QUARTELY ECONOMIC POLICY COMMENT AND FORECAST FOR 2004-2006
BY EESTI PANK

1 December 2004

	Despite the generally good economic situation, further development of Estonian economy is threatened by several external and domestic risks. If the growth of consumption does not retard and saving does not improve, the prospects of Estonian economy might worsen. High oil prices and further development of the dollar rate constitute the highest external risks.
	In the next years, the economic growth rate of 5-6 per cent, which is feasible for Estonia, is expected to persist. Preserving the latter is enabled by a ca ten-per-cent increase in exports, which results from brisker global economy and somewhat improved productivity growth in the economy.
	Eesti Pank forecasts the annual consumer price growth for 2004 to be 3.1 per cent. Presuming moderation in internal demand and wage growth, there is no basis to forecast strengthening of price pressure for the next years.
	Eesti Pank forecasts that the current account deficit will drop below 10 per cent of GDP by the year 2006, which will be brought about by improved external trade balance. This will occur if the growth of private consumption temporarily retards, thus increasing domestic saving.
	The prospects of the financial sector are considered positive in the next years, although the borrowing activity of private persons has been persistently high in 2004. The good prospect of economic growth still supports the ability of companies and households to repay their loans. In the next years the speed of credit growth is expected to somewhat decline, but levelling off risks related to borrowing on the individual level is still appropriate.
	In case the risks related to external environment materialise and loan rate does not stabilise, a stable economic political environment might be endangered, which in turn might affect Estonian accession to the euro area.

WORLD ECONOMY

Global economic growth will accelerate in 2004 and is expected to remain between 4.5 and 5 per cent in the next years. Economic growth of the euro area is accelerating, but inflation might also remain higher than two per cent. However, markets do not presume changes in monetary policy before prospects of economic growth will have become fixed - increasing the base rate of the euro area should take place in the first half of 2005. Improvement of the external environment is not a certainty, though.

ESTONIAN ECONOMY

Economic growth and consumer prices

Pursuant to the forecast of Eesti Pank, the rapid economic growth rate is expected to last - this year's economic growth is going to be 6.2 per cent; in 2005 and 2006 5.6 per cent and 6.0 per cent respectively. Underpinned by favourable external demand, external trade will considerably contribute to the economic growth during the next year, and in line with the turning of the interest cycle and domestic adjustments, the percentage of internal demand will decrease even more. The continuous rise in oil prices constitutes a risk factor for both the Estonian and global economy.

In the second quarter of this year, a one-time acceleration of inflation occurred, and there has been no considerable speeding up of consumer price increase during the second half of the year. The average annual consumer price growth for 2004 is forecasted to be 3.1 per cent. The world market oil price increases have had a strong impact on consumer prices in the second half of this year.

Out of administrative actions, electricity price increase, which is planned to take place during the next year, is going to have the biggest forecastable impact. In 2005, the average annual inflation is expected to be 3.4 per cent. Presuming that the labour market is going to preserve its flexibility, the growth of private consumption is going to retard, and world market oil prices will stop rising, there is no basis to forecast strengthening of price pressure for 2005-2006.

Employment and productivity

The growth of employment characteristic of the previous years was more related to sectors oriented towards internal demand. During the first half of the current year, primarily due to brisker exports, the significance of economic sectors started to turn in favour of the tradable (exporting) sector. The growth of employment will retard and remain at ca 0.5 per cent in the next years.

Accompanied by the growth of exports and the contribution of the tradable sector, we can also expect productivity growth, which, according to the forecast, is going to be 5.5 per cent this year. Growth in real wages will adjust below its medium-term growth rate, constituting 3.7 per cent. Increase in prices, which has turned out to be bigger than expected a year ago, has also its role to play here.

External demand and current account

Estonian exports are forecasted to follow the European trends of production and trade movement, and fastest growth can be expected in the current year. In the following years, the real rate of increase in exports will stabilise at 8-10 per cent.

Regardless of the peak of exports, due to the raised demand for imports and persistently high income outflow, the current account deficit is not expected to decline - pursuant to the forecast, it will remain at 13.1 per cent of GDP, within the same range as last year. Underpinned by the improvement of the balance of goods and services as well as by the slightly increasing inflow of transactions, the current account deficit will aggregate gradually, dropping to 9.2 per cent of GDP by the year 2006.

But acceleration of the growth of export income only does not mean external balance will improve. This presupposes a better compliance of wage formation with productivity growth, development of the tendency to save, and growth retardation of bank loans.

Internal demand

Growth of private consumption is going to remain relatively high this year, i.e., at around six per cent; a slight growth retardation is expected to take place next year. The main factors contributing to the adjustment of private consumption are growth retardation of real income and termination of the stimulating monetary policy in the second half of 2005.

In compliance with the rising interest rates, the speed of loan growth will decrease in 2006, one the one hand instantly reducing the liquidity enabling private consumption and on the other hand increasing the share of interest payments in the balances of private households. The joint impact thereof will condition the adjustment of household balances and the real growth of private consumption will slow down at 4.7 per cent in 2005.

The general government consumption will increase by 5.9 per cent in 2004, and even less in the years to come. This would be a third consecutive year for the general government where the growth of spending surpasses the previous medium term trend.

Financial Sector

The current situation of financial stability can be considered good, as improvement of the economic environment and good prospects for economic growth ensure that both companies and households are able to meet their loan commitments.

The rate of households' loan growth reached its peak in the middle of 2004, and from there on the growth rate is likely to decline. The strong feeling of security on the one hand, and the aggressive behaviour of banks in the loan market on the other still continuously inject optimism to include financial burden.

Although the speed of loan growth is reducing, and the current economic environment is supporting loan servicing, it is still appropriate, taking into account the risen debt burden, to consider the possible risks.

In the longer term, reducing loan growth could avert serious macroeconomic problems. Decreasing demand might endanger the expansion prospects of companies, which in turn might bring along worsening of the labour market situation and finally also bigger solvency problems for loan customers. That gives even more reason to stress the importance of creating financial assets as buffers (especially bank deposits) to level off the possible future loan servicing difficulties.

Another longer-term risk is related to the situation, when banks enter more risky sectors with the view to preserve high profitability. This results in the danger that in case the economic environment proves to be worse than expected, the risk premium of higher-risk customer projects will turn out to be too low, and the necessary capital buffers will be underestimated.

In case the growth rate of loans does not retard and no substantial changes take place in the saving behaviour, the increasing volume of debt obligations and accompanying bigger load of servicing thereof might hinder the growth of internal demand in the future and thus reduce the growth potential of the economy.

The new Financial Stability Review compiled by Eesti Pank will be accessed on the Internet at: as of www.bankofestonia.info.

Economic policy

Budgetary policy has been the main pillar of external balance in the period following the Russian crisis. In case the relatively fast economic growth continues, the general government's current year's budget should have a small surplus. Different form the previous years, this means, together with the supplementary budget, movement towards more expansionary fiscal policy. Even if the growth of expenditure will retard in 2005, high base level of the current year will still have to be taken into account.

Budgetary policy must remain the main force backing balanced economic development, and balanced budget is the absolute minimum requirement. It must also be taken into account that in addition to financing transactions that increase the internal demand, the result of the current budgetary year at the government's disposal is not 'spare money', but the share of the budget that has remained unused involves the obligation to make certain expenditures in the future.

The government's decision to decrease the possibility to deduct interests from the income tax and reduce the Kredex guarantee limit per borrower are a step in the right direction to control the fast loan growth.

Forecast risks

	This forecast is threatened by risks related to global economic developments: The persistent imbalances of the US economy, the continuous rise in oil prices, and inflationary expectations proceeding from low interest rates. All this would mean worsening of the prospects for the Estonian economy, imbalance between external and internal demand, as well as high loan growth. The worsening of the prospects for Estonian economy resulting from the materialization of the external risks creates the threat that the general government's tax yield turns out to be lower than expected.
	Out of internal risks, the one related to private consumption is the highest. If households continue consuming their entire current earnings and increasing their loan burden at the pace similar to that of now, there is no hope for improvement of the external balance.
	In case the risks related to external environment materialize and level of indebtedness does not stabilise, stable economic political environment might be endangered and bring along a considerable retardation of economic development.