Estonia

Oxford Economic Country Briefings, Nov 21, 2007

Highlights and Key Issues

* Pressure on the exchange rate is subsiding as the trade deficit begins to decline. But the improvement is due mainly to a drop in imports as the growth rate slows sharply. Q3 growth fell to 6.4%, confirming the rapid drop towards a medium-term trend below 6%. The severity of slowdown still poses risks to investment plans and asset prices.

* Despite slower growth, inflation has picked up further, to 8.5% in October, as consumer spending growth stays strong and fiscal policy relaxes. The target fiscal surplus has been cut to 1.3% of GDP for 2008, and could go lower as revenues fall with the growth rate and the government sticks to low taxes and structural spending essential to longer-run growth.

* The improving trade balance underpins continued stability of the exchange rate, keeping it on track for the new EUR conversion date of 2011. However, the gap is being closed mainly by reducing import demand, with the rising cost of exports working against the strategy of diversifying trade by promoting new sectors.

* Estonia's strong reserves and net creditor status have enabled it to adjust to the unexpected tightening of global credit conditions, but at the cost of braking the economy that could disrupt investment plans and cause asset price correction. Slower progress against unemployment will add to social tensions over the treatment of noncitizens.

Overview

Growth slows to 6.4% in Q3...

* The strength of reserves afforded by a fiscal surplus and net creditor status has allowed the central bank to fend off downward pressure on the exchange rate, and fundamental pressures for a devaluation are receding as the trade deficit falls. But the lower external gap has been mainly achieved by slowing the economy and restraining imports rather than reviving export growth. GDP growth slowed to 6.4% (on provisional data) in Q3 from 7.6% in Q2, confirming that full-year growth will be below 8%, with a further dip to around 5% likely in Q4. Industrial output growth picked up to 5.8% in September, but this was mainly due to a strong export-led rise in power production, with manufacturing output actually 0.2% lower than a year earlier.

...with inflation rising to 8.5%...

* Although these growth rates remain strong in the EU context, they show monetary tightening - forced on the economy by the currency board arrangement slowing production growth ahead of demand growth. Retail sales growth is also slackening, but was still 12% on the year in September. As a result, consumer price inflation has picked up further, to 8.5% in October from 7.2% in September, with producer price inflation reaching 9% in September. Food has joined housing costs and transport fuel as main factors behind the inflation, which has continued despite a sharp slowdown in monetary growth. Wage growth is also slowing less rapidly than output growth, eroding cost-competitiveness further for businesses that cannot boost productivity.

...despite exchange rate stability

* Inflation would have worsened without the retention of the fixed exchange rate, and the IMF has assisted its preservation by publishing analysis that dismisses any financing problems for Estonia or other new EU member states. The tight management of the foreign exchange market under the currency board, the complicated political process for changing this, and the strong official reserves position have continued to deter speculative attacks on the currency. Although the current account deficit remains large (at some 14% of GDP this year), it is still covered by long-term capital inflows and there has been no resort to the short-term financing, whose supply has anyway dried up since the US sub-prime deterioration.

Slower growth reducing trade gap...

* A stabilisation of imports in local currency terms, while exports rose by 2%, reduced the August trade deficit to EEK3.4bn (EUR0.2bn), below a year earlier. oil transit volumes in January-September were 5.1% lower than a year earlier after Russian supply interruptions following the war memorial dispute six months ago. The government has recognised that Moscow may now permanently switch the oil trade to its own ports, but says that the shipments have become an inefficient use of the railway system, and that the container traffic that is taking their place will be more profitable.

...but encourages fiscal loosening...

* However, reduction of the trade gap is due principally to the rising price of exports, as the fixed exchange rate transmits higher domestic costs, and to the government's unwillingness to tackle excessive domestic demand. The planned cut in the fiscal surplus, to 1.3% of GDP next year, is a relaxation of policy at a time when tightening is usually advised and continues to draw IMF criticism. Finance minister Ivan Padar has added to concerns over fiscal loosening by saying there will be no revision even if GDP and revenue growth come in below official projections, implying that the surplus could be eroded even further. Expenditures have been raised to absorb some of the substantially larger surplus achieved this year, but this ensures a smooth passage for the budget that will get final parliamentary approval on 12 December. Public spending also includes additional outlays on education, export promotion and R&D support, which are central to government initiatives for shifting from low-wage to higher value-added exports.