Andres Saarniit, Adviser to the Economics Department of Eesti Pank

Estonia's current account deficit has been contracting since mid-2007, when the country's economic growth started to slow mainly due to domestic demand. In 2008, the average deficit to GDP ratio was 9.2%. Estonia's foreign trade deficit has also been declining smoothly since 2007. The current account improvement was supported by merchandise exports, which stood strong until the autumn of 2008. Services exports grew much faster than imports throughout the last year, helping offset the goods deficit. By end-2008, the deficit on goods and services had shrunk to 4% of GDP from the approximately 14% recorded in the 4th quarter of 2006.

Current account deficit has been declining according to expectations. Irrespective of declining foreign investment, there were no financing problems in Estonia, and foreign reserves kept growing. Since the economic indicators for the end of 2008 and beginning of 2009 refer to a further decline in domestic demand, current account deficit will also continue to narrow. According to Eesti Pank's forecast, current account deficit will continue to decrease also in 2009.

Whereas weakening domestic demand has been reducing current account deficit for the past year and a half now, the negative impact of investment income on the current account deficit started to recede over the last months of 2008. A lot of foreign capital has been invested in Estonia and local enterprises have also made investments abroad. This is why the size of current account deficit has always been markedly affected by investment income. However, considerable investment income recorded in the current account does not automatically mean the money earned has moved out of Estonia. Due to the accrual method of accounting, reinvested profits are also recorded as outflows. As is characteristic of a recession, the profitability of foreign investment started to diminish towards end-2008. Whereas, for example, the ratio of current account deficit to GDP stood at some 19% in the last quarter of 2006, investment income accounted for about a third thereof. By the last quarter of 2008, the ratio of current account deficit and investment income outflow to GDP had dropped to 5.5% and 4%, respectively.

A positive aspect regarding changes in capital inflows in 2008 is the approximately 40% increase in (gross) official transfers from the European Union. These cash flows will be one of the main factors offsetting the current account deficit in near future.