Press release on the 1997-1998 programme for the economic policy of the Government of Estonia and Eesti Pank

On Friday, 7 November 1997, the Government of Estonia and Eesti Pank agreed on the joint economic programme for the next 13 months. The goal of the programme is to guarantee the continuing macroeconomic stability and to support the balanced economic development in Estonia. Experts of the Finance Ministry and Eesti Pank started the preparation of the programme in August of this year. The programme was drafted in tight co-operation with specialists from the International Monetary Fund.

The General Stance of Estonian Economy

The stable macroeconomic policies of the Government of Estonia and Eesti Pank, based on a sustainable fiscal policy, currency board arrangement and an open foreign trade policy, have helped in a more efficient allocation of the country's resources. Such a choice of policies has resulted in a fast economic growth and a decreasing inflation. The GDP grew by 11.7% in the first half of 1997. Inflation has dropped to 12% in October of this year. The nearly 30% growth in export reflects Estonia's strengthening position in the world market.

As a result of the conservative fiscal policy, the general government budget for 1997 is balanced and the Government is establishing a stabilisation fund exceeding 500 million kroons by the end of this year. Tight budget policy has been accompanied by the decrease in Government foreign debt below 5% of GDP. The continuing privatisation process of infrastructure as well as the pension reform confirm the Government's readiness to continue with structural reforms.

An important factor of the economic success in Estonia has been the fast developing financial sector that is based on private capital. The ratio of banks' financial assets to GDP has increased from 38% in 1996 to approximately 50% in September 1997. The range and quality of financial services offered by Estonian banks and other financial intermediaries have improved considerably in recent years and resulted in a more efficient financial intermediation. Besides other financial intermediaries, the Tallinn Stock Exchange has become an essential institution in mediating savings and investments.

Despite a successful economic development, the Government and Eesti Pank are well aware of the dangers that accompany a rapid economic growth, first of all reflected by the rather large current account deficit and rapid growth of banks' loan portfolio. Current account deficit is an inescapable feature of rapid economic growth that in case of Estonia mostly reflects the investments being financed from foreign sources. However, the current account deficit that reached 9.8% of GDP by the first half of 1997 subjects Estonia to negative influence from the changes taking place in international financial markets. At the same time it has to be noted that more than 70% of current account deficit has been financed by long term capital flows, primarily direct investments and medium to long term bank loans.

The yearly growth of credit volumes that reached 100% level in September can, in case of strong competition, lead to lowered loan standards and financing of inefficient projects, thus threatening the quality of banks' loan portfolio. Mention should, however, be made of the relatively low loan burden of Estonian companies and private persons (approximately 25% of GDP).

Priorities of Economic Policy for 1998

Estonian economic policy is and will be based on principles of open market economy, tight fiscal policy and the currency board system as well as the pegged exchange rate. Consequently, the objectives of the Government of Estonia and Eesti Pank are geared towards maintaining a stable macroeconomic environment and further strengthening the credibility of the currency board arrangement and of economic policies in general, accelerating the preparations of joining the European Union. The main objectives for 1998 include maintaining the current sustainable economic growth, limit the current account deficit and guarantee a further reduction in inflation. In order to achieve these goals, the Government and Eesti Pank will guarantee the continuation of the economic policies of recent years and reinforce them with new financial measures. At the same time, the Government proceeds with the structural reorganisation, including the land reform and privatisation of infrastructure.

Fiscal Policy

The main objective of the tight budget policy is a further strengthening of the stabilisation fund started in 1997. Consequently, the state's foreign reserves will increase by up to 1.3 billion kroons in 1998; domestic saving will also increase. The Government is planning the total public sector surplus to be 1.5-2% of GDP in 1998.

As a principal measure to strengthen the longer-term financial position of the state and to increase domestic saving, a thorough pension reform will be initiated in 1998. The reform is designed to relate pensions directly to personal contributions. According to the draft pension system, pensions will comprise of three parts: a minimum pension provided by the state, a supplementary pension financed through compulsory personal contributions and a supplement financed through voluntary contributions. The Government will present the necessary amendments to be made in legislation to the Parliament already at the end of this year and the beginning of 1998.

Monetary and Banking Policy

The fixed exchange rate of the Estonian kroon against the German mark and the currency board arrangement will be firmly and indisputably the cornerstones of Estonian monetary policy. At the beginning of the Economic and Monetary Union stage three and the introduction of the euro, the latter will replace the German mark as the base currency for the Estonian kroon in accordance with the exchange rate of euro against the German mark to be established by the European Union.

The Government and Eesti Pank have set strengthening the credibility of the financial system as one of their priorities in economic policy. In doing so, they have wished to emphasise the special characteristics of transition economies, necessitating the application of requirements exceeding international minimum standards and the importance of market participants' self-control.

Being convinced that the financial sector's ability to withstand negative developments in global as well as local markets depends mainly on its capitalisation, Eesti Pank continues the policy of strengthening the banks' capitalisation as its longer-term objective. Preliminary evaluations confirm the positive effect of the taken measures on the behaviour of the banks. Regardless of this success Eesti Pank is ready to take additional measures, including raising the capital adequacy ratio to 12% in 1998.

Recent Developments in the Financial Markets

Eesti Pank and the Government have closely followed the developments in Estonian as well as international financial markets that have taken place over recent months and weeks. We are of the opinion that the recent increase in interest rates and correction of share prices on Tallinn Stock Exchange should be regarded mainly as an adequate reaction of the market to the changed situation, not as a crisis of confidence in the credibility of the perspectives for economic growth in Estonia. Competition has forced the interest rates to fall below their medium-term trend average and assets have been overpriced because of excess market optimism. Now these two are going through a necessary correctional phase, which has been unarguably influenced by turmoil in the international capital markets. Consequently, regardless of the significant fall in share prices and rise of interest rates, there is no reason to claim that this will be accompanied by a significant fallback in the economy or a decrease in the credibility of the financial sector. On the contrary, these developments will decrease excess optimism in the whole economy and force economic agents to a more conservative behaviour.

The stock exchange's excessive dependence on companies' one-month profit figures may prove to be a destabilising factor which could hamper the effectiveness of the financial markets. In this situation it is of primary importance to ensure the transparency and compatibility of financial reports and other information. In addition, certain developments in a tightening competition force Estonian banks to pay more attention to acknowledging and following good banking practices.