QUARTERLY ECONOMIC POLICY COMMENT AND FINANCIAL STABILITY REVIEW BY EESTI PANK

14 June 2005

	As regards balanced development, the external environment of the first months of the year was less favourable than expected. Development of exports will receive modest support in the near future, and the low interest rates are more likely to encourage the growth of domestic demand.
	Despite the unfavourable global economic developments, the annual growth of Estonian gross domestic product increased to 7 per cent in the first quarter. Economic growth was more than before based on increased exports.
	External balance improved due to increased saving and growth of exports. Unfortunately the change might not be permanent, and it is not certain that external balance will continue to improve at the same pace.
	Despite high and fluctuating oil prices the growth rate of consumer goods follows the trend forecasted. The temporary acceleration of inflation rate peaked towards the beginning of the year, and in May it dropped to the expected level, which may be considered sustainable in the longer term.
	Although the wage growth reaccelerated, the labour market displayed sufficient flexibility in order to ensure consistency between labour costs growth and productivity growth, thereby supporting price stability.
	Accession to the EU was accompanied by growth in confidence of both borrowers and lenders, which has contributed to the readiness to take bigger risks. This increases the vulnerability of Estonian economy.
	All tax policy related measures, which accelerate inflation, are problematic from the point of view of complying with the Maastricht inflation criterion and adoption of the euro.

GLOBAL ECONOMY

The decline in global economic activity, which started in the second half of 2004, continued. Inhibition of economic growth was the most drastic in the euro area, and the economic growth of Estonia's main economic partners does not meet expectations either. This means worse growth prospects for the year 2005, which postpones raising interest rates in the euro area. Consequently, the monetary policy environment will remain expansive and external demand for Estonian exports may diminish.

ESTONIAN ECONOMY

Economic growth and consumer prices

Despite weak global economy, the economic growth of Estonia accelerated to 7 per cent. The growth surpassed forecasts, and the share of goods and services exports in the economic growth was larger than in previous years. The near-future developments will reveal if there has been expansion of the improved competition based market share and exports will remain strong, or if weakening of external demand has not yet taken effect, causing the exports growth to slow down.

Eesti Pank forecasts a 3.4 per cent growth in consumer prices for the year 2005. The accelerating inflation is not caused by domestic demand pressures, but by economic policy decisions taken in recent past, as well as by the appreciation of fuel in the global market. The annual inflation growth decreased in May as expected, reaching 2.8 per cent. This was supported by labour market flexibility, which ensured the consistency of wage growth with productivity growth. According to forecasts, the inflation rate will remain below 3 per cent in the course of the next two years, and thus the period of temporary acceleration of the inflation rate is over. The risks are primarily related to fluctuating oil prices, and tax political measures may also entail uncertainties.

Employment and productivity

Positive developments in the labour market, i.e., moderate growth in employment and decrease in unemployment, continued. The drop in the number of unemployed registered in the employment office was remarkable: the number decreased by 4,100 people year-on-year.

The annual growth of gross wages accelerated to slightly above 10 per cent and real wages increased by more than 5 per cent. Due to faster economic growth this does not mean, according to preliminary estimates, that the cost per labour unit will rise, but calls in question the assumption that the income tax reform might slow the wage growth and increase the competitiveness of enterprises in the near future.

External demand

Based on foreign trade statistics, the growth rate of Estonian exports accelerated to 26.5 per cent in the first quarter (from the 14.4 per cent of the fourth quarter), despite the slight slowdown of target markets' economic growth. This points to the continuously positive share of net exports in the economic growth and further improvement of the external balance.

Domestic demand and current account

Accompanied by faster increase of gross domestic product promoted by favourable exports growth, internal demand turned out to be faster than expected in the first months of the year. Still, it remained slow enough to ensure further improvement in the external balance. This is proved by the foreign trade deficit, which was only a couple of per cent higher year-on-year, as well as by faster growth in deposits held by private individuals. Budget surplus traditionally supported saving.

Based on the beginning of the year, it can be concluded that the current account deficit will continue to decrease, provided that household consumption does not increase.

Financial sector

Accession to the EU has promoted the optimism of enterprises and households for the future. The belief in the fast continuation of wage growth is stronger than ever, and the latter, together with steadily low interest rates, encourages consumption and investment on account of future income.

The excessive optimism should be dampened by the standstill of the European economy, which may entail great setbacks for the Estonian economy. Due to the setbacks, the business activity of enterprises may be hampered by the excessive debt burden, and households may experience difficulties in flexible reorganisation of their budgets. Household and corporate debt constitutes a large share compared with the volume of their assets, and such developments, if they should continue, make Estonian economy more vulnerable. The households' loan demand will remain strong due to low interest rates.

The extremely low interest margins set a limit to banks' opportunities to yield a profit in the domestic market. In order to maintain their market share and expand the income base, banks are ready to take bigger risks, and have therefore initiated active sales activities in the so far rather modestly positioned consumption loans market. The profits of banks are currently sufficient to meet the capital requirement, but the limited growth perspective of profits does not support the forecasted increase in risk assets.

The new Financial Stability Review compiled by Eesti Pank can be accessed on the web site of Eesti Pank (www.bankofestonia.info).

General government sector

Achieving a fast and sustained rise in the living standard conditions not only maintaining the credibility of Estonian economic policy, but also increasing it. In order to meet this objective, adoption of the euro, which is expected by both market participants and investors, should be accomplished as soon as possible.

The changeover to the euro means, among other things, maintaining the balance between strategic and tactical objectives. Raising of consumption taxes, which was more robust than planned, may in the longer term have a positive impact on employment and consumption structure, but it will remarkably complicate satisfying the conditions necessary to adopt the euro. As regards the objective to meet the Maastricht inflation criterion and adopt the euro, all steps accelerating inflation are problematic.

Historical experience has proven the government's ability to ensure budget balance by cutting costs. At the same time it is natural the growth of expenditure cannot be limited on account of financing reforms aimed to increasing the long-term competitiveness of Estonian economy and the sustainability of fiscal policy.

Spring forecast 2005

* forecast