Republic of Estonia: Staff Report for the 2006 Article IV Consultation
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International Monetary Fund
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Publication Date:
29 Nov 2006
eISBN:
9781451933963
Language:
English
Keywords:
ISCR; CR; Estonia; BOE's growth projection; deficit; forecast; staff projection; fiscal policy; current account; exchange rate; money market; foreign direct investment; Inflation; Baltics; private sector
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Estonia’s commitment to free markets and prudent financial policies has paid off handsomely. Demand pressures and rapid productivity growth have produced strong wage increases and large employment gains. Inflation, while moderate for a fast-converging economy, remains above the Maastricht threshold, and has been pushed up in recent months by rises in nontraded goods prices. Estonia’s economic growth has supported—and been supported by—rapid credit growth, financed increasingly by resource transfers from Nordic banking groups to Estonian affiliates. The macroeconomic impact of EU funds is needed.

Abstract

Estonia’s commitment to free markets and prudent financial policies has paid off handsomely. Demand pressures and rapid productivity growth have produced strong wage increases and large employment gains. Inflation, while moderate for a fast-converging economy, remains above the Maastricht threshold, and has been pushed up in recent months by rises in nontraded goods prices. Estonia’s economic growth has supported—and been supported by—rapid credit growth, financed increasingly by resource transfers from Nordic banking groups to Estonian affiliates. The macroeconomic impact of EU funds is needed.

I. Background

1. Estonia’s commitment to free markets and prudent financial policies has paid off handsomely. Far-reaching structural reforms created a well-functioning market economy, well integrated with the Baltic and EU regions. Labor and product markets are flexible; the banking sector is almost entirely in the hands of reputable regional banking groups; and the business climate is among the most highly rated in the region. Prudent macroeconomic policies, broadly consistent with IMF advice (Box 1), have brought price stability and low public debt. These policies have borne fruit with impressive productivity growth and a corresponding rise in per capita income (Figure 1). The task facing the authorities now—and the challenge facing the government to be formed after the March 2007 parliamentary elections—is to sustain this performance while addressing the overheating risks associated with full employment.

Figure 1.
Figure 1.

EU8 Member States: Progress in Income Convergence to EU25 Average, 1996–2005

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

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

Sources: Eurostat; and staff calculations.1/ Change in the ratio of per capita GDP to that in the EU.

Article IV Fund Policy Advice Implementation

Estonia has had an excellent working relationship with the IMF since becoming a member in May 1992.1 Most Fund policy advice has been taken on board and its implementation has been characterized by a high degree of ownership, which has proven to be key to Estonia’s economic success. In recent years, however, Estonia’s fiscal policy has been more expansionary than advised by the Fund.

1

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

2. GDP growth rose above 10 percent in 2005 amid signs of overheating and is expected to continue at about the same rate—above estimated potential—in 2006 (Table 1).1 Strong exports were the motor of the 2005 acceleration while consumption lagged behind income. In the first half of 2006 the demand mix reversed: consumption growth gathered pace, responding to income growth and record-high consumer confidence following EU accession, but net exports declined as surging imports overwhelmed still-strong export growth. Staff calculations suggest that the economy is operating well above potential, an assessment borne out by tight labor markets and rising inflation in nontradeables.

Table 1.

Estonia: Selected Macroeconomic Indicators, 2001–07

(In units as indicated)

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

Includes trade credits.

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

Includes the Stabilization Reserve Fund (SRF).

The Estonian kroon is pegged at 15.6466 kroons to the euro.

uA01fig01

Domestic and Foreign Contributions to GDP Growth, 1994-2006

(in percent)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

uA01fig02

Actual and Potential Growth, and Output Gap, 1994-2006

(Percent; and Percent of Potential Output)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

3. Demand pressures and rapid productivity growth have produced strong wage increases and large employment gains. The unemployment rate, which had been stuck at about 10 percent for two years, fell below 8 percent in 2005 and labor shortages emerged in a number of sectors, notably construction and health care. Labor markets tightened further in 2006, when strong employment demand was filled largely by retirees and discouraged workers drawn back into the labor force by higher wages. The competition for labor, and the upward pressure on wages, has been intensified by expanded job opportunities in other EU economies. Labor’s share in value added eased in the past two years, however, suggesting that productivity has kept pace with real wages.

uA01fig03

Labor Market Developments, 1996Q1-2006Q2

(In percent)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

uA01fig04

Estonia: Employee Compensation, 1993Q1-2006Q2

(Percent of GDP)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

4. Inflation, while moderate for a fast-converging economy, remains above the Maastricht threshold, and has been pushed up in recent months by rises in non-traded goods prices. Given the euro peg, convergence effects normally keep Estonia’s inflation rate above the euro area average. The economy’s high energy intensity exposes it to oil and fuel price increases, which gave a further impulse to inflation in the last year. That impulse is now waning, but is being replaced by rising nontradables inflation—a symptom of overheating. Average annual inflation therefore remained between 4 and 4½ percent in 2006 prompting the authorities to postpone their target date for euro adoption from 2007 (the date planned upon joining ERM II).

uA01fig05

Breakdown of HICP Q/Q Inflation, 2000Q2-2006Q3

(SA Data, Annualized)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

uA01fig06

Breakdown of HICP M/M Inflation, Jan 99-Aug 06

(SA data, in percent)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

5. Estonia’s economic growth has supported—and been supported by—rapid credit growth, financed increasingly by resource transfers from Nordic banking groups to Estonian affiliates. Banks’ intense competition for market share has driven nominal interest rates to levels similar to those in Nordic markets. The low interest rates—negative in real terms—and exuberant expectations have raised bank credit growth to the nonfinancial private sector above 60 percent per year (Figure 2). The bulk of the new lending was linked to the real estate sector where it contributed to rapid price increases, especially in late 2005. Nonetheless, the stock of private sector credit remains well below euro area averages (Figure 3). Recent developments, including rising euro interest rates, a possible pause in the property boom, and rising debt burdens are likely to slow credit growth from its current torrid pace. Nonetheless, credit can be expected to grow robustly over the medium term as financial deepening and convergence continue (Box 2).

Figure 2.
Figure 2.

Estonia: Credit, Interest Rates, and Property Price Developments, 2000–06

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

Sources: Bank of Estonia; Estonian Statistical Office; Bank of Latvia; and Fund staff calculations.1/ 10+ year euro denominated loan, 1+ year kroon denominated time deposit, both adjusted by the official CPI inflation.2/ For Latvia, the latest observation is 2006 Q1.
Figure 3.
Figure 3.

Estonia: Credit Developments in Estonia and Selected EU Economies, 2005

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

Sources: Eurostat; and staff calculations.

Financial Deepening and Real Convergence

Financial deepening in Estonia over the last decade was associated with significant real convergence in living standards to the European Union average-indeed, Estonia has achieved more real convergence than other new member states for a given amount of financial deepening. As convergence proceeds, bank credit is likely to continue growing rapidly, particularly given the limited development of other financial markets in Estonia. Demand for residential mortgages in particular could remain strong since dwelling sizes and the quality of the housing stock are well below European averages, pointing to an unfilled demand for new or refurbished housing.

uA01bx02fig01

Financial Deepening & Real Convergence, 1997 - 2005

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

6. Foreign-funded credit growth and foreign direct investment have been the counterparts of large current account deficits. Foreign savings, recently in the range of 10–12 percent of GDP, have supported high rates of investment and some consumption smoothing. External liabilities have risen accordingly: Estonia’s negative net external investment position now equals annual output, although three-quarters of this is equity stemming from foreign direct investment. In recent years gross external debt has also risen significantly and now stands at 85 percent of GDP, most of it owed by banks to their parent groups (Tables 3 and 5). Net debt stands at almost 30 percent of GDP (Figure 4).

Table 2.

Estonia: Summary of General Government Operations, 2001–08 1/

(In percent of GDP)

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

Cash basis.

Source: Estonia’s Statistical Office; reflects general government data revised in September 2006 in line with revised national accounts data.

Table 3.

Estonia: Summary Balance of Payments, 2001–11

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Sources: Bank of Estonia and Fund staff estimates.

Excluding interest payments, reinvested earnings and compensation of employees.

The large FDI and equity investment flows in 2005 reflect the aquisition of remaining shares of Hansabank, most of which were held by foreigners, by the Swedish parent owner of the bank.

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.

Includes trade credits.

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

External debt is defined 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 4.

Estonia: Macroeconomic Framework, 2001–11

(In percent of GDP, unless otherwise indicated)

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Sources: Estonian authorities, and Fund staff estimates.

Public savings minus public investment differs from the fiscal balance by the amount of capital transfers received from abroad.

Mainly EU capital grants, all of which are channelled through the budget.

Table 5.

Estonia: Selected Financial Indicators, 2000–06

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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 required reserves. Starting in January 2001, up to 3 percentage points of the 13 percent reserve requirement could be met with high quality euro-denominated foreign instruments. In July 2001, the ceiling on the foreign share was raised to 50 percent. Effective September 2006, the reserve requirement was raised to 15 percent.

Defined as loans overdue by 30–150 days. 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.

Figure 4.
Figure 4.

Estonia: Current Account, FDI, and External Debt, 1995–2005

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

Source: Bank of Estonia.1/ Net of portfolio, financial derivatives, other investment, and reserve assets held by the Bank of Estonia.

7. External competitiveness appears adequate although recent trends call for close monitoring. Overall, the share of industry in total output has increased, suggesting that high profitability is drawing resources into the tradeables sector. Indeed, export volume growth accelerated to nearly 20 percent in 2004–05, bringing further increases in Estonia’s world market share (Figure 5). While price-based and unit labor cost-based real effective exchange rates show trend appreciations, this coincides with a shift in composition to higher-value added exports (Figure 6). Although labor’s share of overall income—which is inversely related to profitability—has been broadly stable during the last five years, it has risen during the last year relative to partner countries, suggesting that the competitive environment is becoming more demanding. Moreover, the pace of technological upgrading in Estonia may have slowed in recent years.2

Figure 5.
Figure 5.

New EU8 Member States: Real Effective Exchange Rates and World Trade Shares, 1995–2005

(2000=100)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

Sources: EC; WEO; and staff caculations.1/ REERulcm is the real effective exchange rate based on unit labor costs in manufacturing. REERlab is the REERulcm divided by an REER based on industry deflators, and corresponds to labor’s income share in manufacturing relative to those in trading partners.
Figure 6.
Figure 6.

Estonia: Export Composition by Technology and Quality, 1992–2004

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

Source: Fabrizio, Igan, and Mody (2006).Note: Low technology industries include food products, beverages and tobacco, textiles, leather, wood and paper products, and basic metals. Medium technology industries are chemicals, plastics, and rubber. High technology industries comprised machinery, electrical and optical equiment, and transport equipment. Each insdustry is divided into three quality segments by ranging the products according to their unit values.
uA01fig08

External Competitiveness Indicators: Manufacturing

(2000 = 100)

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

8. The general government balance is expected to show a sixth consecutive surplus in 2006. Despite an initially balanced budget for 2006, staff projects a surplus of nearly 2 percent of GDP. This better-than-expected outturn is the net effect of higher-than-budgeted revenues (a more than 3 percent of GDP overperformance, reflecting buoyant economic activity and improved tax compliance) and a supplementary budget that allows much of the unbudgeted revenue to be spent. In September, the government approved a draft supplementary 2006 budget with a 1.2 percent of GDP surplus and a draft 2007 budget with a surplus equivalent to 0.8 percent of staff-projected GDP.

II. Discussions with the Authorities

A. Macroeconomic Outlook and Risks

9. The authorities and staff anticipate that growth, inflation and external imbalances will moderate in 2007–08 as demand pressures ease. Rising interest rates and the increasing private sector debt burden should slow domestic demand growth. Export growth should also decline given weakening demand by trading partners but, with imports slowing even more, the external current account deficit would narrow. Continuing productivity growth and the flexible labor market should ease the adjustment to slower growth. Inflation should slow in 2007–08 on account of lower fuel prices but could remain above the Maastricht reference criterion, jeopardizing the timetable for euro adoption. Looking forward, with the attainment of full employment and greater possibilities for emigration, growth in the medium term could become increasingly constrained by the scarcity of labor (Table 4).

GDP Growth, 2001–2007

article image

Includes nonprofit institutions serving households.

Contribution to growth.

10. This outlook is subject to risks whose avoidance was the focus of the discussions. A main risk is that demand does not ease as expected. Overly optimistic expectations could lead to continued consumption growth, reignite the real estate market, extend the credit boom, and slow the decline in the current account deficit. Further increases in the prices of nontradables would draw resources from the tradeables sector, and keep inflation high, extending the delay in euro adoption. Meanwhile, growing labor shortages could push wage growth above productivity gains, undermining competitiveness. In sum, the vulnerabilities embedded in households’ balance-sheets would deepen, exposing the economy to shocks such as a correction in real estate prices or a deterioration in the external environment. Staff and the authorities agreed to focus the present consultation on policy measures to mitigate these risks, and to take up medium-term challenges with the 2007 consultation. Accordingly, discussions focused on overheating, euro adoption and credit growth.

B. Policy Responses to Overheating

11. The authorities agreed that fiscal tightening was the only available macroeconomic instrument to address overheating but felt that the scope for further tightening—and also the payoff—was limited. The scope was limited by the fact that the fiscal position was already very strong compared, for example, with other EU countries. Indeed gross debt would, in 2007, fall below the Maastricht deficit ceiling. Moreover, the authorities had already created a fiscal cushion—there was a comfortable stabilization fund and Pillar I pensions had been prefunded through 2010 at least. As for the payoff, they noted that, given the openness of the economy, the fiscal stance would have only a small impact on aggregate demand or inflation. Thus, while the authorities did plan to resist pressure for excessive spending, they found it difficult to justify large surpluses—particularly in an election year. They nonetheless undertook to seek ways to limit fiscal pressure on domestic resources. Staff suggested that expenditures with high import content could be favored, while expenditures falling on sectors where overheating pressures were greatest, such as construction, could be candidates for postponement.

12. The staff welcomed the effort to resist election year spending pressures but emphasized that the proposed budgets were expansionary. The proposed supplementary 2006 budget would spend much of the revenue overperformance while the draft 2007 budget would allow spending to rise much faster than potential GDP (text table). These expenditures would override the fiscal automatic stabilizers and would be hard to reverse in the future, when aging-related expenditure pressures start to build. Staff also pointed out that increased expenditures financed by EU grants delivered fiscal stimulus even though they did not increase the measured deficit. The timing is unfortunate since the spending is coming on stream just when a fiscal withdrawal was needed. The planned 1 percentage point per year cut in income tax rates during 2007–09 would also come at an inopportune time.

Estonia: Selected Fiscal Indicators In percent of GDP

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Source: Data provided by the Estonian authorities and Fund staff projections.

Virtually all EU funds in Estonia are channelled through the budget.

First difference in the adjusted structural balance, with sign reversed.

13. The authorities emphasized that rising EU-funded expenditures made it difficult to impart a contractionary fiscal impulse. “Sterilizing” the expansionary impact of EU-related spending by cutting expenditures elsewhere would be unacceptable to the Estonian public. Postponing EU-funded projects was also problematic: given the deadlines for using EU funds, there was no guarantee that expenditures could be postponed long enough to situate them at a more appropriate phase of the cycle. Moreover, much of the expenditure was on infrastructure needed to secure long-term growth.

14. With labor shortages pushing wages up across a wide range of skills, staff suggested that consideration be given to easing restrictions on importing labor. The authorities noted that Estonia had no restrictions on inflows of labor from European Union members, but they were concerned that using low-cost labor from other countries could prolong Estonia’s reliance on declining low-wage sectors. They felt it would be better to encourage a shift to more high-technology, high-value-added sectors such as communications or information technology, and accordingly planned to ease restrictions for skilled labor. The authorities were also concerned about the political and social implications of large-scale immigration. The staff nonetheless suggested that, to help address overheating, restrictions could be eased so as to allow a broader spectrum of workers to enter cyclically tight sectors.

15. The mission also reviewed preparations for a medium-term budgetary framework (MTBF) (Box 3). Staff welcomed the progress so far in implementing the framework, which builds upon FAD technical assistance. A MTBF would provide better control over aggregate spending, subject spending programs to improved review and costing, and improve allocation by linking strategic planning to the budget.

Estonia’s MTBF

The Ministry of Finance produces a State Budget Strategy (SBS) for government approval every year. The SBS sets out a macroeconomic and fiscal framework, including expenditure priorities and ministry-level expenditure ceilings, for the budget year and three subsequent years. It was strengthened in 2006 by introducing a new strategic planning system and program classification of expenditures. Staff views the SBS as a sound basis for an MTBF and made recommendations on coverage, improving out-year estimates, simplifying strategic planning, and strengthening the role of the MTBF in the policy debate.

C. Euro Adoption

16. The authorities continue to view euro adoption as a key policy priority. In their view, shared by the staff, euro adoption would lock in the benefits from the currency board arrangement (CBA) (financial and economic integration with the EU, and a stable and predictable policy framework) and remove the residual risks, however small, associated with having a separate currency. They emphasized that the fourteen-year track record of growth and financial probity under the strictures of the CBA, including the bounce-back after the 1998 Russia crisis, was evidence of the flexibility in labor and product markets needed to thrive under a common currency. And they were confident that competitiveness remained adequate.

17. On timing, the authorities did not see a two or three-year delay as problematic. In their view, the political commitment to fiscal balance or surpluses and market confidence in the kroon both assure the viability of the very robust currency board arrangement. This view is shared by market institutions, at least for modest delays. Indeed, in July, when rating agencies downgraded the outlook on Estonia’s ‘A’ long-term sovereign rating from positive to stable (citing a likely two-year delay in euro adoption) money market spreads, which are negligible, did not change perceptibly. Staff agreed that some delay would be manageable but stressed that overheating and convergence-related factors (such as the Balassa-Samuelson effect) could keep inflation above the Maastricht reference value for a protracted period. This would weaken one pillar of Estonia’s CBA, a clear exit strategy. It would therefore be prudent to maintain a policy stance that would position the economy for euro entry as soon as external conditions turned favorable.

Estonia: Nominal Convergence, 2005

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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 of close to ten years.

Unweighted average excluding Estonia.

Deficit data exclude pension reform costs.

Estonia: Inflation Projections

Staff’s baseline projection, assuming current policies, suggests that Estonia will not meet the Maastricht inflation criterion before end-2008 unless there are beneficial shocks. But postponing excise tax increases (now planned for January 2008) or advancing them could bring inflation below the reference value in the second half of 2008.

uA01bx04fig01

Estonia: Annual Average HICP Inflation and the Maastricht Criterion

Citation: IMF Staff Country Reports 2006, 418; 10.5089/9781451933963.002.A001

Source: Eurostat; Eesti Pank; and Fund staff estimates and projections.1/ The dotted lines define one-standard-deviation confidence bands around this series’ projection, where the standard deviation was calculated over the period 2000:1–2006:6.

Inflation projections are assembled from subindices. Core inflation (65 percent of the HICP basket) is linked to euro area inflation, which is moderating, and domestic demand pressures, which are rising. On balance, monthly core inflation is projected to remain close to its average level for January–August 2006. Administered prices (18 percent of the basket) are projected to evolve in line with announced government plans, as estimated by Eesti Pank staff. Nonadministered energy prices (7 percent) and unprocessed food prices (10 percent) are projected in line with the WEO for petroleum prices and food prices respectively.

Estonia: Inflation Developments and Projections Under the Baseline Scenario

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Including alcohol and tobacco.

18. The authorities agreed but noted that their policy options were limited. Given the CBA, the main macroeconomic instrument was fiscal policy which would have only a small impact on prices in a small open economy such as Estonia’s. Thus even a strongly contractionary stance might not bring inflation down by enough, particularly if inflation was well above the Maastricht threshold. Nonetheless, as mentioned above, they would explore the possibility of shifting expenditures away from the nontraded sector which has become a significant contributor to inflation. Another instrument was the timing of planned excise increases, some of which are covered by commitments to the EU. Earlier this year one set of increases had been postponed from July 2006 to January 2008 in order to improve the chances of meeting the Maastricht criterion in 2007. Staff noted that, in view of new, higher, inflation projections, a case could now be made for making these increases in late 2006—the effect on inflation would then peak in late 2007 when the Maastricht target would be, in any event, out of reach. But the authorities felt that the timing could not be fine-tuned since the coalition agreement and (in their view) best practice precluded increasing any tax without a 6-month warning. Moreover, too rapid an increase could lead to a fall in revenue because of lower excises abroad. The authorities also planned to hold further discussions with EU institutions in an effort to seek an interpretation of the Maastricht inflation criterion that would be better suited to conditions in a rapidly converging economy.

D. Rapid Credit Growth

19. Discussions focused on how to ensure that the risks associated with rapid credit growth are well assessed and properly priced. In addition, staff reviewed changes in bank supervision since the 1999 FSAP and discussed the challenges facing the Financial Supervisory Authority (Box 5).3

20. The FSA sees its main challenge as ensuring that banks’ management—at parent institutions as well as local affiliates—are alive to the risks in a profitable but still immature market. Since all the major banks are affiliates of reputable Nordic banking groups, and since their financial performance has been exemplary, the risks might appear minor, but the authorities did not consider them so. First, the loan market was immature: loan portfolios had grown under exceptionally benign circumstances—expanding opportunities for investment, fast-growing incomes, and declining interest rates—which had led to near-zero default ratios and exceptionally high profits (Table 5). It was possible that lenders and borrowers were both overestimating borrowers’ capacity to repay under less favorable circumstances. Second, the major banking groups’ Estonian exposure is relatively small but highly profitable. This has led to aggressive competition for market share and short-term incentives—not always resisted—to relax credit standards. Moreover, with risk assessments increasingly made at head offices it was not clear that credit standards were well-tailored to local conditions. Third, banks were heavily exposed to the booming real estate sector where rising prices had led to an erosion of income cover and to longer maturities. Overall, the authorities viewed the real estate-related risk—which could be triggered by a collapse of prices or a significant growth slowdown—as the greatest source of concern.

Bank Supervision in Estonia

Estonia’s supervisory system was reshaped in 2002 when supervision was transferred from the Bank of Estonia to the new Financial Supervisory Authority (FSA), which was made responsible for all regulated financial intermediaries. In 2005 the FSA was reorganized on a functional basis in order to increase its effectiveness and make better use of its limited resources. The FSA is currently preparing for the adoption of Basel II. Keeping up with the large volume of new regulations, including from the EU, is a significant burden for this small institution.

Because the larger banks, and most of the smaller ones, are affiliates of regional groups, the FSA normally plays the subordinate role of host supervisor. This has required setting up a network of arrangements with other supervisors. Cooperation is reportedly good, facilitated by the relationships supervisory authorities maintain in the Nordic region. Supervisors meet regularly to discuss work programs. They also participate in each others’ onsite work and exchange information derived from offsite work. These issues are being explored further by the Fund’s Nordic-Baltic Regional Financial Sector project.

21. But they noted that, so long as there was no visible asset deterioration, they had few tools to influence banks’ risk management or the pace of credit growth. A doubling of the risk weights on mortgages (to 100 percent) in March 2006 had had little impact on the growth of mortgage lending but did make banks create larger buffers against credit risk by bringing funds from abroad. Both the modest increase in reserve requirements (from 13 to 15 percent) effective September 2006 and efforts at moral suasion had mainly a signaling role. The scope for regulatory measures with more teeth was limited since banks could avoid regulation—and supervision—by booking loans abroad or transforming subsidiaries into branches. The main instrument available was thus to use supervisory interventions to ensure that banks were fully aware of the risks, including mismatches in households’ balance sheets.4 Along these lines, the FSA had placed real estate lending under particular scrutiny, requiring banks to provide detailed quarterly reports and a biannual questionnaire. The staff agreed that Estonia’s financial integration limited the scope for further regulatory measures, or, for that matter, more intrusive, nonmarket measures.5 This put a premium on strong prudential supervision, and staff encouraged the FSA to press banks to make their stress tests more probing by analyzing more varied and more severe shocks.

22. The staff (like the central bank) also urged the government to reduce or eliminate fiscal incentives which could fuel the property boom and were also distortionary. The authorities responded that they intended to reduce the ceiling on the mortgage interest deduction by 40 percent, though this would only become effective in 2008. In other areas there was less readiness for change—there were no plans to increase property taxes and the authorities said it would be difficult to tighten the administration of capital gains taxation given the exemption of owners’ primary residences.

E. Medium-Term Issues

23. While discussions focused on short-term issues it was agreed that flexibility and productivity growth were key to containing medium-term risks. In light of the poor demographic prospects and fiercer competition from abroad, productivity improvements were essential to growth. In particular, it would be important to align the educational system to the changing needs of enterprises and foster an environment supportive of research and development. To meet these challenges the authorities have introduced education and technology programs described in their Action Plan for Jobs and Growth for implementing the Lisbon Strategy. Labor and product market flexibility should also be preserved in order to support continued competitiveness gains. Flexibility and growth should both ease the adjustment necessary to shrink the external imbalance and stabilize the ratio of external obligations to national income. Staff estimates that if growth settles at 5–6 percent as projected in the staff’s medium term macroeconomic framework the needed adjustment could be manageable—about 5 percentage points of GDP. But under more unfavorable assumptions it could be as high as 8–10 percentage points of GDP.6

III. Staff Appraisal

24. After a decade and a half of rapid convergence, Estonia’s very success is creating new challenges. While growth is strong and competitiveness adequate, burgeoning demand is putting pressure on wages and prices that could undermine competitiveness and thus the foundation of sustained rapid growth. The blistering pace of credit growth may be compromising banks’ assessment and pricing of risk. And inflation, while moderate, remains stubbornly above the Maastricht reference value, delaying euro adoption. The institutions that have underpinned Estonia’s outstanding performance to date—flexible product and labor markets and an excellent investment climate—should help ride out these challenges by sustaining productivity-driven growth. But a countercyclical fiscal stance is needed to improve the odds for a soft landing and early euro adoption, and continued supervisory vigilance is needed to contain risks in the financial sector.

25. While six years of surpluses testify to Estonia’s commitment to fiscal probity, overheating pressures and the wide external current account deficit call for a tighter fiscal stance. The surpluses planned for 2006 and 2007 are welcome but too small, implying a procyclical fiscal position. It would have been preferable to save all of the revenue overperformance in 2006, postpone programmed income tax cuts, and make the 2007 budget at least neutral on a cyclically adjusted basis. Better still would have been to take advantage of exceptionally strong economic growth to reduce the share of government expenditure in GDP, positioning the budget for future challenges such as the costs of an aging population.

26. The macroeconomic impact of EU funds needs to be taken into account in budget planning. Estonia’s effective procedures for allocating structural funds have resulted in a rapid uptake, setting a standard for countries in the region. But, while EU projects will contribute to growth, they are also providing fiscal stimulus at a time when withdrawal is needed. This dilemma has no easy solution, as the authorities noted, but it does need to be addressed within the broader context of the budget. In setting priorities and timing the authorities will need to take into account the impact on demand, particularly in sectors—such as construction—where overheating is most pronounced. In addition, consideration could be given to attracting more competitive bids by easing conditions for contractors to make wider use of imported labor.

27. The reluctance to take a countercyclical fiscal stance underscores the need to strengthen the budget framework. Given the CBA and, in time, euro adoption, fiscal policy is the only instrument available for macroeconomic stabilization. Thus, at a minimum, automatic stabilizers should be allowed full play. A medium-term goal should therefore be to shift the focus of policy from targeting the fiscal balance to targeting medium term expenditure growth, allowing the fiscal balance to reflect the business cycle. A full-fledged medium-term expenditure framework will take time to implement, but the authorities can already start placing increased emphasis on expenditures. An important first step would be to end the practice of using supplementary budgets to spend cyclical increases in revenues.

28. Euro adoption at an early date should be a key objective. Estonia’s readiness for the euro is indicated by its sustained strong performance under the nearly identical rigors of the CBA. The euro will lock in the benefits of the CBA and eliminate balance sheet risks associated with a separate currency. These risks are not large but they are increasing with growing external debt and currency mismatches. Some delay in euro adoption would be easily manageable, as has been shown by markets’ unruffled response to a perceived two to three year postponement, but a longer or open-ended delay should be avoided. A clearly articulated strategy for euro adoption would also send a signal of Estonia’s continued commitment to financial stability.

29. Meeting the Maastricht inflation criterion will require getting the maximum effect from a limited set of instruments. A tight fiscal posture, with particular attention to containing demand in the overheating construction sector, is the indispensable ingredient. The timing of planned excise increases will also have a major impact on the time path of inflation but involves a difficult judgment call. If the inflation threshold looks likely to remain out of reach in the near future, consideration could be given to increasing excises now. But if the recent drop in oil prices persists, bringing the inflation threshold within reach earlier, there would be a stronger case for maintaining the current calendar—though supported by a much tighter fiscal stance than is now contemplated. The government that takes office in early 2007 will need to make this assessment at the beginning of its mandate.

30. The openness of the financial sector puts a premium on supervisory vigilance and cross-border cooperation. Openness has brought major benefits, including an inflow of foreign savings intermediated by reputable regional banks. But it has also limited the authorities’ ability to influence bank behavior by regulation. Against this background, the authorities’ supervisory effort is appropriately focused on risks stemming from rapid credit growth, particularly in the real estate sector. To maximize effectiveness, the existing links with Nordic supervisors should be maintained and, if possible, strengthened. The objective should be to ensure that the foreign-owned banks are fully alert to the risks associated with their Estonian operations. Finally, although the property boom seems to have paused, the case remains strong for eliminating mortgage interest deductibility and other distortionary fiscal incentives for real estate investment.

31. It is recommended that the Article IV consultation with Estonia remain on the standard 12-month cycle.

Table 6.

Estonia: Indicators of External Vulnerability, 2000–06

(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.

Credit to households and nonfinancial institutions.

Excluding reserve assets of the Bank of Estonia.

By original maturity.

External debt includes 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.

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.

Table 7.

Estonia: External Debt Sustainability Framework, 2001–11

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Derived as [r − g − p(1+g) + ea(1+r)]/(1+g+p+gp) times previous period debt stock, with r = nominal effective interest rate on external debt; p = change in domestic GDP deflator in US dollar terr g = real GDP growth, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [−p(1 +g) + ea(1 +r)]/(1 +g+p+gp) times previous period debt stock, p increases with an appreciating domestic currency (e > and rising inflation (based on the 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) rei at their levels of the last projection year.

1

This report uses revised national income and product data (covering 2000–06) released by the authorities in September 2006.

2

Estonia’s competitiveness is examined further in an accompanying selected issues paper.

3

The authorities propose to schedule an FSAP update in late 2008.

4

Balance sheet risks are discussed in an accompanying selected issues paper.

5

The regulatory environment is already relatively tough: the new risk weight on mortgages is twice as high as set out in the EU’s Capital Adequacy Directive and higher than in the other Baltic countries; and reserve requirements were higher than in the other Baltics even before the recent increase. Like other countries in the region, Estonia has steered clear of non-market measures to limit credit growth or capital inflows.

6

Debt projections show gross external debt ratio rising by nearly 10 percentage points of GDP by 2011, while “bounds tests” show increases in the order of 15 percentage points (Table 7). However, the current account deficit is projected to shrink to well below the level that stabilizes the debt ratio.

Appendix I. Estonia: Fund Relations1

(As of August 31, 2006)

The 2006 Article IV consultation discussions were held in Tallinn during August 15–25, 2006. The staff team comprised Mr. Rozwadowski (head), Ms. Choueiri and Mr. Lutz (all EUR), Mr. van Eden (FAD) and Mr. Hayward (MFD). Mr. Sierhej (Warsaw Office) conducted discussions on EU funds and Mr. Kosenko (Advisor, OED) attended a number of meetings. The mission met Prime Minister Ansip, Bank of Estonia (BE) Governor Lipstock, Finance Minister Sõerd, senior officials, parliamentarians, and private sector representatives. A press conference was held at the mission’s end.

The authorities released the mission’s concluding statement (http://www.eestipank.info/pub/en/majandus/IMF/_20060825.pdf) and have expressed their intention to publish the staff report.

Membership Status: Joined May 26, 1992; Article VIII.

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Outstanding Purchases and Loans: None

Financial Arrangements: None

Projected Obligations to Fund: None

Exchange Rate Arrangements:

The currency of Estonia is the kroon. The kroon replaced the ruble on June 20, 1992. Since that date, the Bank of Estonia has guaranteed the conversion of kroon bank notes, coins, and reserve deposits of commercial banks at a fixed rate of exchange of EEK 15.6466 per euro (and EEK 8 per deutsche mark until 31 December, 2001). Estonia has accepted the obligations under Article VIII, Sections 2(a), 3, and 4 of the Fund’s Articles of Agreement, and maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions, except for those imposed for security reasons in accordance with the European Council Regulations set forth in the letter from the Bank of Estonia dated November 17, 2006, and notified to the Executive Board in accordance with Decision No. 144-(52/51) (EBD/05/117, October 26, 2005).

Article IV Consultation:

The 2005 Article IV consultation was concluded by the Executive Board on October 26, 2005.

FSAP and ROSCs:

A review under the Financial Sector Assessment Program (FSAP) was completed at the time of the 2000 Article IV Consultation. Further Reports on Observance of Standards and Codes (ROSC) modules were discussed in the 2001 Article IV Consultations and updated during the 2002 Consultation.

Technical Assistance:

Technical Assistance from the Fund,2000–06

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Notes

1

Updated information relating to members= positions in the Fund can be found on the IMF web site (http://www.imf.org/external/np/tre/tad/index.htm).

Appendix II. Relations with the World Bank

1. Estonia became a member of the World Bank on June 23, 1992. The World Bank’s early involvement in Estonia included work on public expenditure issues (1994), local government financing (1995), and the impact of the transition process on living standards (1996). In June 1997, the Bank completed a Public Expenditure Review Update.

2. In June 1999, the World Bank completed a Country Economic Memorandum entitled “Estonia: Implementing the EU Accession Agenda.” In February 2000, the World Bank initiated work on a Regional Development Program for the northeastern-most county of Estonia, Ida Virumaa. The work included the development of an action program designed to: (a) strengthen regional institutions providing labor and education services, as well as other social services; (b) support the development of small and medium enterprises; and (c) mitigate past environmental damages, contributing to sustainable development. The work was completed in June 2000.

3. The Board of Executive Directors approved the first World Bank lending operation in Estonia, a Rehabilitation Loan for US$30 million, in October 1992. In May 1994, loans to support district heating rehabilitation (US$38.4 million) and highway maintenance (US$12 million) were approved. A US$10 million Financial Institutions Development Loan (FIDL) was approved in October 1994, a health project (US$18 million) in January 1995, followed in April 1995 by an environment loan (US$2 million), and an agricultural loan (US$16 million) in March 1996. All the above-mentioned projects have already been completed and closed. In March 2000, the Board approved a Transport Sector Project (US$25 million), focusing primarily on road improvements. The project closing date is December 31, 2005.

4. The Bank’s local office in Tallinn was closed in June 2001. In late 2003 Estonia opted to cancel the undisbursed World Bank loan balances, and the Bank’s last active project (Transport Sector Project) was closed in December 2005. On September 17, 2006, Estonia changed from World Bank borrower status to donor status.

Appendix III. Estonia: Statistical Issues

1. Data provision to the Fund is generally adequate for surveillance purposes, although fiscal data on general government operations is not always timely. The Data ROSC mission that visited Tallinn during May 10–18, 2001 found that the quality of the macroeconomic statistics was generally good. It noted that international standards and guidelines were generally followed. However, the quality of fiscal and monetary data was constrained by incomplete coverage.

2. Estonia is a subscriber to the Special Data Dissemination Standard (SDDS). The Bank of Estonia (BoE) publishes a wide variety of data on the key variables for each of the four sectors—monetary, fiscal, real and external—on its website, with periodic updates.

The following is a summary of both the frequency and the timeliness of key data as made available to Fund staff:

A. Monetary Statistics

3. All monetary data are issued by the BoE.1

  • BoE balance sheet (base money and NIR) are reported monthly, and are available on the eighth day following the end of the month.2

  • Broad money and its components are available monthly from the BoE on the thirteenth banking day from the beginning of the month.2

  • Interest rate updates on domestic and foreign currency transactions are available monthly on the seventeenth banking day from the beginning of the month.2

B. Financial Statistics

4. All financial data are compiled by the BoE and are reported on a monthly basis:3

  • Commercial bank reserves data are available on the eleventh banking day from the beginning of the month.2

  • Commercial bank off-balance sheet data are available on the eighteenth banking day from the beginning of the month.2

  • Average capital adequacy ratios are available on the thirteenth banking day from the beginning of the month.2

  • Nonperforming loans data are available on the seventeenth banking day from the beginning of the month.2

  • Leverage ratios are available on the eighteenth banking day from the beginning of the month.

  • Liquidity ratios are available on the eighteenth banking day from the beginning of the month.

  • NFAs of commercial banks are available on the eleventh banking day from the beginning of the month.2

  • Net open foreign exchange positions are available on the eleventh banking day from the beginning of the month.

  • Short-term external debt are available on the eighteenth banking day from the beginning of the month.

C. Balance of Payments Statistics

5. All balance of payments data are also compiled by the BoE:

  • Daily exchange rate data are available with a one-working day lag.2

  • Monthly imports/exports data are available with a two-month lag.

  • Quarterly balance of payments data are available with a one-quarter lag.2

  • Quarterly public and private external debt data are available with a one-quarter lag.2

D. Government Finance Statistics

6. All fiscal data are published by the Ministry of Finance (MoF). SDDS related data for central government operations have not been disseminated since December 2002.

  • Monthly central government operations data are available with a lag of up to 25 days after the end of the month. The government has started to report monthly data on a consolidated government basis in January 1999 (http://www.fin.ee/?lang=en). Currently, the MoF is using one of its two allowed SDDS flexibility options on the timeliness of monthly central government operations data, but it plans to begin redisseminating these data in the near future.

  • Quarterly data on foreign loans and guarantees by the central government are available with a one-month lag. Currently, the MoF is using the second of its two allowed SDDS flexibility options on the timeliness of quarterly central government debt data, but it plans to begin redisseminating these data in the near future.

  • Comprehensive annual cash data on central government and local government operations to 2001 are reported in the GFS Yearbook 2005. Balance sheet data is incomplete with only liabilities, domestic and foreign, reported. Only annual data to 2001 are reported in the International Finance Statistics. Annual general government operations data (cumulative) for 2002–05 are available on Estonia’s National Summary Data Page (NSDP).

E. National Accounts Statistics

  • Data on GDP (quarterly, by semester, and annually) are currently being issued by the Statistical Office of Estonia (SOE) with a lag of four months after the end of the quarter. Flash estimates of aggregate GDP are available two months after the end of the quarter.4

  • Monthly CPI inflation data are available seven days after the end of the accounting period, and are received directly from the SOE. Monthly PPI and Export Price Index data are available four weeks after the end of the accounting period.4

  • Monthly indicators of output, i.e., retail trade, industrial output, industrial sales, are reported approximately six weeks to two months after the end of the accounting period.4

Monthly wage data (nominal) are produced by the SOE with a two-month lag. Quarterly wage data (nominal and real) are produced by the SOE with a lag of two months.4

Estonia: Table of Common Indicators Required for Surveillance

(As of September 30, 2006)

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Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

Foreign, domestic bank, and domestic nonbank financing.

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

Including currency and maturity composition.

Daily (D), Weekly (W), Monthly (M), Quarterly (Q), Annually (A), Irregular (I); Not Available (NA).

Reflects the assessment provided in the data ROSC published on November 6, 2001 and based on the findings of the mission that took place during May 10–18, 2001 for the dataset corresponding to the variable in each row. The assessment indicates whether international standards concerning concepts and definitions, scope, classification/sectorization, and basis for recording are fully observed (O), largely observed (LO), largely not observed (LNO), or not observed (NO).

Same as footnote 7, except referring to international standards concerning (respectively) source data, statistical techniques and revision studies.
1

All monetary data are collected with a frequency of 10 days and are available to Fund staff upon request.

2

These are publicly available data on the Bank of Estonia website: http://www.bankofestonia.info/frontpage/en.

3

Data for individual banks are also available on a quarterly basis.

4

Indicates publicly available data on the Statistical Office of Estonia website (http://www.stat.ee).

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Cover IMF Staff Country Reports
Republic of Estonia: Staff Report for the 2006 Article IV Consultation
Author:
International Monetary Fund
Volume/Issue:
Volume 2006: Issue 418
Publisher:
International Monetary Fund
ISBN:
9781451933963
ISSN:
1934-7685
Pages:
46
DOI:
https://doi.org/10.5089/9781451933963.002
  • Figure 1.
    View in gallery
    Figure 1.

    EU8 Member States: Progress in Income Convergence to EU25 Average, 1996–2005

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

  • View in gallery

    Domestic and Foreign Contributions to GDP Growth, 1994-2006

    (in percent)

  • View in gallery

    Actual and Potential Growth, and Output Gap, 1994-2006

    (Percent; and Percent of Potential Output)

  • View in gallery

    Labor Market Developments, 1996Q1-2006Q2

    (In percent)

  • View in gallery

    Estonia: Employee Compensation, 1993Q1-2006Q2

    (Percent of GDP)

  • View in gallery

    Breakdown of HICP Q/Q Inflation, 2000Q2-2006Q3

    (SA Data, Annualized)

  • View in gallery

    Breakdown of HICP M/M Inflation, Jan 99-Aug 06

    (SA data, in percent)

  • Figure 2.
    View in gallery
    Figure 2.

    Estonia: Credit, Interest Rates, and Property Price Developments, 2000–06

  • Figure 3.
    View in gallery
    Figure 3.

    Estonia: Credit Developments in Estonia and Selected EU Economies, 2005

  • View in gallery

    Financial Deepening & Real Convergence, 1997 - 2005

  • Figure 4.
    View in gallery
    Figure 4.

    Estonia: Current Account, FDI, and External Debt, 1995–2005

    (In percent of GDP)

  • Figure 5.
    View in gallery
    Figure 5.

    New EU8 Member States: Real Effective Exchange Rates and World Trade Shares, 1995–2005

    (2000=100)

  • Figure 6.
    View in gallery
    Figure 6.

    Estonia: Export Composition by Technology and Quality, 1992–2004

  • View in gallery

    External Competitiveness Indicators: Manufacturing

    (2000 = 100)

  • View in gallery

    Estonia: Annual Average HICP Inflation and the Maastricht Criterion

Figure 1.

EU8 Member States: Progress in Income Convergence to EU25 Average, 1996–2005

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

Domestic and Foreign Contributions to GDP Growth, 1994-2006

(in percent)

Actual and Potential Growth, and Output Gap, 1994-2006

(Percent; and Percent of Potential Output)

Labor Market Developments, 1996Q1-2006Q2

(In percent)

Estonia: Employee Compensation, 1993Q1-2006Q2

(Percent of GDP)

Breakdown of HICP Q/Q Inflation, 2000Q2-2006Q3

(SA Data, Annualized)

Breakdown of HICP M/M Inflation, Jan 99-Aug 06

(SA data, in percent)
Figure 2.

Estonia: Credit, Interest Rates, and Property Price Developments, 2000–06
Figure 3.

Estonia: Credit Developments in Estonia and Selected EU Economies, 2005

Financial Deepening & Real Convergence, 1997 - 2005
Figure 4.

Estonia: Current Account, FDI, and External Debt, 1995–2005

(In percent of GDP)
Figure 5.

New EU8 Member States: Real Effective Exchange Rates and World Trade Shares, 1995–2005

(2000=100)
Figure 6.

Estonia: Export Composition by Technology and Quality, 1992–2004

External Competitiveness Indicators: Manufacturing

(2000 = 100)

Estonia: Annual Average HICP Inflation and the Maastricht Criterion