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RR RUEHAG RUEHAST RUEHDA RUEHDBU RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA
RUEHLN RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHTL #0492/01 2081416
ZNR UUUUU ZZH
R 271416Z JUL 07
FM AMEMBASSY TALLINN
TO RUEHC/SECSTATE WASHDC 0035
INFO RUEHZL/EUROPEAN POLITICAL COLLECTIVE
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC

UNCLAS SECTION 01 OF 02 TALLINN 000492 
 
SIPDIS 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EN
SUBJECT: BANKERS PREDICT SOFT LANDING FOR ESTONIAN ECONOMY 
 
REF: (A) TALLINN 33 (B) TALLINN 92 
 
¶1.  (U) Summary:  Macroeconomic analysts in and out of 
government continue to predict Estonia faces a 'soft landing' - 
6 to 8 percent GDP growth - from its period of rapid economic 
growth.  Despite a large current account deficit, rising 
inflation, and a tight labor market, the long-term outlook for 
Estonia is good.  The major Swedish banks which dominate the 
market here will continue to play a stabilizing role as the 
housing market cools, and consumer credit tightens marginally. 
Areas to watch include inflation, which is expected to continue 
rising into 2008, and Estonia's inflexible labor market.  End 
Summary. 
 
¶2.  (U) In recent months, several factors have raised concern 
about a possible hard landing for Estonia's economy, which has 
been growing at more than 10 percent for the past two years. 
Wage increases of 16.5 percent in 2006 (rising to 20 percent for 
the first quarter of 2007), slower consumer credit growth since 
the beginning of 2007, devaluation fears in neighboring Latvia 
earlier this year, and recent cautionary reports from Moody's 
and other credit agencies, have all added to the debate about 
the direction of the Estonian economy.  The cyber attacks in May 
on internet infrastructure, and the subsequent disruption of 
trade with Russia have further created an air of uncertainty. 
Nevertheless, analysts from both the public and private 
financial sector are confident that the economy will not see a 
sharp correction, but rather a relatively soft landing of around 
6-8 percent annual GDP growth over the next two years. 
 
Between Two Giants: Size Does Matter 
 
¶3.  (U) Estonia is often described as having a small, open 
economy, but Hardo Pajula of SEB Uhispank's Capital Markets 
Division told us the operative word should be "miniscule."  To 
put the economy of what many refer to as "Talsinki" in 
perspective, he noted that Tallinn and Helsinki, Finland are 
basically one economic zone akin to New York City and suburban 
New Jersey or Connecticut.  The difference here is that a 
balance-of-payments transaction occurs each time trade occurs 
between the two capitals.  Much of the recent concern about 
potential vulnerabilities in the Estonian economy has focused on 
its current-account deficit, which stands now at 15 percent of 
GDP, but Pajula told us he is not overly concerned about this. 
Estonia is sandwiched between the economies of Sweden and 
Finland, together 36 times larger than Estonia's to the west, 
and that of Russia, 60 times larger to the east.  Given that 
these much larger neighbors are both running current account 
surpluses of 7-10 percent of GDP, it is inevitable, Pajula said, 
that Estonia's economy is running a deficit. 
 
¶4.  (U) A few factors help counter this imbalance.  The GOE has 
been running a budget surplus since 2001, and has a reputation 
for fiscal responsibility.  Also, the national currency is 
pegged to the Euro and not heavily traded in currency markets. 
Finally, Estonia does not have a public-debt market which could 
spread instability throughout the economy.  Marje Josing, 
Director of the Estonian Institute of Economic Research, (the 
source agency for most raw data on Estonia's economic 
performance) was as sanguine as SEB's Pajula about the current- 
account deficit.  Stressing how - in just the past 15 years - 
the Estonian economy has successfully weathered high 
unemployment and Russian "double tariffs" in the mid-1990s, the 
Russian currency crisis in the late 90s, and now the process of 
wage and price convergence with the EU, Josing said she is not 
worried about the long-term outlook.  The heads of two Ministry 
of Finance (MOF) Offices (International Cooperation, and 
Economic Analysis) noted that Estonia has met or exceeded the 
IMF's goals, and Estonia's experience joining the EU could be a 
case study for an economic convergence.  The MOF estimates that 
the 2007 budget surplus should be larger than the currently 
projected 1.9 percent of GDP, if the GOE does not decide to 
increase spending in a September supplementary budget. 
 
Credit Expansion and Inflation 
 
¶5. (U) Another frequently cited concern is the rapid expansion 
of consumer credit thanks in large part to a real estate boom 
and flexible borrowing policies (including loans via mobile 
phone).  Many blame easy credit as another factor driving up 
inflation (currently 5.7 percent), and thus keeping Estonia out 
of the Eurozone.  Annual private credit growth soared above that 
of peer countries from 2001-05, and in 2006 short-term interest 
rates averaged 3.2 percent.  However, Estonia has none of the 
traditional monetary tools to tighten credit.  The currency is 
pegged to the Euro at a fixed rate, and the money supply in the 
country is effectively controlled by Sweden's private banks. 
The two biggest players, Hansapank (owned by Swedebank) and SEB 
Eesti Uhispank together control 78 percent of the market.  While 
loan portfolios in the Baltic countries are a fairly small share 
of these banks' overall exposure, they are highly profitable 
 
TALLINN 00000492  002 OF 002 
 
 
ones.  On July 19, SEB announced profits for the first half of 
2007 were up 30 percent over the same period last year. 
Hansapank's Maris Lauri told us that while its parent 
Swedebank's assets in the Baltics represent only 10 percent of 
their total portfolio, they generate one-third of the company's 
profits. 
 
¶6.  (U) While much of this money has been pouring into real 
estate, that market appears to have levelled off and loan growth 
is now finally slowing.  The Bank of Estonia reported in June 
that "...the credit standards of [private] banks have become 
stricter,...the number of customers capable of borrowing has 
declined and this has resulted in a fall in the number of 
transactions..."  Officials at the Bank told us that 90 percent 
of households are owned by their occupants, not speculators, and 
banks are now charging higher interest rates for home equity 
loans than for initial mortgages.  Non-traditional, sub-prime 
lenders such as the Baltic Investment Group (BIG) are still 
cropping up, but they represent a very small percentage of the 
banking market.  This rapid credit growth has raised concerns 
that foreign banks could pull back on their position in Estonia 
if they began to experience a high rate of defaults, causing a 
disruption in the financial market.   All analysts we spoke to, 
however, agreed that there are few scenarios in which Hansapank, 
SEB and the others might pull capital out of the Baltic market. 
It would take a major EU-wide financial shock to cause them to 
severely reduce their exposure here. 
 
¶7.  (U) Even with GDP growth projected to slow, and a tightening 
of credit by the private banks, financial experts agree that 
inflation has not yet peaked.  The wage increases of the past 
year have yet to work their way through the economy, and public 
sector wages - typically lagging at least twelve months - have 
not caught up with increases in the private sector. 
Furthermore, noted Maris Lauri of Hansapank Markets, much of the 
EU structural funds slated to be spent in Estonia over the next 
six years will go into construction and agriculture, where they 
will quickly end up in the hands of consumers, driving up 
demand. 
 
¶8.  (U) A final area to watch is labor market flexibility.  Ref 
A noted the tight labor market in Estonia, and the political 
reluctance to bring in greater numbers of foreign workers. 
Additionally, while Estonia ranked 17th overall in the World 
Bank's 2006 "Ease of Doing Business" Index, it was 151st in the 
specific category of "Employing Workers."  Two issues accounting 
for this low score are the inability of workers to get flex-time 
or non-traditional employment contracts, and bureaucratic 
barriers to obtaining work visas for foreign nationals.  A joint 
working group with representation from the Ministries of Economy 
(MOE) and Internal Affairs has been discussing the foreign labor 
issue for over a year.  However, a memorandum including 
recommendations for simplifying the visa and immigration process 
for highly skilled foreign workers was adopted by the GOE only 
on June 14.  A contact at MOE told us that the Ministry of the 
Interior will come up with relevant legislative proposals by 
November 1st, but as far as she knows there is no study 
currently under way. 
 
GOLDSTEIN