Cablegate: Estonian Gdp Growth Slows More Than Expected

DE RUEHTL #0200/01 1581157
R 061157Z JUN 08




E.O. 12958: N/A


1. (SBU) SUMMARY: A preliminary Estonian GDP growth figure
showing only 0.4 percent growth in the first quarter of
2008 has shocked analysts and the public. Senior
government economic advisors cite steeper-than-expected
declines in consumer spending and a sluggish real estate
market as the primary causes of the slowdown. While
slowing growth has increased concerns that the Estonian
economy faces a "hard landing," Estonian analysts stress
the fundamentals of the economy are strong. A May IMF
review concluded that Estonia's economic slowdown was
necessary after two years of unsustainable growth, although
the slowdown has been faster than expected and may result
in overall negative GDP growth for 2008. End Summary.

Cautious Consumers Slowing Growth

2. (SBU) In mid May, the Estonian Statistics Office
released a "flash estimate" for Estonian GDP growth at 0.4
percent for the first quarter of 2008, the lowest in eight
years. As a comparison, growth in the fourth quarter of
2007 was 4.8 percent. While noting the growth estimate was
based on preliminary figures, Aare Jarvan, Economic Advisor
to the Prime Minister, acknowledged that growth this year
has slowed faster than the GOE expected. (The Bank of
Estonia's (BoE) forecast for 2008 was 2 percent growth.
Other estimates predicted growth as high as 4-5 percent.)
Jarvan cited the slowdown in consumer demand and a steeper-
than-expected decline in the real estate market as the
primary causes. According to BoE figures, this year real
estate turnover has returned to 2004 levels and prices have
decreased 10-15 percent from peak levels in 2007.

3. (SBU) Both Jarvan and Tanel Ross, head of the
International Relations Department at the BoE blamed the
decline in private consumption, in part, on higher than
expected inflation. According to the Statistics Office,
inflation in April was running at 11.4 percent. Rising
energy costs, food prices and wages have contributed
significantly to inflationary pressures. (Note: These
factors not unique to Estonia. End Note.) Both Jarvan and
Ross said they thought inflation in Estonia had now peaked
and should begin to decline. However, Jarvan noted, the
April figure was "a bit surprising" as the "direction was

4. (SBU) Despite the unexpectedly low estimate of first
quarter growth, Ross noted, the BoE has not revised its GDP
growth forecast for 2008. While the "risks have clearly
increased," Estonia's economy has not "ground to a halt."
Jarvan pointed out that unemployment in Estonia remains
very low (about 4.2 percent) and wage growth is still
strong (20 percent year-on-year.) The bottom line, he
concluded, is there has not been a dramatic change in
disposable income. Ross, however, cautioned that
employment and wages are lagging indicators and he fully
expects to see changes (i.e. downturns) there as well. He
also noted that while wage growth is still high, it is
slower than in previous quarters. The combination of
slower growth and steady employment levels signal declining
productivity, which will be a longer-term concern for the
Estonian economy. On the bright side, Ross said, initial
data indicates that private sector wages have been more
responsive to changing economic conditions than public
sector wages. (Note: Over the past few years the GOE has
significantly increased public sector wages including for
police, medical, educational and rescue workers as well as
white collar civil servants. Ross indicated that, as one
measure of response to Estonia's slowing economy, he does
not expect the GOE to implement any additional wage
increases in the near term. End Note.)

5. (SBU) Experts here contend economic fundamentals remain
strong and there are positive factors in the economy.
Estonia's low debt and the government's commitment to
maintaining a balanced budget are key. According to Ross,
banks are still lending, although at a slower pace than in
previous years and the BoE forecast of 13-15 percent credit
growth is on target. While Banks are providing relatively
less credit to households, they are lending more to
manufacturers. Also, the quality of the banking sector's
loan portfolio remains high. The share of non-performing
loans (those overdue more than 60 days) is below one
percent of the total. This is expected to increase
slightly in the near term, but not to exceed 2 percent in
2008. Also positive, the Estonian current account deficit
is decreasing steadily. Exports are outpacing imports
(which have showed negative growth this year), and net
savings have increased. The BoE expects the current
account deficit to fall to around 10 percent of GDP this

TALLINN 00000200 002 OF 002


6. (SBU) According to Ross, the short- to medium- term
health of the economy will depend on both domestic and
external factors. Government spending is key; the GOE
needs to keep outlays in line with economic growth. The
GOE should not look to stimulate domestic demand. Rather,
Ross advised, the GOE should keep macroeconomic policy
neutral and allow some increase in unemployment to occur.
Inflation is also important; the health of the economy will
depend in part on how quickly inflation declines. The
banking sector is another key factor. Scandinavian banks
control approximately 95 percent of the Estonian banking
sector. Continued health of these banks and their
willingness to lend (e.g. no credit crunch) is crucial.

Then there's the Budget

7. (SBU) The GOE has demonstrated a consistent commitment
to balanced budgets and continues to have the lowest
government debt level in the EU. The GOE's budget has been
in surplus since 2001. However, in April the GOE announced
the need for a supplementary budget for 2008 to make up for
an unexpected revenue shortfall. (Estimates on how big a
shortfall the government faced ranged up to 3 percent of
GDP). After negotiations within the Government coalition
and among ministries, the Cabinet approved a supplementary
budget which cut expenditures by 3.2 billion kroon (USD 320
million) and adjusted revenues down by 6.1 billion eek (610
million). On average, ministries and agencies cut their
budgets by 7 percent - in line with the level recommended
by the GOE at the start of the process, making the
outcome a win for the government. The Ministry of Defense
faced the smallest cut (0.8 percent) and the Ministry of
Foreign Affairs absorbed the largest (14 percent). The
Parliament began debating the budget proposal on June 4 and
has committed to finish by the time of the June 18 recess.

8. (SBU) Jarvan told Pol/Econ Chief the GOE's original
budget forecast had been "terribly wrong." The primary
cause of the imbalance was lower than expected VAT receipts
- which make up about a third of central government income.
(Personal income and social security taxes have been in
line with expectations.) Jarvan commented that the
changing structure of domestic demand has made a
significant impact on VAT receipts: the two biggest areas
of decline were sales of cars and real estate. Despite
speculation in the press, Jarvan noted, the GOE does not
plan to tap the Government's stabilization reserve fund or
halt planned cuts in personal income tax rates. However,
the three parties in the coalition have formed a working
group to discuss priorities for the 2009 budget.

IMF Weighs In

9. (SBU) An IMF Mission in Estonia May 7-19 for regular
Article IV Consultations provided its own assessment of the
Estonian economy. Of note in the conclusions:

-- Estonia's economic slowdown was necessary after two
years of unsustainable high growth, although the slowdown
has been faster than expected and may result in overall
negative GDP growth for 2008.

-- Inflation should moderate in 2009.

-- Although Estonia's current account deficit is shrinking
it is still "larger than warranted" and needs to narrow
further to improve Estonia's external competitiveness.

-- The GOE's quick response to the budget gap demonstrates
its commitment to prudent fiscal management. The
Government's proposal to freeze state wages should be
extended to other levels of government.

-- The Government should adopt the draft labor law
currently under discussion as it would go a long way to
addressing labor market rigidities.


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