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SEB: Internal Estonian devaluation continues - The strong rebound in the fourth quarter of 2009 might be the first tangible sign of a turnaround, although part of this growth was probably borrowed from the first quarter of 2010 as companies built up stocks in anticipation of higher excise taxes in January, writes SEB on Estonia in their latest Eastern European Outlook, published March 24th, 2010.

- But even a possible temporary relapse leaves two major pillars of our main scenario intact, continues SEB's outlook. First, we see a substantially higher probability of euro adoption in January 2011, as the last uncertainty about the budget criterion seems to have faded. Second, we envisage much stronger growth in major trade partners than we foresaw in Eastern European Outlook half a year ago.

- Unemployment has climbed rapidly since its all-time low in the second quarter of 2008. While consumers' unemployment expectations have receded in the past year, their sanguine mindset is not yet supported by hard statistics, although the latest weekly figures show that the total number of unemployed may have begun to stabilise.

- To the extent that viable recovery remains hostage to a job market upturn, the present situation gives little reason for cheer. It is equally true, however, that the worst fears of mass unemployment channeling into political disorder have not materialized. The upturn in Nordic economies adds positive sentiment for economic development.

- Unemployment and weak domestic demand make recent double-digit growth look like distant history. Indeed, year-on-year growth in nominal wages dropped below zero in the first quarter of 2009 and has meandered in negative territory ever since.

- Thus, Estonia has largely managed to stick to its course of internal devaluation without straying into political mayhem, which is known to be the Achilles heel of this adjustment pattern. Deflation has been working through the system since last spring, when CPI inflation slipped to -0.3 per cent. After reaching its nadir at –2.2 per cent in October, the CPI rate has worked its way towards zero. Month-on-month inflation rates and survey-based expectation indicators point towards the end of deflation.

- There is now also strong evidence that the squeeze on domestic spending and accompanying deflation have improved Estonia's international competitiveness, as measured by the real effective exchange rate. Year-on-year growth in total exports beat expectations in January, reaching 11 per cent.

Euro around the corner

- Through an astute mix of window dressing, one-off fixes and genuine cuts, the government was able to turn a massive budget deficit equivalent to 11.7 per cent of GDP in the first quarter of 2009 into a surplus of 2.7 per cent in the third quarter of 2009 and to finish the year with a preliminary shortfall of 1.7 per cent, to be revised when the official public finance figures come out on March 26. [e-focus edit: The figures are now publicly announced and are available here]

- While we expect this fiscal feat to win the government the desired euro ticket, the heavy politicization of the issue may yet come back to haunt it.

- Barring the relatively unlikely event that the euro will indeed bring with it rapid and perceptible economic advances, disillusionment with the whole project can easily set in, concludes SEB their Eastern European Outlook, March 2010. Hence, we expect policymakers to start loosening their fiscal stance as soon as the positive answers from the Commission and the ECB come through in late spring – assuming that Greek-related turbulence does not postpone the accession process in the first place. We thus envisage the public sector deficit widening back to 2.5 per cent of GDP in the run-up to the March 2011 election, and then receding to 2.0 per cent on the back of stronger growth.

SEB's Eastern European Outlook is produced twice a year. The March 24th, 2010 Outlook is available at www.sebgroup.com [> About SEB, > Download facts and reports, Reports: > Eastern European Outlook]