IV
MONEY AND CREDIT MARKETS

The conviction that financial crises in emerging markets are over deepened in the second half of 1999. Economy recovered in Europe as well. In compliance with the above, Estonia's foreign position continued improving and the capital inflow was maintained in the third quarter as well. Several indicators confirm the improvement of the monetary environment: growing money supply, decreasing interest rates and recovered borrowing. Although the money supply grows still faster than loan volumes, the non-financial sector borrowing started to grow at the end of the quarter. Interest rates decreased slowly and reached the lowest ever. No activity is noticeable in the foreign exchange forward market and therefore interest rates lack external pressure, which in 1997-1998 had caused a sharp rise in money market interest rates. Considering the growth rate of the money supply manifested in the third quarter, the current monetary environment could be regarded even as expansive. The growth of money supply is based on sustained capital inflow and economic recovery. Still high real interest rates have survived as an after-effect of the tight monetary conditions in 1997-1998.

CAPITAL FLOWS

The surplus of the financial account of the balance of payments was relatively modest during the first three quarters of the year - 2.9 billion kroons (see Figure 4.1). This complies with diminishing demand for external financing accompanied by shrinking current account deficit. Although the gross foreign capital inflow is comparable to 1998 (8.2 billion kroons), the year 1999 is characterised by the fact that both banks and government sector have increased their foreign reserve holdings. Eesti Pank's gross foreign exchange reserve on the reserve account of the balance of payments increased by 690 million kroons during three quarters in 1999. The gross reserve has increased by about 400 million kroons during three quarters.

The volatility of commercial banks' reserves held with Eesti Pank and hence that of Eesti Pank's foreign reserves and the purchase-sale turnover of the foreign exchange have significantly decreased in the third quarter against the previous quarter. This was mainly caused by smaller constraints in liquidity management, as there was no need to refinance major external liabilities. The declining volatility of reserves at the end of the month could possibly be influenced by the fact that Eesti Pank started to pay interest on the commercial banks' reserve requirement as of July 1999 (see Monetary Developments & Policy Survey, First Half of 1999, p 40).

Foreign capital flows as regards external liabilities and claims of Estonian residents, are characterised by a change of direction in the direct investment net inflow (Estonian residents made more direct investments abroad than non-residents in Estonia) and the return of the money, both by the banking and the government sectors, placed in foreign reserves at the beginning of the year. However, the balance of payments in the third quarter will be exceptional for the year as gross three-quarters foreign direct investment (FDI) in Estonia was 3.3 billion kroons and portfolio investments 2.7 billion kroons. Other liabilities to non-residents increased by 2.1 billion kroons. Direct investments abroad constituted 690 million kroons and portfolio investments one billion kroons. Other investment abroad increased mainly through growing deposits by 3.5 billion kroons.

Just like at the beginning of the year, the role of the banking sector in involving new external resources was limited to refinancing previous liabilities. Due to growing external reserves in the banking sector, the capital outflow through the sector has exceeded two billion kroons in 1999. Together with a slight decrease in the external liabilities it has significantly reduced the net external debt of the banking sector. In the second half of the year banks have somewhat reduced their level of external reserves in order to finance increasing lending activities and foreign projects. In 1999 banks have no major refinancing needs, larger repayments await at the beginning of 2000. The external borrowing of the business sector, mostly financed by parent companies in the first half-year, remained modest in the third quarter. Direct investments were mainly channelled to the industrial sector. In the third quarter the government sector returned more than 300 million kroons from exteral deposits and in the fourth quarter another 500 million kroons[1] in order to finance budgetary expenditures.

MONETARY AGGREGATES

The growth rate of monetary aggregates exceeded the forecasts made in the economic environment of the first half-year. Although the monetary policy survey on the first half of the year mentions that the rapid growth of money supply in the environment of moderate external capital net inflow and slow financial deepening indicates economic revival, the statistics on the real sector did not yet confirm it strongly. The broader money supply had grown by 27% by November 1999 against the same month in 1998 (see Figure 4.2). Because of the weak budgetary position of the government sector the broader money supply together with government resources had grown by 18%. It should be taken into consideration that beginning from October the deposit growth rate is subject to low comparison level (same period in 1998). Banking closures in autumn eliminated deposits in ERA Pank and EVEA Pank from the statistics of October 1998. It is evident anyway that throughout 1999, especially beginning from early summer, apart from statistical factors, the growth of the money supply has also been supported by increasing economic activity, continuous capital inflow and increased saving.

Compared to the first half-year, the growth of deposits remained modest in the third quarter (see Table 4.1). Whereas it should be considered that the tremendous growth of deposits by financial institutions in the second quarter has its specific implication on the quarterly comparison. The decline of private deposits was subject to traditional seasonality in July-August. Their growth accelerated significantly in September. This complies with the growth of the loan volume issued to this customer group (mainly study loans - see Credit Market, pp 32-35). The growth of corporate and non-residents' deposits has been relatively stable by quarters already from the beginning of the year. The deposits of the government sector continued decreasing in the third quarter.

The structure of the broader money supply has not much changed during the second half of the year (see Figure 4.3). The growth in the share of demand deposits characteristic of the first half-year, has stopped whereas the share of time deposits has increased to a certain extent. The share of foreign currency deposits has decreased a couple of percentage points. Interest rates of time deposits have decreased by about 0.5 percentage points against summer.

Compared to regular seasonal post-summer decline, the cash demand maintained its high level in August-September[2] . The reason for that could be an unusual cycle of the economic Growth[3] in 1999 as well as beautiful summer days lasting for a longer period than usually. The share of cash in the broader money supply did not increase and, thus, the growth of the cash demand complies with the general fast growth rate of the money supply.

MONEY MARKET

Liquidity Buffers in the Banking Sector

The liquidity of the banking system has continued to grow in 1999. This is reflected both in positive cash net flows (including those with short maturity; see Financial Sector, pp 39-46) and in the increasing share of domestic and external liquidity buffers on banks' balance sheets. During all three quarters of 1999 the monthly average balance of banks' accounts with Eesti Pank exceeded the additional liquidity requirement and the monthly minimum requirement (by 62 million kroons in the first and second quarters, by 116 million kroons in the third quarter). In December a further increase can be anticipated in the liquidity buffers, as credit institutions may want to keep additional liquidity cover over to turn of the millennium. Secondly, the credit demand would be somewhat lower during the holidays (see Figures 4.4 and 4.5).

Short-Term Interest Rates

A gradual decline of the kroon's money market[4] and swap interest rates as well as short-term kroon and foreign currency loans was inhibited in the third quarter. Lower interest rates together with increasing demand deposits by commercial undertakings and continuously shrinking turnover of short-term loans by resident commercial undertakings refer to the increased liquidity of the real sector.

Estonia's Inter-Bank Money Market Interest Rates and Turnover

Together with shrinking demand the turnover of the inter-bank overnight market has been small ever since February 1999. The average turnover has reached only 19 million kroons a month. Whereas no transactions have taken place in the overnight market in the fourth quarter.

The sharp adjustment of the money market interest rates (TALIBOR, TALIBID) in the first quarter was followed by a stable decline (see Figure 4.6). In December interest rates are expected to stabilise or even decrease slightly. The slight lowering of the money market yield curve in the third quarter reveals adjustment with shrinking demand[5]. Beginning from November 1998 money market interest rates have decreased by more than 13 percentage points and dropped through the 1996-1997 level. By early December the spread between kroon and euro money market interest rates has fallen, dependent on maturity, to 72-264 basis points (see Figure 4.7).

As of September 1998, the credit institutions' open net forex position in euro and national currency units has increased steadily. It reached close to 7 billion kroons by the end of the third quarter, being already 8.3 billion kroons by end-November. The volume of forward and other off-balance sheet positions in euro and national currency units has been relatively stable: shrinking to 3.7 billion kroons by end-August and growing again to 4-4.3 billion kroons in the fourth quarter. Previously, the credit institutions' short position in forward market was so low in the third quarter of 1997.

Weighted Average Short-Term Lending Rates

A forecasted fall in resident and non-resident short-term kroon lending rates was curbed in the third quarter. This could be ascribed to the shrinked spread between loan and deposit rates as well as to the scarcity of long-term kroon resources. A precondition of further decrease of short-term kroon lending rates (first and foremost, money market interest rates) is the reduction in the risk margin of the kroon in the currency forward market.

The average monthly turnover of resident corporate short-term kroon and foreign currency loans declined by about 30% in the third quarter against the second quarter, down to about 200 million kroons (the annual downfall being about 40%). Whereas the weighted average resident corporate short-term lending rate was sustained on the level of the second quarter, growing by about half a percentage point to 11.4%.

CREDIT MARKET

During the first nine months of 1999 the credit institutions' absolute stock of loans to residents remained unchanged and was within 22.5-23 billion kroons. Financing of local economy by credit institutions during this period has decreased mainly due to a drop in credit institutions-ownedresidents' bonds (first and foremost, financial institutions' bonds). In the third quarter the residents' loan stock increased by 709.6 million kroons whereas most of it originated from increased borrowing by private individuals and financial institutions in September. Local corporate lending continued shrinking, decreasing by 132.7 million kroons over the quarter (see Figures 4.8 and 4.9).

Because of the strong year-ago period in 1998, the annual growth rates of loan and credit aggregates continued falling in the third quarter as well: the annual growth rate of lending shrank to +2.5% and the annual gross volume growth rate of loans and debt securities to -1.8%. The annual growth rate of lending to local private individuals is remarkable whereas that of lending to private undertakings decreased until the end of the quarter. In the third quarter private lending increased significantly at the expense of study loans and the restructuring of housing loans within the banking group in September[6] . The relatively rapid annual growth of lending to local financial institutions reflects partly the restructuring of loans through the reduction of the volume of financial institutions' fixed income debt securities on the balance sheet of the credit institutions.

Shrinking loan stock of private undertakings in the third quarter against 1998 indicates lower investing activity in the real sector. This was caused by lower borrowing demand and banks' conservative lending policy carried into the third quarter as well. Most probably corporate expectations were not high enough by the third quarter in order to increase their risk acceptance for making investments.

Increasing domestic demand, improving anticipation and lower interest rates accompanying economic recovery lead to expectations that undertakings will start to expand their activity. In long-term perspective it will bring along recovered lending volumes. At the beginning of the fourth quarter there were some signs of growing loan stock of domestic private undertakings. The borrowing by private individuals grew slightly as well at the turn of the third and fourth quarters, but similar to September the growth in private borrowing in October still partly reflects the influence of study loans and intra-banking group rebooking of housing loans.

Long-Term Interest Rates

Throughout 1999 loan interest rates for local private undertakings and resident private individuals have been decreasing (see Figure 4.10), reflecting low borrowing demand in the real sector and banks' high liquidity. By September[7], weighted average interest rates of kroon and foreign currency loans for local private undertakings decreased for long-term loans to 9.8% and for short-term loans to 10.5%. Similar to declining lending rates the weighted average interest rates of time kroon deposits decreased slightly as well during the quarter (see Figure 4.11 and Table 4.2).

Despite of the sustained decline of nominal interest rates, ex post real interest rates of local private sector loans computed on the basis of consumer price index, have remained firmly within 7-7.5% for long-term real interest rates and within 8.5% for short-term real interest rates. Short-term nominal interest rates have been more volatile, with short-term loan real interest rates fluctuating more as well (see Figure 4.11 and Table 4.3). Although the small loan turnover of 1999 reflects rather low-demand-created lower economic activity, high real interest rates could partly also cause low loan turnover or in future inhibit the acceleration of the real sector's lending activity.

[1] The balance of government sector deposits abroad decreased to 2 billion kroons. Due to the privatisation receipts of Eesti Telekom (Estonian Telecom) placed in foreign reserves the balance exceeds the end of 1998 level by 700 million kroons.
[2] Comparing the 1999 cash demand with the previous year, it should be considered that besides traditional growth in summer, it had increased due to the instability caused by bankruptcy of Eesti Maapank (Land Bank of Estonia) as well.
[3] Traditionally the growth of the gross domestic product in the second quarter is significantly faster than in the third quarter but in 1999 the difference was relatively small: the economic activity was high also in the third quarter.
[4] Whereas the spread between kroon and euro money market rates has squeezed during the last three months. This reflects an increase in the short-term euro interest rates and a decrease in the Estonian kroon money market rates.
[5] The demand for short-term resources has been decreased, first and foremost, by the liquidity growth both in the banking and real sectors. Whereas the volume of short- and long-term deposits by resident commercial undertakings has grown by 155 and 60 million kroons, respectively, during the third quarter.
[6] In September housing loans issued to bank employees by subsidiaries were partly rebooked onto the bank's balance sheet, increasing statistically the volume of credit institutions' housing loans to private individuals. The rebooking continued at the beginning of the fourth quarter as well.
[7] Due to single large transactions weighted average interest rates of corporate short-term loans have been more volatile than those of long-term loans.