II REAL ECONOMY

Due to the slowdown in the foreign demand, both the exports and the growth rate in manufacturing declined in the first half of the year. Although a rapid growth continued in the service sector, which is oriented to domestic market, the real growth of GDP fell from 9% in the first quarter to 6% in the second quarter. The structure of domestic demand reflected a slowdown in the growth of private and public consumption and a faster growth of investments. The growth of investments share in GDP offset a slight increase in domestic saving, and the balance of savings and investments has shown only minimum improvement. Domestic demand exceeded GDP by about 9% in the first half-year (against 10% in the same period in 1997). Therefore the current account deficit remained close to the level of the same period in 1997.

DOMESTIC DEMAND

Private and Public Sector Consumption

Conditions for the private consumption growth were not as favourable in the first half of 1998 as a year ago. The first half of 1997 was characterised by the rapid growth of real wages and private consumption loans. The growth of real wages slowed down in the second half of the year whereas the rapid growth of private consumption loans continued until November, promoting consumption.

In the first half of 1998, the growth rate of real wages fell to 4.5% and monthly volumes of consumption loans have gradually decreased. The growth of the loan stock came to an end in October 1997 and it has been continuously declining ever since: as of end-July 1998 the stock was 14% below October 1997. According to preliminary estimates the private consumption growth has been below GDP growth at the beginning of the year. It becomes evident by several indicators. Firstly, the retail sales growth has continuously declined since the beginning of 1998 unlike the second half of 1997, reaching 1% in constant prices in the second quarter. Secondly, private deposit growth has accelerated, the stock in end-August exceeded by 17% the stock of the beginning of the year.

In the first half of 1998, the government consumption has increased even more slowly than private. The growth of government final consumption against GDP characteristic until the end of 1996 stopped in the middle of 1997. In the first and second quarters of 1998, government spending to GDP ratio was below the level of the same period last year.

Investment and Saving

The investment activity was continuously high in the first half of the year. Since the third quarter of 1997 investments to GDP ratio has been 30% or above. Herewith it should be stressed that these are mainly private sector investments. Government investment was below 4% of GDP in the first half-year, which is consistent with the restrictive economic policy. In mid-1997 the fiscal policy was set to restrain the growth of government spending (including investments), to generate a general government surplus and transfer it to the Stabilization Reserve Fund established in the second half of 1997. The target for 1998 is a general government surplus of 2.5% of GDP.

Unlike the government sector, the private sector has to use foreign saving for investments as well. Considering investment dynamics by economic sectors, since 1997 the share of manufacturing (and the open sector as whole) has been increasing (see Table 2.1). Such a development is understandable, considering that:

1. export has been the engine of the economic growth;
2. investments in industry are mainly financed out of own funds and they are less dependent on bank loans than in the service sector.

In the first quarter of 1998, investments into manufacturing grew faster than average - 1.6 and 1.3 times, respectively - although the danger of excessive investments into domestic market oriented activities is still there in near future. Borrowing in construction, real estate and other fields in the sheltered sector has recently been increasing more slowly than borrowing in the manufacturing. Unlike export-oriented activities, these investments are more dependent on bank loans and therefore also on developments in international financial markets.

FOREIGN DEMAND

Over the last year and a half foreign demand increase has been the main variable causing Estonia's economic growth. Although this trend continued, the export environment in the first half of 1998 was less favourable. World market prices for our main export articles were low and relations with trade partners became more complicated at the beginning of the year. The above is reflected in figures: between early 1997 and the end of the first quarter of 1998 the annual export of goods in real prices increased by more than a third whereas in the second quarter the export growth rate fell to 15%. The growth rate declined both on the eastern and on the western directions. The export growth slowdown was reflected in industrial developments at once (see Domestic Supply).

Shrinking domestic demand slowed down the growth of imports in the first half-year as well. The trade deficit was above 20% of GDP but due to the high services surplus in the second quarter of 1998, the current account deficit in the first half-year was contained on about the level of the first half of 1997 (see Figure 2.1).

Unlike 1997 when bank-facilitated capital amounted about 60% of the financial account balance, in the first half of 1998 private sector incorporated most of the resources. In the first half-year both direct and portfolio investments exceeded 5% of GDP, being above the average 1997 level as well (see Figure 2.2).

DOMESTIC SUPPLY

Since 1996 the economic growth rate has been continuously increasing but in early 1998 the growth slowed down (see Figure 2.3). In the first quarter the real GDP growth was 9.3% whereas manufacturing, construction and transport continued to be among the fastest growing branches (see Table 2.2). In the second quarter the annual growth rate of the industrial production slowed down by half, dropping to 7% in constant prices (14% in the first quarter). It also explains the GDP growth rate drop to 5.5%.

It is essential to know whether declining demand or limited resources caused the slowdown in the manufacturing. In several key subbranches, like in dairy, textile and chemical industries (with total share of about 30%) declining exports and decreasing output growth were visibly linked (see Figure 2.4). Therefore the conclusion is that problems are mostly related to the unfavourable export environment. The impact of rapidly developing industries, such as paper, timber and furniture, is less significant although opening of new and expansion of existing businesses promotes economic growth.

According to indirect indicators, the first half-year was relatively successful in many economic fields. The rapid growth in transport, storage and communication continued in the second quarter as well. Thus, the trade turnover in Tallinna Sadam (the Port of Tallinn) increased by more than a quarter. Although in the first quarter construction growth was extremely fast, it is evident that this year the number of construction permits issued both for residential and non-residential housing has decreased against early 1997 (see Figure 2.5). Therefore a slowdown in the construction growth could be expected in the second half of the year. At the same time the expectations of construction companies were optimistic and contracts signed ensured work for a longer period than before. Only energy and financial intermediation manifested a clear downward trend according to preliminary estimates, and due to the Stabilization Reserve Fund programme the public sector savings remained on the 1997 level.

According to Eesti Konjunktuuriinstituut (EKI; the Estonian Institute for Market Research) the utilization level of production capacities was the highest ever (71%) in the second quarter and the number of companies whose economic activities are restricted by the lack of suitable equipment is increasing (see Figure 2.6). It is evident that companies' investment needs are continuously high and shrinking lending could affect their further production potential. Nevertheless, the economic growth has been rapid enough to boost profits making it easier for companies to finance investments. It was also facilitated by the high level of foreign direct investments in Estonia in the first half of 1998.

The tightening of the financial environment in end-1997 had no visible impact on the output of the non-financial private sector in the first half-year. According to the Estonian Institute for Market Research, the number of companies with financial constraints restraining production, did not increase. Estimates show that links between the financial and real sectors are more modest and total corporate liabilities smaller than in many other countries. In the first half-year the bank loan stock grew rapidly both in industry, construction and transport (see Table 2.3). The end-1997 stock exchange crash influenced financial sector outcomes with six months time lag whereas its impact on the real sector would appear even later. Recent developments show that the crisis in Russia has a more direct impact on the real sector. In June, businessmen were still optimistic forecasting production growth, but the disappeared eastern exports has put many producers into a very complicated financial situation.