ESTONIAN ECONOMY

SHORT SURVEY

The year 1997 showed the first remarkable results of the structural reforms of the earlier years, the efforts to integrate Estonia into international economy and the expansionist development of the banking sector. Trust in the Estonian economy increased, supported by the strict fiscal policy of the Government. Faster growth of the government spending as compared to the growth rate of the gross domestic product (GDP) stopped and starting from the summer the budget revenue began to exceed expenditures. The increase of consumer prices turned out slower than predicted. Taking advantage of the increased trust, banks received favourable foreign loans in the first half of the year and brought several new products to the lending market. The volume of the leasing portfolio increased rapidly. The decline of the interest rates that prevailed until September encouraged domestic demand. The strong US dollar and the weakened German mark had a favourable impact on the dollar based export due to growing profitability and/or competitiveness. The rapid growth in banking, processing industry and transport and communication led to a certain euphoria and extensive use of financial instruments oriented to financial leverage. Positive expectations were amplified by the quickly rising price of shares and several favourable evaluations given to the development in Estonia (the good progress towards the European Union membership, positive rating by international rating agencies, etc).

Economic growth accelerated in 1997 due to the intensive investment activity and the considerable increase in external as well as domestic demand. At the beginning of the year the rapid growth was put down to a milder winter as compared to the previous year (the beginning of 1996 was unfavourable for Estonian economy for its harsh winter), but the later development proved that already in the fourth quarter of 1996 the economy started to grow faster. In the first three quarters of 1997 Estonia's GDP increased by 10.6% as compared to the same period of 1996. The sale of industrial production at constant prices increased by 13.4% compared to 1997.

However, the rapid economic growth also had certain negative aspects. In some cases, the supply side obstacles emerged (for example on the labour market, and especially in the building sector). The current account deficit remained large, supported by the intensive inflow of foreign capital and the import preference. Although the inflation rate slowed down, the role of the demand side factors in the structure of the price rise increased. In the second half of the year the inflation rate accelerated.

In the fourth quarter, the banks as well as the entire financial sector suffered from the problems caused by the changes in international financial markets, accompanied by speculative attacks against the Estonian kroon. The developments on the financial markets at the end of 1997 provided financial intermediaries with another valuable experience. Having operated in the conditions of increasingly more favourable markets, the banks tended to underestimate the possible risks on both domestic and foreign markets, and sometimes applied financial instruments too strongly oriented to financial leverage. This strategy proved to be unsuitable for Estonia's quickly changing market. At the same time, Estonia came out from the crisis that hit international financial markets at the end of the year with a moderate correction and turn to a more conservative economic policy. This increased the sustainability of development and dampened the growth expectations and success euphoria that had reached too high by late summer. According to early estimations, the changes that took place in the financial sector in the fourth quarter had no immediate negative impact on the real economy but nevertheless provided a necessary signal for the revision of various development programmes and investment projects. The increase of interest rates and tightening of the loan conditions will probably led to a certain correction in the economic growth rate in 1998.

DEMAND

In 1997, economic growth was supported by the increase of both external and domestic demand. However, the role of these two components changed to some extent as compared to 1996. In 1996, for example, economic growth relied mostly on the increase of domestic demand. Although domestic demand increased also in 1997, the main generator of growth was the increase of external demand. In the first nine months of 1997, the domestic final consumption in current prices exceeded the respective level of the previous year by 20%, but external demand increased by 36%. The rapid increase of external demand boosted its share in domestic demand from 37% in 1996 to 40% in 1997.

Domestic demand

The increase of domestic demand can be contributed to the rapid increase of demand in the private sector. The increase of demand in the public sector remained modest in 1997. Investments in nominal terms increased by 40% in the first three quarters, while nominal growth of the government consumption remained at 14-15%.

Private consumption increase was facilitated by the growth of the real income. The real wages increased by 7.6% in 1997. On the other hand, private consumption increase was supported by the intensive inflow of foreign capital, and the wider loan supply by higher risk-prone attitude of banks. As a result, the private individuals' access to credit resources improved considerably in 1997. In private consumption, the share of food and other essentials decreased, while the share of spending on transport, leisure, other goods and services increased.

Besides the lessening of liquidity constraints, the increase of private consumption was also boosted by the growing confidence in the continuation of economic growth. Presumably, this tendency also increased the expectations of economic agents about their future income and due to increase in permanent income reduced current savings. Private consumption grew faster than disposable income.

The year 1997 was characterized by the lively investment activity. Thus, for example, in the first three quarters of 1997 investments into fixed assets amounted to 25.8% of GDP. The share of public sector investments decreased as compared to 1996, the share of private sector investments increased. The rapid development of the private sector investments was supported by the increase of businesses' profitability, the optimistic future outlook, the favourable situation on the international financial markets as well as the increased loan supply by the credit institutions.

In the past couple of years the growth of public sector consumption has slowed down, exceeding, however, the growth rate of GDP. 1997 was exceptional because the public consumption increase was slower than the GDP growth. Another peculiarity of the past year - government sector final consumption increased slower than tax revenue and accounted for 20-21% of the total domestic demand.

External Demand: Export of Goods and Services

The export of goods[1] in 1997 amounted to EEK 28.8 billion, increasing by 35.6% last year. In the structure of exports, the share of direct export decreased, while the share of processed goods increased considerably (mostly machinery and equipment).

Export of timber and paper dominated, but in particular, the sale of unprocessed timber to the Nordic wood-processing and pulp companies. The structure of the export into the industrial countries was considerably diversified by subcontracting in textile and clothing industry as well as in the production of machinery and equipment.

Electricity and mineral products export to the CIS countries increased. Also the noticeable export growth in transport vehicles (mostly car seat-belts) was not sufficient for compensating for the decline in food export.

The export of services amounted to more than EEK 18 billion in 1997 and increased by 37% a year. Transport services export grew particularly rapidly. The fastest growth was recorded in the volume of freight transport, but passenger transport, too, overcame the 1996 decline and increased by a remarkable 77%. The biggest contribution to passenger transport came from sea transport which is also testified by the increase in the share of Estonian shipping companies on the Tallinn-Helsinki passenger route and the acquisition of a number of new vessels in 1997.

The share of travel services export in the total export of services remained significant, although the increase of travel services (13%) was lower than the growth in other categories of services. In 1997, the visa requirements were abolished between Estonia and all the Nordic countries.

Domestic Supply

The share of GDP in total supply accounted for 54-55% in 1997. Despite the rapid nominal growth of GDP, its growth rate still remained below the nominal increase of import of goods and services.

In the nine months of 1997, GDP increased by 10.6% in constant prices against the respective period of 1996. In financial intermediation and forestry the annual increase amounted to 22%, in the processing industry to 18% and in real estate, leasing and business services to 14%. For the first time, a small increase (0.2%) was achieved in agriculture, previously constantly declining. The value added decreased only in the energy sector and gas and water supply, where the mild winter reduced domestic demand.

The sale of industrial production increased by 13.4% at constant prices, while in the processing industry the increase amounted to even 16.9% (see Figure 2.1). Another reason for the growing sales volume, besides the launch of a number of earlier made investments, was the favourable situation of the foreign markets and increasing exports. The share of exports in the total sale of industrial production increased to 44.3% over the first three quarters of 1997 (40% in 1996); in the processing industry exports accounted for 51.3% (48% in 1996). The fastest growing areas were timber and paper industry as well as the food and textile industry.

In the first nine months of 1997, a number of Estonian enterprises opened subsidiaries or sales representations abroad as well as acquired shares in foreign companies. The interest was not limited to just financial investments - in the eastern direction in particular, Estonian companies made direct investments to penetrate into the protected markets. The utilization of production capacity in 1997 was among the highest of recent years. Due to high demand, the plant inventory stock was low and, according to the data compiled by the Estonian Institute for Market Research (EKI), stayed even below the normal level in the second half of the year.

Industrial production increase was derived from the improved competitiveness of Estonian companies. Productivity increased considerably in 1997: compared to the first quarter of 1996 productivity at constant prices increased by 17% in 1997, in the second quarter the increase was 20% and in the third quarter - 14.5%. The increase of productivity reduced the labour unit cost (ULC), which estimated decrease was 9% in the first three quarters of 1997.

Actual increase of competitiveness is not as considerable as indicated by the ULC which mainly relies on productivity. The more rapid increase of competitiveness was prevented by the increase of production input prices, which can be characterized by the increase of industrial production producer prices. The average annual increase of the producer prices slowed down to 8.9% in 1997.

In agriculture, the quantity produced remained more or less on the level of 1996. Milk and grain production slightly increased and meat production decreased.

The volume of construction (without subcontracting) increased by more than 15% (in constant prices) as compared to 1996. Construction abroad decreased, while increasing domestically. The utilization of construction capacity was higher than in 1996 and the contract portfolio was larger. The construction services market demand exceeded capacity which was also reflected by the construction price index. The limited potential was characterized by the increase of wage costs in the overall cost structure. At the same time, the deteriorating loan opportunities influenced the market in the fourth quarter of 1997 and the customers' debt burden increased. Increase of accounts payable caused by the customers' liquidity problems affected nearly half of the construction companies.

The supply of services increased due to the growing domestic and external demand. Considerably more transport services were provided in 1997 than in 1996. The volume of freight passing through Tallinna Sadam (the Port of Tallinn) increased by 22% (transit was up by 27%) and 11% more passengers was serviced. The abolition of the visa requirement between Estonia and all the Nordic countries had a favourable impact on the passenger transport and particularly the number of incoming tourists. The share of transport services provided by Estonian companies increased.

Rapid increase continued in the wholesale and retail trade. The turnover of wholesale trade in current prices increased by 35% in 1997, the retail turnover (in constant prices) went up by 15%. Besides the increase of domestic demand the retail turnover was boosted by the growing tourism. In the first three quarters of 1996, EEK 2.8 billion worth of travel services was sold to private travellers, while in the first three quarters of 1997 the respective figure was EEK 3.5 billion.

External Supply: Import of Goods and Services

Import of goods and services in current prices amounted to EEK 55 billion in 1997, increasing nominally by 34% per year. Thus, the increase of external supply of goods and services was higher than the domestic supply (GDP) and the share of external supply increased to approximately 85% of GDP.

Imports increased across all groups of goods. Estonia's main import partners in 1997 were the same as in 1996. The share of imports from the European Union grew up to 75% of the total imports.

Services import amounted to EEK 9.9 billion in 1997, increasing by 39% compared to 1996. Transport services increase was the fastest. Combined with the rapid growth of cargo export, it may characterize Estonia as an important transit country.

Travel services import also increased remarkably (39%) in 1997. Net worth of travel services bought from agencies increased by 74% and the number of Estonian residents using those services grew by 25%. Estonia's most important tourism partner is still Finland, although the number of visits to Sweden and Russia increased rapidly as well.

INVESTMENTS

Just like 1996, 1997 was characterized by high investment activity. According to the State Statistical Office, investments into fixed assets amounted to 25.8% of GDP during the first three quarters of 1997. According to the preliminary estimations, investments into fixed assets increased considerably in the fourth quarter of 1997.

The share of public sector investments decreased in 1997, while the share of private sector investments increased as a percentage of GDP. In 1996, the government sector investments amounted to 5% of GDP, while in 1997 the respective figure was 4%. Both local governments and the central government invested less in 1997.

The increased investment activity of the private sector derived partly from the optimistic future expectations. This was also testified by the results of the regular polls in companies conducted by the EKI. According to those polls, the confidence on future increased in industry and trade. In the first three quarters of 1997, the same tendency appeared internationally. Instability in the international money and capital markets decreased confidence in the fourth quarter.

Private sector investment growth was also facilitated by the favourable foreign environment prevailing during the first three quarters of 1997 as well as the growing confidence in Estonian credit institutions internationally. As a result, the access of the banking sector and the enterprises into international financial markets improved which facilitated the foreign financing of investments.

In 1997, private sector investments were also supported by growing risk-prone attitude of credit institutions, resulting from the intensive inflow of foreign capital, as well as the growing competition in the banking sector. As a result, the commercial banks adjusted the requirements to loan applicants and made access to credit resources easier for the business sector. In 1996, Estonian banks lent EEK 2.1 billion to the enterprises, while in 1997 these loans reached a total of EEK 4.2 billion.

Besides the rapid growth of lending to corporations, the widening of leasing companies activities also facilitated the private sector investments.

One of the main prerequisites for the continuing high level of investments was the increasing profitability of the business sector. The importance of this trend is proved by the fact that profits earned by the companies have traditionally been the main source of investments. According to preliminary data, approximately 60% of the investments came from the companies' own funds in the first three quarters of 1997. In 1996, the respective figure was 54%.

Saving

The share of saving increased to an estimated 17-18% of GDP in 1997, resulting mainly from the growth of public sector savings. In 1996, the public sector savings amounted to 3.5% of GDP, while in 1997 they already reached over 5%. Among the overall government sector, the central government economized the most. As compared to 1996, the savings of local governments and the Health Insurance Fund also increased. The increase of public sector savings stemmed, first of all, from the rapid economic growth which brought in more tax revenue than forecasted.

The share of private sector savings from GDP remained roughly on the level of 1996. The structure of savings changed: the role of enterprises increased and that of households decreased. Increase of the business sector savings in 1997 can be testified by the growing profitability of both the financial and the corporate sector. Thus, according to the State Statistical Office, the profit of companies was nearly two times larger in the first half of 1997 than it had been during the first half of 1996.

Unlike in other institutional economic sectors, the average household savings decreased in 1997. The decline of households propensity to save was first of all indicated by the slowdown of the growth rate of the net position (deposits minus loans) of households against the banking sector. In 1996, the net position of households increased by EEK 806 million against the banking sector, in 1997 the increase of the net position amounted to just EEK 320 million. Although the slowdown of the net position of households can mostly be attributed to the rapid growth of loans issued to private individuals (in 1996, private individuals borrowed EEK 1.1 billion from banks, in 1997, EEK 2.3 billion), we also have to take into account that loans taken by households are largely used for financing current expenditures[2] .

Apparently, households propensity to save is also reduced and propensity to consume increased by the growing wealth due to the rapid increase of share prices at the stock exchange over the first three quarters of 1997. Saving habits might have changed also because of the growing optimism.

The increase of confidence may also have encouraged private consumption because expectations about the future income reduce cautiousness-motivated saving. Additionally widening liquidity constraints reduce households marginal propensity to save.

Foreign Financing

As in earlier years, foreign financing was one of the main sources of economic growth in 1997. The intensive inflow of foreign capital which helped to finance both the investment demand and private consumption amounted to approximately 17% of GDP in 1997.

One of the main reasons for the intensive inflow of foreign capital can be found in the positive institutional and structural changes that have occurred in the economic environment in recent years and have improved Estonia's economic climate and boosted the country's international credibility. In the first nine months of 1997, the inflow of foreign capital can also be attributed to the favourable conditions on the international financial markets (low interest rates and optimistic expectations about the future development of transition economies). The financial and currency crises in several Asian countries, however, turned the conditions on the international financial markets considerably less favourable starting from the second half of the third quarter. As a result, the access of Estonian financial intermediaries to international capital deteriorated considerably.

Another reason for the intensive inflow of foreign capital in 1997 was the high domestic demand. As a result, the active involvement of foreign savings compensated for the shortage of domestic resources.

In 1997, the structure of portfolio investments underwent certain changes: in 1996 investments into equity securities prevailed, while in 1997 foreign investments mainly poured into debt securities. The decline of portfolio investments into equity securities was, first of all, caused by the skyrocketing share prices at the Tallinn Stock Exchange.

In 1997, the volume of investments abroad by Estonian businesses had a jerky rise. In 1996, the external claims of Estonian residents increased by nearly EEK 1 billion (approximately 2% of GDP), while in 1997 investments from Estonia abroad amounted to approximately EEK 9.7 billion or 15% of GDP. This was, first of all, caused by the growing supply of foreign capital and the increased risk-prone attitude of the residents. The resident's claims abroad increased particularly rapidly in the form of portfolio investments into the equity securities, as well as in the form of direct investments and loans.

The rapid growth of direct investments from Estonia abroad was also facilitated by the strengthening of the economic positions of the Estonian businesses. A number of companies were interested in launching subsidiaries or sales representations either in order to circumvent Russia's customs or to penetrate into new markets. In the financial sector, companies were particularly keen to expand to Latvia and Lithuania by acquiring significant stakes in banks and insurance companies and by launching their own leasing firms. The expansion of financial intermediaries into the neighbouring countries could also have been stimulated by the rapid decline of interest rates on the Estonian market.

The increase was rapid also in case of various investment funds which invested a significant portion of their resources into Baltic and Russian securities. Investments into foreign equity securities increased particularly in the third quarter when the boom at the Tallinn Stock Exchange achieved its peak and the need for dispersing the risk became quite obvious. The quotation of securities of several foreign countries and providing access to them by Estonian financial intermediaries also must have played a certain role in the capital outflow.

As compared to 1996, the banking sector share in foreign capital inflow increased, the share of the public sector and other sectors decreased. For the first time after the 1992 monetary reform, the net position of the public sector strengthened against non-residents. The strengthening of the net position of the public sector was derived, first of all, from the transfer of the stabilization reserve funds into foreign credit institutions in the fourth quarter. The low level of investments financed by the government sector from foreign capital also had a certain impact. The increase in the share of the banking sector in attracting foreign capital reflected the increasing credibility of Estonian credit institutions which improved their access to international money and capital markets, as well as the high demand for loans by the corporate sector and households.

The large volume of foreign capital inflow was accompanied by the rapid increase of Estonia's external debt in 1997. The external debts of the banking sector increased particularly rapidly. In the fourth quarter the share of short-term liabilities increased considerably in the structure of the banks' total external liabilities. As a positive note, we can mention that the external debt of the public sector decreased.

PUBLIC SECTOR

Fiscal Policy

The new Government inaugurated in March was based on the same coalition as the old one and took over the fiscal policy of the previous Government. Throughout the post-independence period Estonia's fiscal policy has proceeded from the internal balance of the central government budget. The balance of the central government budget and the consolidated budget has greatly been influenced by the extent of the investment programmes of the public sector. In some years, the savings of the public sector have not been adequate to finance these programmes and foreign loans have been used. In view of the increase of consumption and the decrease of savings in 1996 the Government set the target of achieving a budget surplus in both 1997 and 1998. The surplus will be channelled into the Stabilization Reserve Fund which will help the Government to finance unforeseeable expenses without having to increase the tax or debt burden. The government has also decided to pursue a conservative foreign borrowing policy in these years.

The aim of the tax policy is to preserve the proportional income tax for companies and private individuals. In the field of indirect taxes the Government aims at harmonizing the tax arrangement system with the requirements of the European Union. In addition to legislation, the target is to harmonize the rates of main consumer taxes in the future. For example, the schedule of increasing excise tax on motor fuel has been worked out.

Revenue

According to preliminary data, the tax burden was slightly heavier than in 1996, but did not exceed 37% of GDP. The tax level increased mainly due to higher consumption taxes. From the beginning of the year the excise tax on motor fuel was increased by 50% and from 1 July the excise tax on imported beer and beer produced by large local breweries was increased by 20%. The fuel excise was again raised from 1 December. Although the increase of the government and households final consumption was slower than the GDP growth, the increase of the share of inventories in the structure of domestic demand compensated for this and guaranteed more rapid increase of the VAT revenue. The VAT and excise taxes on motor fuel, tobacco products and alcohol yielded more than a third of the 1997 revenue of the fiscal system and their ratio of GDP neared 14% (see Table2.1).

The collection of the VAT increased more than GDP because the foreign trade deficit did not decrease as expected and the share of VAT paid on imported goods remained high. The increase of the share of VAT was also boosted by the increase of imports prior to the introduction of higher excise taxes on motor fuel and tobacco products (which took effect at the beginning of 1998). The increase of the tax burden was also supported by the tax-free income limit remaining on the 1996 level. The progress of the land reform contributed to the growth of revenue from the land tax - the local governments received 12% more land tax than envisaged in the budget plan.

Unlike in 1996, the gradual increase of the fuel excise did not lead to a significant increase in smuggling and tax fraud. This guaranteed the stable increase of revenue from excise taxes throughout the year. The smooth inflow of revenue was also supported by the relatively stable growth of the economy. In the budget projection the nominal growth of the economy had been stated at 17%. The growth higher than projected brought higher revenue: the central government collected 112%, the local governments 102% and the social insurance and health insurance funds 107-108% of the planned revenue.

In 1997, the distribution of revenue within the government entities was changed. In 1996, the entire personal income tax went to the central government budget, while from the beginning of 1997, 56% of personal income tax went to the local budgets. This increased the independence of local governments and reduced the share of the central government revenue from the previous two thirds to 53%.

Expenditures

The higher than expected increase of budget revenue created the prerequisites for higher expenditures. Unlike in earlier years, however, not all of the surplus was used for additional expenditures, but part of it was set aside for future needs. Although the central government adopted two supplementary budgets in 1997, they amounted to just 1.6% of the originally planned budget, while 12% more revenue was collected than planned.

A number of local governments, too, adopted supplementary budgets. As the surplus revenue of the local governments was considerably smaller than that of the central government, their activity did not affect much the revenue-expenditure ratio of the consolidated budget.

The most important change in the budget policy was the slowdown of the growth of the public sector's final consumption costs. The share of these to GDP had been growing throughout the post-monetary reform period and reached 25% in 1996. Cutting expenditures was one of the priorities of the 1997 budget policy and its results were manifested already in the first half of the year: the ratio of the final consumption costs to GDP fell from 26% in the first half of 1996 to 23% in the first half of 1997. Spending on wages and salaries decreased quicker than the maintenance costs of state-financed institutions and other consumption-related spending (in local budgets, spending on salaries increased by 14% and other consumption-related costs by over 25%). Consumption costs remained within the required boundaries also in the second half of the year because much slower economic growth had been predicted. Thus, the government sector savings amounted to approximately 6% of GDP.

Income transfers increased slightly slower than GDP. Spending on pensions increased 17-18% in a year. Spending on the majority of other social benefits had to be increased more: 20% more child and family benefits were paid out than in 1996, and 40% more unemployment benefits. In all cases spending grew because the size of the respective benefits was increased. At the beginning of 1997, the Government allocated resources for the subsistence benefits to be paid by the local governments who had to arrange the payment of those benefits in accordance with local needs. This change obviously improved the effectiveness of the system and reduced costs which increased only by 10% as compared to 1996. The slower increase of spending on pensions can be attributed to the fact that in 1996 the average increase of pensions had been quicker than the long-term sustainable growth and relied on the reserves accumulated in earlier years. The latter had to be used even in 1997 because the current intake of the social insurance tax was equal to current payments and exceeded them only in the second half of the year.

The savings were not entirely channelled to the government sector investments. The investments financed from savings remained practically on the same level as in 1996, while investments from foreign loans decreased. This was most obvious in case of the local governments whose investments were two times smaller. However, this comparison is somewhat misleading because the international bond issue of the Tallinn municipality allowed a sudden leap in the local government investments. If we compare the year 1997 with 1995, we can see that the volume of local governments' investments remained practically on the same level as in 1995. This was the main reason why the share of the public sector investments in GDP decreased from 5% in 1996 to around 4% (see Table 2.2).

Budget Balance

The monthly revenue-expenditure balance of the central government and local governments began to improve in the third quarter of 1996. This was due to the acceleration of economic growth and the resulting extra revenue. In 1997, the rapid economic growth was supplemented by the impact of the budget policy measures which led to the accumulation of a considerable budget surplus in the third quarter and for the whole year (see Figure 2.2). In recent years the share of investments financed from foreign loans has been gradually decreasing in the central government budget. In the post-monetary reform period the need for intermediating foreign loans to production companies has also been constantly decreasing. The process has been reversed: the repayments have began to exceed the amounts the Government lent on.

A characteristic feature of the Estonian fiscal system is that 15% of the central government expenditure is made up of income transfers. In 1997, the surplus of the revenue of the central government, compared to expenditures, was more than five times larger than the total deficit of the local governments and the Social Insurance Fund. A part of the surplus derived from the Government's decision to apply its owner's rights and channel approximately EEK 400 million of the Estonian Shipping Company profits into the State budget before the company was privatized.

In 1997, the largest deficit in the entire fiscal system was generated by the local governments, whose total budget deficit accounted for approximately 0.3% of GDP. The shortage of revenue of the Social Insurance Fund turned out to be smaller than expected, remaining below EEK 50 million. A novel element in 1997 was that the Health Insurance Fund, the Forestry Capital and the Environmental Fund accounted for more than a fifth of the entire fiscal system surplus which amounted to 2.1% of GDP (see Table 2.1). The above-mentioned non-budget funds generated the surplus mainly due to the quicker than expected growth of revenue and by keeping the expenditures within the limits.

Approximately 50% of the surplus of the consolidated budget was channelled into the Stabilization Reserve Fund that was set up in the last months of the year. The Fund collects Government reserves for the rainy day - should the economic growth in the future turn out slower than expected of should there emerge unexpected expenditures in connection with the completion of economic reforms.

The surplus of the consolidated budget eased the government's loan burden. The foreign loans of the central government were dominated by repayments which reduced the indebtedness in dollar terms. As the US dollar strengthened considerably in 1997, the book value of the central government's debts also increased. In relative terms, the government debt decreased and accounted for approximately 4% of GDP (see Tables 2.3 and 2.4).

The debts of the local governments, too, reduced slightly (by less than EEK 20 million). This happened mainly due to the partial repurchase of the bonds issued by the Tallinn municipality in 1996. Other local governments borrowed nearly EEK 200 million, of which almost half was spent on servicing the earlier loans. The debts of the general government totalled to approximately 7% of GDP.

INFLATION

In 1997, the increase of consumer prices slowed down again: the annual average growth rate fell to 11.2% from 23.3% in 1996 (see Table 2.5). As compared to industrial countries, however, inflation is still relatively high and exceeds also the price increase in other Baltic countries.

Proceeding from the price convergence and the resulting disinflation, the rise of the 12-month indices from May (despite the fact that in the second half of the year only one third of 12-month increase was added) seems to be a deviation. This increase will probably remain temporary, on one hand, being the result of external influences and, on the other hand, attributable to the peculiarities of the administrative price determination in 1997.

Structural changes in the system of inflation factors continued - the share of inflation factors characteristic of transition economies (extensive changes in the economic structure, increase of the share of indirect taxes, price regulation) decreased and the share of factors characteristic of developed economies (nominal exchange rates, interest rates, demand and supply pressure) increased.

Inflation in the open sector decreased over twice as compared to 1996, falling to a record low in April when the 12-month average price increase was 6.0%. The impact of seasonal factors was less felt in 1997 than it had been in previous years.

The dynamics of the regulated prices followed closely, although at a smaller amplitude (the rate of inflation decreased from 26.2% in 1996 to 14.3%), the developments of the previous year. Major changes took place mainly in the first half of 1997, while the price regulations of the second half-year accounted for just one sixth of the 12-month price increase. The decline of the regulative acts in the summer months seems to have become a rule. Thus, the dynamics of the regulated prices in the second half of the year also supported the further decline of the 12-month consumer price index (CPI) which in reality behaved differently. The weight of administrative measures fell in May (nearly a third of the 12-month price increase) when telephone communication tariffs were increased, as well as the price of natural gas and electricity. Changes in the interest rates and excise taxes, as well as inflation expectations probably caused considerably smaller deviations from the trend.

Another contribution to the stability of prices came from the ever tightening domestic and/or international competition. One proof of it was the growing readiness for co-operation between companies and mergers for the sake of increasing the market share and cost-cutting. At the same time, this tendency also entails the danger that the prices will be determined by the big market share of one company or a group of companies. Unlike in the previous years we can firmly state that in 1997 the growth of productivity outstripped the growth of the real wages. This creates prerequisites for balancing the constant wage increase with the rapid increase of productivity, which means that pressure on prices will fade away.

The impact of tax policy actions was smaller than in previous years. Besides the increase of the excise tax on motor fuel in January and December there were no other significant price regulations. The imposition of VAT on heating energy was postponed for another year justifying it with the rapid increase of the cost of living that forces the Government to increase spending on social welfare.

One of the most important external factors, which first of all accelerated inflation in the open sector, was the weakening German mark against US dollar and other currencies which pushed up the price of imports. The dynamics of the nominal rates is reflected in almost all price indicators. The dollar, which plays an important role in payments for imports, increased more than 15% over the year and through the production inputs also affected average production cost. The exchange rate fluctuations were partly also responsible for the deviations from the seasonal changes in the open sector.

The price level of other countries is not just felt through imports. Under favourable conditions of external markets, export demand can also have a significant role, with local producers lured by foreign markets. This reduces domestic supply and, if lack of additional production capacity prevents increase in supply, leads to higher prices. In 1997, such a mechanism worked for some dairy products, although its impact on the overall increase in the cost of living was insignificant. Developments in the opposite direction are also possible.

The combined impact of long- and short-term inflation factors determines Estonia's price level and changes in it against foreign trade partners are described by the real effective exchange rate of the kroon (REER). In 1997, the REER measured in consumer prices was record low at just 3.3% (9.7% in 1996; see Table 2.6). The slowdown of the real rate increase can, on one hand, be attributed to the decline of domestic inflation. On the other hand, the growth of REER was slowed by the weakening of the nominal exchange rate of the kroon against the currencies that mattered in Estonia's foreign trade. As compared to the industrial countries, Estonia's price level increased on average 8% in 1997, reaching approximately 45% of the price level of those countries.

The REER also indirectly characterizes changes in the competitiveness of Estonian products. Based on producer prices, the REER changed slightly less than 2% as the nine-month average, which pointed to the weakening position of Estonian companies. However, we have to take into account the fact that the REER underestimates competitiveness lower than it actually is, ignoring productivity increase.

UNEMPLOYMENT, INCOME AND CONSUMPTION

Labour Market

The decrease of the Estonian population began in 1991 and it has continued ever since, affected the most by the negative birthrate and emigration. Death ratio has decreased, but since the number of live births has also diminished, the population growth has not improved (see Table 2.7).

Emigration boomed in 1992-1993 when approximately 54,000 people left Estonia. In the subsequent years emigration has diminished and in 1997 some 10,000 people left the country. Emigration balance was only 3,000, that is, two times smaller than the decrease of the population due to the negative population growth. Thus, the latter was the most important reason for the decline in population in 1997.

In the 1990s, the artificially boosted employment level began to decrease rapidly. According to the employment studies, the employment rate (excluding the temporarily unemployed) in the age group of 15 to 69 year-olds had decreased from 75% at the beginning of the 1990s to 60% in 1997, in which the employment among women had fallen to 52%.

The employment has decreased the most in production - industry, agriculture, fisheries and forestry. At the same time, the share of the employed in the service sector has increased, accounting for over 50% of the total number of the employed. Participation rate amounts to nearly two thirds of the total working-age population.

The job-seekers registered by the Labour Market Board accounted for an average of 5.1% of the labour force in 1997. If we compare this indicator with the results of the employment study, we can conclude that approximately half of the job-seekers turn to the employment offices. The main reason is the low efficiency of the state employment services (see Table 2.8). The average number of the unemployed entitled to the unemployment benefit was 19,253 people a month, which is 2.2% of the working-age population. As compared to 1996, the number of those receiving unemployment benefits increased by 3.9% in 1997, while the overall number of non-working job-seekers decreased by 10.2%. This difference in the increase of the registered unemployed can be attributed to the changes in the status of the unemployed at the beginning of 1997. In earlier years every person registered as a job-seeker was given preference in granting social benefits, while from the beginning of 1997 only those officially declared unemployed were entitled to benefits in the majority of counties.

Average Wage

According to the preliminary data, the average nominal wage was EEK 3,571 per month in 1997, increasing nearly 20% in a year. By spheres of economic activity, the annual wage increase was above the average in fisheries, real estate, leasing and business services, financial intermediation, the energy sector, gas and water supply and education (see Table 2.9). Wages were relatively lower and increased less in the service sector. This affects the living standard of a large part of the working-age population.

The real wages increased sharply in the second and fourth quarters of 1997 (11.8 and 13.6%, respectively) which brought the annual growth rate to 7.6% (in 1996 real wages increased only 1.8%).

Income and Savings

According to a survey of household budgets, the income and spending increased at a moderate rate in 1997. At first glance, judging by the 22.9% increase of the net income, the increase of household income was even quicker than the growth of wages. However, a closer look shows that the increase of income in 1997 was affected by the active utilization of savings accumulated in earlier periods.

In the structure of income, the main role still belonged to wages which accounted for more than half of the income of households (see Figure 2.3). The use of savings increased more than twice in 1997 and their share in total income exceeded the income earned from production activity. The use of bank deposits and the sale of securities made up two thirds of the utilization of savings, one third derived from borrowing and loans repaid by private individuals.

The share of income from insurance security remained roughly on the level of 1996, accounting for 22% of the households' total income. Nearly three fourths of the social insurance payments was made up of pensions, the rest was dominated by child benefits and social welfare benefits. In 1996, a separate subsistence benefits (applied for by 3.8% of households) and housing benefits (13.7% of households) were paid, while in 1997 these were combined into a uniform subsistence benefit issued by local governments. According to the Ministry of Social Affairs, 8.6% of households applied for the subsistence benefit in 1997 which totalled EEK 406 million ie 10.6% more than in 1996 (EEK 367 million, of which EEK 89 million was subsistence benefit and EEK 278 million was housing benefit).

In the structure of consumption, spending on food decreased by 3 percentage points and spending on durable goods and services increased by the same amount (see Figure 2.4). Spending on transport, housing, clothing, etc increased more or less proportionately with the increase of the total spending.

From the third quarter of 1997 the minimum of subsistence is being calculated, based on vital needs (the monetary expression of these is derived from the household budget studies). In the third quarter the 30-day living wage per person amounted to an average of EEK 1,011, of which EEK 571 was the cost of the minimum food basket. The respective figures for the fourth quarter were EEK 1,141 and EEK 570. Actually, the 10% of households in the lowest income category spent an average of EEK 504 per household member per month in the third quarter, of which EEK 301 was used for food; in the fourth quarter the respective figures were EEK 535 and EEK 304. The difference between spending by the lowest and the highest income category differed 11 times, in case of spending on food, the difference was 4.3 times.

In 1997, the financial activity of the population increased, with more and more people involved in the stock exchange and the real estate market. More families applied for a bank loan (an increase of 1.9 times), deposited money into banks and bought securities (an increase of 1.4 times). At the same time the use of bank deposits and the sale of securities increased 2.8 times. Thus, the net savings of the population decreased (the formation of savings minus their utilization) by nearly a third.

BALANCE OF PAYMENTS FOR 1997

The deficit of the current account of the 1997 balance of payments, EEK 8.45 billion, was larger than in 1996. The increased import demand, due to the rapid inflow of foreign capital, pushed the current account deficit to nearly 13% against GDP. Like in earlier years, the current account deficit was considerably larger in the fourth quarter than it had been in the previous three quarters. As compared to 1996, the financial account surplus increased more than the current account deficit (74 and 65%, respectively). The reserves increased over 50% more as compared to 1996 (see Table 2.10 and Statistical Appendix, Table 2).

The trade deficit increased by a third as compared to 1996. At the same time the ratio of the foreign trade deficit to exports was smaller than in 1996, both on the quarterly basis and for the whole year. In 1995 and 1996, imports increased quicker than exports, while in 1997 the increase was practically similar. The most important export articles were machinery and equipment, timber and clothing, footwear and headgear. Imports was dominated by machinery, chemical products and food products. Estonia's most important foreign trade partner was still Finland. Due to the growing volume of goods processed in Estonia, Sweden rose to the second place, followed by Germany and Russia (see Statistical Appendix, Tables 3, 4, 5, 6). For the third consecutive year the share of the EU countries increased both in exports and imports, mainly due to the diminishing share of the CIS countries.

The surplus of the services balance amounted to nearly EEK 8.5 billion, compensating for half of the foreign trade deficit. The import of services increased at a slightly higher rate than export, mainly in the case of tourism services. Still, the balance of the tourism services had a larger surplus than in the previous years. The balance of the transport, construction, finance, computer and various other services was also positive.

The fact that approximately a quarter of the current account deficit of the 1997 balance of payments was made up of the deficit of the balance of income is quite remarkable. A year ago the balance of balance of income had been nearly zero. As the income earned by Estonian residents abroad stood at roughly the same level as in 1996, the deficit was caused mostly by the growing income earned by foreign investors in Estonia.

On the financial account, the inflow of direct investments and portfolio investments as well as other capital increased.

Direct foreign investments into Estonia (EEK 3.6 billion) and direct investments from Estonia to abroad (EEK 1.8 billion) were among the largest of the recent years. As compared to earlier years, the share of investments into the share capital and the share of reinvested income increased among direct investments into Estonia, the share of the loan capital, on the other hand, decreased. The preferred economic sectors were industry and the real estate and leasing services. The bulk of the investments came from the Nordic countries, just like in earlier years. The direct investments of Estonian residents to abroad mainly increased in the form of long-term loan capital and equity investments. Investments were mainly made into the real estate, leasing and business services and the financial sector. More than two thirds of the total investments was made into Latvia and Lithuania.

In recent years, the share of portfolio investments has been increasing in both investments and financing. The volume of equity or debt securities in the possession of non-residents increased by nearly EEK 6 billion in 1997. The portfolio investments of Estonian residents abroad increased by EEK 2.3 billion. As before, the most active investors and borrowers were the banks and the leasing firms affiliated to them.

Like in 1996, the inflow of foreign capital mostly took the form of other investments, mainly loans and deposits. The claims and liabilities of the trade credit increased at a practically equal rate. The biggest share belonged to the banking sector which attracted nearly EEK 6 billion in loans and deposits. At the same time, credit institutions deposited EEK 1.4 billion abroad and lent EEK 1.1 billion to non-residents. The inflow of short-term capital increased as compared to earlier periods. Other sectors too attracted foreign capital, borrowing EEK 3.3 billion from abroad. The transactions of other sectors were mostly determined by the financial institutions connected with banks. More long-term loans were taken than short-term loans. Other investments were strongly influenced by the government sector which deposited money abroad in the framework of the Stabilization Reserve Fund and paid back more loans than took new ones. Some loans were repaid ahead of schedule.

The balance of payments reserves increased by nearly EEK 2.8 billion in 1997, the biggest increase since 1992.

INTERNATIONAL INVESTMENT POSITION AND NET EXTERNAL DEBT

In 1997, the claims of Estonian residents on non-residents increased by EEK 11.4 billion and by the end of the year amounted to EEK 30.2 billion. The liabilities of Estonian residents to non-residents increased by EEK 20.1 billion and amounted to EEK 54.8 billion. The sum total of liabilities exceeded claims by 1.8 times and Estonia's international net investments position was negative by EEK 24.5 billion at the end of 1997 (see Table 2.11).

Estonia's long-term as well as short-term investment position were negative. 85% of investments made abroad were short-term. The bulk of it were the gold and foreign exchange reserves of the central bank, deposits and portfolio investments.

Foreign investments into Estonia were equally divided between long-term and short-term investments. A large part of the long-term capital consisted of direct investments which placed Estonia among the top three Central and Eastern European countries in terms of per capita direct investments (USD 775) at the end of 1997. The short-term capital was dominated by portfolio investments which, in turn, was influenced by the rapid increase of prices at the Tallinn Stock Exchange.

Approximately 90% of external claims were made up of repayable capital, while in case of external liabilities the share of debt capital was somewhat smaller, amounting to nearly two thirds. If we include under external claims and liabilities only the sums that had to be repaid, then the net external debt of the Estonian economy totalled EEK 9.7 billion by the end of 1997, amounting to nearly 15% of GDP (see Figure 2.5). The net external debt of the government sector has decreased and amounted to 3.5% of GDP at the end of 1997.

[1] In the analysis of the foreign trade the exports and imports are different from the figures released by the State Statistical Office (SSO). The reason for this is that the data of the SSO are based on the general trade system, while Eesti Pank uses the method of the special trade system. The latter does not include the re-export of goods previously imported into customs warehouses and the goods for provisioning ships and aircraft. Import does not contain customs warehousing, but does include deliveries of goods from customs warehouses for free circulation and processing.
[2] Although the majority of loans issued to private individuals were housing loans, we must take into account that the bulk of the loans are used for purchasing the existing apartments and dwellings. Under the system of national accounts (SNA) such spending is not regarded as investment.