QUARTERLY ECONOMIC POLICY COMMENT BY EESTI PANK
Although in spring analysts assumed the enlivenment of the world economy at an accelerating rate throughout the year, the expected recovery of investments and private consumption has not taken place yet neither in Europe nor in the USA.
The price pressure is still low in most major economies and the inflation rate is under control. In the euro area, the price increase fell below the 2% target of European Central Bank in the summer months and in the USA the inflation was even lower. This allows central banks to keep base interest rates at the lowest level of recent years in the coming months and to stimulate economic growth through cheap credits.
The growth rate of 6.5% of the Estonian GDP in the second quarter indicates that the small and open Estonian economy has achieved higher than expected growth supported by foreign credit flows. The growth of the Estonian GDP exceeded that of the euro area by six percentage points in the second quarter.
Still, the growth of export volumes has been smaller than in previous years due to the weak economic situation of Estonia's major trade partners.
The investment activity of the first half-year is supported by the interest rates that - were (and still are) on the lowest level of all times, the growing capital expenditure of the government sector and implementation of major infrastructure projects aimed at, in the Estonian context, long-term developments.
With external price pressures decreasing, the difference of the inflation rates in Estonia and the euro area corresponds broadly to the assumptions of the forecast. 2.6% price increase in August is assumed to be the lowest this year and the annual inflation is expected to reach approximately 4%. The realisation of such a development is supported by the European Central Bank's estimate about the stabilisation of the euro area inflation around 2%.
In the first quarter the nominal growth rate of the goods export (excluding subcontracting) amounted to 7% and in the second quarter the growth rate accelerated to 13%, remaining below the corresponding rates of the last year. The growth of the services export was also slower than in the previous years.
Slight acceleration occurred in the growth of direct export of goods and services, but further rapid growth in external demand did not materialise.
Domestic Demand and Current Account
The rise in domestic demand that exceeds considerably the growth of export income has led to the increase of the current account deficit. It has to be noted that instead of the expected 90% direct investments cover only 50-60% of the current account deficit at the moment. This has increased the gross and net indebtedness of the Estonian economy by some percentage points.
Eesti Pank did not expect the financing of economic growth from earlier reserves and foreign credits to such an extent. Contrary to expectations, the external monetary policy environment has not toughened and domestic saving has even decreased year-on-year instead of the predicted increase.
In the second quarter, the development of the financial sector was mostly influenced by the low interest rates and the resulting high credit demand of the real sector, which can be seen in the remarkably high growth of the banks' loan and leasing portfolios. At the same time the stock market suffered from the negative mood of world markets.
Loans to households increased most rapidly, growing from 8.2% of the GDP to 10.5%. At the same time, the growth of savings has been considerably slower and since the third quarter of 2001 households have borrowed more than saved. Investments into real estate development have increased as well and sometimes on the account of the companies' main fields of activity. This has put pressure on the prices of business land and the anticipated rate of return might not meet the expectations.
The capitalisation of banks remains strong and the liquidity buffer stays on an adequate level.
The economic environment has been more favourable than expected for revenue collection and the budget surplus achieved in the first half of the year had a small positive impact on the external balance. Preparation of the second supplementary budget indicates that the fiscal policy is not oriented on sparing in the coming months. Therefore, the private sector should help to improve the external balance through increased saving.
Delayed recovery process of the world economy and large fluctuations of the international financial markets in the summer months have forced analysts to make corrections in international forecasts. Thus, the average economic growth of the euro area was downgraded to 1.1% in 2002 and to 2.5% in 2003, which is 0.2-0.3 percentage points below the spring forecasts. Downgrading has been even bigger for the US economy. Despite considerable cuts in the prospects of the recovery of global economic growth, most forecasts have still not abandoned the growth scenario of the second half-year.
Proceeding from the above, there are grounds to expect the acceleration of Estonia's export growth, although the weakness of external demand makes the extent of the growth rather uncertain. The growth is more likely to occur in the export of goods rather than the export of services. In order to secure Estonia's reliability and balanced development, a slowdown of the growth in investments and loans is advisable. Domestic saving has to be increased in 2002-2003, with fiscal policy playing a major role in it.
Supporting Economic Balance
Estonia's economic development in recent quarters indicates certain risks that can inhibit economic sustainability. In the interests of the Estonian economy it is necessary to curb the rate of borrowing and increase domestic saving. Having consulted with the government and market participants, Eesti Pank has decided to take pre-emptive measures to support smoother balancing of the Estonian economy. The first steps to be taken include:
1. Withdrawal of the government sector deposits from commercial banks under an agreement with the Ministry of Finance. Up to 1 billion kroons worth of government funds are to be temporarily and at market terms deposited at the Eesti Pank.
2. Proposals on tightening of the credit terms of commercial banks are being worked out in cooperation with the Financial Supervision Authority.
Eesti Pank is going to watch the broader economic situation closely in the coming months and, if necessary, will consider further measures on supporting economic balance.
The steps mentioned above are aimed at reducing the impacts from expansive monetary policy environment and signalling the need to bring credit growth into line with current economic developments.
Table 1. Estonia's major economic indicators 1995-2001*
1995 1996 1997 1998 1999 2000 2001 1st half
Real growth of GDP (%) 4.3 3.9 10.6 4.7 -1.1 6.4 5.3 4.9 Growth of special export (%) 21.6 11.8 48.8 18.8 -2.1 50.9 3.6 -14.2 Growth of special import (%) 36.4 26.4 41 13 -8.5 43.1 4.1 -4.1 Current account balance (% of GDP) -4.4 -9.2 -12.2 -9.2 -5.8 -7.5 -6.7 -11.7 General government budget balance (% of GDP) -1.2 -1.5 2.2 -0.3 -4.6 -0.7 0.4 2.1 12month consumer price index (%) 29 23.1 11.2 8.2 3.3 4 5.8 4.2 12month export price index (%) 15.2 11.4 7.5 2.1 0 7.8 32.9 8 Consolidated balance sheet of commercial banks (% of GDP) 38.1 43.7 63.1 55.9 62.5 68.7 71.6 74.2 Share of foreign ownership in banking sector (% of share capital) 29 33.4 44.2 60.7 61.6 83.6 85.4 86.3 Capital adequacy of banks (%) 13.7 12.1 13.5 17 16.2 13.2 14.4 14.7 Change of Talse (%) 60.3 65.6 -65.8 38.3 10.1 4.7 6.6 Consolidated loan portfolio of banks (% of GDP) 25.3 27.5 30.3 30.7 33.4 40.7 42.6 45.1 M2 (% of GDP) 25.3 26.9 30.4 28.3 33.9 37.5 41.9 42.5 2month Talibor (%) 7.9 15.7 18.1 5.1 6.1 3.9 3.8
*I half-year of 2002 - preliminary estimate