QUARTERLY ECONOMIC POLICY STATEMENT OF EESTI PANK

  • Estonia's economic growth has reached its peak. The growth, which reached 11.6% in the third quarter, mainly results from private consumption.
  • Inflation, which fell in September and October due to the cheapening of oil prices, is now on the rise as fuel prices are increasing again.
  • Employment is still at a very high level, whereas discrepancies between productivity and wage growth persist.
  • Credit growth is expected to maintain its current level, although the real estate market is showing signs of declining demand.
  • The financial standing of banks is strong and their capitalisation and liquidity are sufficient regarding the current economic environment. The short-term risks of the banking sector are well-managed with the help of parent banks.
  • The main risk facing the banking sector is the concentration of the loan portfolio on financing real estate development and related investment.
  • When assessing the risks to economy and the operational environment of banks, Eesti Pank decided to maintain the current capital requirement level in the new prudential ratios taking effect in 2007.
  • In the context of economic peak, Eesti Pank suggests saving instead of increasing debt burdens.

GLOBAL ECONOMY

Euro-area economic growth reflects a continuous rise in the interest rate
The economic growth of two major economic regions - the USA and the euro area - has been divergent. In the United States, economic growth slowed down, primarily due to the cool-down of the real estate market. In addition, the dollar, which has been stable during the last half-year, started to depreciate at the end of November.

The euro-area economic growth, on the other hand, picked up speed. The growth constituted 2.8% and 2.7% in the second and third quarter, respectively, which is a percentage point higher compared to the autumn of 2005. Different from the USA, euro-area financial markets are expecting the increase in interest rates to continue. On 7 December, the Governing Council raised the key interest rates to 3.5%. Markets are anticipating at least one more interest rate increase in spring 2007.

ESTONIA'S ECONOMY

Estonia's economic growth still relies on domestic demand
The Statistical Office estimates Estonia's third-quarter economic growth to be 11.6%. Estonia's GDP growth has been exceeding 11% for almost a year - since the third quarter of 2005. No significant changes have taken place in the growth situation of export, private consumption, and investment. The country's economic expansion has reached its peak. However, Eesti Pank forecasts it to decline close to 8% in 2007. As before, risks arising from strong domestic demand need close monitoring.

The inflation level is to remain around 4%
Based on the data of the Statistical Office, third-quarter consumer prices increased almost as much as in the two previous quarters, i.e., 4.4%. The fall in the price of oil helped inhibit price hikes in September and October, but core inflation (based on the consumer basket without food, alcohol, tobacco, and fuels) has still continued to grow. The influence of the cheapening of oil prices was no longer discernible in November, thus inflation increased to 4.6%. Rapid wage growth has brought along more expensive services, and the expected price rise of gas and distant heating give reasons to believe the over-four-per-cent inflation level will persist in the near future. Nevertheless, price pressures may somewhat abate owing to the depreciation of the dollar.

Private consumption is gaining momentum
Private consumption growth made the biggest contribution to economic expansion. Retail sales growth accelerated to 19.7% in the third quarter. The 12.7% real growth of net wages and persistently rapid growth of employment in the third quarter also refer to the more vigorous growth of private consumption expenditure.
Investment activity was high in the third quarter as well. Again, private sector investment accounted for a majority thereof. Borrowing remained active, which means external debt increased, too.

Employment at a historically high level
Third-quarter labour market developments corresponded to expectations. The demand for new employees is still extensive and more and more supply-side constraints are manifesting themselves. The favourable labour market situation has promoted wage growth, which has, unfortunately, not been accompanied by an equally rapid productivity growth.
The number of the unemployed registered with the employment office declined to 12,000. For example, in Tallinn and Harju County, the number of vacancies (5,000) exceeds for the first time that of registered unemployed (3,500); the score was still even in August. The number of employees reached its highest level since 12 years (650,000 people). Demand for labour force increased primarily in domestic-demand-oriented fields: construction, wholesale and retail trade, and transport, storage and communications.

Favourable outlook for export markets
Although the third quarter showed signs of a decline in the growth of export and manufacturing, the competitiveness of the sectors open to foreign competition has not weakened. Exports growth slowed primarily due to a deceleration in the growth of electronic devices export, but the value added by these export articles has always been rather little for Estonia, as they include a lot of imports. The economic expansion of our main trading partners, Finland and Sweden, is still rapid, and this should have a favourable impact on Estonia's exports.

Private consumption accounts for the majority of tax revenues
Estonia's robust economic growth led to a rapid growth rate of government income, whereas tax revenues exceeded the level forecasted. The contribution of social tax, the receipt of which sped up to 22.5% in November, was the largest again. The very good VAT income can be mostly attributed to the increased private consumption. The state budget surplus is reaching 4 billion kroons, i.e., 2% of GDP.

ESTONIA'S FINANCIAL SECTOR

The situation of Estonia's financial sector has been favourable during the past half-year. According to the Eesti Pank forecast, economic growth is expected to slow down to 7-8% during the next couple of years. If the slowdown is gradual and moderate, there will be no problems with financial stability in the near future. The level of capitalisation and liquidity of the banking sector is suitable for the current economic environment and the short-term risks of the banking sector are well-managed with the help of parent banks.

Credit growth shows no signs of abatement
The economic situation in Estonia has facilitated the residents' income growth and created a favourable environment for increased optimism. Therefore, the loan growth rate of households has persisted at a very high 60-per-cent level throughout 2006. The household debt burden, which has increased to 38% vis-à-vis GDP and to 70% vis-à-vis disposable income, is on the rise. As both loan amounts and key interest rates have increased, the household expenditure spent on repaying loans have grown as well. So far, the negative impact of interest rate increases has been offset by income growth. Families that have taken loans during the past year and a half face a bigger risk of running into difficulties should interest rates rise or their income decrease.

The growth rate of corporate debt has remained above 25%. Financial risks of the corporate sector have been increasing along with growing loan burdens. Besides financing their main activities, enterprises take more and more loans to purchase real estate. This may undermine the competitiveness and profitability of the corporate sector.

Focusing on real estate increases risks of banks
Although the annual growth rate of client deposits has been relatively rapid (33%), a lion's share of the funds lent by banks is obtained from their parent banks in the Nordic countries. The quality of banks' loan portfolios remained good in the third quarter as well: the share of loans overdue for more than 60 days was rather moderate, amounting to 0.3%.

The main risk the banking sector is facing may be the overly large share of real estate development and related investment in the loan portfolio. The real estate sector used to offer banks a splendid combination of risk and profit, enabling them to boost their profit at a rapid speed. However, strong dependence on the real estate market increases banks' vulnerability, should negative developments occur in the market.

The number of real estate transactions on the fall
Resulting from a high price level and increased supply, demand has been decreasing in the real estate market. Although the volume of real estate transactions was nearly a half bigger year-on-year, it succumbed to the volume of the second quarter. In addition, the number of purchase and sale transactions of real estate was 8-10% smaller in the third quarter compared to the second half of 2005. This shows that the real estate market is balancing out, as the earlier high demand has subdued because of increased supply and higher prices. Smaller demand is also reflected in the average value of real estate transactions, the growth of which decelerated to 34% as regards apartments in the third quarter of 2006. This provides a basis for presumptions that the peak of purchasing and selling housing took place in the fourth quarter of 2005.

Economic policy survey
Estonia's third-quarter economic growth vas rapid. It again exceeded the feasible 7-8% level and was even inflationary in some sectors. Our economic expansion is being driven by very strong domestic demand, which, in turn, relies on the credit boom financed from abroad and a rapid income growth. In addition, discrepancies between wages and productivity growth persist.

A situation like this requires economic policies curbing the risk of overheating. The steps taken by Eesti Pank so far, as well as the state fiscal policy have, in general, supported such approach. Owing to the measures enforced by Eesti Pank, banks increased their capital buffers, which means they are better prepared to face setbacks in less favourable times.

During the three-year transition period within the framework of the new capital adequacy accord (Basel II), which take effect next year, Eesti Pank decided to preserve a 100% risk weighting for housing loans in calculating the floor for the capital adequacy ratio and adhere to the current 10% capital requirement as regards credit risk as a whole.

Taking into account Estonia's current economic situation, it is important that the government's fiscal policy does not amplify the economic cycle. The government and the Riigikogu should refrain from any further increases of expenditure; instead, any supplementary fiscal revenues should be channelled to reserves. The new convergence programme approved by the government at the end of November is to be considered a positive development, as it sets out that in addition to 2007, the government aims at keeping the budget in surplus in the next years as well. In light of the approaching elections, it should not be forgotten that the current economic situation requires policies that would not amplify the already too rapid economic expansion.

Owing to increasing debt burdens, the risks of private persons and enterprises are on the rise. So far, signals that could have changed the attitudes of borrowers (e.g., interest rate increases, signs of stabilisation in the Tallinn housing market, delay in the changeover to the euro, and signs of the risk of economic overheating) have not cooled off people's optimistic future expectations. That may be due to the inert behaviour or borrowers, which is especially clearly demonstrated in case of both enterprises initiating new real estate development processes and households intending to take out new housing loans.

In the context of the current economic peak, it is time for both lenders and borrowers to review their optimistic attitudes, so that their saving, investment, and borrowing decisions would be in compliance with the needs and risks of future economic cycles.

Table 1. Economic forecast of Eesti Pank*

  2003 2004 2005 2006 2007 2008
GDP (EEK bn) 132.9 146.7 173.1 205.5 236.1 268.3
Real GDP growth (%) 7.1 8.1 10.5 11.8 8.3 7.6
Harmonised Index of Consumer Prices (HICP) (%) 1.4 3.0 4.1 4.4 4.5 4.7
GDP deflator growth (%) 2.3 2.1 6.7 6.2 6.1 5.6
Current account (% of GDP) -11.7 -12.6 -10.4 -12.5 -13.5 -13.3
Current account plus new capital account
(% of GDP)
-11.2 -11.8 -9.4 -10.9 -12.2 -12.0
Real private consumption growth (%) 6.8 7.0 7.9 15.4 12.5 8.8
Real government consumption growth (%) 0.3 2.2 1.1 2.5 1.8 1.6
Real investment growth (%) 7.0 13.5 12.7 14.7 12.0 9.7
Real export growth (%) 7.6 17.1 21.5 13.1 11.0 10.0
Real import growth (%) 10.6 15.2 15.9 14.9 12.6 9.8
Unemploment rate (%) 10.0 9.7 7.9 5.7 5.1 5.1
Change in the number of employed (%) 1.5 0.2 2.0 7.1 1.9 0.4
Value added growth per employee (%) 5.5 7.8 8.3 4.4 6.3 7.2
Real wage growth (%) 8.6 5.9 8.3 12.0 10.6 9.3
Average gross wage growth (%) 9.7 7.8 11.4 15.8 15.1 14.1
Nominal money supply growth (%) 10.9 15.8 42.0 33.0 25.0 16.2
Nominal credit growth (%) 26.9 33.0 50.4 45.5 34.9 21.1
External debt (% of GDP) 66.0 78.3 86.0 81.8 90.4 98.5

* as at November 2006