Republic of Estonia: Staff Report for the 2005 Article IV Consultation

The staff report for the 2005 Article IV Consultation on the Republic of Estonia focuses on the economic outlook and risks. Robust economic growth continues, largely driven by domestic demand. Estonia has achieved significant nominal convergence; meeting all of the Maastricht criteria, save for inflation. Estonia’s banking system remains financially sound, with strong profitability continuing despite increased competition. It is important for Estonia to maintain the high degree of market flexibility that has been achieved.

Abstract

The staff report for the 2005 Article IV Consultation on the Republic of Estonia focuses on the economic outlook and risks. Robust economic growth continues, largely driven by domestic demand. Estonia has achieved significant nominal convergence; meeting all of the Maastricht criteria, save for inflation. Estonia’s banking system remains financially sound, with strong profitability continuing despite increased competition. It is important for Estonia to maintain the high degree of market flexibility that has been achieved.

I. Background

1. Estonia has made extraordinary progress in the 14 years following independence. It has successfully established a market economy and joined the EU. This was done by following sound macroeconomic policies (broadly consistent with Fund advice (Box 1)) and implementing far-reaching structural reforms which touched virtually every sector of the economy. As a result, the country is witnessing a remarkable convergence in real terms to EU levels, with purchasing power parity per capita income increasing to 46 percent of the EU15 level in 2004 from 32 percent in 1995 (Figure 1). Estonia has also achieved significant nominal convergence, meeting all of the Maastricht criteria, save for inflation. The country entered ERM II in late June 2004, unilaterally maintaining its peg to the euro with a currency board arrangement and is aiming at an early euro adoption.

Figure 1.
Figure 1.

New EU8 Member States: Progress in Income Convergence to EU15

(GDP per capita in Purchasing Power Standards (PPS))

Citation: IMF Staff Country Reports 2005, 394; 10.5089/9781451812497.002.A001

Source: Eurostat.

Estonia: Nominal Convergence

(Data for 2004)

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Sources: Eurostat, IFS, and country authorities.

Estonia: interest rates on new kroon-denominated loans to non-financial corporations and households with maturities over five years.

Lithuania: primary market yields of government bonds with maturities of close to ten years.

The rest of the new EU8 countries: secondary market yields of government bonds with maturities close to ten years.

Unweighted average excluding Estonia.

2. Nonetheless, there are risks in both the short and medium terms: in the short term, there is the very real risk that inflation will exceed the Maastricht criterion and jeopardize the early adoption of the euro. With average inflation forecast at 4 percent in 2005—well above the estimated Maastricht criterion of about 2¾ percent—meeting the Maastricht inflation criterion in June 2006 (the earliest possible test date) is increasingly unlikely. Over the medium term, vulnerability to external shocks remains, with a persistent and large current account deficit and a rapidly expanding stock of gross external debt. The current account deficit averaged slightly above 8 percent of GDP during 1995–2004 with FDI financing three quarters of the gap. However, over the last three years, FDI coverage of the current account has dropped to about half of the deficit and bank credit has increased. This has translated into a rapid expansion of gross external debt to over 80 percent of GDP in 2004, up from 55 percent in 2001.1 At the same time, net external debt increased at a much slower pace, to 26 percent of GDP (Figure 2).

Figure 2.
Figure 2.

Current Account, FDI, and External Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 394; 10.5089/9781451812497.002.A001

Source: Estonian authorities.1/Net of portfolio, financial derivative, other investment, and reserve assets held by Estonian residents.

Article IV Fund Policy Advice Implementation

Estonia has had an excellent working relationship with the IMF since becoming a member in May 1992.1 The Fund’s assistance has been gauged to fit Estonia’s needs during various phases of the country’s development. Initially, during a period of stabilization, the IMF provided policy advice and financing; more recently the Fund has provided extensive technical assistance while continuing with policy advice in the run up to EU accession. Most Fund policy advice was taken on board and its implementation has been characterized by a high degree of ownership, something that has proved critical in Estonia’s successful transformation into a market economy.

However, more recently, fiscal policy has been easier than advised by the Fund and has not contributed to a needed restraint in aggregate demand and a curbing of inflationary pressures.

Estonia is generally at the forefront with issues of transparency and good governance. In response to Fund advice, they have pledged to refrain from all off budget transactions, which, while legal, are non-transparent.

1 For a detailed discussion of the history of Estonia’s relations with the IMF see “The IMF and the Baltics: A Decade of Cooperation,” by Adalbert Knoebl and Richard Haas, IMF WP/03/241.

3. Robust economic growth continues, largely driven by domestic demand. Aided by declining real interest rates and large EU grants, real GDP growth increased to nearly 8 percent in 2004 from 6¾ percent a year earlier (Table 1). Growth continued to increase in the first half of 2005, reaching 8½ percent year-on-year. Relatively buoyant economic activity in the Nordic countries, Estonia’s main trading partners, resulted in high export growth despite sluggish demand in the rest of the EU.

Table 1.

Estonia: Selected Macroeconomic Indicators, 2000-06

(In units as indicated)

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

In percentage points.

Lower reserve requirements introduced in 2001 have led to a decline in international reserves under the mechanics of the currency board, which was more than compensated by the improvement in the net foreign asset position of commercial banks. In addition, net short term debt of the banking system has become negative.

Includes trade credits.

Net of portfolio assets (including money market instruments), financial derivative assets, other investment assets, and reserve assets held by Estonian residents.

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

Estoniankroon is pegged at 15.6466 kroons to the euro.

uA01fig1

Contribution to GDP Growth 1999–2005

(In percentage points)

Citation: IMF Staff Country Reports 2005, 394; 10.5089/9781451812497.002.A001

Selected Indicators, 1999–2007

(In units as indicated)

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Sources: Estonian authorities and Fund staff estimates.

Contribution to growth, in percentage points.

4. Inflation has increased since mid-2004 and remains significantly above the Maastricht criterion. Headline inflation accelerated to 5 percent, year-on-year, in March 2005 from just below 1 percent at the beginning of 2004, driven by rising energy prices, price increases related to EU accession, and a jump in food prices. Although headline inflation has since declined to 4.2 percent—and is expected to retreat further by year-end, as the initial effects of EU accession-related price increases wane—it is still forecast to remain above the Maastricht criterion in 2005 and, indeed, with current policies, also by the time of the earliest possible test date in mid-2006. Measures of core inflation, however, are somewhat more reassuring, suggesting that inflationary pressures may abate in the future. Specifically, inflation excluding energy and seasonal food prices has risen much less—about 3 percent year-on-year—while inflation excluding energy, food, alcohol and tobacco prices has remained flat at around 2 percent since early 2004.

5. With output estimated to be close to potential, sharp wage growth in the first half of 2005, combined with signs of labor shortages in the construction sector and an overall decline of unemployment, could signal nascent overheating. Wages increased 11 percent in the second quarter of 2005. The unemployment rate, according to the harmonized EU definition, declined by 1.9 percentage points to 8.1 percent in 2005Q2, while overall employment continued to increase.

6. The current account deficit has widened further, increasing external vulnerabilities. Despite strong export growth—goods exports grew 17½ percent in volume terms in 2004—the current account deficit increased to 12.7 percent of GDP in 2004 from 12.1 percent in 2003 (Table 2). This reflected a fall in the public sector saving rate combined with a further, though small, decline in private sector saving, with domestic investment remaining robust (Table 3). Strong export performance in the first half of 2005, however, resulted in a substantial improvement of the current account, with the deficit declining to 10.4 percent of GDP.

Table 2.

Estonia: Summary Balance of Payments 2000–10

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Sources: Bank of Estonia and Fund staff estimates.

Excluding interest payments and reinvested earnings.

Including operations in debt securities.

Excludes Government deposits held abroad (including in the SRF).

Changes in gross international reserves may differ from flows implied by overall balance of payments due to valuation changes.

5/ Gross international reserves 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.

Includes trade credits.

Short term debt is defined on the basis of original maturity.

Starting in 2000, the definition of external debt was widened to include money market instruments and financial derivatives.

Net of portfolio assets (including money market instruments), financial derivative assets, other investment assets, and reserve assets held by Estonian residents.

Includes government guaranteed debt.

Table 3.

Estonia: Macroeconomic Framework, 2000–10

(in percent of GDP, unless otherwise indicated)

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Sources: Estonian authorities, and Fund staff estimates.

Includes net lending.

Measures of Current Account

(In percent of GDP)

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Source: Estonian authorities.

Excluding interest payments and reinvested earnings.

7. Following four years of conservative fiscal policy, the fiscal stance eased in 2004, and the fiscal surplus is projected to decline further in 2005. There was substantial over-performance of revenue in 2003 and, with the more-rapid-than-advised unwinding, a significant expansionary fiscal impulse in 2004. The fiscal surplus (on a cash basis) declined to 1.7 percent of GDP from 2.9 percent in 2003 (Table 4) as the government increased expenditures in a supplementary budget in late 2004 and revenues decreased—temporarily—because of a one month deferral of VAT related to EU accession (about ½ percent of GDP). Developments for the first half suggest that the fiscal surplus will decline further in 2005, despite stronger-than-budgeted revenues, as higher pension expenditures are planned for the second half of the year, and a recent supplementary budget allocates a good part of revenue overperformance to additional spending.

Table 4.

Estonia: Summary of General Government Operations, 2000-06

(In percent of GDP)

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Sources: Data provided by the Estonian authorities, and Fund staff estimates and projections.
uA01fig3
Sources: Ministry of Finance; and staff estimates.1/ Staff projection.

8. The rapid expansion of credit to the private sector continued in 2004 and the first half of 2005, financed increasingly by borrowing from abroad. Domestic banks have funded their operations both by borrowing from their foreign parent banks as well as by issuing foreign currency denominated securities on international markets. Credit growth to households accelerated to above 50 percent in 2004, year-on-year, and the stock of credit has reached nearly 25 percent of GDP, the highest among the new EU8 members. Household loans for real estate accounted for over 80 percent of this: the number of residential dwellings completed—and their prices (unadjusted for quality changes)—have nearly tripled between 2000 and 2004. Credit growth to enterprises accelerated to 48 percent at end-June 2005 from around 25 percent a year earlier, with one-half of all lending to non-financial enterprises channeled into real estate, leasing, and business activities. As a result, credit to the private sector, as a percent of GDP, and its growth rate, remained somewhat above the trend implied by Estonia’s income level (Figure 4).

Figure 3.
Figure 3.

New EU8 Countries: Real Effective Exchange Rates and Export Penetration, 1995–2005

Citation: IMF Staff Country Reports 2005, 394; 10.5089/9781451812497.002.A001

Sources: Country authorities; Eurostat; Direction of Trade; and International Financial Statistics.1/ Economy wide.2/ The data for 2000 is atypical due to transitory boom in electronic goods assembly.
Figure 3.
Figure 3.

New EU8 Countries: Real Effective Exchange Rates and Export Penetration, 1995–2005

Citation: IMF Staff Country Reports 2005, 394; 10.5089/9781451812497.002.A001

Sources: Country authorities; Eurostat; Direction of Trade; and International Financial Statistics.1/ Economy wide, 25 trading partners.
Figure 4.
Figure 4.

Credit Developments in Estonia and Other EU Countries

Citation: IMF Staff Country Reports 2005, 394; 10.5089/9781451812497.002.A001

Source: Eurostat.
uA01fig4
Sources: Bank of Estonia; and staff calculations.

9. The largely foreign owned banking system remains financially sound, with strong profitability continuing despite increased competition. The risk weighted capital-adequacy ratio, while recently declining, remains well above the 10 percent requirement (Table 5). Spreads of loan/deposit rates tightened due to increased competition from newly established banks. Despite lower margins, bank profits continued to be strong as loan volumes grew. Non-performing loans remained all but nonexistent at about 0.2 percent of total loans.

Table 5.

Estonia: Selected Financial Indicators, 2000-05

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Sources: Bank of Estonia; and Fund staff estimates.

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. Starting in January 2001, 3 percentage points of the 13 percent reserve requirement could be met with high quality euro-denominated foreign instruments. In July 2001, this foreign share of reserve requirements was raised to 50 percent.

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.

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

10. Confidence in the currency board remains strong and Estonia’s entry into ERM II has been uneventful. Estonia’s credit rating was upgraded in mid-2004 by Fitch to A from A- following upgrades by both Moody’s and S&P in 2002 (Table 6) and is one of the highest among the new EU members.

Table 6.

Estonia: Indicators of External Vulnerability, 2000-05

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities, Bloomberg, Standard & Poor’s, and Fund staff estimates.

Total general government and government guaranteed debt excluding government assets held abroad.

Excluding reserve assets of the Bank of Estonia.

At remaining maturity.

Starting in 2000, the definition of external debt was widened to include money market instruments and financial derivatives.

Based on a wider definition of gross external debt than previously reported. Were it not for the change in definition of external debt, the gross debt to GDP ratio would have declined in 2000.

Net of portfolio assets (including money market instruments), financial derivative assets, other investment assets, and reserve assets held by Estonian residents.

Tallinn stock exchange index (TALSE), end of period.

Standard & Poor’s long-term foreign exchange sovereign rating.

One-month spread between Tallinn interbank borrowing rate (TALIBOR) and the corresponding EURIBOR rate.

II. Report on the Discussions

11. The discussions focused on policies required to maintain macroeconomic stability in the run-up to euro adoption and thereafter. There was general agreement that the challenge of macroeconomic policies over the near term is to limit risks in the external and financial sectors and to minimize possible inflationary pressures in order to ensure the timely adoption of the euro, with staff seeing a need for greater fiscal restraint. Over the medium to longer term, the goal of policy was seen as supporting sustainable real convergence by preserving external competitiveness and maintaining the flexibility of the Estonian economy.

A. Economic Outlook and Risks

12. The authorities viewed the macroeconomic outlook in the short term as favorable, but with some upside risk for inflation. They project real GDP growth of at least 6.5 percent in 2005-06, driven largely by domestic demand with support from the external sector, although the latter is subject to some uncertainty. Average headline inflation is forecast to accelerate to about 3½ percent in 2005—from 3 percent in 2004—as a result of rapidly growing energy prices, increases in administered electricity prices, and EU-related increases in tobacco and fuel excises. 2006 inflation is forecast to decline to 2.6 percent by the end of the year. However, they recognized that there are upside risks to their inflation forecast which they see coming mainly from higher-than-expected energy prices and possible increases of administered prices by local governments. The authorities also acknowledged that further fiscal stimulus could fuel second-round effects from these supply shocks and result in higher inflation in 2006 when Estonia could be evaluated for full EMU entry membership. The current account deficit is projected to decline to 10½ percent of GDP in 2005 as private saving, aided by increased participation in the second-pillar of the pension system, is forecast to rebound.

13. This inflation outlook means that it is unlikely that Estonia will meet the Maastricht criterion by June 2006, the earliest possible test date. The chart below shows the baseline forecast and an alternative, more optimistic forecast where inflation is 0.1 percent a month less than in the baseline. Even under the more optimistic scenario, the estimated inflation criterion would not be met before October 2006. However, in the view of both the authorities and staff, this is neither a cause for undue alarm, nor should it be viewed as a set-back. The Maastricht criterion aside, inflation is decreasing toward a low core rate, and the inflation differential in Estonia is largely a by-product of real convergence. Furthermore, accession related factors themselves account for part of the explanation as to why inflation is higher than in established EU members with relatively low inflation. It is also worth noting that markets have not been perturbed by a possible delay in adopting the euro.2

14. Over the medium term, the authorities expect generally positive macroeconomic developments. They forecast real GDP growth to remain close to potential at around 6 -7 percent. The current account deficit is projected to decline to about 6 percent of GDP by 2010 (from 12.7 percent in 2004), driven by higher private saving. In their baseline scenario, the authorities forecast headline inflation at around 2½ percent over the medium term.

15. Staff broadly agreed with this assessment, but saw the risks stemming from inflation and slower external growth. The main near term risk is inflation, while high external imbalances and growing foreign indebtedness, especially when used to finance mortgages, pose risks over the medium term. Upward risks to inflation are significant and come from the continuing high growth of energy prices and further wage pressures. Regarding external imbalances, a worsening of economic activity in its main trading partners could reduce growth and widen the current account deficit.

B. Fiscal Policy

16. The 2005 budget is projected to have a slight surplus, on the order of 0.4 percent of GDP. In that there was a large surplus of 1.7 percent of GDP in 2004, this will impart a fiscal stimulus equal to about 1¼ percent of GDP. As in the past, revenues appear to have been stronger than budgeted, the result of higher-than-forecast growth. In previous years this led to supplementary budgets in which much of the tax windfall was not spent, but rather used to acquire financial assets. Staff advised that the 2005 supplementary budget do the same. This would have kept the fiscal position broadly unchanged and not injected an ill-timed and unnecessary stimulus to an economy showing signs of overheating. The authorities acknowledged the prudence of such a policy. However, subsequent to the mission, they announced a supplementary budget that will increase spending by about 1 percent of GDP with an amount equal to about 0.4 percent of GDP being saved.

17. The new coalition government has committed itself to several expenditure and revenue initiatives within the context of a balanced budget. Beginning in 2006, the new coalition agreement envisages a further increase in the levels of the basic pensions and higher maternity benefits (the latter to be increased to 15 from 12 months). The authorities maintained that the planned pension increase, the major item in the additional spending package, would be financed by a combination of recently revised upward projections of social tax collections and a somewhat smaller-than-expected number of pensioners. To provide the additional financing required for these new spending initiatives, the coalition has agreed on two revenue measures. First, they intend to slow the pace of the previously announced income tax rate reduction to 1 percentage point annually from the current 2 percentage points. This would delay the reduction of the income tax rate to 20 percent from the current 24 percent until 2009. Second, the authorities intend to increase dividend payments from government-owned Estonian Energy and Estonian Telecom. Initially the authorities planned to accelerate the scheduled increase in excise taxes to gain additional revenue, but, in the course of the discussions, decided, because of its inflationary impact, to postpone this until after the adoption of the euro. However, they also emphasized that should the expected additional revenues not cover the entire package of new expenditures, other spending would be cut to balance the budget.

18. Given the additional expenditures planned by the new government, staff saw the proposed slower path of cuts in income tax rates as appropriate in limiting macroeconomic imbalances. However, it pointed out that the additional revenue measures considered by the authorities to finance their new spending initiatives could have adverse side effects. In particular, higher dividend withdrawals might be counterproductive at a time when Estonian Energy requires significant investment funds in order to upgrade its technology. The authorities maintained that the future investment needs of the energy and telecommunications companies would not be undermined. Regarding Estonian Telecom, the authorities pointed out that this would not hurt the company’s investment plans because it is a mature firm with few investment needs.

19. An annually balanced budget is part of the coalition agreement; indeed, this has also been the policy of previous governments. Difficulties with this approach emerge when the economy is growing above its potential rate. In this case, a balanced budget is pro-cyclical and exacerbates macro imbalances. Thus staff argued, as it has in the past, that the budget be balanced over the cycle and the automatic stabilizers be allowed to operate. And, given that the 2005 budget at the time of the mission was projected to be in strong surplus, staff recommended that a balanced budget be targeted only over the medium term—and consequently the surplus be lowered gradually—so as not to be pro-cyclical. In addition, staff noted, a gradual reduction of fiscal surpluses over the next several years would provide an opportunity to better provision for the future needs of Estonians. The authorities argued that the balanced budget target was appropriate, given the low level of public debt, and maintained that it would be difficult to justify to the public the need for continued fiscal surpluses over the medium term. Staff agreed that, from a debt sustainability viewpoint, the target appeared appropriate over the longer term, but saw a short-term need for fiscal restraint to reduce external vulnerabilities and support the adoption of the euro.

20. The authorities voiced resolve in introducing medium-term budgeting for the next budget cycle in order to improve expenditure control and maintain fiscal prudence. This approach was suggested by a recent FAD TA mission. Given the increase in the size of the government over the past several years, staff welcomed this, especially in light of growing demand for healthcare services in Estonia’s aging population. Staff also noted that the government’s wage bill has increased significantly (by around 1 percent of GDP) in recent years, reflecting large increases in both health and education employment, as well as sizeable increases in healthcare wages this year. However, the authorities pointed out that part of the expenditure increase was due to EU related spending, and that the growth of wages in the public sector was not excessive, if adjusted for education level differentials with the private sector.

C. Financial Policy and Euro Adoption Issues

21. The authorities shared staff concerns about the high growth rate of credit. However, they pointed out that, to a great degree, the boom in credit is a result of Estonia’s sound macroeconomic development, the decline in real interest rates, improved external credit ratings, and financial deepening. They also noted that credit conditions in the Euro-area were looser than conditions in Estonia warranted. While agreeing with this assessment, staff noted that fast credit growth could spur inflationary pressures. Furthermore, it argued that continued high credit growth rates had stimulated a rapid expansion of the real estate sector and, given that real estate lending is largely financed from abroad, contributed to external risks.

22. The authorities stressed their readiness to use all available tools, including prudential regulations, to safeguard credit standards. They pointed out that levels of credit in Estonia were low by EU standards and financial stability indicators remained sound, with risk adjusted capital adequacy ratios well above the required 10 percent, and nonperforming loans close to zero. The authorities also noted that periodic, forward-looking stress tests of the banks’ balance sheets both by the Financial Supervisory Authority, as well as by the banks themselves, indicate that the banking system is sound. Staff agreed but noted that there were signs of overheating in the real estate market, as evidenced by strong mortgage demand and developing labor shortages in the construction sector. Therefore, staff suggested consideration be given to further reducing mortgage interest deductibility and to maintaining the limits on the housing activities of Kredex—a quasi-government loan guarantee agency—to restrain the growth of housing demand.

23. The authorities pointed out that the strong performance of exports and broadly stable traded goods prices suggest that the current exchange rate peg was appropriate. Estonia’s external competitiveness remains relatively strong (Figure 3). Market shares of Estonian exports in both world and EU markets increased in 2004. With respect to relative cost measures, the economy-wide unit labor cost-based real effective exchange rate has remained broadly unchanged since 1999, the CPI-based real effective exchange rate has appreciated on average by about 2 percent a year, in line with estimated Balassa-Samuelson effects, while the PPI-based real effective exchange rate has stayed roughly flat. The authorities also acknowledged the importance of labor market flexibility in the context of the currency board in maintaining Estonia’s competitiveness over the past decade. Staff agreed with this assessment and noted, in light of the continuing high current account deficits and given the currency board arrangement, that maintaining labor and product market flexibility is vital in preserving Estonia’s competitiveness over the medium term and ensuring sustainable real convergence in the run-up to euro adoption and thereafter.

24. Discussions on euro adoption covered several technical issues. First, it will be necessary for Estonia to harmonize its reserve requirements with EU norms. Neither the authorities nor staff saw lowering reserve requirements, from 13 percent to 2 percent, as causing any insurmountable liquidity problems. Owing to the availability of funds from foreign parent banks and access to external borrowing, changing reserve requirements on domestic deposits will not materially alter liquidity. Second, the possible need for a constitutional amendment to give the government the power to declare the euro legal tender has been raised in Brussels. The authorities argued against the need for a constitutional amendment which would involve delaying adoption of the euro and felt that an amendment to the Bank of Estonia Law that makes it clear that the euro is the legal currency of the country would be sufficient to remove any doubt on this issue.

25. The authorities acknowledged the risks associated with the high current account deficit and the rapid accumulation of gross external debt, but saw the external position improving over the medium term. Their argument was twofold. First, the high level of FDI in Estonia over past years is expected to result in robust export oriented growth over the medium term. Second, saving is expected to increase, supported by the growing second pillar pension fund and a decline in consumption smoothing, as income levels continue to increase. They noted also that conventional indicators suggest that Estonia’s vulnerability to a crisis was similar to that in the other Baltic countries (Table 8) and net external debt was not excessive.3 Moreover, they pointed out that the major banks had treasury mandates with their parents that significantly reduce rollover risks. Staff agreed with this assessment, but pointed out that, nevertheless, risks remain. In the staff’s baseline scenario, gross external debt is forecast to rise initially to around 90 percent of GDP, before declining gradually to 84½ percent of GDP by 2010 (close to its 2004 level), with net debt at roughly half those levels (Tables 2 and 7)4. Staff pointed out that if the expected rebound in private saving did not materialize, the outlook would be less sanguine. The alternative scenario (Table 9) attempts to quantify this by assuming that consumption, met by imports, continues at a high level. In this case, a higher external debt path results (above 90 percent) in the medium term. Thus external vulnerabilities increase, as does the likelihood of a hard landing.

Table 7.

Estonia: External Debt Sustainability Framework, 2000–10

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.