Deutsche Bank : Estonia: country report

Estonia

Estonia

Frontier country report | December 18, 2015

Current account balance remains positive, GDP growth to rebound in 2016 1

10

5

0

-5

-10

-15

-20

Current account surplus in 2015/16, GDP growth to rebound in 2016 Current account balance improved significantly since 2007 and remains in positive territory, with expected surpluses of 2.1% of GDP in 2015 and 1% in 2016. Despite weak external demand (stagnation in Finland, recession in Russia), the economy continues to grow in 2015 at a projected rate of 1.3% for the year, supported by domestic demand. In 2016 we expect real GDP growth to strengthen to 2.5% on higher capital spending (inflow of EU funds from the 2014-2020 budget), improved exports and robust private consumption.

Low inflation, sound banking system

07 08 09 10 11 12 13 14 15 16

Current account balance, % of GDP Real GDP, % yoy

Sources: IMF, Eesti Pank, Deutsche Bank Research

Very strong public finances 2

% GDP

12

10

8

6

4

2

0

-2

-4

Inflation hovers around zero due to low commodity prices, with no adverse

effects on real economy. We expect HICP inflation of 0.1% in 2015 and 1.5% in 2016. Banks are profitable (RoA at 1.4% as of Q2) and well-capitalised (CAR of 34.2%). Asset quality is high, with loans overdue more than 30 days at a low 1.5% of total (October). The loan-to-deposit ratio declined to 104% in Q3 2015 from 170% in 2008, reflecting reduced dependence on foreign parent funding.

Strong fiscal metrics, prudent policies

Gross general government debt of 10.4% of GDP (2014) is the lowest in the EU and fully covered by liquid fiscal reserves. After a surplus of 0.7% of GDP in 2014, we expect budget deficits of 0.2-0.3% in 2015/16 due to limited fiscal expansion (PIT rate cut, public-sector wage hikes). The victory of the Estonian Reform Party in March general elections ensures the continuation of prudent, market-oriented policies (rank 16 in 2016 World Bank Doing Business report).

Vulnerability to external shocks

07 08 09 10 11 12 13 14 15 16

Gross public debt Fiscal balance

Sources: IMF, MoF, Deutsche Bank Research

Wages grow in excess of productivity, eroding Estonia's competitiveness 3

% yoy

14

12

10

8

6

4

2

0

-2

-4

-6

Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3 2012 2013 2014 2015

Labour productivity per employee Average monthly gross wages

Sources: Statistics Estonia, Deutsche Bank Research

Estonia remains vulnerable to external shocks, both via the trade channel

(imports + exports above 160% of GDP) and the banking sector (80% Swedish- owned). Economic conditions in Sweden are especially important (18% share in Estonia's exports in 2014), followed by Finland (15%), Latvia (11%), and Russia (10%). Gross external debt will remain high at about 100% of GDP in 2015/16, but in net terms it declined from over 50% of GDP in 2008 to -11% in 2014. Roll- over risk from a high share (46%) of short-term external debt is mitigated by a significant share (19%) of intra-company lending.

Increased tensions with Russia negative for exports

The recession in Russia and its ban on some EU food products negatively affected Estonia's trade, with exports to Russia declining by 16% in 2014 and 37% yoy in January-October 2015, and total exports down by 1.7% and 3.9% in the respective periods. Although we expect total exports to recover somewhat in 2016 on higher demand from the EU, exports to Russia will likely remain subdued.

Demographic trends cloud growth prospects

Negative net migration and a low fertility rate (1.5 in 2013, latest available) have led to a decline in the working-age population. Wages have continued to grow in excess of productivity (6.9% yoy vs. 5% yoy, resp., in Q3), which might erode Estonian firms' competitiveness. Thus, apart from the government's efforts to raise labour participation, productivity gains will be crucial to maintain favourable growth prospects as Estonia converges with advanced economies.

Global Macro & Sovereign Risk Contact Internet

Sandra Stankiewicz | [e-mail] | [phone] http://www.dbresearch.com

Estonia

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2 | December 18, 2015 Frontier country report