Estonian Economy in Anticipation of the Euro
Governor of Eesti Pank
The world has been experiencing a real economic crisis for more than a half a year. By now it is almost certain that economic recovery in advanced countries is not expected before 2010. Also in medium-term, economic growth may be modest compared to the rapid development of the past decade.
In the older European Union Member States the harsh reality is still approaching. In Finland and Sweden the volume of industrial production has decreased by a quarter on annual basis and unemployment is increasing. The economies of new Member States may also fall more drastically than it is currently expected. So, according to the risk scenario, the decrease of the Estonian gross domestic product in the first half-year might be measured in double-digit figures.
Earlier risk factors have remarkably decreased
In Estonia, economy started to slow down already in the middle of 2007 - considerably earlier than in most other European countries. The most significant change in the Estonian economy over the past half-year is the sharp and rapid decrease in several risk factors, which has been facilitated by the reserves accumulated by the government and banks in earlier years.
Estonia's current account deficit - i.e. the difference between economy's savings and investments or dependence on the current inflow of foreign capital - has decreased very sharply. This year the economy's current income and expenses will probably be in balance for the first time in the last fifteen years and the possibility of the current account surplus cannot be excluded either. The total volume of Estonia's external debt is also very likely to decrease. At the same time, the external debt of banks operating in Estonia should decrease as well because the growth in household deposits and the weak loan demand enable to repay some of the money borrowed from parent banks in previous years.
Here I would like to stress that the balancing of the current account is a correction resulting from the very large investments of previous years. In the medium and long term, the inflow of foreign investment into Estonia will definitely continue. Estonia's capital formation per person is still significantly lower than in the European Union on average and the average return on investment remains higher than in the so-called old Member States.
From the point of view of economic competitiveness, wage growth moderation is no less important. Rapid wage growth was partly a reaction to the considerable increase in profits in previous years. Relative increase in the salary fund gave a bigger share of the results of the economic growth to employees. By the beginning of the last year, wage growth reached a level that clearly endangered Estonia's competitiveness. Wage growth reaching 15% is evidently too much at a time when output per employee is decreasing. In the first months of this year, however, wage growth has actually stopped compared to the previous year.
Yet it has to be emphasized that wages in Estonia are still low compared to the EU average. Those analysts and entrepreneurs who think that wages should be lowered in order to maintain Estonia's competitiveness are mistaken. Estonia is not and will not become a country of very low wage level. After the necessary correction, Estonia's wage level will continue to increase together with the overall economic development.
Simultaneously with the deceleration in wage growth, inflation or price increase is also stopping. During the past half-year, the overall price level in Estonia has not increased, which is the first time after the adjustment in prices following the accession to the European Union. The inflation of 2009 is likely to be negative. In the years to come, the fixed exchange rate of the kroon and the currency board system will keep prices stable. That being said, it is worth mentioning that the halt in wage growth and the decline in interest rates of the euro support the real purchasing power of income. From the perspective of price stability it is important that the prices controlled by the state and local governments should rapidly respond to changes in the expenditure base and economic environment.
It is understandable that the balancing of the current account - i.e. the difference between the economy's savings and investments - and a halt in the increase of prices and wages is a natural change after the robust growth rate of recent years. Rapid normalisation of these essential risk factors shows Estonia's flexibility and adaptability. The positive changes in the economy over the past six months have created first preconditions for a gradual economic recovery. The matter of fact is that our households and enterprises have enough resources to look ahead much more confidently than at the moment. We have let some of the doomsayers intimidate us too much. It is rather the question of if and how Estonia can use the current opportunities.
Path to new economic growth
It is characteristic of the today's world that countries relying on the growth of domestic demand as well as economies relying on the export of industrial goods suffer equally. The growth model based on cheap loan money and American and Asian demand is now exhausted both in Estonia and in the rest of Europe. Economic recovery in Estonia and Europe will therefore be based on profound structural changes.
Further development of the Estonian economy must rely on areas with higher value added in order to ensure a future increase in wages and income. Enterprises must review their current business plans, rearrange their activities and, if needed, end businesses with no perspective. The main task of the government is to contribute to these rearrangements. This requires primarily maintaining the economic environment that is open, stable and supports business. Harsh and hasty steps, no matter whether taken in banking or fiscal and tax policy, will have positive influence neither on Estonia's credibility nor the country's economic growth. In this context there are four areas of critical importance as regards the recovery of economy and investments: labour market, budget, credibility of the banking sector and accession to the euro area.
Estonia's fiscal policy has so far endured the crisis successfully. The rapid increase in the 2008 budget expenditure contributed extremely strongly to the avoidance of economic recession. This year the deficit accompanying the decline should definitely remain within the limits set by the Maastricht criteria. In the next two years the objective should be the structural balance and surplus of the budget. The fiscal stance should be gradually strengthened in order to maintain the credibility of the Estonian economy and to facilitate new investments. The government has no easy choices while making short-term fiscal decisions; in any case the financing of social expenditure targeted at vulnerable population groups and at the same time the maintenance of a reasonable volume of state investments should be ensured. Yet the question is not only about the restoration of the budget balance. The changed economic situation is also a suitable time for thinking about the long-term fiscal sustainability.
In the short run, it is appropriate to use flexible employment solutions in the labour market. All in all, employment still has to decline in areas with decreasing demand since this is the only way to create preconditions for growth in other sectors of the economy. Well-functioning unemployment insurance and retraining are clearly supportive measures. But the employment will eventually depend on how easy or expensive the creation of new jobs is and whether wage agreements reflect the economic situation of a specific enterprise. The new Employment Contracts Act that will enter into force in the middle of this year should increase labour market flexibility. Yet it is equally important to avoid raising taxes related to labour force.
Economic adjustment and growth largely depend also on banking. As a result of previous years' very high profits and rather strict banking standards, banks operating in Estonia are very well capitalised. Nevertheless, this year the total volume of bank loans and loan margins will probably decrease, which means that the spread between interest rates on bank loans and Euribor will remain higher compared to the low level of previous years. This reflects mainly the changed situation in global financial markets.
The share of direct investment and widening of the capital base will be more significant in the next years. The indebtedness of Estonian companies is not low. However, there are all the necessary preconditions for the banks to continue financing good projects and support companies in the changed conditions as well. Just as the society as a whole, banks should look beyond the current situation when making decisions and, in the case of loan decisions, consider the positive economic outlook in the medium and longer term. In this situation we respect the government's decisions to support export crediting and to finance start-up companies. At the same time, I believe that at the moment there is no need for extensive state intervention in the banking system.
Adoption of the euro
The euro changeover is a natural stage of development in the Estonian economy. Since in the economic sense we have participated in the euro area for almost 17 years through our monetary system, it is an expected and natural course of events that Estonia will join the euro area. In the light of the current situation of the global economy particularly, the clear and concrete perspective of changeover to the euro adds confidence and helps to increase Estonia's credibility.
According to current estimates, by the end of 2009 Estonia will meet all criteria required for the adoption of the euro, including the inflation criterion, which has been a problem so far. But as already mentioned, the budget deficit criterion will certainly become one of the key challenges. This year and also in the future the consolidated budget deficit must definitely remain below 3% of GDP. Estonia has no problems with meeting other criteria - general government debt is one of the lowest in the European Union, the exchange rate has remained stable for almost 17 years, legislation is in compliance with that of the euro area, we do not have any problems with the central bank independence and there is no reason to believe that the assessment of the long-term interest rate criterion would turn out negative. Eesti Pank is technically ready for the euro changeover and one year is a sufficiently long period for both the public and the private sector to complete all the necessary preparations. Eesti Pank has assessed the outlook for the adaption of the euro based on its own forecasts and we believe that Estonia could adopt the euro in 2011. At the beginning of 2010, the European Commission and the European Central Bank will carry out their next regular assessment as regards Estonia's readiness for the euro changeover. When the new forecast of the Ministry of Finance is completed, the working group gathered by the Prime Minister will thoroughly analyse all prospects of the euro changeover and the potential schedule.