Peter Lõhmus. Main Trends in Estonian Economy in 1998 and 1999: Speech on the Press Conference of Eesti Pank

MAIN TRENDS IN ESTONIAN ECONOMY IN 1998 AND 1999

Peter Lõhmus
Deputy Governor
Eesti Pank

Throughout years, Eesti Pank has increased the role of long-term, i.e. strategic planning. When we started, we proceeded from a rather narrow aspect of banking and monetary policy framework – the process was concentrated on Eesti Pank. From year to year, the need for a basic document setting economic policy goals for the whole economy has become more evident. Such a document should not only be a forecast for possible developments but should serve as a basis for short-term steps to be taken. Without such a basis it is easy to lose sight of the long-term goal, especially in a controversial year like 1998.

The main policy guidelines foresee the continuation of the existing monetary policy based on the currency board arrangement with the fixed exchange rate of the Estonian kroon against the German mark and the euro. A strong financial sector together with conservative fiscal policy is the unconditional prerequisite for a stable economic growth in Estonia, its importance being increased by the unstable external conditions.

1998 IN RETROSPECT

 The latest events have shown that Estonian economy is strong and flexible enough to withstand external shocks. This is a quality that the euro-zone is expecting from its member states. Quite a number of economic indicators for 1998 are likely to coincide with those predicted at the end of 1997. Development in the first and second half had a different pace. The 7.4 per cent GDP real growth of in the first half declined most probably to zero in the fourth quarter. The CPI dropped from over 10 per cent in the first half to 6.5 per cent in the second half of 1998. In addition, the balance of payments is most likely to improve more than expected only over the last months of the year and the annual current account deficit will be a single digit number (approximately 9%).
 The opinion that the so called Russian crisis will directly be followed by a depression in industry, was true: absolute volume as well as annual growth rate of industrial sales hit the lowest point in October. The sudden growth in processing industry sales in December (7.2% real growth compared to December 1997) and the sales volume close to the results of the 1998 best months was due to extremely good results of wood processing. The annual real growth of industrial sales remained on the level of 2.9%. More rapidly, both annually and over the last months of the year, have developed wood processing and apparatus building, i.e. branches the export of which was anyhow directed towards western markets. Foodstuffs that earlier were exported to Russia, have not found substitute markets and finding such markets (at least in the lost volume) is not likely. Thus, rather big structural changes can be expected in industry.
 The year also showed that when rapid changes take place, the statistics mechanisms could not be adjusted as quickly as necessary. For example, we have two different CPI baskets: the average CPI in 1998according to the former basket was 10.6% while it was 8.2 according to the new basket. It is logical to conclude that we have to adjust the prospects for 1999 according to the new basket (i.e. if other conditions remain the same, approximately 5% instead of 7%).
 The capitalisation of the banking sector improved when new strategic investors were recruited. It can be claimed, with certain reservations, that at the end of 1998 international credit conditions also somewhat improved for Estonia. The obtained resources were mostly used for refinancing earlier short-term liabilities, increasing reserves and, most probably, also for carrying out projects abroad.

ESTONIAN ECONOMY IN 1999

 The following external factors shall have a major impact on the economic development in 1999:
  (i) the aftermath of the Russian crisis in the first half of the year;
  (ii) the further development of west-oriented export;
  (iii) the cost and amount of foreign financing.
The 'cautiously optimistic' scenario for the economic development (i.e. economic growth of up to 4%) is based on the condition that (i) will only have a marginal influence on the economy in the first half of the year; (ii) will be neutral as to the basic scenario and (iii) will turn towards a positive direction over the year, taking into consideration the ongoing infrastructure privatisation. All in all, such a development of the external environment reflects a forecast according to which the zero-growth or slight decline in the first half of 1999 will turn to a more rapid growth in the third and fourth quarter.
 The relative stabilisation process that took place in the credit market can be of temporary nature, for the situation of the real economy will remain tense. As a new trend, mention should be made of the sharper than earlier increase of real interest rates while the nominal interest rates have remained relatively unchanged. Besides the declining inflation, the problem of real interest rates (resp. the increase of the share of loan servicing costs in total costs) is made more acute by a possible slow-down or even a decline in the growth rate of turnover and profits over the first half of 1999.
 Thus, economic growth in 1999 first of all depends on Estonia's capability to export to western markets, which, in turn, depends on the economic growth in the Western Europe. In order to avoid a too rapid adjustment of the current account deficit and to carry out structural reforms (investments) in the private sector, Estonia still needs foreign capital inflow in 1999 as well as in medium term perspective. Inflow of foreign direct investments is one of the major sources for increasing companies' own capital. Increasing the enterprise sector capitalisation is, in turn, the main development factor since the stabilisation of the extremely rapid growth in the credit market.
 Fiscal policy is considered to be one of the main indicators of a stabilised transition economy. Despite positive total figures and the established stabilisation reserve fund, the surplus of consolidated budget accumulated over last two years (2.1% and 0.5% in 1997-1998, respectively) is relatively small compared to the real economic growth over the period (11.4% and 4-5%, respectively) and current account deficit.
 The final budget for 1999 was, however, drafted according to an optimistic scenario. The developments at the beginning of the current year should force the government to think about a negative supplementary budget in the nearest future. Taking into account the long-term development and costly indispensable reforms, one cannot agree to including revenues obtained from a single sale of state property in the budget - hopefully no more expenditures are planned to be financed from such revenues. Tax burden can only be reduced through essentially cutting the present state expenditures.
 Taking into account the easing of fiscal policy and a still high current account deficit, Eesti Pank continuously stresses the higher than international standards requirements imposed on the banking sector, including domestic liquidity buffers. Parallel to that, the existing framework is being made 'more market-oriented'. With this, in the continuously unstable world economy and high current account deficit, we aim to maintain the soundness of Estonian economy, including its financial sector, by ensuring the necessary inflow of foreign investments (especially direct investments), more rapid adjustment of interest rates and increase of resources necessary for the development of the financial sector.
 In a broader sense, the Estonian fiscal policy has to keep in mind longer term objectives than one budget year. That means that fiscal policy as well as other major economic-policy choices has to be dealt with in more detail within the framework of medium term economic programme carried out in co-operation with the EU, i.e. planning for three years in average. The need for a longer planning period and dealing more with the substance of fiscal as well as other economic-policy matters stems from, among other things, the fact that the end of the primary stabilisation period means that economic-policy choices become more complex.
 As to planning for a longer period, one should stress that a significant budget surplus this year and, more important, in the next years, is an unconditional prerequisite for further stable economic growth and increase of real income. On one hand, the state continuously has to increase the reserves necessary for a sudden change in external conditions that makes it impossible for the private sector to raise foreign investments. On the other hand, the state has to guarantee that sufficient funds are available for the necessary structural changes, first of all the pension reform, over the next years.
 The economic policy carried out since has brought Estonia to the top list of transition economies according to their economic achievements, including the country ratings. Monetary policy based on rules and a relatively conservative fiscal policy have enabled the government and the central bank to focus on the institutional development. The continuously stable export growth to Western Europe has shown that the real sector in Estonia has adjusted itself to the competition in Europe. It is certain that this is a great advantage to Estonia when joining the European Union. Member state status further increases the competition pressures through the disappearance of borders.
 The importance of the economic slogans to be used in the pre-election competition should not be over estimated. Nevertheless, promises that are positive to their core can leave an impression that economic reforms are over and it is time to give up concepts directed towards increasing efficiency and competitiveness. Restructuring economy - allocating resources to branches that have a relative advantage - still goes on. Privatisation of large-scale infrastructure enterprises, pension reform and the general public sector reform are at the initial stage only. Their quick and effective implementation is a prerequisite for the further economic growth and increasing Estonia's competitiveness.
 A number of elections' programmes centre around separate problems only, not including the system as a whole. Prior to elections income policy aspects are more stressed: growth of average salary in general or in a specific profession, ratio of average pension and salary, changes in income tax rates and structure, etc. When dealing with such promises it is essential to know whether long term development or only the elections year has been kept in mind. In the latter case, it is most probable that the short term rapid growth in income will be replaced by a slower than ever growth in the long term perspective.
Peter Lõhmus. Main Trends in Estonian Economy in 1998 and 1999: Speech on the Press Conference of Eesti Pank