II
ECONOMIC DEVELOPMENTS IN THE AUTUMN OF 1999

EXTERNAL ENVIRONMENT

In the third quarter of 1999 several institutions have increased their world economic growth forecasts. The International Monetary Fund (IMF) raised its GDP growth forecast to 3% in end-September of 1999 (the forecast in end-1998 was 1.5% and in March 1999 - 2.3%). The driving forces behind output growth are the USA and Asian countries, supported by the revival of the economies of the euro-area countries. The improving growth outlook should translate into higher export growth for Estonia.

Developed Countries

In the member states of the Organisation for Economic Cooperation and Development (OECD) the economic growth continued in the third quarter of 1999, being 2.9% according to preliminary data[1] . It was below the level in the first quarter (4%) but exceeded the growth rate both in the second quarter (1.6%) as well as in 1998 as a whole (2.3%). The economic growth in OECD countries was promoted by expanding external demand as the emerging economies started recovering. The revival has been especially significant in Asian developing countries in which the GDP decrease of 1.8% in 1998 contrasts with the IMF forecast of a 5.2% growth in 1999. In the third quarter the growth of domestic demand in OECD countries remained on the level of the previous quarter (2.6%). Among G7 countries the United States was the leader once again, although the economic revival in Europe reduced the difference with the euro-area countries. Japan continued attempts to revive its economy but two quarters of economic growth were followed by a decline in output in the third quarter.

After the slowdown in the second quarter, when the GDP grow by only 1.9%, output growth in the United States reached 5.5% in the third quarter. Such acceleration was generated by higher grow in public consumption, investments and stock building. Although the United States had a record trade deficit in July, higher export growth, facilitated by increasing external demand curbed its further widening. Unemployment dropped to 4.2% - the lowest level since 1970. The annual inflation rate reached 2.6% by September, mainly due to an increase in energy prices. Annual inflation rate, excluding energy and food prices, was 2.1% in September, being the lowest since 1966. Nevertheless, the Federal Reserve, watching up closely inflation rate risks, increased the benchmark interest rate once more in August.

In Japan the economic climate has improved compared to the beginning of the year. The economic growth and several other economic indicators show signs of revival. For example, the industrial output has increased again, with an annual growth rate of 2.8% in September. Whereas the revival is neither sustainable nor equally spread through sectors. Due to decreasing public consumption as well as private consumption and investments, the GDP fell by 3.8% in the third quarter. Whether the economic revival would continue, depends among other factors on the extent the appreciation of the yen (12% in the third quarter) would damage the business climate, as in case of weak domestic demand, economic revival would rely more on exports. Regardless of some economic revival, the unemployment rate in September (4.6%) was higher than at the beginning of the year. Due to the recession, deflation has been prevailing during seven months out of nine. The consumer price index declined by -0.2% in September.

After the slowdown in the euro-economies in end-1998, the economic revival continued in the third quarter as well. The GDP grew by 4% against the second quarter. Facilitating factors were the most accommodating monetary policy environment of the last twenty years (low base rate and the weakening of the euro compared to the beginning of the year) and fiscal incentives. France was the leader of growth among the large economies in the euro-area. The GDP in Germany grew about 3%.

Surveys on business and consumption climate and the growing numbers of orders have allowed to forecast further recovery. It would support the downward trend in unemployment as well: in September the unemployment rate had fallen to 10%. Inflation has remained relatively low (an annualised 1.2% in September) although there are upward pressures as the money growth is gaining pace due to increasing energy prices and economic recovery.

The economic recovery continued also in Great Britain in the third quarter. The GDP grew by 3.8% against the first quarter, exceeding the long-term trend level. The unemployment continued to fall. In September it reached the lowest level since 1980 - 4.2%. Regardless of the recovery and increase in the energy prices, the annual inflation decreased to 2.1% in September. According to central bank forecasts it could remain below 2.5% until mid-2001.

Among Nordic countries economic growth in Sweden was one of the highest in Europe - 3.7% in the first half of the year. It was sustained mainly by strong domestic demand in the third quarter (retail trade annual growth rate was 4.2% in September) but got some support from growing exports in the second half of the year, too. Sweden has not yet decided on the accession to the EMU as most of the Swedes oppose the idea and there are dissenting opinions in the ruling party as well. Inflation has remained low (in September the annualised average was 0.9%) but has been gaining pace since the beginning of the year. The unemployment reveals a downward trend, the indicator being 5.5% in September.

The Finnish economy has maintained its sustainable pace regardless of the large growth manifested over the recent past. Although the times of the fastest growth seem to be over, the Finnish economy continues to benefit from the favourable financial environment in the euro-zone.

Emerging Countries

The economic growth in emerging countries has been unstable in 1999. A noticeable revival has taken place in Asian countries, which entered the crisis earlier (Korea, Singapore and Malaysia could be singled out) whereas Latin America anticipates economic recovery only in year 2000.

East Asian countries are a positive example. Their economy is recovering from the crisis due to the US market-driven continuous demand, which has raised growth forecasts in the region to 4.5%.

Latin America has overcome the critical time of the beginning of 1999 caused mainly by the devaluation of the Brazilian real in January. Cheap share prices have won foreign investors back to the region, stock market indices have significantly grown this year (Bovespa in Brazil 100%, stock market in Mexico 60%). However, fears of accelerating inflation in the region create concern. Markets in Argentina and Chile are going up as well, with Venezuela being an exception in this region as political tension in the state has corroded confidence. Domestic debt could cause problems in Brazil, as its states are still not able to pay their debts to the central government.

In Central and Eastern Europe the acceleration of growth or deceleration of output decline is mainly based on the growing West European demand and lower interest rates. This year the economic growth should be the highest in Hungary and Poland whereas the GDP in the Check Republic could decline. In year 2000 all Central and Eastern European countries expect the growth rate to be between 0..4%. Slower growth has forced governments to implement several changes: mainly to tighten fiscal policy and speed up privatisation.

Latvian and Lithuanian economies have lost much of their strength through the crisis in Russia. In Latvia a 1% growth of GDP is forecast whereas in Lithuania - a 2% decline. Lithuania's problems involve large budget and current account deficits. Domestic consumption has declined both in Latvia and Lithuania after the first half-year, thus, the current account deficit has been decreasing as well. However, this does not apply to the budget deficit. Industrial production has decreased compared to 1998.

Russian economy has manifested some recovery in the second half of the year, mainly because the domestic market-oriented industrial production has grown and the rouble was devalued in end-1998. The annualised growth of GDP is anticipated to be 1.5-2%, inflation will probably remain within 45-50%. The current account surplus diminished from 15% of GDP in the fourth quarter of 1998 to 8% in the second quarter of 1999.

Price Developments

Prices for Raw Materials

The global growth of economic activity has pushed up raw materials prices. The respective CRB index has revealed an upward trend since the beginning of the year and grew another 4.9% in the third quarter. Prices of crude oil continued growing as well: by the end of the quarter the price reached 25 dollars a barrel (growth 27%). A sharp rise in gold prices in end-September should be mentioned, too (13.8% in the third quarter). This happened because the central banks achieved an agreement to limit the sale of gold.

Stocks

In the third quarter stock markets in developed countries were under pressure mainly because the US equity market fell (see Table 2.1). The downfall was extremely clear between the second part of August and end-September with the Dow Jones index dropping more than a thousand points. Investor attitudes were influenced by the widespread opinion that the US equity market is overestimated and the "bubble" could burst any minute. It has still not yet happened as the economic growth continues to be high.

Interest Rates

Interests continued to rise in main bond markets in the third quarter, in connection with accelerating output growth and inflation. Short-term interest increase was most noticeable in Germany (see Table 2.2) where the market expected tightening monetary policy. The US Federal Reserve raised the benchmark rate by another 0.25% on 24 August (the previous rise was at the end of the second quarter) and the Bank of England made a similar on 8 September. The cycle of raising benchmark interest rates in these countries could continue. Long-term interest rates rose most in Europe, with the ten-year interest rate rising more than 0.5%. In Japan, on the other hand, interest rates decreased as the central government attempted to maintain a favourable borrowing environment in order to revive growth.

Currencies

The most significant change in foreign exchange markets was the 12% strengthening of the yen against the US dollar (see Table 2.3). The euro and British pound, both on declining trends from the beginning of the year, also strengthened against the dollar in the third quarter of the year. This change was due to the economic recovery, taking place in Europe and Asia. Therefore the assets in these markets promise relatively higher returns whereas US equity and bond markets are losing their attractiveness.

ESTONIA'S ECONOMY

Domestic Demand

Private Consumption and Investments

It is logical to assume that in a small open economy private consumption is more stable than investing (see Figure 2.1). Throughout 1999 the private consumption has declined several times less than the overall domestic demand. This has been subject to continuous growth of pensions and wages as well as to decreasing number of the employed and changing saving performance.

Although the growth rate of the nominal wages slowed down, the growth of the real wages remains on the level of 1998. In the third quarter the growth of the nominal wages exceeded 8%, providing a 5% increase in the real wages. As the government sector is responsible for most of the growth because of the salary rise in the beginning of 1999, the growth in the calculated average wage does not reflect adequately the adjustment of economic agents with changing circumstances (see Figure 2.2). In the private sector the growth of wages has been significantly slowing down since the fourth quarter of 1998 and in the fields of activity in which the production volume has considerably decreased, even a drop in the nominal wages can be seen. As expected it has been faster in the companies operating in sectors open to external competition.

Although the wage growth has been relatively high throughout 1999, it has not managed to offset the diminishing private consumption caused by a downfall in employment and consumption propensity. Thus, the private consumption continued falling in real terms for the third quarter although it was roughly equal to the third quarter of 1998 in its nominal value. The above can be confirmed by a 4.5%-improved collection of personal income tax and the production growth in domestic market-oriented industries.

The consumption has been relatively stable even during the economic recession whereas the investor activity has been far below the previous year throughout 1999. Investments in the private sector have decreased most. Nevertheless, first positive trends are noticeable already: investing continued to fall in the first half-year, reached the bottom by the third quarter and although investments in fixed assets remained 11% below 1998, according to preliminary estimates, they exceeded the level of the second quarter of 1999. Beginning from September the corporate loan stock has revealed an upward trend and the import of machinery and equipment for free circulation has also grown compared to the beginning of the year, although it still remains below the 1998 indicators. Apart from the fields of activity closely related to the government sector, the largest contribution to the slow recovery of investments came from transport, storage and communication, with investments growing more than one fifth.

Government Sector

The consumption in the government sector continued growing in the third quarter, although somewhat inhibited by the negative supplementary budget. The latter expressed clearly the government attitude to the growing budget deficit and increased public confidence in the balance to be achieved during upcoming periods.

Although due to seasonality-induced low current expenditures a target was set to balance the budget in the third quarter, the actual general government deficit was 236.7 million kroons (see Figure 2.3) of which 343.2 million kroons was the central government deficit whereas the other government sector units had a consolidated surplus of 106.5 million kroons. As to the GDP by expenditure approach, the government consumption was still the only component promoting domestic demand.

In order to finance the deepening deficit as domestic surpluses had been exhausted, deposits in foreign assets were reduced by 20 million euros on 31 August. It covered the need only in September. In October the government had to return another 20 million euros.

The amount of the annual deficit in the government sector depends largely on to what extent the central government expenditures can be postponed to year 2000. Dependent on these steps the general government deficit could be up to 5% of the GDP this year.

Domestic Saving

Thanks to relatively small current expenditures related to seasonal factors, the government sector saving became positive in the third quarter as well, reaching 4.5% of the quarterly GDP. Growing private saving and low consumption behaviour maintained the private sector savings on a relatively high level. Based on profits and depreciation the corporate saving diminished in the first half of the year but in the second half-year, the 1998 level is forecast to be surpassed. The savings in the third quarter reached the level of 1998.

Domestic Supply

Judging by the most significant indicators, Estonia's economy is overcoming the economic recession of the three previous quarters. In the third quarter of 1999 the GDP recovered the level of 1998.

Transport, storage and communication have been the key activitiessupporting economic growth. Besides the favourable tourist season, transport was also promoted through the recovery of the pre-crisis level of transport services export due to growing transit.

Due to the crisis starting in the manufacturing in August 1998, the sale of industrial production in September, October and November exceeded for the first time this year the level of the same months of 1998 (see Figure 2.4). The gross industrial sales in the third quarter was still 1.1% below the same period in 1998, sales of manufacturing exceeded the level of 1998 by 1%. Thus, estimatedly the decline of the value added in the manufacturing has stopped and the level of 1998 was achieved in the third quarter.

Among other industries construction played a major role in affecting gross domestic product although its volume is due to low investment demand still far below the 1998 level. Thus, construction together with subcontracting decreased by 8% in the third quarter.

Eesti Konjunktuuriinstituut (EKI; the Estonian Institute of Economic Research) forecasts furthers improvement in business outlooks in the fourth quarter and business undertakings visualise borrowing demand and production volumes. Therefore, probably a significant economic growth will be achieved in the last quarter of 1999 although the annual growth of value added will remain negative.

Financial indicators confirm that companies have recovered from the setbacks of end-1998: in the second quarter they earned nearly 1.3 million kroons of profit.

Flexible adjustment to the economic environment has, first and foremost, taken place in the employment policy. The falling production volume has been met with the optimum cut in the labour force, as a result of which the overall labour productivity in the national economy even slightly exceeded the respective indicator of 1998. At the beginning of the year the number of registered job-seekers kept growing and the unemployment rate reached 12% according to the labour force studies but beginning from the second quarter some stabilisation and a seasonal trend can be noticed. At the same time the unemployment cannot be expected to decrease sharply as the export-oriented sector has not yet manifested any economic activities developing faster than others and requiring additional labour and traditional activities attempt to use the labour more efficiently. Adjustment in remuneration has been considerably slower. The continuing growth in wages has increased labour cost per unit and, thus, slightly reduced corporate profitability and the competitiveness of domestic goods and services.

External Sector

The third quarter fully confirmed the fact that export is the growth generator in a small open economy. The growing demand in Western Europe in the first half-year, especially the foreign trade revival in the second quarter brought along an increase in the export of goods and services from Estonia.

In September the export of goods exceeded for the first time this year the year-ago period (see Figure 2.5). During the first two quarters export declined by 10.1% and 8.3%, respectively, but increased by 2.6% in the third. Export of goods made in Estonia recovered the level of 1998 as well. It should be underlined that the export of goods originating from Estonia had dropped by about 900 million kroons in the third quarter of 1998. Therefore, the recovery of the export levels prior to the Russian crisis would take a long while.

By today the structure of Estonia's export goods and destinations has changed significantly. The share of wood products and furniture has increased considerably and that of foodstuffs has decreased. Sweden has become the major export partner whereas the share of CIS states has fallen below 10%. The decline in the export of goods made in Estonia was offset by a very rapid growth of exports of goods processed in Estonia at the end of 1998. In 1999 the share of reexport growth has been relatively modest (below 3%) and the significant increase in other exports due to its small volume cannot have much implication on the gross exports.

The export of goods was suspended sharply in the third quarter of 1998 whereas that of services had taken place a quarter earlier already. The volumes of services' export were still below 1998 during the first half of 1999 and surpassed the year-ago figures in the third quarter. As together with the import of investment goods the import of transport services has diminished as well, the surplus of the services' balance achieved the highest level ever and covered the trade deficit.

Decreasing import of goods reflects, first and foremost, a smaller demand for investment goods. In the first half of the year the import decreased by 16.3%, in the third quarter it was put on hold and import was 10% below the year-ago level. The import volume of goods to be processed has stabilised at over 800 million kroons a month, remaining still slightly below the end of 1998. The fallen share of investments in the economy is best reflected in the import of machinery and equipment for free circulation which regardless of the hold on the downward trend beginning from the third quarter, is still a couple of percentage points below the year-ago level of the GDP.

Although the negative trade balance in the third quarter was similar to that in the second quarter, the current account deficit changed positive due to smaller investment requirements, favourable tourist season and government sector saving (see Figure 2.6). The current account balance is said to be temporary according to current estimates and caused by growing exports at the expense of previous investments and seasonal factors.

In the third quarter direct investments in fixed assets were made in small businesses only and therefore their inflow remained also below the first half-year. Summa summarum the financial account surplus exceeded 600 million kroons, of which about half were deposits returned from Germany by the government sector. The downfall is characterised by diminishing foreign liabilities and changes in the liabilities' structure towards extended maturities.

Trends in the Immediate Future

In the third quarter the increasing external demand created preconditions for recovering from the recession cycle. Although the domestic demand remained modest, the gross domestic product achieved in the third quarter for the first time its 1998 level. Nevertheless, corporate adjustment to the changed economic environment lies still ahead. The economic growth has been achieved on the basis of existing production capacities, development of the services' sector and largely also due to the maintained structures whereas in upcoming periods more changes in the supply-side structure should take place.

The upcoming reconstruction would mean even further concentration of undertakings on their main activity and increased efficiency of labour force. This would bring along the recovery of investment and import volumes, generating some growth in the current account deficit as well. Structural changes are facilitated through high liquidity of financial institutions and accessibility of loan resources.

Although the price convergence was suspended this year, the recovered economic growth and increasing productivity should bring along the growth of price indices in upcoming periods beyond the 1999 indicators. The economic-growth-generated inflationary pressure is supported by the disappearance of the excessive supply of foodstuffs, increasing prices of raw materials in the world market as well as by continuing administrative price actions. The above combined impact could make consumer prices plunge up to 5% in year 2000 (see Table 2.4).

The maintained export growth during the last months of the year has made possible to revise upward the growth forecast. Nevertheless, the economic growth of 1999 will be negative (0..-1%). Growing investment demand accompanying the economic revival will increase slightly the trade deficit at the end of the year and the current account deficit will reach 5% of the GDP, being still twice below the level of 1998 (9.2%). In year 2000 the economic growth of 4,5% is possible, accompanied also by an increasing current account deficit.

[1] GDP forecast by Goldman Sachs. The following GDP forecasts are annualised.