I SHORT SURVEY OF THE ESTONIAN ECONOMY AND EXTERNAL ENVIRONMENT

THE 1997 REVIEW

Rapid development was characteristic of Estonia's economy in 1997 - the annual growth rate of 11.4% was among the highest in Europe (see Table 1.1). The rapid growth was accompanied by near-maximum utilization of production resources and low unemployment. The annual average inflation rate was moderate - 11%. The increase in real wages and salaries (7%) outstripped by economic growth at the constant employment level indicated that the productivity increased and competitiveness did not fall. Growing consumption characteristic of 1997 was in line with the GDP growth (final data is currently missing) whereas consumption and housing loan boom was something new.

The economic growth as well as the growing consumption were sustained by the capital inflow throughout the year (net inflow of EEK 11 billion), major channel being the financial sector. These developments brought along the peak of the current account deficit - 12.9% of GDP (up to 16% in the fourth quarter). It reflects unbalanced external sector. At the end of the year the favourable external environment deteriorated sharply and a speculative attack against the kroon took place in October. It was followed by a preliminary stabilization in the securities market as well as by shortening of foreign liabilities' maturities. In the economic policy demand dampening and higher savings were focused upon (Stabilization Reserve Fund was established). Additional liquidity requirements have been introduced for banks. Previously banks' capital adequacy ratio had been raised to 10% to ensure higher capitalization of the banking sector.

MONEY AND CREDIT MARKETS

The declining foreign currency inflow through the financial sector in the first half of 1998 brought along further tightening of the monetary environment. The rising interest level enhanced the growth of time deposits and changed the structure of broader monetary aggregates. In early summer the cash preference exceeded the regular seasonal increase. It was due to Eesti Maapank (Land Bank of Estonia) and Eesti Hoiupank (Estonian Savings Bank) related issues. Parallel to the falling growth rate of monetary aggregates, the lending activities fell as well, reaching 35% in annual accounting in June-July. Both monetary aggregates and loan growth indicators reached the targets indicated in the Memorandum of Economic Policies[1] approved of by the International Monetary Fund (IMF), some were even lower. The first half-year revealed in foreign capital inflow structure a shift for increasing the stake of foreign direct investments. The share of the financial sector declined.

In the first half-year liquidity and interest rates were mainly affected by changes in the external environment. The 'overliquidity' caused by the end-1997 liquidity shock was over by the second quarter, the interest rate level fell as well. The reserves increased due to the inclusion of banks' financial guarantees into the reserve requirement base. Parallel to the growing reserves with the central bank (compared to end-1997) the role of the inter-bank money market declined. At the same time the market reflected external environment related uncertainty - instability in Russia spurred interest rates in July and even more so in August. In summer the open net foreign currency position restarted reflecting the international uncertainty. Unlike 1997 this time it was both currency speculations as well as real sector companies hedging their exchange rate risk. As the favourable external environment was not restored, the interest rate level remained higher than in 1997. The foreign capital inflow into the banking sector being well below expectations, spurred sentiments that the interest rate would continue rising.

FINANCIAL SECTOR

The main trend in the first half-year was a significant slowdown in the sector's growth (except in leasing activities). The volume of the consolidated balance sheet increased only by 5% during the first six months (against 33% in the same period of 1997). Stock prices in the securities market fell nearly to book value. The above was mainly due to the unfavourable external environment, due to the lack of fresh capital inflow. By today the securities market has subdued into a secondary market. Insurance losses were caused by tough competition (including sales below cost) and unsuccessful investment of reserves related to an exchange drop. The financial crisis in Russia made the return of east-oriented investment funds negative and the volume of funds decreased substantially as well.

The adaptation of the financial system with the end-1997 liquidity shock was well manifested in the suspension of the capital net inflow (except refinancing), lower growth rate and liquidation of overleveraged positions. Outcome of excessive risks taken earlier (Eesti Maapank, Eesti Hoiupank) was exposed as well. The impact of the end-1997 liquidity shock was manifest in the negative productivity of the banks' equity capital in the second quarter of this year. External environment has become problematic again (Asia in the second quarter, Russia in July-August), causing longer financial sector adaptation period than expected.

Financial regulation involves the implementation of the EU capital adequacy directive for market risks, bank reports on a consolidated basis, limits to open net foreign exchange positions of banks.

In the first six months banks' liabilities grew mainly at the expense of domestic deposits. Non-residents' liabilities underwent a minimum decrease (from 39 to 35% of aggregate liabilities). No major difficulties in refinancing foreign liabilities were observed. The maturity structure of non-resident liabilities has undergone a minimum lengthening (for maturities under a year). The loan volume growth has outstripped the balance sheet growth, the share of loans issued in German marks continued growing. The securities portfolio continued decreasing, the share of overdue loans in the portfolio was constant.

REAL ECONOMY

The rate of economic growth has slowed down: in 1997 it was 11.4%, in the first quarter of 1998 - 9.3% and in the second quarter according to the preliminary estimates - 5.5%. Currently the growth slowdown is associated with decreasing domestic and export demand. The latter being related to Russia and other trade partners. These developments brought along a slight decline in the current account deficit - down to 10% of GDP in the first half-year. On the macroeconomic level resource restrictions were not significant in the first quarter. The adjustment of real economy to the changed economic environment is still problematic, being related with overdue loans and, according to the latest estimates, with the impact of Russian economic crisis on Estonia as well.

The inflation rate is comparable to the level of 1997, although the annual average was slightly higher during the first eight months due to an administered price change at the beginning of the year (about 12% over the year). There are few new trends in inflation development, administered prices and US dollar exchange rate changes against the German mark dominate.

The consumption growth rate declined in the first half of the year. The slowdown in private consumption brought along only a 5% increase in the consumption loan stock. The retail trade growth rate increased by only 1% against the same period in 1997. The private investment based investment growth will probably exceed the 1997 level. The foreign demand has decreased this year: the export growth rate fell from 33% in the first quarter to 15% in the second quarter. Crisis in Russia was not the only cause, although exports to the east have slowly been declining throughout 1998. On the supply side transport, communication and construction represented the rapid growth, whereas financial intermediation and energy represented decrease. Businessmen have been continuously optimistic during the first six months, although available data represents only short-term expectations (Estonian Institute for Market Research studies expectations for only one quarter). Currently the major problem is the Russia-related drop in the east-oriented exports and its impact, especially on the fish processing industry and other branches of foodstuff industry.

EXTERNAL ENVIRONMENT DEVELOPMENTS

The Asian financial crisis starting in mid-1997 has been longer and deeper than expected. It is clear by today that no rapid improvement in financial markets is to be expected. The extensive depreciation of financial assets of developing countries has significantly undermined their economic growth outlooks. The financial crisis in Russia in October added new aspects which are too early to evaluate. The financial performance of developed countries is currently good but the financial crisis could affect them too.

The development of developing countries, including Estonia, is, first and foremost, affected by changes in investor attitudes of industrial countries towards emerging markets. Since the second quarter of 1998 it has manifested itself in the capital withdrawal from some regions and tightening of financial terms in others. In the environment where the economic growth is largely dependent on foreign funding, any changes in the availability, price or maturities of foreign credits are significant. Exchange rate fluctuations of main international currencies, especially that of the German mark against the US dollar, are significant for Estonia's economy. The latter would be reflected in Estonia's competitiveness, inflationary pressure, etc. It is difficult to estimate the scope of the drop in export demand in neighbouring markets due to problems in Asia and Russia.

Global Financial Markets in the First Half-year

In the debt market, the slowdown of capital inflow to developing countries, which started in the second half of 1997, has continued this year as well. The volume of primary issue of securities (both debt and equity securities) and syndicate loans decreased by about a third in the first six months against the already unfavourable second half of 1997. In the early second half of 1998, the situation worsened even more and in August new issues came to a halt. It is possible that in the changed circumstances the share of official credits increases at the expense of decreasing private capital.

Parallel to reduced capital inflow, the terms of emerging markets bond issue declined in the first quarter: the spread[2] grew from 2.5% in the fourth quarter of 1997 to 3.2% and maturities shortened. Background: since 1995 until mid-1998 the average interest of 10-year maturity bonds in G7 countries have fallen from 7.5 to 4.5%. The same trend prevailed in developed markets in the first half of 1998. It was supported by Asian economic crisis related supplementary capital flows to government bonds issued by G7 countries (excluding Japan).

After Mexican crisis the spread in the secondary market decreased to 3.4% in early October of 1997, pressure against the Hong Kong dollar in late-October raised it up to 6.4%. During 1998 the previous level has not been restored: it was the lowest in end-April - 4.6% - and was followed again by a downturn in financial markets in developing countries. It became evident that the projected economic growth for several East-Asian countries as well as for Russia should be adjusted downward. Previous overoptimistic forecasts had underestimated the negative impact of the financial crisis. The situation deteriorated even further in the third quarter. By mid-September the interest rates of developing countries' eurobonds had exceeded their level against US Treasury bonds during the Mexican peso crisis in late 1994 - early 1995.

In foreign exchange markets, Estonia's economy is the most effected by the exchange rate of the German mark against the US dollar. During the first six months the mark's exchange rate was within 1.76 - 1.85 DEM/USD. Comparing the above to the gradual weakening of the German currency over the last three years, certain signs of mark stabilization can be observed. Both the faster economic growth in Germany and relatively good prospects for the single currency have affected the German mark favourably, provided that European Central Bank has both the necessary resources as well as the will to ensure the stability of the single currency. Risks related to the financial environment in Russia have made the outlook for the exchange rate of the mark somewhat insecure.

Further weakening of the Japanese yen was feared in the first half of the year. It could bring along another 'wave' of devaluation of Asian currencies which now would involve China as well. There is also some uncertainty about the survival of the currency board system in Hong Kong. In July-August the Hong Kong dollar was under continuous pressure but up to now the country has been ready to defend its monetary arrangement. A significant impact on Estonia's financial market could come from other currency board system countries - here the simultaneous speculative attack against Hong Kong dollar and Estonian kroon in October 1997 could be recalled.

In equities markets, the situation varied from quarter to quarter during the first six months. Share prices in the USA raised by 13.5% in the first quarter and only by 2.9% in the second quarter. Equity markets in Western Europe were stronger and growth rates (based on US dollars) were 23.8 and 6.8%, respectively. The weakness of equities markets in the second quarter was best seen in Asia where the drop in price reflected the ever increasing uncertainty about the depth and length of the regional economic crises. The Japanese stock index grew by 6.1% in the first quarter but dropped by 13.9% in the second quarter. In the rest of Asia the 32.6% increase in stock prices in the first quarter was spurred by expectations that the financial crisis would have a limited impact on the real economy. In the second quarter it became clear that the crisis impact on economy is more extensive, stock prices fell by 36.7%.

[1] See more about Memorandums of Economic Policies approved of by the IMF in the previous issue of Monetary Developments & Policy Survey (Eesti Pank, Tallinn, 1998, pp 60-61).
[2] The price difference of Emerging Markets Bond Index (EMBI) against US Federal Funds Rate.