Martin LindpereBank of Estonia
The case of Estonia: from localcredit boom to global bust
Martin Lindpere, Bank of Estonia 26/06/09
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Estonia before the EU accession in 2004
•12 years of experience under the currency board system (kroonfixed to euro)
–Currency board tested not only in good growth years (early bankingcrises, Russian crisis etc)
•Increasing ties with the European Union
–Very high openness to trade and investment
–Highly integrated banking market since 2000
•High level of labour market flexibility
Martin Lindpere, Bank of Estonia 26/06/09
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The drivers of economic performance in the boom years
•EU accession and favourable external environment in 2005-07
–Estonia
•Enhanced labour mobility and strengthened wage pressure
•Increased productivity (incl in the exporting sector)
•Fastened financial liberalization, lower interest rates and longer maturities inlending
–External world
•Period of relatively fast growth, low interest rates and abundant credit
Martin Lindpere, Bank of Estonia 26/06/09
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Capital inflow fed credit boom and financial deepeningwere extremely rapid
Source: Bank of Estonia, Statistics Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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However, foreign liabilities were mostly inhousepositions of Nordic banking groups
The banking market is very strongly integrated to Scandinavia
Source: Bank of Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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It was largely a real estate boom
The turnaround of the boom started from the real estate sector in 1H 2007
Martin Lindpere, Bank of Estonia 26/06/09
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Policy responses
•Currency board continued
–European interest rates unfortunately low
•Tightening in prudential regulations
–Reserve requirements (signalling, but also liquidity buffers)
–Capital adequacy
•Fiscal surpluses
–Fiscal surpluses were formed in the amount of 10% of GDP by 2008
–Ex post evaluation: reserves still too little
•The arms for undoing the massive capital inflows were nevertheless short
Martin Lindpere, Bank of Estonia 26/06/09
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Unwinding of imbalances
•The domestic boom started to reverse in 2007 when asset overpricingbecame obvious and expectations turned
–Currency board and fixed exchange rate very important in cementingexpectations
•Some supply side reaction from banks was also at play
–Incl better synchronised interest rate cycle from Europe
•2007 global financial turmoil fastened the unwinding, but added otherconcerns
–Liquidity of wholesale-based financial groups
Martin Lindpere, Bank of Estonia 26/06/09
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Lessons from the first phase of unwinding (until 3Q2008)
•Procyclical assessment of potential growth dangerous
–It is principal part of overshooting
–However, how to escape from global mistake?
•Annual data lags behind hopelessly
–Bad – as policy analysis deals with historic problems
–Good – adjustment more step-by-step?
•Current account primarily expectations-issue, not relativeprice/misalignment issue
Martin Lindpere, Bank of Estonia 26/06/09
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The level of prive and income convergence achieved by2007
Source: Eurostat
Martin Lindpere, Bank of Estonia 26/06/09
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However, from competitiveness point of view labor costadvantage is still on our side, especially if comparedagainst Nordic countries
Source: Eurostat
Martin Lindpere, Bank of Estonia 26/06/09
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But problems travel rarely alone, QIV 2008 globaltrade shock added new problems
Source: Eurostat
Martin Lindpere, Bank of Estonia 26/06/09
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Likewise in EU, the shock to industrial production inEstonia has taken us back quite a few years in time
Why should a symmetric shock bring us to the exchange rate question?
Source: Eurostat
Martin Lindpere, Bank of Estonia 26/06/09
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The loan conditions have also become tighter, aselsewhere
Supply factors: interest rate cycle became more synchronised with Europe since 2006
Source: Bank of Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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Credit stock is going to decline in 2009
Source: Bank of Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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Predominantly demand factors were driving the currentaccount since 2007 but the supply factors joined thegame since end-2008
Large adjustments possible without recourse to exchange rate
Source: Bank of Estonia, Statistics Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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Labour market responded rapidly to the global crises,core inflation as well
Source: Bank of Estonia, Statistics Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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1st challenge: surviving the global crash
•Which industries stabilise, which vanish, which rebound?
–A lot to do in private sector, but what could be value added from thepublic policies?
•Which level of fiscal expenditures to target
–How temporary is the global shock?
•And no small thing: how to get over prejudices?
–Currency board functions well, but much of discussion goes on in “normalmonetary policy” paradigm
–Eg story of huge short term debt burden gets already quite ridiculous
•Exchange rate policy can be stabiliser, but again: you have to playwith the specific rules
–Under fixed exchange rate: build up your own buffers both on financialand fiscal side
Martin Lindpere, Bank of Estonia 26/06/09
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2nd challenge: to meet the Maastrich criteria inorder to join the euro club
•Just now things look promising
–Inflation has been on fast track decline
–Public sector deficit is obviously an issue: not much experience onassessment during ‘exceptional times’
•However, things are not clearcut
–Budget has been able to adjust a lot, but is it enough?
–Budget consolidation should still make long-term sense
•Eg right balance on public investment, education
•EU money is good, but are the targets right?
•For global reasons Estonia might miss the convergence play welluntil next year
–Good or bad?
Martin Lindpere, Bank of Estonia 26/06/09
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All in all: policy conclusions
•Economy has shown its flexibility
•Fiscal prudence has paid off:
–Deficits now are manageable
–Reserves provide room for manoeuvring
–Still: many things to do …
•Financial system integration has paid off:
–No extraordinary stress in financial stability
–High reserve requirements and higher capital adequacy requirements nowvery valuable
•Currency board and fixed exchange rate has paid off:
–Inflation expectations under control
–Clear anchor for restructuring supports (wage) flexibility