CHARACTERISTIC FEATURES OF CHANGES IN THE STRUCTURE OF FINANCIAL FLOWS IN 1996[1]

The following survey looks at the financial flows between the foreign, corporate, financial and the public sector. As the share of foreign financing of the economic growth is constantly increasing, attention has been focused on the financial flows between the foreign and domestic institutional sectors.

Keeping in mind that from the point of economic development it is important to know how big is the role of financial flows between economic sectors in financing investments and how the resources are divided between different sectors, the survey also looks at the financial flows in the context of savings and investments. Therefore, we also study the financial positions of different economic sectors, that is, the difference between the increment of financial assets and financial liabilities.

INVESTMENTS AND SAVINGS

In 1996, the level of investments made into the Estonian economy was still high, amounting to 26.7% of the gross domestic product (GDP). Active investments were supported by both the intensive inflow of foreign capital and the increase in the capital investments of the public sector. Approximately 70% of the investments were made into the corporate sector while investments into the public sector made up 18-19% of total investments.

Despite the fact that in 1996, too, the main source of investments were domestic savings, the share of foreign savings in total investments amounted to nearly 35%. The level of savings in the public sector and households did not change much in 1996, but the volume of savings in the production sector decreased considerably as compared to 1995.

Foreign Sector

The improved outlook of economic development, the relative success of structural reforms and the belief of foreign investors in the increasing political stability in the Baltic region have improved the international credibility of Estonia. As a result, the circle of financial institutions and companies in the corporate sector, who obtained or improved access to international financial markets, widened in 1996. At the same time, the price of the foreign financial resources invested into the Estonian economy decreased somewhat. This was first and foremost apparent in case of foreign resources intermediated by the local credit institutions. Also, the range of financial instruments among the foreign capital inflow diversified in 1996. Thus, for example, the share of foreign portfolio investments into the equity securities of Estonian companies increased considerably, as did the volume of foreign capital flowing to the country through the credit lines opened to Estonian commercial banks.

As a result of the above mentioned tendencies, the level of foreign capital inflow reached 13.1% of the GDP in 1996 (6.9% in 1995). The deficit of the current account increased also considerably, amounting to 10.3% of the GDP[2]. According to both the net level of the foreign capital inflow to Estonia and the current account deficit, Estonia takes up the leading position among the countries of Central and Eastern Europe (see Table 1).

Changes in Foreign Capital Flows by Financial Instruments

In 1996, the structure of the foreign capital flows underwent a considerable change as far as the structure of financial instruments is concerned (see Figure 1). One of the most important changes was the considerable decrease in foreign direct investments. In 1995, the net flow of direct investments[3] accounted for 80% of the foreign capital invested into Estonia, while in 1996 the respective share was just 17%. This was, first of all, due to the 28% decline in foreign investments made into Estonia, as well as the impact of direct investments abroad by Estonian residents which amounted to half a billion kroons.

The decrease in direct investments was mostly compensated for by foreign investments made into the equity securities of Estonian resident companies as well as foreign deposits. The biggest role was played by the money flows into the Estonian economy in the form of deposits. In 1995, the increase of the residents' deposits in foreign financial institutions exceeded the increase of corresponding foreign liabilities by 200 million kroons while in 1996 the net flow of foreign deposits into Estonia amounted to 2.5 billion kroons. There were three reasons for this. Firstly, the deposits of foreign companies, credit institutions and private individuals in Estonian banks increased considerably due to the growing international credibility of the Estonian financial sector. Secondly, the money inflow has increased due to the credit lines opened to Estonian banks by foreign financial institutions. And thirdly, both Estonian commercial banks and companies of the corporate sector reduced their deposits in foreign credit institutions.

The increase of Estonia's credibility on the international arena and the rapid development of the stock exchange have strongly supported the growth of foreign portfolio investments into the equity securities of Estonian companies. Since the volume of the financial flows of this type increased more than ten times in 1996 as compared to 1995, the net flow of foreign investments into the equity securities amounted to 27% of the surplus of the financial account. The investments by non-residents into the shares of Estonian companies were distributed nearly equally between banks and production enterprises, exceeding one billion kroons in both cases. However, the great quarterly fluctuations of foreign investments made into the equity securities of companies in other sectors points to the accidental nature of such investments. Thus, the respective figure is unlikely to be large in the future.

Besides foreign direct investments, the share of foreign loans also decreased in the surplus of the financial account. The decrease in foreign loans granted to the public sector was not slowed down by the more active borrowing from abroad of the companies themselves, which amounted to 500 million kroons.

MAJOR TRENDS OF DEVELOPMENT

As compared to 1995, the increase in foreign claims by residents slowed down last year (see Figure 2). This apparently points to the emergence of more profitable investment opportunities in Estonia. One proof of it is the transfer of money deposited with foreign credit institutions to Estonia. At the same time changes in the structure of foreign claims indicate that both companies in the corporate sector and commercial banks preferred potentially more profitable but also riskier financial instruments and investment projects in their choice of investments abroad. This can be seen both from the increase in direct investments abroad and the growth of portfolio investments into the equity securities of non-resident companies as well as from the withdrawal of deposits from foreign banks.

In 1996, foreign liabilities increased by nearly 8 billion kroons (see Figure 3). The structure of foreign liabilities changed considerably as well. In 1995 foreign direct investments made up 53% of total foreign liabilities, while in 1996 their share was 21%[4]. The share of portfolio investments, loans and deposits increased to 66%. Thus, we can presume that in 1996 the role of Estonian companies in the selection of areas into which foreign investments were made increased.

The share of the banking sector[5] in incorporating foreign resources increased in 1996 while the share of the public sector and other sectors decreased (see Figure 4). The decrease of the share of the public sector in incorporating foreign resources resulted first and foremost from the fact that the central government borrowed less in 1996. This decrease was not compensated for even by the funds raised through the issue of municipal bonds by the Tallinn city government. Despite the considerable decrease in foreign direct investments into other sectors, the net flow of foreign capital into those sectors increased from 1.97 billion kroons to 3.87 billion kroons in 1996. The decrease in direct investments was compensated for by the sale of equity securities to foreign investors, more active borrowing from abroad and the withdrawal of deposits placed with foreign credit institutions in previous periods.

The increase of the role of the banking sector in incorporating foreign financial resources derived first and foremost from the growing credibility of Estonian commercial banks on the international scene which made access to foreign financial markets easier for them. The growing confidence of the credit institutions in the favourable economic development in the future also had a positive impact and gave a boost to the lending activity. Therefore, the shortage of domestic loan resources was compensated for by attracting more foreign resources. The increase in the banks' foreign liabilities exceeded the growth of foreign claims by 1.8 billion kroons in 1996.

Changes in the structure of the inflow of foreign capital by financial instruments, claims and liabilities indicate that in 1996 more foreign resources was spent on financing private consumption and the current expenditures of the companies. In 1996, the volume of foreign currency loans granted by banks to households increased considerably (by 562 million kroons) [6]. In most cases such loans partially used for financing consumption have come from foreign resources. As compared to 1995, the share of direct foreign investments into the fixed capital decreased while the share of loan capital increased. The likelihood of those loans being used for covering the companies' current expenditures, such as tax or wages arrears, is relatively high. Thirdly, foreign portfolio investments into shares traded on the secondary market have increased considerably. As in this case the companies and private individuals selling the shares do not take any obligations before the foreign investors, the resources acquired this way are likely to be used also for financing consumption expenditures.

PUBLIC SECTOR

Financial Position, Investments and Savings

The overall deficit of the public sector increased from 484.8 million kroons in 1995 (1.2% of the GDP) to 791.1 million kroons in 1996 (1.5% of the GDP), according to the Ministry of Finance. The main reason for the budgetary weakening of the public sector was the growth of investments. While the expenditures of the public sector increased by 26.3%, investments increased by 36.2%. As the increase in the current expenditures and total income of the public sector remained largely unchanged, the savings by the general government were practically the same as in 1995. In both 1995 and 1996 the public sector savings amounted to approximately 3.5% of the GDP.

In 1996, the reasons for the public sector deficit were very different from those in 1995. In 1995, the overall deficit stemmed mainly from the capital investments made from loans granted to the central government while in 1996 the deficit derived from the use of foreign loans taken by local governments for financing investment projects. Therefore, the biggest deficit in the fiscal system was caused by the local governments whose expenditures, according to the Ministry of Finance, outstripped their income by 558.5 million kroons. According to the Ministry, the deficit of the Social Insurance Fund and the central government amounted to 140.7 million kroons and 129.1 million kroons, respectively. Other non-budget funds ended the fiscal year with a small surplus.

One of the most characteristic features of 1996 was the high level of the public sector investments. The share of capital investments in the total expenditures of the government sector amounted to 12.2%, accounting for 5% of the GDP (4.5% of the GDP in 1995). Approximately 70% of the capital investments were covered from the public sector savings.

The resources allocated for capital investments by the local governments increased considerably. As compared to 1995, the investments made from local budgets doubled in 1996 (from 540 million kroons in 1995 to 1,120 million kroons in 1996). The bulk of the money was channelled into the economic and educational sphere. Investments by the central government remained more or less on the same level as in 1995. The decline in the share of the public sector capital investments made by the central government was caused mainly by less investments made from foreign loans. Thus, investments by local governments and the central government were nearly equal in size. Like in previous years, investments made by the non-budget funds remained relatively modest.

Financing of the Deficit

In both 1995 and 1996, the deficit of the government sector was mainly financed from foreign sources. 70% of the deficit of the fiscal system is estimated to have been covered from foreign resources. An important new tendency was the growing amount of foreign resources used by the local governments. Thus, for example, the bonds issued by the Tallinn municipal government brought in more money than the total sum of the foreign loans taken by the central government in the whole 1996. This trend increased the share of debt securities in financing the deficit in 1996. Foreign financing was particularly intensive in the first half of the year, with both local governments and the central government actively seeking foreign loans.

Unlike in 1995, when foreign financing contributed to the growth of domestic assets, 30% of the general government's deficit was covered from domestic financing. Both the surpluses of the previous years as well as loans from the domestic financial sector were used to cover the deficit. As a result, the public sector savings decreased from 3.9% of the GDP in 1995 to 3.1% of the GDP in 1996. The main reason for the decrease in the savings was the more frequent and substantial increasing of pensions and the decision to start paying full pensions to working pensioners. The government's two supplementary budgets, too, helped to decrease the savings.

OTHER SECTORS

Corporate Sector

In 1996, the financial deficit of the corporate sector increased markedly. The financial deficit of the manufacturing sector was estimated at 50% of the investments made by the companies. The shortage of the companies' internal resources was mainly covered from resources obtained from abroad and from the domestic financial sector. The role of the domestic financial sector in financing the financial shortage of production companies has increased in particular. A new trend was the increase in the share of financial institutions (mainly leasing firms) in covering the shortage of resources in the corporate sector.

In 1996, the price of the borrowed funds decreased slightly and the access of companies to domestic credit resources was made easier. The decline in the price of the financial resources can be seen in the fall of the interest rates on loans to companies from 15.8% at the beginning of the year to 13.4% at the end of 1996. One can also presume that the growing confidence of the local credit institutions in the good economic development outlook has increased the risk readiness of the commercial banks. As a result, the requirements set on borrowers by the banks have been somewhat eased.

In 1996, the range of the financial instruments used for covering the financial deficit widened. The biggest change was the decrease in foreign direct investments and the increase in the share of both domestic and foreign portfolio investments and loans.

As we already mentioned, the share of foreign loans increased in 1996. More was borrowed from both the Estonian banking sector and from foreign financial institutions. Foreign loans amounted to 485 million kroons (350 million kroons more than in 1995) and loans from Estonian banks stood at 2.45 billion kroons (840 million kroons more than in 1995). The increase in the loans granted by the Estonian banks to local companies in 1996 was guaranteed by the increase in savings by foreign credit institutions, companies and private individuals as well as by local households. The flow of funds through the credit lines opened to Estonian banks by foreign credit institutions also contributed to the growth of the credit resources. The increase in foreign borrowing, on the other hand, resulted from the improved access to the international money and capital markets by several companies.

In 1996, the increase in the production sector claims, in absolute terms, was considerably smaller than the increase in liabilities. In the structure of the corporate sector claims the share of direct investments abroad increased, while the share of deposits decreased. In 1996, the volume of direct investments abroad by production companies amounted to 416 million kroons, exceeding the level of 1995 by 15 times. In 1996, the companies' total deposits in domestic and foreign credit institutions were smaller than in 1995. Deposits in the Estonian banking sector increased by 1,440 million kroons while deposits in foreign financial institutions decreased by 412 million kroons. The modest size of deposits made by the companies was probably due to the rise of more profitable investment opportunities in Estonia.

Households

The savings by households exceeded their investments in both 1995 and 1996. Household savings are estimated at 20% of the total 1996 savings and their investments amounting to more than 1 billion kroons. Thus, we can say that the savings made by private individuals helped to cover the financial deficit of the corporate sector from domestic resources.

The year 1996 is characterised by the considerable increase in loans granted to households. As compared to 1995 when private individuals received 241 million kroons worth of loans from banks, in 1996 total loans to private individuals amounted to 1,061 million kroons. The increase was the sharpest in long-term loans. Thus, for example, the balance of the foreign currency loans with the term of more than five years increased from 0.3 million kroons at the end of 1995 to 519.8 million kroons at the end of 1996. In most cases these were long-term housing loans. The increase in those loans was facilitated by the inflow of financial resources through the credit lines opened to Estonian banks by foreign financial institutions. The volume of long-term kroon loans increased as well. To a certain extent private individuals have also been granted loans for consumption. The reasons for the increase in loans granted to households are manyfold: the growth of the banks' credit resources, the continuing stabilization of the economy and the growing purchasing power of the population.

In 1996, the deposits of private individuals also increased considerably. In 1995, the deposits of private individuals in Estonian commercial banks increased by 850 million kroons, while in 1996 the increase was 1,676 million kroons. The deposits have mainly increased due to the growing savings of households. The growing deposits are also linked with the more active borrowing of private individuals since often part of the borrowed resources is deposited in a bank for a certain period of time. As compared to 1995 when the increase in deposits by private individuals exceeded loans granted to them by 609 million kroons, the respective figure for 1996 was 616 million kroons. The increase in deposits has also been facilitated by the growing trust of private individuals in the Estonian kroon and the banking sector.

Martti Randveer

[1] The author of the present article, Martti Randveer, is an expert of Eesti Pank Macroeconomic Reserch Department.
[2] Due to amendments to the customs regulations that took effect from 1 October 1996, this figure is not adequately comparable with the respective figures of previous years.
[3] The net flow equals to the difference between the increment of claims and liabilities (for example, the net flow of foreign direct investments into Estonia equals the foreign direct investments into Estonia minus direct investments abroad by Estonian residents).
[4] The structure of foreign liabilities that were created in 1996 is referred to.
[5] The resources incorporated by the banks also include foreign portfolio investments made into the equity securities of Estonian credit institutions. However, the bulk of the money earned from the sale of bank shares will not go to the commercial banks but other sectors. Thus, the banks in this case have actually not incorporated foreign resources
[6] Under the requirements of Eesti Pank commercial banks have to describe as foreign currency loans all the loans in which repayment is linked with some foreign currency.