Estonian Economy Falling, Euro Adoption in Trouble

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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

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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

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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

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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