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SURVEY OF THE ECONOMIC POLICY

In the third quarter Estonia's economy developed in a relatively stable external environment. The opinion spreading from the beginning of the year that the revival of the world economy will come in the summer of 1999 and especially in the second half of the year, has been confirmed. The positive impact of the revival on Estonia's economy took longer and became evident only in autumn.

When production volumes had recovered the 1998 level in the third quarter, it was possible to claim that the currency board-based monetary system has successfully passed the performance test in the economic downfall as well. The monetary policy environment favourable for balanced economic growth had recovered already in spring. The stability and lending capacity have increased in the banking, too. Thus, preconditions for economic recovery in end-1999 have been set. The external environment that is more stable than before also supports it.

MONETARY DEVELOPMENTS

In the second half of 1999, the conviction was spreading that financial crises in developing markets have passed and revival outlooks for Europe's economic recovery looked prosperous. The currency board system has proved its resistance to external shocks and secured the credibility and stability of Estonia's monetary policy. This is well manifested in the sustainable capital inflow throughout the post-crisis period, including the autumn of 1999. There is no activity noticed in the forward market that can be explained by a total lack of external pressures.

The improvement of the monetary environment starting already in the first half of the year continued in the autumn as well. Considering the growth rates of money supply, it could be regarded rather expansive. However, the vast money growth cannot be considered a sign of imbalance. It is backed by continuous capital inflow, growing deposits proving the integrity of the banking sector and the recovery of economic activity. It is clear now that the accelerating growth of money in the second quarter indicated economic recovery.

As an after-effect of stringent monetary conditions of 1997-1998 the high ex post real interest rates of loans have been preserved. They are sustained by continuously low inflation rate, which has decreased faster than nominal interest rates. The impact of the growth of real interest rates a year ago has mostly passed, especially as lending is recovering. Against the background of declining nominal interest rates and low inflation rate, the price of domestic capital is not likely to drop in short term. Low inflation indicates a relatively stronger position in the external competitiveness as the real effective exchange rate of the kroon has even depreciated during the last year and the appreciation of the kroon against the currencies of industrial countries has been contained below 3%. The position of the euro against the US dollar which contrary to the long-term trend has been weak for most of 1999 has also supported stronger external competitiveness. Its negative implication could be recovery of inflationary pressures.

The rapid recovery of the favourable monetary environment after the Asian and Russian crises proves the efficiency of Estonia's monetary policy. Maintenance and increase of the confidence in our monetary system during the last two years not only in Estonia but also abroad confirm our choices and open ways to more reliable plans for future. The development over the recent years has confirmed that the currency board system is fit to back the nominal and real convergence of our economy with the European Union. The European Commission shares this opinion in principle.

FINANCIAL SECTOR

In the third quarter the lending capacity (liquidity) of the banks increased. From the beginning of the year until autumn the credit demand has been modest due to relatively small investments. At the end of the third quarter the decrease in the non-financial sector loan stock stopped. In domestic market-oriented sectors even some growth in lending was traceable. In our key export sector - manufacturing - the loan stock diminished until end-September.

Throughout the economic downfall the granting of housing loans continued. Therefore the retail loan stock has been relatively stable, regardless a setback in consumer borrowing.

Due to low borrowing demand bank assets have an increasing share of tradable securities and deposits placed in non-resident credit institutions. In 1999 the maturities of banks' external liabilities have been continuously extended, increasing even more the stability of the banking sector. Modest loan demand and limited trading opportunities in the stock market have slightly decreased banks' return on equity. The stability of the banking system has not diminished as the result of the crisis but rather grown.

REAL ECONOMY AND EXTERNAL SECTOR

The third quarter fully confirmed the point that export is the driving force in a small open economy. The demand growth in the first half-year in Western Europe, especially the foreign trade revival in the second quarter, brought along an increase in Estonia's export of goods and services. Although the domestic demand remained modest, the gross domestic product reached in the third quarter for the first time the level of 1998. The continuous export growth in the last months of the year allows revising previous forecasts upward, with the annual growth of the GDP being 0..-1% and anticipate a more than 4% economic growth in year 2000.

The export growth was probably based on previous investments and therefore economic revival did not bring along any worsening in the savings-investments balance. Due to the seasonal reduction of the consolidated budget deficit, it even improved and the current account is balanced. Economic revival accompanied by growing investment demand could increase trade deficit in the last months of the year. Nevertheless, over the year the current account deficit could be about half of 1998 and instead of 9.2% about 4.5% of the GDP.

The labour market has been flexible enough to maintain the previous labour productivity level and achieve even a slight rise over the year. The market has been more rigid in wage policy than in employment: reflected in the downward, but still preferential growth of the average wages compared to the GDP. Probably, the reason for that was uncertainty in the short-term developments of the world economy. Whereas adjustment in the export sector has been so much faster than in domestic market-oriented economic activities.

The standstill in the economic growth and productivity increase inhibited price convergence in the open sector as well. The price adjustment continued only in the closed sector due to administrative measures applied. The consumer price index dropped to an annualised 2.7% in the third quarter, the lowest level in the transition phase. The external environment did not inhibit the price increase any more as it had done in the first half-year. The foodstuff prices have overcome the downfall as well. Regardless the accelerating price increase in the last months of the year, the consumer price index in 1999 will be contained within 3.2..3.3%. In the year 2000 the price increase will reach 4-5%.

GOVERNMENT SECTOR

The downward revised budget adopted at the end of the first half of the year curbed government expenditures in the second half of the year by about 1% of the anticipated annual GDP. Thanks to the seasonal factors the government saving in the third quarter was traditionally the largest of the year. The consolidated budget deficit diminished to 1.3% of the quarter's GDP. With low private sector investment demand, it improved significantly the external balance. The adopted budget foresees increasing government spending during the last months of the year and the deficit over the quarter could again exceed 5%, reaching about 5% of the GDP for the year. Although even after the downward revision of the budget expenditures, the budget deficit is still high for Estonia, it indicated government plans to recover the balanced fiscal policy in medium term.

ECONOMIC POLICY CONCLUSIONS

Within the currency board framework the private sector bears most of the adjustment burden during the economic standstill. The three quarters-long downfall - from the fourth quarter of 1998 to the third quarter of 1999 - has confirmed that although budget deficit helps to stabilise domestic demand, it cannot offset the implications of the falling external demand on the economic growth.

In the post-crisis phase the private sector has successfully adjusted its expenses to decreasing earnings, both in the business sector and in households. The above has maintained or even increased confidence in Estonia's economic policy and helped to survive without external borrowing. Estonia's external debt of the GDP compared to the autumn of 1998 has not grown, but rather diminished. Most of the foreign capital inflow has not been debt generating; ie it will not be repayable.

In the government sector poor timing of reforms (eg major salary growth in the public sector) and overoptimistic estimates of economic recovery have brought along too large a deficit in the consolidated budget. As this can be financed from reserves and privatisation receipts, the price of such a policy is not yet felt. It is not possible to evaluate the recent fiscal policy adequately because long-term economic policy planning has only started in Estonia and the cost of further structural reforms is not determined yet. The elaboration and disclosure of such schemes is one of the major tasks in the current stage. It is not possible to implement second stage structural reforms and to ensure sustainable economic growth without such programmes although the automatic regulatory mechanism in the currency board framework helps to overcome major mistakes in short term.

The impact of the Russian crisis has been controversial. On one hand, it created an additional incentive for Estonia's economy for even closer integration into Western Europe. On the other hand, the crisis coincided with the demand slowdown in Europe slowing down economic restructuring as well. Only the forestry and timber industry have had rapid growth in the post-crisis environment, being based on previous investments. The same applies to tourism as well.

One of the lessons of the crisis indicates that the recovery of an economy-friendly monetary environment will take less time than the recovery of the real sector anticipation if correct economic policy choices are made. We can also be more confident by saying that our monetary system is fit to support the nominal and real convergence of our economy with the European Union.