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Eesti Pank Bank of Estonia Andres Sutt The Estonian Economy: Current State and Prospects Eesti Pank Bank of Estonia Andres Sutt The Estonian Economy: Current State and Prospects 18 October 2006

Eesti Pank Bank of Estonia The Estonian economy and goals for economic policy • Eesti Pank Bank of Estonia The Estonian economy and goals for economic policy • • What are the factors behind high economic growth? What are the risks down the road? The main policy challanges Euro adoption Andres Sutt The Estonian Economy: Current State and Prospects 2

Eesti Pank Bank of Estonia The Estonian economy stands on solid ground GDP per Eesti Pank Bank of Estonia The Estonian economy stands on solid ground GDP per capita (PPS, EL 25=100) Andres Sutt The Estonian Economy: Current State and Prospects Latvia 2006 Poland Lithuania Slovakia Hungary Estonia Malta Portugal Czech Rep Slovenia EU-25 EU-15 Germany 1996 Finland Estonia has surpassed many new member states according to GDP per capita 140 120 100 80 60 40 20 0 3

Eesti Pank Bank of Estonia Historically low level of unemployent is also a sign Eesti Pank Bank of Estonia Historically low level of unemployent is also a sign of success Unemployed, thousands Rate of unemployment, % 100 17 95 90 15 85 80 13 75 70 11 65 60 9 55 50 7 45 40 5 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Andres Sutt The Estonian Economy: Current State and Prospects 4

Eesti Pank Bank of Estonia Employment grew by 40. 9 thousand (yoy) Employed, thousand Eesti Pank Bank of Estonia Employment grew by 40. 9 thousand (yoy) Employed, thousand 660 Rate of employment, % 63 650 62 640 61 630 60 620 59 610 58 600 57 590 56 580 55 570 54 560 53 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Andres Sutt The Estonian Economy: Current State and Prospects 5

Eesti Pank Bank of Estonia Could current GDP growth be above the potential? Estonia Eesti Pank Bank of Estonia Could current GDP growth be above the potential? Estonia GDP real growth (12. 09. 2006) 5 year average Estonia GDP real growth (13. 09. 2006) 14% 12% 10% 8% 6% 4% 2% 0% -2% 1996 1997 1998 1999 2000 2001 2002 2003 2004 Andres Sutt The Estonian Economy: Current State and Prospects 2005 2006 6

Eesti Pank Bank of Estonian export growth keeps up with global economic growth 6, Eesti Pank Bank of Estonian export growth keeps up with global economic growth 6, 0% 40% 35% 5, 0% 30% 25% 4, 0% • The economies of Estonia’s main trading partners, Finland Sweden, grew 6. 6% and 5. 5% in the second quarter of 2006. 20% 15% 3, 0% 10% 5% 2, 0% 0% -5% 1, 0% -10% 0, 0% -15% 95 96 97 98 99 00 01 02 03 04 05 06 07 Trade partners’ weighted average SKP (% y-o-y, left scale, EC forecast) Estonian real export growth (%y-o-y, right scale) Andres Sutt The Estonian Economy: Current State and Prospects 7

Eesti Pank Bank of Estonia GDP growth is driven by real estate, construction and Eesti Pank Bank of Estonia GDP growth is driven by real estate, construction and financial intermediation (40% of GDP growth, 26% of GDP) II Q 2005 Constant prices GDP total 36257 Manufactoring sector 6550 Construction 1678 Wholesale and retail sale 4797 Financial intermediation 2074 Transport and communication 4779 Real estate and other business 5276 Hotels and restaurants 600 Other 10502 II Q 2006 Growth Impact, pp 40503 7384 2039 5359 2559 5221 6122 647 11172 11. 7% 12. 7% 21. 5% 11. 7% 23. 4% 9. 2% 16. 0% 7. 8% 6. 4% 11. 7 2. 3 1. 0 1. 5 1. 3 1. 2 2. 3 0. 1 1. 8 Andres Sutt The Estonian Economy: Current State and Prospects 9

Eesti Pank Bank of Estonian economy is characterized by a large current account deficit Eesti Pank Bank of Estonian economy is characterized by a large current account deficit % GDP (quarters) 4 quarters moving average -4 -6 -8 -10 -12 -14 -16 -18 -20 2002 2003 2004 2005 Andres Sutt The Estonian Economy: Current State and Prospects 2006 10

Eesti Pank Bank of Estonia Risks arising from rapid development : • What does Eesti Pank Bank of Estonia Risks arising from rapid development : • What does high loan growth mean to the Estonian economy? • Is price stability in danger? • Will economic competitiveness last? Andres Sutt The Estonian Economy: Current State and Prospects 11

Eesti Pank Bank of Estonia What does high loan growth mean to the Estonian Eesti Pank Bank of Estonia What does high loan growth mean to the Estonian economy? Supporters of credit growth: – – good economic performance and high expectations favorable loan conditions low interest rates low starting point Andres Sutt The Estonian Economy: Current State and Prospects 12

Eesti Pank Bank of Estonia As interest margins on housing loans are all but Eesti Pank Bank of Estonia As interest margins on housing loans are all but compressed. . . Estonia Finland Andres Sutt The Estonian Economy: Current State and Prospects 2006 2005 2004 2003 2002 5, 0% 4, 5% 4, 0% 3, 5% 3, 0% 2, 5% 2, 0% 1, 5% 1, 0% 0, 5% 0, 0% Euro area 13

0 Andres Sutt The Estonian Economy: Current State and Prospects PL (2002) LV (2003) 0 Andres Sutt The Estonian Economy: Current State and Prospects PL (2002) LV (2003) LT (2003) SK (2001) EE (2004) HU (2001) CZ (2001) SI (2002) MT (2002) IE (2002) FI (2002) FR (2002) AU (2003) DE (2002) NL (2000) UK (2001) SE (2003) DK (2003) Eesti Pank Bank of Estonia . . . and Estonian homes are quite small. . . (m 2 per inhabitant) 60 50 40 30 20 10 14

Eesti Pank Bank of Estonia Therefore: loan growth is normal. The problem – its Eesti Pank Bank of Estonia Therefore: loan growth is normal. The problem – its pace remains very high. Loans to households (growth in stock; m-o-m) 3 000 2 500 mio kr 2 000 1 500 1 000 500 Housing loans july. 06 apr. 06 jan. 06 oct. 05 july. 05 apr. 05 jan. 05 oct. 04 july. 04 apr. 04 0 jan. 04 Loan stock to households increases by 2. 5 billion kroons a month. Other households loans Andres Sutt The Estonian Economy: Current State and Prospects 15

Eesti Pank Bank of Estonia Loan burden is approaching the level of Finland Debt Eesti Pank Bank of Estonia Loan burden is approaching the level of Finland Debt burden of households (% GDP) 70% 60% 50% 40% Estonia Sweden june. 06 dec. 05 june. 05 dec. 04 june. 04 dec. 03 june. 03 dec. 02 june. 02 dec. 01 30% 20% 10% 0% Finland Andres Sutt The Estonian Economy: Current State and Prospects 16

Eesti Pank Bank of Estonia First signs of normalisation on the real estate market? Eesti Pank Bank of Estonia First signs of normalisation on the real estate market? Prices of flats (per square metre) and average monthly gross wage 25 000 Tallinn flat Tallinn wage kroons 20 000 Tartu flat Tartu wage 15 000 10 000 5 000 0 1 2 3 4 1 2 3 4 1 2 2000 2001 2002 2003 2004 2005 2006 Source: Statistical Office of Estonia Andres Sutt The Estonian Economy: Current State and Prospects 17

Eesti Pank Bank of Estonia Another sign of normalisation on the real estate market? Eesti Pank Bank of Estonia Another sign of normalisation on the real estate market? Real estate transactions of dwellings and buildings 12 000 9 000 6 000 3 000 0 2'03 3'03 4'03 1'04 2'04 3'04 4'04 1'05 2'05 3'05 4'05 1'06 2'06 Source: ESA Value of transaction, mln kr Number of transactions Andres Sutt The Estonian Economy: Current State and Prospects 18

Eesti Pank Bank of Estonia 7, 5% Interest rates are on the rise 7, Eesti Pank Bank of Estonia 7, 5% Interest rates are on the rise 7, 0% Real sector long-term lending rates 6, 5% 6, 0% 5, 5% 5, 0% 4, 5% 4, 0% 3, 5% Enterprises Households (exc. BIG loans) aug. 06 june. 06 apr. 06 feb. 06 dec. 05 oct. 05 aug. 05 june. 05 apr. 05 feb. 05 dec. 04 oct. 04 aug. 04 june. 04 apr. 04 feb. 04 dec. 03 oct. 03 aug. 03 june. 03 3, 0% Housing loans Andres Sutt The Estonian Economy: Current State and Prospects 19

Eesti Pank Bank of Estonia Is price stability in danger? • Inflation developments are Eesti Pank Bank of Estonia Is price stability in danger? • Inflation developments are under public attention in the context of joining the euro area. • 1 -2 pp faster inflation rate than in the euro area is normal given the relatively higher rate of economic growth. • In the Estonian economic policy framework, the effect of stability-oriented measures will apprear in two or three years time. Andres Sutt The Estonian Economy: Current State and Prospects 20

Eesti Pank Bank of Estonia Higher growth = higher inflation? 2 pp difference with Eesti Pank Bank of Estonia Higher growth = higher inflation? 2 pp difference with the euro area remains Euroarea HICP Estonian CPI Difference 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% 1999 2000 2001 2002 2003 2004 2005 Andres Sutt The Estonian Economy: Current State and Prospects 2006 21

Eesti Pank Bank of Estonia CPI growth components Other prices Adm. prices (pp) Food, Eesti Pank Bank of Estonia CPI growth components Other prices Adm. prices (pp) Food, alc and tobacco Motorfuel CPI total 6, 0 5, 0 4, 0 3, 0 2, 0 1, 0 0, 0 Andres Sutt The Estonian Economy: Current State and Prospects 07. 06 04. 06 01. 06 10. 05 07. 05 04. 05 01. 05 10. 04 07. 04 04. 04 01. 04 10. 03 07. 03 04. 03 01. 03 -1, 0 22

Eesti Pank Bank of Estonia Will the competitiveness last? • The success of the Eesti Pank Bank of Estonia Will the competitiveness last? • The success of the Estonian export sector shows the competitiveness of our economy • But production cost are rising. . . • Exporting enterprises are most vulnerable, as they cannot change their prices at will Andres Sutt The Estonian Economy: Current State and Prospects 23

Eesti Pank Bank of Estonia IMF: Estonian exports’ market share has risen REER (2000=100, Eesti Pank Bank of Estonia IMF: Estonian exports’ market share has risen REER (2000=100, l. s. ) Share in world export (2000=100, right scale) Andres Sutt The Estonian Economy: Current State and Prospects 24

Eesti Pank Bank of Estonia IMF: Estonian exports’ technology-content has increased high medium-low Right Eesti Pank Bank of Estonia IMF: Estonian exports’ technology-content has increased high medium-low Right scale: goods that are produced with a given level technology (% of total country exports) Andres Sutt The Estonian Economy: Current State and Prospects 25

Eesti Pank Bank of Estonia Competitiveness is supported by flexibility of price adjustment and Eesti Pank Bank of Estonia Competitiveness is supported by flexibility of price adjustment and wage formation • Estonian companies change prices more frequently than euro area companies. – 43% Estonian but only 34% of euro area companies change prices two or more times a year. • Companies in Estonia adjust prices more quickly than in the euro area in response to changes in demand or production costs. – 51 -66% of Estonian enterprises but only 22 -26% of euro area companies react within 1 month. • Wage formation takes place mainly on company level. • 80% of Estonian enterprises pay “flexible” wages. Andres Sutt The Estonian Economy: Current State and Prospects 26

Eesti Pank Bank of Estonia Fast wage growth = fast growth of productivity? Labour Eesti Pank Bank of Estonia Fast wage growth = fast growth of productivity? Labour productivity Growth of real wage 14% 12% 10% 8% 6% 4% 2% 0% 1998 1999 2000 2001 2002 2003 2004 Andres Sutt The Estonian Economy: Current State and Prospects 2005 2006 27

Eesti Pank Bank of Estonia Is the decline in export growth a sign of Eesti Pank Bank of Estonia Is the decline in export growth a sign of deteriorating competitiveness? Estonian export growth has declined to 13% ( 2006 II Q), without fuel transit and fuel production Total export Export exc. fuel 35% 30% 25% 20% 15% 10% 5% 0% -5% I qt 2004 III qt 2004 IV qt 2004 I qt 2005 III qt 2005 IV qt 2005 I qt 2006 Andres Sutt The Estonian Economy: Current State and Prospects II qt 2006 July. 06 28

Eesti Pank Bank of Estonia Main tasks of the economic policy • The performance Eesti Pank Bank of Estonia Main tasks of the economic policy • The performance of the economy is stronger than any time in past 10 years, but the main tasks of the Estonian economic policy remain unchanged. • The time of rapid output growth is the best time for implementing reforms. • The adoption of euro continues to be an important goal. Andres Sutt The Estonian Economy: Current State and Prospects 29

Eesti Pank Bank of Estonia The main tasks of the economic policy have not Eesti Pank Bank of Estonia The main tasks of the economic policy have not changed • A favourable investment climate requires a credible currency, a sound financial system, sound public finances, and flexible adjustment mechanisms. • At the peak of the cycle, cooperation between economic policy makers is important to avoid overheating and to handle the risks arising from high loan growth. Andres Sutt The Estonian Economy: Current State and Prospects 30

Eesti Pank Bank of Estonia Avoiding the overheating requires continued tight budget policy Plans Eesti Pank Bank of Estonia Avoiding the overheating requires continued tight budget policy Plans for 2006 and 2007 include a general government budget surplus When growth declines, the budget surplus (in %) may be smaller. Real GDP growth (l. s. , %) Budget balance (r. s. , % of GDP) 14 2, 5 12 2 10 8 1, 5 6 1 4 0, 5 2 0 0 2003 2004 2005 2006* 2007* 2008* * GDP data as of 12. 09. 2006 Andres Sutt The Estonian Economy: Current State and Prospects 31

Eesti Pank Bank of Estonia How to manage the risks of rapid credit growth? Eesti Pank Bank of Estonia How to manage the risks of rapid credit growth? Measures by the Bank of Estonia: - Strenghtening of financial sector: • higher capital requirement; • higher required reserve level; • cooperation with neighbouring central banks and financial surveillance authorities A clear role for fiscal policy: – – Dampening too high (wage growth) expectations Ending the income tax exemption for interest on housing loans? Andres Sutt The Estonian Economy: Current State and Prospects 32

Eesti Pank Bank of Estonia The times of rapid output growth are best for Eesti Pank Bank of Estonia The times of rapid output growth are best for reforms • Ageing of population • Flexibility of the economy, primarily the flexibility of labour market institutions • Competitiveness of the education system • Favorable business climate Andres Sutt The Estonian Economy: Current State and Prospects 33

Eesti Pank Bank of Estonia Adopting the Euro at a first possibility remains a Eesti Pank Bank of Estonia Adopting the Euro at a first possibility remains a top economic policy priority • Euro adoption is the anchor of the Estonian economy. • Euro adoption is unrealistic in 2008 • The main risk of “indefinite” postponement: risk of loss in credibility. • Conservative and stability-orientated policies are the key in managing the risks for the economy. Andres Sutt The Estonian Economy: Current State and Prospects 34

Eesti Pank Bank of Estonia Thank you for your attention! Andres Sutt The Estonian Eesti Pank Bank of Estonia Thank you for your attention! Andres Sutt The Estonian Economy: Current State and Prospects 36