end of 2015 12 614 2 928 3 015 4 928 11 23 496

Depreciation charge 1 000 277 219 356 8 1 860

Disposals 0 0 0 -28 0 -28

Balance at the end of 2016 13 614 3 205 3 234 5 256 19 25 328

Carrying amount

Balance at the end of 2015 15 144 655 598 770 20 17 187

Balance at the end of 2016 14 240 642 445 541 12 15 880

Prepayments for fixed assets

Balance at the end of 2015 0 0 910 0 0 910

Balance at the end of 2016 9 0 1 387 28 0 1 424

Total fixed assets

Balance at the end of 2015 15 144 655 1 508 770 20 18 097

Balance at the end of 2016 14 249 642 1 832 569 12 17 304

The cost of fixed assets acquired in 2016 was EUR 553 thousand; in 2015 it was EUR 940 thousand. The major part of buildings acquisitions was for procurements for renovating buildings. Hardware acquisition was for purchasing servers and network equipment. The largest software procurements were for purchases of software licences, and development work for the account module and the statistics module for the bank. The largest part of the prepayment for acquisition of fixed assets was for the development work for the ESCB’s software systems. The major part of inventory acquisition was spent on development of the secure entry system for the bank.

ITEM 15 – OTHER FINANCIAL ASSETS

Item 15 reflects the shares in the Bank for International Settlements and SWIFT.

Eesti Pank holds 214 shares (200 voting shares) in the Bank for International Settlements at an acquisition cost of EUR 217,118, and 5 shares in SWIFT at an acquisition cost of EUR 17,150.

ITEM 16 – OFF-BALANCE-SHEET INSTRUMENTS REVALUATION DIFFERENCES

Item 16 reflects valuation changes in swap and forward transactions in foreign currency outstanding at year-end. These valuation changes are the result of the conversion of such transactions into their euro equivalents at the exchange rates prevailing on the balance sheet date, compared with the euro values resulting from the conversion of the transactions at the average cost of the respective foreign currency on that date. Eesti Pank Annual Report 2016 77

ITEM 17 – ACCRUALS AND PREPAID EXPENSES

thousand EUR

31/12/2016 31/12/2015

Interest income 30 558 18 349

Securities 29 335 17 346

Derivative instruments 638 295

Monetary policy operations 538 438

Fixed-term deposits and current accounts 33 8

Intra-Eurosystem balances 10 260

Reverse repurchase transactions 3 0

Loans 1 2

Prepaid expenses 899 809

Claims on the Financial Supervision Authority 845 839

Other claims 327 259

Total 32 629 20 256

ITEM 18 – SUNDRY ASSETS

thousand EUR

31/12/2016 31/12/2015

Foreign exchange transactions 11 311 6 698

Loans to employees of Eesti Pank 5 628 6 350

Credits related to margin calls 247 0

Other 41 66

Numismatic banknotes and coins of the Estonian kroon 0 932

Derivative instruments 0 567

Total 17 227 14 613

Housing loans secured by real estate have been granted to employees of Eesti Pank for a maximum of 30 years. The interest rate on housing loans granted before 2012 is the deposit facility interest rate payable to credit institutions plus the risk margin but together no more than the upper limit of the interest rate. The deposit facility rate equals the ECB deposit interest rate, which was between -0.4% and -0.3% in 2016; in 2015 it was between -0.3% and -0.2%. The upper limit on the interest rate is twice the interest rate on the European Central Bank’s main refinancing operations. The interest rate on housing loans granted since 2012 is the six-month EURIBOR plus 0.5% but no more than the upper limit on the interest rate. The interest rate on housing loans granted since June 2014 is the six- month EURIBOR plus 1.25%. In addition, study loans have been granted for a maximum of ten years with an interest rate of 5%. From 1 July 2015, Eesti Pank stopped providing loans to employees.

The item reflects balances related to swap transactions in foreign currency outstanding at year-end. These balances arise from the conversion of such transactions into their euro equivalents at the respective currency’s average cost on the balance sheet date, compared with the euro values at which the transactions were initially recorded.

The accounting policies for collector coins and collector banknotes were changed in 2016, and the balances of nominal values of Estonian kroon collector coins and banknotes recorded under other assets and other liabilities were reduced in the Balance Sheet (see Item 35 “Other income and expenses”). Eesti Pank Annual Report 2016 78

ITEM 19 – BANKNOTES IN CIRCULATION

Item 19 reflects Eesti Pank’s share of the total euro banknotes in circulation (see “Bank- notes in circulation” in the notes on accounting policies). The value of euro banknotes actually issued by Eesti Pank is smaller than the allocation of such banknotes to Eesti Pank. The claim arising from this difference is reflected in Item 12 “Net claims related to the allocation of euro banknotes within the Eurosystem”.

thousand EUR

31/12/2016 31/12/2015

Euro banknotes 1 218 549 1 058 419

Adjustments of euro banknotes 1 866 289 1 909 220

ECB banknotes (8%) -246 774 -237 398

Total 2 838 064 2 730 241

ITEM 20 – CURRENT ACCOUNTS (INCLUDING COVER FOR THE MINIMUM RESERVE SYSTEM)

Item 20 reflects the current accounts of credit institutions with Eesti Pank. The remuneration paid on the balance on the current accounts of credit institutions, held to cover the minimum reserve, is calculated at the latest available marginal interest rate used by the Eurosystem in its tenders for main refinancing operations. The balances held in excess of the minimum reserve requirements are remunerated at the lower rate of either 0% or the deposit facility rate. The deposit facility rate equals the ECB deposit interest rate, which was between -0.4% and -0.3% in 2016; in 2015 it was between -0.3% and -0.2%. The average balance on the accounts of credit institutions was EUR 2,696,401,564 in 2016 (EUR 1,374,732,397 in 2015).

ITEM 21 – LIABILITIES TO OTHER EURO AREA RESIDENTS DENOMINATED IN EURO

Item 21 reflects mainly the current accounts of the Financial Supervision Authority and the Guarantee Fund held with Eesti Pank. Interest on the current account of the Finan- cial Supervision Authority is calculated monthly from the average balance of the current account using the EONIA (euro overnight index average) interest rate, and the interest rate on the Guarantee Fund account is the deposit facility rate.

ITEM 22 – LIABILITIES TO NON-EURO AREA RESIDENTS DENOMINATED IN EURO

Item 22 reflects the euro deposits of non-euro area residents and reverse repurchase transactions with non-euro area residents.

ITEM 23 – LIABILITIES TO NON-EURO AREA RESIDENTS DENOMINATED IN FOREIGN CURRENCY

Item 23 reflects the US dollar denominated reverse repurchase transactions of non-euro area residents with non-euro area residents.

ITEM 24 – COUNTERPART OF THE SPECIAL DRAWING RIGHTS ALLOCATED BY THE IMF

Item 24 reflects the liability to the IMF arising from the IMF’s decision of 7 August 2009 to increase the SDR issues for all of its member states. This was done in order to increase Eesti Pank Annual Report 2016 79

global liquidity using support from the foreign reserves of the member states. As a result, Estonia received SDR 61,965,241 (see Item 2 “Receivables from the IMF”).

ITEM 25 – ACCRUALS AND DEFERRED INCOME

thousand EUR

31/12/2016 31/12/2015

Accounts payable 1 332 1 072

Tax liabilities 968 902

Interest expenses 928 505

Derivative instruments 814 487

Monetary policy operations 81 0

SDR allocation 28 7

Repurchase transactions 5 0

Deposits of credit institutions 0 11

Employee salaries payable 684 643

Recreation reserve 454 457

Other liabilities 836 178

Total 5 202 3 757

ITEM 26 – SUNDRY LIABILITIES

thousand EUR

31/12/2016 31/12/2015

Euro coins 45 124 41 445

Forward transactions in foreign currency 123 355

Foreign exchange transactions 10 0

Other liabilities 24 35

Estonian kroon banknotes 0 39 695

Estonian kroon coins 0 7 466

Loans to employees of Eesti Pank 0 15

Total 45 281 89 011

Estonian kroon banknotes and coins can be exchanged for euros at the shop of the Eesti Pank Museum with no limit of amount or duration at the central rate of 1 EUR = 15.6466 EEK.

In 2016 the exchange liability of EUR 45.1 million for the kroons issued was transferred to income (see Item 35 “Other income and expenses”) on the assumption that not all the kroons cash will be exchanged for euros and the probability of them being exchanged diminishes gradually each year. A provision was set up to cover the estimated exchange liability (see Item 27 “Provisions”).

The nominal value of the kroon and euro collector coins issued was transferred to income and the liabilities in the Balance Sheet were reduced. This was because the probability of collector coins being bought back is very low, and the value of their precious metal exceeds their nominal value (see Item 35 “Other income and expenses”).

The item reflects balances related to forward transactions in foreign currency and currency exchange transactions outstanding at year-end. These balances arise from the conversion of such transactions into their euro equivalents at the respective currency’s average cost Eesti Pank Annual Report 2016 80

on the balance sheet date, compared with the euro values at which the transactions were initially recorded.

ITEM 27 – PROVISIONS

Item 27 reflects general risk provisions and the provisions made in 2016 to cover the exchange liability for the kroon.

The aim of general risk provisions is to cover the financial risks of monetary policy operations and investment assets with provisions. The increase in general risk provisions stems from various risk assessments using Value at Risk, Expected Shortfall, and other methods. In deciding the size of provisions, the amounts set aside for provisions in the past four years are considered as well as the risk assessments. There was an additional provision of EUR 7.5 million on 31 December 2016 (EUR 4.0 million on 31 December 2015), meaning the total provision increased to EUR 37.5 million.

A provision of EUR 29.6 million was set up in 2016 to cover the liability for exchanging kroons for euros. As it is highly probable that not all kroons will be exchanged for euros, Eesti Pank created a formula for calculating the size of the exchange liability for the kroons. The Eesti Pank Executive Board decided to transfer the liability to exchange the kroons issued into circulation with a value of EUR 45.1 million to income and to set up a special purpose provision of EUR 29.6 million. Future exchanges of kroons for euros will be funded from the provision. The size of the provision will be reviewed regularly in future (see Item 35 “Other income and expenses”).

ITEM 28 – REVALUATION ACCOUNTS

thousand EUR

31/12/2016 31/12/2015

Equities 8 182 0

Foreign currency 6 885 6 642

Securities 2 101 3 016

Gold 1 871 842

Total 19 039 10 500

Revaluation accounts represent revaluation reserves that arise from unrealised gains on assets and liabilities.

The unrealised losses at the end of the year are recognised in the Profit and Loss Account as expenses under “Write-downs on financial assets”.

ITEM 29 – CAPITAL AND RESERVES

Changes in capital and reserves in 2016:

thousand EUR

31/12/2016 Distribution of profit for 2015 31/12/2015

Fixed capital 100 000 0 100 000

Reserve capital 122 581 22 581 100 000

Special reserve 214 314 0 214 314

Total 436 895 22 581 414 314 Eesti Pank Annual Report 2016 81

Under Section 30 of the Eesti Pank Act, at least 25% of the annual profit must be allocated to increasing statutory capital up to the amount set by the Riigikogu20. The amount set by the Riigikogu in the statutory capital is given in the Eesti Pank Act as EUR 100 million21. At the decision of the Supervisory Board of Eesti Pank, Eesti Pank directs at least 25% of its annual profits to building up its reserve capital22. Following the decision of the Eesti Pank Supervisory Board of 28 April 2015 on the distribution of Eesti Pank’s profits for 2014, Eesti Pank’s reserve capital was equal to its statutory capital. With Eesti Pank’s reserve capital equal to its statutory capital, the Riigikogu decided on 12 April 2016 to continue increasing Eesti Pank’s reserve capital up to EUR 300 million. After these allocations, part of the profit can be allocated for establishing and supplementing endowments and foundations for specific purposes, at the decision of the Supervisory Board of Eesti Pank. The remaining profit is transferred to the state budget. The bank transferred 25% of its profit for 2015, or EUR 7.5 million, to the state budget in 2016.

20 Eesti Pank Act § 30 (2) 21 Eesti Pank Act § 25 (2) 22 Eesti Pank Act § 30 (3) Eesti Pank Annual Report 2016 82

NOTES ON THE PROFIT AND LOSS ACCOUNT

ITEM 30 – NET INTEREST INCOME

thousand EUR

2016 2015

Net interest income 16 770 14 866

Interest income 45 686 42 659

Derivative instruments 16 931 18 076

Intra-Eurosystem balances 16 184 13 088

Securities 12 367 11 393

Reverse repurchase transactions 86 12

Fixed-term deposits 44 22

Current accounts 32 43

Deposits 27 8

Loans to employees of Eesti Pank 15 17

Interest expenses -28 916 -27 793

Derivative instruments -20 854 -20 971

Securities -7 778 -6 689

Repurchase transactions -148 -79

Current accounts -98 -54

Intra-Eurosystem balances -38 0

thousand EUR

2016 2015

Intra-Eurosystem interest income 16 184 13 088

Monetary policy operations 9 721 2 595

Bonds held for monetary policy purposes 6 127 9 141

TARGET2 181 733

Allocation of banknotes within the Eurosystem 145 571

Transfer of foreign currency reserves 10 48

Intra-Eurosystem interest expenses -38 0

Monetary policy operations -38 0 Eesti Pank Annual Report 2016 83

ITEM 31 – NET RESULT OF FINANCIAL OPERATIONS, WRITE-DOWNS AND RISK PROVISIONS

thousand EUR

2016 2015

Net result of financial operations, write-downs and risk provisions -31 17 184

Realised gain arising from financial operations 10 278 24 546

Securities 7 240 6 205

Exchange rate income 3 417 7 681

Equities -5 11 246

Derivative instruments -130 -186

Financial asset management costs -244 -400

Write-downs on financial assets -2 809 -3 362

Securities -2 729 -445

Exchange rate write-downs -85 -147

Net change of loan portfolio write-downs 5 -3

Derivative instruments 0 -22

Equities 0 -2 745

Provisions for foreign exchange rate, interest rate and credit risks -7 500 -4 000

ITEM 32 – NET INCOME FROM FEES AND COMMISSIONS

thousand EUR

2016 2015

Net income from fees and commissions 46 -8

Fees and commissions income 106 117

Current accounts service fees 102 100

Fines, arrears and other 4 17

Fees and commissions expenses -60 -125

Commission fees -53 -118

TARGET2 fees -4 -5

Other fees and commissions -3 -2

ITEM 33 – INCOME FROM EQUITY SHARES AND PARTICIPATING INTERESTS

thousand EUR

2016 2015

Income from equity shares and participating interests 3 488 2 852

Interim profit distribution of the ECB 2 646 2 224

Partial allocation of ECB profit 739 408

Dividends from the Bank for International Settlements 58 61

Dividends from participation in the IMF 45 7

Dividends from investments 0 152 Eesti Pank Annual Report 2016 84

The item mainly shows the profit distributed to Eesti Pank by the European Central Bank earned on euro banknotes and securities purchased under the securities markets programme, the third covered bond purchase programmes, the asset-backed securities purchase programme and the public sector asset purchase programme (see “Interim profit distribution of the ECB” in the notes on accounting policies).

ITEM 34 – NET RESULT OF POOLING OF MONETARY INCOME

thousand EUR

2016 2015

Net result of pooling of monetary income 10 951 11 183

Monetary income reallocation 10 952 11 214

Monetary income pooled by Eesti Pank -16 185 -13 384

Monetary income allocated to Eesti Pank 27 137 24 598

Adjustment for the monetary income of previous years -1 -31

The net result of pooling of monetary income from the Eurosystem central banks in 2016 totalled EUR 9,907,796,698, which includes the share of Eesti Pank. The monetary income pooled by the Eurosystem is allocated among the Eurosystem central banks according to the subscribed ECB capital key. The difference between the monetary income pooled by Eesti Pank of EUR 16,184,931 and that reallocated to Eesti Pank of EUR 27,137,129 is the net result EUR 10,952,198 in monetary income.

The amount of each national central bank’s monetary income is determined by measuring the actual annual income that derives from the earmarkable assets held against its liability base.

Earmarkable assets are: lending to euro area credit institutions related to monetary policy operations denominated in euro; securities held for monetary policy purposes; claims equivalent to the transfer of foreign reserve assets to the ECB; net intra-Eurosystem claims resulting from TARGET2 transactions; net intra-Eurosystem claims related to the allocation of euro banknotes within the Eurosystem; interest claims accrued recorded at the end of the month on monetary policy transactions with a maturity of over one year; and a limited amount of each national central bank’s gold holdings in proportion to each national central bank’s capital key share.

The liability base consists mainly of: banknotes in circulation; liabilities to euro area credit institutions related to monetary policy operations denominated in euro; net intra-Eu- rosystem liabilities resulting from TARGET2 transactions; net intra-Eurosystem liabilities related to the allocation of euro banknotes within the Eurosystem; and interest liabilities accrued recorded at the end of the month on monetary policy transactions with a maturity of over one year. Any interest paid on liabilities included within the liability base is to be deducted from the monetary income to be pooled.

Gold is considered to generate no income. Securities held for monetary policy purposes under Decision ECB/2009/16 of 2 July 2009 on the implementation of the covered bonds purchase programme, Decision ECB/2011/17 of 3 November 2011 on the implementation of the second covered bond purchase programme, and Decision ECB/2015/10 of 4 March 2015 on a secondary markets public sector asset purchase programme are considered to generate income at the latest available marginal interest rate used by the Eurosystem in its tenders for main refinancing operations. Where the value of an NCB’s earmarkable assets exceeds or falls short of the value of its liability base, the difference is offset by applying to Eesti Pank Annual Report 2016 85

the value of the difference the latest available marginal rate for the Eurosystem’s main refinancing operations and the total income or expense for the year is considered in the allocation of monetary income.

ITEM 35 – OTHER INCOME AND EXPENSES

thousand EUR

2016 2015

Other income and expenses 17 911 1 055

Other income 47 533 1 055

Exchange liability for Estonian kroons 45 054 0

Expenses compensated by the Financial Supervision Authority 671 679

Exchange liability for Estonian kroon collector coins 621 0

Income from the sale of collector coins and numismatic products 546 187

Exchange liability for euro collector coins 435 0

Income on financial asset management 153 148

Rental income 20 25

Other income 33 16

Other expenses –29 622 0

The income from the liability to exchange Estonian kroons is recorded under other income. As it is very probable that not all kroons will be exchanged for euros, Eesti Pank created a formula for calculating the size of the exchange liability for the kroons. The Eesti Pank Executive Board decided to transfer the liability to exchange the kroons issued into circulation with a value of EUR 45.1 million to income and to set up a special purpose provision of EUR 29.6 million. Future exchanges of kroons for euros will be funded from the provision. The size of the provision will be reviewed regularly in future.

Under the cooperation agreement between the Financial Supervision Authority and Eesti Pank, the Financial Supervision Authority reimburses monthly 100% of the cost of the support services provided by Eesti Pank. Eesti Pank provides the Financial Supervision Authority with information technology, accounting, real estate and administration services. The Financial Supervision Authority covers the depreciation costs of the fixed assets used.

From 2016 the nominal value of collector coins that have been issued is no longer recorded as a liability on the Balance Sheet as the probability of the coins being bought back is very low and their value as precious metal exceeds their nominal value. A change in the accounting principles meant that the nominal value of the kroon and euro collector coins issued was recorded as income and the liability in the Balance Sheet was reduced.

Income from asset management includes the service fee paid by the Guarantee Fund to Eesti Pank for investing their assets. Income from the rent of the training centre of Eesti Pank is recorded under “Rental income”.

Other expenses records the expenses for setting up the provision for the exchange liability for the kroon (See Item 27 “Provisions”). Eesti Pank Annual Report 2016 86

ITEM 36 – STAFF COSTS

thousand EUR

2016 2015

Staff costs -9 090 -8 635

Wages -6 662 -6 345

Social tax -2 238 -2 124

Compensations and benefits -139 -116

Unemployment insurance -51 -50

Compensation and benefits include pension benefits and fringe benefits tax calculated on the preferential price for the rent of the training centre.

On average, there were 231.8 full-time equivalent employees at Eesti Pank in 2016, and 232.1 in 2015.

ITEM 37 – ADMINISTRATIVE EXPENSES

thousand EUR

2016 2015

Administrative expenses -5 090 -4 886

Information technology maintenance -1 742 -1 631

Financial asset management -949 -812

Real estate renovation and administration -889 -902

Business travel -448 -416

Public relations and publications -293 -299

Office -147 -145

Training -145 -208

Economic research -128 -109

External representation -95 -100

Communications and transport -47 -53

Legal expertise and arbitration -1 -8

Other administrative expenses -206 -203

The costs of financial asset management comprise the cost of market information, fees and costs for cross-border payments, and management costs of foreign reserves.

The costs of public relations and publications cover the costs of public events, publications, information agencies, the public website and online databases, public relations research polls, information campaigns, and the Museum of Eesti Pank.

Business travel expenses reflect the costs of staff business travel on behalf of Eesti Pank and for work with international organisations and financial institutions. There were a total of 732 business trips in 2016; there were 747 in 2015.

ITEM 38 – BANKNOTE PRODUCTION SERVICE

Eesti Pank participates in the production of euro banknotes together with other central banks of the euro area. The Governing Council of the ECB sets the amount of euro cash that must be produced each year for the euro area countries. Eesti Pank procured its euro Eesti Pank Annual Report 2016 87

banknotes through a joint tender with seven other euro area central banks. Production of the second series of 50-euro banknotes for the Eurosystem was paid for.

ITEM 39 – OTHER OPERATING EXPENSES

thousand EUR

2016 2015

Other operating expenses -1 262 -916

Production of collector coins and numismatic products -625 -218

Production of coins -349 -426

Cash circulation management -89 -96

Other expenses -199 -176

ITEM 40 – DERIVATIVE INSTRUMENTS

thousand EUR

31/12/2016 31/12/2015

Currency swaps and forward transactions

Assets 249 824 357 966

Liabilities -247 537 -359 000

Value of interest rate future contracts

Purchase 18 854 37 592

Sale -20 815 -304 606

Value of currency futures contracts

Purchase 13 262 0

Sale -13 962 0

Value of interest rate swap contracts 0 4 353

ITEM 41 – CONTINGENT LIABILITIES

thousand EUR

31/12/2016 31/12/2015

Contingent liabilities 2 322 1 941

Contractual obligations to produce banknotes 1 631 1 272

Unpaid share capital (75%) of the Bank for International Settlements 691 669

Production of banknotes At the end of 2016, the contractual liabilities of Eesti Pank for printing banknotes and minting coins in 2017 amounted to EUR 1,631 thousand.

Bank for International Settlements Since 1930 Eesti Pank has a contingent liability to the Bank for International Settlements for the unpaid part of the share capital (75%) of the BIS denominated in Swiss gold francs, which totalled EUR 690,692 at the end of 2016 (see Item 15 “Other financial assets”). Eesti Pank Annual Report 2016 88

KPMG Baltics OÜ Telephone +372 6 268 700 Narva mnt 5 Fax +372 6 268 777 Tallinn 10117 Internet www.kpmg.ee Estonia

Independent Auditors’ Report (Translation of the Estonian original)

To the Supervisory Board of Eesti Pank Opinion We have audited the accompanying financial statements of Eesti Pank (the “Bank”), which comprise:  the balance sheet as at 31 December 2016,  the profit and loss account for the year then ended, and  notes, comprising significant accounting policies and other explanatory information. In our opinion, the accompanying financial statements give a true and fair view of the financial position of Eesti Pank as at 31 December 2016, and of its financial performance for the year then ended in accordance with the Guideline of the European Central Bank of 3 November 2016 on the legal framework for accounting and financial reporting in the European System of Central Banks (ECB/2016/34), and the Bank of Estonia (Eesti Pank) Act. Basis for Opinion We conducted our audit in accordance with International Standards on Auditing (Estonia). Our responsibilities under those standards are further described in the Auditors’ Responsibilities for the Audit of the Financial Statements section of our report. We are independent of the Bank in accordance with the ethical requirements that are relevant to our audit of the financial statements in Estonia, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Other Information The Executive Board is responsible for the other information. The other information comprises the overview of the financial position of Eesti Pank, but does not include the financial statements and our auditors’ report thereon. Our opinion on the financial statements does not cover the other information and we do not express any form of assurance conclusion thereon. In connection with our audit of the financial statements, our responsibility is to read the other information and, in doing so, consider whether the other information is materially inconsistent with the financial statements or our knowledge obtained in the audit, or otherwise appears to be materially misstated. If, based on the work we have performed, we conclude that there is a material misstatement of this other information, we are required to report that fact. We have nothing to report in this regard. Responsibilities of Executive Board and Those Charged with Governance for the Financial Statements The Executive Board of the Bank is responsible for the preparation and fair presentation of the financial statements in accordance with the Guideline of the European Central Bank of 3 November 2016 on the legal framework for accounting and financial reporting in the European System of Central Banks (ECB/2016/34), and the Bank of Estonia (Eesti Pank) Act. The Executive Board of the Bank is also responsible for such internal control as the Executive Board determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, the Executive Board of the Bank is responsible for using the going concern basis of accounting in accordance with Article 4 of the applicable Guideline (ECB/2016/34).

KPMG Baltics OÜ, an Estonian limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. Reg no 10096082. Eesti Pank Annual Report 2016 89

Those charged with governance are responsible for overseeing the Bank’s financial reporting process. Auditors’ Responsibilities for the Audit of the Financial Statements Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditors’ report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with International Standards on Auditing (Estonia) will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements. As part of an audit in accordance with International Standards on Auditing (Estonia), we exercise professional judgment and maintain professional skepticism throughout the audit. We also:  Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control.  Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Bank’s internal control.  Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by the Executive Board.  Conclude on the appropriateness of the Executive Board’s use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Bank’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditors’ report to the related disclosures in the financial statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditors’ report.  Evaluate the overall presentation, structure and content of the financial statements, including the disclosures, and whether the financial statements represent the underlying transactions and events in a manner that achieves fair presentation.

We communicate with those charged with governance regarding the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit.

Tallinn, 16 March 2017

/signed/ Eero Kaup Certified Public Accountant, Licence No 459

KPMG Baltics OÜ Licence No 17

2 Eesti Pank Annual Report 2016 90

APPENDIXES

APPENDIX 1. THE RESPONSIBILITIES OF THE SUPERVISORY BOARD OF EESTI PANK The Eesti Pank Supervisory Board oversees the work of Eesti Pank in all its activities. The Supervisory Board has responsibility for:

• approving the Statute of Eesti Pank; • supervising how the Eesti Pank budget is adhered to; • approving the Eesti Pank annual report and submitting it to the Riigikogu; • nominating a candidate for Governor of Eesti Pank to the President of the Republic; • appointing and removing from office the Deputy Governors of Eesti Pank and the Head of the Internal Audit; • nominating and removing from office the members of the Supervisory Board of the Financial Supervision Authority at the proposal of the Governor; • approving the principles for payment of the Executive Board; • approving the Statute of the Internal Audit Department of Eesti Pank; • nominating the internal auditors of Eesti Pank and approving the internal audit work schedule; • setting the salary for the head of the internal audit department of Eesti Pank; • nominating the independent auditors of Eesti Pank in accordance with the Eesti Pank Act; • distributing the profit of Eesti Pank as required by law and the profit distribution strategy approved by the Supervisory Board; • reviewing and approving written proposals and other documents submitted to the Riigikogu in the name of Eesti Pank; • taking decisions on the design of the national side of euro coins and on the denomination and design of collector coins in accordance with European Union rules; • approving the design of Eesti Pank’s insignia; • deciding the establishment, reorganisation and liquidation of the independent divisions of Eesti Pank at the proposal of the Governor; • approving the statutes of the independent divisions and representations of Eesti Pank; • approving the statutes of the Fiscal Council and nominating and recalling members of it.1

1 See the obligation added to §4² of the Eesti Pank Act in 2014; agreements between the member states of the Euro- pean Union meant that more thorough supervision was started of compliance with the requirements for fiscal balance in the Stability and Growth Pact. In Estonia, the Fiscal Council supervises fiscal balance. Eesti Pank Annual Report 2016 91

APPENDIX 2. DECISIONS OF THE SUPERVISORY BOARD OF EESTI PANK IN 2016

No 1-1, 26 January 2016

Approval of the nominal value for the Tallinn collector coins

No 3-1, 29 March 2016

Annual Report of Eesti Pank 2015

No 3-2, 29 March 2016

Amendments to the procedure for nominating the Deputy Governor of Eesti Pank

No 3-3, 29 March 2016

Amendment of the principles for payment of the Executive Board

No 3-4, 29 March 2016

Nomination of the Deputy Governors of Eesti Pank

No 4-1, 26 April 2016

Profit distribution strategy of Eesti Pank

No 4-2, 26 April 2016

Eesti Pank profit distribution for 2015

No 4-3, 26 April 2016

Approval of the design and nominal value of the silver and gold collector coins dedicated to Hanseatic Tallinn

No 4-4, 26 April 2016

Bonuses for the Deputy Governors of Eesti Pank

No 4-5, 26 April 2016

Salary of the Deputy Governors of Eesti Pank

No 4-6, 26 April 2016

Salary of the Head of the Internal Audit Department

No 4-7, 26 April 2016

Bonus for the Governor of Eesti Pank

No 4-8, 26 April 2016

Salary of the Governor of Eesti Pank

No 5-1, 17 June 2016

Amendment of the work schedule for 2016 of the Internal Audit Department of Eesti Pank

No 6–1, 27 September 2016

Appointment of a member of the Supervisory Board of the Financial Supervision Authority

No 6–2, 27 September 2016

Appointment of the auditor Eesti Pank Annual Report 2016 92

No 9-1, 13 December 2016

Approval of the work schedule for 2017 of the Internal Audit Department of Eesti Pank

No 9-2, 13 December 2016

Approval of the Statute of the Internal Audit Department of Eesti Pank

No 9-3, 13 December 2016

Approval of the new guidelines for the professional behaviour of members of the Super- visory Board of Eesti Pank Eesti Pank Annual Report 2016 93

APPENDIX 3. DECREES OF THE GOVERNOR OF EESTI PANK IN 2016

No 1, 8 January 2016

Issue of collector coin dedicated to Jaan Poska

(officially published: RT I, 12.01.2016, 14)

Under the decree a silver collector coin dedicated to Jaan Poska with a nominal value of ten euros was issued in the Republic of Estonia on 22 January 2016.

No 2, 19 January 2016

The list of statistical actions of Eesti Pank under the official statistical programme

(officially published: RT I, 22.01.2016, 4)

The decree confirmed the list of statistical work under the state statistical programme for 2016–2020 and repealed Eesti Pank Governor’s Decree No 19 of 29 December 2014 “List of statistical actions of Eesti Pank under the official statistical programme” (RT I, 06.01.2015, 8).

No 3, 5 February 2016

Requirements for reporting of supervisory financial information on an individual basis

(officially published: RT I, 09.02.2016, 19)

The decree sets the requirements that must be met to comply with the minimum requirements for the submission of supervisory financial information reports to the Financial Supervision Authority under Regulation (EU) 2015/534 of the European Central Bank on Reporting of Supervisory Financial Information.

No 4, 25 April 2016

The issuing of the collector coin for the Estonian delegation and athletes at the Games of the XXXI Olympiad in Rio de Janeiro

(officially published: RT I, 26.04.2016, 16)

Under the decree a collector coin for the Estonian delegation and athletes at the Games of the XXXI Olympiad in Rio de Janeiro with a nominal value of ten euros was issued in the Republic of Estonia.

No 5, 28 April 2016

Amendments to Decree No 4 of the Governor of Eesti Pank of 9 May 2008 “Approval of TARGET2-Eesti rules”

(officially published: RT I, 04.05.2016, 3)

The amendments to the TARGET2-Eesti rules mostly clarify the procedures for ensuring payments and continuity in TARGET2-Eesti and the conditions for maintaining dedicated monetary accounts for securities settlement.

No 6, 30 May 2016

Establishment of the requirement for the systemic risk buffer

(officially published: RT I, 01.06.2016, 2)

The decree sets a requirement for credit institutions operating in Estonia to hold a systemic risk buffer at the level of 1.0 per cent of the total risk exposure in Estonia. Eesti Pank Annual Report 2016 94

No 7, 30 May 2016

The list of other systemically important credit institutions and the requirement for the other systemically important institutions buffer

(officially published: RT I, 01.06.2016, 4)

The decree designates other systemically important institutions operating in Estonia in the meaning of section § 8648 of the Credit Institutions Act as Swedbank AS and AS SEB Pank. These two credit institutions must hold other systemically important institution buffers of 2 per cent of their total risk exposure.

No 8, 15 June 2016

Amendment of Decree No 6 of the Governor of Eesti Pank of 23 May 2014 “Establishment of substantive and formal requirements for the balance sheet and income statement of credit institutions”

(officially published: RT I, 22.06.2016, 16)

The previous wording of the decree was amended and extended. Annexes 1-6 were added to the decree with new wording.

No 9, 28 June 2016

Amendments to Eesti Pank Governor’s Decree No 11 of 2 July 2014 “The format for trans- mitting supervision reports under banking regulations”

(officially published: RT I, 01.07.2016, 5)

The format requirements for the submission of supervision reports were amended and Annex 2 to the decree “Codes of reports for the submission of reports in XML format” was repealed.

No 10, 9 December 2016

Amendment of Eesti Pank Governor’s Decree No 3 of 5 May 2016 “Establishment of sup- plementary reports on credit institution’s balance sheet”

(officially published: RT I, 14.12.2016, 1)

The amendments amended and extended the wording of the decree. The amended norms apply for preparing and submitting reports starting from the reporting period that ends on 30 June 2017.

No 11, 22 December 2016

Amendments to Eesti Pank Governor’s Decree No 22 of 7 December 2010 “Establishment of reports on credit institutions’ reserve requirement calculation”

(officially published: RT I, 29.12.2016, 12)

The decree amends the reporting period for submission of reports on reserve requirement calculation. Eesti Pank Annual Report 2016 95

APPENDIX 4. PUBLICATIONS OF EESTI PANK IN 2016

Annual Report The Annual Report gives a review of the central bank’s activities during the reporting year and the financial statement. Its appendixes contain a list of decrees of the Governor of Eesti Pank and of the decisions of the Supervisory Board, and a list of the publications of the year. Issues published in 2016: • The Annual Report of Eesti Pank for 2015 Financial Stability Review The Financial Stability Review is Eesti Pank’s main publication analysing financial stability. It gives the results of the bank’s analyses and its assessment of financial stability, and discusses policy measures. The Financial Stability Review is published twice a year. Issues published in 2016: • Financial Stability Review 1/2016 • Financial Stability Review 2/2016 Estonian Economy and Monetary Policy The Estonian Economy and Monetary Policy is an Eesti Pank review released four times a year that summarises the main recent events in the global and Estonian economies. Twice a year, in June and December, the review also contains the forecast for the Estonian economy for the current year and the next two calendar years. Issues published in 2016: • Estonian Economy and Monetary Policy 1/2016 • Estonian Economy and Monetary Policy 2/2016 • Estonian Economy and Monetary Policy 3/2016 • Estonian Economy and Monetary Policy 4/2016 Balance of Payments Yearbook The balance of payments yearbook is a longer analysis of the external sector statistical data for the year with multiple tables and figures. It also includes chapters on methodology: concepts and explanations for external sector statistics, compilation systems, the legal basis, data protection, and the principles for the release and correction of data. The yearbook is published once a year. Issues published in 2016: • Estonia’s Balance of Payments Yearbook 2015 Working Papers The Working Papers are summaries of the economic studies conducted at Eesti Pank. The target group of the Working Papers is, above all, economists and economic experts, and the papers are often published in English only. Papers published in 2016: • Working Papers of Eesti Pank 1/2016: Merike Kukk. Debt repayment problems: what are the implications for consumption? • Working Papers of Eesti Pank 2/2016: Alessandra Cepparulo, Juan Carlos Cuestas, Maurizio Intartaglia. Financial development, institutions and poverty alleviation: an empirical analysis. • Working Papers of Eesti Pank 3/2016: Urška Čede, Bogdan Chiriacescu, Péter Harasztosi, Tibor Lalinsky, Jaanika Meriküll. Export characteristics and output volatility: comparative firm-level evidence for CEE countries. • Working Papers of Eesti Pank 4/2016: Punnoose Jacob, Lenno Uusküla. Deep Habits and Exchange Rate Pass-through. Eesti Pank Annual Report 2016 96

• Working Papers of Eesti Pank 5/2016: Svetlana Makarova. ECB footprints on inflation forecast uncertainty. • Working Papers of Eesti Pank 6/2016: Simona Ferraro, Jaanika Meriküll, Karsten Staehr. Minimum wages and the wage distribution in Estonia. • Working Papers of Eesti Pank 7/2016: Lenno Uusküla. Monetary Transmission Mechanism with Firm Turnover. • Working Papers of Eesti Pank 8/2016: Nicolas Reigl. Forecasting the Estonian Rate of Inflation using Factor Models. • Working Papers of Eesti Pank 9/2016: Merike Kukk. What are the Triggers for Arrears on Debt? Evidence from Quarterly Panel Data. • Working Papers of Eesti Pank 10/2016: Karsten Staehr. Capital Flows and Growth Dynamics in Central and Eastern Europe. • Working Papers of Eesti Pank 11/2016: Georgios Bampinas, Theodore Panagiotidis. Oil and stock markets before and after financial crises: A local Gaussian correlation approach. Occasional Papers The Eesti Pank Occasional Papers is a series of papers where the bank publishes reviews of its analysis and research work. The papers cover a wide range of topical subjects and may be of interest to everyone interested in economics, including professional economists, political decision-makers, people in business, and anyone who simply wants to know more about economics. Issues published in 2016: • Occasional Papers of Eesti Pank 1/2016: Jaanika Meriküll, Tairi Rõõm. The assets, liabilities and wealth of Estonian households: Results of the Household Finance and Consumption Survey. • Occasional Papers of Eesti Pank 2/2016: Pierre Lafourcade, Andrea Gerali, Jan Brůha, Dirk Bursian, Ginters Buss, Vesna Corbo, Markus Haavio, Christina Håkanson, Tibor Hledik, Dmitry Kulikov, Matija Lozej, Brian Micallef, Dimitris Papageorgiou, Juuso Vanhala, Marin Zeleznik. Labour market modelling in the light of the financial crisis. Labour Market Review The Labour Market Review discusses the most important trends in the Estonian labour market, labour supply and demand, labour costs, institutional developments of the labour market, and other related issues. The Labour Market Review is published twice a year. Issues published in 2016: • Labour Market Review 1/2016 • Labour Market Review 2/2016 Financing of the Economy The review of financing and lending in the non-financial sector covers banking and leasing statistics, financial accounts analysis and credit supply and demand. The review is published once a year. Issues published in 2016: • Financing of the Economy. February 2016 Estonian Competitiveness Report Eesti Pank publishes the Estonian Competitiveness Report once a year starting from 2013. Competitiveness can be analysed in several different ways and each issue con- Eesti Pank Annual Report 2016 97

siders several widely-used groups of indicators for competitiveness. Competitiveness is assessed through assessment of Estonian export capacity using relative productivity growth, changes in export indicators and similar, and of competitiveness indicators for relative prices and costs. Issues published in 2016: • Estonian Competitiveness Report Blog posts • Mari Pärnamäe. European funds affect not only the level of GDP but also the dynamics of GDP growth. • Madis Müller. The joys and risks of low interest rates. • Kaspar Oja. From downward revision of growth estimates to a spiral of pessimism? • Teet Puusepp. Payments may start to reach their destination faster at the start of the working day. • Jaanika Meriküll. What do we know about the wealth of Estonian households? • Kristo Aab. What is behind the reduction in Estonian exports. • Indrek Saapar, Raido Kraavik. The changed business environment is encouraging banks to adapt their activities. • Nicolas Reigl, Dmitry Kulikov. The profitability of companies in Estonia. • Taavi Raudsaar. Lower profitability is weakening the ability of companies to pay their loans. • Taavi Raudsaar. Low energy prices are weakening the ability of companies in energy and oil-shale oil producers to pay their loans. • Taavi Kimmel. The economies in the main destination countries for Estonian exports mainly improved at the start of the year. • Sulev Pert. A large part of the fall in prices in recent years has been due to external factors. • Reet Reedik. How long will interest rates remain low? • Karsten Staehr. Does more expensive production mean a drop in exports? • Rasmus Kattai. You go further by going steadily. • Kaspar Oja, Orsolya Soosaar. How will it end if wages rise faster than profits? • Jaanika Meriküll, Karsten Staehr. The statutory minimum wage has helped reduce wage inequality in Estonia. • Rasmus Kattai. The economic impact of Brexit on Estonia should be quite small. • Raoul Lättemäe. The IMF’s four magic fixes. • Sulev Pert. Changes in consumption have slowed inflation. • Kaspar Oja. Statistics give conflicting signals about imbalances in the labour market. • Karsten Staehr. The 2016 Nobel Prize in Economics: the big picture for contracts. • Teet Puusepp. What is a cheque and how can it be cashed in Estonia? • Jana Kask. Better safe than sorry, or what the capital buffers of banks are needed for. • Mari Tamm. Real estate funds in Estonia have doubled in size in a short time. • Kaspar Oja. The low investment rate limits the ability of the Estonian economy to grow. • Tairi Rõõm. The European household survey shows net assets are as unevenly distributed in Estonia as in the euro area as a whole. Other publications • From the Mark to the Kroon. Eesti Pank, 2016. In Estonian, English and Russian. • The Euro. Eesti Pank, 2016. In Estonian, English and Russian.