Estonias finance minister has pledged a fresh round of spending cuts to support the countrys bid to join the eurozone by year end, as authorities seek a safe haven for the collapsing economy amid a global slump.
In an interview with Emerging Markets Ivari Padar said the government would streamline our budget strategy while weighing the negative short term impacts and the positive long term impacts of the euro adoption.
Estonias fiscal position has deteriorated from a 3% surplus in 2007 to a 3% deficit at the end of last year. The government needs to cap the budget deficit at 3% in order to meet its January 2011 target to adopt the euro.
Padars comments follow Wednesdays release of shocking GDP figures that reveal the economy contracted by 15.6% in the first quarter of the year the second worst quarterly contraction in the European Union after Latvias 18% drop.
After years of sky-high growth, the global downturn has wreaked havoc on capital inflows, exports and domestic consumption. SEB predicts GDP will shrink by 12% this year and a further 2.3% in 2010.
Padar said the further budget cuts would have some negative impact on domestic demand and thus employment, income and growth in the short run.
But he argued that government spending to boost domestic consumption would have limited power to offset the downturn since Estonia is a small, open economy. As a result, people would spend their money to buy imported goods and this would not increase the production and GDP in Estonia.
Violeta Klyviene, senior Baltic analyst at Danske Bank, said: In general, Estonia has the same chance to fulfil the Maastricht criteria [on euro adoption] this year, but uncertainties with regard to the budget situation have increased significantly.
Estonias currency is pegged to the euro so the exchange rate cannot act as a shock observer in the crisis. Instead, a painful adjustment in nominal prices is taking place, further eroding domestic consumption.
Padar argued the economy had overheated in the bull run of previous years and the painful adjustment in both income levels and prices would continue until 2011.
We all have to admit that income growth has been unsustainably rapid during the past three years, exceeding productivity growth starting from 2006. Now we have to face the reality of income decline during this and next year. But he said deflation would boost the countrys competitiveness and medium-term growth potential.
Nordic banks dominate in Estonias financial system but their balance sheets are now under pressure as unemployment and loan defaults soar. But Andres Lipstok, the governor of the central bank of Estonia, argued the banking system is now stable.
He said several years of quality earnings by local subsidiaries have given parent banks room to cover losses from loan defaults in Estonia this year. He added the country in any case needed to focus on developing high-value goods and services to ensure sustainable growth in the future.