Estonian Economy Falling, Euro Adoption in Trouble

C O N F I D E N T I A L TALLINN 000259 SIPDIS AMEMBASSY ANKARA PASS TO AMCONSUL ADANA AMEMBASSY ASTANA PASS TO USOFFICE ALMATY AMEMBASSY BERLIN PASS TO AMCONSUL DUSSELDORF AMEMBASSY BERLIN PASS TO AMCONSUL LEIPZIG AMEMBASSY BELGRADE PASS TO AMEMBASSY PODGORICA AMEMBASSY HELSINKI PASS TO AMCONSUL ST PETERSBURG AMEMBASSY ATHENS PASS TO AMCONSUL THESSALONIKI AMEMBASSY MOSCOW PASS TO AMCONSUL VLADIVOSTOK AMEMBASSY MOSCOW PASS TO AMCONSUL YEKATERINBURG E.O. 12958: DECL: 2019/09/02 TAGS: ECON EFIN ECIN EN SUBJECT: Estonian Economy Falling, Euro Adoption in Trouble CLASSIFIED BY: Karen Decker, CDA; REASON: 1.4(B),(D) Classified by Charge Karen Decker for Reasons 1.4 B & D. ¶1. (C) Summary: On August 27, the Ministry of Finance (MoF) predicted the Estonian economy would contract by 14.5 percent in 2009, with positive growth only occurring in 2011. Unemployment will remain above ten percent for at least the next four years. In a meeting the same day with visiting Treasury acting-DAS Eric Meyer, Minister of Finance Jurgen Ligi said the 14.5 percent fall is the MoF's pessimistic scenario. The best case foresees a contraction of 13.6 percent this year. Even then, recovery will be delayed until Estonia's main trading partners, Sweden and Finland, begin to see positive growth. Government leaders subsequently stated publicly, and the Central Bank told us privately, that though the GOE will need to make significant additional cuts to the budget to meet the Maastricht Criteria, Estonia is on track to adopt the euro in 2011. Estonia's euro-adoption plans have been endorsed quietly by European Commission officials, who have told the GOE to "keep a low profile" (and adhere strictly to Maastricht criteria) and they will "slide into" the Euro zone. That said, Ligi told Meyer that if the economy does contract 14.5 percent, as his ministry publicly predicts, the GOE would not attempt to keep the budget deficit below three percent and would abandon its goal of joining the euro zone in the near term. Above all, the Estonians reiterated to Meyer that Estonia's economy was stronger and more resilient than its Baltic neighbors. End summary. Economy Continues to Contract -------------- ¶2. (U) On August 27, the Ministry of Finance released figures for its economic outlook through 2013. The MoF predicts a decline in GDP of 14.5 percent for 2009, with GDP falling another 2 percent in 2010, before growing 1.5 percent in 2011. GDP will fall this year due to a drop in private consumption (-15.6 percent),government consumption (-5.8 percent),and investment (-26.6 percent). This fall is mitigated by improvement of Estonia's current account. Exports are predicted to fall 19.2 percent in 2009, but imports will fall further, by 27.4 percent. The MoF believes exports will grow very slightly in 2010, by 0.1 percent, while consumption and investment only start to grow in 2011. The MoF foresees unemployment remaining high for several years: 14.4 percent for 2009, 16.8 percent for 2010, 16.6 percent in 2011, 15.4 percent in 2012, and 13.7 percent in 2013. Minister of Finance Ligi told Treasury DAS Meyer on August 27 that he expects Estonia to see a late recovery from this economic crisis. Because much of Estonia's economy is export driven, Estonia will only recover once its main trading partners (Sweden, Finland) recover. Ligi expects the Nordic states to have a late recovery. ¶3. (U) Also on August 27, Governor of the Central Bank Andres Lipstok gave Meyer a more positive picture of the economy. Lipstok said the economy was showing signs of bottoming out, and he expected recovery to begin before the end of 2009. He explained the Central Bank is in a strong position, the current account is in surplus, the GOE still has reserves to buoy the fiscal situation, and private banks are liquid and sufficiently capitalized. Central Bank Deputy Governor Marten Ross stated the short term outlook is positive, but he refused to speculate about the medium term. Echoing Lipstok's slightly more positive assessment, on September 2 SEB Bank announced it expects the economy to contract 13.6 percent this year, and 0.3 percent in 2010. Wages Also Falling -------------- ¶4. (U) After over a decade of double digit wage growth, the MoF predicts wages will fall 5.7 percent this year and 4 percent next, before beginning a slow increase. Central Bank Deputy Governor Ross told us wages fell 5 percent by Q2, and would go down another 5 percent by the end of the year. The Central bank predicts wages will start to grow again in 2010. Falling wages are already having a positive effect on competitiveness. Ross said Nordic companies are looking to move production facilities from Norway, Sweden and Denmark to Estonia. The previous week Ericsson announced it would open a facility in eastern Estonia. Ross explained that wages in Estonia are one-third the level in Finland, while differences in productivity between the two countries are much smaller. This makes Estonia attractive to investors. No Fear of Devaluation -------------- ¶5. (U) Central Bank contacts all dismissed fears that Estonia would need to devalue, even in the face of an external shock (i.e. Latvian devaluation),arguing the currency board remains strong. Ross rhetorically asked whether Estonia were already using the euro, and Latvia devalued, would Estonia have to leave the euro zone to devalue as well? He said with Estonia's fixed exchange rate (unchanged since introduction of the kroon in 1992),he foresaw no reason for devaluation. Ross added that Russian devaluations have not affected Estonia's currency board or increased speculative pressure. Minister of Finance Ligi later told us that Estonia will not devalue its currency. Bad Here, but Worse in Latvia and Lithuania -------------- -------------- ¶6. (SBU) Ross said the amount of non-performing loans has started increasing in Estonia, but remains below the levels in Latvia and Lithuania. Most Estonian borrowing was in euros, and the drop in euro exchange rates has helped Estonian borrowers. Also, he said that banks in Estonia were more conservative in their lending than in the other Baltic States. Importantly, Ross stated that Estonia's currency board and fixed exchange rate provided more stability than Latvia's "something similar to a currency board." Because of Estonia's stronger position, Swedish banks have not needed to recapitalize their subsidiaries in Estonia. Lipstok added that Estonia will see earlier recovery than will Latvia and Lithuania since the GOE began to adjust its budget sooner, it had budgetary reserves, and that Estonia's efforts to join the euro in 2011 have boosted investor confidence, reducing the cost of capital in Estonia by about one percent. However, he conceded that the Central Bank's scenario for Estonia to have a V-shaped recovery depends on Germany also having a V-shaped, not a W-shaped, recovery. Not as Positive for Euro Adoption -------------- ¶7. (SBU) On August 26, the Central Bank issued a statement claiming the government would need to cut an additional 2.5 to 3 billion EEK [USD 228 to 274 million] from the state budget to maintain a Maastricht-criteria budget deficit for 2009 of less than 3 percent. Lipstok told us euro adoption is on track. Although the GOE had cut the equivalent of 7 percent of GDP from the budget, it would need to cut an additional percentage point. On August 27, PM Ansip said the GOE would need to cut or find an additional 2.8 billion EEK for the budget for this year. He reiterated that meeting the Maastricht criteria and adopting the euro in January 2011 remains his government's priority. The same week other Estonian political leaders, including President Ilves and former PM Mart Laar, stated the current government will have failed if Estonia does not adopt the euro in 2011. ¶8. (C) Minister of Finance Ligi told Treasury DAS Meyer August 27 that the GOE hopes to adopt the euro in 2011, but that this depends on economic circumstances. If the economy follows MOF's best case scenario, falling only 13.6 percent this year, Ligi said the government would strive to keep the budget deficit under three percent. However, if the economy falls 14.5 percent, as MOF publicly predicts, then Ligi said the GOE would not be able to sufficiently cut the budget and stay under the Maastricht Criteria of a three percent budget deficit. In this case euro adoption is "hopeless," Ligi said. ¶9. (C) Even though the government has already cut 7.6 percent of GDP from the budget (equivalent to 20 percent of the budget),under the best case scenario the GOE will have to cut an additional 400 million EEK [USD 36.3 million] this year and 4.5 to 5 billion [USD 409 to 454 million] next year. Ligi (and other government officials publicly since) ruled out any pension cuts. While the Cabinet is still considering what to cut from the budget, Ligi expected half of this amount to come from budget cuts and half from dividends from state-owned companies. These will primarily be Eesti Energia (the electricity monopoly) and Tallinn Port. (Comment: Using dividends to plug budget holes will impact services and postpone these companies planned investments, such as opening a container port in Tallinn.) ¶10. (C) Ligi concluded by saying that Estonia only has a narrow window to adopt the euro. If it fails in 2011, by the time Estonia reduces its budget deficit below three percent again, economic growth will likely have driven inflation above the Maastricht limit. ¶11. (C) In a subsequent meeting, MFA Counselor Mart Kivine, and Head of the EU and International Affairs Department Martin Poder, told Meyer that EU officials are telling the GOE that euro adoption is a possibility in 2011 if Estonia meets all the Maastricht Criteria and if Estonia "keeps a low profile on adoption." Kivine and Poder stated that the European Commission is showing absolutely no flexibility in the Maastricht Criteria, even though the majority of euro zone states are currently not meeting these criteria themselves. Kivine and Poder also explained the Commission has told Estonia its euro adoption would be jeopardized if Estonia joins in any calls for loosening the Maastricht Criteria or speaks too loudly about its chances. Therefore, the GOE hopes to "quietly slip into the euro zone." Anger but Cooperation with Swedish Banks -------------- -------------- ¶12. (C) Swedish banks control 70 percent of Estonia's banking sector. Central Bank Deputy Governor Ross said that Sweden has not needed to recapitalize its Estonian subsidiaries, although Swedish banks have provided some liquidity support. He added that the Central Bank has an agreement with its Swedish counterpart to use excess reserves to cover losses and to help banks deemed "too big to fail." This agreement has not yet been tested. Despite this cooperation, Minister of Finance Ligi expressed frustration when Sweden blames the Baltic States for its banking woes. Ligi pointed out that Swedish banks made profits, and paid taxes in Stockholm, over the past ten years that greatly outweigh any current losses. He also said that the Swedish banks in Estonia have told the GOE there will be social unrest if the GOE does not help cover losses from non-performing loans. Ligi claimed he told the Swedish banks not to expect such support. Comment: Struggling, but Proud -------------- ¶13. (SBU) A common refrain heard from all sides is that the economic situation in Estonia is tough, but the country has survived much tougher times. Even with the sharp GDP drop this year, GDP has only fallen to levels seen in 2006 - and Estonians say life was good in 2006. Contacts are uniformly upbeat that the current economic crisis is temporary and that Estonia will soon again see strong growth. Estonians are frustrated that the outside world lumps the Baltic States together. GOE officials are quick to point out that they have consistently pursued more conservative and sustainable economic policies than has Latvia or Lithuania, and that Estonia began to adjust to the current crisis well before its southern neighbors. For now, the public supports the government's efforts to strive for early euro adoption. The only dissenting voice we've heard so far is the Center Party, Estonia's largest opposition party. They advocate abandoning efforts to join the euro soon, instead having the government borrow heavily to increase government spending. We will see whether this message resonates in October's local elections. ¶14. (U) This cable was not cleared by Treasury acting-DAS Eric Meyer. DECKER