Estonia on the way to the euro area Ülo Kaasik Head of Economics Department 22 January 2010
Outline Brief overview of the history and policy set-up The role of the global shock Meeting the Maastricht criteria Future outlook 2
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
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
Year-on-year growth accelerated after joining the EU GDP growth in Estonia 14 12 10 8 6 4 2 0-2 -4-6 5 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Drivers of economic performance before the crisis EU accession and favourable external environment 2005-07 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
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
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
5-year CDS show that risks are still perceived to be considerable 9
Exports: sudden drop after Lehman in line with global trends Exports (in EUR) growth rates in the range of -20..-30% (yoy) Index, 2006=100 180 160 140 120 100 80 60 40 20 0 2006 2007 2008 2009 SE FI EE Source: Eurostat 10
Industrial output volumes have stabilised 130 120 110 100 90 80 70 60 50 40 (2005=100) 2005 2006 2007 2008 2009 115 110 105 100 95 90 85 80 Source: Eurostat Estonia (ls) EU27 (rs) 11
Labour market: activity rate has not decreased employed, thousands unemployed, thousands 750 700 650 600 550 500 2004 2005 2006 2007 2008 2009 12
Lower wages predict negative core inflation in 2010 and moderate inflation in 2011 Sources: Statistics Estonia, Eesti Pank s Autumn Forecast 13
Meeting the Maastricht criteria
Government needs to target surplus in medium term 4 3 2 Estonia's budget balance reference value for the budget balance criterion 1 0-1 -2-3 -4 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009* 2010* 2011* 2012* 2013* Source: Eesti Pank Forecast, State Budget Strategy 2010 2013 (May 2009) 15
Government debt remains at the lowest levels in the EMU 16
Inflation remains under the reference value 12% 10% 8% 6% 4% 2% 0% 2008 2009 2010-2% Maastricht inflation criterion reference value (EC, nov.09) Inflation in Estonia (12 month moving average; EP forecast) 17
There is no instrument to measure long-term interest rates in Estonia 9 8 7 6 5 4 2007 2008 2009 2010 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
The Maastricht criteria have to be met in a sustainable manner
Inflation gap with the euro area is gradually narrowing During 2004-2006 the inflation differential vis-a-vis the euro area remained at approximately 2%, reflecting the convergence process In 2007-2008 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
High level of price convergence means lower inflation in the future 90 80 Estonia in 2008 cz ee hr lt lv pl si sk PRICE 70 60 50 40 30 20 30 40 50 60 70 80 90 100 GDP Source: Eurostat 1995-2008 21
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
Outlook (1) - sentiment is pointing to correction 40 30 20 10 EE FI SE 0-10 -20-30 -40-50 2005 2006 2007 2008 2009 Seasonally adjusted industrial confidence indicators Source: European Commission 23
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
Eesti Pank's economic forecast by key indicators 2009 2010 2011 GDP (EEK bn) 214 212 224 Real export growth -12% 5% 10% Real GDP growth -14% 1% 5% Inflation 0% 0% 2% Budget balance (% of GDP) -3% -3% -1% 25
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