Speech by the Governor of Eesti Pank to the Riigikogu Presentation of the Annual Report of Eesti Pank for 2021

Autori Madis Müller pilt

Madis Müller

Governor of Eesti Pank



Honourable President of the Riigikogu, Distinguished Members of the Riigikogu.

Once a year Eesti Pank has the duty and the opportunity to report to the Riigikogu on our activities. Today I would like to give you a review of the most important activities of Eesti Pank in the past year. I will also speak about the euro area and the Estonian economy as a whole, and I should say at once that circumstances have changed a great deal since we wrote the summary of the events of last year.

This is particularly the case for inflation and the outlook for it.

Central banks assumed last year that the high inflation that had come with the strong recovery from the pandemic would soon subside as companies adapted, supply chains started working again, and life returned to its normal routine. Russia's invasion of Ukraine upset those expectations though, as prices rose even faster for energy, fuels and other commodities, and the war and the sanctions delayed the recovery of supply chains.

So I will speak first of monetary policy, which is the main tool that central banks have for tackling inflation. Stable and low inflation is the main goal of the central bank, as it helps to support long-term growth in our economic well-being.

Estonia is a part of the euro area, and so one of the most important roles that Eesti Pank has is setting the joint monetary policy together with the central banks of the other euro area countries. I told you last year how the European Central Bank had reacted quickly and very firmly to the outbreak of the pandemic to calm the anxious markets and ensure that lending conditions to companies, households, and governments remained reasonable. We did this by launching a programme of extraordinary bond purchases and offering the commercial banks loans at very low interest rates so that they could lend that money further into the economy. The Estonian government was also able to benefit from these low interest rates, as it borrowed from the bond markets to support the economy during the crisis. It was able to do this at a very low price because Estonia is a member of the euro area and because of the extraordinary support measures put in place by the European Central Bank.

The euro area economy is by now recovering from the pandemic, and high inflation means that measures to stimulate economic activity, which also raise inflation, are no longer appropriate.

Negative interest rates will also soon be a thing of the past.

Borrowers in Estonia will feel the impact of this through a gradual rise in the Euribor interest rates. I can illustrate this by showing what it would mean for a borrower with an average housing loan.

People in Estonia are affected most by the six-month Euribor, which was still -0.5% at the start of this year, but is by now rapidly approaching zero. The monthly loan repayments will start to be affected by the rise in Euribor as it turns positive. Monthly payments on a loan of 100,000 euros with a maturity of 25 years for example would increase by 50 euros for each percentage point rise in Euribor.

This would not cause major problems, as the banks follow the rules set by Eesti Pank when they lend, and they assess and calculate whether the borrower can cope with much higher interest rates. However, increased loan payments inevitably leave people with less money available to spend on other things.

We have emphasised for years at the central bank that interest rates cannot remain extremely low forever, and that people who take a long-term loan have to look at how well they will be able to repay their loan when interest rates are higher. We are now reaching that point, though we should still recognise that interest rates remain at historically very low levels even after the central bank has raised them for the first time. There are grounds for assuming though that the incomes of people in Estonia will continue to rise relatively quickly over the coming years, and that will make it easier to service the loans that were taken earlier.

So in summary, the central bank is reducing the support it gives to the economy through monetary policy.

Alongside monetary policy, which we conduct jointly in the euro area, Eesti Pank is also responsible for the stability of the Estonian financial sector. As part of this the central bank imposes requirements on the financial sector. When the pandemic started, we cut to zero the systemic risk capital buffer requirement to help commercial banks during the crisis. This freed up 110 million euros in capital for the banks, which they were able to use to cover possible loan losses or to make new loans. The impact of the crisis was fortunately less than had been feared, and the banks remained strong. That allowed us to end this relief, and reinstate the buffer requirement. And so we are also tightening our policy in this.

We also monitored developments in the real estate market closely. We believe that the review last year of the conditions for KredEx guarantees and the adjustments made to them were a step in the right direction. We consider that the state support for people buying their first home is now better targeted.

I will now give you an overview of our other activities that should be highlighted.

We revised the Eesti Pank strategy last year. Our core tasks are set by law, but there is still always room to decide where we should make particular efforts in the shorter term. The biggest change in our strategy this time was the introduction of sustainable development as a topic of focus. We started to assess and monitor the carbon footprint of our investments in order that we can reduce it in future. We set ourselves as an organisation the same goal, and we will try to reduce our energy consumption and cut our waste, and change several of our habits in order to achieve this.

Under sustainability comes also the proposal by Eesti Pank to consider the approach that would reduce the need to issue one and two-cent coins. We produce dozens of tonnes of them at Eesti Pank each year, which places quite a burden on the environment. You as legislators in the Riigikogu have the opportunity to set rounding rules that would minimise the need for these low-value coins to be issued. We at Eesti Pank have raised the topic, and I hope that we will together find a good solution for it in the near future. If we put dozens of tonnes of coins into circulation each year that people mostly do not use for spending, it is simply a waste for society.

A particular priority for Eesti Pank in the second half of last year was everything that concerned resilience in a crisis.

The central bank is responsible in Estonia for maintaining the uninterrupted operation of the vital services of payments and cash circulation. We ran various exercises together with the commercial banks to establish how we could improve resilience even further. We tested how various cases of interruptions to data communication would affect payments for example. We want to be certain that the settlements between the banks could function at least once a day even if access to pan-European payment systems is lost.

Eesti Pank is also responsible for making sure there is sufficient access to cash. We keep our own stocks to cover any possible increase in demand for cash, and we are also able to add to our cash stocks rapidly if needed. We also have a plan for cooperation with the state treasury if electronic channels stop functioning and the government needs to make payments in cash. These are just a few examples. We have obviously also continued with other efforts to make the information systems of Eesti Pank more robust and to increase security.

We completed a special project in payments last year concerning the digital euro, on which we worked together with the company Guardtime. The project tested whether the technology used for the Estonian e-state would also be suitable as the core technology for digital central bank money. We found that it is technically possible, and discussions are now continuing at the European Central Bank.

In our role of adviser, Eesti Pank has continued with our regular meetings with the government and members of the Riigikogu. We are always ready to discuss the state of the economy and all other topics that concern Eesti Pank with the commissions and fractions in the Riigikogu. We have also continued organising public seminars to give a platform for discussion on issues that are important for society and for the economy, such as the recovery from the crisis or the state of the labour market.

The key messages and recommendations from Eesti Pank came last year largely from the faster recovery of the Estonian economy from the pandemic crisis than had been expected. A consequence of the recovery was that the state no longer needed to provide as much additional stimulus. One key recommendation that followed from this was that the state finances should move away from fiscal deficit. We still consider it worrying that the gap between the revenues and expenses in the Estonian state budget has already become permanent.

We still consider it worrying that the gap between the revenues and expenses in the Estonian state budget has already become permanent

I may also say a couple of words on statistics, which is a very important part of our work. Eesti Pank works alongside Statistics Estonia in compiling official statistics in Estonia. Last year we started to publish additional statistics on interest rates and on savings and loan associations, and there was great interest in this.

And so this summarises our everyday work.

Next I will touch at greater length on our understanding of the state of the wider world and the Estonian economy, and on the outlooks for them.

The world continues to recover from the pandemic, but Russia's invasion of Ukraine faced us with a new crisis. Beyond the human tragedy of this, the impact is felt through even faster energy price rises, which had already started last year as supply was unable to keep up with the rapid recovery in demand. And it was already apparent last year that Russia was reducing the level of gas stocks held in Europe, which was also an important factor in raising energy prices. The outbreak of war in February this year and the subsequent sanctions boosted further the rise in the prices of energy and various commodities. Food is also becoming more expensive, as Ukraine and Russia are both important exporters of agricultural produce. Inflation pressures in the global economy are being increased by the very strict restrictions in China to stop the spread of Covid-19, which have delayed any recovery in supply chains.

I would like to emphasise clearly here that it takes 18 months to two years for the decisions taken by the central bank to affect inflation. That is about how long it usually takes for interest rate decisions to be reflected in overall inflation. This makes it important for the central bank to estimate above all the more permanent price pressures and the expectations of financial markets, businesses and consumers for inflation over the longer term. We would like to see those expectations at around 2%, but in recent months they have shifted higher.

On the positive side though, the labour market in the euro area has never been as strong, nor unemployment so low.

The most recent forecast for the euro area was the European Commission's economic forecast that was released last week, which cut the outlook for growth in the euro area economy this year from the 4% forecast before the war to 2.7%, while the inflation expectations were raised from 3.5% to 6.1%. Inflation next year in the euro area will also be above the 2% level that we target as a central bank.

The European Commission expects economic growth in Estonia to slow from the rate of 8.3% last year to 1% this year. Average inflation for the year is forecast at 11.2% this year. Eesti Pank will release its own fresh economic forecast in a couple of weeks.

The recovery in the Estonian economy from the pandemic was very fast compared to those in other countries of the European Union. Estimates of the economic cycle were still very positive before the end of February. The labour market particularly stood out for this, as businesses said that the main factor limiting growth was the shortage of labour. Resources in the economy were being used to an extent where maintaining growth would require additional investment.

The picture changed from the end of February. Uncertainty has increased. Prices of inputs for some businesses have risen very sharply, and so some investments have been put on hold. At the same time however, consumer confidence has suffered less than in Europe on average. This is because the average incomes of people in Estonia are rising quite fast, and the increase has accelerated in recent months. We need to be careful that we do not fall into a price-wage spiral, which the recent visit to Estonia by the International Monetary Fund also warned about. This would be a threat to the competitiveness of our exporting sector.

The labour market in Estonia is still strong within the overall economy. Corporate surveys show though that expectations for hiring new staff have weakened, as companies become more cautious about their plans for growth under uncertain circumstances.

We currently see a need to monitor the real estate market more closely to ensure that it does not pick up too much momentum. There has been quite a lot of transaction activity there in the past year. The problem is primarily that the supply of new real estate is smaller than the demand to purchase it, which is pushing prices upwards. At the central bank we have not changed the rules for issuing housing loans, but we continue to pay close attention to these developments and are ready to tighten conditions if needed.

I will return now though to one of the main concerns in Estonia this year, which is very high inflation.

About half of inflation in Estonia is the result of the rise in energy prices. Food is also rising in price, as prices for food commodities in the global market are rising. We need to recognise though that inflation in Estonia has become more broadly based, affecting manufactured goods and services increasingly. As I said earlier, the central bank is playing its part at the euro area level to manage inflation. To curb inflation in Estonia though, it is very important that government spending not create excessive price pressures. Fiscal policy has a clear and important role to play in reining inflation back, and it is not wise to use one foot to press the brakes of monetary policy while stepping on the accelerator at the same time with the other foot.

To curb inflation in Estonia though, it is very important that government spending not create excessive price pressures.

This means that if the state is planning to grant subsidies to ease the impact of high inflation, they need to be very well thought through and very well targeted. It is apparent now that the inflation caused by the war in Ukraine is permanent in nature, and so the state is not able to counterbalance it permanently and for everyone. The general problem of widely distributed subsidies and tax cuts is that they cause increased additional demand in the economy, and so give a further boost to inflation.

We understand that under the current circumstances, which includes the recent supplementary budget, the state needs to spend more on national defence and that there are also additional costs from hosting refugees from the war. The Estonian economy does not however need direct support from the state, as demand being too weak is not a problem that we face.

We worry at Eesti Pank that the gap between state revenues and expenses in Estonia is already at around 3% of GDP and is becoming permanent.

This means that around one euro in ten that is spent under the state budget is not covered by revenues, and so more and more will need to be borrowed. The state debt will jump over the next four years from around 20% of GDP to an estimated 30%, and only a part of that will be because of crisis spending. Three years ago the debt of the Estonian state was below 9% of GDP.

The big picture is made less clear though because part of our income comes from support from the European Union. It is often forgotten in discussions of budget balance that a substantial part of the Estonian state revenues, around 2-3% of GDP, currently comes from the European Union budget. Our standard of living is improving though, and this support will be reduced in future. This means that we are actually able in the best case to cover only 85 cents of each euro spent by the Estonian state from our own revenues. This is not sustainable over the long term and it should make us cautious when we are planning additional permanent state expenditures.

Is increasingly hard to argue that borrowing as a state is a simple and cheap way to cover large state investments or expenses. It is important to consider right now the additional price pressures that could come from spending borrowed money. Equally, it is evident that the direct interest costs mean that borrowing by the government is no longer very cheap.

It was suggested not that long ago that targeting balance for the state revenues and expenditures was no longer relevant and was too conservative an approach, but I believe that the opposite should be argued now, as it is no longer appropriate to argue that governments are able to use endless cheap loans to cover their costs.

The key message from Eesti Pank about state finances remains then that when additional spending is planned, it should be clear where the money to finance it will come from.

When permanent spending obligations are agreed, it should not be planned that they will be covered by borrowed money or from the temporary increase in tax revenues that comes from high inflation. Money does not simply emerge from the state budget, but it is first collected into that budget from all of us as taxpayers. The responsible course is consequently to decide on how we will spend our common funds in a balanced and carefully considered way.

I would like to end by noting an approaching anniversary, as this month will mark 30 years from the monetary reform that laid the cornerstone of the success of the Estonian economy and its integration with Europe. We are again today living in difficult times. May we continue to have the confidence and wisdom in Estonia today and in future to take the decisions that will bring future success and opportunities for our people.

Thank you for your attention and I am ready to answer any questions you may have.