Republic of Estonia
Staff Report for the 2009 Article IV Consultation
Author: International Monetary Fund
Publication Date:
08 Jan 2010
eISBN:
9781451812589
Language:
English
Keywords:
ISCR; CR; debt; BoE balance-sheet data; Estonia; quarter; inflation rate; value; real GDP; short-term debt; foreign currency; debt restructuring; output gap; banking system
Download PDF (691.1 KB)

This 2009 Article IV Consultation highlights that the credit-fueled boom has resulted in a relatively large nonfinancial private sector debt stock in Estonia. With declining incomes, unemployment increasing sharply, and asset prices depressed, balance sheets of households and firms are under strain, weighing on domestic demand. Nonperforming loans have increased to more than 6 percent of total, and some banks are reporting losses. Executive Directors have supported the authorities’ aim toward speedy adoption of the euro, noting its effects in fostering stability and confidence.

Abstract

This 2009 Article IV Consultation highlights that the credit-fueled boom has resulted in a relatively large nonfinancial private sector debt stock in Estonia. With declining incomes, unemployment increasing sharply, and asset prices depressed, balance sheets of households and firms are under strain, weighing on domestic demand. Nonperforming loans have increased to more than 6 percent of total, and some banks are reporting losses. Executive Directors have supported the authorities’ aim toward speedy adoption of the euro, noting its effects in fostering stability and confidence.

I. Summary and Appraisal

1. Following a credit boom, the Estonian economy is now undergoing a severe recession, although a full-fledged crisis has been avoided. Sizable fiscal reserves and swift adjustment measures taken in 2008 and throughout 2009 prevented funding problems of the government and supported the currency board arrangement (CBA) at a time of regional stress. Banks’ capital and liquidity cushions, including from their Nordic parents, headed off liquidity problems. And relatively high reserve requirements and a proactive approach to contingency planning, including a precautionary swap arrangement with the Swedish central bank in support of Swedish banks operating in Estonia1, provided additional insurance and further boosted confidence. The non-bank private sector has also reacted quickly, with wage cuts and adjustments in employment, further enhanced by a new labor law.

2. As a result of present and past efforts, euro adoption in 2011 appears within reach. Following recent budget measures and assuming continued fiscal consolidation efforts, Estonia could meet all Maastricht criteria, while the policy record to date provides assurances for continued stability-oriented policies. This is remarkable, as it is being achieved against the background of severe dislocations due to the crisis. Joining the euro zone would remove residual currency and liquidity risks, adding stability to the Estonian economy.

3. The focus should now be on restoring economic stability and laying the foundations for more balanced growth. Euro adoption by itself is unlikely to trigger any major change in the pace of recovery, which staff—unlike the authorities—expects to be relatively protracted given high unemployment and debt burdens, necessary deleveraging by banks, and the need to fundamentally reorient the economy towards the tradable sector. Within the authorities’ export-oriented growth strategy, a slower than expected rebound among Estonia’s main trading partners represents a key risk to the outlook.

Putting Fiscal Policy on a Sustainable Path

4. Staff supports the authorities’ goal of meeting the 3 percent Maastricht deficit criterion. The benefits of euro adoption outweigh the mildly procyclical effects of fiscal tightening during the crisis. Given considerable macroeconomic and implementation risks, staff recommended additional structural measures of some 1 percentage point of GDP in the context of the 2010 budget. This would provide an adequate safety margin for 2010, offset one-off and potentially reversible measures, confront an anticipated shift in tax bases, and help achieve the targeted medium-term structural balance. Following staff’s visit, the authorities decided to further increase excise taxes by about ¼ percent of GDP.

5. While there is some room for further expenditure reductions, much of the adjustment effort may need to fall on the revenue side. The need to protect social safety nets limits the room for spending cuts. Tax administration could be further strengthened and, in keeping with Estonia’s streamlined tax system, poorly targeted exemptions eliminated. Significant deferral benefits in the corporate income tax could also be reviewed. Consideration could be given to enhanced use of environmental and property taxes, which would broaden the tax base and reduce economic distortions. A further increase of the VAT rate would support a shift from consumption to investment and exports.

6. A strengthened fiscal framework could limit the budget’s procyclicality. The annual balanced budget rule could be replaced by multi-year expenditure ceilings consistent with the existing goal to bring the budget to structural balance by 2012. Reduced revenue earmarking and tighter control over local government finances would also help in this regard.

Strengthening Competitiveness

7. The economy needs to regain competitiveness lost during the boom years. Labor and product markets seem capable of delivering the necessary adjustment. The recently enacted labor law provides a timely boost to flexibility, although the agreed-upon increase of unemployment compensation should be implemented as soon as fiscal space allows. Targeting EU-funded projects to the tradable sector and other supporting structural policies can also help to deliver the necessary rebalancing of the economy and spur economic convergence.

8. Seeking euro adoption at the current fixed exchange rate parity remains the best exchange rate policy for Estonia. The economy’s flexibility suggests that the moderate overvaluation identified by staff can be corrected through factor price adjustment alone. While theoretically offering some advantages, a repegging of the kroon at a more depreciated level would be unnecessarily disruptive, both for Estonia and the region.

Addressing Private Sector Debt

9. The large stock of debt by households and corporates is expected to weigh on growth, suggesting a focus on strengthening the credit enforcement and resolution framework. Debtors’ financial difficulties may have eased somewhat recently, thanks to low interest rates and banks’ willingness to reschedule a portion of debt payments. This relief is likely to be temporary, however, as price and wage deflation and increases in euro zone interest rates could result in higher debt servicing burdens. In dealing with private sector debt, heavy-handed policy intervention, such as retroactive limits on debtors’ liabilities, must be avoided. Appropriately designed credit enforcement legislation can facilitate the rehabilitation of viable and speedy exit of non-viable firms and help good faith debtors make a fresh start. In this spirit, the bankruptcy and reorganization acts could benefit from enhanced flexibility to accommodate on a case-by-case basis the need for debt reduction and institutional capacity could be strengthened. Changes to the corporate tax code would be desirable to discourage excessive debt accumulation at the firm level.

Safeguarding the Financial Sector

10. Though the financial sector has proven resilient, deteriorating credit quality and high private sector debt present challenges. Overdue loans are likely to increase further over the course of the year, amid limited near-term growth prospects, a depressed real estate market and rising unemployment. Moreover, some debt restructuring agreements may turn out to be unviable. This will necessitate banks setting aside additional provisions. High capital adequacy ratios should not detract from the need for continued supervisory vigilance.

11. Some recommendations of the last FSAP update still await implementation. In particular, pending legislation on a bank resolution framework should be passed. This would complement ongoing contingency planning for liquidity pressures. Complacency now would risk future problems being less tractable and thus undermine public confidence.

12. Estonia should remain on a standard 12-month consultation cycle.

II. The Crisis and Policy Responses

13. Following a period of severe overheating, the economy is contracting sharply (Figures 1 and 2). Investment already started to slow in mid-2007, along with a bursting of the property bubble, when the two main banks tightened lending conditions. The collapse of global external financing and foreign trade in the Lehman bankruptcy aftermath exacerbated the downturn. Output plummeted by almost 16 percent in the first nine months of 2009. Deflation and wage declines are projected to persist through 2010; the latter may temper the rise in unemployment, which nevertheless will likely reach 16 percent by the end of 2009. The current account should remain in a small surplus in the short term, but declining nominal GDP will worsen external debt and NIIP ratios in 2009. Staff expects the economy to resume growth only in the middle of 2010, with a negative output gap peaking at 8½ percent of GDP.

Figure 1.
Figure 1.

Estonia: The Boom, 2000-08

Citation: IMF Staff Country Reports 2010, 004; 10.5089/9781451812589.002.A001

Sources: Estonian Statistical Office; and Bank of Estonia.
Figure 2.
Figure 2.

Estonia: Effects of the Bust

Citation: IMF Staff Country Reports 2010, 004; 10.5089/9781451812589.002.A001

Sources: Eurostat; WEO; Bank of Estonia; Ministry of Finance; and Eurostat.

14. A full-fledged crisis has been avoided due to existing buffers and a determined response by both the public and the private sector. Sizable fiscal reserves accumulated during the boom years, a very low level of public debt, and, importantly, swift and far-reaching adjustment measures taken in 2008 and throughout 2009 have helped the government to keep the deficit in check and avoid financing problems. At the same time, the increased use of EU structural funds provided some countercyclical fiscal stimulus. In the financial sector, banks’ own capital and liquidity cushions—further boosted by relatively high reserve requirements—and support from Nordic parents prevented liquidity problems in spite of rising nonperforming loans. The private sector has also reacted flexibly, with wage cuts and adjustments in employment, further enhanced by a new labor law. As a result of these supporting policies, Estonia’s CBA has proven resilient to regional tensions: although local currency interest rates, CDS spreads and forward exchange rates increased (Figure 4), Eesti Pank did not experience a significant loss of reserves.

uA01fig01

GDP Growth, 2001-2010

(Percent)

Citation: IMF Staff Country Reports 2010, 004; 10.5089/9781451812589.002.A001

Source: WEO.

Implications of Fund Policy Advice

Relations between Estonia and the Fund remain excellent. While policy formulation and implementation has been characterized by a high degree of ownership—a key factor in Estonia’s economic successes—the authorities report that their decisions benefit considerably from Fund advice. Indeed, policies have been generally consistent with Executive Board recommendations. In 2007–08, however, large increases in current spending, which were contrary to Fund advice, resulted in a structural loosening of the fiscal stance. But recent corrective action, including expenditure reversals and increased indirect taxes (the latter despite initial reluctance) have been in line with staff suggestions. Most of the key recommendations of the 2009 FSAP update have been adopted, except implementation of a bank resolution framework.

III. Outlook and Risks

15. As the economy rebalances, a quick rebound to pre-crisis growth rates seems unlikely. Growth in recent years was unsustainably bolstered by a disproportionate rise in nontradable sectors (construction, financial intermediation, real estate), with negative implications for competitiveness. Adjusting the economy to a more sustainable growth pattern and correcting imbalances will take time and cause temporary dislocations, especially in the labor market. Moreover, the need to reestablish fiscal sustainability, and for the private sector to address the legacy of sizable debt stocks will likely reduce domestic demand for several years (Figure 3). Growth prospects will therefore be constrained, with staff estimates suggesting a slow-down of potential growth to 3–4 percent, compared with 6–7 percent before the crisis.

Figure 3.
Figure 3.

Estonia: Stock Legacies

Citation: IMF Staff Country Reports 2010, 004; 10.5089/9781451812589.002.A001

Source: Bank of Estonia; Eurostat; European Central Bank, Estonia Financial Services Authority; Courts Information System; and staff calculations.

Contributions to Growth, 2006-10

article image
Sources: Estonian Statistical Office; and staff calculations.

Includes changes in stocks.

uA01fig02

Growth and Output Gap

(Production Function Method)

Citation: IMF Staff Country Reports 2010, 004; 10.5089/9781451812589.002.A001

Source: Estonia Statistical Office; and IMF staff estimates.

16. Relatedly, inflation pressures are expected to remain subdued. Under staff’s central scenario, the current period of deflation will only be temporary, driven by the sudden drop of global energy prices in 2008–09 and the collapse of wages and consumption. Based on earlier precedent, recent price declines are not expected to present an obstacle to a positive assessment of the Maastricht inflation criterion, which should be formally met in late 2009. Staff projects inflation to resume in 2011 with the output gap closing and global commodity prices rebounding, but—due to depressed domestic demand growth—remain at 2–3 percent annually in the medium term. Price levels are close to 80 percent of the EU average (more than in most new member states), suggesting that a substantial degree of nominal convergence has already taken place.

uA01fig03

HICP Inflation and Maastricht Criterion

Citation: IMF Staff Country Reports 2010, 004; 10.5089/9781451812589.002.A001

Source: Haver; and IMF staff estimates.

Staff and authorities agreed that regional instability represents the main short-term risk. While Estonia has evaded financial contagion from neighboring Latvia to date, the difficult situation there could pose challenges to economic sentiment and banks’ liquidity. Such risks are mitigated by considerable liquidity buffers and the authorities’ determined contingency planning efforts. Moreover, the high share of external liabilities with foreign parents suggests that potential liquidity, and even solvency tensions can be resolved at a group level and rollover risks are considerably smaller than implied by standard measures of reserve coverage (Box 2). The authorities also pointed to their ambitions for speedy euro adoption, which would not only resolve residual currency and liquidity risks, but also differentiate Estonia from regional peers by confirming its strong policy record. By the same token, a postponement of euro adoption plans would likely lead to an increase of borrowing spreads, which have recently declined on the back of reduced regional tensions and growing anticipated supportive statements by public officials.

How Meaningful is the Ratio of Estonia’s External Short-Term Debt to Reserves for Vulnerability Analysis?

Estonia’s short-term external debt is large. At around 360 percent, Estonia’s ratio of short-term external debt (at remaining maturity) to international reserves is among the highest in Europe, which raises concerns about the potential emergence of liquidity problems. The short-term external debt is mostly owed by banks and private nonfinancial corporations.

Nevertheless, the country has faced little roll-over problems so far. Why?

  • Composition of the debt. Most of the short-term external debt is owed to parent companies, which reduces the likelihood that liquidity problems will be resolved in a disorderly manner. Furthermore, a non-trivial part of the debt is in the form of trade credits, which are usually backed by merchandise.

  • Buffers. Estonia’s private sector holds relatively large assets abroad. This is particularly important for banks, which keep half of their reserve requirements in liquid external assets (Estonia’s reserve requirements are set at 15 percent of banks’ total liabilities).

  • Policies. The Swedish authorities put in place liquidity facilities to support banks, including those active in the Baltics. This has benefited Estonia since its financial sector is primarily Swedish owned. Furthermore, the central banks of Sweden and Estonia concluded a precautionary agreement to compliment the high liquidity buffers of Swedish banks.

These factors are likely to continue playing an important role in the future, which would mitigate Estonia’s exposure to roll-over risks. Eventual euro adoption would further contribute to ameliorate these risks.

uA01fig04

Estonia: Deco mposing the Short-term External Debt

Citation: IMF Staff Country Reports 2010, 004; 10.5089/9781451812589.002.A001

Source: Ba nk of Estonia and staff estimates

17. Staff identified a number of medium-term risks to the outlook related to stock legacies from the boom years. The rapid fall of employment, wages and prices raise the risk of a deflationary spiral, especially given high nominal debt burdens. The need for deleveraging may curtail Nordic banks’ provision of fresh funding to their Estonian subsidiaries. Indeed, net inflows from parents have declined compared to previous years, although external liabilities remain large. Nonetheless, the adjustment that has already taken place in response to the crisis suggests that Estonia’s external debt burden should steadily decline (Table 7) and be robust to several shocks (Figure 6).

Table 1.

Estonia: Selected Macroeconomic and Social Indicators, 2007–10

(In units as indicated)

article image
Sources: Estonian authorities and IMF 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, 2001–101/

(Percent of GDP)

article image
Sources: Estonian authorities and IMF staff estimates and projections.

Cash basis.

Source: Estonia’s Statistical Office.

Table 3.

Estonia: Summary Balance of Payments, 2002-14

article image
Sources: Bank of Estonia and IMF staff estimates and projections.

Excluding interest payments and reinvested earnings.

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 its swedish parent

Includes 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.

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

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

Includes government guaranteed debt.

Table 4.

Estonia: Macroeconomic Framework, 2001–14

(Percent of GDP, unless otherwise indicated)

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

Includes government, private and nonpublic institutions serving households.

Includes private and public capital formation, changes in inventories, and statistical discrepancy.

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

Medium-term balances consistent with the authorities’ stated targets for cylically adjusted balances..

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

Table 5

Estonia: Indicators of External Vulnerability, 2005–09

(Percent of GDP, unless otherwise indicated)

article image
Sources: Estonian authorities, Bloomberg, Standard & Poor’s, and IMF 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 residents.

Tallinn stock exchange index (OMX Tallinn), 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. 2008 data refer to end period.

Table 6.

Estonia: Monetary Survey, 2003–10

(Millions of EEK, unless otherwise indicated)

article image
Source: Bank of Estonia and IMF staff estimates and projections.

Currency board cover is equivalent to base money (e.g., the sum of currency issued plus the kroon liabilities of the BOE in its correspondent accounts).