Financing. of the. Economy

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2 CONTENT SUMMARY LOAN GROWTH IN THE EURO AREA AND IN ESTONIA'S NEIGHBOURS FINANCING OF COMPANIES The impact economic environment and investment activity on corporate financing Internal financing of companies and the need for external financing External financing, debt and leverage Domestic borrowing Box 1: The financing of small and medium-sized enterprises FINANCING OF HOUSEHOLDS The financial position of households The financial behaviour of households Box 2: Crowdfunding Box 3: The draft law on creditors and credit intermediaries FACTORS AFFECTING THE LOAN SUPPLY OF BANKS of Banks The lending capacity of banks Other factors affecting the loan supply Box 4: The effect of lending conditions on credit growth Appendix: State policy on supporting the financing of companies

3 SUMMARY Although lending and borrowing activity in the euro area increased among companies and households from the middle of, it remains quite calm. The recovery in demand was helped by the banks in the euro area starting to loosen their lending standards a little, while the interest rates on loans to companies and households fell. The corporate loan portfolio continued to shrink gradually in the euro area. The corporate loan portfolio declined partly because companies don t want to borrow more at a time of economic uncertainty, weak economic activity and large debts, and partly because it is probably expected that the tighter lending standards of previous years will be loosened. This is also shown to some extent by an increase in the amounts issued in bonds by larger companies. Borrowing by households is somewhat more active in the euro area, and the loan portfolio stayed at around the same level as in the previous year throughout. The financing position of Estonian companies remains good and does not significantly restrict their business operations or investment. Although corporate profits are down, corporate financing is generally good because of the buffers that have been built up, relatively good access to bank lending, and the very low base interest rates. The situation is somewhat more complicated for smaller companies, especially micro companies, whose options for financing are more limited than those of large companies, and for whom loans are generally more expensive. Estonian companies have a larger need for capital from outside the company, which is also seen in an increase in their debt liabilities. This is partly because company profitability has fallen, which has reduced the internal resources available to use as a source of finance and it is partly because investments in fixed capital and inventories have increased in some sectors. The share of corporate debt liabilities provided by loans and leases issued by banks operating in Estonia shrank once again in. Although the portfolio of loans and leases issued by domestic banks to companies grew faster in than in the previous year, the growth in foreign debt liabilities and loan liabilities taken from the financial sector beyond the banks was even faster. By the end third quarter the loan and lease portfolio banks operating in Estonia supplied around 45% of all the debt liabilities of Estonian companies. The purchasing power of households is increasing. Higher household incomes and very low inflation have boosted the purchasing power of households and this has helped raise household consumption and investment. Growth in deposits has helped improve the financial position of households. Higher incomes have increased the ability of households to save and not all increase in resources has been directed into consumption. As a result, household deposits increased by 8% during. This growth once again came mainly from large deposits, but there was also an increase in the number of households with deposits. Household borrowing has grown at a moderate speed. Higher incomes and improved finances have stoked household borrowing, most noticeably with housing loans but also to a lesser degree with other loans. The value of housing loans issued increased by 2 during, leading growth in the housing loan portfolio to accelerate to 2.8%. Growth in the portfolio of other household loans from banks still remains below 1% and the use of consumer loans and instalment credit from sources other than banks has also increased. The capacity for lending banks operating in Estonia remains good. This is aided again by high levels of capitalisation and profitability and by favourable financing conditions. Interest rates on loans to companies and 3

4 households fell in as base interest rates and, to a lesser extent, interest margins declined, but the deterioration in the outlook for the economy led some banks to tighten their credit standards. The main risk for the financing of companies and households remains the danger general economic environment worsening. This would hurt the capacity banks to lend and their risk assessments, and it would reduce the ability of companies and households to finance their activities. 4

5 1. LOAN GROWTH IN THE EURO AREA AND IN ESTONIA'S NEIGHBOURS Weak economic growth and low levels of investment activity held down corporate borrowing in the euro area as a whole in, meaning that the corporate loan portfolio continued to decline. At the same time loan growth still varied between countries in the euro area and in Estonia s neighbourhood. Corporate borrowing remained relatively strong in Finland despite the decline in investment, while it was weak in Latvia despite the growth in the economy, and the Latvian loan portfolio shrank. Companies in Lithuania have been relatively active in investing but careful in their financing, and they have preferred to use other resources for financing their investments 1. Growth in borrowing activity in Sweden was supported by growth in investments and by improved financing conditions 2, and the annual growth in the loan portfolio accelerated at the end year (see Figure 1.1.1). The survey of access to financing by small and medium-sized enterprises in the euro area that was published in December 3 found that the main source of external financing for small and mediumsized enterprises was bank loans and leases, while other financial market instruments were used relatively little. Large companies in contrast had good access to direct lending from the financial markets as well as to bank loans, meaning that their financing base is more varied and is affected less by bank lending. Large and medium-sized companies considered that they had better access to bank lending in the middle of than they had had at the start year, while small compa- 1 Lietuvos Bankas Lietuvos Bankas, Lithuanian Economic Review December. There have been major fluctuations in the growth in the loan portfolio in Lithuania mainly because some banking licences have been withdrawn and some lease companies brought under banks. 2 Riksbank Financial Stability Report 2/ 3 European Central Bank. Survey on the access to finance of enterprises in the euro area, April September Figure Annual growth in corporate credit 1 5% -5% -1-15% euro area Finland Sweden Latvia Lithuania Estonia Sources: European Central Bank, Riksbank, Latvijas Banka, Lietuvos Bankas, Eesti Pank calculations nies considered that their access had not changed greatly and micro companies with between one and nine employees found that theirs had become worse. Companies of all sizes said that the factor that had done most to worsen access to bank loans was the general weak state economy, while they considered the position of equity, credit histories and the willingness of banks to lend as factors having a positive affect on access to credit. Low interest rates, the search for yield among investors, and the relatively tight lending conditions of banks have encouraged non-financial companies across the euro area to issue bonds, particularly larger companies that have easier access to financial markets. The share of financing in the euro area provided through bonds has increased in the past six years. By the end third quarter of, non-financial companies in the euro area had issued a total of 1.1 trillion euros of bonds, which is almost a quarter value total portfolio of loans 5

6 issued by euro-area banks to companies in the euro area. In the first three quarters of the total value of bonds issued increased by about as much as the corporate loan portfolio shrank by (see Figure 1.1.2). Euro-area households were somewhat more active in taking out housing loans than companies were in their borrowing, but the level of activity was still low. The housing loan portfolio for households was about the same size as in the previous year throughout. Borrowing for new housing loans declined in Finland in as unemployment rose and household disposable income and investment fell, though annual growth in the housing loan portfolio remained positive, unlike in the euro area as a whole. More positive developments in the economy and the labour market in Sweden meant that borrowing by households for housing loans remained strong, and annual growth in the housing loan portfolio even accelerated somewhat. Despite a gradual fall in unemployment and rising wages, borrowing activity among households in Latvia remained weak, with the result that the household housing loan portfolio continued to shrink in. In Lithuania by contrast, higher household incomes and a further fall in unemployment had a positive effect on borrowing 4 and the annual growth in the loan portfolio picked up in the second half year (see Figure 1.1.3). A reduction in base interest rates in was largely passed on by the banks into the rates on the loans they issued. Interest rates on newlyissued loans fell in the euro area as a whole and in Finland, Sweden and Lithuania individually, both for corporate loans and for housing loans to households. Interest margins vary between countries depending among other things on the differences in the shares of loans with fixed or floating interest rates, the share of problem loans and the terms for setting the margin rate. Interest rates on corporate loans in Latvia were about the same at the end year as at the start of it and interest 4 Lietuvos Bankas Lithuanian Economic Review December Figure Changes in outstanding amounts of non-financial corporate credit and debt securities in the euro area debt securities quarterly change (right scale) loan portfolio quarterly change (right scale) loan portfolio growth, Q1 = (left scale) debt securities growth, Q1 = (left scale) 4 Sources: European Central Bank, Eesti Pank calculations Figure Annual growth in credit for house purchases 15% 1 5% -5% -1-15% Sources: European Central Bank, Riksbank, Latvijas Banka, Lietuvos Bankas, Eesti Pank calculations euro area Finland Sweden Latvia Lithuania Estonia EUR billion 6

7 Figure Interest rates on new corporate loans Figure Interest rates on new housing loans 7% euro area Finland Sweden Latvia Lithuania Estonia 4.5% euro area Finland Sweden Latvia Lithuania Estonia 6% % 5% 3. 4% 2.5% 3% 2. 2% 1.5% 1. 1%.5%. Sources: European Central Bank, Latvijas Banka, Lietuvos Bankas, Eesti Pank Sources: European Central Bank, Latvijas Banka, Lietuvos Bankas, Eesti Pank Figure Net percentage of banks tightening or loosening credit standards in the euro area Figure Net percentage of banks reporting higher and lower demand for loans in the euro area corporate loans loans to households for house purchase corporate loans loans to households for house purchase Source: European Central Bank Source: European Central Bank 7

8 rates for households started to come down only at the very end year, but in other countries in the neighbourhood and in the euro area as a whole, the interest rates on new loans to companies and households started to fall in the second quarter year (see Figures and 1.1.5). The survey of bank lending in the euro area in showed a gradual increase in the share of banks that were easing their lending conditions, but lending standards remained relatively strict compared to what they were earlier for both corporate loans and housing loans to households. Questionnaires reveal that it is expected that lending conditions will ease further in the first quarter of 215 (see Figure 1.1.6). Most banks reported a recovery in demand for credit, especially towards the end year, from both companies and households. A majority of banks expect that demand from companies will continue to grow in the first quarter of 215 and demand from households for housing loans will remain at the same level (see Figure 1.1.7). 8

9 2. FINANCING OF COMPANIES 2.1. The impact economic environment and investment activity on corporate financing Relatively weak growth and foreign demand and the continuing uncertainty about future demand slowed the growth in the need of companies for working capital in as it had in the previous year, and it did not encourage companies to increase their investment in fixed capital significantly. Different sectors have seen different developments however, and companies in several sectors have done relatively well and have benefited from low interest rates to make investments (see Figures and 2.1.2). Strong private consumption continued to help retail companies in and turnover and profit growth even accelerated, which helped keep confidence high. Growing turnover increased the need for working capital in retail companies to some extent, with the result that they increased their short-term financing from domestic banks and from abroad. Figure Contributions to annual growth of sales turnover in the business sector manufacturing retail trade transport and storage total sales turnover Source: Statistics Estonia Figure Confidence indicators, seasonally adjusted construction and real estate wholesale trade other The turnover, estimates of demand, and confidence of wholesale companies are noticeably down however. Such companies may be more exposed to Russian sanctions and economic problems, and confidence was lowest for such companies in September, which is when the sanctions were introduced. Low confidence and turnover have also restrained investment activity and the need for credit. In the last couple of months the expectations and confidence of wholesale companies have recovered somewhat. points maunfacturing retail services construction External demand remained at about the level of despite the geopolitical tensions and the output of manufacturing, which is mainly exported, even increased to a degree, while confidence has remained close to its average level past ten years in the manufacturing sector Source: Estonian Institute of Economic Research 9

10 Capacity utilisation in manufacturing companies rose again in and is now almost as high as it was before the boom, indicating that companies may need to increase their fixed assets if demand grows even faster. Companies also need to invest in more efficient production if they are to maintain competitiveness when demand is low and wage costs are rising. Investment increased in manufacturing in, partly as a result se factors. Figure Contributions to annual growth of inventories in the business sector 3 2 manufacturing retail trade transport and storage total sales turnover construction and real estate wholesale trade other Circumstances were harder for the construction sector in than in the preceding years, but the fall in turnover and confidence stopped in the second half year. As the government has temporarily halted its orders for civil engineering financed from the European Union budget, surveys of sentiment for the European Commission show that construction companies are the most pessimistic about the current circumstances and the short-term outlook. The ending of reconstruction work on public sector buildings financed by sales of emissions quotas has reduced demand for companies engaged in construction of buildings. However, the small growth in construction of residential space and the construction and expansion of several office and trade buildings has helped to ease the situation somewhat and has increased the need for funding among real estate companies. Assessments of demand and confidence by the service sector dropped sharply in the summer and only started to recover somewhat in the last months year. The drop was partly due to the fall in the assessments of land transport companies, which can be put down to problems with transport to Russia. The turnover of transport and storage continued to decline moderately in and as a result the need of companies in that sector for assets and working capital also declined. However, the profitability sector has improved and investment has started to grow again. After two years with high levels of investment, the energy sector invested less in, but it remains a sector where investment makes up a large share Source: Statistics Estonia Figure Contributions to annual growth of gross fixed capital formation in the business sector manufacturing construction and real estate transport and storage total investments Source: Statistics Estonia energy retail and wholesale trade other 1

11 of value added and where a large proportion of investment is funded with external capital. The main growth in the inventories business sector came in those areas that have been doing relatively well, principally retail, manufacturing and real estate, and in consequence the need for working capital has also increased in those sectors (see Figure 2.1.3). Although corporate investments shrank in the first three quarters of, the decline was mostly driven by the energy industry. Without that, investment in fixed assets would have increased by 8% at current prices. Investment increased most in retail, manufacturing, and transport and storage, and it fell in wholesale and construction as well as in energy (see Figure 2.1.4). Low levels of investment in buildings and facilities mean that investment remains lower as a ratio to value added than it was before the crisis, but investment in machinery and equipment is about where it was at that time Internal financing of companies and the need for external financing Internal company funds are generated by the business activities company, essentially profit, and the part of profit that remains after interest and dividend payments 5. Internal company funds may also be buffers that have been built up earlier 6. What is important in terms capacity of a company for internal financing and its need for external financing is the share of profits created by 5 Corporate finance and economic activity in the euro area. Structural issues report. ECB Occasional Paper No Internal company sources of funds are sometimes called primary funds as there may be a deliberate preference for using internal funds in some companies quite apart from the issue of access to external funds. In the pecking order theory of finance, internal company funds are preferred as external funding through debt or equity always has an element of asymmetrical information, and so can be more expensive for a company. Figure Annual growth in profit (operating surplus and mixed income) by sector manufacturing retail and wholesale trade other Source: Statistics Estonia a company within its value added 7, which measures how profitable a company is and how high its level of investment is. In terms of cashflows companies have to use their value added to pay wages and taxes, invest in fixed assets and inventories, pay interest and pay dividends if required. If they do not have enough resources for all this, then any shortfall will have to be covered from external sources of funds in the form of debt or equity or from the buffers that the company has built up. The value added of companies almost stopped growing in and the profit and profitability of companies declined, mainly because wage costs increased (see Figure 2.2.1). This meant that the capacity of companies to finance investments also declined to an extent. Corporate dividend payouts did not decline at the same time and investments in fixed assets and inventories, or gross capital 7 Value added is the difference between the value of production output and that goods and services bought in for production. construction and real estate transport and storage total 11

12 formation, remained the same or even increased slightly, so the need of companies for external capital increased somewhat as a result (see Figure 2.2.2). Although the need business sector to use external funds has increased, it still remains moderate for the sector as a whole. Data from Eesti Pank's financial account show that companies in the non-financial sector were net borrowers 8 by 22 million euros in the first three quarters of. This means that the business sector had to use that amount in additional funds from outside the sector or from financial buffers built up earlier. Figure Operating surplus, capital formation and net lending/borrowing of companies (4-quarter moving average) % of value added gross operating surplus gross capital formation gross operating surplus minus gross capital formation net borrowing/lending A shortfall in current funding can be covered by companies using funds from outside the company or buffers that they have earlier built up. Growth in corporate deposits continued in and deposits held in banks operating in Estonia grew by 7% in December. Having grown very quickly after the economic crisis, deposits held abroad have remained at between 1.1 and 1.2 billion euros for the past year and a half. A little over half of this is again in Sweden and Finland and a little over half is held in the deposits of manufacturing and trading companies. Corporate deposits have grown consistently as a share of GDP and of value added, meaning that the ability of companies to finance their own activities if needed has also increased (see Figure 2.2.3) External financing, debt and leverage The investment by the Estonian business sector in other sectors, mainly as deposits in domestic banks and as intra-group loans to foreign subsidiaries, has increased over the past year. In consequence gross corporate liabilities in the form of loans and bonds have increased slightly faster than might seem apparent from net lending. Data from 8 Net borrowing means that companies in the non-financial sector took more in as funds from other sectors than they invested or returned there. In the non-financial account this is expressed as gross capital formation exceeding reinvested income Source: Statistics Estonia Figure Corporate deposits EUR million overnight and demand deposits term and savings deposits deposits abroad of Estonian companies annual growth of deposits (right scale) deposits to GDP ratio (right scale) 35% 3 25% 2 15% 1 5% -5% -1 12

13 Eesti Pank's financial account show that corporate debt liabilities were up 11% over the year at the end third quarter of. This increase was driven to a significant extent by the reclassification of companies between institutional sectors at the end of, without which the increase would have been a little below 8%. The third quarter also saw a lot more transactions where an Estonian company took a loan from a foreign parent company and lent that amount onwards to a foreign subsidiary than was earlier the case. Such transactions have no effect on the net debt Estonian corporate sector, but they increased its gross debt by around 2% (see Figure 2.3.1). The domestic banking sector supplied a declining share debt liabilities of companies in. Although the portfolio of loans and leases issued by domestic banks to companies grew faster in than in the previous year, the growth in foreign debt liabilities and loan liabilities taken from the financial sector beyond the banks was even faster 9. By the end third quarter the loan and lease portfolio banks operating in Estonia supplied around 45% of all the debt liabilities of Estonian companies, which was down from the 56% recorded in. The amount taken as loans from abroad and in debt issued there grew appreciably at the same time and foreign loans made up some 36% of total debt liabilities in the third quarter year, and foreign bonds 7% 1. The claims Estonian non-bank financial sector 11 on non-financial companies stood at 1.5 billion euros at the same time, or 8.5% of all corporate debt liabilities (see Table 2.3.1). Figure Contributions to annual growth of debt in the business sector 3 25% 2 15% 1 5% -5% -1-15% loans from the Estonian banking sector loans from abroad effect of reclassifications 27 Q3 EUR billion other domestic loans debt securities total Figure Corporate debt liabilities by sector domestic external.5. 9 This was probably partly because reclassification of several companies between institutional sectors. 1 For more on the growth in debt liabilities see the Eesti Pank Lending Review page The banking sector here includes bank subsidiaries issuing leases. Q3 manufacturing Q3 Q3 Q3 Q3 construction and real estate retail and wholesale trade transport and storage energy 13

14 Table Structure of debt liabilities in the Estonian corporate sector Q3 Total debt liabilities Domestic debt liabilities 75.1% 78.8% 78.5% 78.4% 74.5% 7.3% 68.1% 63.8% 65.7% 64.3% Bank loans, leases and factoring 51.7% 56.6% 56.8% 52.9% % 47.3% 47.6% 46.1% 45. Lending from non-financial institutions 22.3% 2.6% 18.2% 23.8% % 18.6% 13.7% 17.6% 17.4% Domestic debt securities 1.1% 1.6% 3.5% 1.7% 1.5% % 2.4% % Foreign debt liabilities 24.9% 21.2% 21.5% 21.6% 25.5% 29.7% 31.9% 36.2% 34.3% 35.7% Foreign loans 21.3% 18.1% 18.8% 18.7% 22.3% 26.5% 27.7% 29.8% 27.7% 28.7% Foreign debt securities 4.1% % 2.9% 3.2% 3.2% 4.2% 6.4% 6.6% 7. The growth in debt liabilities in was driven by many different sectors 12. Debt liabilities in manufacturing and real estate grew on the back of domestic debt, while the growth in the energy industry came almost entirely from debt taken from abroad and retail companies used more of both domestic and foreign lending than previously (see Figure 2.3.2) 13. Corporate debt has started to increase gradually. Corporate debt liabilities have been increasing faster than GDP since the second half of, which means that their ratio to GDP has started to increase. The ratio of debt to GDP was around 93% in the third quarter of, and it climbed by five percentage points during the year 14. The changes in debt levels varied somewhat across sectors however. The debt energy sector expanded rapidly again and in this was a consequence not only of increased debt but also of a decline in value added, unlike in earlier years. The long decrease in the debt level in the real estate sector stopped in as a result of 12 The debt liabilities by sector are based on the Eesti Pank statistics for banking and the external economy, and so do not cover debts within the non-financial sector or to the financial sector beyond the banks. both growing debt and somewhat lower value added. The debt level retail and manufacturing sectors, which had been relatively low, also rose slightly due to faster growth in debt. Debt liabilities in the primary sector stopped growing last year, having done so for several previous years, but this was largely because some individual but very large long-term debts were paid off, and borrowing activity remained high among companies in the sector (see Figure 2.3.3). Figure Corporate indebtedness by sector (4-quarter moving average) %of value added for the sector manufacturing retail and wholesale trade energy construction and real estate transport and storage primary sector 13 Borrowing from abroad grew mainly, though not entirely, because of one very large loan taken by a retail company from its foreign parent company. The money borrowed was immediately lent onwards to a subsidiary Three percentage points of this came from the reclassification noted earlier. Sources: Statistics Estonia, Eesti Pank 14

15 Figure Corporate equity and debt Figure Corporate indebtedness, financial leverage and liquidity 4 equity domestic borrowing foreign borrowing debt-to-equity (right scale) 75% 12 Estonia euro area % 6 8 EUR billion % 5 45% 4 35% 3 25% debt/gdp debt/equity short-term debt/liquid financial assets Source: European Central Bank After falling for four years, the financial leverage of companies started to grow a little in. Reduced profits and somewhat larger dividend payouts meant that reinvested income declined, and so the growth in corporate equity slowed. As debt liabilities increased more quickly at the same time, the financial leverage of companies, shown in the debt-to-equity ratio has been climbing steadily since the start of (see Figure 2.3.4). The capacity of companies to borrow remains good. The very rapid recovery after the economic crisis and the improvement of balance sheets mean that the financial leverage of Estonian companies remains low and liquidity high in comparison to their levels in the past decade or in other euro-area countries. This means that companies are well protected against possible risks and their capacity to borrow remains good (see Figure 2.3.5). Figure Effect on investment from financial circumstances and expected profits % of responses stimulating restrictive Although falling profits in several sectors have harmed the financial circumstances of companies somewhat, companies still consider their situation to be good. In the survey of manufacturing Source: Estonian Institute of Economic Research *corporate predictions for * 15

16 Figure Turnover of long and short-term financing Figure Number and average value of long-term loans long-term financing (left scale) short-term financing (left scale) annual growth of long term financing (right scale) annual growth of short term financing (right scale) 35 average loan value (left scale) number of loans (right scale) 2 EUR millioin EUR thousand thousand by the Estonian Institute of Economic Research, manufacturing companies say their financial position and expected profit will stimulate investment a little less than in, but they will be quite good in comparison to previous years. This means that the relatively low level of investment is not caused by a lack of financing in the majority of cases. The situation is expected to remain the same in 215 as it was in (see Figure 2.3.6) Domestic borrowing Figure Loan stock growth in short-term long-term Demand for loans and leases from the domestic banking sector increased somewhat in and the total volume of new loans and leases grew by around 4% over the year. This growth could have been even faster, but there were fewer refinancing transactions in several sectors (see Figure 2.4.1). Increased demand for loans is also shown by the rise in the number of loans taken, though the average size of each loan fell at the same time, suggesting that more than before the loans are EUR million construction and real estate manufacuring primary sector retail and wholesale trade transport and storage infrastructure other sectors 16

17 going to smaller projects and companies 15. This was the case in most sectors, but particularly manufacturing, retail and real estate. At the same time the volume of loans to the agricultural sector increased relatively rapidly while the number of loans remained about the same, meaning the average value of each loan increased (see Figure 2.4.2). The loan stock increased over the year by 24 million euros, or 3.1% 16, with a large part growth coming from long-term investment loans to the real estate, manufacturing and agricultural sectors. The loan stock shrank in the majority of other sectors, but only by quite a small amount (see Figure 2.4.3). 15 See also Box 1. The financing of small and medium-sized enterprises. 16 Growth in the loan stock was slowed somewhat by reclassifications. Box 1: The financing of small and medium-sized enterprises Small and medium-sized enterprises (SMEs) play a major role in the Estonian economy and data from Statistics Estonia show that 99.8% of companies operating in Estonia were SMEs, meaning they had up to 249 employees 17. Micro companies with fewer than ten employees accounted for 89% of companies, while small companies with 1-49 employees accounted for 9% of all companies and medium-sized enterprises with employees for 1.8%. This means that at the end of only.2% of companies in Estonia were large companies, numbering together 156 (see Figure B1.1). Figure B1.1. Number of companies, employment and gross value added by size class in Estonia in micro small medium-sized large SMEs employed 79% of all the employees in the business sector in Estonia and created 75% of all the value added, while in the European Union as a whole they accounted for 67% of employees and 58% of value added 18. The only Source: Statistics Estonia size group of companies that has seen the number of people employed grow in the past decade in Estonia is micro companies, and the share employed working in micro companies has risen from 21% to 28%. The economic results for SMEs in the first three quarters of were similar to those for large companies as turnover growth stopped and rising labour costs reduced profits somewhat. share of all companies share of employment share of gross value added 17 This definition of SMEs is used in European Commission Regulation (EC) No 364/24. SMEs are also identified by their turnover and balance sheet size, but the only criterion used in this box is the number of employees. 18 European Commission Annual Report on SMEs in the EU /. 17

18 Among many other factors, good access to funds is important for the further growth and development of SMEs. The funding structure for SMEs differs from that of most large companies. SMEs mainly rely on banks, principally local banks, for funding, as their access to other sources of funds such as issuing equity or bonds or borrowing from abroad is generally more restricted than it is for large companies. As SMEs are often relatively new companies however, they have not had the time to build up a reputation and their short or non-existent credit history makes it harder and more expensive for banks to assess their credit risks. This then raises the cost of borrowing from banks or prevents them from getting credit at all. On top of this it can also be hard for small and young companies to find collateral for loans 19. SMEs have to use their own internal funds alongside funds from banks but the profits and buffers of new companies in particular can be too small to cover some larger investments. Figure B1.2. Main external sources of funds for SMEs leases and hire-purchase bank loans bank overdrafts or credit cards other loans trade credit grants or subsidised loans factoring equity capital debt securities Estonia EU % of respondents* Source: European Central Bank, SAFE *respondents who have used that source of funds or plan to do so in the coming years A joint report into the access to finance of companies by the European Central Bank and the European Commission 2 found that banks play a very important role in funding SMEs in Estonia through various loan products. A relatively large number of companies have also used or planned to use other loans that may be from other companies, including parent companies, or from friends and acquaintances, particularly for micro companies 21. Trade credit and state subsidies and guarantees play a somewhat smaller role in Estonia than they do on average in the European Union, while debt securities are close to non-existent in the funding of SMEs (see Figure B1.2). The same study showed that SMEs had better access to external sources of funding than was the case on average in the European Union (see Figure B1.3). This is partly because the debt of Estonian companies has shrunk significantly since the economic crisis and the capacity for borrowing has increased while the macro economic circumstances are relatively good 22. Partly it has been aided by the high capitalisation levels local banks and the low cost of funds, which means that the supply of credit from the banks is not so restricted. 19 Corporate finance and economic activity in the euro area. Structural issues report. ECB Occasional Paper No European Central Bank. Survey on the access to finance of enterprises in the euro area, April September. 21 Political research organisation Praxis got similar results in their study of Development trends for small and medium-sized companies in (link in Estonian), which found that loans from friends and acquaintances played a major role in funding for micro companies in Estonia alongside bank loans. 22 See also section 2.3. External financing, debt and leverage. 18

19 Figure B1.3. Assessment by SMEs of access to external sources of funds* Figure B1.4. Factors affecting SMEs' access to finance in general economic outlook access to public financial support including guarantees company-specific outlook company's own capital 3 company's credit history 2 1 Cyprus Greece Slovenia Italy Lithuania Spain Ireland France Source: European Central Bank, SAFE * 1 does not affect business activities at all, 1 affects business activities a great deal EU Latvia Netherlands Belgium Germany Finland Estonia United Kingdom Denmark Sweden willingness of bank to provide credit willingness of business partners to provide trade credit willingness of equity investors to invest in companies -3-15% 15% 3 Source: European Central Bank, SAFE * net share of companies noting improvement or worsening of factor The survey of company financing shows that the most restrictive factor for the business activities of around 12% of Estonian SMEs is their access to financing. In the opinion of SMEs, access to external financing worsened slightly in. Business representatives say that this came largely from a decline in the outlook for growth in the macro economy, and so also in that for their own companies. They also find that their access to state support has been reduced but the balance sheets and credit histories ir companies have continued to improve at the same time. The credibility of Estonian SMEs appears to have improved in the eyes of business partners, and trade credit is more and more available. SMEs also say that the willingness of investors to invest in their companies has increased and banks are a little more ready to lend to SMEs (see Figure B1.4). The access of SMEs to bank lending can also be assessed from the statistics for loans issued. Although the Eesti Pank banking statistics do not contain data on the size of companies that take loans, it can be assumed that larger loans are taken by large companies and smaller loans by small companies, and this can be used to assess the access of SMEs to bank loans. There was a sharp fall in the turnover of smaller loans during the recession, but after that crisis the turnover has started to grow rapidly. Interest rates continued to fall for large companies and for SMEs in and the rate for SMEs fell slightly faster 23 (see Figure B1.5). 23 For more on the causes differences in the loan interest rates for large companies and SMEs, see Appendix 2. The of Small and Medium-sized Enterprises in the Eesti Pank Lending Review. 19

20 Figure B1.5. Interest rates on long-term corporate loans Figure B1.6. Share of companies noting access to funds as the biggest obstacle to business activities 8% difference loans for over 1 million euros loans for under 25, euros 25% Estonia Estonia EU 7% 2 6% 5% 15% 4% 1 3% 2% 5% 1% all SMEs micro enterprises small enterprises medium-size enterprises Source: European Central Bank, SAFE Data from the survey by the European Central Bank and the European Commission show that micro companies find it more difficult to access external funds than other SMEs do. Around one in five Estonian micro companies find that access to financing is their biggest problem 24 (see Figure B1.6). Sentiment surveys lending environment by both the European Central Bank and the Estonian Institute of Economic Research find that construction companies have a belowaverage opinion ir access to financing, and the opinion of manufacturing companies is above average (see Figure 1.7). A survey by the central bank shows that companies with foreign ownership have slightly better access 24 Using data from the whole European Union, it can be said that the age of companies is also important alongside their size, with newer companies finding it harder to access financing than older ones. Although this is probably also the case in Estonia, it cannot be calculated because the sample size is too small. Figure B1.7. Assessment by companies credit climate* 1 5% -5% -1-15% -2-25% -3-35% Q1-2 Q3-4 Q1-2 Q3-4 manufacturing real estate retail and wholesale trade Source: Estonian Institute of Economic Research * net share of companies assessing the climate positively or negatively transport hotels and tourism construction 2

21 to financing than the average, which is probably partly because those companies are somewhat larger. Estonian SMEs expect that their financing circumstances will improve to some extent in the years ahead. It is believed that internal sources of funds will continue to grow and trade credit and the ability to attract equity investment will improve. SMEs consider that conditions for overdrafts and credit cards will improve, but conditions for other bank loans will remain as they are. 21

22 3. FINANCING OF HOUSEHOLDS 3.1. The financial position of households The economic circumstances of households improved in as developments in the labour market proved favourable. Although wages grew somewhat more slowly than in, wage growth still remained above 5% in the third quarter. Wage growth will slow in the near future, but disposable household income will be boosted in 215 by a cut in income tax and a rise in pensions and child benefit (see Figure 3.1.1). In the survey of household financial behaviour conducted by TNS Emor, 23% of households reported a rise in their income in, which was more than the 15% who reported a fall and in contrast to the situation in. Among families with loans, 31% reported a rise in income, which was more than the average. Although data from the Tax and Customs Board show that wages have grown faster in recent years for those on low wages than for those with high wages, the difference has not been felt by the people receiving the wages, and the assessment by households on low wages or living on benefits ir income growth is worse than the average. As in, the survey in found a trend for families who consider their current circumstances to be bad to be notably more pessimistic about the future. The most negative were families with low incomes who were receiving 2 euros or less a month per family member. Young families and those with loans are more positive than the average in the Emor survey. Figure Household income, consumption and investment, Q1 25 = 1 (4-quarter moving average) Figure Consumer confidence by household income points average gross monthly wage retail sales investment Source: Statistics Estonia 1st quartile 3rd quartile 2nd quartile 4th quartile The purchasing power of consumers has been improved not only by higher wages but also by very low inflation and falling prices for some groups of goods, most notably motor fuels, electricity and manufactured goods The confidence of consumers fell slightly from its levels at the beginning of. Although consumer Source: Estonian Institute of Economic Research 22

23 confidence about personal circumstances improved, most probably because of rising wages, it was mainly dented by concerns about the fate of the Estonian state. This may be due to the deterioration in the external environment because military conflict between Russia and Ukraine. As it is not certain whether the conflict will end peacefully and as Russia's behaviour has been unpredictable so far, this may affect the confidence of consumers and their financial behaviour in the coming years (see Figure 3.1.2). Figure Households' money surplus after compulsory expenditures and loan repayments no surplus up to more than 255 do not know 3.2. The financial behaviour of households The improvement in the purchasing power of households was shown in the broad-based growth of retail sales, which reached 6% in the fourth quarter of. Wage growth helped boost the financial surpluses of households after compulsory spending and loan repayments. Data from a survey by Emor show that the share of households saying they have no money left over fell from 37% in to 34% in. The capacity to save has improved broadly across all income groups (see Figure 3.2.1). Families with loans mostly make monthly payments of loan principal and interest of less than 2 ir income but the greatest difficulties are faced by the 1 of families whose monthly loan repayments exceed 4 ir income. The financial assets of households increased again in as cash and deposits increased. The value of shares and other equities held by households also continued to increase, though lower corporate profits and a halt in the rise in equity values slowed the increase significantly. As financial assets again grew faster than liabilities did, the net financial position of households continued to improve (see Figure 3.2.2). Household deposits grew quickly in and by as much as 8.4% in the fourth quarter with larger deposits growing faster than smaller ones, as before (see Figures and 3.2.4). The reasons Source: TNS Emor, F-monitor survey Figure Household financial assets and liabilities EUR billion other accounts receivable/payable insurance technical reserves cash and deposits loans shares and other equity net financial assets Q3 Notes: The model for estimating equity owned by households changed in. The dashed line shows what household net financial assets would have been before if the current method had been in use. 23

24 Figure Household deposits by deposit size Figure Household deposits /12/ 31/12/ 31/12/ overnight and demand deposits (left scale) time deposits (left scale) annual growth of deposits (right scale) % EUR billion over 1 EUR billion % 12% 1 8% 6% 4% 2% for saving found by the Emor survey financial behaviour of households have not changed over the years, with 52% of respondents giving just in case, for a rainy day as the reason for saving, and 27% giving for the long term, to ensure the future. There was an increase of 2 in the amount granted in new housing loans in and the new borrowing boosted the annual growth in the housing loan portfolio from 1% at the start of the year to 2.8%, while the value portfolio increased by 6 billion euros (see Figure 3.2.5). The increase in size housing loan portfolio came partly from the improvement in borrowing capacity due to higher incomes, and partly from the very low interest rates, which are likely to remain low in the years ahead. The survey financial behaviour of Estonian households also shows that there is greater demand for loans than there was in and there has been some improvement in the probability of an applicant being granted a loan by a bank. In, 59% of loan applicants got a positive response from the bank, meaning they were Figure Housing loan stock and annual growth EUR billion housing loans (left scale) annual growth of housing loans (right scale) 35% 3 25% 2 15% 1 5% -5% 24

25 granted their loan in full or in part, but in, 66% of applicants did. Households are generally rather cautious about financing investments in real estate, and the value of new housing loans as a ratio to the total value of residential real estate transactions has not risen (see Figure 3.2.6). The real estate market stabilised in the second quarter of as the rapid growth preceding years in prices and in the number of transactions slowed markedly. The adjustment came in the markets for both apartments and residential land. The affordability indicator for real estate, which is the ratio of square metre prices for apartments to gross monthly wages stood at.95 in the third quarter (see Figure 3.2.7). The rapid rise in real estate prices started to have a negative effect on the number of transactions in, and so sellers of real estate had to adjust their price expectations. There was an increase in the number of real estate properties on sale in, giving buyers a wider choice and more time to make it. A lot of new construction permits were issued at the start of because more favourable lending conditions and rising real estate prices meant that a lot of development projects became profitable enough to be worthwhile. New apartments becoming ready could affect the structure real estate market by increasing the share of new and expensive apartments in the volume of transactions, and this could in turn raise the value average transaction in 215. Figure Share of loans in household consumption expenditure and in the volume of real estate transactions turnover of housing loans as a ratio to the volume of real estate transactions (right scale) other household loans as a ratio to private consumption (right scale) Sources: Statistics Estonia, Eesti Pank Figure Real estate affordability 1 4 median price per m2 for apartments (left scale) average gross wage (left scale) median price per m2 of apartments/gross wage (right scale) 16% 14% 12% 1 8% 6% 4% 2% 2. Other household loans It is noticeable with household consumer loans that more and more instalment loans are being taken directly from shops and not from banks. Among families interviewed for the Emor survey of household financial behaviour, 25% had loan obligations to a shop and 57% of those were instalment loans. In, 18% of households had this sort of loan liability directly to a shop, and in only 13% had. Increasing numbers of families say euros All household loans other than housing loans. Sources: Estonian Land Board, Statistics Estonia, Eesti Pank 25