Capital Inflows, Household Debt and the Boom-bust Cycle in Estonia

From 2000 to 2007, Estonia was one of the fastest growing emerging market economies. A housing boom,fuelled by capital inflows and credit, resulted in skyrocketing house prices and an over-expanded construction sector.However, the currency board limited the Bank of Estonia’s ability to curb credit growth, while the fiscal policyframework amplified the cycle through pro-cyclical spending increases and tax cuts. As credit was mostly financedby cross-border loans from foreign banks, the risks of disruptions to credit flows and financial contagion haveincreased. Some have already materialised through tightened lending standards and capital outflows.Estonia is now in a severe recession. To restore high and sustainable growth, the country will need to rebalanceits resources from non-tradables towards exports. Regaining external competitiveness will be challenging, however,given the fixed exchange rate and recent devaluations in partner countries. Flexibility of the economy will thus becrucial. Over the medium term, policymakers could also strengthen incentives for a better functioning of the housingfinance market and gradually remove the pro-cyclical bias of fiscal policy.