QUARTERLY ECONOMIC POLICY STATEMENT OF EESTI PANK

  • Euro area interest rates are on the rise, which means loan repayments are increasing in Estonia.
  • Estonia's economic growth of the first quarter 2006 was even faster than in the second half of 2005.
  • The high pressure of fuel prices on inflation should ease off in summer, but price increase is still going to exceed expectations.
  • The accelerating increase in private consumption is based on the robust wage and credit growth.
  • According to the data on the first quarter of 2006, productivity growth was surpassed by wage growth for the first time since 2003. If such developments continue, the competitiveness of the country will deteriorate.
  • Investment in some domestic market sectors call for prudence. Investment in the construction and real estate sector may entail the greatest risks.
  • Growth in exports slackened off slightly at the beginning of the year.
  • Corporate and household loan burden is still picking up speed, whereas the real estate market prices are showing signs of a slowdown.
  • Different from 2005, the volume of consumer credit is growing rapidly, especially as regards mortgage loans.
  • There has occurred a halt in the improvement of the current account deficit, which has declined to the same level it occupied a year earlier.

GLOBAL ECONOMY

Global economy enjoyed a favourable first quarter

The first-quarter economic growth of both the US (3.6%) and the euro area (2%) was considerably strong. The rise in oil prices stopped at the beginning of May, but continued again towards the end of the month. The price increase of raw materials is starting to bring more pressure upon other prices as well. Against this background, the corrections taking place in global financial markets are only natural, especially after the rapid asset price growth in recent years. Financial markets are also greatly influenced by the expected continuous rise in the key interest rates of all major economies.

The prices of commodities and services increased more than expected, being 2.5% higher in May year-on-year. The objective of the European Central Bank (ECB) is to keep the inflation rate below 2%. In recent months the benchmark was exceeded, and thus the Governing Council of the ECB was compelled to raise the key interest rate, which now constitutes 2.75%. Euribor, which is closely related to the ECB interest rates, has risen by 0.9 percentage points since end-September of 2005. This means that loan repayments are growing in Estonia.

ESTONIA'S ECONOMY

Rapid economic growth continues

According to the preliminary estimate of the Statistical Office, Estonia's economic growth constituted 11.6% in the first quarter of 2006. Thus, the remarkable growth rate characteristic of 2005 has gained even more impetus. Although export volumes continue to expand, a comparison of the flash estimate with the available data on foreign and domestic trade refers to the increased contribution of domestic demand, i.e., consumption and investment, to the GDP growth rate in the first months of the year. Economic growth is further affected by the extremely rapid loan growth of the household and corporate sectors as well as considerable wage growth, which according to the data on the first quarter exceeded productivity growth twice.

Food and fuel prices keep inflation at the same level as in previous months

Based on the data of the Statistical Office, consumer prices increased 1.7% in May year-on-year. In general, inflationary pressures have not declined, and thus the approximately 2 percentage point difference from the euro area price growth is persisting.

The growth in fuel prices has once again put an end to the downward trend of inflation. The upward pressure of fuel prices on inflation should ease off in May or June at the latest. At the same time, the price of food has gone up more than expected.

Private consumption is active

Owing to the rapid wage growth and greater availability of credit, the growth of private consumption exceeded that of GDP at the beginning of 2006. This is proved by the fact that retailers are enjoying a continuous acceleration of the sales turnover growth rate, which amounted to 17% in real prices in the first quarter of this year.

According to the Estonian Institute of Economic Research, the consumer confidence indicator reached another high in May, increasing 18 points year-on-year. Income growth was also record-breaking: the increase in net wages amounted to 18% and the number of the employed went up by an unprecedented 6.8%. The average pension has risen 18.4% year-on-year. Further increases in wage expectations may start to inhibit the competitiveness of enterprises.

Risks accompanying domestic-market-oriented investment

The first quarter of 2006 witnessed a continued high investment activity and the share of stocks and investment in GDP was likely to form 33% or even more. Although investment in manufacturing has increased, the risk remains that too much investment is made in some purely domestic-market-oriented field of activity. Investment in construction, real estate development and other domestic-market-oriented sectors has until recently grown at a more rapid speed than investment in manufacturing.

Productivity gives rise to concerns against the backdrop of solid labour market

The rapid growth of domestic demand and investment activity reflected in the labour market as well. All the main labour market indicators continued to improve as a result of the creation of new jobs in the trading, real estate and manufacturing sector. In the first quarter of 2006, employment growth accelerated to 6.8% (40,200 people found a job), which is the highest growth rate during the past eight years according to the Statistical Office[1].

Labour costs have increased, whereas profitability has presumably declined. Real wage growth (10.8%) exceeded the first-quarter productivity growth (4.5%) by more than twice, which entails a considerable risk to Estonia's competitiveness. As regards the manufacturing sector, wage growth was 15.8% in the first quarter (0.1 percentage points higher than on average) and employment increased 5.3% (1.5 percentage points less than on average). In order to prevent real wage growth in manufacturing from exceeding productivity growth, the respective value added should rise at least 16.8%.

Export growth somewhat weaker

Although the growth rate of exports slowed down slightly in the first quarter, it has still remained comparatively strong. At the same time, the quarter-on-quarter growth in manufacturing exports leaped from 12.7% to 15.7%. The slight decline in the growth rate of goods exports has been offset by increasing demand in the domestic-market-oriented production and services sector. However, from the point of view of maintaining fast and stable economic growth, it is essential to increase the volume of goods and services exports.

As a result of the increase in domestic consumption demand, the growth rate of goods imports picked up speed in the first quarter. The estimated negative balance of foreign trade as a four-month average constituted more than 15% of GDP. Owing to the increase in domestic demand, the current account deficit reached the level of the first half of 2005 - the four-quarter average formed 11.6-11.8% of GDP.

Sizable fiscal surplus highly necessary

In the second half of 2005, the growth rate of government consumption accelerated even more than that of household consumption, but the share of the former in GDP did not increase on annual basis. Similar developments were likely to continue in the first half of 2006, when the growth rate of government consumption picked up speed again.

The political decisions of the government and the central bank play a significant role in reducing the risks that accompany the robust growth in domestic demand. It is essential the government avoid weakening of the fiscal stance in both 2006 and 2007. The government should aim at a fiscal surplus at least as big as in 2005, i.e., 1.6% of GDP, which this year should amount to 3 billion kroons. A smaller surplus would entail growing domestic demand.

ESTONIA'S FINANCIAL SECTOR

Slight signs of stabilisation in the housing loan market

The financial sector situation has remained favourable. The good quality of banks' loan portfolio shows that neither households nor enterprises have had significant difficulties in meeting their financial obligations. At the same time, it has to be emphasised that the good quality of the loan portfolio is only natural under the current favourable economic conditions, and it has to be taken into account that the next quarters will witness a decline in income growth and a rise in interest rates. As economic growth slows down and interest expenses increase in medium term, the solvency of borrowers may deteriorate and the net income after loan repayments may decrease.

Although loan demand slightly inhibited at the beginning of the year as usual, the rapid growth continued towards the end of the first quarter. The annual growth of domestic financing reached 53.9% in April. Starting from mid-2005, the growth rate of household debt picked up speed every month. In March 2006, credit growth already exceeded 63% and as much as 65% in the housing loan market. The hike in real estate prices had a considerable role to play in the growing volume of housing loans.

As a result of demand exceeding supply in the housing market, prices and the volume of transactions posted record growth in the second half of 2005. Due to fast price growth the supply shrunk even more in the light of new price record expectations, which in turn intensified the upward price pressures all the more. Thus, the average value of notarial transactions with houses and apartments increased 34% in 2005 (23% in 2004). However, the beginning of 2006 has showed signs of a possible stabilisation in the form of an increased supply of typical apartments. Nevertheless, statistics provide no proof as regards the possible fluctuations in purchase and sales prices.

Consumer credit is growing rapidly

Besides housing loans, other loans have also undergone robust growth. Although the high growth rate of consumer credit (125% in 2005) can, to a great extent, be explained by the low base level, it is still a clear sign that this loan product is developing at a great pace. The fact that consumer credit is often collateralised by mortgage refers to the increased use of the housing equity withdrawal. The first-quarter increase in consumer credit amounted to 700 million kroons, and the annual growth thereof accelerated to 78.5%.

The growth in household debt burden was even more remarkable. By the end of March 2006, the ratio of household debt to disposable income and GDP increased by 15 and 9.5 percentage points, respectively. This means Estonia's debt growth was among the fastest in Europe.

Conclusion

Risks to Estonia's economy have increased: the year-on-year domestic demand is considerably higher, the current account deficit has widened, and the inflation rate has not declined. There exists the increased risk of economic overheating, which may be followed by a further pick-up in inflation and a faster-than-expected slowdown in the economic growth of 2008.

It is essential Estonia maintain the current economic policy direction. In essence, this means it is necessary either to refrain from a supplementary budget in the second half-year or to use the supplementary budget to channel the majority of the expected extra revenue from taxes into the pension reserve and other reserves.

In order to control the real estate market and its impact on domestic demand, it is necessary to consider cancellation of all tax incentives (e.g., the income tax incentive on housing loan interests) and bringing the base rate of land tax in line with actual market prices. In addition, it is important to emphasise that wages should be in keeping with the production growth.

Economic forecast by main indicators

   difference   
(spring 2006/
   autumn 2005)

 
  2003 2004 2005 2006* 2007* 2008* 2006 2007
GDP (EEK bn) 127.3 141.5 164.9 186.2 206.9 228.4 9.7 11.8
Real GDP growth (%) 6.7 7.8 9.8 8.1 7.6 6.9 1.4 0.7
HICP growth (%) 1.4 3.0 4.1 3.6 3.0 3.7 0.2 0.1
GDP deflator growth (%) 2.1 3.0 6.1 4.4 3.3 3.3 1.2 -0.1
Current account (% of GDP) -12.0 -12.5 -10.5 -9.6 -9.4 -9.0 -1.1 -1.6
Current account plus new capital account
(% of GDP)
-11.4 -11.8 -9.4 -7.9 -7.9 -7.5 -1.2 -1.7
Real private consumption growth (%) 7.4 4.2 8.1 7.7 7.2 7.1 1.0 2.0
Real government consumption growth (%) 5.9 6.9 7.5 9.4 7.0 6.9 1.8 -0.1
Real investment growth (%) 8.5 6.0 13.9 11.9 8.6 7.6 6.3 2.5
Real export growth (%) 5.8 16.0 21.3 15.0 14.1 12.5 1.4 2.0
Real import growth (%) 10.6 14.6 17.4 15.1 13.7 12.2 2.3 2.9
Unemploment rate (%) 10.0 9.7 7.9 7.0 6.4 6.2 -1.8 -1.8
Change in the number of employed (%) 1.5 0.2 2.0 1.3 0.6 0.3 0.3 0.2
Growth in value added per employee (%) 5.1 7.6 7.6 6.7 6.9 6.5 1.1 0.5
Real wage growth (%) 8.8 5.1 7.7 8.3 7.1 6.7 1.6 0.2
Nominal money supply growth (%) 10.9 15.8 42.0 33.0 25.0 23.0 20.0 10.1
Nominal credit growth (%) 27.7 31.8 49.4 40.1 30.7 22.7 10.3 7.4
External debt (% of GDP) 62.7 75.5 89.9 96.2 102.6 106.0 -0.8 3.0

* forecast

[1] There are no comparable statistics as regards earlier years.