Quarterly Economic Policy Statexment of Eesti Pank

Estonia's economic adjustment proceeds according to expectations


Recent economic developments in Estonia are characterised by smooth adjustment following rapid growth in previous years and accord with the base scenario of Eesti Pank's spring forecast. Owing mainly to gradually declining domestic demand, i.e, investment and consumption, the second quarter's economic growth slowed to 7.3%. The total volume of new loans is falling, the real estate market has stabilised, and preliminary estimates point to the fact the peak of private consumption has also passed. Meanwhile, the creation of new jobs continued and unemployment fell to a record low level of 5%. Estonia's export growth has remained rather dynamic, being slightly stronger in the second quarter compared to the first quarter.
Despite Estonia's slowing economic growth, the first-quarter increase in consumer prices was somewhat faster than forecasted. The inflation rate, which amounted to 6.4% in July, reaching the highest level in three years, was driven by the global increase in food prices and the fact that the exceptional period of lower VAT on thermal energy in Estonia has terminated. Domestic demand should continue to slow at the beginning of 2008, thus price pressures should also alleviate. However, certain tax policy measures scheduled to be taken in 2008 will somewhat postpone a perceptible slowdown in the growth rate of consumer prices.
According to Eesti Pank's preliminary estimate, the current account deficit, i.e, the difference between domestic savings and investment, in absolute volume did not deteriorate further in the second half of 2007. This is in line with slowing domestic demand and credit growth and with increasing export growth.
Notwithstanding the smooth slowdown of the economy, the factors endangering soft landing have not disappeared. The biggest threats lie in real wages surging to considerably surpass labour productivity, thus jeopardising Estonia's economic growth and not allowing inflation to decrease in the next years. In order to minimise risks related to falling competitiveness it is important for both employers and employees to adjust their behaviour with a view to alleviating the differences between wage growth and productivity growth.
Moreover, against the backdrop of the expected cooling down of the real estate market, balanced economic development greatly depends on banks maintaining credit policies that are conservative and consider all possible risks. It is important that the annual credit volume growth be kept on the level that is in keeping with the expected growth of private persons' and enterprises' solvency and income. A deceleration in the improvement of the economy's balance indicators may undermine the confidence of foreign investors and rating agencies in the Estonian economy in the circumstances where the global financial sector is being affected by the bad loans problems arising from the US real estate sector.
Fiscal policy still plays a key role in supporting the smooth adjustment of the economy. Eesti Pank firmly holds that the 2007 fiscal surplus must be comparable to the level of the 2006 surplus and that it is important to refrain from increasing expenditure by a supplementary budget. Moreover, it is necessary to send a clear signal that the government is aware of the existing risks and plans to address them via the 2008 state budget and fiscal policy planned for 2008-2010.
Eesti Pank's assessments and recommendations
Eesti Pank expects Estonia's economic growth to slow gradually. The threat of a more abrupt adjustment has slightly increased. Price developments in the local real estate market and the tight labour market constitute the main risks.

As regards wage formation, households and enterprises must maintain realistic expectations. Enterprises will not be able to maintain the prompt wage growth without substantially increasing their productivity. Thus, everybody should take into account that their income growth may be inhibited in the future. It is important to keep wage formation flexible and wage growth productivity-led.

Supported by rapid wage growth and several external factors, inflation has soared faster than expected in recent months. If economic adjustment continues, inflationary pressures should ease next year, although rising excise duties will prevent the headline inflation rate from declining for some time.

The credit market has undergone the expected cool-down. It is important that banks keep the annual credit growth in line with the expected growth of private persons' and enterprises' solvency and income.

In order to ensure economic sustainability, Estonia must continue to pursue conservative fiscal policy. The budget surplus of 2007 should be kept on the level comparable to the surplus of the last year. This means the government must avoid any additional expenditure this year. Taking into consideration various risks and the rather optimistic forecast of the Ministry of Finance, the 2008 surplus should amount to approximately 2%. This means government expenditure should not be increased compared to what was planned for the medium term in spring.

It is in the best interests of Estonia to adopt the euro as soon as possible. Based on current estimations, the earliest possible term for the changeover is 2011. The introduction of the euro would level off risks and make it easier for Estonia to fulfil its longer-term economic objectives.
Overview of the most important developments
External environment has been favourableThe exporting sector has been enjoying rather favourable external demand during the past couple of years and economic expansion has been faster than forecasted. At the beginning of 2007, the EU economic growth was very close to the average growth potential. The growth rate slowed more than expected in the second quarter of the year, but the economic expansion of Estonia's closest neighbours is still fast.
The price growth of oil and commodities has continued at a rapid pace. Both oil prices and the CRB index of commodities reached record-high levels in July and first days of August. In July, the former increased to 78.21 dollars per barrel, which is the new historical record, and raw materials prices have grown approximately 15% since the beginning of the year.
Although the global inflation level is stably low, the ECB does not consider price pressures to be non-existent and market participants anticipate euro-area interest rates to continue to rise.
One of the most notable phenomena in the recent global economic developments is the deepening and transfer into the global financial sector of the bad loans problems arising from the US real estate market. Currently there exist no reasons to believe that an extensive reassessment of financial sector risks would pose a considerable threat to the global and EU (and thus also Estonia's) economy. Nevertheless, taking into account the generally spreading risk apprehension, Estonia should just in case take into account a possible slowdown in the external demand growth rate.
Estonia's economic growth slowed according to expectationsAccording to the preliminary assessment of the Statistical Office, Estonia's economic growth declined to 7.3% in the second quarter of this year. The decline was broad-based and characteristic of the activities focusing on the domestic market as well as of the exporting sector. Domestic demand growth decelerated on account of both private consumption and investment. It is presumed private consumption reached its peak at the end of 2006 and at the beginning of 2007. It is possible that the tenser relations with Russia may have had a slight impact (up to 0.5 pp according to preliminary assessments) on Estonia's economic growth, because commodities procurements were somewhat complicated and the income related to the transit of oil and oil products decreased as well.
The average goods and services export growth rate has been fast, although the situation varies by groups of goods and by markets. Although the growth rate of merchandise exports slowed considerably at the end of 2006 and at the beginning of 2007, we are mainly speaking about the so-called transit goods. When we leave aside transit and the subcontracting sector, there are no reasons to assume the competitive ability of other sectors has substantially declined.
By fields of activity, the construction, banking, and retail sectors experienced the most dynamic growth. The industrial confidence, however, deteriorated, dropping to the level of 2005. Enterprises started to make more careful forecasts of future developments with the slowdown in demand growth being the limiting factor. In addition, materialisation of the real estate market related risks may lead to a deceleration in the construction sector's growth rate.
The spring forecast of Eesti Pank expected this year's economic growth to be 8.4%, which is close to the average of the first half-year. The new autumn forecast of Eesti Pank will be completed in October.
Labour market tensions have not yet alleviated In spite of slower economic growth, the number of jobs increased, although more sluggishly than before. In the second quarter of 2007, 1.3% more people worked in Estonia year-on-year. Employment increased to 62.9% of Estonia's workforce and the unemployment level fell to 5%.
Labour productivity growth (5.9%) has been faster than in 2006. Maintaining at least the current labour productivity rate is a precondition for continuous investment and rapid economic growth in the future. However, currently there are not that many direct signs indicating that wage growth has started to decelerate. Real wage growth is still rapid, raising the purchasing power of people and creating additional costs for enterprises. As long as there persists the danger that productivity improvement is insufficient compared to wage growth, the latter keeps posing a threat to the competitiveness of Estonian enterprises.
Most of the new jobs created in the second quarter of 2007 are in the service sector and in the fields of activity focusing on the domestic market. For example, the number of construction sector workers has not been so large since end-1980s. This, in turn, refers to the fact that although growth rates no longer keep up with the levels of previous years, the construction sector has not yet passed its cyclical peak.
The credit and leasing market is coolingAgainst the backdrop of the expected cooling down of the real estate market, balanced economic development greatly depends on banks maintaining credit policies that are conservative and consider all possible risks. It is important that the annual credit volume growth be kept on the level that is in keeping with the expected growth of private persons' and enterprises' solvency and income.
At the end of the first half-year, the total volume of the loan and leasing portfolios of banks and their subsidiary leasing companies was 42% larger than a year ago. Meanwhile, the loan stock growth has dropped considerably year-on-year. In the first half of 2007, the loan and leasing portfolio of banks grew by 31 billion kroons. This is practically equal to the volume of the loans issued in the first half of 2006 and smaller than the total amount of loans issued in the second half of the previous year.
The deceleration in the growth of bank loans primarily reflects slower housing loan growth, which fell to 49% year-on-year. The consumer credit growth rate still exceeds that of mortgage loans. The credit market started to slow in the second quarter. It was the most evident in the indicators for June, when the volume of loans issued was 23% smaller year-on-year. In June and July, the turnover of housing loans remained for the first time in recent years below the level of the same month of the previous year. The volume of consumer credit growth was also a third smaller in June than in earlier months.
The main reason behind the changes in the credit market was decreasing demand, which was in turn conditioned by higher interest rates that have risen considerably during the past year and by the surge in real estate prices. In addition, the credit policies of banks have also become more conservative and take account of all borrowers-related risks. The expected further increase in interest rates should help inhibit credit growth in future as well. From the point of view of financing business activity, it is positive that the deceleration of the growth rate of financing portfolios is primarily related to the fields of activity focusing on domestic demand.
The quality of banks' loan portfolios is good as before. The share of the so-called bad loans, i.e, loans the servicing of which has delayed over 60 days, constitutes only 0.4% of the total loans issued by banks.
Inflationary pressures are expected to persist in the near futureAlthough Estonia's economic growth is slowing, the inflation rate is not expected to decline in the near future. During the first half-year, the annual consumer price growth fluctuated between 4.7% and 5.8%. Inflation has been driven by strong domestic demand, rapid wage growth, and several external factors.
The July inflation rate was the highest in three years (6.4%), but it was exceptional and caused by the rise in VAT on thermal energy. In addition to the appreciation of thermal energy, the prices of dairy products increased remarkably in July. The 4.6% price increase of milk and dairy products was caused by the notable price growth of milk powder in the global market.
Deceleration of the inflation rate requires a further slowdown in the growth of domestic demand, especially private consumption, which is in turn related to declining borrowing and income growth. Demand pressures should decrease in the second half-year in line with slowing economic growth. Alleviation of price pressures resulting therefrom can be expected to take place next year. However, certain tax policy measures scheduled to be taken in 2008 will somewhat postpone a perceptible slowdown in the growth rate of consumer prices.
The government has to continue with conservative fiscal polices Government expenditure increased rapidly in the first half of 2007 but remained nevertheless below the revenues growth rate. The first-quarter fiscal surplus was close to the 2006 average, constituting 3.5% of GDP. In the second quarter, the general government budget surplus turned out smaller and did not exceed the 3% level.
So far, the government has maintained the budget surplus on a level comparable to 2006. Thus, in the first half of 2007, fiscal policy supported the gradual deceleration of domestic demand and the soft landing scenario. Eesti Pank is of the opinion that similar policies should be pursued in the second half-year as well. By the end of July, the government's current surplus had risen to 3 billion kroons, being again in the same magnitude compared to the same time of previous years.
Eesti Pank's view is that the government must maintain the current conservative trend. Any additional expenditure should be avoided in 2007 as well as in compiling the budget for 2008. According to the forecast of the Ministry of Finance, the dynamic growth of Estonia's economy will continue in the next years, supported by both rapid domestic demand and exports. Taking into account the demand-side pressures that will continue if this forecast comes true, the government will have to continue with tight policies in the years to come and strive for at least 2% consolidated budget surplus of GDP. In addition, should the current forecast prove to be over-optimistic, the government will have to be ready for expenditures in a decline stage.