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Wednesday, March 18, 2009

Devaluation, Euro Membership And Loan Defaults - Some Thoughts For My Critics

by Edward Hugh: Barcelona

Joke - How do you know when a country is in crisis? Well, on the buses on the way to work, and in the bars and cafes during the mid morning break, everyone is reading the economy rather than the sports section in the local newspaper.
Several pieces of news out over the last week are relevant to the whole debate we are having about how to drag the Estonian economy (kicking and screaming it would seem) out of its current slump. In the first place the Estonian parliament passed a supplementary 2009 budget at the start of the week, in an attempt to address the ongoing crisis in the economy and the dramatic decline in revenues. The cuts were approved by 61 votes to 35 against in what was also an effective vote of confidence in the present government. So at least it is clear that the majority of Estonia's politicians back the present course, and the degree of public support for the current path is greater than it would seem to be in, say, Latvia. That is, naturally a very positive point.

The supplementary budget lowers the amount of revenues in the annual budget by EUR 615.5 mln and of expenditure by EUR 419.9 mln. According to the revised budget, state revenue this year is now anticipated to be EUR 5,635 mln and expenditures EUR 5,871 mln. Both these numbers are of course conditional on the economic contraction for 2009 only being the forecast one (on which the budget is based) of 9.5%.

The second piece of news is that the Estonian Finance Mininistry have sent an official loan application today to the European Investment Bank, with a request to borrow Eur 550 million for 5 years. And this point is important, since obviously, as I will argue below, Estonia's private sector (households and companies) is now basically very overleveraged (in too much debt) and the government is being forced to step in and assume greater responsibility for the collective debt as the correction continues.

The third relevant piece of news is that the number of unemployed registered with the Estonian Labour Board was up again last week, and reached 50,527, which means 2418 more people signed on with the board during the week, following the 3,019 who joined the list in the previous week. Meanwhile the Estonian Parliament has been having a debate about what kind of labour market reforms the country needs to handle the present crisis. Since one witty soul appropriately baptised me in my most recent post the "excel economist" I would just like to add-in my own little chart-based contribution. People are leaving Estonia. How do I know that, well just take a look at the spike at the end of the time series shown in the grphic below, the volume of income transfers to Estonia (largely worker remittances) has been on the increase ever since the crisis started in 2007, and during the last quarter of 2008 they really spiked up, just (coincidentally?) as the economy spiked sharply downwards.

We don't know too much about the murky topic of out-migration in the Baltics, since no one seems to consider it a particularly pressing issue. In fact, migrant labour flows could be considered to be a leading indicator for a modern (open) economy (in both directions), but surprisingly little attention is paid to the matter. We do have an old "estimate" that around one third of those working abroad are working in Finland, and now somewhat dated reports of young people working in Finland repairing motorway crash barriers for 150 kroon an hour, but that's all we seem to have, anecdotal evidence. Maybe one of the reforms all those very busy parliamentarians could think about agreeing to would be the introduction of a question in the labour force survey about whether or not the interviewee currently has (or has had in the recent past) a family member working abroad.

The sudden apparent deterioration in labour market condidtions is all the more worrying since up to now, and despite the fact that growth in the Estonian economy started to slow early 2007, the labour market did not show signs of any severe impact until Q3 2008. On the contrary, according to official statistics, unemployment continued to decrease and bottomed out at 4.0% in the second quarter of 2008. Since then the unemployment rate has jumped to 6.2% in Q3 followed by 7.6% Q4. Thus we now have the highest rate effective rate since the middle of 2005, and things are only getting started.

According to the statistics office, nearly half of those signing on have become unemployed due to layoffs, closures or bankruptcies. On the other hand total employment has so far help up reasonably well, with the total number of employed persons in the 3rd quarter running at 652,600, only 0.2% less than in the same period a year earlier (656,500).

Lastly, statistics Estonia reported last week that in January 2009 there was a year on year drop of 29% for exports and 37% for import 37%, meaning that the current account deficit is closing (more on this below). But first let me try to address some of the questions that have come up in the debate about devaluation.

In The Event Of Devaluation What Happpens To Euro Denominated Debts?

Basically this seems to be the big theme in the forefront of everybody's minds, but there seems to be some kind of large misunderstanding here. Essentially we are only talking about two different forms of devaluation (one internal via deflation, and the other external, by changing the exchange rate of the kroon with the euro). I think everyone is agreed that the Estonian economy - due to severe overheating, a massive housing bubble, and rampant inflation, all of which were the effect of faulty monetary and fiscal policy inside Estonia - is now hopelessly uncompetitive by international standards, hence a substantial downward correction in prices is agreed by all parties to be essential.

So the impact of this price downward price adjustment (which should be equal in either case) will be the same on the relative cost of maintaining non kroon loans. Let me put it this way, if you are one of the people in the unfortunate position of having such a loan it will make little difference to you whether your salary is reduced in kroon by 20% and your mortgage payment stays unchanged, or whether your salary in kroon remains unchanged and the currency drops 20% against the euro. Thus most of the argumentation about this topic seems to be highly emotional.

Of course, in both cases there will be loan defaults, but much more than the 20% drop in real salary (since it is unit hourly labour costs that matter here) will be the fall in earnings as the economy enters deep recession and people lose overtime, bonuses, or even their jobs themselves. This is what puts the default rate up, and prolonging the length of the slump long enough for people savings to run out, and for the normal unemployment benefit (of one year's duration) to run out, and people to be forced to try and live on the 59 euros a month social security allowance.

This, in my view, is the strongest argument in favour of the "short sharp shock" of the devaluation route (the so called V shaped recovery), rather than the more protracted "U shaped" one of internal deflation. On the second path you will almost certainly have more unemployment for longer, and with this the risk of loan default will increase. To counterbalance against that is the Estonian's national pride in their currency board, and their desire not to be seen to fail. But sometimes it is a good policy to stand and hold your ground, and others it is the more intelligent policy to retreat, and live to fight another day. All withdrawal is not an act of cowardice, nor is renegotiation a sign of unreliability. To make mistakes is to be human, and I doubt that the word of the United States has been put especially in doubt by the sub prime mortgage fiasco. In market economies "stuff happens", and when it happens normally it is better to take the corrective measures and put the issue behind you.

Of course, there are no guarantees here, and success or failure with devaluation (as with any measure) depends on the rest of the policy mix you put together to accompany the move. I don't think that there is any doubt that Estonia's position is very difficult, so there is no panacea, or easy way out of all this. It would have been better not to get into the mess, but it is a bit late for that now.

What I do think is that devaluation gives you a chance to fight back, and in any even you should feel better fighting, than simply waiting, and sitting and taking it on the cheek. With a current account deficit to reduce and falling government tax revenue there is little the government can do in the way of economic stimulus. Devaluation gives you a kind of indirect stimulus, that is the strongest argument in favour of it. It also places future output on a higher level and thus (arguably) reduces the unemployment and default risk.

Basically 2 years sitting around at home waiting can be very demoralising for anyone, and especially if you are trying to live for the second year on 59 euros a month. I am saying categorically and absolutely clearly here that I see no possibility of any kind of recovery in 2010 (especially given the global environment), and much less so if you just there and wait for it all to happen.

Now, if you devalue, you recover monetary policy, and you then need to keep a tight reign on inflation, but frankly, and again if we look at Hungary, they have devalued 25% and they still only have 3% inflation (and falling) so this may not be such a massive problem. The thing is you need a better monetary policy once the recovery starts, so you don't simply get the inflation again.

But basically, you should be able to foster domestic industries as an alternative to exporst in some things - I know, Estonia is so small it is hard to see how to do this, you obviously need to be very open as an economy, and practice good old Ricardian comparative advantage.So you need to specialise to some extent in new activities, and this is really up to the ministry of industry, or whatever, to formulate projects. Then you need to sell Estonia to some new investors. Price is only part of this, but it is part. Remember, with the present crisis there are plenty of people offering, and few people wanting to invest in new productive activities, but potential investors do exist, and you have to find them. That is the job your politicians should be up to now.

If you have the structure is right, and you can provide a base for some sort of exporting activity, then so much the better when it comes to persuading people to come. So devalution is just a kind of stimulus, it is like a large subsidy to exporters, socialising the costs. It isn't perfect, nothing in this world is, but it is better than nothing. You can keep more people in work this way, and those people create wealth, rather than simply consuming government benefits.

But going back to the loans and the default problem, what about the banks. Well my main point in this regard is that the last thing in the world the banks want to do is to start becoming estate agents, so they are in fact reasonably reluctant to start mass reposessions of property. It is that old story, if you owe them a little money and you can't pay, then you have a problem. But if you owe a lot of money, and you can't pay, they THEY have a problem, and normally they are going to be quite reasonable and down to earth when it comes to finding solutions, which they need as much as you do.

Banks basically prefer to stay in the business of banking, which is what they know about, in the same way that governments really don't want to nationalise banks, even though from time to time they may have to. Governments really don't know that much about running banks, any more than banks know about being estate agents, and holding a lot of property in a country in deep recession is hardly a plus for them, or their international credit rating.

When just a few householders have to throw in the towel and hand their home over to the bank, then banks may try to practise a "hold to maturity" rather than "mark to market" policy, and and profit from any hypothetical rise in property values in the future. But this credit and housing crisis isn't like previous ones in recent history. House prices in boom/bust economies like the Estonian one are unlikely to recover for many many years, and bank balance sheets simply won't let them hold on to dubious assets for such an extended period of time.

Banks want to manage mortgages, not houses, since mortgages pay a stream of income, while houses are only non performing loans, with no income.The same thing has been happening in Spain since the bubble burst, but now banks are swifty moving towards "fire sales" as they can hold out no longer, but even selling at rock bottom prices they are having trouble finding buyers. So what they would really prefer is to keep people in their homes.

This process will also happen in the Baltics, and the best policy for the banks will be to recognise reality, accept their share of the loses, and negotiate with householders while they are still in their homes and still in work, and with the government.Thus I think that those who have the most immediate interest in debt restructuring and devaluation - even though they don't seem to realise it going by their pronouncements - are those very Nordic banks who have been pressing to avoid it. As I say, 100,000 houses with people living in them and working and paying something are worth a lot more than 100,000 empty houses whose owners have long gone to work in Finland (or wherever) and which have been left to rot.

Joining The Eurozone

Now at this point I would like to be clear, I am not arguing for a unilateral devaluation by the Estonian authorities, but rather an acceptance of that as an objective on their part, and a negotiation of such devaluation with the EU authorities (the EU Commission and te ECB). Actually, what is rather to be lamented in this regard is that they themselves are not doing the reposible thing and taking the initiative here.

In fact the Estonian Finance Ministry has estimated that Estonia may well comply with the Maastricht criteria before the end of this year. Prime Minister Andrus Ansip is reported to be considering following the 2006 Lithuanian example and formally requesting an assesment of the fitness of Estonia for Eurozone membership: "We are entitled to request from the European Commission and from the European Central Bank that they would assess the compliance with the Maastricht criteria outside the regular approximation reports cycle," with the Finance Ministry adding that "Although thus far all the countries have adopted the Euro in the beginning of a year, the dates of the transition to the single currency is not so strictly regulated,".

Prime Minister Ansip estimates that Estonia may well comply with the inflation criterion by October, and that an evaluation at that point could lead to Eurozone membership as early as July 2010. Yet one more time I beg to differ.

I differ basically not because I doubt the assertion that Estonia's inflation rate will meet Eurozone criteria later this year, but becuase I doubt the interpretation of how such an application would be considered. You see, complying with the minimal criteria is only a first step in the process, the EU institutions then have to make an evaluation of the sustainability of the path your economy is on, and of the realism of the exchange rate at which you seek to enter, and since Estonia's economy, far from being clearly settled on a sustainable path is right in the middle of a boom-bust correction, and there is widespread agreement that your currency is, as of the present time, pretty overvalued. In have gone into all of this on an earlier occasion in the case of the review of the Slovakian situation, but it is clear that they will be unlikely to be sympathetic to any special pleading about your crisis in Estonia (all of Eastern Europe is in crisis), and (especially over at the ECB) will more than likely take the view that while financial support should be offered the best approach is to let you work out your own "imbalances" before you enter, since experience with those countries who entered in Southern Europe has not exactly been positive, and they may even already be having second thoughts as to whether they made the right decision in giving the go ahead to Slovakia and Slovenia.

My own view, which is pretty much the same as that held by Wolfgang Munchau, is that the countries of the East are playing a self defeating game at the present time, and that Collective Action On The Crisis Is Our Best Hope. What would be a better idea would be for you all to emphasise what you have in common at this point, rather than clinging to what differentiates you one from the other.

Paul Krugman, writing in the New York Times from Madrid (where he was meeting with Prime Minister Zapatero today) had this to say:

In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come. Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe. But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?
Current Account Deficit

Well, now let's take a brief look at the current account deficit issue. The first problem Estonia has is that she has been running one.

And the second problem is that now that the capital flows which were supporting it have dried up, you need to get rid of it. Which isn't as easy as it sounds. The ideal way to straighten out a current account balance is to increase exports and reduce imports at one and the same time.

Now, if we look at the deficit over the last few years (see chart below), we can see that only a part is produced by the goods and services trade deficit.

That is because another part (structurally) of the deficit comes from the negative impact of income flows (these are basically composed of interest on loans and dividends on equities).

And why does Estonia have these negative income flows, well in part as a result of all those bank flows which paid for the loans that so many Estonians were contracting, and in part they are produced by income earned on Foreign Direct Investment. The point is FDI is good, but if you are a borrowing economy, rather than a saving one, then you accumulate over time an imbalance between the investments you make in other countries and the investments others make in your country. The upshot of this is that you accumulate a structural deficit under the income account of your Balance of Payments current account, and this is exactly what has happened to Estonia (see chart below).

So basically, not only does Estonia need to start exporting to create economic growth, it also needs to do more exporting to pay down the debt (hence addressing the structural weakness in the account) and to start accumulating a greater external FDI stock, which among other things can generate income to help you pay for your old age. One of the features of generalised economic corrections like the ones we are suffering from is that we tend to suffer from what Keynes called the Paradox of Thrift. Paul Krugman puts the situation like this (in a US setting, but Estonia'ssituation is not that different, structurally speaking)

I don’t know who else has made this point, but it’s quite clear that we’re in serious paradox of thrift territory here. Or perhaps more accurately, we’re in a paradox of debt.

Consumers are pulling back because they’ve realized that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever. I can’t do this accurately until the Federal Reserve’s flow of funds data have been updated, but almost without question the ratio of household debt to personal income has been rising, not falling, as consumers try to save more.

And guess what, while I don't have the data to hand, I bet you all the tea there is in China that the ratio of household debt to personal income will also have been rising as the economy contracts, even as Estonian consumers try to save rather than borrow. That is, the faster you try to save, the less you really do manage to save as your income contracts, and here is just another reason why you need exports. I'm afraid that those who say "speculations about devaluing of the kroon are irresponsible as no one in Estonia would gain anything from such a move", simply don't understand what they are talking about. (Well that makes two Baltic central bank governors who don't agree with me).

One of the reasons, of course, that it seems so difficult for people to contemplate increasing exports as a way out of this crisis is that the economy has been completely distorted by the construction, financial services and real estate boom. Just one indication of this can be found in the share of construction activity in the whole economy (see chart below). As we can see in the chart, the construction share in Estonian GDP climbed steadily after 2005. This share now needs to drop back again towards its historic average. This correction has started, but there is still a long way to go, and meanwhile the economy contracts and contracts.

So, summing up, and in the words of the IMF:

The recession is sharply reducing Estonia’s imbalances. The external current
account deficit nearly halved between 2007 and 2008, largely due to a
demand-driven compression of imports
but also helped by a drop in income
outflows, reflecting the fall in profits to foreign-owned companies and banks.
Exports continued to grow modestly despite an appreciation of the real exchange
rate, owing to an improvement in terms of trade and a recovery of oil transit
trade with Russia. (my emphasis).

Q4 2008 GDP

So what is happening to the Estonian Economy? Well lets look at the latest GDP data. Now, according to the preliminary estimates from Statistics Estonia output in the Estonian economy dropped by 9.4 percent during the 4th quarter of 2008 (on a year on year basis). This is a huge drop, unprecedented in Estonia since the upheavals of the very early nineties, during the transition from a planned to a market economy. This, however, is not that surprising, since the recession in all highly developed economies is currently more serious than anything seen since the 1930s, and the Baltic correction is one of the most dramatic among these. Compared to the third quarter, the seasonally and working-day adjusted GDP was down by 4.3%, while fourth quarter GDP was even below Q3 at current prices for the first time since 1995 (down by 4.7% - that is GDP was down in what we economists call nominal, as well as real terms. this is quite a significant development to which we will return in the coming months and quarters).

So, following year on year real GDP growth rates which were fluctuating in the 11-12 percent range for six consecutive quarters between mid 2005 and the end of 2006, we now have a strong and sustained contraction (which has now, according to Eurostat seasonally corrected quarterly data lasted for 5 quarters, with no end to the pain in sight). This is why we refer to a boom-bust process, since the normal (garden-variety) recession lasts only 2 quarters.

In 1997, when Estonia went through its last comparable cycle, overheating driven growth lasted for around 5 quarters, and was then followed by several quarters of negative growth, starting in Q4 1998. GDP hit a low point with a 1.6 percent decrease in GDP in Q3 1999, and growth was positive again in Q4 1999, and by Q1 2000 was up at an annual 8.4% rate.

Today nobody is expecting such a rapid recovery as the two crises are very different. In the first place, while during the 1997/98 crisis the downturn only really involved emerging markets, and especially in the Estonian context Russia, the current crisis is more of a depression than a recession and is a global one. West European countries, which were the main export markets for Estonian products by the late nineties, contributed to Estonia's rapid recovery with their own momentum. This year few expect Europe's economies to expand this year, and large question marks still hang over 2010. Further, the Estonian economy had a lot more in the way of sector transition driven easily achievable catch up growth in front of it, now this element will be much less favourable, since Estonia will really need to find substantial productivity and competitiveness improvements in existing activities, and even from abandoning some parts of the higher value sectors (like construction and real estate) which had been fuelling the earlier growth. So nothing here is going to be easy, and certainly nothing like as easy in 1999. The two moments just do not bear serious comparison.

If we look at the Q4 data, the fall in GDP was largely produced by a drop in domestic demand (which fell year on year by 14.8%).

Domestic demand is basically composed of three elements, households’ final consumption expenditures (HFCE), gross fixed capital formation (GFCF) and government spending. HFCE was down year on year by 10.4% in Q4.

Total government consumption expenditure (including transfers) was up 3.5%.

And GCFC (which basically means investment in one form or another) was down by 24% year on year.

So apart from the increase in government spending, the only bright spot in Q4 GDP came from the net trade effect, since this was a by product of the fact that imports fell (11.9%) by more than exorts (3.2%). The drop in imports was driven by a fall in machinery, equipment and motor vehicle imports. Which means simply that both investment and private consumption (or living standards) are falling.

The Credit Driven Expansion Is Over

During boom times the main supports for Estonia's extremely distorted economic growth were the excessively low interest rates available on euro denominated loans (which effectively fuelled the housing bubble) and strong capital inflows, which made possible the rapid increase in the volume of home loans and loans to building developers. During the current downturn as financial regulation is tightened, what Estonia can expect are higher interest rates, an end to real estate as a GDP growth driver and a decline in borrowing.

During the boom time, the inflow of foreign capital, largely through foreign owners of local banks, seemed never ending. Bank liabilities to non-residents (as a share of total assets) rose from the 31-34% range in 2000-2003 to over 50% by 2007/08. Bank liabilities to Estonian residents as a % of GDP increased from 40% at the start of the century to over 60% in 2007/08, while liabilities to non-residents shot up from 20% to 70% of GDP over the same period.

The share of locally owned banks in Estonia is marginal. Only the Baltic Investments Trust is locally owned and this accounts for under 1% of the total market. As of June 2008, 72% of Estonian banking assets were owned by two Swedish banks, Swedbank and SEB, with Swedbank alone holding a more than a 50% share. The ratio of total bank assets to GDP increased from 60 percent to more than 130 percent in the period of 2000-2008, while the share of loans in these assets increased from 58 percent to 76 percent over the same period. On a quick calculation basis, this means that the banks have an exposure to lonas of about 97% of GDP (and rising as GDP contracts, this is the paradox of thrift point, and especially as nominal GDP falls - as Estonia enters negative price deflation this percentage is set to shoot up, as nominal GDP falls more quickly than real GDP - this is yet one more reason why devaluation is a better option - you take some of the sting out of the growing burden of debt).

Home loans and loans to the real estate sector made up 59 per cent of the total loan portfolio of the banks at the end of 2007, compared to 25 percent in 2000, which shows the enormous increase in Swedish bank exposire to Estonian real estate. Net savings (deposits less loans) of private individuals to GDP changed from around a positive 8 percent in 2000 to minus 26 percent in 2008, i.e. households moved from being net savers to becoming net borrowers, and they are now about to go all the way back upstream again, which is why .... well, you know, exports are about to become so vital.

As can be seen from all the above, the Estonian economy is now heavily dependent on the standing and good will of the Nordic banks. The IMF, the Estonian Central Bank, the EU and other stakeholders arguethat the financial standing of the Nordic banks operating in Estonia should be strong enough to cope with both the global financial crisis and the risks related to Estonia's contracting economy. This may, or may not, prove to be the case. If their only exposure was to Estonia then probably they would be right, but what is happening in Estonia forms part of a broader regional picture, and needs to be seen in that light.

But, anyway, this is beside the point. Even were the banks to view favourably future loan applications from Estonian citizens, those very same citizens would be unlikely to be seeking the loans in the first place. As we are seeing, Estonians will be more inclined to save than to borrow in the coming years, and especially given that the Estonian property market has now decisively turned, which means there will be no more juicy increases in house prices to continually tempt them back to the lending counter, nor rising home equity from which to extract that "something extra" with which to buy that nice new car.

Finally, The Impact Of The Property Crash.

Before closing I would like to return to one rather contested (and possibly ill advised) point I made in my previous post. At the start of the post I said:

"At the same time it is estimated that nearly 250,000 Estonians are currently living in homes whose market value is insufficient to cover the outstanding mortgage loans which their owners have taken out, making "exposure risk" a growing problem for the country's banks. During the boom, house sale transactions were commonly financed with a 90% loan to value (LtV) ratio. This is a very dubious practice at the best of time, but in the face of a sharp fall in both house values and wages it becomes well nigh disastrous."

Now, I do say here "it is estimated" and indeed the estimated came from an Estonian journalist (writing in the newspaper Postimees on 27/02) even if the methodology used to make the "estimate" - calculating that between 2006-2008 there were 100 000 households who bought real estate, and then multiplying by the average household size of 2,5 persons, to get a grand toal of 250 000 Estonians). The truth of the matter is that no one really knows how many Estonians have negative equity in their homes at this point in time, other than the fact that the number is large and rising.

What we do know is that property prices in Estonia’s residential real estate market continued to sfall in 2008 (and especially in Talinn and Parnu), after starting to fall in the last quarter of 2007. In fact, i Tallinn the average price of 2-room apartments was down by 17.2% at the end of Q3 2008 from a year earlier. Taking inflation into account, the average price drop was more like 25.3% in real terms. In a broader context, Estonia's 2008 price falls were among the highest seen globally, and were in sharp contrast to the enormous annual price increases we were seeing in the not very distant past, when annual rates peak at an annual price increase of 77.5% in Q1 2006. Record breakers on the way up, and on the way down. Is this, I ask you, a nice way to live?

Demand for properties in Tallinn, for example, reached an all time high in 2006, with the average price of 2 room flats rising by an average of 27% annually from 2001 to 2005 with the rate peaking in 2006, when prices rose by more than 50% year on year.

The average price of a 3-room apartment in Tallinn was down 11.5% - to EKK20,800 (€1,328) per sq. m. - during the year to end-Q3 2008, and down 18.4% from the peak level of EEK25,500 (€1,629) per sq. m. in Q2 2007. In Parnu average prices plunged by around 30% to end-Q3 2008 from a year earlier.

The volume of real estate transactions also continues to fall, after reaching EEK39.8 billion in 2008, down from EEK57.6 billion in 2007 and EEK73.8 billion in 2006. The number of transactions in 2008 was 50,528, up slightly compared with 49,464 transactions in 2007 but well down on the 60,208 transactions registered in 2006.

And along with the decline in notarial contracts the number of building permits has also fallen. Permits for only 4,301 dwellings were filed in the first three quarters of 2008, significantly down compared with the 7,795 permits issued in 2007.

So really we have seen a huge bubble here with the average price of 2-room flats in Tallinn up by 448.7% from 2000 to 2007, in Tartu by 431.5% and in Parnu by 440%. And almost the entire population is affected, since owner-occupancy rates have risen strongly, and are up from 85% in 2002, to 96% in 2004. Estonia's rental market shrank from 12% of households (with 9% privately renting and 3% in social rents) in 2002, to just 4% in 2004.

And the house price boom was supported by a massive expansion of the mortgage market, with an average rate of annual increase of 62% yearly between 2002 and 2006. Outstanding housing loans grew from EEK4.5 billion (€286 million) in 2000 to EEK88 (€5.6) billion in 2007 and EEK 97 (€6.2) billion in 2008; or if you prefer from 4.7% of GDP in 2000, to 37% in 2007. Even more to the point, at the peak of the boom, banks were willing to provide loans with a maximum lending period of 30 years on a loan-to-value ratio of 100%.

Monetary Policy Always Flawed

One cause of Estonia's inflated boom has undoubtedly come from the pronounced tendency of the Estonian people to favour the pegging of the kroon, first to the deutschemark in 1992 and then to the euro in 2001. Initially the peg lead to lower inflation and lower interest rates. Mortgage interest rates fell from over 10% during the late-1990s, to below 4% between 2004 and 2006, while inflation fell from 89% in 1992 to 8.2% in 1998. Between 2002 and 2006, inflation was permanently below the 5% mark (with an annual average of 3.3%).

However pegging is always a problematic strategy, and so it has been in the Estonian case. Follwoing the decision to peg to the euro, interest rates in Estonia have basically followed the key policy rate set by the ECB. Hence when the ECB began to raise key rates in mid-2005, mortgage rates also increased in Estonia. ECB base rates were gradually raised in 25 basis point steps, from 2% in October 2005 to 4% in May 2007, and again to 4.25% in July 2008.

Clearly these rates were lower than warranted by Estonia’s inflation. Yet Estonia's monetary authorities remained relatively powerless because the kroon’s peg to the euro means the central bank could not raise interest rates further, and even if they did, this would only accelerate the preference for euro loans, with the majority of those borrowing sublimely unaware of the risks they were assuming in taking out unhedged foreign currency loans.

I say that Estonia's monetary authorities remained relatively powerless, but relatively here does not mean completely, since more could surely have been done on both the fiscal and the monetary side to avert the present tragedy. The fiscal authorities could have paid more heed to the warnings from the IMF and the credit ratings agencies that a higher level of budget surplus was urgently needed to drain all the excess demand which was violently overheating the system. The central bank (you know those people who now blithely say that "speculations about devaluing of the kroon are irresponsible as no one in Estonia would gain anything from such a move") could have issued very strict instructions to the banks about the income multipliers on loans, loan to value percentages, and documentation needed, and this, as we saw later, would surely have has an effect. And above all, both the central bank and the fiscal authorities could have taken a much less tolerant attitude to the sharp wage inflation which broke out in the second half of 2006. It is not so much a matter of having no policy remedies available, as a lack of the necessary will to look for the tools and find them. All of this is far more reminiscent of what we are unfortunately all too accustomed to seeing in country's with "currency corridors" like Ukraine or even Russia itself than it is of the sort of modern new dynamic and free market economic model we were all lead to believe Estonia had firmly set its path on.

Housing Oversupply And Declining Construction Activity

So what we have before us is a huge housing overhang, a seriously endebted population, and an economy which was dependent on construction and real estate which will now need to "reinvent" itself. It wasn't always like this. Following the break-up of the Soviet Union in 1991, housing construction entered dramatic deceleration and between 1996 and 2001 less than 1,000 dwellings were added to the dwelling stock annually - not even enough to meet "normal" demand. After 2001, housing construction really took off, and in 2007, around 7,200 units were added to the dwelling stock, up from the 5,100 units built in 2006.

This massive increase in dwelling completions has now transformed a housing shortage situation to substantial oversupply one, pushing house prices down in the process. Another 4,282 new dwelling units were completed within the first three quarters of 2008. Although less than the 4,911 completions which were registered in the same period in 2007, these, in a market which is already "oversold" have only added more pressure on an already bloated 645,400 dwelling stock. Maybe it is worth someone remebering at this point that Estonia's population is actually falling. So, as buildings output drops by 25% year on year in Q4 (see chart below) maybe the time has come to ask when will the level of output ever start to rise again? And in the meantime, what will Estonia live from in the meantime? Anyone ready now to have second thoughts about exports?