The case of Estonia: from local
credit boom to global bust
Martin Lindpere
Bank of Estonia
Estonia before the EU accession in 2004
• 12 years of experience under the currency board system (kroon
fixed to euro)
– Currency board tested not only in good growth years (early banking
crises, Russian crisis etc)
• Increasing ties with the European Union
– Very high openness to trade and investment
– Highly integrated banking market since 2000
• High level of labour market flexibility
Martin Lindpere, Bank of Estonia 26/06/09
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The drivers of economic performance in the boom years
• EU accession and favourable external environment in 2005-07
– Estonia
• Enhanced labour mobility and strengthened wage pressure
• Increased productivity (incl in the exporting sector)
• Fastened financial liberalization, lower interest rates and longer maturities in
lending
– External world
• Period of relatively fast growth, low interest rates and abundant credit
Martin Lindpere, Bank of Estonia 26/06/09
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Capital inflow fed credit boom and financial deepening
were extremely rapid
Source: Bank of Estonia, Statistics Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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However, foreign liabilities were mostly inhouse
positions of Nordic banking groups
The banking market is very strongly integrated to Scandinavia
Source: Bank of Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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It was largely a real estate boom
The turnaround of the boom started from the real estate sector in 1H 2007
Martin Lindpere, Bank of Estonia 26/06/09
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Policy responses
• Currency board continued
– European interest rates unfortunately low
• Tightening in prudential regulations
– Reserve requirements (signalling, but also liquidity buffers)
– Capital adequacy
• Fiscal surpluses
– Fiscal surpluses were formed in the amount of 10% of GDP by 2008
– Ex post evaluation: reserves still too little
• The arms for undoing the massive capital inflows were nevertheless short
Martin Lindpere, Bank of Estonia 26/06/09
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Unwinding of imbalances
• The domestic boom started to reverse in 2007 when asset overpricing
became obvious and expectations turned
– Currency board and fixed exchange rate very important in cementing
expectations
• Some supply side reaction from banks was also at play
– Incl better synchronised interest rate cycle from Europe
• 2007 global financial turmoil fastened the unwinding, but added other
concerns
– Liquidity of wholesale-based financial groups
Martin Lindpere, Bank of Estonia 26/06/09
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Lessons from the first phase of unwinding (until 3Q
2008)
• Procyclical assessment of potential growth dangerous
– It is principal part of overshooting
– However, how to escape from global mistake?
• Annual data lags behind hopelessly
– Bad – as policy analysis deals with historic problems
– Good – adjustment more step-by-step?
• Current account primarily expectations-issue, not relative
price/misalignment issue
Martin Lindpere, Bank of Estonia 26/06/09
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The level of prive and income convergence achieved by
2007
Source: Eurostat
Martin Lindpere, Bank of Estonia 26/06/09
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However, from competitiveness point of view labor cost
advantage is still on our side, especially if compared
against Nordic countries
Source: Eurostat
Martin Lindpere, Bank of Estonia 26/06/09
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But problems travel rarely alone, QIV 2008 global
trade shock added new problems
Source: Eurostat
Martin Lindpere, Bank of Estonia 26/06/09
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Likewise in EU, the shock to industrial production in
Estonia has taken us back quite a few years in time
Why should a symmetric shock bring us to the exchange rate question?
Martin Lindpere, Bank of Estonia 26/06/09
Source: Eurostat
13
The loan conditions have also become tighter, as
elsewhere
Supply factors: interest rate cycle became more synchronised with Europe since 2006
Source: Bank of Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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Credit stock is going to decline in 2009
Source: Bank of Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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Predominantly demand factors were driving the current
account since 2007 but the supply factors joined the
game since end-2008
Large adjustments possible without recourse to exchange rate
Source: Bank of Estonia, Statistics Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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Labour market responded rapidly to the global crises,
core inflation as well
Source: Bank of Estonia, Statistics Estonia
Martin Lindpere, Bank of Estonia 26/06/09
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1st challenge: surviving the global crash
• Which industries stabilise, which vanish, which rebound?
– A lot to do in private sector, but what could be value added from the
public policies?
• Which level of fiscal expenditures to target
– How temporary is the global shock?
• And no small thing: how to get over prejudices?
– Currency board functions well, but much of discussion goes on in “normal
monetary policy” paradigm
– Eg story of huge short term debt burden gets already quite ridiculous
• Exchange rate policy can be stabiliser, but again: you have to play
with the specific rules
– Under fixed exchange rate: build up your own buffers both on financial
and fiscal side
Martin Lindpere, Bank of Estonia 26/06/09
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2nd challenge: to meet the Maastrich criteria in
order to join the euro club
• Just now things look promising
– Inflation has been on fast track decline
– Public sector deficit is obviously an issue: not much experience on
assessment during ‘exceptional times’
• However, things are not clearcut
– Budget has been able to adjust a lot, but is it enough?
– Budget consolidation should still make long-term sense
• Eg right balance on public investment, education
• EU money is good, but are the targets right?
• For global reasons Estonia might miss the convergence play well
until next year
– Good or bad?
Martin Lindpere, Bank of Estonia 26/06/09
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All in all: policy conclusions
• Economy has shown its flexibility
• Fiscal prudence has paid off:
– Deficits now are manageable
– Reserves provide room for manoeuvring
– Still: many things to do …
• Financial system integration has paid off:
– No extraordinary stress in financial stability
– High reserve requirements and higher capital adequacy requirements now
very valuable
• Currency board and fixed exchange rate has paid off:
– Inflation expectations under control
– Clear anchor for restructuring supports (wage) flexibility
Martin Lindpere, Bank of Estonia 26/06/09
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