VI MAJOR EVENTS IN ECONOMIC POLICY IN 1998

The main task in the economic policy making in the first months of 1998 was to ensure the implementation of the Memorandum of Economic Policies approved at the end of last year. The goal of the Memorandum was to avoid risks concurrent with the rapid economic growth and disproportionate development of some branches of economy by means of stricter budgetary discipline and formation of stronger reserves for the financial sector. However, slower than expected stabilization process in the economy and fundamentally unfounded optimism predominantly on the financial markets at the end of the first quarter, temporarily questioned the possibility of achieving these objectives. Therefore the Government and Eesti Pank decided to review the economic policy programme and to further reinforce the readiness of Estonian economy in case the global economic situation should continue to deteriorate.

In late spring the economic environment started to change. Risks that cropped up in the banks due to the extremely rapid development of the financial markets weakened substantially the credibility of the banking sector. Meanwhile, the situation on the emerging markets started gradually to deteriorate again. Instability on world financial markets triggered, first and foremost, by the financial crisis in Russia, implied that with great probability the economic situation may worsen worldwide. From the economic policy perspective the question of whether former steps had been adequate acquired special importance. More than ever before it became expedient to sustain a conservative approach in order to avoid any further risks.

FINANCIAL MARKETS IN THE FIRST MONTHS OF 1998 AND ADDITIONAL MEMORANDUM OF ECONOMIC POLICIES

In early 1998, the determinants in the Estonian economic policy environment were the adjustment process that had begun in the financial sector and the structure of foreign funding to the economy at the end of the previous year, as well as continuous uncertainty on emerging markets developments.

Remedies provided by the Memorandum of Economic Policies adopted at the end of 1997 began to take effect. In the fourth quarter of 1997, the Government and Eesti Pank had informed of additional steps in the economic policy field. For example, first transfers were made to the Stabilization Reserve Fund and more stringent liquidity requirements were imposed on credit institutions (see Monetary Developments & Policy Survey. Eesti Pank, Tallinn, 1998, pp 55-58).

According to the Memorandum in 1998, the surplus budget policy will be maintained and currency board system will remain to be the basis for the monetary policy framework. Some of the measures announced last autumn were initially meant to be implemented in the beginning of the next year (such as increasing budget revenue by means of higher excise taxes) or preparation for their introduction was scheduled for the first quarter of 1998 (for example, amending the capital adequacy requirement with the aim to further it to the internationally acceptable principles).

Contrary to common expectations, after the end-1997 and early 1998 adjustments on the financial markets, there was temporarily greater optimism on the credit market and growing assurance in consumption, supported by somewhat more stable external environment at the end of the first quarter. This trend was mainly due to a fall in interest rates and an ongoing inflow of foreign capital into the financial sector.

By that time several indicators referred to the possibility that the growth rate of the economy had slowed down to some extent and was more in conformity with long-term expectations. Nevertheless, this adaptation that had targeted external balance and funding structure in the economy had not been sufficient to guarantee sustainable development in the economy within unstable global economic environment. Above all, it was characterized by only a slight reduction in the current account deficit and still a relatively high proportion of short-term capital in the financing of the economy. Also there was no proof that risks taken during earlier stages had manifested themselves strongly enough and dangers associated with these risks had been eliminated.

Under these circumstances the Government and Eesti Pank decided in May 1998 to supplement the Memorandum of Economic Policies adopted last year with the measures that would better protect the development of the economy against such risks. For the strengthening of the current economic programme it was decided to increase the general government surplus in 1998 and accordingly also planned transfers into the Stabilization Reserve Fund. The public was informed thereof. Stricter savings in current costs were seen as main means of achieving this goal.

In order the improve the buffers of the financial sector and to support the approximation of the credit market to the stabilization objectives in the economy, Eesti Pank disclosed its intention to go on with the harmonization of the banks' capital requirements with the international practice and to complete the process during 1998. It was also decided to update the accounting methods for the reserve requirements kept with Eesti Pank, by expanding the eligible liabilities to some guarantees provided by banks and thus raising the efficiency of the regulations. As the result of these changes, the amount of reserves increased.

ECONOMIC POLICY IN LATE SPRING

Unlike the end of the first quarter, during the second half of the first half-year the economic environment degenerated under the influence of internal and external factors.

The scandal related to Eesti Hoiupank's (Estonian Savings Bank) share issue and the bankruptcy of Eesti Maapank (Land Bank of Estonia; see Background Information on p. 49) revealed the risks characteristic of the rapid development of preceding periods. Their manifestation undermined considerably the credibility of the Estonian financial sector and evoked sharper adjustments on the credit market and a new rise in interest rates. At the same time, the size of the additional budget and its financing scheme adopted on 17 June were in conflict with the Memorandum of Economic Policies.

Simultaneously, the attitude towards emerging markets worsened globally and uncertainties as to the development of Russia's economy increased. In order to forestall loss of confidence in the Estonian economy, the solutions to the problems in the banking sector presupposed the rigid adherence to the current conservative budgetary policy and preservation of full confidence towards Estonia's monetary policy. It was also necessary that measures would help to curb declining credibility in banking supervision activities which under the circumstances was inevitable.

In general, budgetary solutions applied to the problems related to Maapank's bankruptcy fulfilled these objectives well. Despite political pressure, not all deposits of Maapank's depositors were compensated. As a rule, guidance was taken from the principles of the Deposit Insurance Fund Act passed by Riigikogu (the Parliament) but not yet come into effect.

In conclusion, all these events failed to influence the objectives of the economic policy programme amended in spring. The agreed principles were approved also by the Board of the International Monetary Fund during the discussion that took place on 3 September.

The economic and political environment became more complicated towards the end of summer due to escalating difficulties in Russia's economy. More relevant was, however, the overall instability on the international financial markets triggered by the events in Russia (in Latin America, then in the USA and Western Europe) that can considerably curtail the development prospects for the economies of the industrialized countries.

Unlike earlier complications on the emerging markets that had affected Estonia's economy primarily indirectly through financial markets, the above problems are going to have a more direct impact on the real economy. But partial stabilization of the Estonian economy after the adjustments undertaken by the financial markets in the fourth quarter of 1997, the conservative economic policy sustained over the recent years and the significant reorientation to the economic area of the developed countries that took place after the 1992 monetary reform, helped to avoid major and immediate backlashes originating from the financial crisis in Russia.

One can, however, assume that the above factors are going to affect the economic growth in Estonia through medium term. To maintain the sustainable growth potential of the economy in the near future, the key issues will be: further stabilization in the external sector, adequacy of the current measures of the economic policy in the light of the less favourable financial environment and the ability of the developed countries to sustain a sufficient growth even if instability of the financial markets will increase.

The experience of the last year has shown that the budget surplus on the general government level plays an important role in curbing consumer demand and thus reducing the foreign trade deficit. Transfers of the budget surplus through the framework of the Stabilization Reserve Fund held in foreign assets have strengthened the credibility of the Estonian monetary system and helped to prevent further speculative attacks against the Estonian kroon. Considering that the external environment continues to be unstable, targeting the budget surplus as an economic policy goal will be called for also in the future - not only for the purpose of promoting domestic savings but also for ensuring the stable development within the government sector as well. Public sector reform has not been completed yet and therefore it will be premature to state that the current expenditure structure is optimal and that the costs of the government sector should grow in line with the rest of the economy, even if the over 10% annual real growth rate will drop, for example, to 5%. As, in addition to the public sector reform, several other structural reforms that require one-time expenditures (such as pension reform) are still going on, the expenditures and revenue of the government sector will have to be balanced for a much longer time span than just one year.

In conclusion, the current economic environment calls for further caution and conservatism in order to enhance internal saving capacity of the economy in the short-term perspective. For more long-term progress to be achieved, structural reforms need to be carried out simultaneously in order to increase efficiency in the economy.