ECONOMIC FORECAST OF EESTI PANK FOR 2006-2008

  • Estonia's economic growth is forecast to increase by 11.8% in 2006 and by 8.3% and 7.6% in the next two years, respectively. Although Eesti Pank expects no rapid economic downturn, the peak in economic activity has already been achieved.
  • Economic growth still relies on domestic demand mainly supported by a prompt income growth and substantial foreign capital inflow.
  • Estonia's employment level is persistently high and income is growing. Labour shortage and wage growth may pose a serious threat to the competitiveness of several sectors.
  • In the next years, export growth will remain above 10%. Import growth will be within the same range. Current account deficit is not expected to decline in the near future.
  • The inflation level of 2006-2008 will be above 4%. Taking into account the current interpretation of the Maastricht inflation criterion, which is the precondition for the adoption of the euro, Estonia will not be able to fulfil the criterion until 2008.
  • The productivity growth of enterprises together with wages depending thereon, prudent monetary and fiscal policies, and the strong financial sector will help alleviate possible economic setbacks at the end of this decade.

GLOBAL ECONOMY

For the third year in a row, global economic growth of 2006 will be above 4.5%, meaning this is the fastest growth period since the 1970s. However, global economic expansion should slow by 0.5-0.7 percentage points during the forecast horizon, i.e., until 2008. Compared to the spring forecast, oil prices have fallen, but they may still remain high in the future due to limited oil production. Based on futures transactions, markets expect the average price of oil in 2007 to be approximately 65 dollars per barrel.

According to the European Commission's forecast, euro-area economic growth should slow to 2.1% and 2.2% in the next two years, respectively, but will still exceed the potential level. In 2007, euro-area consumer price growth will decline as a result of rising interest rates. Owing to relatively weak economic activity, the European Central Bank was able to postpone raising the interest rates, which are now expected to recover at a level close to their historical average. The dynamics of currency exchange rates also favour a fall in inflation.

ESTONIA'S ECONOMY

Economic growth
In recent years, Estonia's economic growth has been faster than the 7-8% that would be practicable for the country under normal circumstances, and this trend is expected to continue, at least in 2007. Estonia's economic growth is forecast to increase by 11.8% in 2006 and by 8.3% and 7.6% in the next two years, respectively. Various economic barometers reveal that the country's economic expansion is based on strong domestic demand, and the confidence indicators of the construction sector, the trade sector, and the industrial sector are still growing at a rapid speed.

The construction and real estate sector is operating at its utmost production capacity. It is likely the real growth of this branch of the economy is going to slow down, despite the extensive investment made there in the first half-year.

Inflation
This year's inflation rate is going to be 4.4% and next year's 4.5%. By 2008, it will speed to 4.7%, mainly due to the raising of alcohol, tobacco, and fuel excise duties. Nevertheless, inflation is expected to decline after 2008.

Compared to the previous forecast, inflationary expectations are considerably higher, as the country''s dynamic economic expansion has been accompanied by stronger wage and price pressures. For example, the rise in food prices and housing expenditure has been steeper than expected. Both oil and thermal energy prices will continue to influence consumer prices.

Private consumption
This year, private consumption is forecast to grow by 15.4% and in 2007-2008 by 12.5% and 8.8%, respectively. The hike has been conditioned by high employment and income growth, as well as readily available bank loans. In 2007-2008, 4-5% of private consumption will be covered by loans. In addition, rapid pension growth and lowering of the income tax rate are expected to continue in the next two years.

Investment
According to the autumn forecast, the investment growth of 2006-2008 should amount to 14.7%, 12%, and 9.7%, respectively. By the end of the forecast period, i.e., by 2008, the share of household investment in GDP will reach 9%, which is one of the highest indicators among European countries. From the point of view of the demand side, household investment still has room for growth, even in the context of declining credit growth. As to corporate investment, investments made in machinery and equipment have somewhat increased this year. However, it is not sure whether this trend is going to persist and how much of the funds are channelled to enhance productivity.

Labour market
Although employment indicators are very good, there exist clear signs of labour shortage. Despite the fact that in the next years more people will enter the labour market than leave it, the period under review does not foresee the problem easing off. Nominal wage growth will undergo a slow decline in 2006-2008, remaining within the range of 14-16%. The unemployment rate will be inhibited at around 5%.

The rapid wage growth characteristic of the beginning of 2006 will either continue or even pick up speed. At the beginning of 2007, many enterprises will review wages again, the size of which primarily depends on whether wage costs have had an impact on enterprises' profitability. Recent statistics show that owing to price rises and a hike in production output, profitability has remained high. In future, the main question will be how enterprises can increase productivity to cover their wage costs.

Current account
Although growing production costs are inhibiting the rapid export growth, it will still be above 10% over the forecast horizon. During the next couple of years, Estonia's export demand will remain strong, as the rapid economic expansion of our main trading partners, Finland and Sweden, is continuing. Estonia is unable to take full advantage of the demand originating from our neighbouring countries. This is due to worsening competitive edges, such as increasing labour costs and shortage of production resources (including labour force). According to the forecast, export growth will not differ much from that of imports. Current account deficit will start declining only when the growth rate of domestic demand subdues. The balance of goods and services is somewhat improved by the inflow of wage income of the residents working abroad, which for the first time exceeded a billion kroons (1.07 billion) in the second quarter of this year.

Credit growth
This year's credit growth will amount to 45.5%, but according to the forecast, it is expected to slow in the next two years (to 34.9% and 21.1%, respectively). A further growth of housing loans should be inhibited by Euribor, which has been increasing since mid-2005, but the impact thereof is considerably abated by rapid income growth and positive future expectations. In addition, the maturities of housing loans have extended significantly over the past five years, which has made it possible for people with lower income to take out bigger loans.

National budget
General government expenditure will increase somewhat faster this year compared to 2005, but, according to the national budget strategy, the growth rate thereof will remain as fast as that of GDP over the forecast horizon. The general government can be expected to remain relatively conservative in its activities during the next years. It is essential that the fiscal surplus of the forecast horizon be maintained at the same level as in previous years, as this is the precondition for stable economic growth.

Summary: risks to Estonia's economy have increased
Eesti Pank expects no rapid economic downturn in Estonia. As before, the country's economic expansion relies on domestic demand mainly supported by prompt income growth and extensive inflow of foreign capital. Domestic demand is increasing fast and the Estonian economy is highly dependent on foreign capital. Due to high demand, costs are growing rapidly, too. This, in turn, results in higher prices, which may be accompanied by a larger-than-expected inflation. Should the risks to the economy materialise, the economic growth of the coming years may be considerably weaker compared to the current situation. .

It is only natural for Estonia's economic growth to start declining, as its current level is rather high, but the question is how fast and to which extent it will take place. According to the Eesti Pank's forecast, economic environment should remain favourable until 2008. However, the competitiveness of several sectors may start to weaken owing to the shortage of production resources and labour force, as well as to the appreciation of labour costs.

Table 1. Economic forecast by main indicators

   difference   
(spring 2006/
   autumn 2006)

 
  2003 2004 2005 2006 2007 2008 2006 2007 2008
GDP (EEK bn) 132.9 146.7 173.1 205.5 236.1 268.3 19.3 29.2 39.8
Real GDP growth (%) 7.1 8.1 10.5 11.8 8.3 7.6 3.6 0.7 0.8
HICP growth (%) 1.4 3.0 4.1 4.4 4.5 4.7 0.9 1.4 1.1
GDP deflator growth (%) 2.3 2.1 6.7 6.2 6.1 5.6 1.8 2.8 2.3
Current account (% of GDP) -11.7 -12.6 -10.4 -12.5 -13.5 -13.3 -2.9 -4.2 -4.2
Current account plus new capital account
(% of GDP)
-11.2 -11.8 -9.4 -10.9 -12.2 -12.0 -3.1 -4.3 -4.5
Real private consumption growth (%) 6.8 7.0 7.9 15.4 12.5 8.8 7.6 5.3 1.7
Real government consumption growth (%) 0.3 2.2 1.1 2.5 1.8 1.6 -6.9 -5.2 -5.3
Real investment growth (%) 7.0 13.5 12.7 14.7 12.0 9.7 2.8 3.3 2.1
Real export growth (%) 7.6 17.1 21.5 13.1 11.0 10.0 -1.9 -3.1 -2.5
Real import growth (%) 10.6 15.2 15.9 14.9 12.6 9.8 -0.2 -1.1 -2.5
Unemploment rate (%) 10.0 9.7 7.9 5.7 5.1 5.1 -1.2 -1.3 -1.1
Change in the number of the employed (%) 1.5 0.2 2.0 7.1 1.9 0.4 5.8 1.2 0.1
Value added growth per employee (%) 5.5 7.8 8.3 4.4 6.3 7.2 -2.4 -0.6 0.7
Real wage growth (%) 8.6 5.9 8.3 12.0 10.6 9.3 3.7 3.5 2.6
Average gross wage growth (%) 9.7 7.8 11.4 15.8 15.1 14.1 4.1 4.8 3.5
Nominal money supply growth (%) 10.9 15.8 42.0 33.0 25.0 16.2 0.0 0.0 -6.8
Nominal credit growth (%) 26.9 33.0 50.4 45.5 34.9 21.1 5.4 4.2 -1.6
External debt (% of GDP) 66.0 78.3 86.0 81.8 90.4 98.5 -14.4 -12.2 -7.4