Slowdown in investment growth

The flash estimate from Statistics Estonia shows the Estonian economy growing in the first quarter by 1% year on year, and shrinking by 1% quarter on quarter.

In recent quarters the contribution of the exporting sector to economic growth has strengthened somewhat, while developments in the non-tradable sector have diverged. The construction sector declined in the first quarter, reflecting a slowdown in investment growth. In contrast the retail sector grew, showing that household consumption growth continues, which is also supported by the high levels of confidence among households. Compared to the fourth quarter 2012, the contribution of net-taxes to growth was probably more subdued in the first quarter of this year.

Growth in exports was fast in the first quarter, though the relatively weak external environment does not yet favour broad-based growth in exports. Growth in the exporting sector is also restricted by the weak economy in Europe. This is also reflected in exports by the Estonian manufacturing sector, which mainly grew in the first quarter owing to markets outside the euro area, while manufacturing exports to the euro area remained at the previous year’s level. Growth in the European economy is expected from the second half of this year.

The weak economic position of Estonia’s main trading partners Finland, Sweden and Russia is a consequence of the general economic weakness in Europe. Although the expectations for growth in manufacturing in Finland and Sweden are higher than half a year ago, this has not yet had an impact on actual manufacturing output, which continued to decline in both countries in the first quarter. Russia’s economic growth is additionally inhibited by the low price of exported raw materials.

Faster growth in Estonian manufacturing output than in that of the main trading partners indicates a strong competitive position for Estonian manufacturers. Accelerated growth in labour costs in manufacturing in the past year may, however, restrict the competitiveness of exports in future. As price pressure in Europe is low at present, it is difficult to pass higher costs into prices in markets with tight competition.

Eesti Pank’s most recent forecast predicted that the economy will grow by 3% in 2013.

Source: Bank of Estonia

Author: Kaspar Oja, Economist at Eesti Pank

Estonia needs a medium-term fiscal framework

On 3 May the Executive Board of the International Monetary Fund (IMF) approved the report on Estonia’s economy and outlook, which acknowledged Estonia’s current comprehensive economic policy and stressed the need for a medium-term fiscal framework.

The IMF finds that the Estonian economy is on the right track for recovery and that inflation has slowed, but that economic policy must still focus on supporting fiscal and financial stability and on reinforcing competitiveness. To achieve this, economic growth and employment growth need to be facilitated, a resolutely prudent fiscal policy maintained, and cross border cooperation in the financial sector strengthened. The IMF recommends that Estonia increase in the credibility of its fiscal policy by adopting a simple and transparent fiscal framework for the medium term.

“The IMF quite rightly identified Estonia’s main challenge as reinforcing sustainable economic growth and financial stability and that is what we are working for”, said the Governor of Eesti Pank, Ardo Hansson. “We agree with the IMF that although economic policy so far and the adoption of the euro have helped to reduce imbalances and vulnerabilities, Estonia needs to continue with a prudent fiscal policy and support the current and future strengthening of the financial sector. Setting a medium-term fiscal framework will equally help reduce uncertainty and strengthen budgetary discipline”.

The IMF finds that Estonia’s financial sector has become steadily stronger as the improved balance sheets of the banks alleviate the risks from the external environment, and that the banks are well capitalised and have sufficient liquidity buffers. To strengthen financial stability however, it is important to enhance cooperation with the financial supervision authorities, the central banks and the governments of the home countries of the banks operating in Estonia.

“We share the view of the IMF that promoting sustainable economic growth will require external competitiveness to be strengthened, and knowledge-based activities will be a key factor in this. The existence of sufficiently qualified labour resources is ever more important for the longer-term development of the economy. As the aging population and the decline in the labour force are processes that cannot easily be reversed, it becomes more important than ever to focus on developing an economic environment that favours the creation of jobs with higher added value. This means encouraging life-long learning, effective cooperation between the education system and employers, and policy measures that favour the mobility of the labour force”, explained Hansson.

The report approved by the IMF Executive Board is based on the thorough annual Article IV consultation report on Estonia’s economy and outlook from March this year, for which IMF representatives spent almost two weeks meeting figures from the public and private sectors in Estonia.

Source: Bank of Estonia

Inflation was at its lowest for two and a half years in April

Information from Statistics Estonia shows that inflation fell in April from 3.5% to 3.1%, which is its lowest rate for two and a half years, while the consumer basket was 0.1% cheaper than in March. A notable feature in price developments in April was the volatility of energy prices, and about one third of inflation was caused by the rise in the electricity price to a level 28% higher than that of last April. In contrast, motor fuels had a braking effect on inflation as the oil price on world markets fell by around 6% from its level in March, making the price of motor fuels in Estonia 6.6% lower than a year ago. Elsewhere, the cheaper prices for energy slowed inflation in the euro area to 1.2%.

Food price inflation in April was 5.2%, and the price rises for food, tobacco products and alcohol made up more than half of total inflation. The high comparison base from last year means that a temporary slowdown in the rise of food prices is to be expected in the coming months, but then a strengthening of demand in world markets could accelerate food price rises and make them broader-based.

Core inflation without food and energy remained low in April at an annual 0.9%. It was held down particularly by lower prices for communications services and manufactured goods, including durables like home electronics and cars. The reason for this was weak global demand and the strengthening of the euro against the currencies of Asian countries. An exception among manufactured goods was clothing and footwear, which increased in price by 5.3%. In the last year, Estonia has seen the fastest rise in the prices of clothing and footwear of any country in the European Union.

The Eesti Pank forecast of December 2012 predicted an average rise in the harmonised consumer price index of 3.6%, but price increases in the first months of the year have been lower than expected. Eesti Pank will publish its next economic forecast on 12 June 2013.

Author: Rasmus Kattai; Head of the Economic Policy Division, Eesti Pank

Source: Bank of Estonia

Shadow economy in Estonia at 30 pct of GDP

A survey commissioned by credit card Visa and made by Austrian professor of economics Friedrich Schneider shows that the size of the shadow economy in Estonia is about 30% of the country’s GDP.

According to the report, in Europe as a whole, shadow economy shrank from 19.3% in 2011 to 19% of GDP in 2012.

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EC estimates 3 pct growth to Estonia in 2013

In its spring economic forecast published on Friday, the European Commission upheld the 2013 economic growth estimate of 3% offered on Estonia in its winter forecast.

Estonia’s 3.2% economic growth in 2012 was supported by robust domestic demand and moderate export growth. In 2013, the forecast real GDP growth of 3% is expected to be more balanced and continues converging to its long-term average trend, reaching 4% in 2014, the Commission said in its spring forecast of 2013, titled “The EU economy: adjustment continues.” It said risks to the forecast on Estonia appear broadly balanced and mainly related to the external sector.

According to the Commission, sound fiscal policy combined with the remarkable adjustment capacity of the economy has supported Estonia’s resilience to the sovereign-debt crisis. The Commission’s forecast is consistent with the forecast of the Estonian Finance Ministry, which holds out GDP growth of 3.0% for Estonia for this year and 3.6% for 2014.

The Commission said expectations are that the relatively good economic performance of Russia and the resilience of the Nordic countries to the sovereign-debt crisis will have a positive effect on Estonia’s foreign trade. Based on a progressive recovery of Estonia’s main trading partners from mid-2013, export growth is expected to continue supporting GDP, with a strong trade surplus in services still largely offsetting a persistent trade deficit in goods. Export growth is seen to boost investments by private enterprises, which will offset the effect from the contraction in public investment as the majority of projects financed through the revenue from the sale of excess greenhouse gas emission certificates will be completed.

Overall, declining global commodity prices in 2013 and 2014 are assumed to ensure that inflation in Estonia will continue its slow decline. Although core inflation is relatively low, it might soon start increasing as the unemployment rate has already passed below the natural rate of unemployment.

Source: BNS via Estonian Review

The risks to financial stability are low

The risks to financial stability in Estonia are low. The situation in international financial markets has improved in the last half year, partly through the steps taken to strengthen the financial framework of the euro area and the efforts of the euro area central banks. The main threat to Estonian financial stability remains the fragmentation of the euro area debt markets, which could hinder growth across all of the European Union. The markets partly recovered their confidence at the end of last year, but this could disappear rapidly if not all member states contribute sufficiently to implementing the European Union reforms or if they do not improve their own national fiscal position. For any potential banking crisis to be resolved quickly and effectively, it is necessary for public finances to be in good condition.

The financial environment is also weakened by the delay to the recovery of growth in the euro area, as the worsening ability of borrowers to repay loans is increasing the loan losses of European banks and may erode their capitalisation. The assessments by banks of the quality of their own assets should be conservative and transparent for uncertainty to be reduced and the economy to be stably financed in the euro area. Problem loans should be written down rather more than less, because this helps confidence to recover.

The parent banks of banks operating in Estonia have borrowed funds on better terms than other big banks in Europe. However, it should be noted that the financing model of Swedish banks continues to be based in large part on short-term funding from the financial markets. The Swedish central bank and financial supervision authority have placed new liquidity requirements on the biggest banks from the start of this year in order to strengthen financial stability and maintain the confidence of the markets. Eesti Pank considers this to be quite appropriate given the indebtedness of the private sector, real estate market risks and the relatively large and concentrated banking sector in Sweden.

Despite the poor state of the external economy, Estonian growth accelerated in the second half of 2012 with support from private consumption and investment. The increased confidence of households meant that private consumption grew faster than wage income and savings decreased to some extent. Low interest rates and the income from the sale of emission quotas continued to support investment activity. Although the confidence indicators of Estonia’s trading partners show that their expectations for the external environment have improved, a recovery in external demand is not yet evident. The outlook for Estonian growth depends to a large extent on exports, as economic growth based solely on domestic demand is not sustainable.

The short-term risks to financial stability arising from the Estonian economy remain small. Although the loan portfolio started to increase again last year and the real estate market picked up, it is too early to speak of excessive loan growth. Against the output growth of recent years, loan demand has been moderate. However, the volatility of the external environment needs to be taken into account when new financial obligations are taken, as it may affect the ability to service debt. Most loans in Estonia are taken with a floating interest rate, so borrowers need to bear in mind that interest rates have been very low for a relatively long time, but at some point they will start to rise. To cope with that happening, the borrowers need to be able to adjust their spending levels. Having sufficient financial buffers helps to reduce the risks to loan repayment ability.

The low interest rates have reduced the profitability of banks, adding pressure on them to increase their lending margins. The larger banks have so far avoided widening their revenue base with riskier loan projects or other high-yield investments. If the lending margin remains high for too long, it could start to hinder the financing of viable projects that support the long-term development of the economy.

Source: Bank of Estonia

Estonia posted highest inflation in Eurozone

A fresh monthly update from Eurostat shows that Estonia continues to have the highest annual inflation rate in the Eurozone, at 3.8 percent, reported ERR.

For the Eurozone as a whole, annual inflation was at 1.7 percent in March.

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Estonia catching up with Finland?

Estonian economist Toomas Karm believes that Estonia could catch up with Finland in per capita GDP in 20 to 25 years. Below is his opinion article that was published in Äripäev last week.

“If one is more conservative than IMF, for instance, and estimates that Estonia’s economy growth will be between 3% and 4% a year and Finland’s economy will grow 1.8% a year, Estonia can catch up with Finland in per capita terms in 20 to 25 years,” said Karm.

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The challenges ahead are a declining population

Growth accelerated in Estonia in the second half of 2012 driven by domestic demand, and this was reflected in the labour market, as the share of the service sector in employment increased. Confidence indicators from our largest trading partners show that the outlook for the exporting sector has improved in recent months.

The unemployment rate also dropped in the second half of 2012, with the number and share of the long-term unemployed both falling. Unemployment is structural in nature and this is reflected in the continuing large differences in unemployment levels between regions and educational levels. A high level for natural unemployment is not inevitable. It is important for the state to use labour market and social policy levers to reduce obstacles to finding employment for the unemployed and those who have left the labour market.

The existence of sufficiently qualified labour resources is ever more important for the longer-term development of the economy. Preliminary estimates suggest that the working age population shrank during 2012 by almost one percent. Longer-term population forecasts are more pessimistic than earlier ones because of the high emigration by young people during the past decade. This means that even if the birth rate rises, the number of births will be lower, and there will be fewer young people reaching working age.

The decline in the population and labour force are processes that cannot easily be reversed. For this reason, more focus than ever needs to be put on developing the economy in a way that favours the creation of jobs with higher added value. This means encouraging life-long learning, effective cooperation between the education system and employers, and policy measures that favour the mobility of the labour force.

Source: Bank of Estonia

Authors: Orsolya Soosaar, Natalja Viilmann from Bank of Estonia

Rapid economic adjustment helps prevent reform fatigue

At Eesti Pank on Wednesday Ardo Hansson, Governor of the central bank, compared the economic adjustment made in the Baltic States with that in Greece, Ireland and Portugal. He said that rapid economic adjustment helped prevent reform fatigue, the build-up of excessive debt and the economic damage caused by a prolonged period of uncertainty.

Hansson was speaking in the Eesti Pank museum, where he was presenting the analysis he had written with Martti Randveer, Head of the Economics and Research Department at Eesti Pank, comparing the way that Estonia, Latvia and Lithuania adjusted after the economic crisis with the way that Ireland, Greece and Portugal did.

He explained that the results of the research show that the three Baltic states stand out in international comparison after the global financial crisis for the speed of their economic adjustment and that they have regained the majority of the total output that was lost during the crisis. The three states have also managed to lower unemployment and reduce several pre-existing imbalances and vulnerabilities.

He added that the research revealed several similarities in economic developments between the Baltic states and Ireland, Greece and Portugal, but it had shown several major differences too. “The economic adjustment in the Baltic states was twice as fast as that in Ireland, Greece and Portugal. The main reason for this was the difference in the ability of the six countries to mitigate the impact of the sudden stop in private sector capital flows that happened in 2007-2009”, he said.

The research identified that the drawbacks to the rapid adjustment were the risk of costly excess volatility, political difficulties and the likelihood of mistakes in economic policy. On the other hand, rapid adjustment helps in avoiding reform fatigue, the build-up of excessive debt and a long period of uncertainty weighing on economic activity. In addition, a rapid adjustment helps to bring about a faster closure of unsustainable activities, making resources available for productive means elsewhere in the economy.

“The current evidence of the recovery of the economies suggests that the strategy of rapid adjustment has overall been a successful response to a very difficult situation in the Baltic economies. Our analysis shows clearly that any build-up of imbalances and vulnerabilities should be addressed early and decisively as adjustment afterwards through wages and prices is likely to be protracted and painful”, explained Hansson.

He added that the current financial and sovereign distress in the euro area also offers proof that a strong external anchor in the form of membership of a currency union cannot be a substitute for policy discipline in other areas, but that, on the contrary, it increases the need for stronger discipline in other economic policies.

Source: Bank of Estonia