ECONOMIC POLICY COMMENT BY EESTI PANK
In the world economy the year 2001 meant rapid slowdown in all major economic centres. At the beginning of the year Japan entered into recession, followed by the USA and Germany in the middle of the year. Preliminary estimates put the annual growth of the world economy at 1.2%, which is more than three times below the growth rate of 2000.
Although there was no collapse in the world economy, the recovery of the growth in Europe is likely to be relatively slow.
Alongside with the continuing slowdown of economic growth, central banks kept cutting interest rates in the last quarter of 2001 and governments continued encouraging consumption. The US Federal Reserve lowered base rates by another 1.25 percentage points and the European Central Bank by 0.5 percentage points.
Restoration of Industrial and Consumer Confidence
All together, in 2001 the Federal Reserve and the European Central Bank lowered interest rates by 4.7 and 1.5 percentage points, respectively. The impact of expansive and coordinated economic policy, which was felt throughout 2001, began to bear first fruits in the USA at the end of the year - economic growth turned positive in the fourth quarter (1.4%) and indicators of industrial and consumer confidence improved. Several early indicators of the European economic space pointed to signs of recovery at the beginning of 2002.
The Estonian economic forecasts for the next four-five years presume that economic growth of our major trade partners will reach the estimated potential level, which in the euro area would mean at least 2.5% annual growth of the GDP. According to international market analysts, Europe will not reach such a level this year, despite the improved outlook.
In 2001, the difference between economic growth rates of Estonia and the developed industrial countries of Europe increased. Preliminary estimates put Estonian economic growth at 5.3% in 2001, which outstrips the respective euro area figure by nearly four percentage points.
Economic Growth Stood on a Stable Basis
The relatively rapid economic growth in 2001 mostly derived from strong internal demand, based mostly on increased investment activity. While in 2000 private consumption was the engine of internal demand, then in 2001 the real growth of private consumption remained below the GDP growth in all quarters.
Regardless of increasing investment activity, where the share of investments again rose above 25% of the GDP, the current account deficit remained unchanged and amounted to 6.5% of the GDP.
Being a small open economy, Estonia's inflation curve was influenced by external shocks in 2001. In the first quarter, the fall of the inflation rate was blocked by domestic factors, including administrative price changes. External pressures strengthened at the beginning of summer, contrary to predictions. The increase of consumer prices began to slow down in the third quarter, after external pressures eased. The 2001 average price increase was 5.8%.
Competitiveness of Estonian Companies Improved
The growth of export to the Baltic countries, Russia and other Central and East European countries contributed considerably to the preservation of economic growth, as did the improved competitiveness in a number of groups of goods, such as in the furniture industry, for example. Due to the constantly improving purchasing power of Russia and its rapid economic growth, Estonian food industry was able to restore considerably the positions it had lost in 1998. For instance, food export to Russia increased by 80%. All told, the nominal growth of the volume of normal export(1) (export without subcontracting) to Russia, the Baltic countries and other Central and East European countries accounted for more than one third of the total growth of normal export.
Although in late 2001 the demand on Estonia's export markets was the weakest of the past years, the nominal growth of Estonia's normal export, which reached 10% in the fourth quarter, increased by 2.2 percentage points faster than in the third quarter. On an annual basis, however, the growth rate slowed down to 11.5%, dropping by more than 20 percentage points. In view of economic growth and declining import demand in the major trade partner countries of Estonia, such a growth rate of export meant that, on average, Estonian companies maintained or even improved their positions on foreign markets in 2001.
(1) Normal export is export without goods re-exported after processing in Estonia.
Government Sector Revenue Exceeded Expectations
In 2001, the government sector played a major role in maintaining economic balance as budget surplus (0.4% of GDP) was achieved for the first time since 1997. The surplus was based on the relatively rapid economic growth, improved tax collection (the government sector budget revenue exceeded the planned target by 2%) and tight expenditure management policy on the central government level.
The local governments' budget deficit, however, grew to 0.6% of the GDP in 2001. Compared to 2000, expenditures increased by 40%. This indicates a continued need for legislation guaranteeing uniform fiscal policy on the entire government sector level.
Private Consumption Growth Outpaced Income
Unlike businesses and government, the consumption spending of private individuals increased faster than their income. The main additional source of consumption was borrowing from banks, the cost of which dropped to the lowest level since the restoration of independence. Demand for leasing products continued to grow rapidly - in 2001 financing of the Estonian economy by leasing firms increased by 39%. Although lending to individuals and companies accelerated, it did not lead to a noticeable deterioration of the loan portfolio of the financial sector. Still, risks increased in several sectors - the share of bad loans rose in retail and commercial real estate development sectors, for example. This process needs closer monitoring in the future.
Although the year 2001 proved that the foundations of the Estonian economy are strong enough to preserve balanced development also in the conditions of weakening world economy, the current year will hardly turn out to be easy for the Estonian economy. World economic growth is recovering but in the most important economies for us - the euro area and Scandinavia - growth will be rather modest. Therefore, external demand can prove to be even weaker for Estonia in 2002 than it was in 2001. Without growth in export earnings, however, it is difficult to expect domestic demand to continue strong.
Cheapening of Loans Will Stop
In addition to the above, the fourth quarter of 2001 probably marked an end of the monetary policy loosening by major central banks and in the first half of 2002 base interest rates are expected to stabilise at the current level. This means that unlike in 2001, bank loans are not going to get cheaper in Estonia.
The external inflational pressure on Estonian prices will become clearer in the coming months. In the first couple of months, the increase of food prices in particular has been faster than anticipated and the annual CPI increase has stood above 4% in January-February. The difference of the consumer price growth in Estonia and the euro area dropped to 1.5-2 percentage points in the first months of 2002, but this could prove to be temporary.
2002 Economic Growth to Fall Short of Last Year's, Confidence to Preserve
Maintaining balanced development and relatively rapid growth of the economy in the conditions when strong recovery of external demand is not in sight yet and the lowering of credit prices has slowed down may prove even a bigger challenge than in 2001.
First of all, the year 2002 requires the preservation of the reliability of the financial sector and strict control over spending on the level of individuals, companies and the government sector. Such policy coordination between the different sectors of the economy has to keep interest marginals low and preserve adequate liquidity reserves in case the recovery of demand proves to be slower.
Although the 2002 economic growth is likely to be below that of 2001, continuing confidence of foreign investors and improved growth outlook of the world economy create good opportunities for focusing on strategic goals and structural reforms.
Table 1. Estonia's major economic indicators 1995-2001
1995 1996 1997 1998 1999 2000 2001* GDP real growth (%) 4.3 3.9 10.6 4.7 -1.1 6.4 5.3 Growth of special export (goods export with subcontracting (%) 21.6 11.8 48.8 18.8 -2.1 50.9 3.6 Growth of special import (%) 36.4 26.4 41 13 -8.5 43.1 4.1 Current account balance (% of GDP) -4.4 -9.2 -12.2 -9.2 -5.8 -6.5 -6.5 General government budget balance (% of GDP) -1.2 -1.5 2.2 -0.3 -4.6 -0.7 0.4 12-month consumer price index (%) 29 23.1 11.2 8.2 3.3 4 5.8 12-month export price index (%) 15.2 11.4 7.5 2.1 0 7.8 32.9 Consolidated balance sheet of commercial banks (% of GDP) 38.1 43.7 63.1 55.9 62.5 68.7 71.6 Share of foreign ownership in banking sector (% of share capital) 29 33.4 44.2 60.7 61.6 83.6 85.4 Capital adequacy of commercial banks (%) 13.7 12.1 13.5 17 16.2 13.2 14.4 Change of TALSE (%) 60.3 65.6 -65.8 38.3 10.1 4.7 Consolidated portfolio of commercial banks (% of GDP) 25.3 27.5 30.3 30.7 33.4 40.7 42.6 M2 (% of GDP) 26.5 28.3 32 29 34.5 38.6 42.9 2-month TALIBOR (%) 7.9 15.7 18.1 5.1 6.1 3.9
*) Preliminary estimate