Economic policy statement of Eesti Pank

The state and the financial sector should step up economic restructuring

The global economic situation has markedly deteriorated over the past months and uncertainty about the future persists. The deepening downturn in Estonia's main external markets has weakened our economic outlook. In October 2008, we assumed our trading partners' this year's economic growth would average to 1.5%, but now a contraction of over 1% can be expected.

Since external demand has eased considerably, Estonia's real economy may decline up to 5.5% this year. Economic growth and external demand are expected to start recovering in 2010. Whereas the economies of Estonia's main trading partners are projected to decrease 3% on average, Estonia's economy may contract up to 9% per cent in 2009. At the same time, the economic policy measures enacted or announced by major economic regions should help the global economy overcome the difficult times. The possibility of economic growth rekindling faster than forecasted should not be ruled out, either. The new growth cycle will be able to rely on our continuously strong economic fundamentals, which should be reinforced even further: the sound banking system, flexible business environment and labour market, and fiscal reserves accumulated in previous years.

Inflation has fallen rapidly and will not exceed 2% in 2009. The price level is not projected to rise in 2010, either. Many companies have changed their operating strategies and have brought prices and wages into line with the new market situation. This is also proved by rapid changes in the labour market: employment has started to drop, flexible working contracts are becoming more widespread, and nominal wages have started to decline in some sectors.

Since the growth outlook for the coming years will be much lower than projected, it is important the government bring their expenditure in line with the changed environment. In Eesti Pank's opinion, the government should decrease all the expenditure components, including social expenditure, because otherwise the state would not be able to cover it in the next years. In addition to the overall macroeconomic projection, it has to be taken into account that resources for financing the fiscal deficit are also drying up. Although the government's planned expenditure cuts will also improve the longer-term fiscal position, Eesti Pank's opinion is that next years' expenditure is not in line with anticipated lower tax revenues. In addition, the structural reforms necessary for more efficient public management should also be carried out. The main preconditions for attracting new investment are reliable public finances and a stable tax system further enhanced with the adoption of the euro as soon as possible.

In light of the plan for a nearly 8 billion kroon fiscal expenditure cut, current projections expect this year's deficit to form approximately 3% of GDP. This tightening supports also the perspective of joining the euro area. However, it is still too early to assess the full effect of the government's measures, since it depends on the details of enacting the steps. For example, the actual impact of the health insurance fund and local government cuts on the fiscal balance is still unclear. In addition, even more adverse economic developments cannot be ruled out, thus the government may be forced to make additional cuts.

The financial sector should contribute to economic restructuring and adjustment by providing companies with sufficient loan resources. The capitalisation and liquidity of the banks operating in Estonia is good. Banks have expressed readiness to continue financing good business projects, although the steep economic deterioration and tightening credit conditions have made it more difficult for borrowers and lenders to come to an agreement. Although a certain decline in corporate debt burden is completely natural in the current economic environment, it can be seen that the financial sector's willingness to take risks has dropped too much and banks have overreacted to changing circumstances. This may hinder the necessary economic restructuring.

Eesti Pank believes there is no need for extensive state intervention in the functioning of the financial system. It is important to bear in mind that the external environment has changed the future outlook for many business areas. Therefore, in addition to short-term financial support, it is essential to restructure companies by, for example, merging them or changing the ownership structure. Neither state support nor the financial sector must prevent these processes from taking place. Possible state intervention has to be clearly limited to abolishing market failures. In Eesti Pank's estimate, this may temporarily increase the volume of the measures applied (export guarantees, etc.), but the central bank sees no need to finance the financial sector by additional measures.

Key economic indicators for 2007-2010

  Eesti Pank's forecast      2007       2008       2009**     2010** 
GDP (EEK bn) Base scenario 239 248* 242 245
Risk scenario 239 248* 230 222
GDP growth (%)   Base scenario 6,3 -3.5* -5.5 1.0
Risk scenario 6.3 -3.5* -8.9 -3.5
Inflation (%) Base scenario 6.8 10.6 2.0 0.3
Risk scenario 6.8 10.6 0.2 -1.7

*   Q4 data are estimated.
** Forecast.