Andres Lipstok: Estonia's economic environment and central bank
activities
Speech by Mr Andres Lipstok, Governor of the Bank of Estonia (Eesti Pank), at the the
presentation of Bank of Estonia's 2008 Annual Report to the Riigikogu, Tallinn, 11 June
2009.
* * *
Dear Riigikogu,
Thank you for the possibility to present you Eesti Pank's 2008 Annual Report. I am going to
start with a brief retrospect of the Estonian economic environment and then address issues
concerning the activities of Eesti Pank.
The Estonian economic environment in 2008 and 2009
2008 was an exceptional year in the world economy. Developed economies have not faced
the risk that banking and financial markets could collapse and the global financial system
stop functioning since the beginning 1930s. But the financial crisis, which was caused by
previous years' incorrect decisions, made this a very likely scenario. In the final months of the
past year major banks were too afraid to lend money to each other and trading with
privatesector bonds nearly ceased. Loss of confidence in financial markets, loan losses amounting
to 3-4 billion dollars and a sharp decline in crediting the private sector had an immediate
impact on global trade, investment and economic growth. Global trade contracted 17% in the
fourth quarter of 2008 and at the beginning of this year.
Major central banks and governments have taken unprecedented steps to alleviate the
economic situation. The Federal Government and the central bank of the USA have
channelled funds worth over 787 billion dollars into banking and the private sector. In the
European Union, the fiscal stimulus amounts to 1.8% of GDP and to 225 billion euro. Banks
have received direct support and state guarantees in the amount of 393 billion euro. Such
massive intervention has put brakes on the rate of recession.
The past couple of months' stabilisation in the global economy has come at a high price.
Major economies face rapidly expanded fiscal deficits and central banks' balance sheets and
total volume of base money have promptly increased. Therefore it cannot be said for sure
whether the current "green shoots" refer to a new growth cycle. Only structural reforms and
maintaining confidence in fiscal and monetary policy can help the economy out of the crisis
on a more permanent basis.
When speaking about this year's forecasts, the EU economy as a whole is expected to
undergo a 4% recession. Small economies which are more dependent on exports and
international capital flows suffer from the crisis disproportionally more. Sweden and Finland,
our close neighbours, can expect a recession of up to 4.7%. As we know, the global financial
crisis and the collapse of markets caused serious difficulties to several new Member States.
It is clear the events that took place at the end of the last and at the beginning of this year
were real challenges for the Estonian monetary and financial system, testing their resilience
and ability to adjust to the changing external environment. Today I dare to look at the
situation with moderate optimism and repeat what has already been said in March: Estonia
has all the possibilities of successfully passing through the crisis.
Estonia's monetary policy and financial stability in 2008
Turning to the tasks of Eesti Pank, I would like to start with an overview of the functioning of
the monetary policy framework. The objective of Eesti Pank, member of the European
System of Central Banks, is to ensure price stability in Estonia. To this end, we rest on the
currency peg to the euro, the currency board arrangement and the EU exchange rate
mechanism ERM II. The success of this system is confirmed by the slowdown in the price
rise which started in 2008, and the halt in the growth rate of consumer prices in recent
months. Looking ahead, Eesti Pank forecasts the price level to decline somewhat in both this
and next year. It is clear the Estonian monetary policy or the monetary policy framework will
not and must not be changed. The exchange rate of the Estonian kroon will remain as it is
and we will accede to the euro area at the current exchange rate. I would also like to stress
that price stability is one of the most important factors supporting economic growth.
The second main objective of Eesti Pank is to support the stability of the financial system,
especially the credibility of the banking system. Similarly to choices made in monetary policy,
Eesti Pank has over the years proceeded from clear and comprehensible principles also in
banking. We have firmly supported the common banking market of the EU and the
NordicBaltic region. In addition, we have emphasised the relevance of the capitalisation and
liquidity of the banks operating here. Eesti Pank kept the obligatory minimum capital
adequacy ratio at the level of 10% and increased the reserve requirement to 15% of the total
liabilities of a bank.
Against this background I dare to say that so far the banking sector has coped well with the
crisis. The average capital adequacy ratio of the Estonian banking sector is currently above
22%. The capitalisation of the subsidiaries of the banks operating in Estonia is absolutely
sufficient to cope with loan losses markedly bigger than the current estimated 2% level
without including additional capital. The credibility of the banks operating in Estonia is thus
not threatened by a possible increase in the share of so-called bad loans in the loan portfolio
in the course of this year compared to the current 5.2%.
The integration of the banking system with the Scandinavian and European markets, which is
one of the most important factors supporting stabilisation, is another issue. The banking
groups operating in Estonia are able to manage capital and liquidity in a flexible way at group
level. The integration of the banking system consists in the readiness of banking groups to
promptly channel money flows to various subsidiaries and branches according to need.
The integration of banking is supported by cooperation in the Nordic-Baltic region. I am
convinced the daily information exchange and cooperation agreements of our region set an
example of ensuring financial stability for the entire European Union. In the final months of
2008, Sweden initiated support schemes, which have had a very positive impact on banking
groups as a whole, i.e., national support measures have been implemented from group level
also on subsidiaries and branches. In this context, Estonia has in the EU actively supported
the principle that the implementation of rescue packages must not discriminate against other
Member States.
2009 economic policy priorities in Estonia
Now I would like to say a few words about the current monetary and economic policy
situation and the most important priorities for 2009.
By now it is clear that the Estonian enterprises and households have thoroughly changed
their behaviour and expectations over the past half a year. In this respect, a big part of the
adjustment process has already taken place and Estonia's primary macro vulnerabilities have
considerably decreased. The current account, i.e., the difference between investment and
savings, has practically balanced and the financing of the economy's current expenditure is
ensured by current income. In addition, Estonia has no problems with financing its external
debt. Companies and people in Estonia have taken serious steps to pave way for getting
through the global crisis and recovering growth.
Therefore, the state needs to implement some important macro-level objectives to support
the recovery of economic growth. Here I mean, above all, the readiness to join the euro area
as well as medium-term and long-term stability of fiscal policy.
In the current situation, accession to the euro area is Estonia's utmost short-term objective.
The adoption of the euro will ensure the stability of the money used in Estonia and is
extremely important for further reinforcement of the banking system and the investment
climate. It can be said the clear perspective of joining the euro area is an absolutely
necessary precondition at the national economy level for the permanent recovery of growth.
Declining inflation has created all the possibilities in Estonia to meet the Maastricht criteria by
end-2009, which makes it possible to join the euro area on 1 January 2011 at the latest.
In this context and from the point of view of monetary and financial system stability, fiscal
policy has two tasks in 2009. First of all it must be made sure that the current account deficit,
which cannot be avoided in the prevailing economic environment, remains below 3% of GDP
both this year and in 2010. In order to achieve this, Eesti Pank is of the opinion that in
addition to the steps taken in February, this year's fiscal deficit needs to be reduced by a
further 6.5 billion kroons.
In addition to fiscal consolidation, it is important to ensure long-term fiscal sustainability.
Once the acute crisis is over, the first thing to do is to achieve fiscal balance. Then it is
necessary to restore the public sector's extensive fiscal reserves. The national budget
strategy recently approved by the government creates a necessary macro framework
according to which the budget should reach balance by 2011. Eesti Pank is of the opinion the
new strategy is a timely and ambitious document which requires cooperation also at
Riigikogu level.
Taking into account that government expenditure as a ratio to GDP has soared, budget
adjustment must be done primarily on the expenditure side. Tax revenue increases may
support the adjustment, but they should not play the main role. If only tax advances were
used to finance costs at the current level, Estonia's long-term economic growth would be
imperilled. Also, we support the principles of the current tax policy, according to which the
share of indirect and pollution taxes would increase on account of direct taxes.
I would like to emphasise once again that the measures taken over the past half a year in
both the public and the private sector have improved Estonia's ability to exit the crisis. This is
confirmed by the fact that most of the rating agencies as well as the IMF's recent mission to
Estonia have expressed positive assessments of Estonia's economic outlooks. To support
economic growth, it is necessary to reinforce the principles of open economy and market
flexibility and to ensure the stability of the national economy. In order to meet these goals,
the best state support is the resumption of investment in the private sector and using the new
possibilities that accompany every crisis.
Thank you for your attention!