Estonia Business Forecast Report Q1 2009

Elevated Risks Of A Hard Landing

Estonia is facing serious pressures on all fronts. The risks of a prolonged recession lasting into 2009 are building while there is real potential for a systemic banking crisis. Problematically, there is very little that policy makers can do to mitigate the downside for the economy. External demand and credit conditions govern the extent to which capital will flow into Estonia and the outlook for both global capital markets and eurozone private consumption is very weak for the medium term. At the same time, the large external asymmetries that have been built up in Estonia are to the extent that they can be unwound only over an extended period of time. While our core scenario is for a recovery to begin in 2010, we highlight that the risks are distinctly to the downside. In the event that the eurozone slips into recession in 2009, we would not expect any marked improvement in the Estonian situation until 2011.

Estonias relations with Russia are likely to remain fractious through the medium term. Flashpoint disputes over the expansion of NATO, Russian foreign policy within its 'near abroad and Estonias treatment of its ethnic-Russian minority are not expected to be fully resolved within our five-year forecast period. From an economic perspective, this means that the risks of sudden trade embargoes or diversion of Russian goods intended for trans-shipment through Estonia will remain.

Estonian economic growth has collapsed into negative territory, recording the worst quarterly outturn in over a decade in Q208. GDP contracted by a real 1.2% year-on-year (y-o-y), confirming that the country is now facing a hard-landing scenario after years of above-trend growth. Worryingly, negative growth was recorded in every major component of GDP by expenditure with the exception of general government consumption. Exports declined by 4.9% y-o-y while private consumption and gross fixed capital formation (GFCF) fell by 2.0% and 2.5%, respectively. On the back of the latest data, we have revised down our medium-term forecasts for Estonia, with the economy now expected to contract by 1.1% for full-year 2008 and recovering only mildly to an expansion of 1.2% in 2009.

The confluence of a tightening external capital market and a weak domestic macroeconomic environment does not bode well for the Estonian banking sector. The high integration of domestic banks with the global financial system, at a time when non-performing loans are spiking and demand for credit collapsing amid a recession, raises serious risks of a systemic crisis.