• Eesti Pank forecasts economic growth for 2005 to be 5.7 per cent, and in the next two years, feasible economic growth of 6 per cent should persist.
• Rising fuel prices and economic policy decisions made in the recent past will push the average consumer price growth in 2005 to 3.4 per cent. As of May 2005, the growth rate of consumer prices is expected to fall, and the average inflation rate for the next two years is going to be 2.7 per cent.
• Additional increases in oil prices in the world market, which might have an impeding effect on economic growth, constitute the greatest external risk to Estonia's price stability.
• The developments of the previous nine months indicate improved consistency between domestic consumption and exports. If this tendency continues, a moderate improvement of the external balance during the entire forecast period will occur.
• Due to the postponed rise in interest rates, there is a growing risk that banks are underestimating the credit risk accompanying lending, and borrowers are overestimating their ability to fulfil their growing financial liabilities in the future.
• As regards external balance, abandoning budgetary balance would be a great risk. In order to maintain the credibility of Estonia's economic policy, a reduction in the income tax should be accompanied by a decrease in the growth rate of the general government's consumption expenditure.
• Proceeding with a sustainable fiscal policy is especially important due to the transition to the euro, which is planned to take place in 2007. Adoption of the euro will increase the credibility of Estonia's economy.

WORLD ECONOMY

The world economy is performing considerably well so far during the forecast period. Oil prices constitute the biggest source of uncertainty. The economic growth of the euro area is expected to rise in the near future, although growth is presently impeded by weak domestic demand and a strengthened currency. Private consumption and investment activity are still expected to gradually activate during the year, but due to the strengthening of the euro, overall economic growth is going to be less export-oriented, therefore remaining below the potential level.

The business cycle of the Nordic countries is in a somewhat more favourable position than the euro area, as both Finland and Sweden are more tied to the USA via the technological sector. However, economic growth is expected to fall slightly in Scandinavia as well. Due to the declining demand for imports, the economic growth of several of the new Member States of the EU is also expected to slacken in 2005.

ESTONIAN ECONOMY

Economic growth and consumer prices

Estonia's dynamic economic growth is going to continue on the strength of the Scandinavian growth cycle throughout the entire forecasting period. The slight slowdown of this year, characterised by 5.7 per cent economic growth, will be followed by a rise to slightly above 6 per cent in the following two years. At the same time, economic growth is based on external demand more than ever.

Consumer prices are predicted to rise to 3.4 per cent in 2005. This is not being caused by domestic demand pressures, but by economic policy decisions taken in the recent past, as well as by the rise in fuel prices in the global market. During the following two years, the appreciation of consumer prices will drop to 2 per cent. This year's inflation of consumer prices is being affected mainly by the rise in electricity prices, which increased the price level by slightly less than 0.5 percentage points.

Employment and productivity

The modest growth of employment, which was characteristic of 2004, is going to continue in the next couple of years. The growth of employment in the tradable and export sector is a positive trend. The creation of new jobs is supported by capital inflow via structural funds and the decline in the tax burden of the labour force. Unemployment is expected to decrease in a stable manner during the forecast period, falling to 9.4 per cent in 2007.

At the same time, a big discrepancy exists between the number of vacant positions and the skills of the unemployed. The supply-side constraints of the labour market might worsen the economic growth potential over the longer term.

If the developments, which started in 2004 continue, it can be predicted that the growth in productivity over the next couple of years is going to be stably faster than the growth in real wages. Disposable income will increase faster than growth in wages due to tax rebates.

External demand and current account

Notwithstanding the weakness of the euro area, Estonia's exports and foreign trade balance have improved considerably at the beginning of the year. Total exports are increasing mainly on the strength of a stronger technological sector, but food has also contributed remarkably to the growth of exports, especially in the form of dairy and meat products. During the forecast period, exports will increase by 10 per cent a year on average. This will be supported by a more open economy and better utilisation of capacity. The growth of imports is going to be weaker this year due to a slowdown in the growth of domestic demand, reaching 6.3% and rising with the growth of domestic demand in the following two years to 8.5% and 9.3% respectively.

Good exports prospects and the slower growth of domestic demand will improve Estonia's external balance, which is going to continue on the strength of increasing net imports in the next years as well.

Domestic demand

The strengthening foreign trade balance, decrease in the real growth of retail sales, and a faster growth rate of deposits indicate a relative slowdown in the growth of domestic demand this year. The social policy measures to be realised in 2006 together with the gradual recovery of the growth in gross wages cause the real private consumption growth rate to be much faster than the growth of GDP. Consequently, the precondition for achieving budgetary balance is a slower growth of general government spending.

Financial Sector

Rising interest rates in the developed countries have caused an outflow of funds from the Central and Easter European financial markets. As the Estonian banking sector utilises foreign capital mainly via Scandinavian parent banks, we do not expect supply-side constraints, and credit growth is still determined by demand-side factors.

According to the forecast, the banking sector is going to need 15 billion kroons in 2005 and 11 billion kroons in the following two years to finance the gap between the money supply and the demand for credit (in 2004, the banking sector in Estonia used 14 billion kroons worth of foreign capital as a net amount, and in 2003 11 billion kroons).

The postponed rise in interest rates and growth in wages accompanying economic growth, as well as the aggressive marketing tactics and heavy competition of banks, have maintained loan growth at a high level. If this tendency continues, there is a growing risk that banks will underestimate the credit risk that accompanies lending, and borrowers overestimate their ability to fulfil their growing financial liabilities in the future.

Thanks to the strong capitalisation and high profitability of banks, the strong growth of loans does not endanger the banking sector's stability but causes Estonia's economic growth as a whole to depend more than before on changes in loan interest rates. The conception that the increase in wages is going to continue at the same pace and that interest rates are going to remain at the same level as today is misleading. Therefore, it is of great importance that borrowers properly evaluate the risks that accompany borrowing. The best way to hedge the risks accompanying borrowing is to create a capital buffer through regular saving.

In 2004, as a result of active lending activity, banks earned the highest profit as a consolidation group - 3.7 billion kroons - which is a billion more year-on-year. As regards financial stability, it is important that banks refrained from rushing to pay the high profit as dividends, but utilised the funds in their capital buffers. Capital buffers will come in handy when servicing loans under the circumstances of slower economic growth becomes problematic. The financial sector does not expect the emergence of any important supply-sided constraints during the next few years, thus loan growth is likely to persist.

Economic policy

The year 2004 witnessed a historic event - Estonia's accession to the European Union. As expected, joining the EU entailed intensive integration of Estonia's product and financial markets with the rest of the world. Market participants expect the integration to continue, as well as the quick adoption of the euro by Estonia.

The continuation of strong economic growth and the credibility of Estonia's economic policy have been relying greatly on maintaining the revenue and expenditure balance of the general government, while the improvement of the external balance has been heavily supported by budgetary policy. The reduction of the tax burden has enabled an increase in investment in the private sector, thus contributing to the maintainance of rapid economic growth. The general government budget has maintained a surplus, as reducing the tax burden has helped curtail the ratio of general government consumption, i.e. wages and running operation and maintenance costs of administrative agencies to GDP.

The coalition agreement entails the message that the government wishes to reduce the income tax rate, raise pensions, increase child and family benefits, and at the same time, maintain budgetary balance. In order to implement these social policy initiatives and maintain budgetary balance, the government has to constrain the growth of consumption expenditure considerably in the next two years. In so doing the social expenditure planned by the new government will not force an expansion of domestic demand, as government consumption will be replaced by private consumption.

The change in the government's tax policy, i.e. the slowdown of the income tax reform, is going to generate additional receipts ca 0.5% of GDP in the next two years compared to the original plan. However, this is not sufficient to cover the increase in pension and other social expenditure, and the government needs to find other solutions to reduce the growth of expenditure. If the current revenue and expenditure are imbalanced, and the growth of social expenditure is financed, for example, from the stabilisation reserve or by issuing bonds, then we will be dealing with a budgetary deficit, which will have a remarkably worse impact on the economy.

Proceeding with a sustainable fiscal policy is especially important due to the transition to the euro, which is planned to take place in 2007. Adoption of the euro will increase the credibility of Estonia's economy.

Forecast by main economic indicators

* forecast