ESTONIAN ECONOMYAND MONETARY POLICY

2/2015

Eesti Pank

The Estonian Economy and Monetary Policy is an Eesti Pank review that contains a description of the

main recent events in the global market and in the Estonian economy and the forecast for the Estonian

economy for the current calendar year and the next two.

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ISSN 1736-7867Layout and design Urmas RaidmaPrinted by Folger Art

CONTENTS

SUMMARY .......................................................................................................................................... 4

THE EXTERNAL ENVIRONMENT ......................................................................................................... 6

THE GLOBAL ECONOMY ................................................................................................................ 6

Box 1: Key political events: the IMF fiscal policy message to the countries of the euro area .......... 9

THE EURO AREA .......................................................................................................................... 10

Box 2: The monetary policy environment of the euro area .......................................................... 11

ESTONIA’S MAIN TRADING PARTNERS ........................................................................................ 13

THE ESTONIAN ECONOMIC ENVIRONMENT .................................................................................... 16

ECONOMIC ACTIVITY ................................................................................................................... 16

Box 3: The impact of the fall in the oil price on the Estonian economy ........................................ 17

DOMESTIC DEMAND .................................................................................................................... 19

Box 4: Investment by the Estonian corporate sector .................................................................. 21

EXTERNAL BALANCE AND COMPETITIVENESS ........................................................................... 23

THE LABOUR MARKET ................................................................................................................. 25

Box 5: Matching of jobs in Estonia ............................................................................................. 27

PRICES ......................................................................................................................................... 28

GENERAL GOVERNMENT FINANCING ......................................................................................... 30

ECONOMIC FORECAST 2015-2017 .................................................................................................. 31

THE INTERNATIONAL ECONOMIC ENVIRONMENT ....................................................................... 31

REAL GDP GROWTH .................................................................................................................... 32

PRICES ......................................................................................................................................... 36

Box 6: Indicators for Estonian core inflation ............................................................................... 38

GENERAL GOVERNMENT FINANCING ......................................................................................... 39

RISKS TO THE FORECAST ........................................................................................................... 40

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SUMMARYAs has been the case several times previ-ously, growth has not revived in the global economy at the expected rate. Growth has

been slower than forecast in both advanced

and emerging economies, with emerging econ-

omies proving particularly weak. Their progress

is largely dependent on the export of commodi-

ties, but commodities prices have not started to

rise and have remained very low. Commodities

importers, mainly advanced economies, have

mostly benefited from low commodities prices.

Growth in Estonia has not accelerated this year as it had been expected to, and has been slower than it was last year. Production

capacity in the business sector should make the

Estonian economy capable of growing by around

3% this year, but actual growth is forecast to be

only 1.2%. It is mainly being held back by weak

demand in trading partners, and export oppor-

tunities for companies are few and far between.

In consequence, less is being invested in fixed

assets as there is no desire to increase produc-

tion capacity. Economic growth will accelerate in

the next two years, but quite modestly to 2.2% in

2016 and to 3.1% in 2017. This outlook for growth

in the years ahead is more pessimistic than it was

six months ago.

The economy has largely grown in recent years on the back of increased employment, but this will not be possible any longer. Lower unemployment and increased employ-

ment have aided the Estonian economy since the

crisis: it has been relatively easy for businesses

to find new employees, while household incomes

and consumption have risen significantly. The

real disposable income of households has also

been lifted by a rise in the income tax threshold,

increased social benefits, a cut in income tax

rates and falling prices. A shrinking working-age

population will cause employment to start to fall,

and that will restrict GDP growth in future through

both output and consumption.

The matching of job-seekers and vacant positions has so far been better than expected, but the situation in the labour

market will become tighter in the near future. The unemployment rate has already

fallen to 5.2% and the share of people active in

the labour market has climbed to its highest level

this century among the working-age population.

This means that neither of those routes will be

able in future to compensate for the shrinking of

the working-age population to the same degree.

Some easing will arrive when the work capacity

reform comes in in 2016, although many of those

entering the labour market will probably not find

work immediately because they do not have the

appropriate skills or knowledge, and the unem-

ployment rate will rise in consequence. The

shortage of labour means that the rise in the

average gross wage will not slow significantly in

the next two years.

The competitiveness of the exporting sector and so the potential for growth of the economy is under more pressure than previ-ously. The share of Estonian exports in foreign

markets has declined this year, possibly because

of higher labour costs and reduced price-based

competitiveness. Demand from trading partners

will increase in the years ahead but the recovery

in demand will be fragile. If foreign markets prove

weaker than expected, a decline in the competi-

tiveness of exporters could lead exports to shrink

by even more.

Faster growth in Estonia depends primarily on increased growth potential. Labour

productivity has fallen steadily this year, because

although value added is almost unchanged from

a year earlier, employment has increased by

4%. Falling productivity and rapidly rising wages

are not together sustainable, and in the coming

years growth can only increase through higher

productivity.

The faster productivity growth than in the rest of Europe has abated, but Estonia has several advantages that can aid growth. The

capacity for growth is supported by stable public

finances and the low sovereign debt, the flexible

labour market, lower indebtedness in the private

sector, and favourable borrowing conditions.

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Interest rates on loans will remain low throughout

the forecast horizon, but there is a risk that

Swedish asset prices may fall, which would harm

the ability of the banks to provide funding.

Inflation will turn positive at the start of next year and will pick up further throughout the forecast horizon. The rise in inflation will be

broad-based as most commodities prices are

currently low. The expected increase in these

prices will pass through to consumer prices here

concurrently with a rise in the prices of other

imports, since trading partners will also see

prices rising faster at the same time. Services

prices will rise in response to higher labour

costs, and around one third of the expected rise

in prices will come from higher consumption

taxes, as excise on fuel, alcohol and tobacco

will increase. Higher inflation will put a brake on

growth in consumption.

Estonian fiscal policy has been appropriate for the current economic climate, especially given that revenues from taxes on labour and consumption have substantially outstripped overall economic growth. Although the tax

base for direct and indirect taxes is above its long-

term sustainable level, the general government

needs to restrain growth in spending. A fiscal

policy that stimulates growth through domestic

demand would take the economy even further

out of balance. Increased spending should be

based on the long-term capacity for growth in the

economy, and there should be a clear source of

funding for each additional item of spending. The

government confirmed in its last budget strategy

its commitment to keeping the budget in balance

in the medium term, and Eesti Pank forecasts

that this can be achieved. The conservative fiscal

policy should be adhered to so that fiscal policy

can be used if necessary to counterbalance the

economic cycle.

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THE GLOBAL ECONOMY

Global economic growth has proven some-what lower in 2015 than was expected at the start of the year. Growth in emerging econo-

mies has slowed further while that in advanced

countries has been weaker than projected. As a

result, global growth has been more modest this

year than it was last year. The most recent fore-

cast from the International Monetary Fund (IMF)

put growth for 2015 at close to 3.1%, which is

0.3 percentage point less than in 2014 (see Table 1).

The external environment has become less favourable for a majority of developing coun-tries. Financial markets have become more vola-

tile and the expectation is that US monetary policy

interest rates will rise soon. Capital inflows to devel-

oping countries have diminished in consequence

and their currencies have depreciated against

the US dollar and the yen, and to a lesser extent

against the euro. The slower growth in emerging

economies has been driven by China as the rapid

engines of growth there have started to run slower

to an extent and the country is moving gradually

towards a more sustainable economic model.

Having grown by 7.4% last year, the Chinese

economy will not pass 7% this year, and indicators

for activity concur that the Chinese economy has

clearly started to cool. Slower growth has reduced

demand in China, and this in turn has affected the

whole global economy, especially the outlook for

countries that are dependent on commodities

exports. Despite the slower growth, the Chinese

economy still provides more than one third of the

total global growth.

Global inflation has remained low in reaction to the slower growth and to low commodi-ties prices, especially the oil price. Inflation

in industrialised countries has remained close

to zero and below the levels targeted by central

banks. Monetary policy in advanced countries

has remained accommodative as a result and

interest rates have favoured borrowers. Financial

markets expected at the start of the year that

the Federal Reserve in the United States would

start to raise interest rates in the autumn, but

those expectations have now been deferred to

the end of the year1. More modest inflation pres-

sures have meant that the central banks in most

emerging economies, including China and India,

have been able to loosen their monetary policy in

order to stimulate their economies. Despite rapid

inflation, the Russian central bank cut its mone-

tary policy interest rate further in the summer

but central banks that are battling high inflation

or depreciating currencies have had to raise

their interest rates. The central bank in Brazil

has raised rates there even though the economy

has been in recession and has thus given a clear

message that price stability is its top priority.

Low interest rates mean that asset prices have risen in financial markets. The S&P

500 stock market index in the US has remained

close to all-time highs this year, the Japanese

Nikkei index was up almost 14% in the middle of

1 Bloomberg data from 26 November 2015 put the probability derived from interest rate future transactions that the Federal Reserve would raise rates in December at over 70%.

THE EXTERNAL ENVIRONMENT

Table 1. GDP growth in different regions (change, %)*

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

World 4.9 5.5 5.7 3.1 0.0 5.4 4.2 3.4 3.3 3.4 3.1

Advanced economies 2.7 3.1 2.8 0.2 -3.4 3.1 1.7 1.2 1.1 1.8 2.0

Emerging markets and develo-ping economies 7.3 8.2 8.7 5.8 3.1 7.5 6.3 5.2 5.0 4.6 4.0

Euro area 1.7 3.2 3.0 0.5 -4.6 2.0 1.6 -0.8 -0.3 0.9 1.5

United States 3.3 2.7 1.8 -0.3 -2.8 2.5 1.6 2.2 1.5 2.4 2.6

China 11.3 12.7 14.2 9.6 9.2 10.6 9.5 7.7 7.7 7.3 6.8

Japan 1.3 1.7 2.2 -1.0 -5.5 4.7 -0.5 1.7 1.6 -0.1 0.6

United Kingdom 2.8 3.0 2.6 -0.3 -4.3 1.9 1.6 0.7 1.7 3.0 2.5

* GDP at constant prices, 2015 is forecastSource: World Economic Outlook, October 2015

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November from the start of the year, and the Euro

Stoxx index in the euro area has climbed 10% this

year (see Figure 1). Optimism has been boosted

by the postponement of interest rate rises in the

USA and by signals from the European Central

Bank that monetary policy could be loosened

even further. Uncertainty about when exactly US

rates will rise has markedly increased volatility

in financial markets however (see Figure 2). This

was amplified at the end of summer by nerves

in the Chinese stock market as the share index

dropped almost 40% in a month and a half,

having risen rapidly for almost a year prior to that.

Other stock markets around the world also fell

under the impact from China. The descent of the

Chinese stock market was arrested in September

by the Chinese central bank and government

interventions, and share prices in major markets

started to rise again in October.

Yields in bond markets have been affected by the likelihood of interest rates rising at different times in the major advanced economic regions. The expectation that rates

in the US will soon rise while no rise is planned in

other major economic regions in the near future

has led bond yields to move in different directions.

The spread of interest rates on US and Japanese

two-year sovereign bonds has increased by some

20 basis points since the start of the year, and the

spread on US and German bonds has increased

by over 40 basis points. The divergence in

interest rates has led the dollar to appreciate,

and in the middle of November the dollar was up

by over 7% over the year against the yen and by

almost 14% against the euro. There has been no

major change in the euro area since the start of

the year in interest rate spreads over Germany.

After the third Greek bailout package was agreed

at the end of summer, the yield on Greek ten-year

government bonds had fallen from almost 19% to

7% by the middle of November.

Prices in commodities markets have mainly moved downwards in the past six months. The price of a barrel of oil hit a new low of

40 dollars but then rose back to around 50 dollars

and has remained below 50 since October. The

oil price has lost more than 40% in the past

12 months (see Figure 3). This is partly because

supply remains strong and partly because

Figure 1. World stock indexes (01/01/2015=100%)

90%

100%

110%

120%

130%

140%

150%

160%

01/2015 04/2015 07/2015 10/2015

S&P 500 Nikkei 225 SSE CSI 300 Euro Stoxx 50 MICEX

Source: BloombergLast observation 19/11/2015

Figure 2. Stock market volatility indexes in USA and Europe

10

14

18

22

26

30

34

38

01/2014 07/2014 01/2015 07/2015

VIX (USA)V2X (Europe)

Last observation 19/11/2015 Source: Bloomberg

Figure 3. Commodity price changes

-50% -40% -30% -20% -10% 0%

lumber

wheat

iron ore

steel rebar

oil

gold

nickel

CC CRB

change since 19/11/14 change since 01/01/15

Last observation 19/11/2015 Source: Bloomberg

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demand is down slightly in emerging econo-

mies because economic activity there has been

quieter. Slower growth in China has had a major

impact on prices of metals, as China takes in

around half of all metal commodities. Prices for

metals overall have fallen by more than 20% this

year, while food prices have fallen more than 10%

at the same time.

Growth has continued to recover in the USA. The IMF finds that growth should pick up

to 2.6% this year. It was weaker than expected in

the third quarter at an annualised rate of 2.1%.

This has been strongly affected by a reduction

in stocks, which could indicate that companies

are feeling uncertain about sales in the future.

Although the dollar has strengthened and

Chinese growth has been slower, the contribu-

tion of net exports has not slowed GDP growth

in the USA much. Growth has again been driven

largely by private consumption, which has been

aided by improvement in the labour market and

an increase in the purchasing power of house-

holds. Inflation has remained around zero

throughout the year, mainly because commod-

ities prices have been low. Core inflation, which

excludes volatile energy and food prices, has

increased gradually during the year from 1.6% in

January to 1.9% in September.

The Chinese economy has continued to cool. Although activity indexes indicate a clear

slowing of growth, official statistics show the

Chinese economy grew by 6.9% year on year in

the third quarter. China’s growth target for the

year is 7%, which would be the slowest level

seen for the past 15 years. China has started to

work on reforming its economy and is moving

steadily towards markets playing a larger role. On

11 August the Chinese central bank announced

a change in its exchange rate policy. Under the

new policy the daily fluctuation limits for the yuan

will continue to be set at +/-2% against the dollar,

but the central rate is taken as the closing rate in

the market of the previous day, having previously

been set by the central bank itself. The yuan has

lost 3.3% against the dollar this year. The cooling

of economic activity has led the Chinese central

bank to loosen its monetary policy several times

this year, cutting both interest rates and the

reserve requirements for banks.

Growth has remained weaker than expected in Japan. The economy shrank during the

second quarter by 0.3% and then did so again in

the third quarter, with initial estimates putting it a

further 0.2% down. Lower demand from neigh-

bouring countries brought Japanese exports

down by 0.8% during the second quarter and

this had a significant negative impact on GDP

growth. Although household incomes increased,

private consumption was lower than expected,

and it also made a negative contribution to GDP

growth. Inflation in Japan has remained around

zero, as it has in other advanced countries. In the

first months of the year inflation reached 2.3%,

but this was driven by a rise in VAT last April.

Core inflation has gradually perked up in Japan,

reaching 0.9% in September. Modest levels of

economic activity and low inflation have led to

the expectation that the Japanese central bank

will take further measures to loosen monetary

policy, and in September the Japanese Prime

Minister unveiled a new package of measures

to revive economic growth. The plan aims to

increase Japanese GDP by around 20% over the

next five years.

The economy in the United Kingdom has continued to grow fast. Growth slowed to 2.3%

in the third quarter, and while private consump-

tion remains strong, exports were weaker than

expected. Manufacturing output has declined

each quarter for the past three quarters, but

confidence remains high in industry despite this.

The labour market has clearly started to improve

as unemployment fell to 5.3% in September, its

lowest level for seven years, while wage growth

is picking up. Inflation in the United Kingdom has

remained around zero this year and core inflation

has fallen over the year from 1.4% in January

to 1% in September. The weaker outlook for

global growth and weak inflation pressure has

led markets to expect a delay in the tightening

of monetary policy by the Bank of England, as

with the Federal Reserve in the USA. It is now

expected that interest rates will rise in the United

Kingdom only at the end of 2016.

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Box 1: Key political events: the IMF fiscal policy message to the countries of the

euro area

It is the mission of the International Monetary Fund, the IMF, to support the sustainability of global

economic growth by giving member states economic policy advice on monetary, fiscal and financial

policy and on structural reforms. As the world economy has not yet recovered from the global finan-

cial crisis, the IMF has advised countries to use monetary policy to create an economic climate that is

supportive of growth. This can help in making structural reforms that will boost potential GDP. It is the

opinion of the IMF that the fiscal policy of members should also support growth where possible, but the

fiscal policy of countries with open economies is an important tool for ensuring that growth is stable.

Since the global financial crisis, the IMF has recommended euro area countries follow fiscal policies that

encourage growth by focusing on cutting taxes on labour and capital and by maintaining sustainable

fiscal stances. The IMF then recommends compensating for the lost tax revenues by widening the tax

base or reducing non-productive costs in the public sector. The IMF recommendations are not universal

however, and countries that are in a strong fiscal position have been advised to use their budgets for

infrastructure investments and structural reforms. At the same time these countries may not increase

their budget deficit to more than 3% of GDP though, as that is the upper limit set in the European

Union’s Stability and Growth Pact. The IMF is primarily thinking of countries with large current account

surpluses, like Germany and Holland, where demand could be boosted in the shorter term by public

sector investment, which would also lift the potential GDP of the country in the longer term. A stimulus

like this would help balance the economy of the whole euro area. Analysis by the IMF suggests that

highly productive infrastructure projects at a time of slow growth could even have a revitalising effect in

the short term without significantly increasing sovereign debt as a ratio to GDP. The size of the positive

impact of such large projects, and how quickly it would be felt, obviously depends to a large extent on

the need for infrastructure investment in each country and the return on each individual project.

The primary advice from the IMF for countries with large debt levels is to reduce budget deficits and

meet fiscal goals. Spain has been advised for example to slow the growth in sovereign debt to a

sustainable level by cutting its budget deficit in steps of 0.5 percentage point a year. Fiscal discipline

is important not only to ensure that public debt is sustainable, but also to underpin the stability of the

economy, especially for small countries. As a small and open economy, Ireland has been advised by the

IMF to keep its budget in balance over the economic cycle so as to reduce its debt burden and leave

it in a better position to weather any external shocks. The IMF classes Sweden as a small and open

economy too, and one where the ageing population and the large financial sector make reducing the

budget deficit necessary. Luxembourg has a small but growing debt and has been advised to keep its

budget in surplus in the medium term.

The IMF mission came to Estonia on its official visit in autumn 2015 for the Article IV Consultations.

The assessment at the end of the visit found that the outlook for Estonian economic growth over the

medium term is supported by strong key figures such as the excellent financial position of the public

sector and large government investments. The IMF finds that Estonia could make its structural budget

balance requirement more flexible over the longer term while still maintaining a conservative fiscal policy.

It is the opinion of Eesti Pank that productive public sector investment can favour economic growth, but

the conservative fiscal policy that has been followed so far must be maintained and the budget kept

in balance over the medium term. Estonia is a small and open economy like Luxembourg or Sweden,

and is exposed to risks coming from the external environment. As the economic climate and budget

revenues are changeable, it is better for the government to have some flexibility while maintaining struc-

tural fiscal balance, by building up buffers when the economy is growing and taking countercyclical

measures if risks materialise.

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THE EURO AREA

The euro-area economy has continued its slow recovery. It grew in the second quarter by

0.4% quarter-on-quarter and 1.5% year-on-year

with support coming from private consumption,

which was boosted by low energy prices, rising

real wages and low interest rates. A cheaper

euro has helped improve the competitiveness of

exports from the euro area, and net exports made

a positive contribution to growth in the second

quarter. Although global demand is generally

quite uncertain, confidence lifted in the euro

area in September and in October. The index of

economic confidence published by the European

Commission was notably higher as retail, indus-

trial and services companies have better expec-

tations for demand in the coming months. The

flash estimate shows that the economy grew in

the third quarter by 1.6% year-on-year and 0.3%

quarter-on-quarter. Activity indexes predicted

growth of 0.4% in the third quarter, thus the

actual estimate is slightly below this expectation.

Although interest rates are favourable, investment in fixed assets has been restrained in the euro area. Capacity utili-

sation in industry has increased, hitting 81% in

the second and third quarters, which is around

its historical average (see Figure 4). Despite this,

investment was down 0.5% in the second quarter,

and euro-area investment is now 15% lower than

it was before the financial crisis.

The situation in the labour market has improved slightly. Employment in the past six

months has been higher than a year earlier, and it

was up 0.9% over the year in the second quarter.

The number of people in employment is still

smaller than it was before the crisis, and in the

second quarter of the year it was 2.2% lower than

in the first quarter of 2008. The unemployment

rate has fallen steadily over the year, to 10.7% in

October. The labour market varies widely from

country to country as unemployment is highest

in Greece and Spain at over 20%, but it fell in

the euro area’s largest economy, Germany, to

4.5% at the end of summer. High unemployment

has kept wage pressures weak in the euro area,

though this again varies from country to country.

Inflation has not risen in the euro area, as commodities prices have been low. Energy

was almost 9% cheaper in the consumer basket

in September and October than a year earlier. The

weakness of the euro has led prices of imports

and commodities to fall by less, and without this

depreciation, the downwards pressure on prices

would have been even bigger. Core inflation in the

euro area has remained around 1% (see Figure 5).

Lower inflation has led the inflation expectations

reflected in financial derivatives to decline some-

what in the second half of the year for both the

short and long terms. The forecast in the markets

for long-term euro-area inflation remains around

1.8–1.9%.

Figure 4. Investments in the euro area

60%

65%

70%

75%

80%

85%

90%

80

85

90

95

100

105

2008 2010 2012 2014

investment in fixed assets, Q1 2008 = 100 (left scale)capacity utilisation (right scale)

Sources: Eurostat, European Commission

Figure 5. Euro-area inflation

-1%

0%

1%

2%

3%

2012 2013 2014 2015

all items core inflation

Source: Eurostat

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Box 2: The monetary policy environment of the euro area

The monetary policy environment of the euro

area remained favourable in the second half of

2015. The Governing Council of the European

Central Bank held monetary policy interest rates

at their lowest levels under the economic and

monetary union, with the minimum bid rate on

main refinancing operations at 0.05% and the

lending facility rate at 0.30%, and the deposit

facility rate cut by a further 10 basis points on

3 December to -0.30% (see Figure B2.1). The

Governing Council has emphasised that key

interest rates will remain low for an extended

period, and said it is willing and able to act by

using all the instruments available within its

mandate if warranted in order to maintain an

appropriate degree of monetary accommoda-

tion. Even so, monetary policy should be in line

with the price stability aim of keeping inflation

rates below but close to 2% over the medium term. The December forecast by experts from the

Eurosystem finds that inflation will remain low in the euro area for some time yet, but will rise to

1.6% in 20172. The Governing Council of the European Central Bank observes the risks to price

stability closely, particularly the transmission of monetary policy measures into the economy,

and developments in the exchange rate and in energy prices, including the impact of geopolitical

tensions.

Annual growth of the money supply in the euro area has increased significantly in 2015, primarily

because of the comprehensive package of accommodative measures passed by the European

Central Bank. The broad monetary aggregate M3 has increased by close to 5% in the second

half of the year. The annual growth in the stock of household deposits has remained constant,

while there has been a slight acceleration in the rate for corporate deposits. The worrying events

of the summer in Greece caused a temporary outflow of deposits from banks there, but this

did not have a major impact on the overall deposits of the euro area. The interest rates for

non-financial sector deposits remain low at close to 0.5%, and have fallen by more than

150 basis points from 2012. Annual growth in lending to the non-financial sector picked up in

summer and autumn 2015 with growth in the volume of housing loans climbing above 1% and

the stock of corporate loans starting to increase gradually for the first time since early 2012. This

indicates that the monetary policy measures have had a positive effect on the credit channels

to the private sector. However, the latest Bank Lending Survey of the euro area shows that the

lending conditions to the non-financial sector have loosened3 and demand for credit has started

to grow. This has been facilitated by the reduced costs of funding for the banks. Although opin-

ions vary from country to country, euro-area credit institutions are generally expecting these

trends to continue in the coming quarters, and have noted a marked improvement in the credit

market, especially for companies. The positive impact of various monetary policy measures

2 European Central Bank press conference, 3 December 2015.

3 See http://www.ecb.europa.eu/stats/money/surveys/lend/html/index.en.html. Changes in lending conditions are inter-preted in the survey by analysing the net difference in the shares of those banks that have noted in the review that they have tightened credit conditions such as margins or collateral demands, and those banks that said they have loosened their conditions. A negative net rate means that a majority of banks have loosened their credit conditions.

Figure B2.1. Eurosystem key interest rates and EONIA

-1%

0%

1%

2%

3%

4%

5%

6%

2008 2009 2010 2011 2012 2013 2014 2015

ECB's key interest rate EONIA or Euro OverNight Index Average deposit facility rate lending facility rate

Source: European Central BankLast observation 03/12/2015

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has gradually been passed into the loan interest

rates of the non-financial sector, and the loan

rates on mortgages and on corporate loans are

more than 140 basis points lower than in 2012.

The package of monetary policy measures from

the European Central Bank is still large and its

expected positive total effect on the economy

of the euro area will be seen in the medium term

because monetary policy passes through into

the economy with a lag4. The Eurosystem is

offering credit institutions targeted longer-term

refinancing operations (TLTRO) from September

2014 to June 2016, which are primarily for further

lending onwards to non-financial companies in

the private sector. In the five rounds of offers so

far, 400 billion euros have been lent. The port-

folio of covered bonds bought under the third

covered bond purchase programme (CBPP3) started in autumn 2014 stood at 138 billion euros

on 27 November, and that of the asset-backed securities purchase programme (ABSPP) stood

at 15 billion. The portfolio bought under the public sector asset-purchase programme (PSPP)

started in March 2015 stood at 445 billion euros at the end of November (see Figure B2.2), of

which 48 million was purchases by Eesti Pank as at 30 November. The total value of purchases

planned under the three programmes is 60 billion euros each month. The balance sheet of the

European Central Bank was worth 2.7 trillion euros in November, which was 30% larger than

in autumn 2014 due to the measures that were taken. In July 2015 the European Central Bank

published the guiding principles of Eurosystem-preferred eligible securities, which should be

followed for purchases of asset-backed securities. In September the issue share limit for the

public sector purchase programme was raised from 25% to 33% for transactions where the

Eurosystem does not hold a blocking minority. The Governing Council decided at its meeting of

3 December to extend its purchases of assets for a further six months, so they will continue until

at least March 2017, and certainly until there is visibly a lasting correction in euro-area inflation

that is in line with the price stability goal of the Eurosystem. The meeting also announced a

reinvestment policy for securities purchased under the asset purchase programmes once they

have passed their maturity, and it added euro-denominated marketable debt instruments issued

by regional and local governments located in the euro area in the list of assets that are eligible

for regular purchases. It was also decided to extend the main refinancing operations (MROs)

and the three-month longer-term refinancing operations as fixed rate tender procedures with full

allotment for as long as necessary, and at least until the end of 2017.

The accommodative monetary policy in the euro area has helped short-term money market

interest rates to fall in 2015 to their lowest ever levels. Expectations for short-term interest rates

remain low, which also affects long-term interest rates. EONIA5 was more stable between May

and November than in the first half of the year, partly because of increased excess liquidity, and

it ranged from –0.14% to –0.11%, excluding the last days of each month, when interest rates

are higher for technical reasons. At the end of November the three-month EURIBOR6 was down

4 The transmission mechanism of the non-standard monetary policy measures taken by the European Central Bank is described on pp 32–51 of the ECB Economic Bulletin 7/2015.

5 Euro OverNight Index Average for overnight lending between banks in the euro area.

6 The Euro Interbank Offered Rate for lending between banks across Europe.

Figure B2.2. Eurosystem holdings under the expanded asset purchase programme

0

100

200

300

400

500

600

700

Oct

No

v

Dec Jan

Feb

Mar

Ap

r

May

Jun

Jul

Aug

Sep

t

Oct

No

v

Dec

2014 2015

EU

R b

illio

n

public sector purchase programme third covered bond purchase programme asset-backed securities purchase programme

Source: European Central BankLast observation 27/11/2015

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10 basis points from May at –0.11%, the

six-month EURIBOR was down 9 basis points

at -0.04%, and the twelve-month EURIBOR was

down 11 basis points at 0.05% (see Figure B2.3).

The money market yield curve as shown by the

gap in the 1 and 12-month EURIBORs was the

same as in May at 20 basis points. The stable

movements in the EURIBORs was replaced by

a sharp fall in the second half of October. This

was partly a consequence of the press confer-

ence after the European Central Bank’s mone-

tary policy meeting, where the bank’s president

said that the degree of monetary policy accom-

modation would need to be re-examined at the

December monetary policy meeting, when the

new Eurosystem staff macroeconomic projec-

tions are available7.

7 European Central Bank press conference, 22 October 2015.

Figure B2.3. Euro-area money market interest rates

-1%

0%

1%

2%

3%

4%

5%

6%

2008 2009 2010 2011 2012 2013 2014 2015

3-month EURIBOR6-month EURIBOR12-month EURIBOR

Source: BloombergLast observation 30/11/2015

ESTONIA’S MAIN TRADING PARTNERS

The economies in Estonia’s trading partners have generally been satisfactory, though economic activity is still weak in Finland and Russia. Estonia is affected most by the

economic difficulties in Russia as the deprecia-

tion of the rouble and falling demand have sharply

reduced demand for imports there. The low level

of economic activity in Russia and the slowing

growth in China are in turn having a negative

impact on the external trade of other trading part-

ners. Growth in Estonia’s main trading partners is

largely driven by household consumption, which

is supported by the stable labour market and

falling consumer prices. The purchasing power of

Finnish households is being limited by high unem-

ployment and modest real wage growth. The

Swedish economy is performing well with support

from the accommodative monetary policy of the

central bank and the weaker Swedish krona.

Recent developments in the other two Baltic states have generally been about the same for the past few quarters. Annual growth

increased to 3.3% in Latvia in the third quarter

and to 1.7% in Lithuania (see Figure 6) and both

economies also grew in the third quarter in quar-

terly terms. Growth has largely been driven by

rising household incomes in recent quarters

and by private consumption, while exports have

been a drag on the economy because demand

for imports in Russia has been weak. Exports of

goods from Lithuania have continued to decline,

but Latvia has managed to offset its loss of goods

exports to Russia to an extent, as exports have

increased to the USA, the European Union and

Asia. Investment activity in Latvia and Lithuania

has increased, with the impetus coming from

construction and from investments in machinery

and equipment. Trends in the labour market

Figure 6. Trading partners' GDP, yearly growth rate

-10%

-5%

0%

5%

10%

2010 2011 2012 2013 2014 2015

Latvia Finland Sweden Lithuania Russia

Source: Eurostat

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have been positive as employment increased

in the first half of the year and unemployment

has fallen from a year earlier. Although services

prices have risen steadily, low commodities

prices have kept inflation weak in Latvia, while

prices in Lithuania have been falling throughout

the whole year (see Figure 7).

The Finnish economy slipped back into recession, with the flash estimate from Statistics Finland reporting third quarter GDP to be 0.2% down on the previous year, and down on the previous quarter too. The

economy has been constrained by the weak-

ness of the external environment and by struc-

tural and cyclical problems. The difficulties in the

Russian economy have reduced foreign trade,

while global demand for investment goods,

which make up a large part of Finnish exports,

has been weak for a long time. Manufacturing

and construction have made negative contribu-

tions to total growth though there has been a

rise in new orders for manufacturing in the first

nine months of this year. Household consump-

tion is being limited by high unemployment and

low real wage growth. The Finnish government

had to accept a broad based programme of

budget cuts, which is putting further pressure

on household purchasing power, which was

already weak. Employment has been falling since

the start of 2013. Low commodities prices and

weak domestic demand mean that consumer

prices have been falling throughout this year.

Economic activity in Sweden has remained strong. Growth accelerated in the third quarter

to an annual 3.9% and was also strong in quar-

terly terms. It has been boosted considerably by

strong domestic demand combined with foreign

trade benefiting from a weak Swedish krona.

Exports of goods to the USA and Germany

increased significantly in the first three quarters

of this year, while car production has led a rise

in manufacturing output volumes. Economic

activity is also supported by the expansionary

monetary policy of the Swedish central bank,

which has encouraged household consump-

tion and investment. Although low commodi-

ties prices have kept inflation around zero, core

inflation excluding energy prices has picked up

in the past few months. Higher core inflation led

the Swedish central bank to keep its repo rate at

–0.35% in October. At the same time the central

bank decided to extend the government bond

purchasing programme to the middle of 2016.

The bank also warned that high levels of house-

hold indebtedness and low interest rates make it

necessary to find a balance between supply and

demand in the housing market.

Economic activity in Russia has declined considerably. The flash estimate showed

the economy shrinking a little more slowly

in the third quarter, though still by a substan-

tial 4.1% over the year. Exports stayed deep in

negative territory and the foreign trade surplus

contracted. Output volumes in construction and

manufacturing continued their slide downwards

in September, while private consumption was

restricted by the fall in real incomes. Geopolitical

tensions have not eased, and the economic

pressure from sanctions between Russia and

the European Union was added to the pressure

from the low oil price and the volatility in the

rouble exchange rate. The rouble depreciated

against the US dollar to an all-time low in August,

though a rising oil price has strengthened it in

the past three months. Inflation pressures have

not eased, and annual consumer price growth

was 15.6% in October. The Russian central bank

finds that the balance between high inflation

and low growth has not changed, and it kept its

monetary policy rate at 11% in October.

Figure 7. Trading partners' CPI inflation

0%

3%

6%

9%

12%

15%

18%

-2%

-1%

0%

1%

2%

3%

4%

2012 2013 2014 2015

Latvia Finland Sweden Lithuania Russia (right scale)

Source: Eurostat

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Estonia’s nominal effective exchange rate (NEER) fluctuated a lot against the curren-cies of its main trading partners this year. This has mainly been because the rouble has

been so volatile. The rouble hit an all-time low

against the euro in December last year, which

raised Estonia’s NEER against a basket of the

currencies of its trading partners. The rouble

started to strengthen at the beginning of 2015,

pushing the NEER down, but in August the

rouble was again down against the euro and so

the Estonian NEER rose in consequence. The

stronger Estonian NEER is also partly due to the

Swedish krona being weaker (see Figure 8).

Figure 8. Change in the euro exchange rate and NEER from the start of 2012

-20%

0%

20%

40%

60%

80%

100%

-8%

-4%

0%

4%

8%

12%

16%

2012 2013 2014 2015

Estonian NEER against trading partners (left scale)SEK/EUR (left scale)RUB/EUR (right scale)

Sources: Reuters, Eesti Pank

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THE ESTONIAN ECONOMIC ENVIRONMENTECONOMIC ACTIVITY

Growth was modest in the first three quar-ters of 2015. The economy grew over the year

by 1% in the first quarter, 2% in the second and,

according to the flash estimate from Statistics

Estonia, 0.5% in the third. Third quarter growth

was markedly slower than was expected in the

June forecast, though this is only a flash estimate,

and these have subsequently been corrected

upwards by an average of 1.3 percentage points

in recent years. A large share of the growth in

the first three quarters of this year came from net

taxes on products (see Figure 9). These revenues

have been lifted by faster growth in retail sales

and by better tax collection.

Growth in 2015 has been weak partly because of the depreciation of the rouble, which has reduced exports of goods and services to Russia. Goods originating from other countries

play a large part in exports to Russia though,

and so the drop in Russian demand has a limited

impact on the Estonian economy. The impact is

mainly felt in the value added of intermediation

sectors like transport and storage or wholesale.

As well as exports to Russia, which have little

value added, transit has also declined and in the

second quarter of 2015, less than half as much

was unloaded as transit goods in Estonian ports

as a year earlier. There are also companies in

other sectors, including the industrial sector, for

which Russia is an important export destination.

The diminution of Russian purchasing power has

hit tourism too, and the number of overnight stays

by Russian tourists in Estonian accommodation

establishments was down by one third over the

year in the first nine months of 2015.

Industry was affected in the first three quar-ters of 2015 by lower commodities prices, which primarily caused difficulties for the energy sector and the oil-shale oil and chemical industries. Output from the chemical

industry was 13% down on a year earlier over this

period, while production of electricity, steam and

hot water was down 12% and oil production was

down 3% (see Figure 10). Lower output volume

does not give the full picture though of how diffi-

cult circumstances are for those sectors, because

lower prices caused a sharper fall in turnover and

so profits fell further than production did. The

case was similar for agriculture, where output

volume fell little, but lower prices for agricultural

produce meant that company revenues were

down considerably. Box 3 discusses the impact

of the oil price on the Estonian economy.

Production fell in manufacturing across the board, even in sectors that are not directly affected by commodities prices. Output was

down on a year earlier in almost two thirds of

branches of industry in the first three quarters of

the year, indicating that the risk of competitive-

ness being hurt by higher costs for labour and

production may be being realised. A counter

Figure 9. Contributions to GDP growth by sectors in Q1-2 2015

-0.6 -0.3 0.0 0.3 0.6 0.9 1.2

transportation and storage

real estate

healthcare

energy

wholesale and retail trade

agriculture, forestry and fishing

professional, scientific and technical activities

net taxes and subsidies

Source: Statistics Estonia

percentage points

Figure 10. Industrial production growth

-8

-4

0

4

8

2012 2013 2014 2015

computers, electronic and optical products (pp) energy (pp) oil-shale oil production (pp) other (pp) total (%)

Sources: Statistics Estonia, Eesti Pank

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example can be found in wood processing

though, where production and exports have

grown consistently in recent years.

Potential growth in Estonia has been below expectations for long-term growth. GDP

growth has been weak for structural reasons,

which are unlikely to change in the near future and

have affected potential growth as well as actual

growth. One example of this is the reduction in

trade with Russia, which is unlikely to recover in

the years ahead, while at the same time it is diffi-

cult to redirect the goods destined for Russia to

other markets. Exports from Estonia to Russia of

goods originating in other countries were down

almost 40% in the first three quarters of 2015.

Lower potential growth is also related to a lower

investment rate than previously.

A worse cyclical position for the economy in the third quarter is indicated by lower capacity utilisation as industrial output fell. Capacity utilisation stood at 71% at the start of

the fourth quarter of 2015 (see Figure 11), and this

is a little below the average level for periods of

stable growth in the Estonian economy given the

structure of the industrial sector. The employment

rate is very high from a long-term perspective,

and wages are rising fast, indicating a positive

labour market gap, where actual unemployment

is below the NAWRU rate.

The Eesti Pank estimate of the output gap for recent years is above where it was in the June forecast. This is due to data revisions by

Statistics Estonia that have raised GDP. We have

also adjusted the equilibrium for capacity utili-

sation for changes in the structure of demand.

Output levels have been below those of 2008,

before the crisis, for some time now in some

branches of industry, including production of

construction materials, which increased rapidly

during the construction boom but has now

suffered a drop in demand.

Figure 11. Capacity utilisation

-20%

-15%

-10%

-5%

0%

5%

10%

50%

55%

60%

65%

70%

75%

80%

2007 2009 2011 2013 2015

capacity utilisation (left scale)real GDP growth (right scale)

Sources: European Commission, Statistics Estonia

Box 3: The impact of the fall in the oil price on the Estonian economy

In the third quarter of 2014, Brent crude averaged 102 dollars per barrel, but in the third quarter

of 2015 this was down by almost half at 53 dollars a barrel. This fall in price has had a major

impact on both consumer prices and volume indicators for the economy. The impact of the fall

in the oil price has been offset to some extent by the weakening of the euro against the dollar,

because of which the oil price has not fallen as far in euros as it has in dollars.

The oil price impacts the economy through three channels.• The first channel is the effect on purchasing power. A lower oil price means lower spending

on heating and fuel, so both households and businesses have more money available anddemand increases for the goods and services of companies selling in the domestic market.

• The second channel through which the oil price affects GDP is supply in the economy. Themost affected by this channel in Estonia are companies in energy and oil production, wherethe price of production output depends on the development of the global market price ofoil. If the oil price falls, these industries may not necessarily cut their output volumes, so thetechnical contribution of these sectors to growth is not inevitably negative if the oil price falls.A lower oil price affects profitability, leading to reduced investment in the energy sector

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and all else being equal, this will reduce purchases from other sectors by owners and employees in this sector. Fluctuations in the oil price can alter the risk assessments of all the companies in the economy, affecting investment and recruitment. This effect is small in Estonia next to the effect on energy and oil production.

• The third channel through which the oil price has an impact is foreign demand and Estonian

exports. Whether a lower oil price increases exports to a given country or not depends largely

on whether that country is an oil exporter or importer. The first channel of purchasing power

generally dominates for net importers as a lower oil price largely increases the purchasing

power of residents, boosting short-term growth and increasing demand for goods from other

countries. Oil exporters see their purchasing power decline though, and exports to those

countries likewise decline. This means that Estonian exports to the great majority of European

countries should be increased by a lower oil price, while those to Russia would fall.

The sensitivity of other indicators to changes in the oil price depends on the price level of oil.

This is due to taxes on energy products, as energy sources are often taxed by volume, with

excise on fuel being charged per litre for example rather than as a percentage of the price of

fuel. A low oil price means that taxes make up a larger part of these prices while other economic

indicators are relatively less dependent on the price of oil.

A scenario analysis from the Eesti Pank EMMA model can be used to measure the impact of a

fall in the oil price taking account of all of these channels. Assessments by other European Union

countries of how much their imports depend on the oil price are used in calculating the impact of

cheaper oil on exports to the European Union. Exports to the European Union made up some 70%

of all goods exports from Estonia in 2014, and the only one of Estonia’s main trading partners that

is not in the European Union is Russia. Russia is an oil exporter though, and so demand there is

rather reduced by a lower oil price and this must be remembered when interpreting the results of

the analysis. The scenario portrays the fall in the oil price in euros and reflects the weakening of

the euro against the dollar, as this reduces the impact of the falling oil price.

The fall in the oil price increases Estonian GDP

for 2015 by around 0.5% from where it would

have been had oil remained at the same price

in euros as in the third quarter of 2014 (see

Figure B3.1). The dominant channel for the

impact of the oil price is the purchasing power

channel as cheaper oil reduces consumer

spending on energy and leaves consumers

with more money to buy other goods. This is

clearly shown in private consumption, which

has grown rapidly in the past year. The posi-

tive impact of the lower oil price dissipates in

2017 because the scenario is based on futures

for oil, which anticipate that oil will rebound to

some extent. The economy will also adjust to a

degree to the lower oil price, and this will also

reduce the impact of the price fall.

Russia probably contributes to the total impact on the Estonian economy of the change in the

oil price, but this is hard to quantify in the same way. As Russia is an oil exporter, a fall in the

oil price reduces purchasing power there and through that, Estonian exports to Russia. The

amount of value added in exports to Russia is small however, and a cut in those exports would

Figure B3.1. Impact on Estonian GDP of the decline in oil price

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

2014 2015 2016 2017

EU trade channel (pp)energy and oil production channel (pp)purchasing power channel (pp)total impact (%)

Sources: Eesti Pank, European Central Bank

Note: The figure shows the impact on GDP in comparison to what it would have been had the oil price stayed at its level of Q3 2014

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DOMESTIC DEMAND

Private consumption has been the main driver of economic growth in 2015. This has been a

good year for consumers because real dispos-

able income has increased substantially. Private

consumption increased by a little over 5% in the first

half of the year (see Figure 12). Data from the Tax

and Customs Board show wage growth picking up

further in the third quarter, while the fall in consumer

prices meant that real wages rose even faster.

Consumer confidence has also remained high, and

for these reasons, consumption growth is likely to

have remained brisk in the third quarter. One indi-

cator of this is the retail sales index, which was up

8% on the year in the third quarter.

Households have built up savings, but borrowing has increased at the same time. The annual growth in deposits was fast in the first

ten months of the year at 7-8%, partly in response

to the rapid growth in real incomes. Sentiment

surveys show that consumers think that now is a

good time for saving as opinions on the value of

savings are well above their long-term average.

The growth in savings can be linked to a change

in saving behaviour. The savings rate has been

substantially higher than it was in the previous

decade even though consumer confidence has

been high, unemployment has been low, and real

wages have risen rapidly. As consumption has

increased, so credit to finance consumption has

started to increase (see Figure 13). This credit

has increased partly because of the change to

VAT on company cars8.

8 A change in the Value-Added Tax Act came in on 1 December 2014 that limited how much VAT companies can cancel off if they are buying a vehicle that is not only for work. The number of vehicles bought by companies fell as a result of the change and the number bought by private individuals rose.

Figure 12. Private consumption

-15

-10

-5

0

5

10

15

0%

3%

6%

9%

12%

15%

18%

2012 2013 2014 2015

growth of private consumption (left scale)growth of retail sales volume index (left scale)consumer confidence barometer (right scale)

Sources: Statistics Estonia, Estonian Institute of Economic Research

have less of an effect on the Estonian economy than is often assumed. Exports from Estonia to

Russia have declined while the oil price has been in retreat, but this is also due to factors other

than the oil price. The Russian economy has been affected by sanctions as well as the oil price,

and the economic climate has been poor there for some time.

Overall the lower oil price has a positive effect on consumers and on exports to the European Union

but it has a negative effect on the profitability of energy and oil production, which in turn affects other

businesses. The combined effect of these channels is that GDP in 2015 is larger by some 0.5% than

it would have been had the oil price not changed. This assessment does not, however, consider the

negative effect that may come from a weakening of purchasing power in Russia.

Figure 13. Credit stock growth

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

2012 2013 2014 2015

corporate credithousing loans other household credit total credit stock

Source: Eesti Pank

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Investment was down in the second quarter for the fourth consecutive quarter, mainly because companies cut investment. There

was also a reduction in investment in residen-

tial space in the second quarter (see Figure 14).

General government investment has been falling

since the second quarter of 2014 as the European

Union budget period changed. It increased in the

second quarter of this year though, rising 8%

over the year. Lower investment has reduced

investment as a share of GDP, bringing it down

to 24.1% in the first half of the year, though this

is still one of the highest figures in the European

Union. The same is true in the business sector,

where investment is still among the largest in the

European Union as a share of GDP. Investment

in the corporate sector is covered in more detail

in Box 4.

Demand for new living space has been moderate, and in conjunction with increased supply, house prices have risen more slowly. Low unemployment, rising incomes and low

interest rates have together improved the finan-

cial circumstances of households. At the same

time that base interest rates have been extraordi-

narily low, the other lending conditions of banks

have been conservative, and interest rate margins

rose slightly in the second and third quarters (see

Figure 15). Data from the Construction Register

and the Estonian Land Board indicate that more

new residential space was taken into use and

bought in the second and third quarters of this

year than a year ago. The stock of housing loans

issued increased by 4% over the same period.

Statistics for permits for use indicate some reduc-

tion in investment in reconstruction of residential

space already in use9. Residential investment

as a whole was down in the second quarter in

consequence. The average square metre price of

apartments was around 6% higher over the year

in the third quarter, both in Tallinn and elsewhere

in Estonia10. Land Board data suggest however

9 The drop in investment for reconstruction work may have been affected by the new Building Act. This allowed residential space to be reconstructed from 1 July 2015 without building or use permits being required. Statistics for building and use permits are an important source of information for compiling statistics on investment for renovation of residential space however.

10 Real estate prices for the whole of Estonia rose by around 9% in the third quarter, but the average rise was inflated by increased shares of transactions in Tallinn and for new and more expensive apartments.

that price rises in Tallinn slowed in November

to 2%. Incomes have risen at the same rate as

real estate prices though, and so the affordability

of property has not really changed in 2015 (see

Figure 16).

The ability of companies to finance their own activities and investment is good. Financing capacity has been buoyed by profits built up earlier and by strong competition between the banks to lend to companies. Companies

continue to have good access to bank lending

as a result, and interest rate margins have

come down. Corporate profits in the first half of

2015 were smaller and dividend payouts were

larger, meaning that equity shrank. Despite

this, the profitability of companies is good in

Figure 14. Gross fixed capital formation

-30

-20

-10

0

10

20

30

40

50

2010 2011 2012 2013 2014 2015

general government investments (pp) investments in dwellings (pp) business investments (pp) gross fixed capital formation, year-on-year growth (%)

Sources: Statistics Estonia, Eesti Pank

Figure 15. Bank lending rates

0%

1%

2%

3%

4%

2012 2013 2014 2015

corporate credit housing loans 6-month EURIBOR

Sources: Eesti Pank, European Central Bank

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international comparison, and there has been no

significant deterioration in their financial standing

or capacity to borrow. Large and foreign-owned

companies in particular continue to have good

access to funds from abroad. Funding capacity

has therefore not significantly restrained invest-

ment activity.

Corporate investment has been brought down by the reduction in investment in capital-intensive sectors. Corporate invest-

ment was lowered by a little over 10% in the first

half of 2015. As it did in the second half of 2014,

investment fell in the energy sector in the first half

of this year as large-scale projects came to an

end. Investment was cut again in agriculture too,

probably because of the change in the European

Union funding period and because of the difficul-

ties the sector faced. The decline in the transport

of goods has led companies in transportation

and storage to cut their investment markedly.

Data from the Tax and Customs Board show that

investments in those capital-intensive sectors

continued to be reduced in the third quarter, but

those same data show that investment fell more

slowly across the whole business sector than in

the preceding four quarters.

Changes in inventories made a negative contribution to GDP growth in the first two quarters of 2015. Inventories as a share of sales

revenue did increase by the end of the first quarter

because there was a sharp slowing of growth in

both the domestic economy and external demand,

but they were reduced noticeably in the second

quarter to correct the relatively large stocks that

had built up in the preceding quarter. Inventories

were so volatile mainly because of the inventory

cycle in manufacturing.

Figure 16. Transactions with apartments

2 000

2 500

3 000

3 500

4 000

4 500

5 000

5 500

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

2008 2010 2012 2014

affordability (price per square metre divided by mean wage, left scale)average price per sq m, thousand euros (left scale)number of transactions (right scale)

Sources: Land Board, Statistics Estonia

Box 4: Investment by the Estonian corporate sector

Although corporate investments have shrunk

over the past four quarters, investment by

the corporate sector and by the economy as

a whole as a ratio to GDP remains among

the highest in the European Union. Corporate

investment as a share of GDP is now lower

than it was in the 2000s though (see Figure

B4.1). Large-scale investment is needed by the

economy for increased production capacity

and faster economic growth to be achieved. It

is clear that not every unit of capital invested

has equal weight in creating GDP growth, and

so the structure of investment matters as well

as its ratio to GDP.

Investment as a ratio to GDP has fallen in the

past four quarters in capital-intensive sectors.

Although those sectors receive a large part

Figure B4.1. Investments by non-financial corporations

0

5

10

15

20

25

2004 2006 2008 2010 2012 2014

ratio

to

GD

P

energy (pp) transportation and storage (pp) agriculture, water supply (pp) other (pp) total (%) EU 28 (%)

Sources: Statistics Estonia, Eurostat

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of corporate investments, they produce a

much smaller share of value added. Corporate

investment increased a lot after the economic

crisis because of the energy sector, where

the volume of projects peaked in 2013, before

falling from the middle of 2014 as the projects

came to an end. Capital-intensive branches of

industry that have also cut investment include

water supply, agriculture and transportation

and storage. Investment by other sectors as a

share of GDP increased in 2014 and in the first

half of 2015 it remained at the same level as

in the previous year. Invested units of capital

clearly have very different weights in creating

value added and so in achieving higher income

levels. Investment weighted for value added11

has increased in recent years at about the

same rate as GDP, and so investment intensity

has not particularly changed (see Figure B4.2).

Investment weighted for value added is still well

below where it was in the 2000s.

It is to be expected that investment would fall

as higher income levels are reached. Data

from the European Union12 show that countries

with a lower income level have had a higher

ratio of investment to GDP. Countries that are

richer, and that are growing less quickly, invest

relatively less of their GDP (see Figure B4.3).

Investment falls as a share of GDP while higher

income levels are being reached, because of

capital deepening in the economy and a change

in the economic structure to become more

service and knowledge-based. In 2000-2007

the income level in Estonia averaged 54% of the

European Union level, but in 2014 it had climbed

to 74%. The decline in the rate of investment

from the 2000s together with a rise in the income level is to be expected, though convergence

of income levels requires the Estonian investment rate to be higher than the rates in countries

with higher incomes.

11 An index has been made for investment weighted for value added, in which investment in each sector is weighted by that sector’s average share of value added. Average investment in the period is used as a reference value and the average values are calculated for 2004-2014. The index excludes education, health, art and leisure activities and other service activities, but as these sectors got less than 2% on average of the investment by non-financial companies in 2004-2014, their exclusion does not significantly affect the value of the index.

12 The data are for 2000-2007. and exclude the crisis and subsequent years. Croatia, Greece, Lithuania, Luxembourg, Malta and Poland are not included because of missing data.

Figure B4.2. Investments by non-financial corporations

8%

10%

12%

14%

16%

18%

20%

22%

24%

26%

2007 2009 2011 2013 2015

ratio

to

GD

P

investment weighted by value addedactual investment

Sources: Statistics Estonia, Eesti PankNote: four-quarter moving average

Figure B4.3. Investments by non-financial corporations and level of income in the European Union, 2000-2007 average

Estonia, 2000–2007

Estonia, 2014

5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

5000 15000 25000 35000

inve

stm

ent

shar

e in

GD

P

GDP (PPS) per resident at constant (2010 EU) prices

Sources: Eurostat, Eesti Pank

23

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Investment as a share of GDP has fallen less at

constant prices since the 2000s than it has in

nominal terms (see Figure B4.4). This is because

technological development has meant that

prices for capital goods have risen more slowly

over the long term than those in the rest of the

economy. Large import intensity has probably

caused prices for capital goods to converge

already for the most part with European Union

average price level. This means that invest-

ments in recent years have consumed a smaller

share of income than they did a decade ago,

though in real terms at constant prices the

share being put into investment has not shrunk

so much.

Figure B4.4. Investments by non-financial corporations

10%

12%

14%

16%

18%

20%

22%

24%

2000

2002

2004

2006

2008

2010

2012

2014

ratio

to

GD

P

ratio at constant prices (2005) nominal ratio

Sources: Statistics Estonia, Eesti Pank

EXTERNAL BALANCE AND COMPETITIVENESS

Estonian external demand has fluctuated in 2015 and has varied widely across markets and groups of products. Although there have

been few countries where demand has been lower

this year than it was last year, some of those few

are among Estonia’s main trading partners. Some

of Estonia’s main trading partners export more

to China than the European Union average, and

some Estonian producers export through their

parent companies to other emerging economies

too. The reduction in investment activity in Asia

and South America may thus have had a negative

impact on Estonian exporters.

Estonian exports of goods and services were down in the first nine months of this year by 3% over the year according to initial esti-mates. The fall has mainly been driven by exports

of goods, as economic growth in nearby countries

has been slow and weaker demand in Russia has

only partially been offset by demand in the European

Union. Estonian goods exports were down more

than 3.5% in the first nine months, which is slightly

more than the average fall in demand for imports in

trading partners. Since both the import intensity of

exports of goods and investment activity declined

at the same time, imports of goods decreased even

more and the trade balance improved. Imports of

goods were down over 4.5% over the year in the

first nine months of this year.

Although the main destination countries for

exports of services are the same as for exports

of goods, the increase in exports of services

to the European Union and the USA has been

more successful in counterbalancing the drop in

demand from Russia. Annual growth in exports

of services at current prices came to a halt in the

first two quarters or went slightly into reverse. The

flash estimate for external sector statistics and

the balance of payments shows services exports

shrinking slightly further in the summer months,

but over the first nine months of the year the fall

was notably less than that in exports of goods.

Competitiveness indicators have been giving contradictory messages in 2015. The main

indicators covering the whole economy and price

competition have indicated worsening compet-

itiveness in most months, but the trends have

been very varied and volatile in different sectors.

The real effective exchange rate calculated from

unit labour costs has mostly risen throughout the

year, while the real effective exchange rate calcu-

lated from consumer prices has mostly fallen (see

Figure 17).

Unit labour costs in Estonia have risen faster than those in export partners and changes in the nominal exchange rate have not been enough to offset that. Unit labour costs have

risen faster in 2015 than the average for recent

years, but the rise has been uneven across the

year and across different sectors. Although

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corporate profitability is down, they are still good

in international comparison, and assessments

by businesses suggest that non-price competi-

tiveness has improved and Estonia’s advantage

as a producer lies in more than cheap labour

resources. The World Economic Forum published

its league table of international competitiveness

at the end of September, and placed Estonia 30th

out of 144 countries, which is one place lower

than a year earlier.

External balance has probably mainly been improved by cyclical factors. The current

account position improved a lot from the second

quarter of 2014 to the second half of 2015 (see

Figure 18), with the current account deficit getting

smaller as a ratio to GDP than a year before or the

surplus larger in each quarter. The current account

position improved through both an increased

surplus on the goods and services account and a

smaller outflow of investment income as a share of

GDP. This reflects the lower profitability of foreign-

owned businesses. Investment has fallen even

faster as a share of GDP though, with the result that

the current account position has strengthened.

The flash estimate for the balance of payments

shows that the improvement in the current account

stopped in the third quarter as weak exports of

goods reduced the current account surplus from

a year earlier, though the current account balance

still remained positive. The current account surplus

in the first nine months was a little over 2% of GDP

of those same months, and the Estonian economy

was a net lender.

The current account surplus has also reduced net external liabilities. Assets have

increased faster in the past year or 18 months

than external liabilities (see Figure 19), with debt

liabilities in particular declining. However, it is

not clear whether liabilities have been reduced

because of strategic decisions or as a result of

short-term liquidity management. The net inter-

national investment position, which is the differ-

ence between external assets and external liabil-

ities fell to -40% of GDP by the end of June. This

is close to the -35% that the economic manage-

ment guidelines of the European Union consider

still to be in balance.

Figure 17. Yearly change in real effective exchange rate

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

2011 2012 2013 2014 2015

from CPI from ULC from GDP

Source: European Central Bank

Figure 18. Current account

-15%

-10%

-5%

0%

5%

10%

15%

2011 2012 2013 2014 2015

ratio

to

GD

Pprimary income secondary income services goods current account balance

Sources: Statistics Estonia, Eesti Pank

Figure 19. Gross and net external debt

-20%

0%

20%

40%

60%

80%

100%

120%

140%

ratio

to

annu

al G

DP

gross external debt net external debt

Source: Eesti Pank

2010 2011 2012 2013 2014 2015

25

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THE LABOUR MARKET

The working age population fell by 0.8% in 2014, mainly because of natural demographic processes (see Figure 20). For the working age

population to remain stable if the effect of migra-

tion is excluded, enough people have to reach

working age to compensate for those exiting and

for deaths. The number reaching the working age

of 16 in 2013-2017 is around 62-63% of the number

of those exiting working age. In 2014 the net migra-

tion balance improved for the second year in a

row, and the impact of migration on the number of

people of working age was only 0.05%. The migra-

tion balance improved for several reasons. One is

that the small birth cohorts are now reaching the

age most susceptible to emigration, and economic

factors are also at play, as Estonian wages and the

chances of finding work have both increased, while

the recession in Finland, the main destination for

emigration, has probably made it harder to find

work than it was before.

Although the working age population has shrunk, increased labour market partic-ipation has boosted the size of the labour force, expanding it by 1.2% in the first three quarters of 2015. The labour force participation

rate in the first three quarters of the year averaged

69.5%, which was 1.4 percentage points higher

than a year earlier. Labour force participation has

mainly increased because of greater participation

by the over-50s, though labour market activity

has also increased among those aged under 25.

Data from the labour force survey show that employment increased in resident production units by an average of 3.3% in the first three quarters of 2015 (see Figure 21). Estimates of

growth in employment may have been affected

by the introduction of compulsory registration of

employees from July 2014, which helped move

workers from the shadow economy into official

employment. The labour force survey finds quar-

terly growth in employment accelerating in the third

quarter, which contrasts with the marked slowing

of GDP growth. Data from the Tax and Customs

Board show there to have been fewer people

declared as receiving a wage in the third quarter

than in the second once seasonal factors are taken

into account. This gives grounds to believe that the

estimate from the labour force survey for growth in

employment may be optimistic.

Seasonally adjusted unemployment increased in the second quarter of 2015, but it was on account of increased labour force participation rather than lower employment. Faster growth in employment stopped this increase

in the third quarter (see Figure 22). The share of the

long-term unemployed has fallen, and in the first

three quarters of the year it averaged 40.1%, which

was five percentage points lower than a year earlier.

As with employment, estimates for unemployment

taken from different sources do not always agree

with each other. Registered unemployment has

increased monthly since May 2015, as the number

exiting registered unemployment has fallen and the

number newly registering has risen.

Figure 20. Labour supply

60%

62%

64%

66%

68%

70%

72%

-3%

-2%

-1%

0%

1%

2%

3%

2010 2011 2012 2013 2014 2015

working age population, year-on-year growth (left scale)labour force, year-on-year growth (left scale)labour force participation rate (right scale)

Sources: Statistics Estonia

Figure 21. Employment year-on-year growth

-15%

-10%

-5%

0%

5%

10%

2010 2011 2012 2013 2014 2015

wage recipients (Tax and Customs Board) employment in domestic production units (Labour Force Survey) employees (enterprise statistics)

Sources: Statistics Estonia, Tax and Customs Board

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Eesti Pank estimates that the unemploy-ment rate was below the natural rate in the first three quarters of 2015. Rises in unit

labour costs in 2015 show that that the position of

employees in wage negotiations has continued to

strengthen. The natural unemployment rate has

declined together with the overall unemployment

rate. One sign of this is that the long-term unem-

ployment rate, which can be seen as an indicator

of structural unemployment, has come down,

and another is that the vacancy rate has barely

moved even as unemployment has fallen. This

indicates that matching efficiency in the Estonian

job market has improved. Matching is analysed in

more depth in Box 5.

The annual growth in the gross monthly wage was slower in 2014 and early 2015, but it picked up in the second quarter of 2015 to 5.8%. Tax and Customs Board data

indicate that wage growth was faster in the

third quarter in both private companies and the

general government (see Figure 23). Wage pres-

sure has been sustained by the reduction in the

amount of available labour, as a record share of

the working age population is in employment and

the labour force participation rate is also hitting

unprecedented highs. Wage growth for the low

paid is affected by a rising minimum wage, which

has risen significantly faster than the average

wage. The impact of this is not restricted to those

earning the minimum wage, but touches also

those earning a wage close to the minimum.

The Tax and Customs Board shows general government wages rising much faster in the first three quarters of 2015 than those in the private sector, mainly because of pay rises in health and education. An important role has

been played in setting pay rates in both sectors

by the minimum rate agreed in collective agree-

ments, with the minimum hourly wage for doctors

rising under the agreement by 12.5% in 2015 for

example. The government has declared higher

pay for teachers to be a priority and has set a

target of raising the wages of teachers to 120%

of the average wage in the coming years. The

rise over the year in the average wage declared

by companies in the Commercial Register was

affected in the first half of 2015 by the require-

ment to register employees. The result of this was

that an estimated 8000-9000 employees whose

average wage income was close to the minimum

wage moved out of the shadow economy and into

official employment. The addition of these lower

paid employees slowed the growth in the average

wage from what it would have been without the

change in registrations.

Wages rose faster in the first three quarters of 2015 than labour productivity did, with the result that unit labour costs grew faster than in 2014. The rise in real unit labour costs

was broad based in the first half of 2015 and one

of the sectors that saw it accelerate was manu-

facturing, where companies compete in foreign

markets with producers from other countries.

Labour costs as a share of value added were still

only 6.4% higher in manufacturing than they were

ten years ago.

Figure 22. Unemployment

0%

4%

8%

12%

16%

20%

2010 2011 2012 2013 2014 2015

registered unemployment rate unemployment rate NAWRU

Sources: Statistics Estonia, Töötukassa, Eesti Pank

Figure 23. Annual change in average wages

-4%

-2%

0%

2%

4%

6%

8%

10%

2010 2011 2012 2013 2014 2015

average declared wage growth average real gross wage growth real wages

Sources: Statistics Estonia, Tax and Customs Board

27

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Box 5: Matching of jobs in Estonia

It is important for the potential for growth of

the Estonian economy that the available labour

matches as well as possible with the positions

vacant. The concept of matching comes from

job search theory in labour economics, where

a matching function describes how job vacan-

cies are filled from available labour resources.

The more free labour there is and the more

vacant jobs there are, the more new employ-

ment relations are formed. Jobs are not neces-

sarily filled with the same degree of efficiency

in the labour markets of different countries, or

even in the labour market of a single country at

different times. So when vacancies and unem-

ployment both increase at the same time, it

can be said that matching in the economy has

worsened. The relation between any given indi-

cator of labour shortages and unemployment

is shown by the Beveridge curve. A worsening

of matching is shown by a shift of the curve to

the right, as can be seen for the euro area in

Figure B5.1.

According to the European Commission13

labour matching has got worse in the euro

area, because there has been little recovery in

low-skilled jobs in many countries. The creation

of high-skilled jobs has also been slower than

the rate of entry into the labour market of grad-

uates from higher education. In consequence,

those graduates have had to accept jobs that

require lower qualifications than they possess.

Unemployment in Estonia has fallen to around the level of 2006–2007, but labour shortages are

shown by business confidence surveys and by the vacancy rate to be much less severe than

they were at that time. The result is that the Beveridge curve has shifted to the left (see Figure

B5.2), implying that the efficiency of matching has improved. The gap between vacancies and

available labour gives only a very general picture of job matching. In theory the Beveridge curve

could also shift to the left, indicating greater efficiency, when job exchange becomes more effi-

cient even though there is no change in the fit of available labour with the demands of vacancies.

The quality of job matching and changes in it can be analysed much more directly by looking at

data on the qualifications of workers and the skill requirements of their jobs.

Figure B5.3 shows various indicators for over and under qualification found from the labour force

survey. The simplest of them shows the employees’ self-assessment of the match between their

work and their qualification. The main problem with this indicator is that it may not be objective

and it usually produces a smaller proportion of the underqualified than other indicators do.

13 http://ec.europa.eu/europe2020/pdf/themes/27_skills_gaps_and_labour_mobility_02.pdf

Figure B5.1. Beveridge curve, euro area Q2 2003 - Q3 2015

Q3 2015

0

2

4

6

8

10

12

6% 8% 10% 12% 14%la

bo

ur s

hort

age

ind

icat

or

(bar

om

eter

)unemployment rate (seasonally adjusted)

Sources: European Commission, Eurostat, Eesti Pank

Figure B5.2. Beveridge curve in Estonia Q2 2003 - Q3 2015

Q3 2015

0

5

10

15

20

25

30

35

40

45

0% 4% 8% 12% 16% 20%

lab

our

sho

rtag

e in

dic

ato

r (b

aro

met

er)

unemployment rate (seasonally adjusted)

Sources: Statistics Estonia, Eesti Pank

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PRICES

Consumer prices fell faster in the third quarter, and deflation has now been present for more than one and a half years. Prices fell

further mainly because energy became cheaper

(see Figure 24). Economic activity has had a

more or less neutral impact on inflation in recent

years, as GDP growth has been close to its

potential. The imbalances created in the labour

market by wage pressures have reduced corpo-

rate profits in 2015, as companies have found it

hard to cover their higher labour costs by raising

prices (see Figure 25).

The fall in energy prices was broad based in the third quarter, with prices for motor fuel falling furthest from a year ago. Lower global oil

prices have passed into prices for other fuels with a

lag, and prices for imported natural gas and for heat

are down. Electricity is also cheaper, as demand

and consumption are lower. The price of electricity

Another approach is to compare the educa-

tion of the employee and the level of education

needed for the job, but survey data unfortunately

do not usually directly report the level of educa-

tion required. Assumptions must then be made

instead, and for example the level of qualification

required can be assumed to be the one most

commonly held by those doing the job. Another

indicator for overqualification shown in the figure

is the share of graduates from higher education

working in a job that requires medium or low

skills (ISCO categories14 4-9).

Most indicators show that the share of over-

qualified employees was smaller in 2010, when

employment was at its lowest point after the

crisis, than it is now. This may be because the

workers most likely to lose their jobs were those who were worst matched with them. In recent

years there has been no major change in over or underqualification as employment has increased.

Around half of those employees who had higher education but were working in jobs that

required lower skills were to be found in trade, manufacturing, transportation and storage, and

public administration from 2009 to the first half of 2015. Around one fifth of those with higher

education working in those sectors considered themselves overqualified, with the exception of

public administration where only 5% thought they were. The probability of people with higher

education working in jobs that require lower qualifications and also considering themselves

overqualified is greater in North East Estonia, among non-Estonians, and smaller among people

of prime working age. There are above-average shares of those without higher education who

are overqualified, both by self-assessment and by job category, among people with an educa-

tion in technical and production activities; agriculture, forestry and fishing; and services; and

notably below-average shares among people with backgrounds in mathematics and statistics,

and information technology.

Overall it appears that although unemployment has fallen in recent years and the employment

rate has risen, the matching of jobs has not deteriorated. The relatively high indicators for over-

qualification are a sign that the labour force could be deployed more efficiently.

14 ISCO is an international standard classification for jobs, which divides jobs into nine categories at the most general level: 0 - armed forces occupations, 1 - managers, 2 - professionals, 3 - technicians and associate professionals, 4 - clerical support workers, 5 - service and sales workers, 6 - skilled agricultural, forestry and fishery workers, 7 - craft and related trades workers, 8 - plant and machine operators, and assemblers, 9 - elementary occupations.

Figure B5.3. Over and underqualification

0%

5%

10%

15%

20%

25%

30%

2009 2010 2011 2012 2013 2014

share of graduates working in medium and low-skilled jobs

share of graduates among managers and top specialists

share of graduates who consider themselves overqualified

share of non-graduates who consider themselves overqualifiedshare of employees who consider themselves underqualified

Sources: Statistics Estonia, Eesti Pank

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fell by less in the third quarter because outages

caused interruptions to production and transmis-

sion capacity in the Nordic electricity market.

Although global prices for food commodi-ties are down and the Russian market has fallen away because of sanctions, consumer prices for food continued to rise slowly in the third quarter. Food price inflation has been

kept up by rapid rises in prices for fruit and vege-

tables, as in most countries in the European

Union. The seasonality of food prices may have

changed from last year, and the weather has not

been favourable. Alcoholic beverages have also

become more expensive at a rapid rate, as excise

on alcohol was raised at the start of the year.

Prices for dairy and meat products in turn have

fallen even lower on the European market and in

Estonia. The impact of production difficulties will

appear in prices after a long lag.

Inflation for manufactured goods has been below the average for the euro area in 2015. The euro fell against the dollar at the start of the

year, which lifted prices of goods imported from

outside the euro area. The impact of the lower

exchange rate has passed into consumer prices

quite modestly in Estonia. One reason for this may

be that the nominal effective exchange rate has

only fallen a little at the same time, because the

Russian rouble weakened against both the euro

and the dollar. It is principally durable goods like

cars and electronics that have become cheaper

among manufactured goods, but prices have also

risen more slowly than usual for clothes and shoes.

Services inflation picked up throughout the first half of the year, reaching 2.1% in the third quarter. The rise has been below the long-

term inflation rate, as price rises are kept in check

by administrative measures. The introduction of

free public transport in Tallinn in 2013 and of free

higher education have made services inflation

around one percentage point lower for the past

three years (see Figure 26). Without these factors,

services inflation has accelerated steadily as

wages have continued to rise strongly. The long

fall in prices for communications services, which

was bigger in Estonia in 2012–2014 than almost

anywhere else in the euro area, came to an end

in the second quarter. Fewer Russian tourists

has meant cheaper accommodation services

Figure 24. CPI growth

-2

-1

0

1

2

3

4

2013 2014 2015

food (pp)energy (pp)core inflation (pp)CPI total (%)

Sources: Statistics Estonia, Eesti Pank

Figure 25. Composition of GDP deflator growth

-15

-10

-5

0

5

10

15

20

25

2008 2010 2012 2014

mark-up and taxes (pp) unit labour cost (pp) GDP deflator (%)

Sources: Statistics Estonia, Eesti Pank

Figure 26. Sevices inflation

-5

-4

-3

-2

-1

0

1

2

3

4

5

2013 2014 2015

other services (pp)free education (pp)communications (pp)free public transport (pp)services total (%)

Sources: Eurostat, Eesti Pank

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but leisure services continued to become more

expensive at a rapid rate.

GENERAL GOVERNMENT FINANCING

The budget deficit of the Estonian general government stood at 84 million euros at the end of the first half of 2015. The deficit was

slightly larger than at the end of the first half of

2014, when the budget was in surplus for the

whole year by 0.7% of GDP. The fiscal position

has deteriorated this year because of several

changes planned in the state budget that have

increased transfers to households and reduced

the tax burden on labour.

The increase in general government spending was broad based in the first half of the year and stood at 6.4% (see Figure 27). The biggest spending increase was in social

benefits, as child support increased in January,

and in general government labour costs, which

were up almost half a percentage point of GDP

over the year. The rise in labour costs slowed in

the second quarter though. General government

investment recovered in the second quarter, and

indeed one reason why the budget surplus was

larger than planned last year was that investment

was reduced.

Although labour taxes were cut, the Estonian tax burden increased in the first half of the year. Income tax and social security

rates were cut at the start of this year. Excise on

alcohol was raised at the same time, but had only

a small impact on tax revenues in 2015, because

inventories were stockpiled before the tax rise,

and alcohol consumption declined. Tax revenue,

which provides around 83% of the income of the

general government, increased by 6.7% in the first

half of 2015 (see Figure 28)15. The growth in tax

revenue remains rapid, because VAT fraud has

been reduced sharply. As a result, the effective

VAT rate has risen16. Continued rapid wage rises

have raised government revenues from labour

taxes even though the tax burden on labour has

been reduced.

15 In general government finances, income tax is recognised on an accrual basis, and social security contributions at net value.

16 Tax revenue in the first half of this year was one percentage point higher in the main components of VAT than it was a year earlier.

Tax receipts continued to rise rapidly in the third quarter of 2015 and at the start of the fourth quarter. The state treasury received

8.5% more in taxes in the first ten months of this

year than a year earlier17. The annual growth in

VAT receipts was a little slower than in the first

half of the year, but it was still above 10% on

average. Extraordinary dividends in the financial

sector increased the October receipts for corpo-

rate income tax about fivefold over the year. In

the first ten months of this year, 39% more was

paid in corporate income tax than a year earlier.

The windfall in revenues allows the government

to achieve much better fiscal results in 2015 than

was planned when the budget was drafted.

17 The calculation is based on monthly data from the state treasury, and growth there cannot be compared directly to growth in general government tax revenues.

Figure 27. Government expenditure growth

-15

-10

-5

0

5

10

15

20

2010 2011 2012 2013 2014 2015

investment (pp) consumption (pp) social transfers (pp) labour costs (pp) other (pp) total expenditure (%)

Source: Statistics Estonia

Figure 28. Tax revenue growth

-8

-4

0

4

8

12

2010 2011 2012 2013 2014 2015

indirect taxes (pp) direct taxes (pp) social contributions (pp) total tax revenue (%)

Source: Statistics Estonia

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ECONOMIC FORECAST 2015-2017

The Eesti Pank economic forecast is produced jointly by experts from the central bank's Economics

and Research Department and Financial Stability Department. The Eesti Pank forecast is a part of the

joint forecast for the euro area produced by the euro area central banks and the European Central

Bank, which uses shared assumptions about the external environment. The assumptions about the

external environment cover the interest rates in the euro area money markets, the exchange rate of

the euro and commodity prices. The economic forecasts produced at the same time by the other

central banks of the euro area are used for the assumptions for demand and prices in Estonia's trading

partners. The external assumptions used in the forecast are based on information available as at 18

November 2015, and the Estonian economic indicators on data available as at 13 November 2015. The

Eesti Pank forecasts are compiled using EMMA, the macro-model of the Estonian economy developed

and regularly updated by Eesti Pank.

THE INTERNATIONAL ECONOMIC ENVIRONMENT

Global economic growth will be slower this year, though forecasts by international insti-tutions18 show it will be faster in the years ahead. Advanced countries will continue to

return to moderate economic growth, but this will

not be enough to compensate for slower growth

in emerging economies. The IMF estimates that

the economy in advanced countries will grow by

2% this year, with growth again led by the United

States and the United Kingdom. The risks to

emerging economies have increased, and the

IMF estimates their growth will slow from 4.6%

last year to 4% this year.

Expectations of a rise in US monetary policy interest rates have reduced inflows of capital to emerging economies. Funding conditions have tightened in consequence. The cooling of the Chinese economy will have a

major impact on its main trading partners in Asia.

Slower growth and reduced investment in China

will also affect commodities markets substan-

tially, and through that, the economic growth of

commodity exporting countries. The outlook for

growth in the other large emerging economies –

India, Brazil and Russia – is also worse than was

expected at the start of the year.

The euro-area economy will continue to grow at a modest rate. Growth will be supported by

commodities prices, favourable interest rates,

and a depreciation of the euro in response to more

accommodative monetary policy. The improving

18 The IMF, the European Commission and the OECD

labour market, lower inflation and low interest

rates will raise the purchasing power of house-

holds, which will boost private consumption. Low

interest rates will support growth in the euro area

in investment, which has remained modest so

far, and the cheaper euro will help improve the

outlook for growth for euro-area exporters.

Large-scale immigration by asylum seekers has started to affect the economies of the euro area and of other European Union countries. Since the start of 2014, more than

1.2 million people have applied for refuge in the

European Union. It is still too early to estimate

the total economic impact of the mass immigra-

tion by refugees. The short-term effect is seen in

increased public spending, which has a positive

impact on economic growth. The latest estimate

by the European Commission is that immigra-

tion will affect the budget balance of countries

differently, depending on whether the country

is a destination or a transit country for the refu-

gees. Countries that are mainly transit routes for

the inflow of refugees will see their fiscal position

worsen by 0.2% of GDP because of increased

public spending. Destination countries will see

a deterioration in their budgets of 0.2% of GDP

this year and the impact from immigration will

be slightly greater in 2016. The impact of the

migration crisis on growth will be smaller than the

impact on the budget position19.

Inflation in the euro area will be below the target of the European Central Bank in the years ahead, meaning that the monetary po- licy of the bank will remain accommodative

19 European Commission. Economic Forecast, Autumn 2015.

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and interest rates low. It is assumed that

short-term money market interest rates in the

euro area will remain negative throughout the

forecast horizon, with the three-month EURIBOR

averaging -0.12% in 2017. The euro exchange rate

against the dollar is also expected to be consid-

erably lower (see Table 2). The euro will slide to

an average of 1.086 against the dollar in 2016.

The dollar to euro exchange rate will be affected

by differences in interest rate policies, as markets

expect US rates to rise by the end of this year, but

the accommodative policy in the euro area will

continue in the years to come.

Uncertainty about the external environ-ment means that the forecast for growth in Estonia's main trading partners has mainly been adjusted downwards. The Russian

economy has slumped this year because of

low levels of economic activity and the effect of

sanctions, and economic growth is very likely to

be negative next year too. Geopolitical tensions

will be joined in putting pressure on the Russian

economy by the low oil price, falling investment,

and a reduction in real incomes that will limit

private consumption. The Russian central bank

finds that if oil remains at 50 dollars a barrel,

the economy will shrink by up to 1% in 2016.

The negative impact of the economic difficulties

in Russia and the slowing growth in China will

be passed into the import demand of Estonia's

main trading partners. At the end of October

the Swedish central bank raised its forecast for

growth to 3.3% on the back of strong domestic

demand, but it cut its forecast for 2016. The

Finnish economy will continue to struggle and it

is not certain to exit its recession this year after

three years. The purchasing power of Finnish

households is being restricted by government

spending cuts, and in the short-term the recovery

of growth in manufacturing and construction will

remain modest. The outlooks for the Latvian and

Lithuanian economies are overshadowed by

the economic difficulties in Russia. The nega-

tive effect from Russia should dissipate, and the

European Commission expects growth in Latvia

and Lithuania to be supported by domestic

demand and recovering exports and to reach

around 3% next year. Economic activity in trading

partners may well be boosted by cheaper oil and

the continuation of accommodative monetary

policies. As economic sentiment has improved

in the euro area, so confidence has improved in

Estonia's trading partners in recent months.

Pressure from rising commodities prices will remain weak throughout the forecast horizon. Market expectations for the oil price are

considerably lower than in the June forecast at

57.5 dollars per barrel by 2017. The oil price is

lower because of both demand-side and supply-

side factors. There is still an excess of supply in

the oil market, with OPEC producing above its

target and production of shale oil in North America

surpassing expectations. Pricing for oil in the

markets has also started slowly to consider the

prospect of increased supply from Iran. Demand

in emerging economies has fallen at the same

time, especially because of the slower growth

in China. Food prices have been falling since

2012 because of excess supply following consec-

utive good harvests. The outlook for food

commodity prices will remain subdued in the near

term, the main downside risk being that demand

growth in emerging economies could slow sharply.

REAL GDP GROWTH

Estonian economic growth will pick up steadily from 1.2% this year, to 2.2% in 2016 and 3.1% in 2017 (see Table 3 for the main forecast indicators). The rate of growth will

rise because of a recovery in growth in exports

and investment (see Figure 29). A large part of

Table 2. External assumptions in the forecast

June 2015 projection

2014 2015 2016 2017 2015 2016 2017

Foreign demand growth (%)* 1.9 -1.5 2.6 3.8 1.1 3.7 4.6

Oil price (USD/barrel) 98.9 53.8 52.2 57.5 63.8 71.0 73.1

Interest rate (3-month EURIBOR, %) 0.21 -0.02 -0.19 -0.12 0.01 0.05 0.21

USD/EUR exchange rate 1.33 1.11 1.09 1.09 1.12 1.12 1.12

*Foreign demand growth is the weighted growth of imports of trading partnersSource: European Central Bank

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Table 3.Economic forecast by key indicators*

Difference from June forecast

2014 2015 2016 2017 2015 2016 2017

Nominal GDP (EUR billion) 19.97 20.46 21.45 22.66 0.00 -0.29 -0.55

GDP volume** 2.9 1.2 2.2 3.1 -1.0 -0.9 -0.5

Private consumption expenditures*** 3.5 5.2 3.5 2.8 0.6 0.3 -0.5

Government consumption expenditures 3.0 0.8 1.6 1.5 -2.2 0.1 -0.5

Fixed capital formation -1.8 -5.8 1.3 4.8 -8.2 -3.5 -1.0

Exports 1.8 -2.5 1.0 4.9 -4.1 -3.8 -0.8

Imports 1.4 -2.8 2.8 4.8 -3.2 -2.3 -1.2

Output gap (% of potential GDP) 0.3 -1.1 -1.7 -1.3 0.1 -0.5 -0.6

CPI -0.1 -0.4 1.2 2.9 -0.4 -1.4 0.2

Core inflation 0.5 0.8 1.1 1.4 0.2 -0.1 -0.5

Services 1.1 2.0 2.0 2.6 1.1 0.5 -0.4

Non-energy industrial goods -0.1 -0.3 0.2 0.3 -0.5 -0.6 -0.5

Energy -4.0 -6.7 -0.7 3.9 -1.8 -4.3 0.6

Food, including alcohol and tobacco 1.1 1.0 2.4 4.8 -1.2 -2.3 1.1

HICP 0.5 0.1 1.5 3.1 -0.4 -1.3 0.1

GDP deflator 2.1 1.3 2.5 2.4 -1.2 -0.6 -0.6

Unemployment rate (% of the labour force) 7.4 5.9 5.8 7.1 0.0 -0.2 -0.4

Employment**** 0.8 3.3 0.2 -0.8 2.3 1.2 0.1

Average gross wage 5.6 5.1 4.8 5.6 0.5 -0.7 -1.0

ULC 3.7 4.6 1.4 1.2 0.4 0.1 -0.4

GDP per employee 2.1 -2.1 2.0 3.9 -3.2 -2.1 -0.6

Private sector debt, outstanding amount 2.7 4.5 4.3 4.9 1.1 -0.9 -1.2

Private sector debt, outstanding amount (% of GDP) 76.5 78.1 77.6 77.1 0.9 1.2 1.2

Current account (% of GDP) 1.0 1.8 -0.6 0.2 0.7 -0.3 0.5

Budget balance (% of GDP) 0.7 0.1 0.1 0.0 0.2 0.2 0.2

Cyclical component (% of GDP) 0.1 0.5 0.4 0.1 0.0 0.2 -0.1

Temporary measures (% of GDP) -0.3 -0.5 -0.3 -0.3 0.0 0.0 0.0

Structural budget balance (% of GDP) 0.9 0.1 0.1 0.2 0.2 0.2 0.2

* Numbers reported are annual rates of change in per cent, if not noted otherwise, ** GDP and its components are chain-linked, *** including NPISH, **** employment by domestic production unitsSources: Statistics Estonia, Eesti Pank

Figure 29. GDP growth by expenditure approach

-6

-4

-2

0

2

4

6

8

10

2010 2012 2013 2015 20172011 2014 2016

net exports (pp)

private consumption (pp)

gross fixed capital formation (pp)

other (pp)

GDP real growth (%)

Sources: Statistics Estonia, Eesti Pank

forecast

Figure 30. Demand in trading partners

-4

-3

-2

-1

0

1

2

3

4

2012 2013 2015 20172014 2016

Russia (pp) Latvia (pp) Lithuania (pp) Finland (pp) Sweden (pp) other (pp) Total (%)

Sources: Eurostat, European Central Bank, Eesti Pank

forecast

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economic growth in recent years has come

from private consumption, which will continue to

support growth throughout the forecast horizon,

though its contribution will diminish. Worse

external assumptions mean that the forecast for

growth is lower than it was in the June forecast

(see Figure 30 and Table 2). The slower growth in

the third quarter of 2015 than was expected also

has a technical impact on the forecast, and that

impact will pass on into 2016.

Faster growth depends primarily on poten-tial growth in the years ahead. GDP will

remain below its potential and there are spare

resources in the economy that could be put back

into use to put short-term growth above potential

growth. Despite this, the output gap is small and

stimulating domestic demand alone will not help

lift growth over the long term. Potential growth,

which has been weak in recent years, will accel-

erate throughout the forecast horizon to close to

3%. Potential growth will be led mainly by total

factor productivity (TFP), while the labour force

will shrink and the contribution of capital will be

smaller than before because of reduced corpo-

rate investment. Potential growth may still turn

out faster if investment increases faster than fore-

cast and capital is used more effectively.

The main pillar for potential growth is TFP, and growth in this is likely to accelerate in the years to come. TFP growth has been held back so far by the hangover from the crisis because excess production capacity and weak growth in markets have made it unnecessary to make production more complex. The skills of the long-term unemployed

may have deteriorated in the meantime and when

they find work again, it may have a short-term

negative impact on TFP. These negative factors

will disappear. Estonian companies are starting to

compete more and more with Nordic companies

in areas where production is more competitive

in Estonia than in the Nordic countries. Estonian

companies are in consequence moving gradually

higher up the production chain. As demand has

grown slowly, companies are looking for ways

to stretch out within the production chain, by

increasing their role through vertical integration

and by making production more complex. This is

aided by cheap credit.

Growth in private consumption will slow during the forecast horizon. Rapid growth in

real disposable income will lead to strong growth

of 5.2% in private consumption in 2015. Wages

will rise more slowly next year, but will again

rise faster during the second half of the fore-

cast horizon. Social benefits will also increase

again, though they will do so more slowly than

they have this year. Growth in disposable income

will also be limited in the second half of the fore-

cast period by a fall in employment. As a result,

disposable household income will increase more

slowly in 2016 and 2017 than it has this year. Real

purchasing power will also grow at a slowing rate

throughout the forecast horizon because infla-

tion will rise. Private consumption growth will be

down to 2.8% in 2017.

Households will be able to smooth their consumption with savings, but the savings rate will still remain high. The growth in real

disposable income will be high this year, with the

consequence that the savings rate is expected to

be above 5% of disposable income. Consumer

surveys show that the probability of consumers

saving during the next 12 months has remained

high since the middle of 2014. The higher priority

given to savings means that the savings rate will

be above the long-term average throughout the

forecast horizon. The savings rate will come down

a little though, as real disposable income will rise

by less and households will want to smooth their

consumption.

Increased investment in residential space will be encouraged in the coming years by rising incomes and low unemployment. Furthermore, interest rates will remain low.

Statistics for building permits issued in recent

quarters and estimates from the banks reveal

signs of increased activity in real estate develop-

ment. Rises in property prices will be reined in

by increased supply and by the relatively weak

competition between banks in the housing loan

market, and by a gentle rise in interest rate

margins.

Profits that have been built up, good access to bank lending and low interest rates will keep the ability of companies to finance their own activities and investment

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favourable throughout the forecast horizon. Companies will be able to regain their profitability,

meaning that their internal funds will increase.

Company finances will also benefit from capital

transfers from the European Union during the

forecast period. Demand for credit from compa-

nies will increase moderately in the coming years

and debt liabilities will increase at the same rate

as GDP.

Growth in corporate investment will recover gradually in the coming years. Investments

in transportation and storage and agriculture,

which have dropped considerably of late, will

probably fall further in future as the goods trade

has decreased, trade barriers have been erected,

and agriculture is affected by other problems

specific to that sector. Investments are also likely

to continue to decline in the energy sector next

year, but at a much slower rate than before.

Rapid wage rises and a shrinking labour force

have given companies ever more reason to make

their production more efficient with machinery

and equipment. Confidence will improve as

foreign demand recovers, and the utilisation

of production capacity will increase. This will

help investment growth recover, which it will do

moderately at first, but accelerating to 5.6% in

2017. Corporate investment as a ratio to GDP will

remain below where it was in the 2000s, and will

climb to 15.8% by the end of 2017.

Investment will fall in 2015 but then recover the next year and pick up even further in 2017 to increase by 4.8%. The increase in

investment will mostly be led by the business

sector. Investment in residential property will

grow moderately and general government invest-

ment will also increase, but the rate at which it

does so will slow temporarily in 2016 because of

the change in the European Union budget period.

The working age population will continue to shrink throughout the forecast horizon, by an average of 0.8% per year. The migra-

tion balance will have little effect on the number

of people of working age. The changes in the

working age population will be due to the natural

demographic processes of the birth rate 15 or

more years ago, deaths among people of working

age, and people exiting working age.

The labour force participation rate will remain high throughout the forecast period and will be raised further from the second half of 2016 by the work capacity reform. This will compensate for the shrinking working age population in the years of the forecast. The work capacity reform will be

introduced in the middle of 2016 and will require

people who are partly capable of working to be

active in the labour force in order to receive inca-

pacity benefits. The retirement age for both men

and women will be raised from 63 to 65 between

2017 and 2026. The age structure of the popu-

lation will start to have a negative impact on the

labour force participation rate from 2016 as the

age groups with lower participation rates will

start to increase as a share of the population

aged 15-74. This will be counterbalanced by a

continuation of the trend of the past decade of

activity in the labour market increasing among

the older age groups because of improved health

and changes in the nature of work.

The rapid growth in employment seen in the third quarter of 2015 will not continue throughout the forecast period. As employ-

ment grew strongly in the third quarter, it will

be higher in 2016 than in 2015, but in quarterly

comparison it will start to decline from the first

quarter of 2016 and will be down around 0.8%

in 2017 (see Figure 31). The labour supply will

increase during the forecast period, but mainly

because of the work capacity reform. Those

entering the labour market under the reform will

only start to compete really for jobs after some

Figure 31. Annual growth in employment and the labour force

-6%

-4%

-2%

0%

2%

4%

6%

8%

2010 2011 2012 2013 2014 2015 2016 2017

employment in resident production units labour force

Sources: Statistics Estonia, Eesti Pank

forecast

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time, during which they will have taken additional

training and used other active labour market

measures. At the same time there will be a reduc-

tion in demand for labour as wages have climbed

so high and the improvement in foreign demand

has been delayed.

The unemployment rate will remain at 5.9% in 2015 and 5.8% in 2016, and it will rise in 2017 after the work capacity reform to 7.1%. The

reform will start to affect the unemployment rate

from the middle of 2016. People returning to the

labour market in order to receive incapacity bene-

fits will probably spend more time than the average

looking for work, and at least at first they will be

structurally unemployed. The estimate in this fore-

cast of the effect of the work capacity reform is the

same as the estimate in the June forecast.

The rate of wage rises in 2015 has not been in line with weak economic growth and lower productivity (see Figure 32). Wage growth will

slow slightly over the forecast years, but it will

pick up again at the end of the period as produc-

tivity growth will return and inflation will increase.

The rise in the average wage will be boosted by

the rise of around 10% in the minimum wage in

both 2016 and 2017, and by the previously agreed

wage rises in healthcare for next year and prob-

ably by above-average wage rises in education.

The pick-up in GDP growth will help slow the rise in unit labour costs from 4.6% in 2015 to 1.4% in 2016, and the trend will continue in 2017. Labour productivity growth

will rebound as the recovery in foreign demand

allows companies to use their labour resources

more intensively and to invest in making produc-

tion processes more efficient. Reduced employ-

ment indicates that companies will eliminate jobs

that are less productive.

Slower growth in unit labour costs will favour the price competitiveness of Estonian exports. This will help improve the profitability

of companies and make Estonian exports more

attractive in partner countries. In the past year

or year and a half, Estonian exporters have

mostly had to face falling prices, but these will

be replaced in future by moderately rising prices.

This will also help exporters increase their market

share by the end of the forecast period.

Increasing foreign demand will boost export growth, although by less than was forecast in June. Growth in exports will be restrained

throughout the forecast horizon by the continuing

pessimistic outlook for the economies of Russia

and Finland, and the reorientation of some leading

Estonian exporters within international produc-

tion chains. As growth in foreign demand is more

modest than before, Estonian exports will not

return to annual growth before the middle of 2016.

The external balance will not deteriorate in the forecast horizon. The current account posi-

tion will weaken at the start of the forecast period,

but will remain close to balance. The change in the

current account position mainly reflects an increase

in investment activity and volumes of imports for

production. The current account being close to

balance will allow net external liabilities to continue

to decline gently as a ratio to GDP. Cash flows are

unfortunately volatile with interest rates very low,

and the net international investment position will not

improve as quickly as in recent years.

PRICES

Consumer prices will continue to fall until the end of 2015 because a rise in the price of the main commodities has been postponed by about half a year. The fall in energy prices will slow

in the first half of 2016 because of the low reference

base. As global prices for most commodities are

currently low, the increase in inflation will be broad

based. Increased activity in the external economy

will provide a stable base for a rise in consumer

Figure 32. Wage and productivity growth

-2%

0%

2%

4%

6%

8%

10%

2010 2011 2012 2013 2014 2015 2016 2017

average monthly gross wages nominal GDP per person employed

Sources: Statistics Estonia, Eesti Pank

forecast

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prices in 2017, with faster price rises in Estonia’s

trading partners and more expensive imports.

Consumer prices will be down 0.4% in 2015, but inflation will rise to 1.2% in 2016 (see Figure 33). Deflation is forecast to end in early

2016. The effect of the comparison base is large for

both energy and food because the sharpest fall in

the oil price came at the start of 2015. At the same

time food prices started to be affected strongly by

the Russian import ban. Price levels will be raised

from February by tax rises, though they will come

in later than was previously anticipated. Inflation

will continue to rise in 2017, as new tax rises have

been agreed and the effect of the introduction of

free higher education will pass out. Current infor-

mation suggests that tax rises will raise inflation by

an estimated 0.7 and 0.9 percentage point in the

next two years (see Figure 34).

The biggest price rises in the consumer basket in the forecast horizon will be in food prices, and prices for fruit and vegetables

will continue to rise in the near term. Inflation in

the coming years will mainly be driven by higher

excise on alcohol and tobacco, which will be

responsible for around half of the rise in food

prices. Global market prices for dairy and meat

products will start to rise in the second half of

2016, having been low in part because of the

Russian import sanctions and the removal of

European Union production quotas. Consumer

prices for food in Estonia were very sensitive to

rising world market prices for food commodities

during the last upturn and so the rise forecast for

2017 is above the average for the euro area.

The forecast for energy prices is lower throughout the forecast horizon than in the previous forecast. Prices will continue

to be lower over the year until the second half

of 2016, but they will fall more slowly from the

start of the year because the reference base will

be lower. Energy prices will also be lifted by 1.6

percentage points following the rise in the excise

on motor fuel.

Inflation will remain low for manufactured goods throughout the forecast horizon. Prices of manufactured goods are already rela-

tively high in Estonia, even when compared with

those in neighbouring countries to the north, and

tighter competition in the domestic market will

hold inflation down. It will rise somewhat during

the forecast period though, as imported goods

will be more expensive. This will partly be due

to the recent depreciation of the euro, which is

passed on more strongly into consumer prices

for manufactured goods. The price of manufac-

tured goods is also affected by the low reference

base and relatively large wage rises.

Service price inflation has been low for the past

three years because of administrative measures

and falling prices for communications, but it will

rise faster during the years of the forecast. The

effect of the higher education reform will pass out

in September 2016, after which services inflation

will rise by about a percentage point and climb to

close to 3% in 2017. Service prices will continue

to rise as prices and wages continue to converge.

Figure 33. CPI inflation and its components

-10%

-5%

0%

5%

10%

15%

2011 2012 2014 20162013 2015 2017

food core inflation energy CPI total

Sources: Statistics Estonia, Eesti Pank

forecast

Figure 34. Tax changes and regulated prices

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

2005

2007

2006

2008

2010

2012

2014

2016

2009

2011

2013

2015

2017

per

cent

age

po

ints

contribution of taxes to inflation contribution of regulated prices to inflation

Sources: Statistics Estonia, Eesti Pank

forecast

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Box 6: Indicators for Estonian core inflation

Prices for oil and food have fluctuated widely in recent years. This has drawn increased attention

to the indicators for core inflation, which is total inflation stripped of its temporary volatility and

noise. Core inflation should be seen as the underlying part of inflation that matters in deciding

monetary policy and leaves aside short-term fluctuations in prices.

Central banks compile the indicators for core inflation with two main goals, which are monetary

policy and forecasting. Calculating core inflation is particularly important in those countries

where monetary policy is inflation targeting. Inflation targeting is often built on the core inflation

indicators, which compare price rises with long-term targets. Many central banks also use core

inflation indicators in inflation forecasting, and in that case core inflation has to be able act as a

leading indicator.

Roger20 has described the properties that core inflation indicators should ideally have. The

qualitative characteristic of core inflation should be its reliability, as it should be easy to calcu-

late, comprehensible to the public, and grounded in economic theory. Marques et al21 listed

econometric criteria that can be used to assess quantitatively whether indicators of core infla-

tion are appropriate. The most important property is that the core inflation indicator should be

unbiased22. Additional requirements concern cointegration and causality over the long term,

as core inflation should be the attractor for total inflation, not the other way round. As it is not

very often possible in practice to find an indicator that meets all the qualitative and quantitative

requirements, and as preferences may change over time, it is usual to observe more than one

indicator of core inflation, or a combination of indicators.

The most widely used indicator for core inflation is total inflation minus food and energy. Food

prices, such as prices for fruit and vegetables, can vary a lot because of the weather, while the

price of energy is affected by supply shocks.

Blinder23 favours excluding food and energy

on the grounds that they are dependent on

external factors that are beyond the control

of a central bank. Monetary policy should

focus more on the other prices which make up

domestic inflation. The consumer price index

based on Estonian data and without energy

and food is not particularly appropriate as a

measure of core inflation because it is biased.

The bias arises because Estonian food prices

have been converging rapidly with those in the

European market, and so there is no reason to

exclude all of them from the indicator for core

inflation. There are several other proven indica-

tors that better meet the requirements for core

inflation, by excluding only prices for seasonal

20 Roger, S. (1998) Core inflation: Concepts Uses and Measurement. Reserve Bank of New Zealand Discussion Paper No. G98/9 (July)

21 Marques, C. R.; Neves, P. D.; Sarmento, L. M. (2000) Evaluating Core Inflation Indicators. Banco de Portugal WP 3-00

22 The average long-term difference between total inflation and core inflation is zero.

23 Blinder, A. S. (1997) Commentary on Measuring Short- Run Inflation for Central Bankers. Federal Reserve Bank of St. Louis Review

Figure B6.1. Indicators of core inflation

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

2002 2004 2006 2008 2010 2012 2014

CPI total CPI excluding energy CPI excluding energy and food CPI excluding energy and seasonal food CPI excluding administered measures

Sources: Statistics Estonia, Eesti Pank

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food, energy prices, or administrative measures

(see Figure B6.1).

Another widespread method of calculating

core inflation is to analyse the cross-sectional

distribution of price changes in the consumer

basket. Ball and Mankiw24 use the asymmetry

in price changes for goods to calculate core

inflation. From this they draw conclusions

about the effect of supply shocks on consumer

prices. Due to menu costs the supply shocks

presumably affect only individual sectors and

their effect is temporary. Figure B6.2 shows the

cross sectional skewness of Estonian inflation.

The skewness of the distribution of prices was

strongly positive until 2013, but then it turned

negative. This shows that large rises and falls in

the prices of individual goods and services can

have a strong influence on inflation. The skewness turned negative because the distribution of

prices was affected by a series of administrative measures, notably free higher education and

free public transport in Tallinn. Estonian data show skewness to stem mainly from administered

prices and seasonal factors, not from the stickiness of prices caused by menu costs.

Calculating core inflation helps make the distinction between underlying inflation and tempo-

rary effects and it is an important component for forecasting. The Estonian data suggest the

indicator for core inflation should be relatively broadly based, and administrative price rises and

seasonal effects should be excluded from total inflation.

24 Ball, L.; Mankiw, N. G. (1995) Relative-Price Changes as Aggregate Supply Shocks. Quarterly Journal of Economics, February 1995, p. 161–193

Figure B6.2. Coefficient of skewness

-6%

-4%

-2%

0%

2%

4%

6%

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

cross sectional skewness of the CPI basket cross sectional skewness of CPI basket excluding higher eduction and public transport

Source: Eesti Pank

GENERAL GOVERNMENT FINANCING

The general government budget surplus will shrink to 0.1% of GDP in 2015 as spending will rise faster because the government increased child support and family benefits, and there has been a broad-based rise in labour costs. Investment will probably increase

faster in the second half of the year than it did

earlier because all the projects from the European

Union budget for 2007–2013 have to be finished

by the end of 2015. At the end of September, 7%

of the value of approved projects was still unpaid,

a total of 231 million euros that has to be covered

from the funds of the previous budget.

The tax burden will increase significantly in 2015, climbing by a percentage point to 33.5% of GDP. The increase in tax revenues in

the second half of 2015 will be restrained by the

slower rise in labour costs. The high reference

base from 2014 means that the annual growth

in value added tax will come down in the fourth

quarter; the declaration of all transactions of 1000

euros or more has reduced tax fraud, and this

started to affect revenues in the fourth quarter of

2014. Although tax policy measures will have a positive effect on the budget in 2016–2017, the tax burden will diminish slightly by the end of the forecast horizon. The tax burden

will continue to shift from labour to consumption

in the coming years because the government is

planning to raise the tax-free income threshold

and lower the social tax rate, and at the same

time to raise excise sharply and reduce VAT

reductions. The tax burden will be lower as the

impact of tax on extraordinary dividend payments

fades out, and also because the growth in labour

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Figure 35. General government fiscal position

-3%

-2%

-1%

0%

1%

2%

3%

4%

2010 2011 2013 2015 20172012 2014 2016

structural fiscal position temporary measures cyclical component nominal fiscal position

forecast

Sources: Statistics Estonia, Eesti Pank

per

cent

age

of G

DP

costs will cool during the years of the forecast

and labour taxes will account for a smaller share

of GDP.

The budget will remain in surplus throughout the forecast horizon, though the surplus will shrink to close to balance in 2017 (see Figure 35). Spending growth will slow throughout the

forecast period because higher growth in invest-

ment will be precluded by the change of the

European Union budget period, which will reduce

investment in 2016, and by the government deci-

sion to limit growth in labour costs in the budget

for next year. Social spending will be higher in

2017 because of income tax rebates for the

low-paid. This will be counterbalanced though by

slower growth in spending on pensions following

the indexing of pensions. The combined effect

of the temporary factors on the budget balance

will be modest during the forecast period and the

structural fiscal position will remain in surplus.

Pulling one way, the economic cycle will again

have a positive effect on budget revenues during

the forecast horizon, but in the other direction

additional payments to the second pension pillar

will reduce tax revenues for a time.

RISKS TO THE FORECAST

It is possible that growth in the Estonian economy could turn out faster than fore-cast, but there are also several reasons why it could be slower. The biggest downside risk in

the years ahead is uncertainty in foreign markets

and a slower recovery in demand for Estonian

exports than expected. This year the market

share of Estonian exports in their destination

markets stopped growing after several years of

increase. The economic circumstances in several

partner countries have been worse than usual,

though it may also be that Estonian compet-

itiveness has deteriorated. The decline in price

competitiveness caused by large wage rises may

continue to reverberate for a long time and may

impede the potential for growth in the economy.

Opportunities for growth in the real sector may

start to be limited if the Swedish real estate

bubble pops. In that case, banks may cut the

supply of credit, which would reduce the options

for financing investment. A fall in asset prices in

Sweden could also lead to a drop in demand for

Estonian exports, and this would have a wide

impact across the Estonian economy because

Sweden is one of the main destinations for

exports. Uncertainty caused by the European

migration crisis also surrounds the Estonian

economic forecast, because it is not yet clear

how much of an economic impact the migration

will have.

The risks from excessive growth in labour costs have increased. It is important for price

based competitiveness how businesses cope

with the increasingly constrained opportunities

to find new employees. Estonian companies have

so far considered that the biggest limitation on

increased production is the lack of demand, and

labour shortages have not generally been equally

significant. The labour market is reaching a

stage however where spare labour resources are

disappearing fast, as the working age population

is shrinking and most job seekers have already

found a job. This suggests that upward pressure

on labour costs will not go away, and the decisive

issue will be how companies cope with this while

still staying competitive in foreign markets.

The lack of movement of labour between sectors may raise unemployment. Easing

wage pressures without sharply braking wage

growth will require a greater share of investment

to go on increasing efficiency and productivity

than before. Companies with low productivity will

inevitably be expelled from the market when this

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happens. If retraining is effective and workers are

able to move from dead companies to companies

capable of surviving, it will increase the potential

growth of the economy. However, if employees

prove unable to change position it will increase

the risk of a rise in unemployment.

The biggest impact on inflation during the forecast horizon may come if price move-ments for oil and other energy sources differ from expectations. Energy prices have

been volatile in recent decades as they depend

on a lot of factors that affect supply and on global

demand. If energy prices should start to rise

rapidly from their current very low levels, it would

have an immediate and significant impact on

consumer prices. A rise in energy prices would

also be seen in consumer prices a long time later

because of increased production prices. If the

recovery in the global economy is delayed and

demand remains weak, the price of imported

goods may rise by less than forecast. This would

restrict inflation in the whole consumer basket,

meaning inflation would be lower than forecast.

The Eesti Pank forecast for economic growth in 2015-2016 is more pessimistic

than forecasts by other institutions. As the

flash estimate for the third quarter was worse

than expected, the outlook for growth for this year

was cut to 1.2%. The average of the forecasts by

other institutions is 0.6 percentage point higher.

The negative impact of the flash estimate passes

through into next year, and the Eesti Pank growth

forecast is half a percentage point lower than the

average of 2.7% from the other institutions. The

outlook for 2017 is about the same as the average

of the other institutions, and even 0.1 percen-

tage point higher. The Eesti Pank forecast for

consumer prices for 2015–2016 is lower than

those of most other institutions. This is mainly

because of new information about energy

prices, which has put the inflation forecast for

this year 0.12 percentage point lower than the

average of the other forecasts. The forecast for

the years ahead is still largely dependent on

assumptions about the oil price, as the Eesti

Pank inflation forecast for next year is a full

0.5 percentage point below the average fore-

cast by the other institutions. Like the growth

forecast, the inflation forecast for 2017 is

similar to those of the other institutions, as

the Eesti Pank forecast is only 0.2 percen-

tage point above the average (see Table 4).

Table 4. Estonian economic forecasts by various institutions

GDP real growth, % CPI inflation, %

2014 2015 2016 2017 2014 2015 2016 2017

Eesti Pank 2.9 1.2 2.2 3.1 -0.1 (0.5*)

-0.4 (0.1*)

1.2 (1.5*)

2.9 (3.1*)

Ministry of Finance 2.9 1.7 2.6 3.4 -0.1 (0.5*)

-0.3 (0.2*)

2.0 (2.3*)

2.9 (3.1*)

European Commission 2.9 1.9 2.6 2.6 0.5* 0.1* 1.8* 2.9*

IMF 2.9 2.0 2.9 3.0 0.5* 0.2* 1.6* 2.0*

OECD 2.9 1.8 2.5 2.9 0.5* 0.1* 1.3* 2.4*

Consensus Forecast 2.9 1.7 2.7 -0.1 -0.2 1.6

SEB 2.9 1.9 2.7 3.4 0.5* 0.5* 2.3* 2.7*

Swedbank 2.9 1.6 2.6 2.8 -0.1 -0.4 1.6 2.5

Nordea 2.1 2.0 3.0 3.2 -0.1 -0.1 2.0 2.5

Source: Eesti Pank, December forecast 09/12/2015; Ministry of Finance, Summer 2015 forecast 16/09/2015; European Commission. Economic Forecast. Autumn 2015. 06/11/2015; IMF, WEO, October 2015, 06/10/2015; OECD, Economic Outlook, November 2015, 09/11/2015; Eastern Europe Consensus Forecasts, November 2015; SEB, Eastern European Outlook, October 2015, 07/10/2015; Swedbank Economic Outlook 10/11/2015; Nordea economic forecast, 02/09/2015.