Republic of Estonia
2007 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Estonia
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International Monetary Fund
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Publication Date:
30 Jul 2007
eISBN:
9781451812527
Language:
English
Keywords:
ISCR; CR; Estonia; criterion; lending; CPI basket; current account; unemployment rate; foreign currency; short-term debt; sustainability analysis; Inflation; Baltics
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The Republic of Estonia’s 2007 Article IV Consultation reports that surging domestic demand has widened the external current account deficit and pushed the economy against capacity constraints. Wage increases have begun to erode competitiveness and kept inflation above the Maastricht threshold for euro adoption. There are signs of an incipient slowdown, but a resurgence of demand and an eventual hard landing, with growth stagnating, cannot be ruled out. A strong fiscal stance is needed to subdue wage and income expectations and improve the odds of a soft landing.

Abstract

The Republic of Estonia’s 2007 Article IV Consultation reports that surging domestic demand has widened the external current account deficit and pushed the economy against capacity constraints. Wage increases have begun to erode competitiveness and kept inflation above the Maastricht threshold for euro adoption. There are signs of an incipient slowdown, but a resurgence of demand and an eventual hard landing, with growth stagnating, cannot be ruled out. A strong fiscal stance is needed to subdue wage and income expectations and improve the odds of a soft landing.

I. Introduction

1. After more than a decade of remarkable growth, Estonia is grappling with an overheated economy in the face of increased regional uncertainties. Far-reaching structural reforms and macroeconomic stability supported the fastest convergence among the EU’s new member states and an exceptionally rapid increase in living standards. But booming domestic demand has now pushed the economy up against capacity constraints and magnified existing convergence-related imbalances. The external current account deficit has widened, inflation is up, and real wages are rising faster than productivity. At the same time, the external environment has turned less benign: pressures on the Latvian currency in February have put a spotlight on financial vulnerabilities in the Baltics, and regional political tensions in April-May have added to the uncertainties. And the safe haven of euro adoption now looks several years away. The consultation largely focused on the authorities’ policy options under the current, more demanding, circumstances.

uA01fig01

Income Convergence in New Member States, 1995 and 2006

(PPS per capita GDP at current prices, percent of EU25 average)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Eurostat.1/ Except for Romania where data is for 1999.

Implementation of Fund Policy Advice

Estonia has had an excellent working relationship with the IMF since becoming a member in May 1992. The authorities’ policy decisions have generally been consistent with Board recommendations in the Article IV context. Policy implementation has been characterized by a high degree of ownership, which has proven to be key to Estonia’s economic success. In recent years, Estonia’s budgets have been less contractionary than advised by the Fund, though in practice fiscal outcomes have turned out to be better than budgeted.

II. Background

2. Demand surged in 2006 but there are signs of an incipient slowdown. Rising incomes, the favorable investment climate, and low-interest financing fueled an investment and consumption boom which raised real domestic demand by 15 percent in 2006—more than twice the 2005 increase. Real GDP growth rose to 11.4 percent, well above staff’s estimate of potential growth; the external current account deficit widened to nearly 15 percent of GDP; and resources shifted from traded to non-traded sectors (Figure 1). But demand now appears to be moderating: domestic demand growth decelerated in the last quarter of 2006 and the first quarter of 2007, owing mainly to slowing investment. And housing prices, which took off at the end of 2005, have now stabilized relative to family incomes. Preliminary data indicate that the current account deficit exceeded 21 percent of GDP in the first quarter of 2007, though this was mainly due to increased repatriation of profits.

Figure 1.
Figure 1.

Estonia: Selected Economic Indicators

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.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/ Includes statistical discrepancy.3/ Calculated using HP filter.4/ There is a break in the GDP series in 2000 which makes the periods 1996-2000 and 2000-06 not comparable.

Estonia: Growth Rates of Real GDP and Main Components Year-on-year percent change

article image
Sources: Estonian statistical office; and staff calculations.

Includes consumption of nonprofit institutions serving households.

Contribution to real GDP growth

uA01fig02

GDP and Domestic Demand, 2000Q2-2007Q1

(Annualized quarter-on-quarter growth, in percent, s.a.)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Statistical Office
uA01fig03

Average apartment price as a share of monthly wages

(2000Q1=100)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

3. Inflation has accelerated into the 5–6 percent range, well above the Maastricht threshold for euro adoption (currently about 3 percent). A rising contribution of nontradables prices is evidence that overheating pressures are being added to the underlying convergence-related price dynamic. The increasing role of core inflation suggests that it will be difficult to meet the Maastricht criterion within the next few years.

uA01fig04

Contributions to Inflation, Dec 1999-Apr2007

(Y-o-y, in percent)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Sources: Eurostat; and IMF staff calculations.
uA01fig05

Contributions to Inflation, 2000Q2-2007Q1

(q-o-q annualized, s.a.)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

4. Domestic growth and new employment opportunities in the EU have tightened the labor market, increasing labor costs (Figure 2). The unemployment rate has fallen sharply in the past two years to a post-transition low of less than 6 percent. Previously marginal groups were the biggest beneficiaries, suggesting that there is little slack left in the labor market. Vacancy rates rose in 2006, particularly in the services and construction sectors where demand was strongest and employers had to compete for labor with foreign firms. The tightening fueled real wage increases, which reached 14 percent year-on-year in the first quarter of 2007. Labor force survey data suggests that the increase in real wages overtook productivity growth in mid-2005, pushing up real unit labor costs (ULC) and thus reducing the share of profits in value added. The national income accounts-based measure of real ULC, which displayed a more benign trend through mid-2006, has now also started to rise.

Figure 2.
Figure 2.

Estonia: Labor Market Developments

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Sources: Statistics Estonia, and staff calculations.1/ Tradables includes the following sectors: agriculture, forestry, fishery, mining and quarrying, and manufacturing. Non-tradables includes the rest.2/ Real labor productivity is defined as real value added per hour worked. All series are seasonally adjusted. Growth rates are y-o-y changes.
uA01fig06

Labor Force Participation, 2006Q4

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

uA01fig07

Employment Rate, 2006Q4

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Eurostat.

5. More generally, indicators of external competitiveness are mixed (Box 2). Increasing penetration of world markets since 2000 (notwithstanding a modest retreat in 2006) and continued strong profitability are “bottom line” evidence that exports remain competitive. On the other hand, indices calculated by staff using approaches akin to the CGER’s as well as other approaches suggest a real exchange rate overvaluation in the order of 10 percent—the mid-point of a wide range. However, as recognized in a recent Board paper, econometric estimates such as these are subject to uncertainties which “may be particularly severe for countries undergoing rapid structural change and for those for which sample length is relatively short”—both of which apply in Estonia.1

6. Estonia’s regional integration has meant that the capital account has become a two-way street. Gross FDI inflows—largely reinvested profits—continued to rise relative to GDP, but net FDI fell as residents invested abroad and now covers less than a quarter of the current account deficit (Figure 3). The decline in net FDI flows was offset by increased bank financing, intermediated by local affiliates of Nordic banks. Gross external debt, nearly all private, was 96 percent of GDP at end-2006 while net debt was 27 percent of GDP.

Figure 3.
Figure 3.

Estonia: Current Account, FDI, and External Debt, 1996-2006

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

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

Estonia: Competitiveness

Strong export growth has boosted Estonia’s market share by 40 percent since 2000, even after some reversal in 2006. Constant market shares analysis confirms the importance of Estonia-specific factors behind this strong export growth. In contrast, indices calculated by staff, including measures related to the CGER macro balances and external sustainability approaches, show real exchange rate overvaluation in 2006 (see next page of this box). This is consistent with the observation that the share of labor compensation in GDP seems greater than warranted by labor productivity. However, the indices referred to above presume that parameters are stable—an assumption that may not be warranted in a fast-converging economy undergoing substantial structural changes.

uA01bx02fig01

WEO-Based World Trade Shares, 1995-06

(2000=100)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Sources: WEO database (Winter 2006); Eurostat; DG EcFin; and staff calculations.

Constant Market Shares (CMS) Analysis of Export Changes 1/

(Billions of U.S. dollars, unless otherwise indicated)

article image
Source: U.N., COMTRADE; and IMF Staff estimates.

CMS analysis decomposes export growth into four components: growth due to changes in world total demand; growth due to changes in world commodity-specific demand; growth due to market distribution effects; and finally, growth due to residual effects. The last (residual) component captures the impact of Estonia-specific factors-competitiveness-related factors (such as movements in the exchange rate or changes in product type/quality) and terms of trade changes.

Estimated Real Exchange Rate Overvaluation, 2006

(In percent)

article image

Percent difference between REER-real ULC based in 2006 and its average level during 2001-05.

The real exchange rate correction needed to generate a current account deficit that would stabilize NIIP at 100% of GDP, assuming real interest rate of 6% (historical average), growth rate of 7 percent (potential rate over next 5 years), and current account elasticity ranging from 0.35 to 0.75.

Measured as the deviation from the predicted ratio of Estonia’s domestic price level to the U.S. price level, given Estonia’s GDP per capita relative to the U.S. (at PPP exchange rate).

uA01bx02fig02

Real Effective Exchange Rates, 1995Q1-2006Q4

(2000=100)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Staff calculations.1/ Real ULC is calculated using the industry (ex-construction) deflator. It is a proxy for labor’s share in manufacturing value added.
uA01fig10

Productivity and Labor Costs

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Sources: Eurostat and staff calculations.

7. Credit expansion, while still vigorous, has slowed. The deceleration of bank credit which began in the second half of 2006 continued in the first few months of 2007. About half of the new credit was to non-financial corporations; the rest was to households and of this four-fifths was mortgages. Three-quarters of bank lending was euro-denominated. Domestic deposits fund roughly half of bank lending but resources from Nordic parent banks are gaining importance. Intense competition for market share has driven bank lending rates very low; indeed real lending rates were negative until recently (Figure 1).

uA01fig11

Contribution to Private Sector Credit Growth, 2000Q4-2007Q1

(Y-o-y percent change)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

uA01fig12

Flows of Private Sector Credit, 2000Q4-2007Q1

(In percent of GDP, seasonally adjusted)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

uA01fig13

Structure of Liabilites, Jan99-Apr07

(In billions of Estonian kroons)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

8. Banking sector indicators are strong. Banks are well capitalized, although liquidity ratios have declined in recent years. Profitability is high compared with banks in the EU. Non-performing loans (NPLs) more than 90 days overdue are negligible although there has been some increase in arrears in the 1-60 day range, and NPLs are lagging indicators in a period of rapid credit growth. Ultimately, since Estonian banks are affiliates of larger institutions that manage risk on a consolidated basis, their soundness depends on parent institutions’ readiness to supply liquidity or capital if necessary. Parent banks’ incentive to stand behind their Estonian affiliates is likely strengthened by the affiliates’ good track records and by the parents’ interest in protecting their brand names in an integrated regional market. The cyber-attacks on Estonian internet servers earlier this year temporarily disrupted access to major banks’ websites, but did not compromise the integrity of the financial system.

Financial Soundness Indicators of the Banking Sector, 2000-2007Q1

article image
Source: Eesti Pank.

9. Estonia’s track record of sound macroeconomic and prudential policies helped it brush off contagion effects of exchange rate pressures in Latvia earlier this year. While macroeconomic developments show similarities among the Baltic countries—booming domestic demand, rising inflation, widening external current account deficits, and burgeoning credit—Estonia is distinguished by its stronger fiscal position and its more dynamic and diversified economy (Figure 4). Eesti Pank’s timely response in 2005-06 to early signs of overheating (increasing public awareness of risks, raising the risk weight on mortgages and reserve requirements on deposits) also helped to maintain confidence. Credit ratings agencies—most recently S&P—have maintained Estonia’s investment grade and “stable” outlook, citing the competitive economy, the CBA, favorable prospects for euro adoption, and the tough fiscal policy stance. Money market spreads did increase slightly in April but remain relatively small. In the equity market, the global correction in February-March 2007 reversed the previous six months’ gains in the Tallinn index, which has since, however, regained some of the lost ground.

Figure 4.
Figure 4.

The Baltics: Recent Developments, 2000-07

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Eurostat; UN Comtrade; and IMF staff calculations.1/ 2006 data as of September 2006.2/ Technology content of exports is defined as the weighted share of exports in each of 3 technology categories (low-tech, resource intensive, and medium- and high-tech) where the weights reflect the share of each category in total exports and the relative ranking of each technology category (⅙, ⅓, ½, respectively).
uA01fig14

The Baltics: Stock Market, Jan03-Jun07

(January 1, 2003=100)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Bloomberg.
uA01fig15

The Baltics: 3-month Interbank Offer Rate Spreads, Jan03-Jun07

(In basis points, versus the EURIBOR)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

10. Estonia’s long-standing commitment to fiscal prudence—budget surpluses are the norm and government debt is negligible—was reinforced in 2006 by a large fiscal surplus. This solid performance was partly driven by a strong increase in non-tax revenue which more than offset the impact of a long-planned cut in the income tax rate. The revenue increase was partly a one-off: the authorities’ achievement was to resist spending it.

Estonia: Selected Fiscal Indicators, 2003-06

(Percent of GDP)

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

First difference in the structural balance, calculated based on a HP filter estimate of the output gap and adjusted for the impact of EU funds on domestic vs. external demand, with sign reversed.

III. Discussions with the Authorities

11. Discussions focused on increasing the likelihood of a soft landing and containing risks in the now less-forgiving economic environment. The mission also discussed the challenges of population aging and sustaining productivity growth.

A. Macroeconomic Outlook

12. Forward-looking indicators suggest that the recent moderation of demand may continue. While consumption still has momentum, driven by large private sector bonuses and public sector wage increases and by the prospect of income tax cuts and pension increases, it is likely to lose steam. The housing market has already cooled—apartments for sale are sitting longer on the market—and appears unlikely to reignite soon as prices are already unaffordable for many households and euro area interest rates are rising. The flow of credit has slowed and the major banks affirmed that they are tightening lending conditions across the board. More broadly, market sentiment has shifted in apparent recognition that the pace of income growth is not sustainable in the face of capacity constraints.

uA01fig16

Sale periods of apartments and private houses

(in months)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Arco Vara.
uA01fig17

Weighted average annual interest rate on housing loans

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Eesti Pank.
uA01fig18

Confidence indicators, 2003-07

(seasonally adjusted)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Source: Estonian Institute of Economic Research

13. Against this background, the mission and the authorities had both prepared baseline scenarios in which demand slows in 2007, and the economy returns to a medium-term convergence path consistent with external stability. In staff’s projection, GDP growth declines to about 9 percent in 2007—still above potential—as supply constraints bind. Consumption and investment growth slow in the face of capacity constraints, declining profitability, and a rising debt burden, although domestic demand is still strong enough to drive inflation up to 5½ percent and edge the current account deficit above 15 percent of GDP for the year. In the outer years, income growth declines further as profitability is squeezed, leading to slower wage growth. The demand slowdown drives GDP growth toward its potential rate and reduces the current account deficit. External debt sustainability analysis suggests that under the baseline scenario, a current account adjustment of some 6 percentage points of GDP would stabilize the debt ratio and the net external asset position by the end of the projection period (Table 3 and Figure 5). An adjustment of this magnitude should not cause major economic strain so long as the flexibility and growth of the economy are sustained.

Table 1.

Estonia: Selected Macroeconomic Indicators, 2001–08

(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.

Table 2.

Estonia: Summary of General Government Operations, 2001–081/

(In percent of GDP)

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

Cash basis.

Source: Estonia’s Statistical Office, and authorities’ November 2006 Convergence Program; reflects general government data in September 2006 in line with revised national accounts data.

Table 3.

Estonia: Summary Balance of Payments, 2001–12

article image
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.

Figure 5.
Figure 5.

Estonia: External Debt Sustainability, Bounds Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks in case of growth and non-interest current account shocks, and 2 standard deviation shocks in case of interest rate shock. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and current account balance.

Baseline Macroeconomic Forecasts, 2007-09

article image
Sources: Eesti Pank; Ministry of Finance; and staff projections.
uA01fig19

Salient Features of the Staff’s Medium-Term Scenarios, 2001-12

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.A001

14. The authorities and staff agreed that this soft landing was not a sure thing. The main risk is that the slowing of demand may not be sustained. A prolonged boom would fuel inflation, boost production costs—particularly wages—and erode competitiveness. At the same time household debt and real estate exposures would rise, amplifying balance-sheet vulnerabilities. The pricing-in of risk premia would then cause a rise in interest rates and possibly a real estate market correction. Weakened competitiveness would slow growth, producing second-round effects on investment and possibly a credit crunch as banks retrenched in response to deteriorating balance sheets. A period of stagnation and possible financial sector strains could ensue if the wage and price adjustments needed to restore competitiveness were slow to materialize. The authorities’ alternative scenario was similar though slightly less severe.

B. Fiscal Policy

15. With the macroeconomic outlook uncertain, the authorities agreed that the fiscal stance should be kept tight to help steer the economy toward a soft landing. For 2007, the government had for the first time presented parliament with a surplus budget, setting an important precedent and sending a helpful signal of fiscal restraint. But staff pointed out that this budget contained a substantial increase in current expenditure (12 percent in real terms), including large public sector wage increases. Moreover, the projected surplus, while larger than budgeted, was significantly smaller than last year’s outcome, implying an undesirable fiscal stimulus. Given that it would be difficult at this late date to produce the negative fiscal impulse suggested by a widening output gap, staff advised the authorities not to introduce new expenditures in the supplementary budget but instead to save any revenue overperformance. The authorities responded that the public sector wage increases were needed to attract and retain high-quality staff and emphasized that real increases would not exceed productivity gains in the private sector. Regarding the supplementary budget, the government planned not to allow for increased spending. However, the government decided to increase public pensions in mid-2007 in line with expected strong social tax revenues.

Budgets and Outcomes, 2005-07

(% of GDP, cash basis)

article image
Source: Ministry of Finance

Authorities’ projection.

16. The authorities agreed with staff that fiscal surpluses should be sustained in the 2008–l11 budget strategy, but differed on the magnitude. Staff made a case for surpluses of 2–3 percent of GDP on average. First, with output projected to be above capacity through 2010, a strong fiscal program was needed to contain demand pressures both directly and by dampening household expectations. Second, substantial surpluses would signal continued fiscal responsibility, reinforcing the investment climate and supporting the CBA. And third, they would help position the budget for the costs associated with population aging.2 The authorities considered it politically unfeasible to target such large surpluses, but announced a target of at least 1½ percent of GDP. This was subsequently reduced to ½ percent—characterized as a floor—in the medium-term strategy document approved by the cabinet at end-May.

17. Staff raised concerns about the medium-term budgetary implications of changes in taxation and pension entitlements currently under consideration. The government has announced that income tax rates will be cut by a further 2 percentage points and the income tax threshold will be raised by 50 percent by 2011, and it has broached plans to raise (first pillar) public pension benefits significantly over the next four years. Also, a revamp of the corporate income tax, required by 2009 to conform with the EU’s parent-subsidiary directive, is likely to be revenue-reducing. Staff argued that care should be taken to ensure that the medium-term budget targets are not compromised. The authorities reiterated their commitment to maintaining fiscal discipline, noting that offsetting measures will be implemented if necessary to respect their surplus targets.

18. The authorities outlined their progress in strengthening the medium-term budgetary framework (MTBF). They have aligned it with the political cycle (2008-11), pinned down the surplus target, and plan to use it as a basis for the annual budget process starting with the 2008 budget. Staff advised them to plan expenditure on the basis of conservative growth assumptions and to adhere to the implied expenditure ceilings irrespective of revenue developments. Staff also suggested that the MTBF include an economic classification of expenditure priorities to enhance transparency. The authorities have requested a fiscal transparency ROSC, which is likely to take place this fall.

C. Euro Adoption

19. With euro adoption several years away, the mission stressed the need to signal continued commitment to this goal. Estonia meets all but one of the Maastricht criteria by comfortable margins; the sole obstacle is inflation, which, on current projections, would not fall below the Maastricht threshold before 2010 (Box 3). While the authorities do not possess effective macroeconomic instruments to reduce inflation, they recognized the importance of sending a clear signal of commitment to euro adoption. They thus decided to advance planned increases in several excise taxes to early 2008, ensuring that the impact on inflation will have faded by the time inflation comes within reach of the Maastricht criterion. This strong signal was supported by statements reaffirming that euro entry was a government priority and identifying 2011 as a possible date.

D. Financial Sector Risks

20. The authorities viewed currency risk as negligible in Estonia given their unwavering commitment to the CBA. They recognized that the wide external imbalance, the delay in euro adoption, and earlier exchange rate pressures in Latvia had given rise to a market perception of increased risk, but they did not share that perception. If market pressures were to develop, the automatic adjustment mechanism of a CBA would come into play via a contraction of kroon liquidity and possibly large market-driven interest rate increases. The CBA was further anchored by the prospective exit to the euro and the structure of the financial system in Estonia—practically no government debt, rudimentary asset markets, and a banking sector composed of affiliates of larger Nordic banks. The mission agreed that these conditions made disruptive exchange rate movements highly unlikely.

Estonia: Inflation Projections

Staff’s projections, assuming current policies, have Estonia not meeting the Maastricht inflation criterion before 2010. Demand pressures will continue to push up core inflation in 2007 and excise tax increases will provide a further boost in 2008; inflation should start to come down in 2009 as the impact of these factors subsides.

uA01fig20

Inflation and Maastricht Criterion, Dec1999-Dec2009

(Annualized average, in percent)

Citation: IMF Staff Country Reports 2007, 255; 10.5089/9781451812527.002.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 from actual data for the period January 2000-December 2006.

The projections are made using a disaggregated approach that takes into account the macroeconomic environment. Core inflation (67 percent of the HICP basket) reflects domestic demand pressures. Administered prices (18 percent) evolve in line with announced government plans. Non-administered energy prices (6 percent) and unprocessed food prices (9 percent) are in line with the WEO petroleum and food price projections.

21. Instead, the authorities were concerned about balance-sheet risks accumulated over several years of rapid credit growth. They noted that the brisk competition for market share and the relative immaturity of the market—which has not seen a downturn since the bank privatizations earlier this decade—may have led to insufficient attention to borrowers’ debt servicing capacity in the event of a housing market correction or a recession. While Eesti Pank did not have effective instruments to slow credit growth, it had required larger buffers by increasing reserve requirements and the risk weight on mortgages.

22. The recent slowdown in credit growth suggested that market discipline had now taken hold. Eesti Pank’s campaign to increase the awareness of risk through public statements and policy signals, combined with increased financial market concern about Baltic risks, had contributed to a shift in behavior: parent banks—subject to market discipline by ratings agencies and shareholders—had called for tighter credit conditions and a scale-back of lending targets by as much as fifty percent. Against this background, the authorities considered that risk buffers were likely still sufficient.

23. The mission acknowledged that risk buffers were large but noted that their adequacy should be tested against a more demanding standard than used so far; the authorities were unconvinced. While banks do perform stress tests under instructions from their parent banks or the Financial Supervision Authority (FSA), the mission advised the authorities to press for scenarios embedding more severe and more varied shocks, tailored to Estonian conditions. Staff also urged the authorities to perform a systemic stress test based on a large but plausible macroeconomic shock, including possibly a large increase in the interest rate, and to use the outcome to review capital requirements. The authorities noted that Basel II rules, to take effect in 2008, would require banks to carry out more systematic programs of stress testing; moreover, in the run-up to Basel II, the FSA was currently assessing the risk models prepared by the largest subsidiaries of Nordic banks. They agreed that a systemic stress test could be informative but pointed out that since local banks are affiliates of larger institutions which manage risk centrally, assessments based on the relatively small Estonian part of the overall portfolio were of doubtful usefulness. Moreover, intrusive regulatory interventions could lead to offshore activity or to the conversion of subsidiaries to branches. The mission recognized that increased integration complicated both supervision and regulation but noted that a clear assessment of Estonia-specific risks would allow the authorities to press—if necessary—for a joint intervention with the home country supervisor.

24. The FSA emphasized that it was already focusing its efforts on strengthening cross-border coordination in bank supervision. Informal contacts with partner supervisors were frequent and helpful. In addition, the FSA and the Swedish Financial Inspectorate (FI) exchanged information routinely and held regular formal meetings. More recently, the FSA had begun having direct meetings with the head offices of Swedish financial institutions with large affiliates in Estonia. The FSA and FI were also preparing a joint letter of intent establishing procedures under which each would participate in the other’s onsite inspections. The authorities were looking forward to an FSAP update in early 2008 as an opportunity for further review.3

25. The authorities also underscored the need for a multilateral approach in developing crisis management procedures. They stressed that the first line of defense in the event of a bank run would be the banks’ own resources, including from parent institutions. While Eesti Pank could furnish some additional liquidity and the Deposit Guarantee Fund could provide coverage comparable to that in Sweden and Finland, the authorities emphasized that under some circumstances complementary support by home country institutions would be needed. In late 2006, the authorities had signed two MOUs which defined procedures to be followed in the event of a crisis: an international MOU involving Swedish and Baltic central banks and a domestic agreement among Eesti Pank, the FSA, and the Ministry of Finance.4 While the MOUs provided a framework for a rapid response, they did not precommit either side to specific measures or address burden sharing. The authorities were also participating in domestic and cross-country multi-party crisis simulation exercises.

26. The mission reiterated the case for removing distortionary tax incentives favoring housing investment. The authorities agreed that the mortgage interest deduction could be cut further and eventually eliminated but said that no proposals were presently under consideration. On the capital gains tax, they pointed out that the exemption of owner-occupied housing was common practice internationally; in Estonia recent improvements in tax administration had raised compliance rates for the tax on non-exempt housing.

E. Competitiveness and Productivity

27. The authorities saw no problems with the current level of competitiveness. The main indicators they rely on—export performance and the profitability of the export sector—were healthy in 2006 and they expected them to remain so as wage growth moderated. Staff pointed to real exchange rate indices suggesting some erosion of competitiveness in 2006-07 (Box 2). The authorities agreed that excessive wage increases could erode competitiveness but they noted that it was normal for the real exchange rate to appreciate during a boom; this should unwind when the economy slows down. This dynamic was amplified in Estonia by the widespread use of bonuses, which typically constitute 20 percent of total salary and are partly linked to indices that move with the business cycle—sales, profits, or turnover. The high wage growth in the first quarter of 2007 was thus in part the result of bonuses based on the exceptional performance of firms last year. Symmetrically, bonuses provided room for some automatic wage moderation in downturns.

Bonus Payments, 2006

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Source: Eesti Pank

28. Staff and the authorities agreed that labor market flexibility is key to sustaining productivity growth and easing external adjustment. While the mobility of labor across jobs in Estonia is high by European standards, some indicators (notably, the World Bank’s Doing Business index) have highlighted rigidities that could pose problems in a downturn. The government has initiated a review of the 1992 Employment Contracts Act with a view to simplifying hiring and firing procedures and reassessing the framework for severance payments and unemployment insurance. Proposals are also underway to ease the labor shortage by doubling the quota for long-term non-EU workers to 1 percent of the population and, more importantly, streamlining the application procedure for work permits. To encourage immigration of skilled workers, the authorities intend to introduce a floor for the salaries of foreign workers.

29. The mission emphasized the importance of promoting sustained productivity growth over the medium term. The mission presented research showing that total factor productivity growth, particularly in trade and business services, has been the main driving force behind Estonia’s remarkable growth performance to date.5 The basis of this performance—liberal economic institutions, conservative macroeconomic policies and increasing integration with EU markets—remains in place; the challenge is to continue to move toward (and eventually shift) the technology frontier. The authorities indicated that Estonia is moving up the value-added ladder—labor-intensive industries such as textiles are losing their comparative advantage and moving overseas as entrepreneurs shift toward knowledge-based and R&D-intensive activities. Staff noted that its own work supported the same conclusion.

IV. Staff Appraisal

30. After more than ten years of exceptional growth and stability, the resilience of the economy is being tested by burgeoning demand and increased regional uncertainty. Rapid transformation inevitably entails risks but the strong policies and flexible institutions that have underpinned Estonia’s enviable economic performance to date should mitigate them. There are signs of an incipient market-driven adjustment, but this is still fragile. Thus, assertive policies—within the authorities’ limited room for maneuver—are needed to improve the odds of a soft landing, and continued supervisory vigilance is needed to contain financial sector risks.

31. For the immediate future, a tight fiscal stance is needed to curtail demand and signal a renewed commitment to a conservative fiscal posture. Since the 2007 budget implies a surplus well short of the remarkable 2006 outcome, the authorities need to send a clear signal of their determination to keep the fiscal position tight, reassuring financial markets and dampening unrealistic expectations on the part of consumers and borrowers. At the present stage, that signal can best be sent by placing a moratorium on new spending under the supplementary budget in spite of a large projected revenue overperformance.

32. Equally important is a more ambitious medium-term fiscal framework. Estonia’s past commitment to budget balance or surplus served it well, but a more ambitious and transparent framework is now needed to lock down expectations, buttress the CBA, and position the budget for future age-related expenditures. The 2008-11 budget strategy, approved after the mission’s departure, is a welcome departure insofar as it establishes the principle of surpluses rather than balance. But the surplus floors cited in the strategy fall well short of what is needed: if adhered to, they would deliver a procyclical impulse and increase rather than reduce the size of government relative to GDP. And the practice of specifying floors rather than targets muddies the signal of the government’s intentions (particularly since budgets have overperformed by large margins in recent years) and undermines fiscal policy transparency. A review the 2008 budget target later in the year in light of economic growth and evolving risks will be the opportunity to prepare a budget that is appropriately tight. The mid-2008 revision of the MTBF for the outer years should be used to prepare a strategy that sends clearer signals of the authorities’ medium-term fiscal program.

33. Although the banking system appears strong, financial sector risks call for sustained supervisory vigilance. While the authorities’ commitment to the CBA is credible, a collapse in real estate prices, a sharp hike in interest rates, or a protracted economic slowdown could lead to financial stress. The authorities’ campaign to raise public awareness of macroeconomic risks appears to have borne fruit and should be kept up. In the meantime, though the risk buffers seem wide, the authorities should regularly review their adequacy through more active use of stress testing as well as sustained close supervision of credit standards, internal controls, and risk assessment procedures. In particular, the FSA could increase the frequency and comprehensiveness of stress tests, as well as the severity of the shocks used.

34. Bank supervision and risk management have been complicated by Estonia’s close integration with the Nordic countries and the openness of its capital account. Thus, recent steps to institutionalize cooperation with the Swedish financial supervisor are welcome and cooperation will need to become still closer when the region moves to Basel II in 2008. The authorities’ review of the risk models developed by the larger banks in the run-up to Basel II is a welcome opportunity to ensure that those models and the associated stress tests are well adapted to the Estonian situation. Based on this assessment, there may be a case for reviewing the adequacy of risk buffers, in consultation with the home supervisor.

35. Euro adoption should remain a key objective. Adopting the euro will lock in the benefits of the CBA while eliminating the residual balance-sheet risks associated with a separate currency. In view of the robustness of the CBA and the policy framework, markets have accepted a three- to four-year postponement but a longer or open-ended delay would not be welcome. The authorities have few instruments to accelerate the process but they need to reassure markets and minimize the costs of delay. The recent decision to change the timing of planned excise tax increases in order to maximize the chances of euro entry by 2011 was both an effective step to reach that goal and a clear signal of the authorities’ commitment to it.

36. With some indicators pointing to real exchange rate overvaluation, and given the CBA and prospective euro adoption, labor and product market flexibility are essential. In a rapidly converging economy such as Estonia’s, competitiveness must be assessed in a dynamic context and from a medium-term perspective. In this regard, market flexibility will facilitate a shift of resources from non-traded to traded sectors, easing the external adjustment, and a shift toward the higher value-added sectors, improving the foundation for continued growth. The existing vibrant business environment must be maintained by keeping red tape and other operating costs to a minimum. While the labor market has shown remarkable flexibility in the upswing, the ongoing review of the Employment Contracts Act is a good opportunity to weed out outmoded labor market rules and procedures whilst preserving an appropriate balance between flexibility and social objectives. In the face of current labor market tightness and a secular decline in the labor supply, relaxing temporary immigration restrictions across the skill spectrum could help keep business costs down and relieve growth bottlenecks.

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

Table 4.

Estonia: Macroeconomic Framework, 2001–12

(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: Financial Soundness Indicators of the Banking Sector, 1999-07

(In units as indicated)

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Source: Bank of Estonia.
Table 6.

Estonia: Indicators of External Vulnerability, 2001–06

(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-Alternative Scenario: Macroeconomic Framework, 2001–12

(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 8.

Estonia: External Debt Sustainability Framework, 2002-2012

(In percent of GDP, unless otherwise indicated)

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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 terms, g = real GDP growth rate, 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 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.

1

See Methodology for CGER Exchange Rate Assessments, November 2006 (http://www.imf.org/external/np/pp/eng/2006/110806.pdf).

2

Age-related expenditures and policy options are discussed in an accompanying Selected Issues paper.

3

The FSAP will be preceded by a MONEYVAL mutual evaluation of Estonia’s AML/CFT measures.

5

See the accompanying Selected Issues paper for an analysis of productivity developments based on firm-level data.

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Cover IMF Staff Country Reports
Republic of Estonia: 2007 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Estonia
Author:
International Monetary Fund
Volume/Issue:
Volume 2007: Issue 255
Publisher:
International Monetary Fund
ISBN:
9781451812527
ISSN:
1934-7685
Pages:
49
DOI:
https://doi.org/10.5089/9781451812527.002

Income Convergence in New Member States, 1995 and 2006

(PPS per capita GDP at current prices, percent of EU25 average)
Figure 1.

Estonia: Selected Economic Indicators

GDP and Domestic Demand, 2000Q2-2007Q1

(Annualized quarter-on-quarter growth, in percent, s.a.)

Average apartment price as a share of monthly wages

(2000Q1=100)

Contributions to Inflation, Dec 1999-Apr2007

(Y-o-y, in percent)

Contributions to Inflation, 2000Q2-2007Q1

(q-o-q annualized, s.a.)
Figure 2.

Estonia: Labor Market Developments

Labor Force Participation, 2006Q4

Employment Rate, 2006Q4
Figure 3.

Estonia: Current Account, FDI, and External Debt, 1996-2006

(In percent of GDP)

WEO-Based World Trade Shares, 1995-06

(2000=100)

Real Effective Exchange Rates, 1995Q1-2006Q4

(2000=100)

Productivity and Labor Costs

Contribution to Private Sector Credit Growth, 2000Q4-2007Q1

(Y-o-y percent change)

Flows of Private Sector Credit, 2000Q4-2007Q1

(In percent of GDP, seasonally adjusted)

Structure of Liabilites, Jan99-Apr07

(In billions of Estonian kroons)
Figure 4.

The Baltics: Recent Developments, 2000-07

The Baltics: Stock Market, Jan03-Jun07

(January 1, 2003=100)

The Baltics: 3-month Interbank Offer Rate Spreads, Jan03-Jun07

(In basis points, versus the EURIBOR)

Sale periods of apartments and private houses

(in months)

Weighted average annual interest rate on housing loans

Confidence indicators, 2003-07

(seasonally adjusted)
Figure 5.

Estonia: External Debt Sustainability, Bounds Tests 1/

(External debt in percent of GDP)

Salient Features of the Staff’s Medium-Term Scenarios, 2001-12

Inflation and Maastricht Criterion, Dec1999-Dec2009

(Annualized average, in percent)