• he risks to financial stability in Estonia have increased slightly, though they remain small
• Weak external demand and rapidly rising labour costs are hurting the ability of companies to repay loans
• The credit and real estate boom in Sweden and Norway is increasing the risks to banks operating in Estonia
• Steps have been taken in the Nordic countries to contain the boom, but they have not been sufficient in Sweden
• Rapid growth in incomes and low interest rates on loans are boosting the rise in property prices
• The countercyclical capital buffer will probably be 0% for the next half year

International financial markets have been affected by the continuation of very accommodative monetary policy and by the increased risks in emerging markets. Bond yields continued to fall at the start of the year and stock markets to climb. In the spring there was uncertainty because of Greece, as negotiations about the debt programme dragged on, and because of the expectation for further US monetary policy decisions. On top of this came the impact of the correction that started at the end of summer in the Chinese stock market. Falling prices spread to other large stock markets and also affected the price of shares listed on the Tallinn stock exchange.

Estonian economic growth slowed a little in the first half of 2015, to 2% over the year in the second quarter. The growth was largely based on rising private consumption, which was driven by increased employment and rapid wage rises. Higher incomes and low base interest rates back up the ability of households to pay their loans. Estonian exports were smaller in the first eight months of this year than at the same time last year, and the outlook for growth in Estonia’s main export partners has deteriorated. Labour costs have continued to rise for Estonian companies relatively rapidly, and this has reduced the profitability of those companies. The risk has increased that the profitability of Estonian companies will be reduced even further by weak foreign demand and rapidly rising labour costs. This could weaken the ability of companies to pay their loans and thus worsen the loan quality of banks.

Increased credit volumes and continuing rises in real estate prices in Sweden and Norway have increased the risks to financial stability for the whole economy. The Swedish banking groups that make up a large part of banking in Estonia get the majority of their funds using market-based financing. This makes them vulnerable to changes in the risk sentiment of financial markets. If financial markets were to reassess the risks to the Nordic economies and banks, it would increase the financing and liquidity risks of the banks operating in Estonia. If interest rates were to rise and loan servicing costs increase, or real estate prices to fall, the high indebtedness of Nordic households could lead them to consume less, and this would then affect the revenues of Nordic companies and their ability to repay their loans. As the Nordic countries are an important export market for Estonian companies, this would have an impact on growth in Estonia. To reduce such risks, it is important that macroprudential measures be taken, some having already been taken with a view to strengthening the banks. Sweden still needs to do more, particularly to contain the rise in property prices and indebtedness.

Rising incomes and low interest rates have increased the risk of the rise in Estonian real estate prices accelerating, and lending becoming concentrated in the real estate sector. Average prices for apartments have risen relatively fast, but the share of borrowing in financing for residential property purchases has not risen at the same time. There has been more activity in real estate development for both residential and commercial space, and the growth in loans to developers has become faster. For the sake of financial stability it is important that lenders and borrowers remember that the extremely low interest rates could rise and the cost of servicing loans could increase.

Low base interest rates and bond purchases by central banks have led bond yields to fall. This has made investors more interested in alternative assets. Increased appetite for risk has led asset prices to rise and has increased the risk that they may fall sharply. Low interest rates also affect the ability of financial institutions to earn income. This is reflected in a slight reduction in the net interest income earned by the banks operating in Estonia. More vulnerable to interest rates remaining low are life insurance companies, whose liabilities largely consist of insurance contracts with guaranteed interest rates. As life insurance is only a small part of the Estonian financial sector, and the insurers have sufficient buffers, the risk to Estonian financial stability from this vulnerability is modest.

As the macroprudential supervisor, Eesti Pank monitors and analyses the risks to the functioning of the financial system and where necessary takes measures to reduce such risks. One way Eesti Pank can reduce the risks from loan growth is by introducing a countercyclical capital buffer requirement. As loan growth is set to be in line with general economic developments for now and for the near term, the countercyclical capital buffer will probably be 0% for the next half year.