QUARTERLY ECONOMIC POLICY COMMENT OF EESTI PANK

  • 2005 was characterised by rapid economic growth, positive labour market developments, which exceeded expectations, and the stronger confidence of both companies and private individuals in the future. The robust economic growth of the second half of the year was supported by a rise in exports, as well as the development of the real estate sector. The preliminary average data from the beginning of 2006 refers to the continually rapid rise in industrial production and exports.
  • The average consumer price index grew 4.1 per cent in 2005. The beginning of 2006 saw an expected increase in inflation, which reached 4.6 per cent. This complicates the meeting of the inflation criterion necessary for the adoption of the euro.
  • The robust economic growth led to the rapid growth of government income, allowing several tax revenue sources to exceed the forecasted level. The fiscal surplus of 2005 remained at the same level year-on-year, constituting nearly 1.8 per cent of GDP. Taking into account the accelerating economic growth, the surplus should have been considerably more substantial than in previous years.
  • Banks' assets increased mainly on account of household real estate loans. Housing loans made up approximately a third of banks' assets at the end of 2005. As euro area interest rates rose, so too did the interest rates of household loans, which were approximately 0.5 pp higher in February 2006 (3.7 per cent) compared to October 2005.
  • It is important to ensure that the development of Estonia's economic environment will make meeting the Maastricht inflation criterion occur as soon as possible and help reduce the risk of economic overheating in order to inhibit wage growth pressures and slow the rise in real estate prices, which are already too high.

GLOBAL ECONOMY

Euro area interest rates started to rise
The 2005 economic growth of the USA and the euro area, which amounted to 3.1% and 1.7%, respectively, did not meet expectations. As a result of the surge in oil prices, inflation rose to 4% in the USA and 2.4% in the euro area. The euro area's economic recovery and the rise in inflation brought about the need to increase the ECB key interest rates. The interest rates, which were raised in December 2005 and March 2006, rose by a total of 0.5 pp, but the euro area interest rate level is still conducive to economic activity.

ESTONIA'S ECONOMY

Strong exports facilitated economic growth
Estonia's economic growth reached 9.5% in 2005, owing to the accelerated economic growth of our main exports partners, Finland and Sweden, as well as to the continually vigorous domestic demand.

In 2005, the average inflation rate was 4.1%, which was in accordance with the autumn forecast of Eesti Pank. The beginning of 2006 saw an expected increase in inflation, which reached 4.6 per cent. This complicates meeting the inflation criterion necessary for the adoption of the euro. The cost of the consumer basket was most affected by the prices of housing-related services: for example, the price of water, sewerage services, and thermal energy increased 8.7% compared with January 2005. Transportation costs increased approximately 11% as a result of the surge in fuel pieces. A slowing of the growth of prices cannot be expected to happen before summer. The main risk areas of inflation comprise the prices of fuel, gas, and thermal energy.

Unemployment rate is the lowest since 1995
Labour market indicators improved mainly as a result of the creation of new jobs in the trading and real estate sectors. Unemployment constituted 7.9% in 2005 (the number of unemployed was 46,500) and employment grew 2%. Labour costs rose in accordance with the growth in productivity.

Current account deficit decreased only slightly
Supported by favourable export possibilities, the Estonia's exports trade has continued its robust growth. Goods exports accelerated to 32%[1]. Estonia's exports are growing faster than the imports of our main trading partners, which means our prospects in the target markets are improving.

As a result of income growth, the disposable income of households increased considerably faster than private consumption. Nevertheless, the growth in domestic demand was too rapid, and the current account deficit decreased only slightly. As imports surpassed exports, the foreign trade balance continued to deteriorate (by approximately 711 million kroons). The current account deficit was 10.5% of GDP. In absolute value, the deficit amounted to 17.3 billion kroons, which is 4% less than in 2004.

The investment activity of companies was more vigorous
In 2005, both household and corporate investment increased. Companies accounted for a larger share of the investment growth than earlier. At the same time, nearly a half of all corporate investment was made in real estate. As a result of this, residential construction picked up speed again, supported by the increased optimism of private individuals and the rapid rise in household income.

The positive economic outlook will support investment activity in the next months as well. Although it is likely the ECB will continue to raise its key interest rates, market participants have already considered such developments and, according to expert estimates, will not be able to exercise considerable control over the market.

Rapid pension rise
In the second half of the year the average gross monthly wage grew 11.8%, which, together with the 2.4% increase in employment, contributed to the growth in employment income mentioned earlier. The disposable income of households also rose with the lowering of the income tax rate. The rapid rise in the average pension payout was even more impressive: from 8.5% in the first half of the year to 18.3% in the second half of the year. This also accounted for the historically high consumer confidence.

State budget still in surplus
The faster-than-predicted economic growth led to continuous extra tax revenue. The tax revenues collected were by 1.2 billion kroons more than planned, and despite the supplementary budget, the surplus of general government resources was approximately 1.8% of GDP. Thus, the fiscal surplus remained at the same level as in 2004. Taking into account the rise in economic growth, the surplus should have been considerably more substantial than in previous years in order to offset the increasing domestic demand.

Loan interest rates on the increase
As the euro area interest rates rose, the interest rates of euro-denominated household loans increased approximately 0.5 pp in February 2006 compared with October 2005 (3.7% in February).

Household and corporate loans and leases increased by a record 13.9 billion kroons in the fourth quarter, which exceeded the third-quarter growth by 3.5 billion kroons.

The increase in the prices of the real estate market accelerated towards the end of 2005. Based on the data from the Statistical Office of Estonia, the purchase-sale prices of dwellings increased 45% year-on-year in the fourth quarter (37% in the third quarter). The increase in residential property prices in 2005 surpassed the growth in income, which may cause difficulties with the repayment of loan principals and interest in the future.

The increase in the ECB key interest rates, which amounted to a 0.5 pp rise, has not had a great impact on the ability to repay loan principals and interest against the background of the robust economic and wage growth. At the same time, it is possible that the situation of some households may get tighter, should the interest rates rise more than 3 pp. For instance, for an average lender, a growth of 2.5 pp in the interest rate on housing loans would mean an approximately 30% increase in the monthly repayment amount.

The economic policy objective: to meet the inflation criterion
The aim of Estonia's economic policy is to ensure that the development of our economic environment will make it possible to meet the Maastricht inflation criterion as soon as possible and to help reduce the risk of economic overheating. Meeting the above-mentioned objectives implies the following.

1)   The ratio of the fiscal surplus of 2006 has to be equal to that of 2005.It is important to avoid such economic policy measures which would increase domestic demand. For example, instead of boosting domestic demand, which is strong enough and would inhibit the improvement of the external balance, as well as spur upward price pressures, it would be more expedient to put the fiscal surplus into a reserve.
2)   The growth rate of real estate loans has to subside. In order to achieve this objective, the banking regulations related to housing loans were tightened as of 1 March 2006.
3)   It is important to take into account the impact of administered prices on inflation and the Maastricht inflation criterion.

[1] The accounting of goods exports has comprised more components of transit trade since the accession to the EU than before it occurred.