Estonia's economy on the way towards a more sustainable development path

According to the recent data, the Estonian economy is cooling faster than expected in Eesti Pank's autumn forecast. This has been caused by less supportive external environment, which has brought along slower external demand growth and a rise in commodity and food prices, as well as an increase in risk margins. In addition, the increasing uncertainty and high inflation have reduced domestic demand. At the same time, faster economic adjustment helps speed up the decline in the current account deficit and in inflation.

Both the domestic and external environment are less favourable than last autumn
The long-awaited economic adjustment is under way in Estonia, but it is no longer as smooth as expected due to the less favourable external environment. The economic activity indicators are following a downward trend in several major economies, referring to a further slowdown in growth. It is likely the situation will not improve considerably in 2009, either. In addition, external price pressures have strengthened, having an adverse impact on consumers' purchasing power. In the spring forecast of Eesti Pank, the domestic demand volume has been cut back due to both the decline in investment arising from the cooling of the real estate sector and the slackening consumption caused by rapid inflation and households' uncertainty regarding their future economic situation. According to the base scenario of Eesti Pank's spring forecast, economic growth will be 2% in 2008 and 3% and 5% in the next two years, respectively.

In Eesti Pank's opinion, the speed at which economic growth will recover depends on Estonia's success in utilising the existing export potential. Subject to the external environment, the economy should pick up again either at the end of 2009 or at the beginning of 2010. In order to ensure a smooth transition to the new growth cycle, it is necessary to reallocate some of the domestic demand oriented resources to exports. In addition, good business projects should continue to receive financing from the financial sector.

Inflation at the start of a downward trend
The current price hike in Estonia is considerably faster than the long-term inflation rate, but the level is going to be temporary. According to the central bank, the 2008-2010 inflation is mainly characterised by a gradual abatement of the domestic pressures, administrative measures, fluctuating food and other commodity prices in the global market and rising energy prices. Although this year's average inflation rate is going to be faster compared to 2007, the first half of 2008 is to witness the start of a longer-term downward trend in price growth. Eesti Pank's base scenario forecasts inflation to be 9.8% in 2008 and 4.5% and 3% in 2009 and 2010, respectively. The central bank expects the Estonian inflation rate to reach close to the Maastricht inflation criterion at the end of 2010. In order to meet the criterion, the timing of the administrative measures influencing prices is extremely important.

Fiscal policy should support the adjustment
The government should support the economic adjustment in the current phase of the cycle by continuing to pursue responsible fiscal policies, which is of vital importance in helping maintain the credibility of the economy and foster investments. Without budgeted expenditure cut by approximately 3 billion kroons, the fiscal deficit would amount to over 1% of GDP this year. In order to balance the budget, planned expenditure should be cut by 8 and 11 billion kroons in the next two years, respectively. Another precondition for the recovery of a rapid and sustainable growth is the continuation of the economic policy measures supporting market flexibility and productivity growth.

Possible alternative developments
It cannot be ruled out that the Estonian economy will grow faster than forecasted owing to the more favourable external environment or a more rapid reorientation to export by Estonia's enterprises. At the same time there is the risk that economic growth will slow faster than forecasted should the recent years' investments be based on too optimistic expectations. A smaller-than-expected slowing of wage growth may also postpone the decline in inflation.

Economic forecast by main indicators

Difference    
from the      
autumn forecast 

Source: Statistics Estonia, Eurostat, Eesti Pank, Eesti Pank's autumn forecast 2007, spring forecast 2008.