Eesti Pank: risks to the financial system are continuously low

Recent indicators confirm that the adjustment of the Estonian economy has continued in the first half of the year. The slowing economic growth is primarily related to declining domestic demand, which reflects the increased caution of households in both the acquisition of real estate and everyday expenditure and consumption. Export volumes have decreased, but the data of the first months of the year show that the cutback has occurred mainly in the export of transit goods (e.g., oil products). Meanwhile, the export of such groups of goods that provide higher value added has continued to grow. Estonia's external balance has also considerably improved, mainly owing to smaller imports.

Stable economic development and the creation of a favourable business environment for the private sector require a balanced general government budget at the least. Strong fiscal policy in conjunction with private sector investments in improving productivity make way for a recovery in growth in the next years. According to the estimate of Eesti Pank, the next year's general government expenditure may increase 4-5% year-on-year.

The deceleration of domestic price pressures, which manifests itself chiefly in the slowing price rise of services, is backed up by slower domestic demand growth and smaller wage growth in the private sector. The vigorous oil price hike may, through fuel and thermal energy prices, raise Estonia's this year's inflation more than forecasted, but as other domestic price pressures are withdrawing, we expect the slowdown in price growth to be more pronounced in the second half-year.

In the near future, the main threat to Estonia's financial stability is the escalating credit risk. The slowing economic growth has resulted in an increase in the number of bankruptcy petitions submitted by enterprises. The real estate development sector is also facing greater difficulties. As regards households, the risk of job loss, which has already slightly materialised in some sectors, has become more serious. At the same time, the financial vulnerability of households can be somewhat subdued by savings the volume of which increased in the first quarter.

Although the volume of overdue loans can be expected to expand in both this and the next year, it will not threaten the functioning of the Estonian financial system. Based on stress tests of overdue loans, Eesti Pank forecasts their share to increase to 1.5-2.6% by end-2008 and to 2.2-3.1% in 2009. Because banks have preserved their earlier years' profits in own funds, their capitalisation has increased, enabling them to cope with the growing loan losses.

The credibility gap in international financial markets has not narrowed remarkably over the past half a year. Changes in the external environment reach the Estonian banking sector through parent banks. From the point of view of liquidity risk, it remains important that parent banks be able to raise funds from markets. The Nordic financial groups are credible and so far it has not been difficult for them to include funds, though they have to pay a higher price for them.

In Eesti Pank's opinion, the risks to the functioning of the Estonian financial system are still low, since the banks' capital and liquidity buffers are sufficient to endure the forecasted setbacks.