The Estonian Economy – 2010 November 3


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The Estonian Economy – 2010 November 3

  1. 1. The Estonian Economy Monthly newsletter from Swedbank’s Economic Research Department by Elina Allikalt No. 5 • 3 November 2010 Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000. E-mail: Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720. Maris Lauri, +372 6 131 202. Elina Allikalt, +372 6 131 989. Annika Paabut, +372 6 135 440. Strong short-term fiscal position founded on great adjustments during the crisis  Successful fiscal adjustments introduced during the recession, as well as many favourable circumstances, allowed Estonia to weather the recent crisis without fiscal collapse. Even more important, a rapidly changing economic situation allowed the country to meet all Maastricht criteria and become eligible for euro adoption.  Because of a faster-than-forecast economic recovery, budget revenues are overshooting targets in 2010, and further increases are drafted in 2011 budget. Expenditures are also growing, supported by investments and some one-off causes. Overall, deficits are being held under control, reserves have stabilised, but the debt level is about to increase, although from current low levels.  Unlike most countries in the EU, which are primarily focusing on additional austerity measures, Estonia can, thanks to its strong fiscal position, concentrate more on current imbalances and problems in the economy, as well as on other longer-term fiscal issues. After many years of unsustainable growth rates and an overheating economy, Estonia entered into recession in early 2008, triggered by collapsed domestic demand. The initial recession was further exacerbated by the global financial crisis in late 2008, which brought the financial sector, as well as export demand, to a halt. These circumstances called for swift action in order to stabilise the economy in a rapidly changing environment. With a fixed currency peg regime in place (and a clear commitment to stick with it), “internal devaluation” was the policy chosen to live through the crisis. Through this choice, fiscal policies took the main burden in the adjustment process as possible monetary policy options under the currency board regime were very scarce. However, unlike what befell many emerging as well as advanced European countries, a growing public sector deficit- debt spiral, its spillover to the rest of the economy, and, for some, the need for international financial support were avoided in Estonia. The main reasons were as follows:  The government had collected a substantial amount of reserves during the boom years by registering budget surpluses for several consecutive years. At the end of 2007, reserves peaked at EUR 1.4 billion. This provided a critical cushion in 2008-2009 to cover fiscal deficits because interest rates for external financing were very high during that period due to negative risk estimates for the Baltic region.  The actions taken by the government to adjust the fiscal position in accordance with the changing economic environment were quick and wide-ranging. Most of the austerity measures were introduced with two supplementary budgets in 2009, totalling EUR 1.2 billion, or 9% of GDP. Also, due to surpluses in previous years, the fiscal position in which Estonia entered into recession was stronger than those countries’ that had already been running deficits in boom years.  The financial sector stayed stable despite global turmoil. Since most of the banks in Estonia are foreign owned, no financial help from the government to the local banking
  2. 2. The Estonian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued Nr 5 • 3 November 2010 2 (6) sector was needed (in contrast to, e.g., the Parex bank in Latvia). Successful fiscal adjustments led to a budget deficit of just 1.7% of GDP in 2009 (down from 2.8% in 2008), allowing the government to further “take advantage” of the low level of the economic cycle and meet all the Maastricht criteria necessary to be eligible for euro adoption in 2011.1 2010 budget – faster economic recovery boosts revenues The 2010 budget law was passed by the Parliament in December last year, based on a much more negative economic outlook than was the overall market consensus at that time. Unofficially, the base scenario by the Ministry of Finance (MoF) was regarded as the negative risk scenario because the government wanted to avoid any possible future negative adjustments in the budget as it was targeting a budget deficit below the Maastricht criterion. The general government budget saw a deficit of 2.8% of GDP for 2010 in a situation of a 2% economic decline and a 2.4% decrease in budget revenues. However, the economic recovery has been much quicker than forecast at that time, even far above the positive risk scenario. According to the latest MoF forecast, revenues are expected to be overshot by about EUR 200 million, or 3.6%, compared with the original forecast; as a result, the budget deficit is now expected to reach just 1.3% of GDP (see table). About two-thirds of the above-mentioned increase in revenue expectations is attributed to higher tax collection (1.1% annual growth at the end of September). Better economic recovery has primarily increased indirect tax collection – VAT and excises (6.3% and 9.9% growth, respectively). On the other hand, the situation in the labour market has turned out worse than expected, affecting social tax (-6.9%) and personal income tax (+2.1%2 ) collection and forcing the ministry to lower expectations. On average, tax collection this year is forecast to be on the same level as last year, with strong possibilities for an even better outlook. 1 So far, the price stability criterion had been the only one not able to be met. But economic decline and internal devaluation led to deflation, which allowed that criterion to be met. 2 PIT collection is behind plan, but positive annual growth is reported due to smaller tax reliefs this year than usual. The share and amount of non-tax revenues were exceptionally large in 2009 (about 25% of total) to offset the drop-off in tax revenues, and this trend will continue this year as well. While in the budget law non-tax revenues were seen to decline by 7% this year, these are now expected to increase by 7% (the annual growth at the end of September was 17%). The biggest impact behind this increase is a 20% higher inflow of grants. Also, a big difference in expectations has been the successful selling of Assigned Amount Units (AAUs) under the Kyoto protocol. At the same time, expectations are lower with respect to fines revenues (-32% annually at the end of September). Table. 2010 forecast by the Ministry of Finance 2010 budget law 2011 summer forecast Economy (annual growth): GDP -2.0% 2.0% private consumption -6.7% -3.3% investment (excl. inventories) -8.0% -3.2% export 0.1% 15.1% import -3.1% 12.8% unemployment rate 16.8% 17.5% employment growth -3.2% -5.0% gross wage real growth -4.0% -3.2% Consumer Price Index 0.2% 2.6% Budget (EURm): revenues 5,401 5,596 tax revenues 3,946 4,075 non-tax revenues 1,455 1,521 expenditures 5,735 5,685 deficit (general government) 371 181 % of GDP -2.8% -1.3% Source: MoF Chart 1. State budget revenues at the end of September (% of annual plan) 0% 20% 40% 60% 80% 100% revenues taxes PIT CIT socialtax VAT excises non-tax (ex.grants) grants 2010 (budget law) 2005-2009 Source: MoF, Swedbank calculations
  3. 3. The Estonian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued Nr 5 • 3 November 2010 3 (6) Chart 2. State budget revenues and expenditures, 2005 - 2011 (EUR billion) 0 1 2 3 4 5 6 7 2005 2006 2007 2008 2009 2010 f orecast 2011 budgetnon-tax rev enues tax rev enues expendituresSource: MoF While revenues have been above expectations, expenditures are being made below the plan. At the end of September, expenditures were down by 1.5% in annual comparison with the total level being even lower than in 2008. On one hand, the expenditures have been growing with respect to co- financing of grants (+11%) and several social costs (e.g., pensions, +4%, and parental benefits, +17%) but, on the other hand, there has been a fallback in mandatory pension pillar transfers (a temporary freeze as part of the austerity program) and lower payments to the Health Insurance Fund (-9%; due to weaker social tax collection). Also, current expenditures are 4% lower, including a 6% fall in personnel costs. Revenues up by 2% but expenditures by 5% in 2011 The budget draft for 2011 was approved by the government in September and sent to the Parliament. According to the draft, the general government deficit is set to reach EUR 241 million, or 1.6% of GDP, up from the 1.3% forecast for 2010 but lower than the 2% set in the latest state budget strategy plan. Total revenues are expected to increase by 2%, including 4% in tax collection. All main tax revenues are envisaged to increase, with the biggest in CIT (up 12% from 2010, mostly due to a small comparison base) and PIT (7%; supported by somewhat better labour market conditions). The only planned tax increase as of now is the 10% hike in the tobacco excise in January; there has been discussion to introduce a plastic bag tax during next year also but that has not been decided yet. Non-tax revenues, on the other hand, are expected to decrease by 4%, influenced by smaller revenues from AAU sales (due to comparatively large revenues in 2010) and declining dividend revenues. The inflow of grants will continue to grow in 2011 as well, with a 12% increase planned. Despite falling non-tax revenues, their share in total revenues will remain unusually large (about one-fourth of the total). Chart 3. Tax revenues, 2004 - 2011 (EUR million) 0 300 600 900 1,200 1,500 1,800 2,100 2004 2005 2006 2007 2008 2009 2010 f orecast 2011 budget PIT CIT Excises VAT social taxSource: MoF Total expenditures are set to increase by 5% in 2011, growing to levels that are higher than those seen in 2008 (see chart 2). More than half of this increase is attributed to social costs, mostly through higher pension payments but also due to the partial recovery of state payments to the mandatory pension pillar, which have been frozen since mid- 2009 as part of the austerity measures. Almost as big an increase as in social costs is also projected for investments; this will mostly be supported by energy efficiency investments carried out according to sold AAU contracts (this will also have a temporary major effect on investments and expenditures in 2012). Current expenditures are also to increase by 4%. Reserves stable and debt to rise The reserves accumulated during the boom years with consecutive years of budget surpluses provided critical fiscal support during the crisis. Because external financing costs were quite high during 2008-2009, covering deficits with reserves was preferred. Some strategic public investments (e.g., to the energy company Eesti Energia) were financed from reserves as well. However, one loan from the EIB was taken in order to cover some co- financing related investment costs and not to exhaust the reserves entirely. The total amount of reserves is forecast at 9.5% of GDP at the end of this year (down from the peak of 12% in 2006). The
  4. 4. The Estonian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued Nr 5 • 3 November 2010 4 (6) budget deficits both this year and next are mostly planned to be financed by reserves. The current government has also not ruled out the possibility of taking a loan to cover some investments, but this will depend on whether it can get that loan with lower interest costs than the interest revenue earned from current reserves. Chart 4. General government reserves and public debt, 2006 - 2014 (% of GDP) 0% 5% 10% 15% 20% 2006 2007 2008 2009 2010 2011f 2012f 2013f 2014f reserv es debt Source: MoF f orecast Estonia has unarguably the lowest debt level in the EU, forecast to amount to only about 8.8% of GDP this year (compared with about 80% on average in the EU). During the coming years, however, the debt level is set to increase as a larger share of deficits are planned to be financed by loans because the government aims to keep reserves at a steady level.3 This stable level of reserves will be supported by social security funds, which will record growing surpluses during this period (see chart 5), while local government reserves will remain unchanged and central government reserves will decline. As budget surpluses resume (planned for in 2014), the debt level will stabilise and reserves will start growing even faster. Short-term deficit under control, long-term challenges ahead The current official state budget strategy for 2011- 2014 sees the general government budget as 3 The debt level increase seen in chart 4, drafted in the latest state budget strategy, can be treated as a negative scenario, i.e., in case reserves are used at a minimum. In addition, future loans are seen as being used only for investment purposes, not to cover current expenditures. reaching balance or a small surplus in 2014.4 .The current government says that budget surpluses must be restored as soon as possible in order to start increasing reserves again, which were being exhausted during the deficit years. One coalition partner recently even went so far as to propose that a mandatory budget surplus requirement should be written into the constitution, but as of now that idea has not gained wider support. Estonia’s conservative fiscal policies are regarded as its biggest strength and are strongly linked to its overall credibility. Chart 5. General government budget balance forecast according to current state budget strategy, 2005 – 2014 (% of GDP) -4% -3% -2% -1% 0% 1% 2% 3% 4% 2005 2006 2007 2008 2009 2010f 2011f 2012f 2013f 2014f Central gov ernment Local gov ernment Social security f unds General Gov ernmentSource: MoF However, reaching budget surpluses should not itself be a major target. Justifiable small deficits should not be feared if they help to broaden macroeconomic stability, especially because unemployment is forecast to remain relatively high for years, domestic demand will be slow to recover, and the economic recovery in debt-ridden Europe might stall (thus affecting export demand). Estonia is in a very unique fiscal position in Europe and the euro zone – while most countries are struggling to find ways to curb their out-of-hand deficit and debt levels, Estonia has the luxury of instead concentrating on other economic issues (e.g., unemployment, productivity, export competitiveness, etc.). Also, almost nonexistent public debt (at least in comparison to Europe and other advanced economies) will impose a much 4 The temporary worsening of the deficit in 2011 and 2012 is mostly connected to mandatory increase in spending (e.g., recovered payments to pension pillars and investment spending according to AAU contracts).
  5. 5. The Estonian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued Nr 5 • 3 November 2010 5 (6) lighter burden on future budgets, as there is no reason to find extra means to service those debts.5 Very telling in this respect is the fact that Estonia is the only country in the euro zone to actually meet all the rules set by the Stability and Growth Pact more than ten years ago which so far have not been reachable to the euro zone on average. Chart 6. Public sector debt and deficit in euro zone countries, 2010 (% of GDP) -18 -16 -14 -12 -10 -8 -6 -4 -2 0 0 50 100 150 Debt Deficit Source: IMF WEO Database October 2010 EE IE EL IT BE ES FR PT SK LU SI FI CY NL AT MT DE Nevertheless, despite a favourable fiscal position in the short term, there are many bigger mid- and long-term issues that need to be dealt with very soon. For instance, like the rest of the developed economies in the world, Estonia also has to tackle the issue of an aging population and shrinking workforce, which are exacerbating socials costs and threatening competitiveness. A big step in this regard was already taken at the beginning of this year with the government’s decision to raise the retirement age from 63 at present to 65 by 2026. Also, a new labour law took effect in mid-2009 that increased the flexibility of the labour market. However, additional policy changes are needed. For example, further increase the attractiveness and dynamics of the labour market in order to cap emigration and raise participation rates. Apart from the declining size of the workforce, the biggest risk for the labour market is the growing number of long- term unemployed, and thus more needs to be done to decrease the probability of their becoming entirely discouraged. Some of the problems can 5 According to the European Commission spring forecast, Estonia has the lowest interest payments in the EU, namely, 0.4% of GDP in 2010, compared with an average of 3% in the euro zone and 2.8% in the EU. also be offset by welcoming more immigrants into the workforce, but as of now this policy change is not widely supported. Different structural changes should be considered, too, in order to accelerate the increase in productivity. Chart 7. Foreign financing in the state budget, 2003- 2011 0 200 400 600 800 1,000 1,200 2003 2004 2005 2006 2007 2008 2009 2010 f ore- cast 2011 budget 0% 5% 10% 15% 20% 25% total, EURm (ls) % of total rev enues (rs) % of GDP (rs)Source: MoF Another area of concern is the state budget’s heavy dependency on foreign financing (i.e., grants) The government successfully used foreign financing (especially EU structural fund instruments6 ) as a supportive measure during the economic crisis, as well as heavy budget cuts, simplifying the application processes and targeting more means to the labour market, entrepreneurship, and innovation-advancing areas. As a result, the amount of foreign financing increased to EUR 830 million in 2009, contributing 15% of total revenues (or 6% of GDP). In the 2011 budget draft, that figure is set to increase to EUR 1,111 million, or almost one-fifth of total budget revenues and 7.5% of GDP (see chart 7). Estonia is among the frontrunners in using EU regional policy instruments, indicating its high efficiency levels. However, the current budgetary period for using this EU financing ends in 2013; although financing revenues will not be cut off immediately after that, there will probably be a noticeable drop that could leave the budget, public investments, and economy as a whole in a “hung over” mode. A more decisive framework therefore needs to be put in place to offset these possible developments. Even more so because, depending on the development level, there will probably be 6 EU structural fund instruments make up about 80-90% of total foreign financing.
  6. 6. The Estonian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued Nr 5 • 3 November 2010 6 (6) many fewer instruments available for Estonia during the next budgetary period after 2013. Elina Allikalt Swedbank Economic Research Department SE-105 34 Stockholm Phone +46-8-5859 1028 Legally responsible publisher Cecilia Hermansson, +46-8-5859 7720 Maris Lauri +372 6 131 202 Elina Allikalt +372 6 131 989 Annika Paabut +372 6 135 440 Swedbank’s monthly newsletter The Estonian Economy is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter The Estonian Economy.