Republic of Estonia: Staff Report for the 2000 Article IV Consultation and First Review Under the Stand-By Arrangement
Author: International Monetary Fund
Publication Date:
10 Jul 2000
eISBN:
9781451812343
Language:
English
Keywords:
ISCR; CR; government; deficit; parliament; reform agenda; assessment framework; banking system; broad money; labor market; General government operation; foreign currency
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The economic recovery seems to be firmly established, supported by strengthened domestic private demand. The Bank of Estonia (BoE) is committed to maintaining the currency board until the euro becomes Estonia's official currency. The compliance with the Basel Core Principles (BCP) has improved and is now high. Monetary and financial policies are transparent. Financial sector assessment program recommendations have been integrated into the government's work program. Good progress is being made in the implementation of the structural reform agenda, including the privatization of major infrastructure companies.

Abstract

The economic recovery seems to be firmly established, supported by strengthened domestic private demand. The Bank of Estonia (BoE) is committed to maintaining the currency board until the euro becomes Estonia's official currency. The compliance with the Basel Core Principles (BCP) has improved and is now high. Monetary and financial policies are transparent. Financial sector assessment program recommendations have been integrated into the government's work program. Good progress is being made in the implementation of the structural reform agenda, including the privatization of major infrastructure companies.

Estonia: Basic Data

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Sources: Estonian authorities; and Fund staff estimates.

Data for 1998

I. Introduction

1. During the discussion of the authorities’ request of the present SBA (EBS/00/18) on March 1, 2000, Executive Directors welcomed the authorities’ intention to phase out during 2000 the discretionary fiscal stimulus provided in 1999 and to achieve overall fiscal balance in 2001. They also noted that the currency board arrangement has served Estonia well and fully supported the authorities’ aim to maintain this arrangement. Directors remarked that the recent improvement in the current account deficit had to a considerable extent been due to cyclical factors. They agreed that a modest widening of the current account should not be a cause for concern in view of the relatively low level of debt and debt service. Directors endorsed the authorities’ intention to work towards the introduction of unified financial supervision.

II. Recent Economic Developments

2. Except for a somewhat wider current account deficit, developments in 1999 were broadly as described in EBS/00/18. Real GDP began to expand again in the last quarter of 1999 and gained strength in the first quarter of 2000 (Figures 1 and 2 and Table 1). The increase in private demand has offset the tightening of the fiscal stance. Exports to CIS markets contracted sharply in 1999, while exports to western markets continued to grow at an adequate pace. The latter appear to have accelerated sharply in the first quarter of 2000, partly driven by an expansion of the electronics sector. There was a pronounced increase of service exports (oil transshipment and tourism).

Figure 1.
Figure 1.

The Battles: Cross Country Comparisons, 1995-1999

Citation: IMF Staff Country Reports 2000, 079; 10.5089/9781451812343.002.A001

Sources: Country authorities; and Fund staff calculations.1/ Change from same period in preceding year.
Figure 2.
Figure 2.

Estonia: Growth of Output and Prices, 1996-2000

(In percent)

Citation: IMF Staff Country Reports 2000, 079; 10.5089/9781451812343.002.A001

Sources: Bank of Estonia; and Fund staff estimates.1/ Change over the same quarter of the previous year in constant prices.2/ Change over the same quarter of the previous year in current DM prices of goods and nonfactor services.3/ Change over the same quarter in previous year.4/ Effective 1998, the CPI weights were adjusted based on 1997 data.
Table 1.

Estonia: Selected Macroeconomic indicators, 1996-2001

(In units as indicated)

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Sources: Estonian authorities, and Fund staff estimates and projections.

Reel GDP growth has been revised up from 4.0 percent to 4.7 percent for 1990 and from -1.4 percent to -1.1 percent for 1999.

Effective 1998, a new CPI index is used that is based on 1997 weights.

The GDP deflator for the Roth quarter of 1999 and thus 1999 as a whole has been revised upward.

Excludes any impact of the Planned pension system reform, which is unlikely to come into effect before 2002. Also excludes possible tax cute and matching expenditure cuts in 2001 currently considered by the government that may amount to 1 percent of GDP

Includes net lending.

Gross international reserves (and thus base money) at end-1999 were inflated by banks shifting resources from accounts abroad to the Bank of Estonia to enhance domestic liquidity in anticipation of Y2K-related problems. These positions were largely reversed in early 2000.

Includes use of Fund credit and trade credits.

Nat of deposits held abroad by the general government and commercial banks.

Includes government-guaranteed debt and Fund credit raider the Systemic Transformation Faddy (on-lent to commercial banks).

Government assets held abroad include the Stabilization Reserve Fund (SRF).

The Estonian kroon has been pegged to the deutsche mark at EEK 8-DM 1 since June 20, 1992.

3. Average CPI inflation had fallen to 3.3 percent in 1999, reflecting low inflation rates in the euro area, the impact of the Russia crisis on agricultural prices, and cyclical factors. The 12-month CPI inflation rate stood at 3.1 percent in April, 2000. Moderate pressure on prices resulted from the economic recovery and several one-time factors such as increases in public transport fares and excises and introduction of tariffs on selected imports, as well as rising energy prices on the world market. Nevertheless, CPI inflation was slightly below program projections. The continuing inflation differential to the euro area largely reflects the relatively fast growth of prices of nontraded goods and services. The producer price index declined for most of 1999, but has increased since end-1999 on account of energy prices.

4. The unemployment rate (ILO definition) reached close to 11 percent at end-1999 and is estimated to have remained at this elevated level over the first quarter of 2000 (Figure 3). Registered unemployment (national definition) rose to about 3.3 percent of the labor force in the first quarter of 2000.1 So far, the return to growth has not led to a reduction in unemployment. There are indications that part of unemployment is becoming structural in nature, owing to skill mismatch; insider-outsider mechanisms or employment protection do not seem to hamper significantly the reallocation of labor and job creation. Public sector wages increased by over 20 percent in real terms during 1999, whereas private sector wages increased on average by only about 2 percent (between 1994 and 1998 public sector and private sector wages had moved fairly parallel). In the sectors that were adversely affected by the contraction of the CIS markets, wages actually declined in nominal terms.

Figure 3.
Figure 3.

Estonia: Unemployment in Percent of Labor Force, 1993-2000 1/

Citation: IMF Staff Country Reports 2000, 079; 10.5089/9781451812343.002.A001

Source: National authorities; and Fund staff estimates.1/ The labor force consists of persons aged 15 to retirement age.2/ Individuals actively seeking employment Data are based on a labor force survey.3/ Unemployed job seekers who are registered with the employment office, but are not necessarily eligible for unemployment benefits.4/ Unemployed job seekers who are registered with the employment office and are eligible for unemployment benefits.

5. The fiscal deficit decreased sharply in the second half of 1999 (Figure 4 and Tables 2 and 3). High public sector wage and pension increases, the contraction of the economy in the first half of 1999, and the impact of one-time factors (EBS/00/18), had contributed to a deficit of 6.6 percent of GDP in the first half of 1999. Discussions between the authorities and the staff led to the passage of a supplementary budget that cut expenditures in the second half of 1999. In addition, the authorities restrained expenditure further by deferring some expenditures (0.6 percent of GDP) to 2000 without incurring expenditure arrears. The fiscal deficit was thus limited to 4.7 percent of GDP for the year as a whole. The deficit was largely financed by the privatization receipts from the sale of 24 percent of Eesti Telecom shares primarily to foreign investors.

Figure 4.
Figure 4.

Estonia: General Government Operations, 1996‐2000

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 079; 10.5089/9781451812343.002.A001

Sources: Estonian Ministry of Finance; and Fund staff calculations.1/ Includes balances of the state and local governments and extrabudgetaty funds.2/ Includes balances of the Social Insurance and of the Medical Insurance Funds. Available only from 1997 onwards.
Table 2.

Estonia: Summary of General Government Operations, 1997-2001

(in millions of EEK)

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Sources: Data provided by the Estonian authorities, and Fund staff estimates and projections.

Excludes any impact from the introduction of the pension system’s second pillar, as it is no longer expected to become effective in 2001.

Starting from 2000, includes revenue from the taxation of dividends and fringe benefits (the latter was introduced as of January 1, 2000). Prior to 2000, revenue from the taxation of dividends was shown under the corporate profits tax.

For 2000, includes spending agencies own revenue and profit transfer from the BOB. Projections for 2001 do not yet include any BOE profit transfers.

For 2000, includes outlays financed from spending agencies own resources.

Wages and Walks of a number of budgetary institutions are included under “other goods and services”.

Used for financing the general government deficit.

Table 3.

Estonia: Summary of General Government Operations, 1997-2001

(In percent of GDP)

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Sources: Data provided by the Estonian authorities, and Fund staff estimates and projections.

Excludes any impact from the introduction of the pension system’s second pillar, as it is no longer expected to become effective in 2001.

Starting from 2000, includes revenue from the taxation of dividends and fringe benefits (the latter was introduced an of January 1, 2000). Prior to 2000, revenue from the taxation of dividends was shown under the corporate profits tax.

For 2000, includes spending agencies own revenue and profit transfer from the BOE. Projections for 2001 do not yet include and BOB profit transfers.

For 2000, includes outlays financed from spending agencies own resources.

Wages and salaries of a number of budgetary institutions are included under “other goods and services”.

Used for financing the general government deficit.

6. Fiscal developments in early 2000 have been broadly in line with the program. Total general government revenues in the first quarter were 5 percentage points of GDP higher than in the same period in 1999, when revenues were depressed on account of one-time factors. Direct taxes performed well, but, as expected, excise tax collections fell in early 2000. This followed on a spike at the end of 1999 when importers had stockpiled excisable goods prior to sharp increases in excise rates of fuel and tobacco products. Expenditures have been kept in line with program targets in the first quarter of 2000 at 40 percent of GDP. The general government deficit in the first quarter of 2000 amounted to about EEK 167 million (or close to 1 percent of period GDP), compared to the program target of EEK 410 million (2.3 percent of GDP). The small deficit and the net repayment of foreign debt were financed by a drawdown of domestic and external government deposits.

7. Interest rates have fallen to historic lows and the banking system remains highly liquid. Lending to the private sector resumed in the second half of 1999 and early 2000 when private sector credit demand began to recover (Figure 5). Lending to leasing companies and mortgage lending to private households have picked up, while the growth of credit to the private enterprise sector has remained relatively modest. Broad money growth, which had stagnated after mid–1998, recovered to about 25 percent year-on–year towards the end of 1999 and the first quarter of 2000. Until the last quarter of 1999, there was little movement in the BoE’s accounts. Subsequently, foreign assets and base money registered a sizable increase related to precautionary Y2K preparations by commercial banks. These developments were largely reversed over the first quarter of 2000.

Figure 5.
Figure 5.

Estonia: Monetary and Financial Indicators, 1995-2000

Citation: IMF Staff Country Reports 2000, 079; 10.5089/9781451812343.002.A001

Sources: Bank of Estonia; Statistical Office of Estonia, IFS, and Fund staff estimates.1/ Growth rates over same month of previous year.2/ Tallinn Stock Exchange index.3/ Foreign assets of commercial banks declined at end-1999 as banks shifted resources from deposits abroad to deposits with the Bank of Estonia to enhance domestic liquidity in anticipation of problems related to Y2K.4/ Tallinn interbank offered rate.5/ FIBOR from April 1996 to December 1998, and EURIBOR from January 1999.

8. The banking system appears to remain in a strong financial condition (Tables 4 and 5), with the average capital adequacy ratio at 17 percent of risk-weighted assets at end-March 2000 (compared to a required minimum of 10 percent). Only six banks are now active in Estonia (plus the branch of one foreign bank). The two largest Estonian banks, which together account for about 85 percent of the banking sector assets, are majority owned by foreign banks. International rating agencies have recently further increased the investment grade ratings for these banks, and both banks have successfully refinanced substantial maturing debts on fine multi-year terms in early 2000. The decision to sell the Bank of Estonia’s share in Optiva Bank to a Finnish financial conglomerate was announced in late April 2000; details of this sale, which may include very limited guarantees by the BoE, have not yet been finalized. This will increase foreign control of the banking system to about 95 percent. Stock market prices continued their upward climb in 2000 (with the main index rising by 37 percent in the first quarter); however, even at current levels the stock market index remains well below its mid-1997 peak. Market capitalization increased substantially in 1999, largely because of Eesti Telecom privatization.

Table 4.

Estonia Banking Survey 1997‐2000

(in millions of EEK)

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Source: Bank of Estonia and Fund staff estimates

The authorities revised the data on deposit money bard& foreign liabilities in December 1998 by including substantial amounts of bonds issued it foreign liabilities that had hitherto been included in ether items (net).

Excludes foreign mob of the Stabilization Reserve Fund

The Bank of Estimates foreign assets rose sharply in December 1999 as commerecial banks shifted funds into their accounts with the Bonk of Estonia to enhance domestics liquidityh in enterprises of Y2K problems.

Table 5.

Estonia: Selected Financial Indicators, 1996-2000

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Source: Bank of Estonia.

Banks must meet reserve requirements on the basis of average reserve holdings over each reporting period. End of period levels can, therefore, be below the level of required reserves.

The minimum risk-weighted capital adequacy ratio was increased from 8 to 10 percent on October 1, 1997.

In percent of total loans. Non-performing loans are defined as loans overdue from 30-150 days and under current regulations all non-performing loans over 150 days are written off. The ratio rose sharply in early 1999 reflecting the impact of the Russia crisis on the financial condition of enterprises.

Defined as the ratio of total liabilities to total capital; a decline in the ratio indicates improvement.

A (-) sign indicates a short position and includes forward contracts. Switches from positive to negative positions are normally associated with short-lived speculation against the kroon in the form of forward sales (e.g., December 1997 and August 1998). The reversal of these positions has been associated with a sharp improvement in the net open position (e.g., December 1998).

Differs from line 5 as this includes positions held vis-i-vis residents (e.g., foreign currency deposits).

Also includes swaps and off-balance sheet commitments.

Commercial banks only. Commercial banks by mid-May 2000 had successfully refinanced on fine terms through multiyear eurobonds the maturities falling due in early 2000.

Excludes currency board cover and Government deposits held abroad (including the Stabilization Reserve Fund).

Calculated as the difference between short-term (under 1 year) average lending and deposit rates on domestic and foreign currency (DM) loans and deposits.

Percentage change over same month in the preceding year.

9. There have been no significant pressures on the exchange market since early 1999 and confidence in the currency board remains strong, as evidenced by historically low interest rates and low swap margins on forward markets. The Bank of Estonia’s level of MR (defined as the excess of foreign assets over currency board cover) remained well above the program floor at end-March 2000 (Table 6).2

Table 6.

Estonia: Monetary Authorities: 1997-2000

(in millions of EEK)

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Source: Bank of Estonia and Fund staff estimates.

Excludes foreign assets of the oaring government’s Stabilization Reserve Fund.

Currency board cover is equivalent to base money (e.g., the some of currency issue plus the kroon liabilities of the Bank of Estonia in its correspondent accounts).

Require’ mon to be met on the beats of daily average of deposits over month Includes liquidity requirement equivalent to 3 percent of the reserve requirement base (imposed since December 1997).

Net of currency hoard cover (program definition).

Including balances in the Stabilization Reserve Fund (SRF).