VZCZCXRO3025
RR RUEHAG RUEHAST RUEHDA RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA RUEHLN
RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHTL #0200/01 1581157
ZNR UUUUU ZZH
R 061157Z JUN 08
FM AMEMBASSY TALLINN
TO RUEHC/SECSTATE WASHDC 0663
INFO RUEHZL/EUROPEAN POLITICAL COLLECTIVE

UNCLAS SECTION 01 OF 02 TALLINN 000200 
 
STATE FOR EUR/NB 
 
SIPDIS 
SENSITIVE 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EN
 
SUBJECT: ESTONIAN GDP GROWTH SLOWS MORE THAN EXPECTED 
 
¶1. (SBU) SUMMARY:  A preliminary Estonian GDP growth figure 
showing only 0.4 percent growth in the first quarter of 
2008 has shocked analysts and the public.  Senior 
government economic advisors cite steeper-than-expected 
declines in consumer spending and a sluggish real estate 
market as the primary causes of the slowdown.  While 
slowing growth has increased concerns that the Estonian 
economy faces a "hard landing," Estonian analysts stress 
the fundamentals of the economy are strong.  A May IMF 
review concluded that Estonia's economic slowdown was 
necessary after two years of unsustainable growth, although 
the slowdown has been faster than expected and may result 
in overall negative GDP growth for 2008.  End Summary. 
 
Cautious Consumers Slowing Growth 
 
¶2. (SBU) In mid May, the Estonian Statistics Office 
released a "flash estimate" for Estonian GDP growth at 0.4 
percent for the first quarter of 2008, the lowest in eight 
years.  As a comparison, growth in the fourth quarter of 
2007 was 4.8 percent.  While noting the growth estimate was 
based on preliminary figures, Aare Jarvan, Economic Advisor 
to the Prime Minister, acknowledged that growth this year 
has slowed faster than the GOE expected.  (The Bank of 
Estonia's (BoE) forecast for 2008 was 2 percent growth. 
Other estimates predicted growth as high as 4-5 percent.) 
Jarvan cited the slowdown in consumer demand and a steeper- 
than-expected decline in the real estate market as the 
primary causes.  According to BoE figures, this year real 
estate turnover has returned to 2004 levels and prices have 
decreased 10-15 percent from peak levels in 2007. 
 
¶3. (SBU) Both Jarvan and Tanel Ross, head of the 
International Relations Department at the BoE blamed the 
decline in private consumption, in part, on higher than 
expected inflation.  According to the Statistics Office, 
inflation in April was running at 11.4 percent.  Rising 
energy costs, food prices and wages have contributed 
significantly to inflationary pressures.  (Note:  These 
factors not unique to Estonia.  End Note.)  Both Jarvan and 
Ross said they thought inflation in Estonia had now peaked 
and should begin to decline.  However, Jarvan noted, the 
April figure was "a bit surprising" as the "direction was 
wrong." 
 
¶4. (SBU) Despite the unexpectedly low estimate of first 
quarter growth, Ross noted, the BoE has not revised its GDP 
growth forecast for 2008.  While the "risks have clearly 
increased," Estonia's economy has not "ground to a halt." 
Jarvan pointed out that unemployment in Estonia remains 
very low (about 4.2 percent) and wage growth is still 
strong (20 percent year-on-year.)  The bottom line, he 
concluded, is there has not been a dramatic change in 
disposable income.  Ross, however, cautioned that 
employment and wages are lagging indicators and he fully 
expects to see changes (i.e. downturns) there as well.  He 
also noted that while wage growth is still high, it is 
slower than in previous quarters.  The combination of 
slower growth and steady employment levels signal declining 
productivity, which will be a longer-term concern for the 
Estonian economy.  On the bright side, Ross said, initial 
data indicates that private sector wages have been more 
responsive to changing economic conditions than public 
sector wages.  (Note:  Over the past few years the GOE has 
significantly increased public sector wages including for 
police, medical, educational and rescue workers as well as 
white collar civil servants.  Ross indicated that, as one 
measure of response to Estonia's slowing economy, he does 
not expect the GOE to implement any additional wage 
increases in the near term.  End Note.) 
 
¶5. (SBU) Experts here contend economic fundamentals remain 
strong and there are positive factors in the economy. 
Estonia's low debt and the government's commitment to 
maintaining a balanced budget are key.  According to Ross, 
banks are still lending, although at a slower pace than in 
previous years and the BoE forecast of 13-15 percent credit 
growth is on target.  While Banks are providing relatively 
less credit to households, they are lending more to 
manufacturers.  Also, the quality of the banking sector's 
loan portfolio remains high.  The share of non-performing 
loans (those overdue more than 60 days) is below one 
percent of the total.  This is expected to increase 
slightly in the near term, but not to exceed 2 percent in 
¶2008.  Also positive, the Estonian current account deficit 
is decreasing steadily.  Exports are outpacing imports 
(which have showed negative growth this year), and net 
savings have increased.  The BoE expects the current 
account deficit to fall to around 10 percent of GDP this 
 
TALLINN 00000200  002 OF 002 
 
 
year. 
 
¶6. (SBU) According to Ross, the short- to medium- term 
health of the economy will depend on both domestic and 
external factors.  Government spending is key; the GOE 
needs to keep outlays in line with economic growth.  The 
GOE should not look to stimulate domestic demand.  Rather, 
Ross advised, the GOE should keep macroeconomic policy 
neutral and allow some increase in unemployment to occur. 
Inflation is also important; the health of the economy will 
depend in part on how quickly inflation declines.  The 
banking sector is another key factor.  Scandinavian banks 
control approximately 95 percent of the Estonian banking 
sector.  Continued health of these banks and their 
willingness to lend (e.g. no credit crunch) is crucial. 
 
Then there's the Budget 
 
¶7. (SBU) The GOE has demonstrated a consistent commitment 
to balanced budgets and continues to have the lowest 
government debt level in the EU.  The GOE's budget has been 
in surplus since 2001.  However, in April the GOE announced 
the need for a supplementary budget for 2008 to make up for 
an unexpected revenue shortfall. (Estimates on how big a 
shortfall the government faced ranged up to 3 percent of 
GDP).  After negotiations within the Government coalition 
and among ministries, the Cabinet approved a supplementary 
budget which cut expenditures by 3.2 billion kroon (USD 320 
million) and adjusted revenues down by 6.1 billion eek (610 
million). On average, ministries and agencies cut their 
budgets by 7 percent - in line with the level recommended 
by the GOE at the start of the process, making the 
outcome a win for the government.  The Ministry of Defense 
faced the smallest cut (0.8 percent) and the Ministry of 
Foreign Affairs absorbed the largest (14 percent).  The 
Parliament began debating the budget proposal on June 4 and 
has committed to finish by the time of the June 18 recess. 
 
¶8. (SBU) Jarvan told Pol/Econ Chief the GOE's original 
budget forecast had been "terribly wrong."  The primary 
cause of the imbalance was lower than expected VAT receipts 
- which make up about a third of central government income. 
(Personal income and social security taxes have been in 
line with expectations.)  Jarvan commented that the 
changing structure of domestic demand has made a 
significant impact on VAT receipts: the two biggest areas 
of decline were sales of cars and real estate.  Despite 
speculation in the press, Jarvan noted, the GOE does not 
plan to tap the Government's stabilization reserve fund or 
halt planned cuts in personal income tax rates.  However, 
the three parties in the coalition have formed a working 
group to discuss priorities for the 2009 budget. 
 
IMF Weighs In 
 
¶9. (SBU) An IMF Mission in Estonia May 7-19 for regular 
Article IV Consultations provided its own assessment of the 
Estonian economy.  Of note in the conclusions: 
 
-- Estonia's economic slowdown was necessary after two 
years of unsustainable high growth, although the slowdown 
has been faster than expected and may result in overall 
negative GDP growth for 2008. 
 
-- Inflation should moderate in 2009. 
 
-- Although Estonia's current account deficit is shrinking 
it is still "larger than warranted" and needs to narrow 
further to improve Estonia's external competitiveness. 
 
-- The GOE's quick response to the budget gap demonstrates 
its commitment to prudent fiscal management.  The 
Government's proposal to freeze state wages should be 
extended to other levels of government. 
 
-- The Government should adopt the draft labor law 
currently under discussion as it would go a long way to 
addressing labor market rigidities. 
 
Decker