Economic policy statement of Eesti Pank

Economic growth is decelerating sharply due to weaker external environment

The Estonian economy was growing faster than expected during the first three quarters of 2011. Now the growth impetus is waning and uncertainties in the external environment are on the rise. Further developments in Estonia as well as in Europe depend on how problems in several euro-area sovereign bond markets are solved. Therefore, Eesti Pank forecasts that the Estonian economic growth will decelerate sharply in 2012. If the external situation deteriorates even more, a recession cannot be ruled out.

The spreading debt crisis and the increasing contagion risk have seriously undermined economic sentiment in both Europe and the rest of the world. Political tensions in several euro-area countries, accompanied by market distrust in proposed economic policy measures have also increased uncertainty. According to the Eurosystem's forecast, euro-area inflation will be in the range of 2.6...2.8% this year and between 1.5...2.5% in 2012. The euro-area growth forecast is 1.5...1.7% for 2011 and -0.4...1% for 2012. The debt crisis in the euro area also markedly worsened the economic situation of Estonia's main trading partners in the second half of 2011. Nevertheless, Estonia's domestic economic imbalances have decreased compared to the situation a couple of years ago and this has boosted resilience to deterioration in the external environment. Weaker economic activity is alleviated by the ECB Governing Council's recent months' decisions to reduce the key interest rate to 1% and to offer additional liquidity to euro-area banks.

The sufficient capitalisation of banks operating in Estonia and the improved loan-to-deposit ratio provide a good basis for financing households and companies. Cash flows from loan repayment and growing deposits are sufficient to support the markedly higher new lending volumes. At the same time, it is likely companies and households are postponing borrowing due to the highly uncertain economic environment. As a result, the loan portfolio will shrink in 2012 as well.

The Estonian labour market has come up with several positive surprises this year. Employment has increased and unemployment has dropped. The expected economic sluggishness in 2012 may make employers want to cut the number of their employees again, but the situation will become aggravated only if there occurs a longer-term standstill or a recession.

This year's robust economic growth has been accompanied by a faster-than-expected inflation rate. This was caused by a rapid hike in the price of energy and food commodities in the global market. Nevertheless, the external environment has put no extra upward pressures on prices since the first half of 2011. As a result, inflation in Estonia will slow in the last quarter of this year and in 2012, too. Wage pressures are not excessive at the moment and slowing economic growth is likely to hinder wage growth as well. In longer term, however, labour-market pressures may pose a threat to Estonia's balanced economic development.

Fiscal policy is also facing greater challenges due to the external-environment uncertainty. It is very hard to assess the medium-term growth potential and the respective revenue level. Based on the 2012 state budget, the next year's government expenditure growth will exceed GDP growth. This will postpone reaching a surplus target and may lead to inflated expectations.

Economic forecast by key indicators