ESTONIA'S ECONOMIC DEVELOPMENT IN 1998

SHORT SURVEY

The external economic environment remained unstable in 1998 (the Asian crisis started in 1997 was followed by a crisis in Russia). This brought along decreasing export opportunities for Estonia and a downward revision of its external financing-based growth strategy. The foodstuff industry’s export market decreased to minimum through the Russian crisis. The rapid growth characterised only the export to the EU markets although it could not offset marketing problems elsewhere and decreasing internal consumption based on less-optimistic-than-anticipated future prospects. The real growth of GDP fell from 11.4% in 1997 to 4% in 1998 and nominal growth from 24 to 12% according to preliminary estimates.

The previous external loan inflow to Estonia was replaced by direct and portfolio investments and banks’ intermediation decreased. Foreign direct investments fully financed the current account deficit, the latter dropping from 13 to 8.6% of GDP.

Considering the risks related to the rapid economic growth and external imbalance, the government had introduced a restrictive fiscal policy in the second half of 1997, pursued until the end of the first half of 1998. The key components of this policy being general government budget surplus and the investment of the surplus abroad, ie in the Stabilisation Reserve Fund set up in 1997. In early 1998, the future prospects in business communities were quite optimistic. It was well manifested in the investment demand maintained on the high level of end-1997, as well as in rapid growth in construction and real estate sectors. In this context the increasing saving in the government sector was the main factor suspended the growing current account deficit.

In the second half of 1998, instead of targeting macroeconomic balance, the focus was on financing the government sector in the previously planned extent. In the environment of lower-than-anticipated economic growth it brought along budget deficit, contained at 0.3% of GDP as an annual total. The private consumption continued to increase and was accompanied by lower investment-demand-secured further external balance improvement.

The labour market responded to slower economic growth with decreasing wage growth rates and increasing unemployment. In end-1998, all unemployment indicators were about 10% above the year-earlier period although the number of officially registered unemployed people did not exceed 2.5% of the working-age population. The 5-6% growth in real wages characteristic of early-1998 decreased to 1-2% in December.

DOMESTIC DEMAND

Private Consumption

Apart from current income, private consumption is also related to the availability of consumption loan, interest rate levels and anticipated income. The 1998 economic environment was less optimistic than in 1997, influencing also consumption decisions. Already from the beginning of the year the retail trade sales growth revealed a continuous downward trend and beginning from July the sales volume remained below 1997 (see Figure 2.1). The more than 20% fall in consumption loan stock against end-1997 was well in line with such a development.

The slowdown in the economic growth was accompanied by the declining wage growth rates. In the second half of the year the annual nominal wage growth rate slowed down in practically all branches of economy except in financial intermediation and government service. The average nominal wages increased by about 15% against 1997 whereas the real wage growth rate was slightly below that of 1997 (6.3 and 7.6%, respectively). The below-average-increase characterises industries dependant on exports to the east, like fisheries. In domestic-market-oriented sectors the growth rate of wages decreased rapidly in real estate but slower than average in sectors providing public services, which are relatively independent from market changes (education, public health, national defence, public administration). The slower growth of nominal wages and increasing unemployment refer to the falling private consumption of GDP, especially in the fourth quarter.

Investments

During the first three quarters the investment activity remained intensive and the current account deficit was relatively high as well. During nine months the share of investments and stocks of GDP was close to 30%. The investment intensity dropped fast during the last months of the year. These were mostly private sector investments; government investments maintained the 1997 level of 4% of GDP. Investment dynamics by industries reveal the increasing share of the manufacturing (see Figure 2.2). This was caused by the accumulation of resources more into the exporting sectors, less dependent on domestic demand. More modest lending did not have any significant effect on corporate investment. Companies finance more than half of their investments from own funds and only one fifth is borrowed from banks whereas the shrinking lending volume restrains investing less than the decrease of profit and other own funds.

According to preliminary data the domestic saving of GDP remained on the 1997 level although there were large differences by quarters. Increasing government saving in the first half of the year was replaced by a reverse process in the second half. This trend was balanced by increasing private saving, especially in the last months of the year.

Public Sector

The public sector’s target for 1998 was to pursue a restrictive fiscal policy and to place the surplus abroad. Also, it was planned to increase the Stabilisation Reserve Fund (established in 1997) for funding future structural reforms and levelling macroeconomic risks at the expense of the saving accumulating in a year. In 1997, 700 million kroons were transferred to the Fund. The budget surplus was intended to be 2.5% of GDP whereas the tax burden was to grow only by 0.5 percentage points, ie the achievement of the target presumed the growth of expenditures to be contained below the GDP growth.

The maintenance of tax-exempt minimum income on the previous level, increased excise tax for alcohol, tobacco and motor fuel as well as the establishing of excise tax for packing brought along the intended increase in the tax burden (see Table 2.1). Declining VAT receipts in the second half of the year caused by falling private consumption and suspended foreign trade growth imposed a counter-effect on growing tax burden. These trends reduced the share of indirect taxes from 14% of GDP in 1997 to 13%.

The target was met only in the first half of the year when the budget surplus was above 2% of GDP and transfers to the Stabilisation Reserve Fund took place[1]. As in the first half of the year private sector was still optimistic and investments increased faster than a year ago, the surplus did not ensure a significant improvement in external balance, although an increase in the current account deficit was avoided.

In the second half of the year the target of budget surplus was practically given up. The government expenditure was to remain on the intended level, although a much faster economic growth rate was considered in forecasting. It resulted the growth of government spending surpassing that of GDP. The surplus budget was reversed into rapidly growing deficit: the 0.7% deficit of GDP in the third quarter was close to 5% in the fourth quarter (see Figure 2.3). The expenditure growth rate reached the peak in December with 12% of the annual current expenditures of the central government made. Consumption expenditures, ie expenditures on wages and purchase of goods and services grew especially rapidly throughout the year with nominal growth reaching 20% (see Figure 2.4). Transfers to households grew significantly less - 11%. The government saving decreased from more than 6% in 1997 to about 4% of GDP in 1998, whereas investments remained on the last year level (4.3% of GDP).

The budget surplus, generated in the first half of the year, was fully consumed and expenditures exceeded revenue by about 0.3% of GDP in annual totals (see Table 2.2). The deficit was the largest in the budget of the central government, more than 0.5% of GDP. The deficit of local governments budget was smaller (about 0.2% of GDP). The surplus of social insurance and other extra budgetary funds was slightly below the central government budget deficit. In the second half of the year, the government sector instead of slowing down domestic demand became a driving engine and the domestic demand growth was contained below GDP growth in the second half-year only due to decreasing growth rates in private investments and stocks.

The deficit was fully financed from domestic sources: the central government deficit from surplus of previous periods and the local government deficit mainly from loans. The government debt remained small, being below 7% of GDP, including the central government debt of about 4% of GDP at the end of the year.

DOMESTIC SUPPLY

Economic Growth

In end-1998, the economic growth slowed significantly and the annual growth rate was contained within 4%. In the first half of the year the real growth of GDP was 7.5%, in the third quarter only 1.7% and in the fourth quarter close to zero.

Already at the beginning of 1998 the economic environment was assessed to be less expansive than a year ago but in the second half of the year the strongest agent was the crisis in Russia. The impacts were first noticed in the manufacturing as about half of the production goes to export (see Figure 2.5). The collapse of export markets generated more problems in the largest of industries - food industry - as more than 75% of agricultural exports is sold to the Eastern bloc countries. Hence the 21% decline in sales volume in the second half of the year against the same period in 1997. In food industry stocks increased rapidly, exceeding by half in end-third quarter the level at the beginning of the year. The moneys tied up in stocks created additional financial problems.

The industrial sales hit the lowest both in absolute volume and annual growth rate in October. Although sales of the manufacturing products showed some growth in December, reaching the level of the best months of the year, it was caused only by outstanding results in timber and electronics industries. The annual real growth in these branches was the highest as well. These are the industries, which have been and still are oriented to western markets. The real growth of sales in the manufacturing was about 3% in 1998. No alternative market was identified for former foodstuff exports to Russia and it is most unlikely to discover one (at least in the same extent). The reorientation of Russia-oriented production capacities requires involving strategic foreign investors and it would be a relatively long-term process.

Among other sectors construction and transport had grown most rapidly in the first nine months (see Table 2.3). In the third quarter these sectors could still offset modest results in the manufacturing but in the fourth quarter the sustainably successful transport sector could not cover the falling sales in the manufacturing and suspending growth in the construction. The construction volumes growing very rapidly during the first three quarters manifested the year-old optimistic economic outlooks. In the last quarter, construction volumes decreased, remaining below end-1997. Although at the beginning of the year the bottom in agricultural production seemed to be over, the actual shrinkage continued due to the unfavourable summer and decreasing exports. 1998 brought along a decrease in fisheries, energy and financial intermediation as well.

Summarising up, it can be said that the share of agriculture and mining sectors decreased whereas the share of manufacturing and service sector remained on the previous level.

The corporate financial indicators referred to a complicated year as well. The corporate pre-tax profit was about 20% below the year-earlier period after the third quarter. It was caused by the turnover growth rate going down and other costs (including financial costs and services purchased in Estonia) going up. Although according to corporate consolidated balance sheet interest-bearing liabilities constituted 75% of own capital in the end-1997, meeting the liabilities could cause difficulties for some companies.

Labour Market

A decrease in the population of Estonia began in 1991 and has continued up to the present moment. It has been affected the most by the negative natural increment and emigration. The culmination of emigration occurred between 1992 and 1993, in later years it has decreased. Also, the earlier over-expanded employment started to decline rapidly in the 1990ies. According to the Estonian employment research, the number of the employed had decreased from 708,000 in 1993 to 643,000 by the second quarter of 1998. The on-going emigration has reduced the number of working-age people and at the same time a certain amount of people are not in the labour market any more.

In 1998, commodity markets’ development trends were also reflected in the labour market. Although the annual average number of the registered unemployed was smaller than in 1997, the first and second half-year clearly differed from each other. Beginning from September the unemployment level exceeded the 1997 indicator (see Figure 2.6) and the wage growth rate slowed down. Falling demand made companies reduce costs, which also found an outlet in slightly increasing unemployment. At the same time capital became more expensive for companies since both nominal and real interest rates stayed on a higher level in 1998 than anticipated in end-1997 and early 1998. The fourth quarter manifested that nominal wages started to adjust to changing economic conditions, being in December only 5.7% above the year earlier period.

EXTERNAL SECTOR

External relations are the engines of economic growth in the environment of open economy and small internal market in Estonia. In 1998, the external environment was less favourable for Estonia, becoming very explicit after August in Russia.

Exports

The growth rate of special export dropped at the end of the year but retained the end-1997 level in volume. The structure of special export changed significantly - eastward (foodstuff) export flows decreasing by half from the beginning of the year level, were balanced by exports of Estonia-processed machinery and equipment to Finland and Sweden. Here previous direct investments had set a firm foundation (see Figure 2.7). Against the background of rapidly decreasing trade turnover in 1998, the key factor in stabilisation of trade was subcontracting. The real growth of the special export decreased from 38% in 1997 to 16% in 1998 whereas the re-export of goods imported for processing increased by about 40%. The share of machinery and equipment continued to increase in the latter. By the end of the year the share of goods exported to the EU Member States was close to more than two thirds.

The export of services maintained rapid development, increasing by 19% during a year according to preliminary data. The share of travel services grew in the services export. The number of foreign tourists visiting Estonia increased, their stay lengthened and expenditures increased. Transport services export developed significantly as well, being, especially at the end of the year, boosted by increasing transit of liquid fuels via Estonia.

Imports

The import of goods and services reached 65.5 billion kroons in 1998, exceeding by 13.5% the nominal volume of 1997. Nearly for the first time import growth rates remained below domestic supply growth rates and the share of foreign supply of GDP decreased. This trend was backed by the adjustment of domestic demand to changing economic environment at the end of the year. In the fourth quarter, the import of goods for free circulation was about 20% below the same period a year ago. At the same time, rapid growth continued in the volume of imports brought to Estonia for processing. Especially big was the share of goods brought in for processing as to machinery and equipment, reaching 36%. This shows how important for the Estonian industry is the subcontracting done for the Finnish and Swedish electronics industry.

Current Account

The foreign trade deficit of GDP, being only slightly below the previous period, showed a rapid downward trend due to decreasing imports in the second half of the year. Especially rapid was the change in the fourth quarter when the foreign trade deficit of 28% in 1997 decreased to 17% of GDP (see Figure 2.8). In previous years, the last quarter was responsible for about 40% of the annual current account deficit whereas in the fourth quarter of 1998 the indicators in absolute terms as well as percentagewise remained below the third quarter. Decreasing import demand and sustainable rapid growth in transport services shrank the current account deficit to 8.6% of GDP in 1998, the deficit decreasing thereby more than 3 percentage points in a year.

External Financing

In external financing a shift towards an increasing share of direct investments and a decreasing share of loan capital took place (see Figure 2.9). The function of banks as an intermediator lessened, remaining significantly below the last two years and capital inflow from abroad via banks was under 1% of GDP (see Table 2.4). The capitalisation of banks grew remarkably in 1998, reducing their sensitive exposure to external shocks: about 70% of investments made in Estonia were made in the financial sector. Nevertheless, it did not change the structure of direct investments by sectors of economy. Most of the direct investments have still been made into industry (33%) and trade (25%). In the end of 1998, total direct investments in Estonia were close to 24,3 billion kroons (about 1,249 US dollars per capita). The share of direct investments of GDP reached the peak of recent years and the current account deficit was (according to estimates) fully financed by direct investments.

Parallel to changes in the structure of the capital inflow the external debt growth rate started to decrease. In the end of 1998, Estonia’s international net investment position reached -40% of estimated GDP whereas the short-term position with maturity less than a year was positive but the long-term position was about -45% of GDP reflecting, thus, the direct investment inflow. Foreign direct investments were mainly made by Estonia’s key export partners: over half of the direct investments came from Finland and Sweden. The net foreign debt was about 16% of GDP at the end of year. More than 90% of debts are those of the private sector whereas the public sector external debt was 4,3% of GDP.

INFLATION

In 1998, the changes in the economic environment were quite sharp and had a significant impact on price adjustment. The prices increased by 8.2% over the year. In the second half of 1998, the price dynamics differed from the previous year: in late 1997 the annual growth of the consumer price index remained close to 12% for months, whereas in 1998 the inflation rate decline accelerated from August and the annual consumer price growth declined below 5% by November. Nearly all price indices behaved the same way (see Figure 2.10). The downward price trend was well explicit in exports with prices falling by December below the same month in 1997. Changes in the economic environment as well as in the nominal exchange rates of currencies facilitated this trend. At the end of the year the kroon appreciated against several currencies applicable in our foreign trade. The nominal exchange rate against the US dollar and Russian rouble changed most, appreciating respectively 5 and 60% in end-1998 (see Figure 2.11). The kroon appreciated against the Finnish markka as well.

Price formation principles are explicitly manifest in price changes of the open sector, subject both to import supply and export demand, ie the situation on world commodity markets. In the second half of the year, both import and export prices decreased and the overall growth of export prices was only 2.1% in 1998.

Despite the liberalisation of most of the prices already in 1992, administered prices continue being significant in our price formation policy as they constitute about one fifth of the consumer basket. In the first half of the year, especially during the first three months, administered prices increased rapidly due to increasing electricity, water and other utility prices. Beginning from June, the price increase has slowed down and yielded an annual average of 13.4% (non-administered prices increased by 6.4%). The effect of tax-political actions was smaller than in earlier years. For example, due to low fuel prices in the world markets and modest domestic demand, the rise in fuel excise in December did not almost have an impact on petrol prices.

The real effective exchange rate of the kroon (REER) reflects changes in Estonia’s price level against foreign trade partners. In 1998, the REER based on the consumer price index increased by 10.4%, leaping in September when the index was more than 20% above the annual (see Figure 2.12). This was brought along by the devaluation of the Russian rouble, as the share of the rouble in the index is about 10%. In practice the share of the Russian rouble in trade transactions is only 1% and therefore the REER does not reflect the actual changes precisely either. All in all the real exchange rate of the kroon appreciated against currencies of major industrial countries by 8.3%, against currencies of transition economies by 17%.

The above indicators do not have single implications on international competitiveness. The latter depends on several price externalities as well -- productivity growth, relative expenditure of labour, size of the market share, administrative restrictions (customs duties, quotas), etc. Just like in any other transition economy, it is difficult to evaluate changes in productivity in Estonia as well. After the crisis in Russia Estonian goods were not competitive on the Russian market any more as the rouble had depreciated two to three times faster compared to the increase in foodstuff prices. Though, nominal growth of exports to the countries of the European Union was close to 30%, ie many times more rapid than the appreciation of the kroon against the currencies of those countries. The productivity growth is also implied in the more than 4% real growth of GDP with the employment level maintained or even decreasing.

[1] 80% of all sums transferred to the Fund in 1998 were transferred there in the first half of the year. As the general government budget expenditures in 1998 exceeded revenue, the reserve increasing source was the central government revenue surplus accumulated in 1997. The aim of investing money abroad was to increase the trust of foreign investors to the Estonian economic policy and decrease domestic demand in order to secure a decrease in current account deficit./p>