QUARTERLY ECONOMIC POLICY COMMENT BY EESTI PANK
- Regardless of global uncertainties, economic growth in Estonia was strong in 2002 - estimated by the Statistical Office of Estonia to be at 5.6%.
- Setbacks of export markets were smaller than expected and increase of export to some European markets has to be considered remarkable.
- Economical environment including strengthening of euro has kept inflation low.
- Current account deficit amounts to 11%, being the most serious threat to economic balance.
- Regardless of certain stabilisation, loan demand remains high and banks continue external financing.
- The state budget has had a weighty role in balancing the economy; this year new costly long-term liabilities have to be avoided.
- Restoration of world economic growth may be further delayed.
- The settlement of the Iraq conflict need not bring the expected economic recovery.
- The danger of negative impacts on Estonian export is not over yet.
- New government should retain the labour market flexibility and budget balance; to control the inflation internal price pressures have to be avoided.
The growth outlook of world economy has not improved considerably over the past three months. Political tensions keep major stock, raw materials and bond markets under pressure and the US dollar continues to weaken against the euro. According to forecasts, economic recovery will be relatively slow in 2003 and the growth potential is expected to be achieved only during the year 2004.
In order to stimulate economic growth, central banks continue maintaining low interest rate levels and cutting rates. In December, the European Central Bank lowered base rates by 0.5 percentage points and financial markets expect further cuts in euro area interest rates due to the low economic growth and euro-dollar exchange rate. In the first half of 2003, 0.5 percentage point cut in the euro area interest rates is expected, plus an additional 0.25 percentage points cut in the second half of the year.
Despite external pressures, Estonian economic growth was good in the fourth quarter of 2002 (5.2%) and for the whole year (5.6%). Regardless of the fact that the GDP growth difference between Estonia and the euro area decreased in the fourth quarter, due to strong domestic demand Estonian economy continued to grow considerably faster than that of the euro area at the end of last year.
Consumer prices remain low due to modest domestic and external price pressure and the strengthening of the euro, which meant smaller than predicted increase in the prices of imported goods in Estonia. As a result, the gap between the Estonian and euro area CPI was the narrowest of all times in December 2002, at 0.4 percentage points. In January 2003 inflation fell to 2.6%, but by early summer the latest price pressures are expected to increase.
The overall increase of employment (+1.4% against 2001) continued last year, being mostly based on strong domestic demand. The decrease of employment and increase of unemployment in the final months of 2002 mainly indicates the seasonal drop in the number of service sector jobs. In the coming months, demand for jobs will mostly depend on the development of the export sector. Although the labour market remained strong last year, in future the preservation of the labour market flexibility will be in the centre of attention, in order to avoid inflationary pressure from wages and guarantee competitiveness of the Estonian economy. The fourth quarter 10.8% wage increase corresponded to productivity developments and has not given rise to additional price pressures.
Considering the structure of Estonia's export markets and goods, the dependency of Estonian export on the global weakening of the external environment is smaller than might have been expected from the growth rate of the world economy. However, the import demand of Estonia's major export markets is still low and in the fourth quarter the annual growth of direct export slowed down to 8.5%.
Timber industry (annual growth 13%) accounted for nearly one third of the total annual growth of direct export; the rapid increase of furniture export (up 16%) that characterised the year 2001 continued also in 2002. The growth of food and textile industry export volumes remained modest. Across countries, direct export increased the most to the United Kingdom (19.3%), Lithuania and Denmark, although Finland (17%), Sweden and Latvia remained Estonia's largest export partners. Total export increased by 11% in 2002 and industrial production was up 7.5%. Despite of modest external demand the export of food products may expand in the EU countries.
Domestic Demand and Current Account
The increase of domestic demand slowed down considerably in the fourth quarter, but the still high share of investments may have exceeded the 30% level against the GDP. However, confidence of businesses in domestic as well as external demand decreased slightly in the fourth quarter.
Private consumption remained high in the fourth quarter. It has been stimulated by the high loan demand due to low interest rates, strength of the labour market and confidence of private individuals regardless of external developments. Although the strengthening of the euro can have a negative effect on some industries, the low and probably decreasing interest rate environment will continue to encourage loan supply in 2003 as well.
The deficit of saving/investment remained an acute problem at the end of last year. Besides high investment activity, the deficit was deepened by the fall in saving interests of Estonian private persons. The current account deficit of 2002 is estimated at over 11% of the GDP.
Preliminary data for the fourth quarter indicate that direct investment still accounted for less than 50% of the total capital inflow, which denotes a structural change in current account deficit financing. The above is a sign of continuing debt capital inflow in which credit institutions play a major role.
In the fourth quarter, banking was still influenced by the favourable interest rate environment and persistently high loan demand. The annual growth of the real sector debt burden stood at 25.2% at the end of January, maintaining the growth rate of previous months. In the conditions of rapid growth of loans the banks have maintained good loan quality, high capitalisation and profitability.
Deposits of businesses and private persons have increased at a slower rate than lending, which means that foreign borrowing will continue in order to finance the gap between private sector savings and loans. By January, bank loans exceeded deposits by 5%, although the combined loan portfolio of leasing companies and banks exceeded domestic deposits by 14% at the end of 2002. The inflow of foreign capital through banks amounted to nearly two billion kroons in the second half of 2002, or approximately 7% of the expected quarterly GDP.
The quality of the loan portfolio has remained relatively high - loans overdue more than 60 days accounted for 1.7% of the total loan portfolio at the end of January. Across sectors, overdue loans increased the most in trade (up 0.3% in the fourth quarter). In January, overdue loans increased slightly in commercial real estate (+0.4%) and consumption loans (+0.35%). In other sectors the quality of loans improved as compared to the third quarter.
Like in 2001, the general government budget had a surplus in 2002 - 1.2% of the GDP, based mostly on better tax collection. The state budget played an important role in balancing the economy. Like in 2002, the 2003 increase of budget expenditure can be seen as supportive of economic balance. However new costly long-term liabilities, which may deteriorate the budget balance, have to be avoided.
Since regaining the independence in 1991 all Estonian governments have supported stable and innovative economic policy, and it will be the case also for the government. New government should retain the labour market flexibility and budget balance; to control the inflation internal price pressures have to be avoided.
Table 1. Main economic indicators 1999-2003
1999 2000 2001 2002* 2003* GDP, billion kroons 76.3 87.2 96.6 106.3 115.6 GDP real growth (%) -0.6% 7.1% 5.0% 5.6% 5.0% Inflation (%) 3.3% 4.0% 5.8% 3.6% 3.3% Current account (% of GDP) -4.7% -5.8% -6.1% -11.1% -9.4% Income balance/GDP (%) -2.0% -4.0% -5.1% -5.5% -5.2% Trade and services balance/GDP (%) -4.9% -4.1% -3.8% -8.1% -6.7% Private consumption real growth (%) -2.7% 6.7% 4.8% 6.7% 4.4% Exports real growth (%) 0.5% 28.6% -0.2% 5.4% 15.1% Imports real growth (%) -5.4% 27.9% 2.1% 8.0% 12.4% Saving/GDP (%) 19.8% 22.0% 21.6% 19.2% 20.8% Investments/GDP (%) 24.5% 27.8% 27.7% 30.3% 30.2%
* - estimation
** - forecast