4. ESTONIA 1 LEGAL COMPATIBILITY
4.5. LONG-TERM INTEREST RATES
The convergence criterion on long-term interest rates is not directly applicable to Estonia, as no appropriate benchmark long-term government bonds or other comparable securities are available for the assessment. The absence of bonds reflects a very low level of gross public debt and prudent fiscal policies, which led to budget surpluses in 2002–2007. Therefore, it does not as such preclude Estonia from fulfilling the long-term interest rate criterion.
While the linkages between long-term bond yields and other financial market indicators are surrounded by significant uncertainties, alternative indicators may reflect developments relevant for the durability of convergence. Hence, they should be included in a broader qualitative assessment provided that they are interpreted with appropriate caution.
Developments in several financial market indicators suggest a sizeable temporary increase of risk perceptions towards Estonia during the global crisis, followed by a significant easing, in particular since late 2009. The rise of risk perceptions at the height of the crisis reflected both a global deterioration of investor sentiment vis-à- vis Central and Eastern European economies and particular regional factors (including concerns about possible spillovers from Latvia). The rapid reversal of the temporary surge in risk perceptions concerning Estonia, which has implied a significant improvement in Estonia's relative financial market performance within the group of new Member States, appears to indicate a resumption of market confidence in the country's fundamentals, backed up by a determined policy response to the crisis.
Among financial market indicators, interest rates on kroon-denominated loans to households and non-financial corporations peaked during the crisis, after a steady increase in previous years. Interest rates returned to their early-2008 levels in late 2009. However, these interest rates include private sector credit risk and are dominantly driven by market conditions in the banking sector, which is not generally the case for in government bond yields. Also, Estonia's kroon-denominated lending market is very limited and mainly based on variable interest rates (with mark-ups set over short-term money market rates), thus failing to
provide a representative sample for a broader long- term convergence assessment. Retail lending market transactions are mainly denominated in euro, resulting from close international linkages.
0 2 4 6 8 10 12 2004 2005 2006 2007 2008 2009 Graph 4.5.1:Estonia - Interest rate indicator
(percent, monthly v alues)
Note: New definition as of Oct-05; Weighted average interest rate on new EEK-denominated loans to households and non-financial corporations . Source: Eurostat.
Kroon-denominated money market quotations, which by definition reflect short-term developments, surged strongly during the crisis. Short-term spreads rose in line with the broader regional trend and peaked at 5.6 percentage points in March 2009. By March 2010, the spread vis-à- vis euro area money market interest rates returned to below 1.2 percentage points, comparable to levels of mid-2008. Estonia's kroon-denominated money market reflects mainly limited hedging activities of foreign firms with kroon exposure, rather than liquidity conditions in the banking sector.
Sovereign credit ratings and credit default swap spreads – indicators of the risks of holding Estonian public sector debt – also signalled an increase in risk perceptions during the global crisis. Despite Estonia's continuously very low general government gross debt and significant fiscal reserves, credit default swap (CDS) spreads peaked at above 700 basis points in February 2009. In addition, two credit rating agencies downgraded Estonia's sovereign credit rating in 2009, affected by adverse developments in neighbouring countries.
Financial markets' increased differentiation between countries in the region, coupled with the government's strong fiscal consolidation in 2009, contributed to a decline in risk perceptions for Estonia in particular since late 2009. CDS spreads narrowed more strongly than those of Member States with higher credit risk and returned to their mid-2008 levels of below 100 basis points in March 2010. They are currently lower that that of
several euro area members. Credit rating agencies revised their sovereign credit outlook for Estonia from negative to stable in early 2010.
In a broader perspective, the durability of convergence, as required by the long-term interest rates criterion, is supported by continued prudent policies in Estonia. Estonia reinforced the credibility of its commitment to sustainability- oriented policies by maintaining strict policy discipline in the context of the global financial crisis. Flexible wage and price setting mechanisms enabled rapid downward adjustment of domestic costs, providing support to price stability and external competitiveness. External imbalances have reversed rapidly over the last year. Public debt remains by far the lowest in the EU, and substantial fiscal consolidation contributed to enhancing the sustainability of public finances, including by maintaining fiscal reserves.
Altogether, while financial market indicators point to an increase in risk perceptions vis-à-vis Estonia at the height of the crisis, their development during the reference period, as well as a broader assessment on the durability of convergence, would support a positive assessment on Estonia's fulfilment of the long-term interest rate criterion.
Convergence Report 2010 - Technical annex Chapter 4 - Estonia
4.6. ADDITIONAL FACTORS
4.6.1. Developments of the balance of payments
Estonia's external imbalances, which had built up during the boom years, started unwinding rapidly with the turn of the economic cycle in 2008, while the global crisis precipitated the necessary economic adjustment. The external deficit (i.e. the combined current and capital account deficit) declined by half in 2008, and turned into a significant surplus in 2009. The strongest correction took place in the balance of trade in goods, where the deficit declined to less than 5% of GDP in 2009, compared to deficits of 18% of GDP in 2006–2007. At the same time, the already substantial trade surplus in services increased further, driven by transport services. The deficit of the income balance narrowed in 2009, as profits in companies with foreign ownership declined. Positive net capital transfers increased in 2009, reflecting higher inflows of EU structural funds in the 2007–2013 financial perspective.
High external trade imbalances of Estonia in the preceding years were primarily driven by strong import demand, rather than by weak export growth. Estonia's export market share surged temporarily in 2005–2006 mainly due to intense transit trade in motor fuels, while it returned to somewhat lower levels in 2007–2008 after the transit trade contracted. However, real effective exchange rates deteriorated in 2006–2007, as Estonia's prices and labour costs increased faster than those of its trade partners. That said, real appreciation based on unit labour costs in manufacturing was somewhat less pronounced than that based on ULC in the whole economy, which reflected particularly fast wage growth in the non-tradables sector. In 2009, the downward adjustment of wages led to a depreciation of the real effective exchange rate (deflated by unit labour costs), and contributed to restoring Estonia's cost competitiveness. 80 90 100 110 120 130 140 150 2004 2005 2006 2007 2008 2009
NEER REER, HICP d eflated REER, ULC d eflated
Graph 4.6.1:Estonia - Effective exchange rates
Source: Commission services.
(v s. 35 trading partners; monthly av erages; index numbers, 2004 = 100)
Conversely, the real effective exchange rate deflated by consumer price inflation remained broadly stable in 2008–2009, reflecting inter alia high inflation due to surges in administered price and indirect taxes. Strengthening competitiveness, together with increasing the value of exports, has become increasingly relevant for gaining market and support the rebalancing of the economy. The current account deficit up to 2008 was financed by strong capital inflows, mainly channelled through the foreign-owned banks, which fuelled imports. In 2009, subdued domestic demand, aggravated by the global downturn, reduced the need for foreign financing, as reflected in net capital outflows. Banks returned excess liquidity to their parent banks, as retail credit demand declined under tightened financing conditions and an uncertain global outlook. A general decline in profits also reduced reinvested earnings, resulting in lower foreign direct investment inflows. 0 10 20 30 40 50 2004 2005 2006 2007 2008 2009
Gro ss natio nal saving
Gro ss capital fo rmatio n at current prices; to tal eco no my
Graph 4.6.2:Estonia - Saving and investment
(in percent of GDP at market prices)
Source: Eurostat, Commission services.
Improved access to credit, provided by foreign- owned banks at favourable conditions, fuelled gross capital formation in Estonia up to 2008, and led to a significant negative saving-investment gap in 2004–2008. Solid general government surpluses up to 2007 contributed to narrowing the gap, while
strong investment demand, including in real estate, deepened the gap in the years of overheating. In 2009, investment activity declined considerably, while private savings increased, reversing the gap into positive net savings.
High net capital inflows through foreign banks up to 2008 also increased the economy's external debt. Banks' external debt liabilities (mainly to parent banks) continue to constitute more than 50% of total external debt. Triggered by a decline in domestic demand, external debt fell in absolute terms in 2009, while its ratio to GDP continued increasing as GDP contracted. The same dynamics were reflected in the international investment position, which deteriorated in relation to GDP in 2009. The stock of foreign direct investment in Estonia declined in 2008–2009, mainly reflecting lower investment in financial intermediation, and real estate and business activities.
The Commission services' Spring 2010 Forecast projects Estonia's external balance to remain in surplus in 2010–2011, with exports growing faster than imports in 2010 and at broadly the same rate in 2011. Over the medium term, the external balance will depend on further enhancing and upgrading the economy's export capacity and on
ensuring sustainable developments in domestic demand. The ongoing economic adjustment supports the re-allocation of resources into tradables sectors, which needs to be enhanced by appropriate policies. Continued strengthening of flexible labour markets and ensuring an attractive business climate are necessary to underpin foreign direct investment inflows. Ensuring consistency between wage and productivity developments will remain key for both sustainable domestic demand and external balances.
4.6.2. Product market integration
As a small and very open market economy, Estonia has experienced an increasing degree of trade openness over the last years. This was mainly driven by the successful trade re-orientation towards the EU, especially since Estonia joined the EU in 2004. It was also fuelled by the recovery of trade flows with the CIS countries. In 2008, the degree of trade openness (almost 80%) was the highest among the small new Member States. The orientation of Estonia's foreign trade is mostly towards the EU-27, which is a sign of a robust process of economic integration being underway. The average 2004-2008 intra-EU trade in goods ratio was almost three times higher than the extra-
Table 4.6.1:
Estonia - Balance of payments (percentage of GDP) 2004 2005 2006 2007 2008 2009
Current account -11.3 -10.0 -16.9 -17.8 -9.4 4.6
Of which: Balance of trade in goods -16.2 -13.9 -18.1 -17.8 -11.7 -3.7
Balance of trade in services 9.2 7.5 6.0 6.1 7.4 9.6
Income balance -5.3 -4.1 -5.2 -6.8 -6.3 -2.9
Balance of current transfers 0.9 0.4 0.4 0.7 1.2 1.6
Capital account 0.7 0.8 2.2 1.0 1.0 2.8
External balance 1) -10.6 -9.2 -14.7 -16.8 -8.4 7.4
Financial account 12.0 8.2 14.2 15.7 8.9 -6.6
Of which: Net FDI 5.7 15.7 4.2 4.6 3.7 1.1
Net portfolio inflows 6.0 -15.8 -8.0 -2.3 3.1 -10.5
Net other inflows 2) 2.5 11.1 21.6 13.9 5.2 2.8
Change in reserves (+ is a decrease) -2.3 -2.8 -3.6 -0.6 -3.1 0.0
Financial account without reserves 14.2 11.0 17.8 16.2 12.1 -6.6
Errors and omissions -1.4 1.0 0.5 1.1 -0.6 -0.8
Gross capital formation 33.1 33.8 38.7 40.2 29.7 19.4
Gross saving 21.7 23.7 22.5 21.3 19.5 24.1
External debt 77.0 86.5 97.5 111.0 118.5 126.8
International investment position -86.5 -85.2 -74.6 -74.3 -75.3 -81.8
1) The combined current and capital account. 2) Including financial derivatives.
Sources: Eurostat, Commission services and Bank of Estonia.
Convergence Report 2010 - Technical annex Chapter 4 - Estonia
EU trade in goods ratio. Trade integration has been particularly pronounced with the Baltic region and the neighbouring countries such as Finland, Sweden, as well as Germany. Trade flows with the EU have also been supported by the currency board arrangement ensuring stable exchange rates. Trade with extra-EU partners remains important with Russia, followed by Norway and the US. Estonia plays a role of quasi-transit country for Russia, notably with respect to vehicles and mineral products, with very limited processing before re-exporting. However, quasi-transit trade with neighbouring Russia started declining in 2007, after Estonia's political tensions with Russia and the development of Russian ports on the Baltic Sea.
The composition of Estonia's trade in goods has evolved over the last decade, but it still shows an export pattern dominated by raw materials (a third of the total) and labour-intensive products. Estonia's manufacturing exports in 2007 show revealed comparative advantages in furniture and telecommunications equipment. Since 2004, the share of labour-intensive products in exports has declined, while the share of capital-intensive products as well as of research-intensive exports has increased. This change reflects the progressive evolution of Estonia's labour skills and cost competitiveness conditions. The deterioration of cost competitiveness affected particularly the low- skilled intensive sectors and hindered export growth in sectors such as textiles and in specific sub-sectors of machinery. Over the period, there was a gradual shift in Estonia's exports from low technology exports to medium-to-low technology exports, such as chemicals, and there are some favourable prospects for an increase in medium-to- high technology exports. However, the share of exports in high technology goods is still much lower than the EU-27 average. In addition, low export unit values indicate that Estonia's trade specialisation is in rather low quality products. Over the period 2005-2007, Estonia attracted strong FDI inflows (around 10% of GDP), well above the EU-27 average. FDI inflows contributed to enhancing Estonia's export capacity, in particular in the electronic sector, but only to a limited extent. Estonia’s trade specialisation in low-technology and low-skilled processed goods was initially influenced by large investments from Sweden and Finland, and by subcontracting arrangements in the machinery sector (12% of total imports and 15% of total exports in 2008). A large
share of total FDI went into the services sector (notably in financial intermediation) with the bulk coming from the neighbouring countries (Finland and Sweden) while a fifth of total FDI went into the manufacturing sector.
Overall, important efforts have been made to improve the business environment, which will also ease the process of integration. Ongoing efforts, in particular the creation of the one-stop-shop and the acceleration of registration proceedings contribute to improving the regulatory framework and to reducing administrative costs, which should further enhance business dynamism. Reforms in the Labour Law aim to facilitate the transfer of resources to the more productive or export- oriented sectors, as well as to foster productivity. Concerning the transposition of the EU Internal Market directives, Estonia's transposition deficit has recently improved and is now below the 1% EU target.
4.6.3. Financial market integration
Estonia's financial sector is well integrated with the broader EU financial sector, which is testified by cross-border ownership links, convergence of market trends and the role of the euro in domestic financial transactions. Estonia has fully implemented the acquis of the Union in the field of financial services and new directives have been transposed in the national law systematically (30).
The Estonian financial sector is heavily bank- based, which is typical of smaller economies. Between 2004 and 2009, the role of banks in financial intermediation grew further, while capitalisation of the stock market fell significantly. The share of debt securities in total assets of the financial sector remained marginal, although it has slightly increased. (30) See: http://ec.europa.eu/internal_market/finances/actionplan/ind ex_en.htm#transposition. 0 20 40 60 80 100 120 140 160 180
EE, 2004 EE, 2009 Euro area, 2004
Euro area, 2009
Debt securities Sto ck market capitalisatio n Do mestic bank credit
Graph 4.6.3:Estonia - Recent development of the financial system relatively to the euro area
(in percentage of GDP)
Source: Eurostat, Bank of Estonia, Nasdaq OMX, Estonian CSD.
The growing domestic bank credit reflects the credit expansion of the post-accession economic boom, driven mainly by construction activity. Mortgages and loans to real estate business account for about two thirds of total credit to the private sector. The total credit to GDP ratio has converged fairly closely towards the euro area average.
Table 4.6.2:
Estonia - Product market integration
Estonia
2003 2004 2005 2006 2007 2008
Trade openness 1) (%)
: 78.3 84.1 87.7 79.7 78.5
Extra-EU trade in goods GDP ratio 2) (%)
15.5 13.9 14.8 20.4 15.5 14.7
Intra-EU trade in goods GDP ratio 3) (%) 40.2 45.3 49.8 49.2 46.8 45.5
Intra-EU trade in services GDP ratio 4) (%) : 13.5 14.0 13.3 12.8 13.1
Export in high technology 5) (%) 9.4 10.0 10.3 8.0 7.8 :
Technological balance 6) (%) -3.9 -4.2 -5.1 -3.5 -1.9 :
Total FDI inflows GDP ratio 7) (%) 9.4 8.0 20.6 10.8 12.8 8.2
Intra-EU FDI inflows GDP ratio 8) (%) : 6.1 20.1 10.6 12.8 6.7
FDI intensity 9)
: 4.0 11.8 8.4 9.8 5.6
Internal Market Directives 10) (%)
: 5.0 1.3 1.1 1.0 1.1
Value of tenders in the O.J. 11)
: 2.7 7.1 7.4 7.4 8.2
Time to start up a new company 12)
: 72.0 72.0 35.0 35.0 7.0
1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments). 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).
3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics). 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments). 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.
6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3). 7) Total FDI inflows (in % of GDP at current prices).
8) Intra-EU-27 FDI inflows (in % of GDP at current prices).
9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).
10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number. 11) Public procurement - Value of public procurement which is openly advertised (in % of GDP).
12) Time to start a new company (in days), Doing Business World Bank. Sources: Eurostat, Commission services.
Convergence Report 2010 - Technical annex Chapter 4 - Estonia 0 20 40 60 80 100 120
EE, 2004 EE, 2008 Euro area, 2004
Euro area, 2008
Co ncentratio n in the banking secto r (CR5 ratio ) Share o f fo reign institutio ns as % o f to tal assets
Graph 4.6.4:Estonia - Foreign ownership and concentration in the banking sector
(in percent, weighted av erages)
Source: ECB, Structural indicators for the EU banking sector, January 2010.
Compared to the euro area and to the peer countries in the region, the Estonian banking market is strongly concentrated, with the five largest banks holding about 95% of the total assets (CR5 ratio). The Estonian financial sector is almost entirely foreign owned. Nordic banks are the strategic investors in the Estonian banking sector as well as in most non-bank financial institutions. -30 -20 -10 0 10 20 30
EE, 2004 EE, 2009 Euro area, 2004
Euro area, 2008
Return o n equity Capital adequacy No n perfo rming lo ans
Graph 4.6.5:Estonia - selected banking sector soundness indicators relatively to the euro area
%
Note: For 2008, EU-27 non performing loans for are a proxy for EA.
*Subsidiaries only. Source: ECB, Bank of Estonia, Estonian FSA, EC calculations.
*
The banking sector has felt the negative impact of economic recession. The share of non-performing loans increased above 6% by the end of 2009 (31),
compared to very low levels in previous years. Increased loan-loss provisions had a negative impact on banks' profits, previously among the highest in the EU. In 2009, banks recorded significant losses illustrated by a negative return on equity ratio. At the same time, banks were increasing their capital buffers, mainly Tier I funds. As a result, the capital adequacy ratio increased to 22% as of end-2009, well above the required minimum and also the euro area average. The evolution of banking soundness indicators corresponded to trends prevailing in the euro area, although featuring higher amplitudes.
(31) Loans overdue for more than 60 days as % of total
portfolio of loans to non-financial sector. Data for Q3 2004 and Q3 2009 (Graph 4.6.5).