ESTONIAN ECONOMY IN THE SECOND QUARTER OF 1997

CHRONICLE

9 April. Riigikogu (the Parliament) passed the Investment Funds Act, which authorizes the creation of contractual as well as shareholding investment funds.

22 April. The Government decided to set up the Estonian Regional Development Foundation which will be financed from the state budget.

25 April. At their trilateral meeting representatives of the Government, the employers and the employees agreed that a security fund has to be set up for the workers in companies that go bankrupt. According to the Government, the fund should be partly financed also by the employers and the employees. The Government also supported the suggestion of paying three months' average wages to the workers of the bankrupt companies instead of the current two months.

28 April. The leaders of the trade unions met with the prime minister to discuss raising the minimum wage to 1,200 kroons per month, setting up an insurance fund for work-related accidents and work-related disease, improving employment policy and retraining programmes, introducing a higher official subsistence minimum and creating a security fund for the workers in companies that go bankrupt.

1 May. The visa requirement was dropped from Estonian citizens to Finland, Sweden, Norway and Iceland. Thus, for example, Estonian citizens can stay in Sweden without a visa for three months within one year, but have to produce a return ticket and daily allowance on entry. The same requirements apply for entry into the other Nordic countries as well.

7 May. Riigikogu made amendments to the Local Budgets Act and the Foreign Borrowing by the Republic of Estonia and State Guarantees for Foreign Loan Agreements Act. From now on, local governments can borrow money or issue bonds only if the total sum of their unpaid loans, debt securities issued earlier and other obligations together with new obligations does not exceed 75% of the revenue planned for the current fiscal year. The sum total of loan repayments, interest payments and debt securities to be redeemed must not exceed 20% of the revenue planned for the current fiscal year. If the state is forced to pay back the loan it has guaranteed and interests on it, the state can require that the loans and all the costs of their repayment be later compensated for by the actual borrower. The amendments take force from 1 January 1998.

15 May. The use of the domestic passport of the former Soviet Union as an official identification document came to an end in Estonia. In accordance with the Aliens Act, all foreigners living in Estonia without a residence permit must be deported from the country.

19 May. New regulations on the issuing and use of privatization vouchers (EVP) took effect, under which privatization vouchers can besides the EVP central register also be kept on an account at the Central Depository for Securities. As before, EVPs can be owned by all private individuals, but only by legal entities registered in Estonia.

20 May. Riigikogu passed the Child Benefits Act under which the size of the child benefits will be fixed by the state budget for every fiscal year. The size of the child benefits cannot be smaller than their size in the previous year (in 1997 150 kroons per month) and all other child supports will depend on it. Besides Estonian citizens, also foreigners with residence permits, stateless persons and refugees are entitled to child benefits.

The Government endorsed the procedure of granting capital subsidies in 1997 through the Agriculture and Rural Life Credit Fund. Capital subsidies are meant for investments into rural businesses and are given to private businessmen and commercial undertakings registered in Estonia.

21 May. Riigikogu made amendments in the Education Act so that the state no longer has to provide finances for student loans. In the future, banks will provide student loans from their own funds. The borrower will pay 5% interest on the student loan guaranteed by the state and the state will compensate the interest margin to the banks.

23 May. The principles of the social insurance reform were discussed at the trilateral talks of the representatives of the Government, the employers and the employees. A consensus was reached on the pension reform which has to consists of the obligatory and voluntary pension insurance. No agreement was reached on how the tax burden should be divided between the employers and the employees in case of other categories of insurance (unemployment insurance, insurance for work-related accidents and disease).

26 May. The Tallinn Stock Exchange started trading the privatization vouchers (EVP). The sale and purchase margin was reduced on the first day already.

27 May. The Government approved a scheme on the basic principles of the salaries of civil servants which will increase the share of the scale salary as compared to benefits. The aim of the new scheme is to secure that civil servants who fulfil similar tasks will also be paid similar salaries. Some concessions will be made for certain departments (the National Tax Board, the National Police Board, the Board of Border Guard and the Customs Board) so that civil servants working for those departments will get higher salaries even under the austerity measures.

30 May. Eesti Ametiühingute Keskliit (the Association of Estonian Trade Unions) decided to seek widening of the range of topics discussed at the trilateral talks on social guarantees. The Association wishes to discuss also the raising of the tax-free minimum to 845 kroons per month and increasing the monthly unemployment benefit to 450 kroons.

11 June. Riigikogu passed the State Statistics Act which provides a legal basis for conducting national statistical surveys. Riigikogu also passed the Energy Act, which will regulate the state supervision over the fuel and energy market and the fuel and energy industry, and the Advertising Act, which among other things will ban advertising tobacco products. The Energy Act and the Advertising Act will take effect from 1 January 1998.

ECONOMIC GROWTH

The annual growth rate[1] of the gross domestic product (GDP) has increased sharply over the past year. In the second quarter of 1996 the GDP increased by 2.7%, in the third quarter by 4.9% and in the fourth quarter by 7.3%. In the first quarter of 1997 Estonia's GDP at constant prices was 10.8% larger than in the first quarter of 1996. The acceleration can partly be attributed to the low growth in the first quarter of 1996 (if the economic growth of the first quarter of 1996 as compared to the first quarter of 1995 would have been 3%, for example, instead of the actual 0.3%, the GDP growth of the first quarter of 1997 would have been close to the growth of the fourth quarter of 1996).

The GDP of the second quarter of 1997 is estimated at 16-16.5 billion kroons, which means a real-term increase of by more than 10% as compared to the second quarter of 1996[2]. However, the low comparison basis can not be used to explain the high GDP increase in the second quarter of 1997 because in 1996 the GDP growth was the highest in the second quarter.

DEMAND

Economic growth was based on the real increase of total demand as compared to the same period in 1996. The real growth of total demand was 26% in the first quarter and 29% in the second quarter, while the nominal growth was even higher -- 39 and 42%, respectively.

The year 1997 is characterised by the sudden increase in exports. In the first quarter of 1997 the value of the exports increased by 9% as compared to the previous quarter, while in the second quarter the growth was 12%. Such a sudden increase is unique for the beginning of a year. The annual export indices were 1.52 in the first and 1.57 in the second quarter. Eliminating the price increase from the worth of the exports, we can see that in those two quarters exports grew by 42-43% as compared to the same quarters of 1996.

Partly, this increase can be attributed to changes in the registration of merchandise stored in the customs warehouses. The new regulations took effect from 1 October 1996 and increased the book value of the exports. But the increase rate of export was exceptionally high even if we take into account the changes in the customs regulations. The total volume of the so-called pure export and the export of the merchandise processed in Estonia was 24% bigger in the first quarter of this year than in the first quarter of 1996 (real growth 19%). The second quarter was even more successful -- the nominal growth of the export was 34% and the real growth was 27%.

The rapid growth of export was facilitated by the favourable market situation, as well as the introduction of visa-free travel with the Nordic countries. The latter leads to the increase in tourism (particularly shopping tourism).

In a small country with an open economy like Estonia the sudden growth of export is, at the same time the main factor contributing to the increase in domestic demand, thanks to growing earnings from export and greater need for inputs of the export-oriented production. The increase in domestic demand has also been supported by the growth in investments, as a result of the increasing inflow of foreign capital and growing consumption by Estonian residents. The latter is based on the use of resources (income from shares sold to non-residents or bank loans) passed on to residents by banks or other financial institutions.

CAPITAL INFLOW

The attractiveness of the Estonian economy and high internal demand caused by the need of capitalization of the economy have guaranteed the continuation of active inflow of foreign capital.

The intensity of foreign capital flows in the first half of 1997 is indicated by the rapid increase in the residents' external liabilities. In the first quarter of 1997 external liabilities increased three times more than in the first quarter of 1996 and amounted to 45% of their total increase in 1996. The bank statistics point to the continuation of the same tendency in the second quarter of this year.

Due to the modest borrowing of the central government, the net foreign debt of the public sector at the end of the first quarter of 1997 was on the same level as in the first quarter of 1996 (approximately 2.6 billion kroons). Formally, the increase in foreign debt has been curbed by the Estonian commercial banks who have acquired debt securities issued originally by the central government and the Tallinn municipality to foreign investors.

On one hand, modest foreign loans point to the aspiration of the central government to keep the growth of the debt burden under control. On the other hand, the role of the Estonian banking sector in attracting foreign resources has increased and helps to meet the domestic demand for investments. Therefore, the demand for foreign loans taken by the central government has been decreasing.

Although in the next quarters foreign loans taken by the central government may exceed the level of the second half of 1996 and the first half of 1997, the rapid and unchecked increase in the foreign debt of the public sector in the near future is unlikely. Thus, if the current development trend continues, the fiscal policy of the government sector would not favour the increase in the domestic demand. But in the conditions of the continuing 10% economic growth it would be wise to consider adopting a more conservative fiscal policy.

Due to the high demand for investments in the corporate sector and the relatively low level of domestic savings, the change in the net foreign debt indicates that the external position of other sectors has been weakening the fastest. At the end of the first quarter of 1996 direct debts of non-residents to other sectors were equal to the debt of those sectors to foreign investors while at the end of the first quarter of 1997 the foreign debt of other sectors amounted to approximately 3.2 billion kroons[3].

In view of the high demand for investments by the corporate sector, the relatively low level of domestic savings, the optimistic economic expectations of companies and the improved access of several production enterprises and financial institutions to the international financial markets, we can assume that the rapid increase in the net foreign debt of other sectors will continue this year. Although at the moment it is impossible to objectively evaluate the effectiveness of the utilization of financial resources received by other sectors from abroad, it is clear that since foreign borrowing eases the financial situation of companies it can thus dampen efforts aimed at reducing costs.

At the end of the first quarter of 1996 the debts of non-residents to the banking sector exceeded the liabilities of the commercial banks to the foreign investors by 1.4 billion kroons, while at the end of the second quarter of 1997 the net foreign debt of the banks had risen to approximately 0.7 billion kroons. The weakening of the foreign position of the banking sector can be attributed to the increased risk-readiness of the banks, better access to foreign financial markets and high domestic demand.

But equally significant was the rapid increase in the banking sector's foreign claims in the first half of 1997 which, according to the data of the consolidated balance sheet of the banks', amounted to 2.2 billion kroons. Thus, the increase in the foreign liabilities of the banks (nearly 3 billion kroons in the first half of 1997) has first of all supported the increase in the foreign claims of credit institutions.

SUPPLY

On the supply side, the growth has been the most rapid in case of imports. In the first quarter of 1997 the domestic supply accounted for less than 50% of the total supply for the first time. The decrease of the share of domestic supply continued in the second quarter.

The main reason for the increase in imports is increased demand which derives from the wider opportunities of financing import, that is, the constant increase in the credit turnover of the balance of payments.

The widening of the financing opportunities of import is mainly based on growing export and more intensive inflow of capital. The growth of exports increases demand for imports due to the increasing monetary income from exports and increasing demand for imported input used for export production. The increase of investments based on capital inflow leads to the increase in imports due to demand for capital goods that are not manufactured in Estonia.

The increase in demand is characterised by preference for imports. In 1996, the ratio of the imported merchandise and domestic demand was approximately 60%. In the first half of 1997, the share of imported merchandise increased to nearly 75%. The new customs regulations introduced from 1 October 1996, somewhat contributed to this increase. However, the continued impact of the changed customs regulations does not explain all the increase in imports. The increase in the import of merchandise in the second quarter again boosted the foreign trade deficit close to 30% of the GDP (in the first quarter the deficit had been 25% of the GDP and is estimated at 28-29% in the second quarter).

The foreign trade deficit is made up of:
 (1)the difference between the cost of pure imports and exports, and
 (2) the difference of the cost of merchandise taken into and out of the customs warehouses. The monthly change of the balances of the above customs procedures in 1995-1997 is given in Figure 1.

Provided that not many new customs warehouses will be built, the increase in the difference of the cost of merchandise imported into customs warehouses for later export and the cost of merchandise actually re-exported can perhaps be explained by accounting procedures. The merchandise that is sent to the domestic market from customs warehouses instead of re-exporting it, is not recorded as imports for the second time in order to avoid double recording.

Supposing that food products and consumer goods imported for free circulation are consumed by households and raw materials are used for the interim consumption, we can say that in the first half of 1997 the import of investment goods increased as compared to the first half of 1996, while the import of merchandise meant for private consumption decreased (see Table 1). The import of capital goods was more or less equal to the current account deficit. Thus, in case the inflow of foreign capital was to stop now, the current income from foreign transactions (that is, earnings from the export of goods and money transfers) would enable Estonia to finance the imports needed in production as well as private consumption.

In the domestic supply of the first quarter the highest economic growth (30%) was recorded in the financial sector. In the manufacturing and non-financial services sector the value added increased by 11.7% in the first quarter (the value added produced in this sector accounts for over half of the total GDP). In the government sector economic growth was 1.8% and in households, 7%.

Although the data for the second quarter GDP is not available yet, we can safely assume that the rapid growth in the financial and manufacturing sectors continued. The sale of industrial production at constant prices, for example, increased by 12.7% in the first half of 1997 as compared to the first half of 1996. In the second quarter, the sales volume was 2.7% bigger than in the first quarter.

The rapid growth raises the question of whether domestic demand is too high and production capacities about to be exhausted. The industrial barometer of the Estonian Institute for Market Research (EKI), however, indicates that the main obstacle for expanding of production is still the low demand. In the third quarter of 1996 this was the main obstacle for 63% of companies, in the fourth quarter of 1996, for 69%, in the first quarter of 1997, for 64% and in the second quarter of 1997, for 60% of companies. However, the position of low demand as the main obstacle for production expansion is clearly weakening.

The lack of the necessary equipment was named as the main obstacle for expansion by a considerably smaller number of producers, but the significance of this factor is on the increase (see Figure 2). Regardless of the rapid growth, production in Estonia has not reached its limits yet. According to the EKI industrial barometer, approximately 60% of the production capacity was used in the second half of 1996 as well as in the first quarter of 1997. In the second quarter of 1997, 65% of the production capacity was used.

INVESTMENTS AND SAVINGS

According to preliminary data, the level of investments continued to be high in the first half of 1997. The increasing share of capital goods in the merchandise imported for free circulation points to active investment (see Table 1). The same trend of development can be seen from the intensive inflow of foreign capital and the increasing profitability of the companies in the first quarter of 1997. According to the State Statistical Office, the profits of the companies from economic activity in 1995 amounted to 1,722 million kroons and to 3,408.8 million kroons in 1996 (in the first quarter of 1996 -- 757 million kroons). In the first quarter of 1997, company profits amounted to 1,764 million kroons, being larger than for the whole 1995.

As we know, the bulk of foreign financial resources is used for financing investment projects and the main financial source of investments into companies is the savings of the corporate and the financial sectors. Therefore, we can assume that the share of the private sector investments[4] in the GDP have increased somewhat as compared to 1996.

Preliminary estimates on domestic savings, however, do not indicate any significant increase in the average inclination to save[5]. According to preliminary estimations, the share of domestic savings in the GDP was slightly under 20% in the first quarter of 1997. As compared to the first quarter of 1996, the savings of the corporate sector seem to have increased. This can be seen, first of all, from the increased profitability of the corporate sector. The savings of the public sector amounted to 3% of the GDP in the first half of 1997 (the respective figure for 1996 was 3.4%).

The saving habits of households have not changed much as compared to 1996 when the volume of savings by private individuals decreased as compared to 1995. Thus, for example, the net position of households strengthened by approximately 600 million kroons against the banking sector in the first half of 1996 (about 2.5% of the GDP), while the respective figure for the first half of 1997 was approximately 400 million kroons (about 1.4% of the GDP) [6].

Although at first glance it would seem logical to expect the saving habit of households to grow (the income of the population has increased at a relatively rapid rate in recent years, macroeconomic stability as well as the stability of the financial sector has increased and investment opportunities have widened) there have emerged several factors over the past 12 to 18 months that can have a negative effect on the private individuals' saving pattern.

In the second quarter of 1997, the capitalization of the stock market had increased to nearly 35% of the GDP, as compared to 8-9% of the GDP at the beginning of 1996. At the same time the share of non-resident investors in the overall investor breakdown has not increased considerably. Therefore, it is possible that the growing wealth of private individuals deriving from the increasing price of shares on the stock market may have contributed to increasing private consumption.

The recent economic developments indicate that the residents' confidence of the future has increased. This, however, can reduce cautiousness-motivated savings.

Due to the intensive inflow of foreign capital, higher risk-readiness of the banks and tightening competition in the financial sector, the liquidity limits of people with above the average income have been considerably reduced during the last year. Higher liquidity limits have probably facilitated private consumption and discouraged the saving instinct of these groups of the population.

The rapid economic growth of the recent quarters and good prospects of the economy have apparently increased people's expectations about their future income. Thus, the efforts to extend meeting one's needs over a longer period and hope for considerably higher incomes in the future can have a reducing effect on the current savings rate.

Besides the above factors, household savings have probably also been affected by the fact that the transition processes of the past 5-6 years have boosted the salary levels of 20-30-year-old specialists with higher education the most. This can partially be seen from Table 2. As those persons, as a rule, are in the first phase of their lifetime consumption cycle, this has a reducing effect on the rate of household savings.

PUBLIC SECTOR

Revenue

The tax burden of Estonia's fiscal system has remained practically unchanged in recent years. The state revenue increased with every month during the second quarter and by 1 July approximately 48% of the planned total annual revenue had been collected. This is 20-21% more than in the first half of 1996. The state income from VAT, beer excise tax and personal income tax was ahead of the planned annual schedule. At the same time, the experience of the first half of 1997 indicates that planning the income from the fuel excise tax is problematic. Thus, for example, 51% of the beer excise tax was collected by the end of the first half-year, but only 36% of the planned annual fuel excise tax. The additional revenue collected thanks to the rapid economic development, thus compensated for the revenue that was not received from the higher fuel excise tax.

Estonia's local governments had collected 47% of their planned annual revenue by the end of the first half-year, the respective figure for the social insurance fund and the health insurance fund was 51%. The size of the wage fund affects, to a greater or lesser degree, all the components of the fiscal system, accounting for approximately half of the total revenue (see Table 3).

All in all, the revenue of the fiscal system in the second quarter of 1997 increased 1.21 times as compared to the same period last year, which corresponds to the GDP growth (see Table 4). Although economic growth in the second quarter was similar to that of the first quarter, collection of revenue had improved. The reason for this improvement can be seen in the fact that the clearings linked to the previous fiscal year (first of all, the return of VAT paid on imports after the merchandise was re-exported) had come to an end.

Expenditures

The expenditures of both the state and the local budgets increase slower than revenue in the second quarter of 1997. The structure of expenditures was similar to that of 1996. The main difference was in the smaller share of financing the social sphere, resulting from the fact that holiday payments were distributed more evenly between June and July. This was particularly characteristic of the local budgets. Investments of local governments were nearly 50% smaller than they had been in the second quarter of 1996. In the overall fiscal system, investments from foreign loans accounted for only 0.5% of the GDP. Expenditures on pension payments increased faster in the second quarter of 1997 than expenditures of the total state budget (17 and 14%, respectively) and expenditures on child and family benefits were approximately 10% bigger than in the same period of 1996 (see Table 5).

Riigikogu (the Parliament) on 19 June passed the supplementary budget and changed the distribution of funds between the state-financed departments, The bulk of the supplementary budget funds (55 million kroons out of the total of 70 million) was earmarked for the government's reserve fund. But a much more significant change concerned the increase in the expenditures of the social insurance and health insurance funds without the use of current revenue. During the discussion of the supplementary budget Riigikogu authorized the increase in the expenditures in those two spheres on account of the surplus revenue left over from the previous year to the amount that is estimated at approximately 0.2% of the annual GDP. All in all, the expenditures of the fiscal system increased by approximately 15% as compared to the respective period of 1996. The increase of the revenue against the increase of expenditures was higher than it had been in the first quarter of 1997.

As before, the slowness of the pension, health care and education reforms gave cause to tensions. In preparations for the pension reform, the respective team has produced a conceptual package of the reform and has begun to draft actual legislation. The health care reform team has began co-operation with experts from the World Bank who have presented their proposals.

Balance of the Budget

In the second quarter of 1997, the surplus revenue of the central government and the health insurance fund was so much higher than the actual expenditures, that it nearly compensated for the deficit of the local governments and the social insurance fund (the new government called the balanced central government budget one of the cornerstones of its economic policy in 1997-1998). The surplus revenue of Metsakapital (the Forest Capital) and the Environmental Fund was practically equal to the overall deficit of the public sector in the first quarter. Thus, in the first half of the year the deficit of the fiscal system was reduced to near zero (50 million kroons) and was much smaller than predicted (according to the economic policy co-ordination memorandum from 18 June 1996 between Estonia and the International Monetary Fund (IMF), the goal had been set to reducing the overall public sector deficit to 0.4% of the GDP).

The increase of money on the bank deposits of the public sector divisions with surplus revenue helped to balance out the decrease of the money on the bank deposits of the divisions that had a budget deficit. The same can be said about the disbursements of foreign loans and their repayments. The money borrowed by local governments from Estonian banks and the debt securities issued by them were by nearly 85% used on repaying earlier loans and repurchasing earlier issued debt securities.

The size of the expenditures financed from domestic resources has remained more or less the same in recent years. Expenditures financed from foreign loans and the overall deficit of the government sector, however, have been fluctuating significantly. This has raised the question of setting one comprehensive fiscal goal for the entire public sector (that is, to start planning the size of the deficit or the surplus). Currently, this role is served only by the limits set on the central government and local governments borrowing. On 7 May, Riigikogu passed amendments to the Local Budgets Act and the Foreign Borrowing by the Republic of Estonia and State Guarantees for Foreign Loans Agreements Act which stipulate that the total borrowing of the local governments must not exceed 75% of the fiscal year's revenue and the cost of servicing the loans has to remain below 20% of the fiscal year's revenue. Borrowing for covering current expenditures is not allowed. Estonia's new government, too, has declared in its programme that it aims at a conservative loan policy.

INFLATION

Several annual inflation indicators that had been declining for some time edged slightly up in the second quarter of 1997. This was due to the administrative price rises that are unavoidable in the conditions of overall price increase. The impact of administrative price rise was felt throughout the quarter. In general, the price increase of the second quarter can be qualified as a deviation from the prevailing development pattern. At the same time, the long-term inflation trend did not change in the second quarter (see Table 6).

One of the factors in Estonian inflation is the nominal rate of the kroon. This needs to be emphasized because the decline in the exchange rate of the German mark contributes to the price increase in Estonia. The price increase of imports, due to the strengthening of the US dollar and other foreign currencies, boosts the rate of inflation. The nominal exchange rate of currencies used in paying for merchandise imported into Estonia increased by an average of 3.7% in the first half of 1997.

The inflation rate was slowed down by the increasing flexibility of the prices, caused by tightening competition. Obviously, inflation has also been lowered by the stormy development of the capital market in recent months. The share boom has led to the growing use of quasi-money on the capital market. This new tendency has taken part of the money supply out of the domestic commodities market. Therefore, the increasing capitalization of the stock market has eased the pressure for higher money supply[7] .

Consumer Price Index (CPI)

Consumer prices increased 4.4% in the second quarter of 1997, or more than in the first quarter (3,0%; see Table 7 and Figure 3). In 1996, consumer prices increased 8.2% in the first quarter and 4.6% in the second quarter. The deviational development of this year (the second quarter CPI is normally smaller than in the first quarter) can be attributed to the exceptional nature of both quarters. The low CPI of the first quarter was equalized by the relatively high CPI of the second quarter, which was partially due to the political decisions postponed in the first quarter (see Table 8). Thus, the price increase of the past 12 months was up by slightly more than one percentage point, reaching 10.8% (see Figure 4). The 12-month CPI increase was 2.9% in case of food in April, being the lowest in the post-monetary reform period.

PRICES OF THE OPEN SECTOR

The prices of the open sector continued their usual seasonal development although it was not as typical as usually. The pattern was less characteristic due to the price increase of those production inputs that are regulated administratively.

The open sector prices increased by 2.3% in the second quarter (2.8% in the first quarter) but the annual increase decreased from the first quarter's 6.6 to 6.5%. In all three months the price increase remained below 1%.

One indication of the tightening competition that slows down inflation was the approximately 20% increase in the advertising turnover and volume in the first half of 1997 as compared to the respective period of 1996.

Among external factors we should mention, besides the strengthening of the US dollar, also the increase in the prices of fuel and coffee on the world market. In Estonia, coffee prices have increased by nearly 30% over the past 12 months, which frequently exceeds the actual impact of external factors. The growing petrol prices gave an additional impetus to the merger plans of local fuel retailers in face of growing competition from foreign fuel concerns.

The deepening of general stability of the market is testified by the decreasing seasonal price increase of several groups of merchandise and the steeper seasonal decline in prices.

REGULATED PRICES OF THE SHELTERED SECTOR

The 7.3% increase in the regulated prices was the highest in the past seven quarters (see Table 7). The downward trend of the annual increase of the regulated prices, which dropped to 10.7% in March and April, climbed to 15% by the end of the second quarter, the same level it had been six months ago.

The increase in those prices is based on the administrative decisions to increase prices which concentrated in the month of May mostly. In April, the price increase had been relatively high and in June it was moderate. The major increases concerned the price of water and sewage, electricity, oil shale and natural gas.

Due to the privatization of capital-intensive state monopolies the financing of their long-term development is undergoing some changes. The changes in the companies' financial plans and price policy are also reflected in the prices of services these companies provide. Adjusting the administratively fixed price structure is paving the way to the price policy that will correspond to the actual costs of producing the respective goods or providing the services.

The price proportions are affected by the different sales price of electricity which is lower for industrial consumers and wholesalers than private consumers. The same principle applies to the heating energy tariffs which in the third quarter will be raised for the private consumers and lowered for the industrial consumers. The main reason for the price increase is the need to invest into the development of modern technical infrastructure.

The imposition of VAT on heating energy sales, which will have a significant impact on the structure of relative prices and which was originally planned for June 1997, was postponed for another year. The postponement was explained by the above-mentioned extensive price increases that will considerably reduce the solvency of the population.

DEREGULATED PRICES OF THE SHELTERED SECTOR

The sheltered sector deregulated prices increased by 5.7% in the second quarter of 1997 (see Table 7). This increase left the annual price increase level at slightly above 20% where it has stayed since the beginning of the year.

The changes in the deregulated prices depend also on the changes in the regulated prices. In the second quarter of 1997 the reaction of economic agents was aimed at anticipating the administrative price increase and most of the prices were raised already in April. In May and June prices were corrected to a lesser extent.

Producer Price Index and Export Price Index

Producer prices increased by 3.1% in the second quarter (see Table 7). This increase was approximately 1.5 times higher than the average increase of the past four quarters. More than two thirds of the price increase was caused by the increase in the price of electricity. Therefore, producer prices in the energy and mining industry increased by 7.8%, but by only 2.0% in the processing industry. The year-on-year price increase was at its lowest level at the end of March when it was 7.5%. By the end of June it climbed to 9.1% (in the processing industry, from 6.3% to 8.2%, see Table 9 and Figure 5).

Besides the 10.5% increase in producer prices in the energy sector, increases were high also in the textile industry (7.3%), dairy production (3.1%), chemical industry (3.0%) and timber production (2.4%). Taking into account the energy consumption volumes, the producer prices should increase the most in the oil shale chemical industry and timber processing but this may not be reflected immediately and directly in the producer price index. In the textile industry, prices have increased 9.3% over the past year. Of this, approximately four fifths (more precisely, 7.3%) occurred in the second quarter. At the same time, for example, the price of textile fabrics has increased 14.6% in 12 months. We also have to keep in mind that unlike in trade the price policy in production is closely linked with long-term contracts and thus the current increase in production costs might influence the producer price index only in the future.

Export prices went up by 1.8% in the second quarter (see Table 7 and Figure 6). This increase also reflects the reaction to the increase in producer prices. Since in the second quarter of 1996 export prices decreased 0.2%, the price increase of the second quarter of 1997 boosted the year-on-year price increase from 5.4% at the beginning of this year to 9.5% at the end of June.

Export prices can be greatly affected by changes in the exchange rate of the US dollar because in most cases payment for exports is in dollars. In the second quarter of 1997 the dollar gained 1.8% against the kroon. The average weakening of the nominal rate of the kroon against the main foreign currencies used in trade[8] can be seen in Figure 7. As we can see, the export price index changes in accordance with the changes in the nominal rate of the kroon. Thus, the change of the export price in kroons derives from the change in the nominal rate of the kroon because the export price is fixed in foreign exchange[9].

Construction Price Index

The second quarter of 1997 was characterised by lively construction activity, magnified by the seasonal boom and the increasing domestic demand. The construction price index which is based on production costs pointed to the 2.4% increase in the construction prices (see Table 7; in the first quarter of 1997 the construction price index was up by 1.9% and in the second quarter of 1996, by 4.2%). Over the past 12 months, construction prices have increased by 9.7%, or two percentage points less than the year-on-year index in the first quarter (see Figure 8).

Among the components of the construction price index the increase was the steepest in case of labour costs (3.1%) which was up in all three months. The wages of masons and electricians increased the most, probably due to the seasonal increase in demand. The prices of machinery and equipment increased by 2.7% and the prices of building materials went up by 2.1% (see Table 10). There is little room for further price increases for the building materials imported from developed industrial countries, so instead, the prices of Estonian-produced materials are soaring. In the energy-consuming building materials industry the price of bricks and building blocks has increased the most, by 9.2%. Their price was undoubtedly also affected by the increase in the price of electricity. Among building types, the cost of multi-storey houses increased the most.

Real Rate Index of the Kroon

The real effective exchange rate index of the kroon (REER), based on consumer prices and the nominal rate of the kroon, increased by 2.7 percentage points in the second quarter of 1997 and is the highest in the past four quarters (see Table 11 and Figure 9). In the past 12 months the real rate of the kroon has increased by 4.5%.

The real rate of the kroon strengthened by 4.2% against the currencies of the developed industrial countries where inflation remains low. This was first of all due to the 4.4% increase in the Estonian consumer prices in the second quarter but also the 0.5% increase in the nominal rate of the kroon (the nominal rate of the kroon weakened by 0.9% against the basket of currencies used in payments for exports). The real rate of the kroon weakened by 0.5% against the currencies of transition economies. This was caused by both the weakening of the nominal rate of the kroon against the currencies of those countries as well as the consumer price increases there. Compared to Estonia, inflation in other transition economies has decreased considerably and thus has a greater impact on the strengthening of the real rate of the kroon (see Table 12). In the first quarter consumer prices in the transition economies increased by an average of 4.6%, while in the second quarter the increase was just 1.8%. Estonian price increase, which reduces Estonia's competitiveness, exceeded the inflation indicators of all the countries used for calculating the REER. This was, however, compensated for by the weakening of the nominal rate of the kroon against the US dollar and the currencies of transition economies.

CAPITAL MARKET

The Tallinn Stock Exchange index TALSE has tripled since 26 November 1996, to the end of July 1997 (see Figure 10). Over the same period, the average ratio of the share price and the expected profitability has doubled. The volume or capitalization of the stock market has increased to 35% of the GDP, exceeding the 20 billion kroons line. The turnover of the stock exchange had grown 12 times by the end of the second quarter. At the same time, the increase in share prices slowed down in the second quarter (TALSE was up 8.97%).

Rapid economic growth, low inflation and decreasing interest rates (see Figure 11) have led to a virtual stock market boom. The entry of foreign institutions with diversified risk portfolios has brought down the risk premiums which is further contributing to the market activity. At the beginning of the quarter the rise of the market was caused by the interest of foreign investors but towards the end of the quarter the market was dominated by local investors.

The profits of five major Estonian banks have exceeded the predictions made at the beginning of the year by an average of 60%. The shares of those banks make up the bulk of trade done at the stock exchange. Over the second quarter, Eesti Forekspank (Estonian Forexbank) increased its profit estimation by 34.3%, Hansapank by 48% and Eesti Hoiupank (Estonian Savings Bank) by 112.5%. Several listed (Kalev, Norma, Baltika) as well as unlisted industrial companies increased their profit estimations, too, which further contributed to the rise of the market.

A large part of higher profits have become possible mainly thanks to the activities of the financial institutions and other companies on the stock market. Most likely, the rapid increase in profits is partly of cyclic nature and will therefore not affect the future expectations of investors.

Despite the continuing increase in the price/profitability ratio the structure of the stock exchange has not changed significantly. Foreign portfolio investments account for over 30% of the stock market. The speculative activity of non-residents has so far been modest. Their interest to buy has not increased while the inclination to sell has somewhat grown. The smallest group of the stock market players (10-15%) is made up of local private individuals but their share is increasing. Continuing economic growth, higher real wages and lowering risk premiums have attracted presumably more risk-weary private individuals. Thus, we can predict that the saving habits will be somewhat improved.

Over 50% of the market players are Estonian companies. The activity of local institutions on the stock market is also characterised by the nearly threefold increase in the commercial banks' loans guaranteed by the stock portfolios and the formation of securities trading divisions at the commercial banks and industrial companies.

LABOUR MARKET

The number of unemployed, registered by the state employment system in June 1997 was more or less the same as it had been in June of the two previous years -- there were 32,000-35,000 unemployed job-seekers of whom 17,000-18,000 had been officially declared unemployed and entitled to the unemployment benefit (see Figure 12).

One positive development has been the reduction of regional differences in the unemployment level. In June 1996 the unemployment level was the highest in Võrumaa county (13%), while in June 1997 the highest level (7.7%) was registered in Valgamaa county (the level was 6.8% in Võru). The level of unemployment was the lowest in Pärnumaa county where unemployed job-seekers made up 1.7% of the working-age population. The labour market situation has considerably improved also in the north-eastern towns, affected by new jobs being created in mining and the continuing exodus of non-Estonian workers to Russia. Thus, for example, in June 1997 unemployed job-seekers made up 5.3% of the working-age population of Narva, while a year ago in June their share had been 7.1%.

In North-Estonian counties and the capital Tallinn the problem is not unemployment but rather the lack of highly skilled labour which forces companies to make extra investments into training their staff in Estonia or abroad. The possibilities of exporting work-force from abroad are relatively limited as well as finding a job outside Estonia (most countries protect their labour markets against the influx of foreign work-force).

In the first half of this year, 48.2 million kroons was spent on implementing the state labour market policy, ie 13.2 million kroons more than in the first half of 1996. More than half of this sum (26.6 million kroons this year and 16.5 million kroons in the first half of 1996) has been spent on paying unemployment benefits.

The main problems of the state employment system are the lack of vacant jobs on offer and limited training possibilities for the unemployed. In the first half of this year, 15 million kroons was spent on retraining programmes for the unemployed whom 2.9 million kroons worth of grants was paid during their training, all together 2.7 million kroons more than in the same period of 1996. A total of 4,740 unemployed were enroled for retraining programmes in the first half of 1997.

The average wage usually increases in the second quarter. In the second quarter of 1997, too, a marked increase followed the decline of wages in the first quarter (the nominal wages increased by 16.7% and the real wages were up by 11.8%). As compared to the second quarter of 1996, the nominal wages were 21.8% and the real wages 10.4% higher in the second quarter of 1997 (see Table 13).

Wages increased the most in forestry, real estate, leasing and business services (see Figure 13). In the processing industry, where approximately 25% of the total work-force is engaged, the wage increase was below the average. On the other hand, the influence of foreign competition has led to the rapid increase in productivity namely in the processing industry. Thus, for example, in the processing industry the production per worker (at constant prices) increased by 28.3% in the first quarter of 1997 as compared to the first quarter of 1996, while the wages increased by 10 percentage points less. The increase of productivity was the fastest in the textile industry (85%), timber processing and woodworking (62%).

Eesti Pank Macroeconomics Department

[1] Quarterly GDP compared to the GDP of the same quarter of the previous year.
[2] The GDP growth rate shows a slight decrease in the third quarter. Proceeding from the July and August exports figures, revenue collection and electronic payments, as well as the September estimation that took into account seasonal factors, the nominal increase in the GDP in the third quarter is put at approximately 16.5 billion kroons. Compared to the third quarter of 1996, this means a real increase of 6-7%.
[3] Nearly half of the change in the net foreign debt is due to the growth in the trade credit owed.
[4] The private sector comprises the corporate sector, the financial sector and households.
[5] There is no reliable data for calculating the volume of domestic savings at the moment and therefore the data provided in this article is based on estimates. Such indirect indicators as the current account deficit, the structure of the financial account and its surplus, the structure of merchandise imported for free circulation and the profitability of the corporate and the financial sectors have been used for estimating the rate of savings.
[6] The above comparison, however, does not give us a precise and complete picture of the household savings because this year private individuals have been more actively investing their savings into securities.
[7] However, this process has a two-fold impact. The increase in the price of shares ensuing from the development of the capital market points to the growing wealth which reduces saving, increases consumption and, through the pressure of demand, increases inflation. Most likely, though, the inflationary pressure caused by the growing wealth is weaker than the disinflationary effect deriving from the growing capitalization of the stock market.
[8] The average rate change has been calculated by weighing the bilateral changes with the share of the currencies used in trade during the 11 months of 1996. More recent data was unavailable.
[9] Understandably, there can also exist a reverse situation, that is, the export price is fixed in kroons. And obviously, some exchange rate risk reducing measures are being used. These factors should explain why the exchange rate curve and the price index curve do not coincide entirely.