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Estonia's record on market reforms and financial instability puts it in the forefront of the reforming economies in Central and Eastern Europe. Balanced budgets, a strong commitment to exchange rate stability within the context of a currency board system, an open and liberal trade and payments regime, and a decisively liberal approach to the role of the State in economic affairs make Estonia stand out among its peers.
Despite this, the return in terms of economic growth has up until this year been rather modest, more or less in line with that of Central Europe as a whole. In 1995 and 1996, real growth amounted to 4-5 pct per year. However, this year, real GDP has surged, increasing by some 12 pct during the first six months. Although the economy is now expected to slow down, real GDP may still grow by 9 pct for the year as a whole.
To a large extent, this is indicative of the potential power of the Estonian economy to catch up with the West. However, along with this strong growth, serious imbalances emerged. These showed up primarily in the form of an excessively rapid increase in bank credits which made possible a huge deficit in the current account of the balance of payments.
In 1996, the current account deficit amounted to USD 447 million or 10.3 pct of GDP, up sharply from the year before. It remained weak in the beginning of 1997 and may reach USD 515 million or 11 pct of GDP for 1997 as a whole. Meanwhile, inflation continues to reflect the fact that Estonia´" price structure gradually is adjusting towards that of the industrialised economies. Thus, in September, consumer price inflation was down to 12 pct yoy.
These imbalances were mainly induced by the private sector which took up loans at a breathtaking speed abroad. Estonia´" general government balance has never deviated far from zero and monetary policy can play no active role in demand management beyond providing a nominal anchor in the form of the peg to the German mark.
It was also the private sector that put an end to the boom this year. When global stock market turned south in late October, the Estonian market was a hit in a massive way. During the course of 1997 through August, share prices went up by some 200 pct. Subsequently though the first half of November, they fell by 50 pct.
The economy is already adjusting to this shock. Higher interest rates and lower stock market prices will have a major effect on the real economy including Estonia´" propensity to import. Growth may fall to 4 pct next year while the current account deficit may be limited to USD 354 million or 6.9 pct of GDP.
Given the reliance on market mechanisms, the economy will soon rebound. The danger also appears to be over for the Estonian kroon.
This does not mean, however, that the adjustment process will be totally without pain. It is now inconceivable that one or a few of the banks, which have no doubt overextended themselves through the period with generous stock market valuations, could be looking forward to rising credit losses. Other than that, the legacy of this episode will serve as a useful lesson on the dangers of highly leveraged investors in the stock market. This, in turn, will hopefully stimulate improvements in the supervision of financial markets as well as to more realism on behalf of market participants.
Stockholm November 25, 1997
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