Peter lõhmus. Recent Economic Trends in Estonia
The Central & Eastern European Issuers
& Investors Forum
Vienna, 19th 20th January, 1999
Peter Lõhmus (Bank of Estonia)
Recent Economic Trends in Estonia (speaking notes)
A year 1998 was a period of first testing of the economy's ability to adjust to new circumstances and of "pain tolerance levels" for the Estonian financial sector and the real sector alike. Estonia entered the year 1998 with a rapidly expanding economy with very high GDP growth levels, extremely strong credit growth and widening current account deficit. At the same time (the end of 1997) the first results of fiscal tightening and increased financial sector prudential standards were about to emerge. As a response of markets to domestic fiscal and monetary tightening as well as continuously uncertain external environment, Estonia saw lower growth rates throughout 1998. Subsiding capital inflows have had contracting impact on the main monetary aggregates and domestic credit. The GDP growth is likely to result in 4%; declining investment demand is improving the current account deficit (from estimated 10% to 8-9% of GDP); supported by tightening liquidity situation, the inflation is steadily declining and dropped to 6.5% on year-to-year basis. The changes in the environment could be characterized by the following figures: as of end of 1998 M2 has grown only by 2% (compared to 38% in 1997) and domestic credit by around 15% (92% in 1997) on year-to-year basis. Against this background interest rates have remain high and the high levels have been transmitted from money market to credit and bond markets.
A strong commitment of authorities towards conservative economic policy and market based, flexible economic framework have been the key factors which have helped to keep Estonian economy well on track in times of less favorable environment for emerging markets. The government is sticking to its commitment to run surplus budget policies. In 1998, despite a turbulent year, the consolidated budget was slightly in surplus; balanced budget is targeted also for 1999. Summa summarum, Estonia has run balanced or surplus consolidated government budgets for 4 years in a row. To demonstrate further commitment towards tightening its fiscal position the government started to deposit accumulated financial savings into a Stabilization Reserve Fund (to be institutionalized within next two month) which were then invested abroad. The Government will continue to accumulate surpluses into Stabilization Reserve Fund, having the size of at 2% of GDP. The ratio of public net external debt to GDP has been stable since 1994, and is only around 3 % of GDP. As the ratio of net private external debt to GDP has risen to 20%, Estonia's total external debt remains low. We consider having a tight fiscal policy as one of the key components of our economic policy - particularly after a loose fiscal stance have led several economies into big difficulties not long ago.
Initial adjustment took place likewise in the financial sector. Due to excessive risk taking, three small banks were closed and one medium size bank was nationalized. This resulted in some loss of confidence vis-á-vis a banking system in the middle of 1998. Nevertheless, banking sector in general was sufficiently equipped with risk buffers and showed reasonable flexibility in adapting to a new situation. Most notably this led to a further consolidation - there are 6 banks currently operating in Estonia which is probably a more reasonable quantity for Estonia than 20-30 banks some years ago. In addition, two Scandinavian banks obtained strategic shareholdings in the two biggest Estonian (and Baltic) banks, that unquestionably strengthened the financial industry and hence, reduced the potential threat originating from weak banking system to the currency board setup. In addition, Bank of Estonia is going to embody all Basle Committee core principles into its banking regulatory framework in this year, including the 10% capital adequacy ratio that covers all the risk components. The creation of a consolidated supervision, including securities firms and insurance, is progressing, albeit in a slower pace than expected.
The real sector has been tested as well - particularly by increased interest rates and loss of some eastern markets. The adaptability of the real sector has been surprisingly strong. The so called "market-based shock absorber" - wages and labor market flexibility in general - has been proven to be a viable "instrument". Sharply increased FDIs ( around 7-8% of GDP in 1998) have had its endorsing role as well. Among other things, continuing high shares of FDIs reflect the persisted investor confidence in Estonian economy.
The impact of Russian crises, although not over yet, has been overstated by many economists. Rapidly declining exports and widening current account deficit in former eastern-block countries was expected by most of them; however, marginal decline in exports and rapidly improving current account is an actual result in Estonia. Moreover, we expect exports to western markets to grow more than 20% in 1998. It is important to know that all the three Baltic states have managed to bring their exports to Russia down from literally 99.99% to 13-25% over 6-7 years. Therefore, a further decline (from 13% to 5-6% in Estonia) does not have such a devastating effect for countries undergoing an extensive process of reorientation anyway.
Privatization is still the most successful part in the sphere of structural reforms. With ongoing Telecom and energy sector privatization and established procedures for railway concession, the privatization of infrastructural enterprises is coming to an end. The area where the progress is less visible is the pension reform. Although a current pension system does not allow the government to build up contingent liabilities, as all current pensions have to be covered by received contributions, the final introduction of the three pillar pension system has an utmost importance due to aging population. Although there have been deep reforms shaping up two of the pillars, the introduction of the second pillar does not seem to be an issue in this year.
After the Asian, Russian and, lately, Brazilian crisis it is evident that the concept of a TRUELY fixed exchange rate and free capital flows has proved to be a viable policy stance for Estonia. In the light of ongoing discussions about reinventing capital controls we are convinced that with Estonia's currency board arrangement, the absence of capital controls and the existence of a liberal market environment have enhanced the credibility of the country's policy stance and promoted both international trade as well as easier access to capital markets and therefore we do not see any reasons to make changes to our monetary policy framework. The introduction of euro is going to strengthen further our ties with stable monetary environment and in a nearby future the current EEK official link with DEM will be replaced by the link with EURO, making Estonia de facto sharer of many benefits of the euro area. The screening of the chapter of EMU showed that Estonia needs only some minor legal improvements to be fully in compliance with the respective requirements.
Comparing our particular economic framework to different ones around the world, we have become more convinced that for a small country there are no efficient ways to isolate its economy from external shocks other than through keeping the fundamentals strong and the system flexible enough. It has been proved that free capital mobility and fixed exchange rate not just require sound macroeconomic policies and flexibility to be successful in a medium and long run, but they can impose discipline by themselves as well - it's a "two way road". By encouraging more transparent and disciplined fiscal and monetary management, the currency board makes it more likely that the supporting cast of other policies and institutions are also in place.
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