• Global economic growth increased in the third quarter, and owing to a fall in oil prices, inflation has somewhat decreased during the past few months. The European Central Bank decided to change its key interest rates for the first time in 2.5 years.
• According to estimates, Estonia's third-quarter economic growth reached 10.8%, which considerably exceeds the estimated growth potential of close to 7%. Inflation, which fell to 3.9% in November, is showing signs of further decline.
• The unemployment rate has fallen to 7%, its lowest level since 1993.
• The estimated current account deficit is around 10% of expected GDP. The external trade balance is, on the one hand, affected by the rapid growth in exports and, on the other hand, by the increased importation of capital goods, which was reflected in high investment activity.
• The current financial stability situation can be considered positive, whereas the growth rate of housing loans reached its historic peak by autumn (57% annual growth).
• The annual growth of real estate prices rose to approximately 30% in the third quarter of 2005, and this trend has been even more intensified by the developments of recent months. Taking into consideration the rapid price growth of the housing market and the fact that banks have started to base their decisions to grant credit on collateral rather than on a customer's ability to service loans, Eesti Pank has decided to tighten banking regulation related to housing loans. As a result, banks have to increase the share of their own funds in the loans they grant.

GLOBAL ECONOMY

Global economic growth increased slightly in the third quarter, putting an end to the recession that had started in the second half of 2004. The economic growth of the euro area has also recovered in the second half of this year, and is expected to gain in strength from the end of 2005 onwards. As the current economic forecasts for the next year are predecting considerably faster economic growth of our main economic partners in the Baltic Sea region, it can be predicted that the external environment will remain relatively favourable for Estonia.

The fall in oil prices over the past few months has been reflected in the inflation indicators of the world's major economies. The annual growth rate of consumer prices, which reached a record high in September, was lower in October both in the US (4.3%) and in the euro area (2.5%). Although the fluctuation of oil prices has revealed itself in recent months' inflation indicators of the EU Member States, the high oil prices have not yet had a considerable impact either on the general price level or on core inflation.

On 1 December the European Central Bank (ECB) decided to raise key interest rates, which had remained at 2% for two and a half years, by 25 basis points to 2.25%. The decision was based on the rapid increase in credit, money supply, and consumer prices. According to current data, financial markets expect the ECB interest rates to increase by an additional 50 basis points in 2006.

ESTONIA'S ECONOMY

Economic growth and consumer prices

According to preliminary data, rapid economic growth continued in the third quarter of 2005. GDP growth, which was 8.5% in the first half of 2005, grew in the third quarter and reached, according to preliminary estimates, 10.8%. Compared to the euro area, Estonia's third-quarter economic growth was 9.3 percentage points greater, which means that the prompt convergence of Estonia's economy to the EU average level continued abated.

The annual consumer price growth rose to 4.9% in September, but dropped to 3.9% by November. The fickle and difficult-to-forecast oil prices have been the main factor influencing inflation in Estonia. Considering the current level of fuel prices and presuming these will not grow, inflation can be expected to remain below 4% in December. Since the government is planning to raise several administratively determined prices, including that of thermal energy, inflation may temporarily pick up speed in January. Regarding 2006, Eesti Pank still predicts a slowdown in price hikes, and the inflation rate is expected to fall to 3.4%.

Employment and productivity

The unemployment rate fell to 7% in the third quarter of 2005, its lowest level since 1993. In the first quarter, the same indicator was as high as 9.5%. Employment growth increased to 2.5% in the third quarter and was especially vigorous in the construction sector, as well as in the real estate, renting and other business services sectors, which is a development well anticipated against the background of the flourishing real estate market. Employment continued to grow in the field of hotels and restaurants as well.
Based on the GDP flash estimate, the real labour productivity growth of the third quarter remained in line with the 6.3% increase in real wages.

External demand, domestic demand and current account

The rapid increase in Estonia's exports of goods continued. The third-quarter growth rate of goods exports fell to 26.9% (from 31.2% of the previous quarter), but remained robust compared to the import growth of our main economic partners. In addition, as the demand for imported goods did not improve as much in other countries, the strengthening of the market position of Estonian enterprises in foreign markets continued.

Both consumption fostered by rapidly increasing income, as well as investment in a broader sense contributed to domestic demand growth in the third quarter. After an almost year-long decline, the importation of capital goods increased by 30% in the third quarter and, according to estimates, the share of investment in GDP exceeded 32%. A major share of the investment can be associated with the real estate sector, which is still being stimulated by low interest rates, the improving availability of bank loans, and a pick-up in income growth.

The third-quarter current account deficit remained at the same level as in the second quarter (9.9% of expected GDP), and the annual deficit is forecasted to be around 10% of the expected GDP.

General government

The faster-than-predicted economic growth led to continuous extra tax revenue. By the end-of October, the state budget had received 81.2% of the expected annual revenues (78% at the same time last year). In September, the surplus, calculated on a cash basis, constituted 4 billion kroons. By the end of the year, the Government expects a surplus of around 2.5% of GDP. Considering the dynamic economic growth, this surplus is more than welcome from the point of view of stable economic development. Thus, such an economic policy should be maintained.

Financial sector

The current financial stability situation can be considered positive, but the accumulation of loan-related risks leaves Estonia's economy increasingly vulnerable in the future. The optimistic outlook triggered by the rapid economic growth of recent years has contributed greatly to the expansion of the loan market, which is increasing the possibility that the financial sector has overestimated the customers' ability to service loans and underestimated the concurrent risks associated with that.

The growth of housing loans increased in the second quarter of this year, reaching a historically high rate of 57% by autumn. Although the robust increase in housing loans is natural in the context of the current economic situation since it reflects the optimistic outlook of Estonian residents, the present growth rate greatly exceeds the level characteristic of stable economic development. This is why it is important to ensure economic policy conditions that will help preserve stable economic development and further increase in income even when the growth in the volume of loans slows in the years to come.

In recent years real estate prices have increased by over 20% - twice faster than the growth in income. The third quarter of this year witnessed an even greater increase in real estate prices, where the annual growth rate has reached approximately 30%. The overpriced housing market contains numerous risks, especially as banks have started to base their decisions on granting loans on collateral rather than on the loan servicing ability of the customer.
Estonia lacks experience regarding the actual reaction of borrowers to a possible deterioration of the economic situation and rising interest rates, especially regarding the modest savings of borrowers compared to the relatively extensive financial liabilities they have assumed.

Taking into consideration the aforementioned points, Eesti Pank has decided to tighten banking regulation related to housing loans:

•       By increasing the risk weighting of housing loans from 50% to 100% in the capital adequacy calculation, i.e. banks will have to increase the share of their own funds as regards the funding of housing loans;
• In order to ensure a level playing field, the supervisors/regulators of branches of foreign banks and parent banks of subsidiaries of foreign banks will be asked to implement, if possible, a 100% risk weighting on housing loans granted to Estonian residents when calculating the capital adequacy ratio;
• By including 50% of the housing loans portfolio to the reserve requirement calculation base should a bank apply a lower risk weighting to the loans it issues rather than that established by Eesti Pank.

In addition, Eesti Pank has decided to make a proposal to the Government regarding a considerable decrease in or even abolition of the deduction of interest payments of housing loans from taxable income. The income tax incentive that is valid for housing loans decreases the actual interest rate level of such loans to a level lower than the interest rates of time deposits, thus misleading the borrower regarding the related risks.

Estonian economic indicators

Economic forecast by main indicators

Difference        
(autumn 2005-      
spring 2005)       

* forecast