ESTONIA'S ECONOMY: OUTLOOK FOR CONTINUED GROWTH

UNCLAS SECTION 01 OF 02 TALLINN 000092

SIPDIS

STATE FOR EEB/CBA, EUR/NB

SIPDIS
SENSITIVE

E.O. 12958: N/A
TAGS: ECON EFIN PGOV EN

SUBJECT: ESTONIA'S ECONOMY: OUTLOOK FOR CONTINUED GROWTH
LOOKS GOOD

REF: (A) 06 TALLINN 989 (B) TALLINN 33


1. (U) Estonia's economic growth has exceeded 10% for two
years running. This has led to the inevitable question:
"How long can it last"? Regional banks, the Ministry of
Finance, and financial media all forecast around 9% real
GDP growth in 2007, down from 11.5% in 2006. While a few
local observers fear a sharper downturn in the coming
months, the vast majority of analysts see the economy
continuing to grow in the 7-9% range for the next several
years. Some officials, including Prime Minister Andrus
Ansip, have continued to express concern about the
possibility of the economy overheating.

STRONG FUNDAMENTALS...
--------------


2. (SBU) Financial sector experts emphasize that Estonia's
economic fundamentals are strong. Unlike Latvia and
Lithuania, the GOE's budget has been running at a surplus
(between 2-6%) since 2001. Moreover, Estonia's membership
in the EU, sound fiscal and banking policies, oil-shale
based energy independence, well-developed communications
infrastructure, and its educated, multi-lingual workforce
provide a strong basis for long-term economic growth.
Rasmus Pikkani, Sampo Bank Chief Investment Officer and
Aivar Reinap, the Chief Editor of Postimees Online both
told us they expect the Estonian economy to continue
growing at least 7-8% in the coming years, barring any
major external shock. They noted that while 7-8% growth is
lower than Estonia has experienced recently, it is still
very respectable compared to the EU average. A recent
Postimees article, which surveyed four commercial banks,
the Estonian Institute of Economic Research, the Central
Bank and the Finance Ministry, reported strong consensus
among experts that Estonia will experience healthy economic
growth in 2007. Growth predictions were remarkably
similar, ranging from 8 to 9.5%. Both President Ilves and
PM Ansip have told us they hope to see a mild cooling of
the economy, as they believe that recent growth rates are
not sustainable.


3. (SBU) Pikkani and Reinap told us they believe Estonia's
economy is less vulnerable to external shocks than it was
4-6 years ago. Estimates are that the share of Estonia's
economy that is dependent on Russia has fallen from 40% at
the time of the 1998 ruble crisis, to roughly 10% today.
Even if the GOR took steps to restrict trade, or the
Russian economy took another sharp downturn, the impact on
Estonia would be relatively limited, they said. Estonia is
now firmly integrated into the EU market and its border
with Russia is part of the EU's eastern border. Also,
since the 1990s, Estonian exporters have successfully
developed mechanisms and relationships for exporting
through neighboring countries to get around unexpected
customs and trade barriers. Pikkani also said he does not
believe a downturn in other EU economies would negatively
impact Estonia. Rather, it could have the effect of making
Estonia relatively more attractive as a lower-cost, near-
shoring locale for companies in the old EU-15.

...AND AREAS TO WATCH
--------------


4. (SBU) While most analysts are predicting a soft-landing
for the economy, this does not mean that there are no
potential dangers on the horizon. Erki Lohmuste, Head of
Macro Analysis at the Ministry of Finance, pointed to two
factors that are generally believed to have the potential
to cause problems for Estonia's economy in the next few
years: an inflationary push caused by across-the-board
demands for increased wages, and excess levels of credit
and consumer debt. The country's growing labor shortage
(Ref B) and the need for structural transition in the
economy toward higher value-added exports and services are
also challenges the economy will have to face. In this
last regard, both analysts and politicians have highlighted
to us the need to pay more attention to education and new
technology as means of increasing productivity.


5. (SBU) As Lohmuste explained, the threat of a credit
bubble is particularly hard to address because most of the
lending comes from large Swedish and Finnish banks. They
control over 95% of the market, but see their operations in
Estonia as a relatively small part of their overall
portfolios. This makes them more willing to make somewhat
riskier loans. Nevertheless, Estonian Central Bank
Governor Andres Lipstock told us recently that he has had

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some success persuading Swedish Central Bank officials to
caution the Swedish commercial banks that have branches in
the Baltics to exercise greater due diligence over their
loan portfolios.


6. (SBU) With respect to inflation, (which has averaged
about 4% since 2002) the GOE is primarily concerned about
meeting Maastrict targets for Euro zone entry. (Note: The
GOE's informal target for this has slipped to 2011. End
Note.) Sampo Bank's Pikkani expressed his concern that
inflation's distortionary effects on consumer prices and
public sector finances could have an impact on long term
growth. As an example, he noted the fact that medical
workers recently negotiated a 20% pay increase. If this
increase is repeated in other public sectors, he asserted,
it will add significantly to inflationary pressure on the
economy. As GOE officials freely admit, they have few
policy tools available to them to address inflation, and
they have steadfastly refused to take any steps that might
result in slower growth in order to rein in inflation.
Estonia's currency has been pegged to the Euro since 1999,
and to the Deutschmark for seven years before that.
Pikkani and Reinap both feel that since Estonia has few if
any monetary tools with which to control inflation, it is
most important for the GOE to maintain its international
reputation for transparency and fiscal responsibility.

GOLDSTEIN