QUARTELY ECONOMIC POLICY COMMENT OF EESTI PANK

Postitatud:

21.09.2005

  • Estonia's economic growth in 2005 has been faster than expected, exceeding the medium-term and longer-term potential. Although one of the reasons behind the faster growth lies in vigorous exports, domestic demand still constitutes the main growth component.
  • Despite the rather optimistic prospects regarding the months ahead, the risks to balanced economic growth have increased considerably.
    • Wage growth faster than productivity growth has a negative effect on Estonia's competitiveness.
    • The debt burden of the private sector has increased to 90% of GDP and the fast growth continues.
    • Despite the income tax reform, the share of public sector expenditure in GDP has not decreased.
    • Foreign trade indicators refer to the threat that the improvement of the external balance is about to come to a halt.
  • All the above-mentioned risks additionally increase the pressure of oil prices on inflation, which has decreased slower than expected. From the point of view of meeting the Maastricht inflation criterion and fast adoption of the euro, the situation is considerably more problematic now than it was in spring.
  • As the current fast economic growth is not sustainable in the long term, the state must take economic policy measures to reduce risks to stable economic growth both this and the next year.
  • Economic policy, which would direct Estonia's economic development to a more balanced path, presumes the following:
    • Purposefully planned consolidated budget in surplus. Considering the fast economic growth, the ratio of budget surplus to GDP must be at least equal to the level of 2003;
    • Readiness of the government and Eesti Pank to engage in activities, which would inhibit the too fast growth of the private sector debt burden and foster domestic saving;
    • Responsible wage agreements between employers and employees.
  • Eesti Pank forecasts economic growth of 8% for this year. The economic growth of 2006 will be around 6.5%. Consumer price growth will be 4.2% in 2005. The next year's inflation rate is estimated to be slightly above 3%.

WORLD ECONOMY

In the second quarter of 2005, global economic growth continued to slow down, while rather abruptly in the euro area.

Global economic activity and inflation are still affected by the continued surge in oil prices, which does not, however, yet reflect in the overall inflation. In August, the oil price hike broke several records, reaching USD 67.29 per barrel (WTI, August 25). The sustained extensive demand, as well as the start of the storm season in the Gulf of Mexico also contributed to the price growth.

ESTONIAN ECONOMY

Economic growth and consumer prices

The first half-year of 2005 witnessed a faster-than-expected GDP growth. In addition to the vigorous increase in exports, domestic demand, especially private consumption also accelerated year-on-year. This resulted in a more than 8% annual GDP growth.

Inflation in July and August was faster than expected. Due to the rising oil prices, the overall consumer price growth accelerated to 3.8% in July and exceeded 4% in August. Although the approximately 2 pp difference with the euro area inflation might be considered a normal indicator reflecting the harmonisation of Estonia's price level in the long term, it is undesirably high as regards meeting the inflation criterion.

Due to the continuous appreciation in oil prices and stronger domestic pressures, interest rates are declining slower than expected. Accelerating wage growth also has a role to play here.

Employment and productivity

The employment growth rate reached 2.3% in the second quarter of 2005. Based on the data provided by the Statistical Office, this was partly due to seasonal jobs, especially in the services sector.

It can be said that in the first half-year, mainly non-tradable sector contributed to creation of employment. As productivity growth prospects are smaller in the services sector, the share of labour costs in GDP increased. If this tendency continues, price pressures will increase in the long term.

The unemployment rate reached record low (8.1%) in the second quarter of 2005. This was due to the decrease in the numbers of both short-term and long-term unemployed. Insufficient additional labour supply may prove to be a bottleneck setting limitations to Estonia's long-term economic growth.

In the current situation, it is advisable to avoid taking measures, which would reduce the labour market flexibility, be it then either a fast rise in the minimum wage or any other similar step.

External demand and current account

The growth in domestic demand in the first half-year of 2004 (prior to the accession to the EU) led to a temporary setback in the external balance intensified by stocking up due to uncertainty and modest saving. Both export income and private sector savings started taking up speed in the second half of 2004.

According to preliminary estimates, the current account deficit of the first half-year of 2005 was smaller than at the same time last year. In addition to exports of goods, domestic demand has also increased year-on-year, and thus it is likely that the second quarter of 2005 witnessed a halt in the improvement of the external balance.

Domestic demand

Although the second quarter of 2004 witnessed exceptional stocking up and investment activity was also high, domestic demand growth in 2004 was still slower than expected. Domestic demand and especially private consumption picked up speed again at the beginning of this year. Based on foreign trade data, this trend seems to have continued in the second quarter of 2005, while it is possible that the private consumption growth even accelerated.

Financial sector

The monetary policy environment has remained stable - the monetary policy interest rates in the euro area have stayed on the level specified in June 2003.

Favourable interest rate environment and tight competition between banks for market shares has resulted in historically low interest rates for the Estonian consumer and in simpler credit conditions of banks. As a result, the number of housing loans has increased again and real estate prices continue to grow. Moreover, the fast appreciation of real estate has spread beyond Tallinn. At the same time, most of the transactions and real estate developments still take place in and near Tallinn, wherefore these are the areas characterised by accumulation of risks.

As a result of active lending activity, banks earned 1.8 billion kroons in profits in the first half of 2005, which is 18.2% more than a year ago.

Economic policy

Estonia's accession to the EU led to close integration of Estonian goods and financial markets with the rest of the world, and this continued in the first half of 2005 as well. Market participants expect further integration, and primarily, the fast adoption of the euro by Estonia, even though meeting the inflation criterion and the fast changeover are much more problematic now than before the summer vacations, as the last months' developments provide no reasons to expect the consumer prices to decline below 3%.

The continuance of strong economic growth and the credibility of Estonia's economic policy have been greatly relying on maintaining the revenue and expenditure balance of the general government, and improving of the external balance has been heavily supported by fiscal policy. For instance, in 2003, the general government budget surplus amounted to approximately 2% of GDP. As forecasts predict the fast economic growth to continue in the future, the 2006 budget should be in a definite surplus.

The spring forecast in the light of recent developments

Taking into consideration recent developments, it can be concluded that inflation will be faster than predicted in spring 2005. At the same time, the revised statistics of previous years and the flash economic estimate allow for upward adjustments in the economic growth projection.

The main reason behind the accelerating inflation lies in the hike of oil prices. If the high level of oil prices should last, the next year's inflation forecast may also prove to have been underestimated. For the time being, we can expect the consumer price growth to be 4.2% this year and slightly above 3% next year, depending on the level of stabilisation of the oil prices.

Estonian economy has, despite weak external environment, been able to vigorously increase the volume of exports. Together with the accelerating growth in domestic demand, this allows to forecast an approximately 8% economic growth for this year. Next year the growth rate is expected to slow down and remain around 6.5%.

At the same time, it should be added that the fast increase in domestic demand constitutes a threat to the further improvement of the external balance. The increasing share of labour costs in GDP, as well as the rising oil prices and second-round effects endanger the inflation forecast. The new economic forecast by Eesti Pank will be published in November.