The euro determines economic growth

Andres Lipstok
Governor of Eesti Pank

The current economic crisis is likely to have bottomed out - or if not, the bottom is rather close. The restoration of confidence in the Estonian economy and the revival of growth depend on the perspective of joining the euro area and on an economic environment supportive of business.

Estonia's fast adjustment is encouraging

The global economic crisis has lasted for nearly a year. Although larger economies are showing signs of recovery, permanent growth revival is not yet a sure thing.

The Estonian economy has so far developed in line with Eesti Pank's spring forecast. In April we anticipated the downturn would abate in the middle of the year and growth would gradually recover at the end of this and in the first half of the next year.

Current economic indicators show that the situation is becoming more stable and the decline in GDP is inhibiting. Industrial production and exports have stopped contracting in recent months and retail trade, which reflects private consumption, has slightly picked up. The drop in GDP was slower in the second quarter than in the previous two ones. If the current trend continues, Estonia's GDP will decrease by almost 13% in 2009. We may expect economic growth to revive in the course of 2010.

Estonia's economic developments have been remarkably in line with forecasts, although our main export markets as a whole have experienced a steeper decline in the first half-year than it was anticipated. The resilience of our economy in the light of the highly unfavourable external environment gives us more confidence in the future.

It should be stressed that 2010 will be related to high risks in both Europe and Estonia. The inhibition of the economic downturn mainly relies on private consumption that is supported by fiscal policy measures and on restocking. Fiscal deficits and public debts have hiked in both the European Union and the USA. According to the IMF's forecast, fiscal deficit makes up 6% of GDP in the EU and more than 10% of GDP in the USA. It is not yet clear how this will affect investment, which has already contracted over the past year, and economic growth. Most of the governments in Europe will have to curtail expenditures and raise taxes in the next years to stabilise their budgets. This means right political choices that support economic revival also if the unfavourable economic environment persists are of utmost importance to Estonia.

Three cornerstones of Estonia's economic adjustment

Although the current economic situation is not easy on the Estonian residents, companies and on the state itself, there exist several factors that help stabilise Estonia's economy.

First of all, the flexibility of economic relations, the economic structure and the business environment have enabled companies to adjust their operation, costs and prices and also caused dead-end firms to close down. Companies in Estonia have quite well grasped changes in demand and supply in our export markets. Rapid reaction is painful at first, but it is a better solution than keeping loss-making firms on life support or postponing inescapable personnel and management decisions.

The second very important factor is the fixed exchange rate of the kroon. On the one hand, the peg of the kroon has ensured low inflation and sometimes even decreased the price level. On the other hand, it has caused a decline in euro interest rates in Estonia and considerably reduced loan costs. Smaller interest rates have, to some extent, offset lowering incomes, and the stabilisation of and certain decline in prices support purchasing power, inhibiting a further contraction in private consumption.

Third of all, the buffers accumulated during the rapid growth years, be them in the state budget, the banking sector, or enterprises, have played a very important role over the past year. Although fiscal surpluses should have been larger in good times, reserves and the suspension of the funded pension system make it possible to avoid drastic expenditure cuts. The relatively expansionary fiscal policy was one of the reasons the first half-year's economic downturn was smaller than feared. The capital and liquidity buffers required by Eesti Pank and accumulated by banks are also important to the economy. Banks have even now enough capital to cover losses and meet loan demand. The share of new loans to enterprises has not really declined during the year.

Investment alleviate unemployment

Flexible economy and stabilising economic policy have helped Estonia survive the shock caused by the global crisis. Unlike many other countries, we have been able to achieve this without substantially increasing the public debt - another factor contributing to growth revival and the restoration of credibility. Therefore, it is the right and even high time to highlight the measures underpinning economic recovery.

Obviously, growth in short term depends to a great extent on our key economic partners. Increasing demand for Estonian goods and services would make it possible to utilise some of the currently idle production capacities. Further price adjustments to new circumstances are also a precondition for keeping up domestic demand and enhancing competitiveness. The revival of investment, especially in areas with higher value added, is the main driver behind a new growth cycle and decreasing unemployment. This is definitely supported by a strong banking sector and labour market flexibility, which also includes the new Employment Contracts Act. But what can the state do to support the investment environment and thus also economic growth and the development of the society in general?

Our main objective is to join the euro area. Without repeating all the advantages of having a single currency, I would like to stress once again the importance of adopting the euro to ensure confidence in Estonia. Accession to the euro area is the primary determinant of the volume of investment made in Estonia, household and corporate loan interest rates and thus also short-term and long-term economic growth. Any longer delay in adopting the euro may bring along serious consequences. It is all very simple: analyses have shown that a postponement of the adoption of the euro, especially for an indefinite time, may cost Estonia up to one percentage point of economic growth. This translates into billions of unreceived tax revenue.

The key to economic growth is the budget

Eesti Pank continues to be of the opinion that Estonia will be able to meet the Maastricht criteria at the end of 2009 to join the euro area in 2011. In June we thought that after the adoption of the second corrective budget the government would have to reduce the forecasted deficit by some 1.5 billion kroons. But the risk that public sector expenditures will be larger and the receipt of non-tax revenue will smaller than anticipated has increased. This may augment the deficit by an additional 1-1.5 billion kroons.

Bringing the fiscal deficit below 3% of GDP in 2010, balancing state revenue and expenditure and achieving a fiscal surplus in the next years are also closely related to the adoption of the euro. Since fiscal expenditures have risen very fast in recent years, constituting almost 45% of GDP (this was also caused by declining GDP and more efficient usage of transfers from the EU), fiscal stabilisation will have to be achieved primarily by curbing public expenditure. Fiscal consolidation has a direct impact on the Estonian economy and it improves the investment climate. Fiscal surpluses provide the state with much ampler possibilities to finance budget expenditure during future downturns without raising taxes or adding to the public debt burden. Therefore it can be said that reaching budgetary balance in a small and open economy with the help of cutting expenditure may also enliven the economy, enhancing, among other things, the confidence of investors.

It should be added that improving the budgetary position and curbing expenditure creates preconditions for increasing productivity in the entire economy. Experience both in Estonia and the rest of the world shows that longer-term strict limits on general budget expenditure help speed up structural reforms and use existing resources more efficiently.

To sum up, it can be said that if we make right choices, we may look into the future somewhat more optimistically. Although the total volume of the goods and services produced in Estonia has temporarily receded to the level of 2005, there do exist preconditions for economic recovery and income growth, even if growth will not reach pre-crisis levels. Economic recovery requires adhering to the economic fundamentals and joining the euro area in the near future. The latter depends on the budgets of 2009 and 2010.

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