Speech by the Governor of Eesti Pank to the Riigikogu Presentation of the Annual Report of Eesti Pank for 2019

Madis Müller
Madis Müller
Governor of Eesti Pank

Honourable President of the Riigikogu, Distinguished Members of the Riigikogu, I am pleased to present to you the annual report of Eesti Pank for 2019.

Rarely has the economy been in such a different position by the start of June from what we expected only half a year ago. This makes it appropriate to say more today about the Estonian economy and the work of Eesti Pank than is described in the report of the bank for last year. But as I have come here to present to you the Eesti Pank annual report for 2019, then I will do both of these things. I will start by noting the key points from the work of the central bank last year, then I will discuss Eesti Pank’s opinion on the economy and on economic policy choices. After that I will be happy to answer your questions.

Eesti Pank in 2019

The Riigikogu has given the central bank a whole range of tasks under the Eesti Pank Act. We have practical responsibilities such as organising cash circulation, developing payment systems and processing and disclosing statistics, but we are also responsible for ensuring the stability of the financial sector, managing Estonia’s foreign currency reserves, advising on economic policy issues, and of course participating as a euro area central bank in setting the monetary policy for the whole of the euro area.

The ultimate goal of Eesti Pank’s work is to support the stable development of the economy and growth in the wealth of our society. We achieve this primarily by maintaining the value of our money and our purchasing power by setting a joint monetary policy together with the other central banks of the euro area. We also do it by keeping the Estonian financial sector solid and watching that cash circulates faultlessly. To do our work we need high-quality economic analysis and statistics, and we take care that our analysis and the data on the economy are available to everyone.

I will start my review of our activities with a practical issue that immediately concerns everybody, and that is the circulation of cash. Access to cash and electronic payments are defined by law as vital services, and ensuring they function reliably is taken very seriously at Eesti Pank.

Cash circulated last year in Estonia without any interruption. The work Eesti Pank has done together with the commercial banks, cash transporters and, increasingly, shops has evidently improved access to cash in the past few years. This has been helped by the spread of cashback services allowing money to be withdrawn from bank accounts through the tills of shops. There are now around 675 such withdrawal points in petrol stations and shops in Estonia.

During the year we issued 840 million euros in banknotes and coins from Eesti Pank and we received 540 million euros back. More than 21 million coins were issued in total and 57% of them, or more than half, were one and two-cent coins. We keep on and on producing these small coins, but they practically never come back to the central bank. We would like to continue the discussion with the Ministry of Finance and the Ministry of Economic Affairs and Communications about introducing rounding rules like those in several other countries, as they would reduce the costs of small coins for consumers and for retailers. Some 70% of the people in Estonia are in favour of this idea and I am certain that it can be done carefully to avoid the risk of price rises.

Electronic payments also functioned faultlessly last year. We in Estonia are leaders in the use of instant payments that allow money to move between accounts in different banks in only a few seconds. By the end of last year Swedbank, SEB, LHV and Coop Pank Estonia had joined the instant payment system, making the service available to the majority of clients of Estonian banks.

One of our strategic goals at Eesti Pank is to be as ready as possible for any type of emergency, which is important if we are to ensure the operation of the vital services of cash circulation and payments. Together with our partners we have wargamed various crisis scenarios, run tests and drawn up crisis resolution plans.

We have invested in making Eesti Pank statistics as usable and accessible as possible, and in the solutions for data collection. Together with Statistics Estonia, who we work well with, we reviewed last year how we divide our work to avoid overlaps.

One of our activities at Eesti Pank that is less talked about publicly is our investment work, which aims to look after the Estonian national foreign currency reserves responsibly and to grow them, and also to cover our operating costs and allow sufficient buffers to protect against the financial risks that are an inevitable part of the operation of a central bank. The investment portfolio of the central bank grew substantially in 2019 to reach 1.2 billion euros by the end of the year. We have mainly invested in high-quality bonds, and to a smaller extent in the stock markets of advanced economies. The return on the Eesti Pank investment portfolio was extraordinarily good last year and we earned almost 39 million euros from our investment. This allowed us to allocate a larger part of our annual profit than usual to the state budget, as we transferred around 19 million euros. Since 1992 Eesti Pank has allocated a total of more than 170 million euros from its profit to the state budget.

Now I come to Eesti Pank’s work with economic analysis, monetary policy and the financial sector, and our economic policy advice. Starting with the euro area I will explain the monetary policy decisions of the European Central Bank that we have helped to take.

Looking back at economic growth last year feels like a far-off memory of something beautiful

We usually speak of global and euro area economic developments to give context to the past year. This time though we are in a unique position where speaking of last year recalls a far-off memory of something very beautiful. But still we should start from the past. The global economy grew by 2.9% in 2019 and the euro area economy grew by 1.2%.

At the end of 2019 we could still talk about a moderate recovery in the global economy after the international trade conflicts, but today we are facing a global recession. It may be remembered that the January forecast of the International Monetary Fund expected growth of 3% this year, but the April forecast of the IMF was expecting a contraction of the same size in the global economy, and the advanced economies may even shrink by twice as much as this. Such a large contraction in the economy in such a short time has very rarely been seen before.

Everywhere entered the crisis simultaneously together, but the exit from it may be uneven and varied

The European Central Bank is publishing a new economic forecast for the euro area the day after tomorrow, 4 June. We know though that the quarantine restrictions left the euro area economy 4% smaller in the first quarter than in the previous quarter, and that the contraction will have been even larger in the second quarter. All forecasts depend on the healthcare situation in the second half of the year. If no new restrictions are needed to combat the virus and the efforts to ease the impact of the crisis prove effective, then the economy may reboot quite quickly in the second half of the year. This is not enough though to return to the levels of last year, where we were before the restrictions were introduced.

The recovery in economic activity may prove uneven across sectors and across countries. People are likely to remain cautious for a long time and to consider postponing their spending. A reduction in foreign demand may also be expected in countries where the spread of the virus has been wider and its impact has been larger. Any forecast can unfortunately only be speculative at the moment, but it is probable that total output in the euro area will return to its levels of before the pandemic only by 2022.

Monetary policy will help the economy recover from the crisis

How the pandemic and the measures taken to limit it will affect economic activity can be estimated with some degree of accuracy by making assumptions about how long the lockdown will last. The impact on inflation is harder to estimate accurately though. Measures taken to combat the virus reduce not only demand in the economy but also supply. A weaker economy will probably be accompanied by lower inflation. Problems in supply chains could though make some goods more expensive at least temporarily. The very wide fluctuations in the price of oil will affect inflation much more in the short term than the monetary policy of central banks will. Short-term fluctuations in inflation are more and more setting long-term expectations for inflation.

The main task of the euro area central banks is to maintain the value of the euro, with a focus on keeping inflation in the euro area sufficiently low and stable. For the economy and wealth of people to grow, it is important that inflation not be too fast, and that it not fall far below the target of 2% a year in the medium term.

At the start of last year the euro area central banks moved in the direction of tightening monetary policy. It became clear over the year though that inflation in the euro area was clearly remaining below the 2% target, and so at the Governing Council of the European Central Bank we decided to help the economy through monetary policy by cutting interest rates and increasing the size of the asset purchase programme. The extremely accommodative monetary policy is an important reason why growth in lending has remained strong and the cost of financing has been favourable for businesses.

In recent months we have taken additional steps at the Governing Council of the European Central Bank to keep financing conditions favourable despite the increased uncertainty in markets. One way we did this was by launching a wide-scale temporary emergency asset purchase programme to ease the impact of the pandemic, while also providing loans to banks on better terms. This was done to allow the banks to lend to businesses and households on better terms.

The financing of companies is now also supported by various state guarantees and support measures. The additional spending by governments to ease the impact of lockdown has increased the debt burden of the public sector in European countries by some 10-15 percentage points. This is an unprecedented fiscal stimulus and it must be used efficiently.

The Estonian economy was not left untouched by the pandemic

The Estonian economy was not left untouched by the pandemic. The first impacts were felt immediately after the emergency situation was declared and the measures were taken to prevent the spread of the virus in the middle of March. The restrictions introduced in Estonia and elsewhere placed obstacles to the operation of supply chains. The closure of shopping centres and the fall in demand affected retailers directly. The coronavirus has also shaken the local labour market, especially in the service sector. Looking at the big picture to compare the current crisis with the previous major crisis shows that the service sector has been hit most now, while in the previous crisis it was construction and real estate.

This makes the question of how to cope with the economic impact of the restrictions to stop the coronavirus the most relevant one in Estonia right now.

The crisis measures taken so far by the government have helped to preserve jobs and to slow the rise in unemployment. Businesses have received wage compensation for 120,000 employees, which is one worker in five in Estonia. Wage support went to three employees out of five in accommodation and catering, and one in four in manufacturing. Without the state support, unemployment would have leapt up. The crisis will reduce tax revenues and raise spending on social transfers. It can be forecast that there will be more pressure on the state budget in the years ahead than previously. As this places a very large burden on the general government budget, taxpayers’ money must be used as efficiently as possible and targeted especially towards areas that can help avoid long-term harm to the economy and support the transition to the post-crisis world.

How fast the Estonian economy recovers will depend on various factors

The recovery of the economy in Estonia and in other countries will depend very much on the restrictions that countries had to use to stop the spread of the virus, and on how long those restrictions remain.

We used two scenarios in the Eesti Pank macro model to assess how the economy will be impacted depending how long the restrictions last. Restrictions lasting until the start of May would have meant the economy suffering a contraction of around 6% in 2020, but if they lasted until the start of August the contraction would have been 14%. Although the restrictions have by now largely been eased, they still affect economic activity and people are probably going to be cautious for some time when planning large purchases. The Estonian economy is oriented towards exports, and so its recovery will depend largely on what happens in our main target markets.

This indicates the recovery may be slower, but there are some other points that suggest the economy will recover faster. Estonia is better placed than it was when it faced the crisis of 2008-2009, as there are no major imbalances in the Estonian economy and the economy as a whole and the financial sector stands on firm foundations. It is not impossible that the deep global recession will prove to be only temporary, and in the second half of this year easing of restrictions will see rapid recoveries in some countries. The support offered by governments and central banks will play an important role in the recovery. There is though overall a lot of uncertainty.

Developments in the financial sector

I will briefly address questions concerning the financial sector, as problems in banking can in the worst case increase the problems in the rest of the economy, but if the financial sector works well, the recovery from the crisis will be much less stressful. Eesti Pank is responsible in Estonia for macroprudential supervision, which aims to increase the resilience of the financial system so that access to lending would not be interrupted even in difficult times. To this end, Eesti Pank has introduced additional capital buffer requirements for the banks and general principles that the banks must follow when issuing housing loans.

The commercial banks in Estonia are generally in a strong financial position in comparison with banks in other countries and with where they were in the previous crisis. Even so we decided at Eesti Pank in March to ease the capital requirements on the banks to prevent problems, and we lowered the systemic risk buffer from 1% to 0%. This released 110 million euros of capital for the banks, which allowed them to offer additional loans to people and companies during the difficult times, or to cover the loan losses that they will certainly face after some time. We also gave a clear signal together with Finantsinspektsioon and the European Central Bank that it was not acceptable for the banks to weaken their capital by paying dividends to their owners at a time when the regulators were loosening the capital requirements for the banks.

It is very important that the banks have given their clients flexible payment holidays, managing to agree together on this that they would not raise interest rates or ask the usual fees for changing contracts when rescheduling these loans, even where risks have increased. This gave substantial relief during the crisis to companies and to families with housing loans for example. Granting the payment holidays to everyone who applied means though that it is not immediately easy to identify the clients who may have long-term difficulties in repaying their loans. The losses caused by these problem loans may only become apparent to the banks after several quarters.

It is worth noting here that the banks were able to grant payment holidays to almost all clients who applied for them almost without using the additional guarantees provided by the state through Kredex. This was partly because the banks had to react before the conditions for the state guarantees had been confirmed, and partly because the conditions that have now been confirmed for the guarantees mean the banks do not think it makes financial sense to use them. This does not mean however that there is no need for the Kredex guarantees. It would be wise in the near future to work with the banks to agree on the exact conditions for new liquidity loans to companies in particular, as the need for such loans will probably increase once the payment holidays end. Kredex guarantees with reasonable conditions would in that case allow additional loans to be granted to companies to continue their business when the banks would otherwise consider the risks would be too high if the economic crisis continues.

The work of Eesti Pank during the coronavirus crisis

If I may I will describe briefly the work of the central bank during the coronavirus crisis. One of the most critical issues for us is maintaining vital services. Fortunately the crisis caused by the pandemic did not immediately affect the operation of payments or the circulation of cash. We were ready for any such effect though, and managed to cope with a temporary spike in demand for cash at the start of the emergency. Demand for cash and volumes of payments have been lower than usual during the emergency and are only now recovering.

We worked with the banks to find ways of releasing flash statistics on how the use of cash and how payments were made changed during the crisis. This information can be found on the Eesti Pank website. As already noted, we lowered the systemic risk buffer that applies to all the banks to 0%, freeing up some 110 million euros in capital for the banks to cover possible loan losses and issue new loans.

At the end of March we produced the preliminary estimate I mentioned earlier for how deep the recession could prove this year. We also made some recommendations for the principles that the state should follow in supporting the economy. Our main message was that the measures taken to avoid companies going bankrupt and to protect people’s incomes should have as direct an impact as possible, and should be introduced rapidly and temporarily.

We worked closely with the Riigikogu and the government during the crisis to explain the recommendations of the central bank and to offer constructive commentaries on plans to support the economy.

We also had to adapt rapidly as an organisation by creating the technical means for many of our staff to work from home and applying the principles of social distancing in our teams for critical functions where remote work is not possible. We managed to do that, and like many other organisations we are already thinking about what we have learned from working during the emergency and what we can take on board in organising our work in future.

It is not directly related to the emergency, but we at the Executive Board, which was renewed last year, are looking more broadly at the Eesti Pank strategy for the coming years. A key point is how we can be the best adviser possible to the government on economic policy questions and also to policy makers in general. This role is given to us by law and we take it very seriously. We want to give independent and expert analysis and commentary on important questions of economic policy, and also to bring together experts and politicians to debate economic policy. Last year Eesti Pank published an impact analysis of the planned changes to the pension system and organised a seminar together with the IMF at which foreign experts discussed what is good and bad in the pension systems of different countries. The emergency made us postpone a discussion on access to banking services that was needed because many companies have complained that the banks are too conservative following the recent money laundering scandals. One topic where the economic impacts should be studied thoroughly is the use of workers from abroad.

Economic policy recommendations for exiting the crisis

Eesti Pank’s focus for the time being is primarily on how to help the economy recover from the crisis, both in helping set monetary policy for the euro area and in contributing to Estonian economic policy choices.

We have reached a stage of the crisis where ever harder decisions have to be made on who should receive state support and how. When the coronavirus first hit it was reasonable to provide immediate support for all companies and people who had unexpectedly lost a large part of their income, but as we exit the crisis we need to be more selective and state support needs to be targeted more precisely. Supporting all companies equally becomes too expensive for the taxpayer and may also be harmful for the economy in the long term as it works against the unavoidable need for the economy to adapt to the new circumstances. It would be wise for the decisions taken today to focus on helping businesses and society as a whole adapt as successfully as possible to these new circumstances.

I will propose a couple of areas that will probably become much more important than they have been after the crisis and where the state could make an important contribution. These ideas are in principle not new.

  1. The first is that the digitalisation of the economy will probably become even more important. Broad and well-targeted support for overcoming Estonia’s backwardness in digitalisation in industry should be considered. After the crisis Estonian manufacturing companies may have new opportunities from changes in global supply chains, and we have to be ready to take advantage of such opportunities. It would also be worth contributing to providing high-quality data communications in every corner of Estonia.
  2. Secondly, more support than before should be given to people for retraining because unemployment will start to rise and there will be change in the jobs needed in the economy. It is worth investing in aligning people’s skills as closely as possible with the needs of the labour market, because that is how we can improve the well-being of people in Estonia. It should also be said though that if wage support lasts for too long, we may be using taxpayers’ money to extend the activities of businesses that in other circumstances would no longer be viable. It makes more sense to provide people with retraining alongside the social support and let them create new jobs.
  3. Thirdly, it is worth considering at the launch of large investment projects whether they meet the climate goals that the Estonian state has already accepted and that both the state and the private sector have to make a major contribution to achieving.

I should also note that when the state provides support to larger companies through loans or guarantees, it would be wise to consider the opinions of market participants about whether the particular company and its business model would remain competitive in the future. It is good to provide guarantees, especially partial guarantees, through Kredex and the Rural Development Foundation rather than direct loans to businesses. This maintains the important second level of control from the opinion of the bank as the lender about the long-term sustainability of the company. The conditions on loans from Kredex and the Rural Development Foundation do not need to be very favourable as they should primarily be intended as the final option for companies that cannot borrow from banks. The conditions for the guarantees should still be such though that the banks consider it reasonable to use them.

It would be even better if it was a requirement for large companies receiving state support that there should be additional contributions from owners or new investors at the same time. In this regard, as concerns strategic sectors and businesses, the state should start from the goal of supporting the continuation of strategically important business, not the current owners of a particular company. There is a substantial risk in lending money to large companies in difficult times. The taxpayer has the right to expect reasonable compensation for this, because otherwise the support will essentially go to the current owners of the company. This means the state should not simply issue cheap loans to large companies, but should demand the right to take a share in the company on agreed terms.

These were the final thoughts that I believe should be considered when the next support measures are discussed. We should remember that state spending is not a complete substitute for the drop in demand from the private sector caused by the crisis. We can only soften the impact of the crisis and create better conditions for the recovery of the economy. How we can do this more specifically will need to be discussed in greater depth as we move forward. We at Eesti Pank are ready to join these discussions and to continue to do all the other tasks that the law has set for us.


Read also: Eesti Pank Annual Report 2019