Estonia

Country Name Estonia
Country Region Central & Eastern Europe

The Banking Environment

Estonian Economy

The Estonian economy is undergoing a rapid period of change. Estonia’s external demand suffered a serious setback due to the global economic crisis, and this, in conjunction with domestic imbalances that emerged during the years of rapid growth, brought along a profound downturn. The volume of the Estonian economy has contracted by nearly 20% compared to its peak and the worst of the recession is over by now. The economy will start to stabilise, but sustained recovery is going to take time. The resumption of economic activity will be led by the exporting sector and it is going to be uneven across sectors. Thus, the revival of external demand is of vital importance to the Estonian economy. The adoption of the euro is a significant economic policy step to support the economy in several ways. Postponement of the changeover would exert a drag on the recovery of growth.

The prices of goods open to external competition have been faster in reacting to the economic downturn. As a result, the cost of the consumer basket is decreasing. This trend was left unaffected by the raising of the VAT in mid-2009. Monopoly services, such as water supply, sewerage, and public transport, on the other hand, have not started to cheapen. The price level in Estonia will change by just a couple of percentage points in the next years. Domestic factors will contribute to a decline in prices, whereas it will be offset by the raising of tobacco and alcohol excise taxes and growing energy prices. Compared to the EU average, the relative price level in Estonia will decline less in the period of economic contraction than the relative income level. The severest financial and economic crisis in recent history will have a distinct impact on the development of the global economy. The large scope of the crisis is reflected in the fact that the global economy as a whole is experiencing a downturn this year. Compared to the spring 2009, financial stress in the world has markedly alleviated, but risks related to it have by far not yet withdrawn.

However, several forward-looking indicators suggest the steepest recession has already bottomed out. Hopes of a recovery have even caused some upward revision of growth forecasts. At the same time, the crisis period has put an additional strain on the government budgets of most of the countries, which means they will have to economise more in the years to come. Soon it will also be necessary to start pulling back economic stimulus measures. The materialisation of the risks accompanying the listed factors may reduce external demand in the next years. Although several confidence indicators reflecting economic activity in Estonia have already bottomed out, they have not yet reached levels confirming a definite turn for the better. A precipitous contraction in domestic and external demand has notably reduced corporate profits and to some extent also the wages of employees. Thus, economic activity will be affected by the adjustment to lower incomes. The faster the economic adjustment process is, the more people’s confidence in the future will grow. Realignments are still in the pipeline in several sectors, so their impact on economic activity is yet to manifest. Budgets are very tight due to extensive realignments, increasing the vulnerability of enterprises and households. Therefore, there is not enough economic impetus to give rise to a new growth cycle. Serious cutbacks on spending have markedly diminished the dependence of Estonia’s economy on foreign capital flows, owing to which the country’s current account is in surplus and external debt is decreasing.

The Estonian labour market started to experience more drastic changes around the turn of the year, when first signs of the depth of the current slump appeared. The steep downturn in output and accompanying expenditure cuts strongly reduced labour force demand. However, people’s unprecedented pessimism about the near-term outlook started dwindling in summer. Nevertheless, employment will continue declining in the final months of 2009 and also in 2010, but at a considerably slower pace than in the first half of this year. A pickup in the creation of new jobs is likely to start next year. Based on the autumn forecast, the general government’s final consumption (in value terms) will decline both in the second half of this and in the next year. The government has materially consolidated the state budget which had grown rapidly during the years of the economic upswing. The actions taken have mostly curtailed costs but to some extent also increased revenues. However, the budgetary position has also been improved by several measures of temporary effect, thus the need to review the expenditure level and income base prevails. Estonia’s small fiscal deficit and low public debt serve as a competitive advantage in the light of rapidly growing public debt in other countries.

Uncertainties regarding further economic developments and future loan losses have not yet shown any signs of abatement, although confidence has already passed its low point. This puts brakes on the revival of the credit market, irrespective of the large capital buffers of the banks operating in Estonia.

The more complicated economic situation has added difficulties to enterprises and households in servicing their debt burden. Exceeding their borrowing capacity in the rapid boom years followed by sharply shrinking sales revenues is currently binding the companies. Thus, credit market activity is currently characterised by low demand and enterprises will have to rely more on internal funds while financing their further growth. These are the factors inhibiting the economic growth potential in the next years.

Excessive optimism, which captured economic agents in the years of rapid growth, has been replaced by caution, sometimes even by undue apprehension. This is why a lot of extraordinary economic measures have been applied. Capacity utilisation is at a very low level and the number of the underemployed is higher than ever before, spending is being postponed and investment decisions are frozen. Uncertainty about the temporary and permanent components in these measures is extremely high. The mentioned circumstances may have a considerable impact on the next years’ economic developments.

In respect of the external environment, the autumn economic forecast of Eesti Pank relies, as usual, on consensus forecasts. These have become more and more optimistic in recent months. Consequently, the external environment may offer some good news in the near future, but threats related to decreasing macroeconomic stimuli slightly further ahead should not be overlooked. The years of crisis have put a heavy strain on the budgets of several countries, which translates into the need to economise more in the years to come. However, the state of the economy in Estonia will be determined not only by external demand, but also by foreign investors’ expectations regarding our economic progress and by the credibility of our economic policy.

Banking Sector Forecast 2010-2011

The situation in the global money and capital markets has stabilised compared to the time the spring forecast was being prepared. Various countries’ financial support schemes for the banking sector have notably reduced banks’ liquidity constraints, and this has brought along a significant decrease in interest rates in the money market. However, prudence arising from uncertainty in economic developments is still evident in the developments of the credit market. The unpredictability of future loan losses forces financial institutions to preserve or even improve their capitalisation on the group level. This may reduce the activity of banks in the credit market and thus harm the resumption potential of the real economy.

The global financial crisis, which intensified in the second half of 2008, shaped events in the Estonian banking market mostly via second-round effects. The deterioration of the external demand environment and the price hike of loan capital played the main role here. External and domestic demand, which had both markedly worsened in 2008, contributed to the decrease in banks’ loan portfolio. The complicated economic situation has aggravated the real sector’s difficulty in loan servicing. As a result, banks have raised provisions for loan losses to cover their risks. The capitalisation of banks has nevertheless remained high, so the impact of supply-side factors curbing credit growth will be relatively modest in the next quarters. Consequently, low demand is one of the factors determining the activity of the credit market. Demand is reliant on the price of credit, which depends heavily on the interest margins prescribed by banks. The adoption of the single currency in Estonia will definitely affect also interest margins, which will fall compared to the current margin levels after joining the euro area. The current interest margin level is very beneficial for banks in supplying credit, since it is markedly higher than previous years’ average. Considering that in Estonia the loan interest margin is, as a rule, fixed until the maturity of the loan, banks have a good possibility of boosting interest income on account of new loans.

Consumer Credit

Households have been fast to change their consumption habits in the course of adjusting to the new economic conditions. This means they have also reduced the inclusion of loan resources to finance them. The main reasons behind the lower volume of consumer credit are declining incomes, growing unemployment and the postponement of planned expenditure. Consumer credit will resume faster than other loans once the economy recovers and starts expanding again. Demand for consumer credit will recover upon the restoration of higher confidence, which in turn depends on the reversal of the current trends in wages and unemployment. Another very important factor in the revival of confidence is Estonia’s accession to the euro area. Thus the postponement of expenditure, which started in 2008, will come to an end next year, bringing along an increase in consumer credit.

Housing Loans

Housing market developments are mostly dependent on two factors: the annual depreciation of housing loans and price changes in the real estate market. Since the average duration of housing loans is approximately 25 years, the volume of housing loans paid back in a year is relatively small. Thus, the depreciation of housing loans does not reduce the loan portfolio volume to a considerable extent. Another significant factor is that the real estate price level has become more affordable. The real-estate affordability ratio  reached its lowest level of the past six months in the second quarter of 2009, plummeting to 0.85 from 2 recorded at the peak of the property boom. Favourable real estate prices are sure to have a positive impact on credit demand, but in order for earlier credit turnovers to materialise, the amount of real estate transactions must increase significantly. On the other hand, since property prices are more affordable, it is possible to acquire real estate also without bank loans, which means the impact of the property market revival on credit volume growth may be weaker than expected.

Corporate Credit

The dynamics of corporate indebtedness indicators in Estonia have shown no signs of a shrinkage over the past year. The volume of corporate credit has contracted less in 2009 than anticipated in the spring forecast of Eesti Pank. Since the indebtedness indicators for some sectors of the economy need to undergo corrections, it will take place over a more protracted period than anticipated. Thus, compared to earlier times, the positive developments in the real economy will have a smaller impact on the corporate credit volume. In addition, excess capacity accumulated in the years of rapid growth has also contributed to lower corporate credit demand. It is possible to use the underutilised resources (e.g., production and storage buildings, machinery and equipment) in new fields of activity also with lower investments, if well-considered actions are taken. The volume of corporate credit turnover will recover more slowly than the volume of household credit turnover and it will remain below nominal GDP growth over the entire forecast period.

This forecast is based on information available as of 2 October 2009 and will be published also in the central bank’s publication Estonian Economy and Monetary Policy No 2/2009.

Banking System

Central Bank

Estonia has an independent central bank, Bank of Estonia (Eesti Pank), although it does report to parliament.

Bank Supervision

The Financial Supervision Authority (Finansinpektioon) is the body responsible for bank supervision.

Market Overview and Trends

There are 18 credit institutions (banks) operating in Estonia. Of these, the majority (including the largest two) are foreign-owned, primarily by Scandinavian banks. There are also ten branches and three representative offices of foreign banks in Estonia.

The major domestic cash management banks are Swedbank Estonia and SEB Pank. The major international cash management banks have minimal presence in Estonia. So far, the Estonian banking sector has coped relatively well with the global financial crisis. However, its most recent performance has been affected by the country’s deepening economic crisis and rising loan losses.

Payment/ Clearing Systems

There are three main interbank payment systems used in Estonia — EP RTGS, TARGET2 and ESTA. Estonia migrated to the pan-European TARGET2 RTGS system on 19 May 2008 for large-value and urgent payments in EUR. Eesti Pank still operates the national RTGS system (EP RTGS) for large-value and urgent payments in EEK and the ESTA retail payment system, a multilateral net settlement system. The Estonian Post Office operates a closed retail payment system, processing payments between its own account holders. There is no connection with the EISS.