1. Martin Lindpere Bank of Estonia The case of Estonia: from local credit boom to global bust

2. Martin Lindpere, Bank of Estonia 26/06/09 2 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

3. Martin Lindpere, Bank of Estonia 26/06/09 3 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

4. Martin Lindpere, Bank of Estonia 26/06/09 4 Capital inflow fed credit boom and financial deepening were extremely rapid Source: Bank of Estonia, Statistics Estonia

5. Martin Lindpere, Bank of Estonia 26/06/09 5 However, foreign liabilities were mostly inhouse positions of Nordic banking groups The banking market is very strongly integrated to Scandinavia Source: Bank of Estonia

6. Martin Lindpere, Bank of Estonia 26/06/09 6 It was largely a real estate boom The turnaround of the boom started from the real estate sector in 1H 2007

7. Martin Lindpere, Bank of Estonia 26/06/09 7 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

8. Martin Lindpere, Bank of Estonia 26/06/09 8 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

9. Martin Lindpere, Bank of Estonia 26/06/09 9 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

10. Martin Lindpere, Bank of Estonia 26/06/09 10 The level of prive and income convergence achieved by 2007 Source: Eurostat

11. Martin Lindpere, Bank of Estonia 26/06/09 11 However, from competitiveness point of view labor cost advantage is still on our side, especially if compared against Nordic countries Source: Eurostat

12. Martin Lindpere, Bank of Estonia 26/06/09 12 But problems travel rarely alone, QIV 2008 global trade shock added new problems Source: Eurostat

13. Martin Lindpere, Bank of Estonia 26/06/09 13 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? Source: Eurostat

14. Martin Lindpere, Bank of Estonia 26/06/09 14 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

15. Martin Lindpere, Bank of Estonia 26/06/09 15 Credit stock is going to decline in 2009 Source: Bank of Estonia

16. Martin Lindpere, Bank of Estonia 26/06/09 16 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

17. Martin Lindpere, Bank of Estonia 26/06/09 17 Labour market responded rapidly to the global crises, core inflation as well Source: Bank of Estonia, Statistics Estonia

18. Martin Lindpere, Bank of Estonia 26/06/09 18 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

19. Martin Lindpere, Bank of Estonia 26/06/09 19 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?

20. Martin Lindpere, Bank of Estonia 26/06/09 20 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