Estonia on the way to the euro area. Ülo Kaasik Head of Economics Department 22 January 2010

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1 Estonia on the way to the euro area Ülo Kaasik Head of Economics Department 22 January 2010

2 Outline Brief overview of the history and policy set-up The role of the global shock Meeting the Maastricht criteria Future outlook 2

3 Monetary system Fixed exchange rate against the euro (since 1999; before that, from 1992, the EEK was pegged to the DEM) Full convertibility of the Estonian kroon Base money is completely backed by high-quality foreign assets 3

4 Other policies supporting the CBA Fiscal policy based on a balanced budget principle Tax system motivating, transparent, simple Liberal trade and investment regime since 1991 Flexible labour market Banking sector fully integrated with Scandinavia 4

5 Year-on-year growth accelerated after joining the EU GDP growth in Estonia

6 Drivers of economic performance before the crisis EU accession and favourable external environment Estonia Enhanced labour mobility and strengthened wage expectations Increased productivity (incl in the exporting sector) Faster financial integration, lower interest rates and longer maturities in lending External world Period of relatively fast growth, abundant credit and low interest rates Inflation was the major obstacle to the adoption of the euro earlier 6

7 Estonia s economy is closely integrated with the EU EU countries account for over 70 per cent of Estonia s exports and 80 per cent of imports nearly 2/3 of foreign trade transactions made in euro in the Q2 2009, EU investment in Estonia constituted 85 per cent of total FDI 7

8 Post-Lehman shock: a rerun of Russian crisis for Estonia Loss in credibility and confidence Global trade shock influenced the highly open Estonian economy Trade decline has been similar to neighbours, reflecting no major relative competitiveness problems. Private sector reacted with a sharp decline in employment, working hours and wages. 8

9 5-year CDS show that risks are still perceived to be considerable 9

10 Exports: sudden drop after Lehman in line with global trends Exports (in EUR) growth rates in the range of % (yoy) Index, 2006= SE FI EE Source: Eurostat 10

11 Industrial output volumes have stabilised (2005=100) Source: Eurostat Estonia (ls) EU27 (rs) 11

12 Labour market: activity rate has not decreased employed, thousands unemployed, thousands

13 Lower wages predict negative core inflation in 2010 and moderate inflation in 2011 Sources: Statistics Estonia, Eesti Pank s Autumn Forecast 13

14 Meeting the Maastricht criteria

15 Government needs to target surplus in medium term Estonia's budget balance reference value for the budget balance criterion * 2010* 2011* 2012* 2013* Source: Eesti Pank Forecast, State Budget Strategy (May 2009) 15

16 Government debt remains at the lowest levels in the EMU 16

17 Inflation remains under the reference value 12% 10% 8% 6% 4% 2% 0% % Maastricht inflation criterion reference value (EC, nov.09) Inflation in Estonia (12 month moving average; EP forecast) 17

18 There is no instrument to measure long-term interest rates in Estonia ReferenceValue Same_Fitch Similar_Fitch_1 Similar_Fitch_2 Same_SP Similar_SP_1 Similar_SP_2 Same_Moodys Similar_Moodys_1 Similar_Moodys_2 18

19 The Maastricht criteria have to be met in a sustainable manner

20 Inflation gap with the euro area is gradually narrowing During the inflation differential vis-a-vis the euro area remained at approximately 2%, reflecting the convergence process In the combination of external pressures (energy, food) and domestic demand resulted in double-digit inflation However, the fixed exchange rate kept inflation expectations in check Convergence-related inflation is expected to remain around 1% in the future: Price level convergence has been in line with income level convergence The shock from labour market integration is over 20

21 High level of price convergence means lower inflation in the future Estonia in 2008 cz ee hr lt lv pl si sk PRICE GDP Source: Eurostat

22 Fiscal policy has supported long-term stability The budget remained in surplus from 2001 to 2007, and the government entered the crisis being a net lender: Strong pro-cyclicality appeared in the 2008 budget, as the forecast error turned noticeable Some adjustments were made already in 2008, although the main corrections were carried out in 2009 Corrections were based on a mix of measures: Expenditure cuts (government consumption expenditures planned for 2010 are 9% below the 2008 level) Tax increases (some 10% higher consumption taxes) One-off revenue and expenditure measures 22

23 Outlook (1) - sentiment is pointing to correction EE FI SE Seasonally adjusted industrial confidence indicators Source: European Commission 23

24 Outlook (2) - cautious optimism The fast convergence period is over One-off shocks from joining the EU have ended A high level of price, financial and real convergence has already been achieved Euro adoption should have positive effects through increased confidence and improved expectations Potential growth is expected to be about 1-2% faster than the EU average. The global crisis has decreased potential GDP, but the negative output gap is expected to persist for some years Inflation in coming years will be mainly driven by global commodity prices 24

25 Eesti Pank's economic forecast by key indicators GDP (EEK bn) Real export growth -12% 5% 10% Real GDP growth -14% 1% 5% Inflation 0% 0% 2% Budget balance (% of GDP) -3% -3% -1% 25

26 THANK YOU!