Andres Lipstok. A Stable Monetary System - the Prerequisite for Enterprise

A Stable Monetary System - the Prerequisite for Enterprise

Andres Lipstok
Governor of Eesti Pank

Dear ladies and gentlemen,

The enterprise of the independent Estonia has become 90 years old. As a matter of fact, we could say enterprise is even older then our state. Numerous coins found in the Estonian territory date back to 11-12th century, so one might guess that money and enterprise were in this region closely related already in the Middle Ages.

The stability of money has occupied the centre position also later in Estonia's development. After the first independence it was thought industry should rely on state credit and the immense Russian market. However, credit inflation, wrong loan decisions as well as cover funds and budgetary deficits resulted in inflation and a decline in the exchange rate. The economy of the young republic got on its feet only after the Eesti Pank's and monetary reform in 1928. The kroon fulfilled its role also in emerging from the severe economic crisis of 1930s, when it was tied to the British pound.

The advantages of a stable monetary system became clear to all of us with the 1992 monetary reform. Without the strong Estonian kroon it would have been considerably more difficult to achieve budget surpluses and a reliable banking system along with economic expansion.

Today, new challenges face both our economy and monetary and financial stability. The growth trend, which was supported by successful domestic reforms, hard-working enterprisers and opportunities made available by Estonia's accession to the EU, has turned into a downturn. Since the boost was rapid and robust, exceeding our growth potential, we nearly exhausted all the advantages supporting it. Here I mean the orientation on cheap labour force.

Now it is time for a so-called version change. A new economic growth cycle in Estonia should be based on production with more added value than so far, and investment, which, in the aggregate, increase the residents' purchasing power.

The financial crisis, which originated last year in the USA and spread quickly over the world, does not make this task any easier. Smaller countries both in and outside the EU are more affected by the global economic crisis. The economy of a small country is largely dependent on exports and a crisis in bigger countries remarkably cuts demand in external markets. In addition, it is more difficult for smaller countries and their enterprises to borrow from financial markets. Let us be honest - we have no idea when the economic growth of big countries and the courage of the financial markets to start lending again will recover. This may take a short time, but may also last several years.

Currently there are two main factors impacting the Estonian economy. On the one hand, the adjustment of domestic demand is continuing after a period of rapid growth. On the other hand, external demand is declining along with slowing economic growth in our main exports markets. Economic downturn will persist this and also the next year. Growth is expected to gradually pick up again starting from the second half of 2009. Many analysts consider even this expectation too optimistic.

How could the state contribute to this? It is clear our economy will reach a new growth path the faster the better is the functioning of market economy in Estonia. Economic growth can only lean on enterprisers' business ideas. The state does not know in which domains a new Skype will emerge. At the same time, the state plays a remarkable role in the functioning of the market economy, especially as regards ensuring monetary and financial stability.

Next I am going to discuss three most important monetary and financial policy issues that support changes in the economy.

Stable money is the most significant factor. I am convinced that the adoption of the euro as soon as possible is the primary economic policy goal for Estonia. At the start of a new growth cycle, when the distrust and uncertainty have passed, everybody will line up behind the starting grid. What could be a better prerequisite for success than a reorganised and purposed economic environment together with a reliable monetary system securing it? Just like the reintroduction of the kroon has constituted the foundation of our development so far, the adoption of the euro will contribute to the success of the next stage of development.

As we all know, inflation has been the main obstacle in our way to the euro. In Eesti Pank's estimate, the likelihood of meeting the Maastricht inflation criterion already in 2010 has increased notably, and this would make it possible to change over to the euro in 2011 or 2012. The cyclical economic downturn in Estonia as well as the cheapening of commodity prices in the world are both conducive to this objective. However, our own will and preparedness are also needed to meet the criterion. This has to be taken into account by both the government in planning their different steps and enterprises in mapping out their development. In order to keep the fiscal deficit from exceeding 3%, an additional cut in expenditure is an absolute must.

Strong fiscal policy is also very important. This supports economic growth in several ways. As mentioned before, it helps us join the euro area. According to Eesti Pank's autumn forecast there exists a serious threat of the budget deficit exceeding the 3% of GDP criterion. This means the government will have to contract expenditure even more.

In addition to meeting the conditions for joining the euro area, we also need to look a couple of years ahead. Though a temporary and moderate fiscal deficit is acceptable in the current economic situation, the objective must be to restore fiscal surpluses and accumulate reserves. I believe the financial crisis has convinced us all of the indispensability of fiscal surpluses and national reserves.

In light of the 8% nominal growth forecasted in August by the Ministry of Finance, both Eesti Pank and several other analysts emphasised the necessity of a budget that is at least in balance. That was the only possible recommendation. Now that it has been realised that the summer forecast was too optimistic and in the next couple of years the budget will be in deficit, Eesti Pank considers budget surpluses essential to ensuring economic sustainability.

Estonia has so far managed without severe setbacks only owing to the fiscal surpluses accumulated in previous years. At the same time, the state should not be too eager in spending the existing reserves. These should last at least for the next two years. The current size of the reserves - approximately 9-10% of GDP - is actually the minimum level for Estonia. In medium and longer term, the goal should be a considerable increase in reserves in order to be ready for next crises.

The third factor conducive to growth is a strong financial system, especially banking. We cannot speak about economic growth if the banking sector fails to be credible or if no loans are issued. The large Scandinavian banking groups operating in Estonia have so far coped well with the crisis. The high liquidity and capital buffers established in Estonia have also played a role here. These decrease the risks originating from slowing growth and contribute to the credibility of the groups as a whole. Another factor supporting the stability of the banking sector is the ongoing cooperation of the government and the central bank with our neighbouring countries.

A lot has been talked about the impact of slowing economic growth on loan quality. It is true that the share of overdue loans in banks has risen, but in Eesti Pank's estimate, it will not exceed the level of 4% of the entire loan portfolio in the next year. Actual loan losses are likely to be even smaller. Our banks are well capitalised and loan losses are under control. Though bank credit conditions have become stricter, it is still possible to get a loan. However, the time of 50% growth indicators and non-existent risk margins has passed.

Dear listeners, the current economic downturn may be uneasy, but it will provide us a unique possibility for a new period of growth.

Thank you!

Andres Lipstok. A Stable Monetary System - the Prerequisite for Enterprise