IMF Concludes Article IV Consultation with Estonia

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.


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.

On June 30, 2000, the Executive Board concluded the Article IV consultation with Estonia.1


Since regaining its independence in 1991, Estonia has been a leader among transition economies in its consistent implementation of strong market and stability oriented policies. These include a currency board tying the exchange rate for the kroon to the deutsche mark (and now effectively to the euro), full convertibility for current and capital account transactions, and an active privatization program (which is nearing completion). Since Estonia applied for EU membership in November 1995, the structural reform program has been driven primarily by the government’s objective of meeting all EU accession requirements by January 2003. The combination of conservative macroeconomic policies and a vigorous structural reform effort has resulted in substantial progress being made toward creating a flexible, competitive, and market driven economy.

Growth faltered in 1999, due mainly to an earlier decline in the stock markets, difficulties in the banking sector, and a sharp contraction in exports to the Commonwealth of Independent States (CIS) in the wake of the Russia crisis. After high growth in 1997 and 1998, real GDP declined by 1.1 percent in 1999, with much of the contraction concentrated in the first half of the year. This contributed to unemployment rising to over 11 percent and a further reduction in consumer price index (CPI) inflation, to 3.3 percent in 1999. Notwithstanding the drop in exports to the CIS, the current account deficit declined to 6 percent of GDP in 1999 (down from 12 percent of GDP in 1997 and 9 percent of GDP in 1998), reflecting the impact on import demand of the economic slowdown. Current account deficits in both 1998 and 1999 were financed by non–debt–creating flows—mainly foreign direct investment. GDP growth started to recover in the last quarter of 1999, largely on the strength of an increase in private demand and export growth to western markets (the latter accelerated sharply in early 2000).

After experiencing a budget surplus in 1997 and near balance in 1998, the fiscal position weakened in 1999. This was due to the impact of the recession on revenue collection and high public sector wage and pension increases. The government cut back expenditures in mid–1999, implementing a supplementary budget. This helped limit the fiscal deficit to 4.7 percent of GDP for the year. The deficit in 1999 was financed mainly from privatization receipts from the partial sale of the telecommunications company. The fiscal position improved substantially in the first quarter of 2000 as revenues picked up with the economic recovery and expenditures were restrained. The budget deficit for the first quarter of 2000 is estimated at about 1 percent of GDP. If the 2000 budget is fully implemented, the ratio of general government expenditures to GDP would fall to 42 percent of GDP in 2000. This is consistent with the government’s intention to reduce the size of the public sector over the medium term.

The currency board and its fixed peg have continued to provide a transparent and credible framework for financial operations and the formation of economic expectations. Following slow growth in monetary aggregates from mid–1998 through late 1999, broad money growth recovered and expanded at about 25 percent (year–on–year) towards the end of 1999 and early 2000, partly funded by a balance of payments surplus. Lending to the private sector also resumed at the same time—albeit at a more moderate pace (less than 10 percent). Reflecting confidence in the currency board, domestic interest rates fell to historically low levels in mid–1999 and the differential to euro area levels has dropped for short–term rates to below 100 basis points by mid–2000. The banking system appears to be in a strong financial condition, as reflected in a high average capital adequacy ratio and the fact that the two largest Estonian banks, which control about 85 percent of the Estonian bank assets, are both majority owned by Swedish banks. The Bank of Estonia continued to improve banking supervision in 1999, building on the implementation of the revised Law on Credit Institutions that became effective July 1999.

The government’s medium–term economic program is reflected in the precautionary stand–by arrangement with the Fund that was approved in March 2000 (for more details see IMF Press Release No. 00/14 and the Memorandum of Economic Policies posted on the IMF’s External Website). It provides for the (i) implementation of fiscal policies consistent with limiting the fiscal deficit to 11 A percent of GDP in 2000 and attain budgetary balance thereafter, (ii) maintenance of the currency board and current exchange rate peg through accession to the EU and joining the eurosystem, (iii) proceeding with the implementation of second generation structural reforms, including pension and health sector reforms, as well as continuing with the privatization of remaining state infrastructure enterprises.

Estonia participated in early 2000 in a joint World Bank–IMF study of its financial sector. In that connection, a report dealing with its observance of standards and codes as they apply to its monetary and financial system will be published in the near future.

Executive Board Assessment

Executive Directors welcomed the further strengthening of Estonia’s economic performance in the recent past. The recovery has gained momentum, inflation remains low, and confidence in the currency board remains high as evidenced, inter alia, by the convergence of interest rates toward euro-area levels. Directors emphasized that these favorable developments owed much to the authorities’ policies. They stressed the importance of maintaining the fiscal consolidation effort under the currency board arrangement. Directors saw fiscal policy as critical in providing a favorable climate for sustained economic growth, including by regulating demand pressures to prevent overheating and an excessive external current account deficit. Against this background, they welcomed the reduction in the fiscal deficit in early 2000.

Directors agreed that the fiscal targets for 2000 and 2001 remain appropriate. They welcomed the authorities’ commitment to take any corrective actions needed to achieve them, and noted the authorities’ intention to target a budget surplus next year should the economy perform better than expected. Directors emphasized that, to safeguard the fiscal position, firm expenditure policies must be in place before proceeding with the planned reduction in taxation in 2001, and that recent revenue measures should be fully implemented.

Directors agreed that the currency board arrangement should remain a cornerstone of Estonia’s economic strategy in the lead-up to EU membership and under ERM2. They emphasized the importance of appropriate macroeconomic and structural policies, particularly in the labor markets, to support the currency board and maintain external competitiveness.

Directors noted the recent rebound in broad monetary growth, partly caused by balance of payments inflows. They noted the challenge for policymakers that could arise from the possibly destabilizing effects of abrupt swings in the banking system’s recourse to foreign borrowing, and in the saving–investment balance of the private sector. The Bank of Estonia will need to monitor developments very carefully to forestall any excessive growth in credit. While reserve requirements are already high, Directors warned that a further increase may become necessary to restrain domestic credit expansion. They also stressed that banking supervision must ensure that banks do not unduly relax their internal risk management procedures.

Directors welcomed Estonia’s participation in the pilot Joint Bank–Fund Financial Sector Assessment Program. They noted that financial sector vulnerabilities have been markedly reduced over the past few years, largely reflecting bank consolidation and restructuring (including, importantly, foreign ownership). Banking supervision has also been considerably strengthened. Directors welcomed Estonia’s compliance with many of the Basel Core Principles and encouraged the authorities’ effort in areas where compliance is not complete. They considered that nonbank financial supervision should be strengthened, and supported the move to unified supervision of the financial sector by a new agency. Directors stressed that this new agency should have adequate budgetary and operational independence, as well as powers to issue and revoke licenses.

On pension reform, Directors agreed that a second, fully funded, defined contribution pillar has certain advantages, but that it would not, by itself, solve the issues arising from the adverse demographic shift. For this, further reform of the first pillar would be required, including a more ambitious and faster increase in the pension age. Directors stressed that care would need to be taken that the transition costs associated with a second pillar are constrained to avoid budget pressures or an excessive increase in public debt.

Directors commended the substantial achievements with regard to structural reforms and the priority accorded by the government to making further progress toward EU accession. They praised the establishment of a well–functioning market economy, the maintenance of a very open trade and payments system, and the fostering of a conducive environment for foreign direct investment. Directors noted that discussions with potential investors were moving forward concerning the privatization of the few remaining major state assets.

Directors were concerned that, notwithstanding a high degree of wage flexibility, the ongoing restructuring of the economy in combination with mismatched skills has resulted in a high level of unemployment. They recognized that this, in part, resulted from the fact that the authorities had resisted measures that would have slowed the transformation of the economy. Nevertheless, Directors emphasized the importance of addressing—including through targeted active labor policies—the problems related to high unemployment, not least in order to preserve a social climate favorable to the continuation of reforms.

Public Information Notices (PINS) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF’s assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

Republic of Estonia: Selected Economic Indicators

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

Based on the definition of the International Labor Organization (ILO).

Export-share weighted real exchange rate (CPI-based) against the 15 major trading partners in 1998.


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. In this PIN, the main features of the Board’s discussion are described.

Republic of Estonia: Staff Report for the 2000 Article IV Consultation and First Review Under the Stand-By Arrangement
Author: International Monetary Fund