(1) The author of this article, Academician Raimund Hagelberg, is Member of the Board of Eesti Pank.


What happens in a transition economy is adjustment to the requirements of the market economy which are constantly changing. A successful economy has to take into account the impact of both these factors. However, the components of the economic environment (see Eesti Pank Bulletin No 2, 1997, pp 39--42) are not equally sensitive and do not change at an equal rate. This is due to various objective and subjective reasons which we will not dwell on in this article. The most important of these components is the main engine of the market economy, the solvent demand, based on the primary incomes from productive economic activity which make up the gross domestic product (GDP).

The actual structure of demand is made up of consumption and investment needs, saving activities, the level of development and reliability of the banking sector, the redistribution of income proceeding from social and other considerations, as well as the shadow economy, the impact of speculative and various other factors. In addition to the domestic factors, the demand and supply of an open economy are increasingly more influenced by the international redistribution relations. The latter are based on the lending relations and other forms of capital movement through banks, but also other channels that are driven by speculative motives and influenced by mass psychosis.

The changes of the economic environment are quickly reflected in the activities of banks, the money supply, the state budget and local budgets, non-budgetary funds, the stock market, the foreign trade balance and the balance of payments, etc. And finally, all these factors are reflected in the gross domestic product, although with a certain time delay. The causal side of the changes and their macroeconomic impact can be analysed by following the dynamics of the respective indicators and connections.

There has been a lively discussion in our economic circles and mass media on the situation of the Estonian economy, its growth rate, achievements, potential dangers and future outlook. The first impetus for this discussion came from the State Statistical Office who published the preliminary data on the growth of the gross domestic product in the first quarter of 1997, followed by even better results for the first six months of 1997. The discussion was heated up by an article in the October issue of The Economist on the currency crises of Thailand and Mexico in the context of Central and Eastern Europe, including Estonia, and the developments in the global stock markets as well as the Tallinn Stock Exchange and the subsequent speculative attack on the Estonian kroon.

The discussion has pointed to a number of problems, including serious ones, that cause great pessimism. Our task is to point to the essence of these problems and to seek solutions. For this, we need to follow the development of the processes, try to discover causal links and take into account the local peculiarities. A compressed database on what has happened has been given in Table 1, Table 2 and Table 3. The analysis below is also based on this data and the respective sources.

The following changes can be noticed in macroeconomic connections, proceeding from the conditional equilibrium of demand and supply:
 - the GDP growth has been outstripped by the increase in domestic demand based on imports and financed from external sources. The increase in the volume of external financial sources has been accompanied by a significant change in their structure -- direct foreign investments are being replaced by portfolio investments, and particularly by other investments which mainly consist of the capital borrowed by banks and trade credit. The bulk of this money is of a short-term nature;
 - the role of banks in arranging economic relations has increased. The ratio of the commercial banks' balance sheet volume to the GDP, which in 1994 was 33%, increased to 42% at the end of 1996 and is currently over 55%. The share of foreign resources and foreign currency has increased in the banks' liabilities and investments;
 - in accordance with the above-mentioned changes, similar changes have taken place in the money supply. M2 has increased rapidly, on the account of the increasing share of foreign currency. The share of bank money (PR) has increased in the base money (M0).


The rapid growth of domestic demand and the increasing role of banking are the characteristic striving of transition economies because the need to increase consumption and investments exists also in reality. The banking, too, strives in its development towards the scope characteristic of the market economy and the respective parameters. Understandably, every step to be taken in a situation like this has to be very carefully weighted and the efficiency of any activity has to be evaluated critically.

The deficit of the current account is in the focus of attention. The current account deficit is caused by the foreign trade deficit, of which over half has been compensated by the surplus of the services balance recently.

Estonia being a country of transit trade and a country providing processing services to foreign companies, its financial situation is also affected by various other factors. In the first half of 1997, for example, 3.5 billion kroons worth of merchandise accumulated in customs warehouses. The positive result stemming from processing and the subsequent export, which becomes manifest after a certain time delay, was unusually small in the first half-year, amounting to only a few hundred million kroons. Provided that in the longer run the economic processes will follow the usual business patterns, the normalization of the customs warehousing situation can considerably reduce the actual deficit of the current account. The expectation of overcoming the deficit this way is, however, utopian and therefore serious attention should be paid to finding additional export channels and replacing imports with locally-produced goods.

The balance of the capital and financial account, where foreign investments have the key role also has an impact on the balance of payments as a whole. So far, the capital and financial account has helped to keep Estonia's balance of payments positive and the foreign exchange reserves increasing, in the first half of 1997 by more than 0.5 billion kroons, for example. The change in the nature of foreign investments gives cause to worry, though -- direct foreign investments have been replaced by portfolio and other investments. The latter are less stable than direct foreign investments which are more closely linked to ownership relations, also the terms of such investments are shorter and the possibilities of recalling them greater. The balancing factor here has been the domestic sources of investment.

The higher than the GDP growth rate of the bank resources has been caused by numerous factors:
 1. The decreasing share of cash in the payments turnover. The ratio of cash in circulation (SRE) to the GDP has decreased from 11.6 to 8.8% while the share of the domestic broad money supply (M2D) has increased from 29 to 33%, the share of the money supply including foreign currency (M2) even from 33 to 40%. The increase of the latter two indicators, and particularly the rapid increase of M2, has been particularly significant this year. This can partly be attributed to the increase of foreign relations, including export and import, but we should not overlook the speculations of the possible devaluation of the kroon that have been in the air for some time and have recently surfaced more acutely. Such sentiments are undoubtedly undermining confidence in the Estonian kroon, testified by the recent increase in the volume of foreign currency deposits and loans;
 2. the development of the securities and the stock market resulting from the widening of the activities of the Tallinn Stock Exchange and other financial institutions. The result has been the rapid growth of the share of the securities, particularly stocks, in the balance sheet volume of commercial banks. This ties up resources and demands great attention from all the parties involved, because the stock market situation by its nature is always volatile;
 3. the two-way international movement of the bank resources -- the remarkable inflow of foreign resources through various credit lines, direct investments and other channels and the investments of Estonian banks into banks abroad in the form of shares as well as acquisitions. All the signs indicate that the latter trend has just begun. At the moment, the rapid growth of the share of non-residents is dominating in the commercial banks' liabilities, one manifestation of which is the considerable increase in the long-term loans given in foreign currency. In case of sensible investments that contribute to the economic growth this is a significant step in the right direction and testifies to the growing trust in the Estonian economy and banking. This trend is now supplemented by the positive country ratings given to Estonia.

However, the inflow of the external resources does not reduce the need to increase domestic savings and other sources of accumulation which form the most solid basis for economic growth and the developments that follow. The need for the better use of domestic reserves through the banking sector is also stressed by the slower increase in deposits as compared to the increase in the banks' balance sheet volume and loan portfolios, although the ratio of bank deposits to the GDP has increased from 22.8 to 32.7% and the share of time deposits has increased as well. However the banks have a competitor in the form of the stock market and other financial institutions. The money that moves through those institutions can, only in a limited extent, be used for the production activities.

The money supply indicators have increased over the past year: the cash in circulation (SRE) by 1.14 times; the bank money (PR) by 2.8 times; M0 by 1.39 times; M1 by 1.36 times; M2D by 1.42 times; M2 by 1.5 times. As we can see, the increase has been the greatest in case of the bank money due to the increase in the reserve requirement meant to boost the security of the banking sector and the money circulation. As the recent developments indicate, additional measures to this end obviously have to be applied in the future as well. The high rate of growth in M2D and M2, particularly in the second half of the year, can be attributed to the increase in time and foreign currency deposits, partly due to foreign sources.

Thus, the increase in the money supply is directly related to the resources concentrating into the banks and the effectiveness of using this resource, including avoidance of potential dangers, depends largely on the investments the banks make. In the macroeconomic context and in the long run, effective investment loans are much more useful than loans meant to cover everyday consumption needs. Unfortunately, the terms of the latter loans are offered on favourable terms by both the banks and their subsidiaries and other financial institutions. The buyers of durable goods and real estate should, however, weight realistically their prospects of repaying the loans. This would help to avoid any unpleasant surprises in the future. The same principle applies to the lenders because concentrating the realisation of loan collaterals will affect the situation and prices on the property market. Although the above thoughts have a pessimistic undertone, the general public should be made aware of those considerations.


And particularly when the needs are enormous and the money scarce. But this is how things are, even in the developed countries and particularly in post-socialist societies. A large part of the GDP is being redistributed through the state budget and local budgets as well as through non-budgetary state funds. Due to the wide scope of this problem we cannot discuss it in this short article, though. However, I would like to stress one point: to overcome temporary problems reserves need to be set up. In a consolidated fiscal system where the possibilities of manoeuvring the resources are limited, the need for reserves is particularly great.

The Estonian Government has decided to set up a 1.3 billion kroon stabilization fund as it has been suggested by the International Monetary Fund (IMF). The plan deserves all-round support even if it means postponing satisfying some important needs. The location of this reserve fund, whether it is deposited abroad or invested otherwise, is of minor importance. What matters is that it exists.

The Estonian fiscal system has so far been close to an equilibrium state. The government sector foreign debt, excluding loans guaranteed by the government, amounted to less than 3 billion kroons on 1 July, or less than 5% of the GDP. The calculations for 1998 have made so that the debt burden will not increase. However, the extensive borrowing through banks and other private channels has led to a significant change in Estonia's net investment position -- in the first half of this year the net foreign debt has increased from 2 billion kroons to 4.2 billion kroons, amounting to approximately 7% of the GDP. Although this indicator is still modest on the international scale, its rapid growth gives cause to worry.


* The overall picture of the Estonian economy, if we focus on monetary relations, does not indicate any particular achievements despite the 11.7% economic growth recorded in the first half of the year. It has to be admitted that the share of foreign resources is relatively high among the sources of economic growth, amplified by the banks and other financial institutions. However, there is no cause to be overly critical and deepen the sense of danger. The Estonian banking and financial sector has, for various reasons, been ahead of other sectors in its development. Now the main task is to apply the money taken in by the banks for the benefit of turning other sectors of the economy more competitive. This is testified by the statistical data which indicate the growth of manufacturing and service sectors. This kind of balancing development is also the best cure against the so-called overheating of the economy.

* During the stock depreciation and attacks against the kroon, the Estonian monetary system has once again proven its strength. But let us be honest -- strong currency can only be based on strong economy. The possibilities of the monetary system are limited and money is very sensitive to any kind of deviations. The fixed exchange rate and the full backing of the base money (M0) provide a stability factor for the monetary system which is particularly important for a small country. The central bank can interfere in the money supply through the bank money, or more specifically, the reserve requirement kept in the central bank. The increasing or decreasing of the reserve requirement works similarly to the regulation through the loans' interest rates but excludes the possibility of issuing uncovered base money. The main channel of strengthening the system is the inflow of foreign currency and the most natural source of it is export. Estonia's position as a re-exporter, which should be improved by the creation of tax free zone(s), more precise recording of the inventory of the customs warehouses and other measures will obviously lead to some adjustments in the balance of payments, including the balance of the current account.

* The internationalization of the Estonian economy has reached a remarkable level, expressed by the big share of both the foreign supply and the foreign demand. The foreign supply has always been larger than the foreign demand and this has an unfavourable impact on the balance of payments. However, we must not overlook the unavoidable characteristics of transition economies that stem from the economic rearrangements, entering new markets and the requirements of technological re-equipment. The stability of the monetary system has played an important role in the internationalization of the economy and the relatively quick organisation of the banking sector and abandoning of restrictions on the use of foreign currency has been followed by the inflow of foreign capital.

* The achievements need to be consolidated. Investments and their financing have an important role in adapting the structure of the economic environment to the needs of the market economy. Proceeding from the chain of investments-productivity-supply-demand-economic growth we can point to the key factors in improving the system and making it more efficient:
  increasing the share of domestic sources of investment on the account of saving in all sectors of the economy. This means changing the current mentality and introducing additional incentives;
  a clear vision of the long-term development strategy of the economy to secure better targeting of the investments and their higher efficiency;
  extensive market research and active promotion campaigns to improve Estonia's competitiveness on an international scale.

All this presupposes close co-operation between the state and the private structures and a general understanding that the transition process will soon be over and in order to proceed a qualitatively new status is needed.

Raimund Hagelberg