Eesti Pank - Bank of Estonia

The global economic outlook is favourable for 2005-2007. Although global output growth is projected to decline to approximately 4% in 2005-2006, the growth rate will still remain near its potential level. Despite the fact that several central banks consistently increased their key interest rates in the first half of 2005, the level of nominal and real interest rates is relatively low. The European Central Bank has not yet started to tighten monetary policy, whereas markets are expecting a rise in key interest rates in the next months. The fiscal policy stance of the advanced economies is also going to be more restrictive in 2006. The rise in oil prices is posing a major risk to global economic growth and price stability. The autumn forecast of the International Monetary Fund[1] also listed regional imbalances between savings and investment, as well as increasing protectionism, as factors jeopardising economic growth.

Economic growth in 2006 will remain divergent among the world's major economies. In the US output growth will decrease in the long-term, which corresponds to its the neutral monetary policy stance. Nevertheless, the US economy will continue to grow considerably faster compared to the euro area and Japan. Several risks surround the sustainability of the US economy, as private consumption is being bolstered by the increasing debt burden and record low level of household saving. In order to maintain rapid economic growth, the US current account deficit should either be decreased or stabilised in the forecast horizon.

The second half of 2005 saw several indications of an expected recovery of economic activity in the euro area, although several international forecasting centres have downgraded the growth outlook because of persistent structural bottlenecks (primarily the high level of unemployment). Positive tendencies have revealed themselves mainly in soft indicators, which provide only circumstantial evidence that economic growth has become more pronounced. An extensive recovery in the euro area depends mostly on the faster growth of capital investment and private consumption. Favourable financial conditions and the high profitability of enterprises will serve as a solid basis for an increase in capital accumulation. Private consumption will probably grow at a slower pace, as consumer confidence is still low and employment indicators remain at their cyclical low. This will reduce demand-driven inflationary pressures in the euro area, although rising oil prices are coming more sharply to the forefront in the first half of 2006.

Economic growth is still considerably faster in the Nordic countries than in the euro area, mainly due to domestic demand. Economic activity is expected to continue to grow in the coming years. In Sweden, low interest rates have induced housing-related capital investments, but this should drop slightly in 2006. Finland's economic growth is also expected to gather momentum after a temporary downturn because of labour disputes in the wood and paper industry.

The economic growth of the new EU Member States in 2006-2007 is expected to remain broad based. Employment growth in these countries depends on economic restructuring in the old EU Member States. The Baltic States form an exception among the new EU Member States with respect to employment growth, as their increase in output volumes relies mainly on capital accumulation and total factor productivity.

Estonia's Economic Outlook

Estonia has experienced rapid economic growth in recent years. Although this growth has been partially based on a growing debt burden, it can still be claimed that Estonia's economic outlook is relatively favourable. The growth of productivity, household income and corporate profitability has been rising quickly and this trend is projected to continue in the medium term.

According to the autumn forecast of Eesti Pank, economic growth will amount to 8% in 2005 and then fall to slightly below 7% in 2006 and 2007 (see Table 5.1). The demand conditions will continue to be favourable as they rely on the rapid growth of income, excessive credit supply and optimistic expectations. On the other hand, the gradually improving external environment and the impact of integration into the EU trade market will ensure sufficient export demand growth.

Table 5.1. Economic forecast by main indicators

The contribution of net exports to economic growth is projected to be positive in 2005. The growth of exports will be remarkably faster than that of imports, and the contribution of domestic and external demand to economic growth will diverge considerably from the trend of the past five years (see Figure 5.1). Due to the favourable external demand, the export-oriented branches of the economy will be successful in the coming years, but the influence of the non-tradable sector (incl. real estate) on economic growth will also remain considerable. The construction, real estate, retail and wholesale sectors, and their respective services sectors (e.g. financial intermediation; see Figure 5.2), also account for growth. The successful boom of the real estate sector is expected to continue, which makes the non-tradable sector a significant driving force behind economic growth for the years ahead.

Figure 5.1. Real GDP growth and its components (%)

Figure 5.2. Share of fields of activity in real GDP growth (%)

Regarding longer-term risks, the supply side of the economy has to cope with the upward movement in the value added chain. We are facing a transition to more knowledge-based products and services, and this will happen against the background of a limited labour force and human capital resources. Estonia's demographic situation is anything but favourable. The more labour intensive sectors of economic activity will be most affected by the limited labour pool.

One of the key processes treated in an earlier forecast - the adjustment of private consumption to a stage of lower growth - already took place for the most part in 2004. The share of private consumption in GDP decreased by more than 2 percentage points; on the one hand, income growth was inhibited, and on the other hand, households preferred to invest more in real estate. The real estate boom will continue in 2005, and this will cause the year-on-year share of private consumption in GDP to remain almost unchanged. The volume of private consumption will increase 7.3% this year, and 6.7% and 5.2% in the following two years, respectively.

The main factor affecting consumption expenditure in Estonia is the disposable income of households. It is still mainly wage income, although government transfers and business income have recently increased faster than employment income. According to the forecast, household income in 2005-2007 will increase faster than private consumption expenditure. Such expectations are based on both the administrative changes in taxation (the raising of the tax-free minimum and lowering of the income tax rate), which will broaden the gap between net and gross wages, and the slight increase in interest rates, which should limit consumption.

Taking into consideration the existing data, it can be stated that the increased income of households would have allowed them to consume considerably more than they actually did (see Figure 5.3), thus it may be concluded that households have started to save more. This development has primarily been conditioned by investment in housing. In addition, saving is fostered by obligatory saving related to pension funds, as well as by the increased supply of savings and investment programs provided by the financial sector.

Figure 5.3. Growth in net wages and private consumption

Structural changes in private consumption refer to the fact that the share of durable goods in consumption expenditure has increased in recent years. Here, expenditure on cars, electronics, household appliances, and furnishings can be pointed out. Trends in expenditures on durable goods are obviously the component of private consumption that reflects the influence of both the real estate boom and favourable credit conditions.

Private consumption related risks to the economy, as a whole, lie in the possible changes in householders' saving behaviour. Should the risks originating from the labour market materialise, wage growth might increase to such an extent that households would be able to spend considerably more than before. On the other hand, private consumption may increase due to incentives and offers from the financial sector in the form of an extensive supply of various short-term financing products.

In 2002-2004, the share of investment in GDP remained at a relatively high level - more than 30%. In 2005-2007, it is forecasted at 29%, which is lower than the last three years' average, but still stands out among the Central and Eastern European countries. The 2005 investment volume growth forecast is 9.6%, mainly supported by the rapid increase in investment by households, as well as by the general government, the latter being facilitated by capital from EU structural funds. Real total investment growth in 2006-2007 will remain in the 5-6% range.

Householders' investment last year, which increased much faster than corporate investment in fixed assets, was the main driving force behind investments. The higher investment activity of households has been supported by the continuously low level of the real interest rate of housing loans and the rapidly developing real estate market. Household investment has also been sustained by the increase in income: wage growth has led to a burgeoning of disposable income, which has been growing since the beginning of the year and will remain around 10% during the forecast period.

Corporate investment in fixed assets has been inhibited for some time now, but has still preserved its notable volume. Taking into account the continuously favourable interest environment and good demand conditions, the macroeconomic environment should favour investment activity during the entire forecast period, i.e. 2005-2007.

Regarding risks, further growth in export-oriented investment is important for Estonia. If recent developments continue and overall investment increases mainly because of investment in the real estate sector, then at some point in the future when the real estate market cools economic growth will slow and the competitiveness of Estonian enterprises will decline.

Out of all the domestic demand components, the fast growth rate of general government expenditure will persist in the coming years. The growth in tax revenues is strong owing to both rapid economic growth and improved tax collection. The 2005 local government elections, as well as the 2007 Riigikogu elections, will boost the political will to spend.

Employment growth has been rising since 2005 - the demand for labour as a production input has grown considerably against the background of increased economic activity. As a result, wage growth has been picking up since the beginning of 2005 and employment growth will presumably reach 1.4% by the end of the year. However, employment growth is expected to gradually slow, falling to 1.1% and 0.4% in 2006 and 2007, respectively.

The labour market is showing more and more signs of turning into an "employee's market", as the demand for labour is outpacing the supply and the pressures on wage growth surpassing labour productivity are increasing. It is also important to relate productivity and wage growth in future wage negotiations in order to ensure a more efficient allocation of production resources.

According to the forecast, nominal wage growth will rise to 11.7% this year and is expected to fall to the nominal GDP growth in the years ahead. The increases in real wages and productivity are in accordance with one another, and real wages will grow by 7.3%, 6.8%, and 6.9% respectively in 2005-2007 (see Figure 5.4).

Figure 5.4. Productivity, real wages and real unit labour cost

The labour market related risk, which jeopardises the economy as a whole in both the short and medium term, lies in the acceleration of wage growth arising from discrepancies between the demand for and supply of the labour force. Taking into account the long-term population forecast, there is every reason to fear that the labour force supply is going to inhibit economic growth in the long run. The problem could be alleviated by a rise in the participation rate, as this is relatively low in Estonia compared with other European countries.

As the developments of the first half of 2005 turned out to be more favourable than expected, they allow more optimistic outlook concerning the further improvement of the external balance. Estonia's exports have been able to maintain a solid growth rate, which allows for the forecasting of a somewhat faster convergence of the current account deficit. The current account deficit is expected to be 9.4% of GDP in 2005, and it should fall to 8.5% and 7.8%, respectively, in the next two years. Such a development presumes a continuously high external demand on the one hand and a slowdown in domestic demand on the other.

The external balance will improve mainly with the support of the goods and services balance (see Figure 5.5). The strong export growth of the past two years will fall slightly in 2006-2007, primarily due to the erosion of the short-term effects caused by the accession to the EU. Import growth will slow mainly due to a slowdown in export growth. The negative balance of the income account will continue to increase (i.e. it will constitute an incremental share of the current account deficit) - reaching 7.1% of GDP by 2007. The growth of the income account deficit is supported by corporate revenues. The transfers account forecast has remained unchanged compared with the previous forecast: its balance will remain below 2% of GDP during the entire forecast period. The transfers account surplus is ensured by capital flows from EU structural funds.

Figure 5.5. Current account structure (% of GDP)

Looking at the current account from the point of view of macro aggregates, it can be seen that the deficit has been decreasing since the beginning of 2005 due to both an increase in the share of private saving and a fall in the share of investment in GDP. Corporate profits, the relatively rapid real wage growth, investment in pension funds, and the new savings programs of commercial banks are fostering the rise in private saving. The contribution of the general government in gross saving remains marginal, dropping slightly due to a decrease in the budget surplus.

In previous years, the financing need of the private sector remained at a high level and grew year by year. In order to cover the need, credit institutions attracted plenty of external resources. According to the forecast, the share of bank loans of the non-financial sector is going to reach 75% of GDP this year, which is approximately 15% higher, year-on-year. Despite a slight rise, the growth in deposits is clearly unable to meet the need for credit. Taking into account additional financing through other channels and the share of foreign direct investment, the gross external debt of 2005 will be approximately 90% of GDP and will increase to around 100% by 2007.

Inflation has been higher than expected during the past months. The main reason has been the rise in oil prices, which has caused upward adjustments of the inflation indicators in the autumn forecast. This year we can expect the harmonised consumer price index to rise 4.2%, but it will fall to 3.4% in the next year and to 2.9% in 2007, when the base effect of oil prices will be cancelled out.

Whereas in spring when the price of a barrel of oil was expected to stabilise at USD 45 by the end of the forecast period, now stabilisation at USD 60 per barrel can be expected. The share of motor fuel in the consumer basket is twice bigger in Estonia than elsewhere in Europe, thus its impact in Estonia is also much stronger. Considering the price of crude oil futures, it is likely that oil prices will not fall very quickly. This means that in addition to oil, the prices of other types of energy will also stabilise at a level higher than before the shock. In Estonia, the prices of transport services have risen rather swiftly after the increase in oil prices, and other types of energy (e.g. firewood, shale oil) have witnessed a price increase as well.

Food price rises have diverged by category of goods. Thus, it is not clear at the moment what the general price trend will be. The upward trend of dairy product prices is slowing, whereas the fall in meat product prices is coming to an end. In addition, we should consider the adjustment of the tobacco and alcohol excise, which should take place in mid-2006. All the same, it can be said that the price growth of food is slowing slightly. Regarding the risks associated with food prices, the pressures primarily accompanying the growth in export demand should be taken into account. Restrictions on external trade may cause an additional price shock, should the bird flu spread further.

Several adjustments in regulated prices will be made during the forecast period, which allows for the expectation of a rise in regulated prices that will inflation to grow by approximately 1.3 percentage points. According to estimates, this influence may extend upwards to 1 percentage point in 2006, as some plans concerning price regulation may still be unknown. In 2006, the main administrative action will be a rise in thermal energy prices, an action influenced by the price growth of major production inputs, primarily shale oil.

The growth of domestic production costs should move hand in hand with changes in core inflation. However, the relationship between domestic production costs and core inflation should be smaller in a small open economy. According to the forecast, core inflation should rise slightly. The main reason here is the rapid convergence of income levels and the accompanying price increase of production inputs. The cyclical position has become less favourable to core inflation and this may soon increase pressures related to cost-push and demand inflation. Cost-push inflationary pressures have remained relatively subdued so far, as the growth in income has helped compensate for the increase in production costs. Demand inflation is fostered by the situation where the rise in income makes consumers more tolerant of price increases, which makes it easier to raise prices.

Regarding the risks that might bring along lower price increases, the possibility of core inflation remaining below the expected level should be pointed out. This will happen if the price rise of transport services stops, the price war in the telecommunications sector reintensifies, competition in the clothing and footwear sector becomes tighter, and household goods cheapen due to the further reorientation of imports from the Asian market. It is possible that such factors might compensate for the upward price pressures accompanying the rapid growth in wages.

ECONOMIC FORECAST OF EESTI PANK FOR 2005-2007