QUARTERLY ECONOMIC POLICY COMMENT BY EESTI PANK

  • The first half-year of 2004 was characterised by strong economic growth. The proportion of export earnings in the growth of economy increased, and the growth of export was distributed more evenly between various components and markets.
  • Accession to the European Union did not lead to a general price increase in Estonia. Neither the consumer prices growth caused by the one-time rise in the price of single goods nor the revived retail sale endangered the general equilibrium of the economy.
  • Due to demand for imports, the current account deficit increased, constituting 14.8% of the GDP. In the case of lasting economic adjustment we may observe decrease in deficit, but this year's deficit is likely to be bigger than forecasted in spring.
  • In the financial sector, strong competition and favourable interests continue to support loan growth, the pace of which is continuously high.
  • The state budget of 2005 fundamentally supports economic equilibrium. Considering this year's supplementary budget, we may observe a continuous growth of expenses increasing the internal demand, the financing of which might become more complicated during the years to come. It has to be taken into account that the current internal demand, which is sustaining the tax yield, might not continue in the same scope it is now.

WORLD ECONOMY

The development of the second quarter's world economy was significantly affected by the sharp rise in oil prices, which retarded the global economic growth and increased inflationary expectations both in the euro area and the USA. The rise in oil prices has affected the growth expectations less in the euro area; according to several forecasts, the euro area growth is expected to be 2% this year. Pressure on the continuation of inflation acceleration can be observed in the next quarter as well, as the retail prices of oil products have not yet equivalently reacted to the rise in oil prices.

Raising of central interest rates has started globally. In the USA, the base interst rates were raised twice during the summer (currently at 1.5%), and at least one more rise is expected at the end of the year. Great Britain has also raised interest rates. In the euro area the base interest rates have remained unchanged, one may expect an increase in interest rates at the beginning of 2005.

ESTONIAN ECONOMY

Economic growth and consumer prices

The 6-per cent economic growth of the second quarter was slower than the 6.8-per cent growth of the previous quarter. The economic growth relies excessively on consumption and investments, which is alarming. During the second half of the year we expect a slight slowdown in the economic growth and stabilization of growth of internal and external demand.

In the second quarter of the current year the annual growth of consumer prices accelerated up to 3.2 per cent. This was mainly due to the one-time price increase, which accompanied the accession to the EU and was caused by the application of customs tariffs and co-ordination of fuel excise duties. In addition, the rapid inflation was sustained by the rise in oil prices on the world market in May and June. We cannot, however, talk about a wider growth of inflationary pressure, as the price increases of other consumer basket components have been modest.

The inflation decrease, which continued in the second half of the summer, confirms that the increase in prices that occurred in spring was a one-time event. According to Estonian Institute of Economic Research, the inflationary expectations of households have significantly decreased compared to the beginning of the year. But the one-time upsurge of May and June means that this year's average increase in prices might be higher than the 2.8 per cent forecasted by Eesti Pank in spring.

Employment and productivity

The growth of employment continued in the second quarter. Compared to the same time last year, approximately 6,000 new jobs (i.e. 1% of employment) were created. At the same time, the growth rate of employment has been retarding for two quarters and is presently lower than that of the previous 4 quarters.

The annual growth of average gross wage did not accelerate significantly in the second quarter, and due to the inflationary acceleration, the growth of real wage slowed down to 4 per cent in the second quarter. This real wage growth can in the long run be considered as supporting the competitiveness of the economy.

Wage growth in small enterprises (up to 50 employees) remained continuously low, constituting 1.9 per cent in the second quarter. Slowdown in nominal wage growth occurred in other private sector enterprises as well. On the other hand, in the case of enterprises owned by the state and local authorities, this year we see no signs of wage growth slowdown; it has remained around 10 per cent.

External demand

Estonian exportation of goods has rapidly accelerated in the first half of this year and the export growth rate has stabilized on a level, which positively contributes to the growth of Estonian economy. This year's export development has also become more balanced by components and various markets. Whereas last year's main factors of export growth were new and non-traditional branches (chemistry, metal), this year's first half displays considerable improvement in the field of traditional branches (wood processing, dairy products).

Internal demand and current account

Although the share of export income increased in the first half of 2004, it was insufficient for balancing the economy. The nominal internal demand growth was twice as fast as the GDP growth in the second quarter. This brought about the reworsening of external balance in the second quarter - up to 14.8% of GDP of four quarters average according to estimates. In large part, such worsening should be temporary and reflect the acquisition of the stock of goods (raw materials, consumer goods and durable goods) prior to the EU accession. Deepening of the goods deficit this time will result in a larger overall annual deficit than expected.

The EU accession brought about significant changes in the foreign trade statistics system and therefore the data on the imports and exports of goods are not comparable to those of previous periods.

Financial Sector

Due to low interest rates and continuously active sales strategy of banks the annual growth of loan and leasing financing has remained high - an average of 27.8% in the second quarter. The share of household loans in the banks' loan portfolio keeps increasing and by the end of the second quarter the household debt burden reached 21% of GDP. Deposits in banks operating in Estonia grew by 0.7 million kroons, causing a worsening loan/deposit ratio, which reached 1.33 by the end of July.

In total, banks earned 1.5 billion kroons of profit on solo basis within the first half of 2004, which exceeds the previous figure more than twice year-on-year. In addition to the maintaining of costs under control, the relatively good quality of assets has contributed to preserving profitability as well.

The capitalisation of banks is at high level thanks to good profit indicators. The total capital adequacy ratio was 12.8% on solo basis at the end of July and 11.4% on consolidated basis at the end of the second quarter. All banks have met the minimum requirements and the inclusion of profits within the own resources on a semi-annual basis should be soon reflected in somewhat higher capital adequacy ratios as well.

Government Sector

55.9% of revenue was collected within seven months, which is 4% less year-on-year. The collection of value-added tax has been the most modest within the last three months. However, central government surplus was over 1.6 billion kroons in July and the government has passed a supplementary budget draft.

Should the relatively fast economic growth continue, the general government budget for 2004 would be almost balanced or display a small surplus. Compared to previous years, this indicates loosening budgetary policy, as the growth of actual funds channelled into internal demand will be larger than provided in the state budget as a result of passing a supplementary budget and several financial transactions. In the light of the previous year's 2.4% surplus, it is difficult to assign value to the 0.3-0.4% suprlus of 2004 from the aspect of economic policy.

In principle, the state budget for 2005 supports economic balance. However, there are signs of continuous increase in costs the financing of which might be aggravated in the coming years. It should be taken into account that the present internal demand, which supports revenues, need not proceed to the current extent. Considering earlier plans, a decision was made to at least partly compensate reduced revenues by raising excise duties on alcohol and tobacco products. In addition to nonbudgetary financing of various investment projects, which is likely to continue, this refers to the fact that earlier cost-cutting plans are not subject to full implementation.

Table 1. Main economic indicators for 2001-2006

  2001 2002 2003 2004* 2005* 2006*
GDP, billion kroons 104.3 116.9 125.8 137.7 151.4 166.9
Real GDP growth (%) 6.4% 7.2% 5.1% 5.5% 5.8% 6.0%
Inflation (%) 5.8% 3.6% 1.3% 2.8% 3.1% 2.9%
Current account balance (% of GDP) -5.6% -11.3% -12.6% -10.2% -9.0% -7.5%
Primary current account (% of GDP) -0.9% -6.6% -6.6% -3.8% -2.8% -1.0%
Real private consumption growth (%) 5.9% 9.9% 5.4% 5.4% 5.2% 5.0%
Real government sector consumption growth (%) 1.8% 5.9% 5.8% 6.5% 3.9% 3.6%
Real investment growth (%) 13.0% 17.2% 5.4% 5.7% 5.2% 6.2%
Real export growth (%) -0.2% 0.6% 6.0% 10.9% 9.9% 8.8%
Real import growth (%) 2.1% 5.4% 9.0% 8.1% 8.1% 6.4%
Employment (thousands) 572.1 579.3 587.9 595.0 598.0 601.0
Growth of value added per worker (%) 5.7% 5.9% 3.6% 4.3% 5.3% 5.5%
Real wage growth (%) 6.9% 7.1% 8.2% 4.1% 5.3% 5.2%
Real money supply growth (%) 15.1% 10.8% 10.2% 10.7% 12.2% 13.9%
Real growth of credit (%) 17.3% 14.3% 27.7% 27.9% 21.7% 16.3%
Gross debt (% of GDP) 55.6% 60.1% 69.1% 72.1% 73.6% 73.9%

* Eesti Pank's spring forecast 2004