1

Hardo Pajula

Estonian economy:Autumn 2007

2

Analytical framework

Output and income growth

Labour market

Inflation

Competitiveness

Balance of payments

Money supply and credit

Interest rates and asset prices

Cap

ital a

ccou

nt

David HumeAll water. wherever it communicates. remains always at a level. Ask naturalists the reason; they tell you. that. were it to be raised in any one place. the superior gravity of that part not being balanced. must depress it.

Exch

an

ge ra

te

3

The watershed

In the second half of this Feb-ruary rumours about an immi-nent devaluation of Latvian currency drove interbank rates from 4.5 to 9 percent and pushed the lat to touch its upper boundary.

In the following two weeks the share prices of Swedbank and SEB fell by 12 and 9 percent respectively, reflecting the worries about their exposure to Baltic credit boom.

100

110

120

130

140

150

160

170

1800

6.0

6

07

.06

08

.06

09

.06

10

.06

11

.06

12

.06

01

.07

02

.07

03

.07

04

.07

05

.07

06

.07

07

.07

08

.07

09

.07

Sh

are

pri

ces,

Ind

ex

13

.6.2

00

6 =

10

0

0

2

4

6

8

10

12

RIG

IBO

R, I

n p

erc

en

t

Swedbank SEB RIGIBOR 6 months

Latvian devaluation rumours start to go around

4

“Bronze night” takes toll on confidence

The images of shattering shop-windows which under other circumstances might have shaken off as a minor disturbance seem to have had in this phase of the cycle a more damaging impact. Its impact on transit and inbound tourist flow has been equally distructive.

-50

-40

-30

-20

-10

0

10

20

300

1.0

6

04

.06

07

.06

10

.06

01

.07

04

.07

07

.07

Fre

igh

t tu

rno

ver:

12

-mo

nth

gro

wth

ra

tes,

%.

-4

-2

0

2

4

6

8

10

12

14

Freight turnover Consumer confidence

"Bronze night"

5

“Fear index” on the rise

Sharply increased risk-aversion will make it harder for parents to raise money.

The boom was predicated on the transfer of cheap funds from the core to perihery. Historically, the problems at the core tend to be amplified in the peripheries.0

5

10

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30

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40

45

50

01

.90

01

.91

01

.92

01

.93

01

.94

01

.95

01

.96

01

.97

01

.98

01

.99

01

.00

01

.01

01

.02

01

.03

01

.04

01

.05

01

.06

01

.07

VIX

, %

6

Key factor: Animal spirits

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations … Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”John Maynard Keynes on long-term expectations

Entrepreneur from Africa

7

Growth and economic sentiment

-4

-2

0

2

4

6

8

10

12

141

2.9

4

12

.95

12

.96

12

.97

12

.98

12

.99

12

.00

12

.01

12

.02

12

.03

12

.04

12

.05

12

.06

Ro

llin

g y

ea

r g

row

th r

ate

, %.

0

20

40

60

80

100

120

140

Eco

no

mic

se

ntim

en

t.

GDP Economic sentiment

8

Aggregate demand and its components

-20

-10

0

10

20

30

401

2.9

4

12

.95

12

.96

12

.97

12

.98

12

.99

12

.00

12

.01

12

.02

12

.03

12

.04

12

.05

12

.06R

olli

ng

ye

ar

gro

wth

ra

tes,

%.

Investment Domestic demand Export Import GDP

9

Industrial output andconfidence

-10

-5

0

5

10

15

201

2.9

6

12

.97

12

.98

12

.99

12

.00

12

.01

12

.02

12

.03

12

.04

12

.05

12

.06R

olli

ng

ye

ar

gro

wth

ra

te, %

.

-5,0

0,0

5,0

10,0

15,0

20,0

25,0

30,0

Co

nfid

en

ce in

dic

ato

r.

Output Confidence

10

Exports and order books

-20

-10

0

10

20

30

40

50

601

2.9

6

12

.97

12

.98

12

.99

12

.00

12

.01

12

.02

12

.03

12

.04

12

.05

12

.06

Ro

llin

g y

ea

r g

row

th r

ate

, %.

-50,0

-40,0

-30,0

-20,0

-10,0

0,0

10,0

20,0

30,0

Ord

er

bo

oks

ind

ica

tor.

Exports Order books

11

Construction output andconfidence

-30

-20

-10

0

10

20

30

401

2.9

5

12

.96

12

.97

12

.98

12

.99

12

.00

12

.01

12

.02

12

.03

12

.04

12

.05

12

.06

Ro

llin

g y

ea

r g

row

th r

ate

, %.

-60,0

-40,0

-20,0

0,0

20,0

40,0

60,0

Co

nfid

en

ce in

dic

ato

r.

Output Confidence

12

Retail sales and consumer confidence

0

5

10

15

20

251

2.9

9

12

.00

12

.01

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.02

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Ro

llin

g y

ea

r g

row

th r

ate

, %.

-40,0

-30,0

-20,0

-10,0

0,0

10,0

20,0

Co

nsu

me

r co

nfid

en

ce.

Retail Consumer confidence

13

Labour market

-10

-5

0

5

10

151

2.9

4

12

.95

12

.96

12

.97

12

.98

12

.99

12

.00

12

.01

12

.02

12

.03

12

.04

12

.05

12

.06Ro

llin

g y

ea

r ra

tes,

%

-30

-20

-10

0

10

20

30

40

Un

em

plo

yme

nt e

xpe

cta

tion

s.

Unemployment Employment growth Expectations

14

Prices and wages

0

5

10

15

20

251

2.9

7

12

.98

12

.99

12

.00

12

.01

12

.02

12

.03

12

.04

12

.05

12

.06

Ro

llin

g y

ea

r g

row

th r

ate

s, %

.

HCPI Nominal wage Real wage

15

Balance of payments

-20

-15

-10

-5

0

5

10

15

20

251

2.9

3

12

.94

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.95

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.96

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.97

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.98

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.99

12

.00

12

.01

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.02

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.03

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.04

12

.05

12

.06

Ro

llin

g y

ea

r ra

tios

to G

DP

, %.

Current account Financial account FDI

16

Credit growth

-20

-10

0

10

20

30

40

50

60

70

800

4.9

8

04

.99

04

.00

04

.01

04

.02

04

.03

04

.04

04

.05

04

.06

04

.07

Tw

elv

e-m

on

th g

row

th r

ate

s, %

.

Corporates Individuals

17

Interest rates and asset prices

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.98

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.99

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.00

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.07Fo

ur-

qu

art

er

gro

wth

ra

tes,

%.

0

1

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5

6

7

8

9

3-m

on

th T

AL

IBO

R, e

nd

of p

eri

od

Stock prices Real estate TALIBOR

18

Main findings

Current statistics tells the story of a strong growth which in reality has already passed.

The leftover growth we do see is skewed heavily towards domestic demand which is particularly susceptible to abrupt changes in the expectations of residents – the animal spirits argument.

As the persistent flow of bad news makes expectations to shift, domestic demand will fall (possibly rapidly) in the second half of this year.

To the extent it does, we are going to see a process of unwinding of accumulated imbalaces with inflation and wage growth coming down and external balance narrowing.

In this different environment the expectations formation becomes once again a key issue. Deeply ingrained inflationary expectations could set fixed exchange rate under intense pressure.