INTRODUCTION

The economic development between late autumn 1997 and summer 1998 confirms Estonia's firm integration into the world economy, both in terms of commodities' and financial markets. Thus, events, significant for the world, influence Estonia's economy both directly and indirectly. This year has been rich in events. Fundamental decisions on European Monetary Union (EMU), continuing financial and economic crisis in Asia and current financial crisis in Russia should be mentioned.

Sustainable economic policy aimed at long-term price stability and economic growth has an ever increasing significance in the rapidly changing and recently unstable economic environment. The currency board based Estonian monetary policy, supported by a relatively conservative fiscal policy has laid a firm foundation for sustainable economic growth and reduced the vulnerability of Estonia's economy by external shocks.

This year has been turbulent in international financial markets but even more so in emerging markets. The unstable external environment has determined several development trends in Estonia's economy as well, but has neither destabilized restructuring of the economy nor the financial system. The speed of the economic growth in Estonia surpassing any expectation in 1997 and undermining the belief in its sustainability has somewhat slowed down during the first half of 1998. Presumably the slower economic growth in 1998 is more stable containing less internal risks than the extremely fast growth a year ago.

Regardless of the stabilizing economic development and slower growth referring to abating gross demand pressure, many of the problems facing Estonia's economy today are the same as in last December when the previous monetary policy survey was completed[1] . Current account deficit, continuing investment boom and slightly unstable price convergence process are realities of today as well. Estonia's financial system is largely dependent on foreign capital, therefore the financial sector is potentially vulnerable should foreign investor preferences change.

Flexibility and adaptability are necessary for economic success today and in future. Flexible prices, quick adaptation to market changes, high capitalization of economy and reserves help the small open economy to respond successfully to potential external shocks. The establishment of the Stabilization Reserve Fund was one step towards increasing the capability to withstand shocks, provided that these reserves are used only for solving strategic problems. Eesti Pank pursues the same goal by strengthening banks' capital adequacy requirements in order to increase the risk tolerance of the banking sector.

The currency board based monetary system survived the speculative attacks against the kroon in October 1997, confirming, thus, once more the right choice made about the monetary system. The financial system responded as expected - the increasing interest rate and decreasing price of financial assets were part of the process to balance external pressures. The adaptation of the monetary system was reflected in the interest rate level dropping in spring close to the 1997 level. As the favourable external environment of last year was not restored and most of the external financing is based on short-term foreign capital, the interest rate level is also slightly higher than in 1997. The uncertainty in international markets (Asia, Russia) appearing in late spring prepared expectations for another interest increase, prices dropped in securities markets in the region as well.

The liquidity shock in end-1997 was not too problematic for Estonia's financial system as a whole although problems appeared on the micro level. These were mostly problems typical to transition economies such as overoptimistic expectations without the experience that securities markets could drop as well, management (corporate governance) mistakes and taking of excessive risks. Consolidation in the banking sector has been and is taking place mainly due to the changing external environment as well as to EMU related increased competition in Europe and all over the world. The consolidated financial system is stronger and relatively better capitalized than before the liquidity shock in October 1997.

The real economy adjusts itself to the changed economic environment much slower than the financial sector. Although the debt burden on Estonia's economy is smaller than that of developed countries, it is growing rapidly. Together with the growth, the dependence on domestic and international financial markets is growing as well. There is no reason to believe that the declining credit growth will not impact real economy. The question is how big is the impact and what is the time frame. It is evident by now that in the first half-year both the declining domestic and external demand had a slowing impact on the economic growth. It was determined by changes in the external environment - impacts of the Asian crisis, uncertainty about emerging markets in world financial markets as well as by restrictive fiscal policy aimed at restraining domestic demand. Another problem is the impact of the Russian crisis on the EU member states and its potential outcome.

As of the end of the first half-year of 1998 it is clear that the main trends in Estonia's economy - restructuring and recapitalization of the economy, decreasing inflation and the approximation of the interest rate level with the anchor currency - are continuing. Indirect estimates prove that the competitiveness of Estonia's economy has not suffered in the current unstable international environment and the Estonian kroon is not overvalued.

Estonia's monetary policy as well as its conservative fiscal policy have fulfilled their goals up to now. The economic policy based on the currency board arrangement and economic policy, oriented on the increase of savings, will guarantee sustainable long-term development. It is important to pursue the economic choices made in order to reduce potential systemic risks related to a current account deficit and the dependency of the financial sector on the foreign capital.

The deepening integration in commodity and financial markets affects more and more the current state and future outlooks of Estonia's economy. Co-operation with international organizations and other countries will become ever more significant. EMU related issues, Estonia's accession negotiations with the European Union as well as uncertainties related to Russia's development are to be considered.

The following analysis was completed in August 1998. Each chapter is supplemented by background information. An overview of recent months has been enclosed to the survey. This monetary policy survey is also available in the Internet.

[1] See Monetary Developments & Policy Survey. Eesti Pank, Tallinn, 1998. Available in Estonian: Rahapoliitiline ülevaade. (Completed in December 1997).