Cablegate: Bankers Predict Soft Landing for Estonian Economy

DE RUEHTL #0492/01 2081416
R 271416Z JUL 07




E.O. 12958: N/A


1. (U) Summary: Macroeconomic analysts in and out of
government continue to predict Estonia faces a 'soft landing' -
6 to 8 percent GDP growth - from its period of rapid economic
growth. Despite a large current account deficit, rising
inflation, and a tight labor market, the long-term outlook for
Estonia is good. The major Swedish banks which dominate the
market here will continue to play a stabilizing role as the
housing market cools, and consumer credit tightens marginally.
Areas to watch include inflation, which is expected to continue
rising into 2008, and Estonia's inflexible labor market. End

2. (U) In recent months, several factors have raised concern
about a possible hard landing for Estonia's economy, which has
been growing at more than 10 percent for the past two years.
Wage increases of 16.5 percent in 2006 (rising to 20 percent for
the first quarter of 2007), slower consumer credit growth since
the beginning of 2007, devaluation fears in neighboring Latvia
earlier this year, and recent cautionary reports from Moody's
and other credit agencies, have all added to the debate about
the direction of the Estonian economy. The cyber attacks in May
on internet infrastructure, and the subsequent disruption of
trade with Russia have further created an air of uncertainty.
Nevertheless, analysts from both the public and private
financial sector are confident that the economy will not see a
sharp correction, but rather a relatively soft landing of around
6-8 percent annual GDP growth over the next two years.

Between Two Giants: Size Does Matter

3. (U) Estonia is often described as having a small, open
economy, but Hardo Pajula of SEB Uhispank's Capital Markets
Division told us the operative word should be "miniscule." To
put the economy of what many refer to as "Talsinki" in
perspective, he noted that Tallinn and Helsinki, Finland are
basically one economic zone akin to New York City and suburban
New Jersey or Connecticut. The difference here is that a
balance-of-payments transaction occurs each time trade occurs
between the two capitals. Much of the recent concern about
potential vulnerabilities in the Estonian economy has focused on
its current-account deficit, which stands now at 15 percent of
GDP, but Pajula told us he is not overly concerned about this.
Estonia is sandwiched between the economies of Sweden and
Finland, together 36 times larger than Estonia's to the west,
and that of Russia, 60 times larger to the east. Given that
these much larger neighbors are both running current account
surpluses of 7-10 percent of GDP, it is inevitable, Pajula said,
that Estonia's economy is running a deficit.

4. (U) A few factors help counter this imbalance. The GOE has
been running a budget surplus since 2001, and has a reputation
for fiscal responsibility. Also, the national currency is
pegged to the Euro and not heavily traded in currency markets.
Finally, Estonia does not have a public-debt market which could
spread instability throughout the economy. Marje Josing,
Director of the Estonian Institute of Economic Research, (the
source agency for most raw data on Estonia's economic
performance) was as sanguine as SEB's Pajula about the current-
account deficit. Stressing how - in just the past 15 years -
the Estonian economy has successfully weathered high
unemployment and Russian "double tariffs" in the mid-1990s, the
Russian currency crisis in the late 90s, and now the process of
wage and price convergence with the EU, Josing said she is not
worried about the long-term outlook. The heads of two Ministry
of Finance (MOF) Offices (International Cooperation, and
Economic Analysis) noted that Estonia has met or exceeded the
IMF's goals, and Estonia's experience joining the EU could be a
case study for an economic convergence. The MOF estimates that
the 2007 budget surplus should be larger than the currently
projected 1.9 percent of GDP, if the GOE does not decide to
increase spending in a September supplementary budget.

Credit Expansion and Inflation

5. (U) Another frequently cited concern is the rapid expansion
of consumer credit thanks in large part to a real estate boom
and flexible borrowing policies (including loans via mobile
phone). Many blame easy credit as another factor driving up
inflation (currently 5.7 percent), and thus keeping Estonia out
of the Eurozone. Annual private credit growth soared above that
of peer countries from 2001-05, and in 2006 short-term interest
rates averaged 3.2 percent. However, Estonia has none of the
traditional monetary tools to tighten credit. The currency is
pegged to the Euro at a fixed rate, and the money supply in the
country is effectively controlled by Sweden's private banks.
The two biggest players, Hansapank (owned by Swedebank) and SEB
Eesti Uhispank together control 78 percent of the market. While
loan portfolios in the Baltic countries are a fairly small share
of these banks' overall exposure, they are highly profitable

TALLINN 00000492 002 OF 002

ones. On July 19, SEB announced profits for the first half of
2007 were up 30 percent over the same period last year.
Hansapank's Maris Lauri told us that while its parent
Swedebank's assets in the Baltics represent only 10 percent of
their total portfolio, they generate one-third of the company's

6. (U) While much of this money has been pouring into real
estate, that market appears to have levelled off and loan growth
is now finally slowing. The Bank of Estonia reported in June
that "...the credit standards of [private] banks have become
stricter,...the number of customers capable of borrowing has
declined and this has resulted in a fall in the number of
transactions..." Officials at the Bank told us that 90 percent
of households are owned by their occupants, not speculators, and
banks are now charging higher interest rates for home equity
loans than for initial mortgages. Non-traditional, sub-prime
lenders such as the Baltic Investment Group (BIG) are still
cropping up, but they represent a very small percentage of the
banking market. This rapid credit growth has raised concerns
that foreign banks could pull back on their position in Estonia
if they began to experience a high rate of defaults, causing a
disruption in the financial market. All analysts we spoke to,
however, agreed that there are few scenarios in which Hansapank,
SEB and the others might pull capital out of the Baltic market.
It would take a major EU-wide financial shock to cause them to
severely reduce their exposure here.

7. (U) Even with GDP growth projected to slow, and a tightening
of credit by the private banks, financial experts agree that
inflation has not yet peaked. The wage increases of the past
year have yet to work their way through the economy, and public
sector wages - typically lagging at least twelve months - have
not caught up with increases in the private sector.
Furthermore, noted Maris Lauri of Hansapank Markets, much of the
EU structural funds slated to be spent in Estonia over the next
six years will go into construction and agriculture, where they
will quickly end up in the hands of consumers, driving up

8. (U) A final area to watch is labor market flexibility. Ref
A noted the tight labor market in Estonia, and the political
reluctance to bring in greater numbers of foreign workers.
Additionally, while Estonia ranked 17th overall in the World
Bank's 2006 "Ease of Doing Business" Index, it was 151st in the
specific category of "Employing Workers." Two issues accounting
for this low score are the inability of workers to get flex-time
or non-traditional employment contracts, and bureaucratic
barriers to obtaining work visas for foreign nationals. A joint
working group with representation from the Ministries of Economy
(MOE) and Internal Affairs has been discussing the foreign labor
issue for over a year. However, a memorandum including
recommendations for simplifying the visa and immigration process
for highly skilled foreign workers was adopted by the GOE only
on June 14. A contact at MOE told us that the Ministry of the
Interior will come up with relevant legislative proposals by
November 1st, but as far as she knows there is no study
currently under way.


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