Andres Lipstok. Presentation at the business seminar in Riga

Presentation by Mr Andres Lipstok, Governor of Eesti Pank

Business Seminar in Riga
December 7, 2005

Excellencies, ladies and gentlemen. I am greatly honoured to address this distinguished audience here today on the competitiveness of the Latvian and Estonian economies.

There is hardly any issue more topical for Estonia and Latvia. Competitive countries can vastly improve the living standards and welfare of their citizens in today's globalizing world by making use of global and regional trade and investments. Competitiveness and open markets are important for our central banks as well. Increasing trade keeps inflationary pressures under control, as has been the case in Estonia over the last couple of years. Globalization offers more opportunities to manage financial risks. For example, well-diversified portfolios of pension funds are important to ensure the long-term success of our pension reforms.

The enlargement of the European Union is a good example of successful globalization. The EU combines economic growth with balanced social development and thus fundamentally supports the competitiveness of its member states. We know that in Latvia and Estonia, market integration in some sectors is even higher than in other parts of the Union. Thus, an important goal for our countries is to support further structural reforms and the free movement of services, including the financial sector, in the rest of Europe.

The European Union provides ample opportunities for its members, but it is up to us to use these possibilities. Both Latvia and Estonia have proved to be rather competitive. Estonian exports have increased their market share in the EU. We are one of the largest recipients of foreign direct investments. In 2005, the World Bank and World Economic Forum listed Estonia in the top 20 countries in terms of competitiveness. However, we must look beyond the near term if we want to stay competitive.

In any country, market forces are the true drivers of competitiveness. In Estonia, the average growth of productivity of 7 per cent over the last 5 years and healthy level of job creation relied on the initiative and inventiveness of our companies. Thus, if we are serious about competitiveness, our main aim should be to make Estonia and Latvia the best places in Europe for doing business. This is not a simple task and needs a strong political will to make the respective reforms possible.

Economic strength does not depend on state subsidies and artificial protection of "national champions". Two Estonian-based software companies, Skype and Playtech, may easily absorb nearly all of Estonia's IT people in the near future, yet neither was created with support from "smart bureaucrats". In a true market economy, companies can and should take care of themselves. The key things are access to qualified labour, developed financial systems and good infrastructure.

Maintaining macroeconomic stability is perhaps the most important responsibility of the state to support competitiveness. The economy needs a stable currency and well functioning financial markets to accumulate savings and to invest. The monetary and financial systems in the Baltic States are quite similar to one another. Our currencies are fixed against the euro, we are members of ERM II and our financial systems are fully integrated with the Nordic countries and Continental Europe.

But over the medium term, monetary and financial stability rests on responsible fiscal policies. The Estonian government has been quite successful in maintaining sound budget policies. Our estimates put the fiscal surplus for 2005 at over 2.5 percent of GDP. As GDP growth for 2006 is expected to be around 7 percent, the fiscal policy target for the next year should be a similar surplus.

Apart from fiscal policies, we should keep a close eye on our banks who may be underestimating the potential risks associated with rapid loan growth. In the Central Bank of Estonia, we see some alarming signs. Credit growth above 50 percent per year is excessive. Moreover, the Estonian real estate market is booming and prices in many areas appear above normal levels. This combination cannot last for more than a few years. At some point the cycle will turn, interest rates will rise, and wage and job growth will slow. Our task is to stay ahead of the curve and ensure that banks have adequate liquidity and capital to meet the slowdown. Close cooperation between central banks and supervisors is a must to ensure the financial stability of the region.

Finally, let me turn to the adoption of the euro. There is no need to repeat the well-known arguments in support of joining the euro area. By fixing our exchange rate, we have been de facto members of the euro area for over 13 years. Joining the euro area will be a natural step in light of the full integration of economic and financial systems with those of Europe. It will further strengthen the credibility of our policies and reduce the remaining medium-term risks.

Estonia has no major difficulties in meeting most of the Maastricht criteria. Our budget position, debt and interest rates are all well within the Maastricht limits. But since this autumn, there have been increasing discussions about meeting the inflation criterion. Let me be clear on this point. It does not make sense to speculate at this stage on whether Estonia will meet the inflation criterion in 2006, either in the first half or sometimes later that year. We do not know the reference value of the criterion with sufficient certainty, nor do we know the future rates of inflation in Estonia.

However, we know that the increase in inflation in the autumn to over 4.5 per cent was directly caused by external factors, namely the price rise of oil and its related products. We have found a rather perfect correlation between our CPI and the price of gasoline in Tallinn. With falling gasoline prices, the CPI has declined as well. Our core inflation - reflecting true price pressures - has been stable for the past few years, hovering at or around 2 per cent. With wage developments well in line with productivity growth, we do not see any second-round effects from oil prices. In this context, I expect the inflation rate to fall closer to 3 per cent in 2006.

The final message I would like to stress here is that Estonia will be technically ready for the euro changeover by the end of 2006. Estonia's sound economic policies and flexible economic structures give us confidence that adopting the euro in 2007 in accordance with the common European framework is a realistic goal.

Thank you very much!

Andres Lipstok. Presentation at the business seminar in Riga