MONETARY POLICY COMMENT BY EESTI PANK
The Third Quarter of 2001

WORLD ECONOMY

This past summer the bottom in the world economy was expected to be over by the beginning of the third quarter and the growth to recover in the second half of the year. In fact, the growth continued to shrink in major economic areas and apart from Japan, also the US and Germany entered economic recession. There are signs indicating that by the end of the year this could spread to the entire eurozone.

All major central banks responded to falling economic activity with large interest cuts. From the beginning of the year US base interest rates have dropped by 4.5 percentage points (including a drop of 2 percentage points between July and November) and in the eurozone by 1.5 percentage points (dropping by 1.25 between July and November). Cheaper loan resources should support consumer confidence that suffered another blow in terrorist attacks on September 11 and prevent the transfer of economic slowdown from industry to service sector which has the largest value added and share of employment.

The cooling of the world economy will have a lagging impact on Estonia.

As terrorist attacks in the US and economic difficulties in Argentina did not increase Estonia's risk rating, the external interest rate signals to Estonia have remained expansive in the third quarter. The fall in the eurozone interest rates spread also to the local money market and brought along a decline in the real sector deposits and borrowing costs.

The global economic growth slowdown reaches Estonia through exports and imports with approximately two-quarter delay. This is best characterized by declining export demand and inflation growth, both of external origin.

ESTONIA'S ECONOMY IN THE THIRD QUARTER

Although in the third quarter the world economy cooled significantly, Estonia's 4.9% growth rate was not essentially different from the indicator of the first half-year. Due to the delayed external impact the difference in the growth rate from the European Union increased in the third quarter, reaching 3.6 percentage points.

However, the shrinking subcontracting in electronics indicates that world trends are reaching Estonia's real economy. The decline in the export of goods confirms that external demand is already worse than a year ago. The general recession is anticipated to reach Estonian economic space early next year, leading to a potential further slowdown in economic growth (according to the forecast down to 3.5% in 2002).

Despite the still high investment activity, the external balance will maintain the level of the previous year in the third quarter as well, and current account deficit should remain below 6% of GDP.

The inflation rate that accelerated under external price pressures at the beginning of the year was replaced by faster-than-anticipated slowdown in summer. Through the shrinking demand in the world market the global recession sent prices for raw materials into decline. Extensive free production resources push downward also prices of finished and half-finished goods. In Estonia the twelve-month growth of consumer prices dropped from 6.9% in June to 4.8% in October.

Balanced consumption

Despite the deteriorating external demand, domestic demand (primarily consumption) has been relatively balance-oriented. In the third quarter consumption spending was primarily controlled by the tight fiscal policy in the government sector - in end-October the consolidated budget surplus was over 1.1 billion kroons. Together with various transfers to households remaining on the level of the previous year, the tight fiscal policy inhibited also private consumption. Besides, the rapid inflation rate at the beginning of the year did not facilitate the growth of private consumption either. As existing direct exports have not yet significantly affected export earnings, companies and individuals have not had to do much adjusting.

The export earnings in the third quarter were still adequate to maintain real sector's loan servicing on the previous level. The lending growth exceeding deposit inflow does not yet directly threaten economic stability. Financing of real estate transactions continuous to show the highest growth whereas the declining international interest rate level has taken the price of credit to the record low (below 9%). Contemporaneously, the share of bad loans has grown most in this sector, which could significantly deteriorate the quality of assets in the financial sector should export earnings continue shrinking. Therefore, the current problem does not lie in the potential use of external credit resources but rather in the higher-than-the-average vulnerability of certain sectors - primarily, real estate development - accompanying suspended economic growth.

ESTONIA MAINTAINS ITS CREDIBILITY UNDER THE COOLING EFFECT

Under the current circumstances it is difficult to assess the length and depth of the global recession. Stimulating economic policy could bring recovery in major industrial countries already in the summer of 2002 whereas a longer recession cannot be excluded either. The strong financial sector and current economic stability show that Estonia has good preconditions to maintain credible economic environment also during the overall global slowdown. This is best characterized by a high credit rating (A-) assigned to Estonia this autumn by two rating agencies (Standard&Poor's and Fitch).

Maintenance of the stability and avoidance of major setbacks manifests adherence to previous economic policy agreements and focusing on longer-term objectives. This means primarily a conservative approach to prospective developments among all economic agents. The private sector should be able to evaluate critically borrowing plans and revise this year's remuneration policy in domestic market-oriented activities. The government sector should set a target of a balanced budget in the upcoming years as well and maintain sustainable speed of structural reforms.