Republic of Estonia
Staff Report for the 2010 Article IV Consultation
Author: International Monetary Fund
Publication Date:
02 Feb 2011
eISBN:
9781455216611
Language:
English
Keywords:
ISCR; CR; Estonia; economy; Eurozone membership; core inflation; inflation risk; real GDP; current account; exchange rate; fiscal policy; banking sector; Global
Download PDF (1.1 MB)

Despite enduring one of the sharpest contractions in the EU, Estonia has been successful in its all-out efforts to join the euro area. Core prices have also begun increasing but at a moderate rate. Recent wage increases have defied not only high unemployment but also increases in vacancies and long-term unemployment. Executive Directors welcomed the authorities’ medium-term goal of returning to budget surpluses to restore fiscal reserves and keep public debt at low levels. Directors observed that the financial sector had weathered the crisis relatively well.

Abstract

Despite enduring one of the sharpest contractions in the EU, Estonia has been successful in its all-out efforts to join the euro area. Core prices have also begun increasing but at a moderate rate. Recent wage increases have defied not only high unemployment but also increases in vacancies and long-term unemployment. Executive Directors welcomed the authorities’ medium-term goal of returning to budget surpluses to restore fiscal reserves and keep public debt at low levels. Directors observed that the financial sector had weathered the crisis relatively well.

I. Context1

1. Despite enduring one of the sharpest contractions in the EU, Estonia has been successful in its all-out efforts to join the euro area. The authorities have resolutely persevered with policies based on satisfying the Maastricht criteria, which entailed a fiscal adjustment of about 9 percent of GDP in 2009. The 2010 fiscal deficit was only some 1 percent of GDP and thus Estonia has earned the distinction of being the only EU country aside from Sweden to keep their fiscal deficit below the Maastricht limit.

2. Driven by external demand, economic growth has strengthened in 2010 (Figure 1). Annual growth resumed in the second quarter with rising exports of intermediate inputs and capital goods and briskly paced increases in manufacturing activity. Exports have continued growing in the third quarter and approached pre-crisis levels. Mirroring export orders and Estonia’s integration in the international production chain, stock building—associated not with increases in retail goods but with increases in imported intermediate inputs—has surged and provided a sizable contribution to growth (but has lowered the measured net export contribution). Gross capital formation and private consumption have remained subdued. The latter reflects weak labor markets and household balance sheets, partly due to an earlier credit boom.2

Figure 1.
Figure 1.

Estonia: The Nascent Economic Rebound, 2007-10

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Source: Haver1/ Percent balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
uA01fig01

Contributions to GDP Growth and GDP Growth

(YoY, percent)

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

uA01fig02

Inventory Changes

(Billions of Kroon) 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Statistics Estonia; Haver; and IMF staff calculations.1/ Finished goods contain goods for resales and finished goods; Intermediate goods consists of materials and supplies and work-in-process.

Contributions to Growth, 2007-11

article image
Sources: Statistics Estonia; and IMF staff calculations.

Includes changes in stocks.

3. Inflation has picked up and recently, defying double-digit unemployment, so have wages. Prices have surprised on the upside reflecting global food and fuel price developments, which have a disproportionately large impact in Estonia (Annex I), but also reflecting adjustments in administered prices that resulted in a 1½ percentage-points boost to inflation in 2010. Core prices have begun increasing at a moderate pace reflecting rising service prices but, after having declined in 2009, their rebounds have exceeded those in neighboring economies (Figure 2). Wages have surprised on the upside and increased by about 1 percent (year-on-year) in the second and third quarters of 2010. This has broadly reflected the strength in manufacturing and traded goods sectors, and has occurred despite high unemployment; the latter has declined from almost 20 percent in the first quarter to 15½ percent in the third quarter of 2010. Still, long-term unemployment has increased—possibly associated with an increase in structural unemployment adversely impacting long-run growth—with rising vacancies (Figure 3). These developments point to the difficulties mismatched skills pose to resource reallocation in an otherwise flexible labor market. Regardless, business sector profitability has improved smartly.

Figure 2.
Figure 2.

Estonia: Recent Price Development, 2009-10 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Source: Eurostat.1/Core is defined as HICP excluding energy, food, alcohol and tabacco.2/ Data on UK are from Dec. 2009-Sep. 2010.
Figure 3.
Figure 3.

Estonia: Legacies of the Bust

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Eurostat; and Bank of Estonia.
uA01fig03

HICP Inflation

(YoY Percent changes)

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

uA01fig04

Core Inflation and Component Contributions

(Percent, Dec. 2009 to Oct. 2010)1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

uA01fig05

Vacancy Rates

(Percent) 2/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

uA01fig06

Net Sales, Personnel Expenditures and Total Profit of Business Sector, 2007-10

(2005 = 100)

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Haver; Statistics Estonia; and IMF staff calculations.1/ Core is defined as HICP excluding energy, food, alcohol and tobacco.2/ the vacancy rate measures the proportion of total vacant posts expressed as a percentage of occupied and vacant posts.

4. Credit provided by the mostly Nordic-owned banking sector has declined. The domestic loan stock has declined by 10 percent since end-2008. Banks tightened credit conditions in 2007 and some firms have turned to external borrowing attracted by lower pricing. Still, survey information and falling interest rates on new loans do not suggest loan supply constraints. Indeed, recently there have been incipient signs of an easing in lending conditions, while a continuing wide distribution of lending premia suggest a desirable discrimination between varying quality risks.

uA01fig07

Factors Influencing Corporate Investment 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Source: European Commission.1/ The balance represents the net balance reporting factor x to be very stimulating, stimulating, limiting and very limiting.

5. Demand factors are likely to be the main driver of weak credit. An increase in private sector debt ratios since 2008 has reflected income declines that have, so far, outpaced deleveraging. Given weak labor markets and house prices that, despite a gradually recovery, have remained about 40 percent below their peak, households and real estate and construction companies appear to be burdened by legacy loans of the earlier credit boom.

uA01fig08

Household Loans 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Statistics Estonia; and Haver.1/ Dots indicate loans in percent of GDP (LHS); and bars indicate the loan stock in billions of Kroons (RHS).

6. Strict expenditure control and one-off revenues explain the better-than-expected fiscal outcome in 2010. The fiscal deficit is projected to have fallen to about 1 percent of GDP (ESA-95), or about 1¼ percent of GDP lower than anticipated in the 2010 budget. Central government spending has been kept close to budget levels even as general elections near. Revenues have been bolstered by one-off sale of CO2 emission rights (about 1 percent of GDP) and, to a lesser extent, by the ongoing recovery. Gross debt will decline to about 7 percent of GDP—remaining the lowest in the EU—and Estonia will continue holding a net external asset position in 2010.

7. Estonia’s external adjustment has continued with some gains in competitiveness. The reversal of the current account balance from a deficit in 2008 to a surplus in the third quarter of 2010 has mainly reflected a marked improvement in the trade balance (Table 3 and Figure 4). Following a sharp contraction in exports and imports in 2009, the former have increased in line with Nordic trading partners’ activity in the first three quarters of 2010 but the latter rebounded less sharply. Competitiveness has improved recently partly driven by cyclical factors (Box 1). The financial account has recorded a sizable deficit reflecting largely banking sector flows abroad, associated with domestic deleveraging and reserve requirement harmonization with the euro area. These funds have reduced liabilities to parent banks and increased liquid foreign assets. As a result, gross external debt declined to 118 percent of GDP at end-September 2010.

Table 1.

Estonia: Selected Macroeconomic and Social Indicators, 2007–12

(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, 2001–12 1/

(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, 2002-12

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 owner.

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.

Figure 4.
Figure 4.

Estonia: External Developments, 2001-10

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Haver; Estonia Statistical Office; and IMF staff calculations.1/ Other is defined as the sum of financial derivatives, other investments, and errors and omissions.

Estonia’s Competitiveness Developments

While competitiveness appears to have improved, mixed signals have continued from standard CGER methods. Taken at face value, current account-based methods suggest that Estonia’s real exchange rate is undervalued by around 2 and 4 percent. Caution should be exerted in interpreting these indicators given cyclical developments as these may reflect the large cyclical decline in imports rather than undervaluation. In contrast, direct assessments of the real exchange rate still suggest that the real exchange rate is overvalued. Regardless, compared to 2009 Article IV consultation assessment these results suggest a small improvement in competitiveness.

REER Overvaluation

article image
Source: IMF staff calculations.

Price- and cost-based indicators broadly support a gradual positive trend in competitiveness. Various measures of REER have declined since 2009. The REER deflated by unit labor costs in the manufacturing or by the export deflator has shown further gains in competitiveness in the second quarter of 2010. In addition, the declines are less pronounced for REER measures that place less weight on the traded sector. These differences may reflect the fact that measures placing less weight on the traded sector may also reflect the previous construction boom as well as Balassa-Samuelson effects.

Regardless, Estonia’s export market share remained broadly stable pointing to gains in non-price competitiveness. Despite the measured appreciation of the REER and weakness in trading partners during the crisis, EU export market shares have remained stable. Improvements in non-price competitiveness may have been associated with large foreign direct investment (FDI) inflows. FDI may have provided access to technology and foreign markets with vertical integration contributing to its external performance. Also, Estonia has been gradually moving up the technology and quality ladder relative to its competitors and it scores broadly well in terms of the quality of human and physical infrastructure and the business environment relative to the EU (Annex II).

Boosting Estonia’s Competitiveness Remains a Challege (Concluded)

uA01fig09
Sources: EU Commission; Eurostat; and Direction of Trade.

II. Outlook

8. Growth is poised to strengthen and remain export-driven in 2011. Growth is projected to increase from 2½ percent in 2010 to 3½ percent in 2011. Exports are expected to continue boosting economic activity mirroring the strength in Estonia’s main trading partners. Still, high household debt as well as slow progress in reducing unemployment will burden final domestic demand, which is expected to remain sluggish. Relatedly, credit growth is also projected to remain low.

9. Inflation is envisaged to persist in 2011. Price increases are projected to rise from about 2¾ percent in 2010 to about 4 percent in 2011. While the impact of administered price increases will wane, the full-year impact of food and fuel prices will be felt. In light of price and wage developments, inflation projections remain subject to large uncertainty but, on balance, core inflation should remain subdued throughout 2011 and increase on average primarily reflecting base effects of the disinflation in early-2010.

10. Positive surprises to the outlook are possible, but downside risks appear more prevalent at end-2010. Faster growth is feasible if trading partners’ activity proves lasting but this could pose sectoral wage pressures associated with labor market constraints. Also, euro adoption could afford a one-time impetus as residual exchange rate risk vanishes and the risk of adverse regional spillovers recedes. But the risk of slower growth—including from renewed uncertainty in global financial and sovereign markets and the tail risk of global double-dip recession—has increased. Besides direct trade-related effects, a faltering recovery or if unemployment otherwise becomes entrenched could result in new nonperforming loans (NPLs) weighing on bank’s willingness to lend. Renewed banking sector shocks, including through parent banks, could also pose risks to domestic financial intermediation.

11. The authorities concurred that growth prospects have improved even as risks have risen. They noted that economic activity remained dependent on trading partners’ growth and expressed some concern about the sustainability of the latter. Still, the authorities were more sanguine regarding private investment prospects as, despite the anticipated overall continued economic slack, capacity constraints in export-oriented sectors may trigger investment. But rising inflation may limit increases in real household incomes and constrain real consumption. Regarding inflation, they noted that while Estonia’s consumption patterns made it more sensitive to food and energy price shocks, increases in some individual prices were unusually large and could reflect inadequate competition. In this connection, legal investigations have been opened. Core inflation was, nonetheless, expected to remain subdued in 2011. They also considered wage increases to be somewhat surprising, but may, in addition to mismatch skills, represent a measurement problem as workers with lower skills and compensation levels were disproportionately laid off as unemployment increased sharply in late-2009 and early-2010. The authorities broadly considered that credit availability was adequate.

III. Policy Challenges

12. Against this backdrop, Estonia faces the challenge of remaining on a sustainable growth path that will lead to steady income convergence while fully employing its resources. The authorities’ policies have largely been in line with Fund Advice (Box 2) but conjunctural circumstances and longer-term challenges warrant continued attention. In this regard, the consultation focused on three key areas.

Implications of Fund Advice

Relations between Estonia and the Fund have remained excellent. Policies have been characterized by a high degree of ownership—a key factor in Estonia’s economic success—and these have been generally consistent with Executive Board recommendations. But large increases in current spending resulted in an ill-timed loosening of the fiscal stance in the boom years. Since then, corrective actions, including expenditure reversals and increased indirect taxation, have been in line with Fund advice. Most of the key recommendations of the 2009 FSSA update have been adopted (Annex III).

A. Safeguarding Fiscal Consolidation and Counter-Cyclical Policy

13. Despite the upcoming elections, the 2011 budget envisages only a small increase in the fiscal deficit, thereby continuing Estonia’s prudent macroeconomic policies. The deficit is targeted to reach about 1¼ percent of GDP (ESA 95 basis)—an increase of about ¼ percent of GDP—largely reflecting the expiration of a number of one-off revenue factors as well as the restitution of contributions to the second pillar. The budget envisages spending to increase primarily to support education and investment, with personnel expenditures to be held at 2010 levels. On the revenue side, aside from a 10 percent hike in tobacco excises, no major tax measures have been introduced and thus total revenues—in the absence of one-time revenues—will decline by about 1¼ percentage points of GDP.

Fiscal Balance and One-off Measures

(Percent of GDP)

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

Estonia: Selected Fiscal Indicators, 2007-11

(Percent of GDP)

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

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

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

14. Achieving the budget target has particular importance for the euro area’s newest member. The authorities argued that, besides keeping the deficit comfortably below the Maastricht limit, sticking to the budget would reaffirm Estonia’s preference for fiscal rectitude even without the incentive of euro adoption. While supporting the target, staff noted that should downside risks emerge, the authorities are advised to allow automatic stabilizers to operate up to the Maastricht limit. Likewise, strict adherence to the budget’s spending limits will be essential to avoid pro-cyclical policy if revenue collections exceed projections.

15. Looking forward, the authorities foresee restoring a balanced budget by 2014 under current policies. Although conservative given Estonia’s net public asset position, this would nevertheless help safeguard fiscal buffers, that are critical for mitigating the impact of volatility, including in the context of ongoing global and regional financial uncertainty, and which proved critical in weathering the global financial crisis of 2008–09. While broadly feasible under current policies with some one-off measures set to expire (including investments obligations associated with CO2 emission rights sales), meeting the target will entail holding operational expenditures unchanged in real terms. This will imply reducing expenditures by about 3 percent of GDP and thus bringing Estonia’s public spending closer to its pre-crisis level (Figure 5). Expenditure pressures are bound to emerge in light of the 2009 cuts (about 5½ percent of GDP), limited social benefits, and improving economic conditions. If offsetting measures are necessary, given the expenditure compression built into current policies, these should focus on the revenue side with a view of minimizing tax distortions and supporting resource reallocation. Specifically, these could include broadening tax bases, increasing the VAT rate to narrow differences with neighboring countries, making greater use of property taxation, and boosting environmental taxes. In addition, as consolidation progresses, the authorities’ long-run target to gradually reduce overall labor taxes can be considered. This focus, however, should not hinder further efforts to improve expenditure efficiency.

Figure 5.
Figure 5.

Estonia: Fiscal Developments and Structure

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Haver; Erostat; and OECD.

16. Enhancing Estonia’s medium-term budgetary framework (MTBF) could help maintain fiscal sustainability and avert pro-cyclical policies. Such a framework could include a target for the cyclically-adjusted overall balance and binding medium-term spending ceilings (Annex IV). Its success in Estonia will hinge on the dual requirements of simplicity and transparency needed to facilitate communication, verification, and accountability. To enhance its credibility and facilitate monitoring, spending limits should exclude those of a cyclical nature (such as unemployment benefits) and relatively unpredictable EU structural-fund related spending. In addition there will be a need to address the high proportion of earmarked spending—complicating expenditure control—and ensure that the MTBF operates effectively at the general government level. Regarding the latter, the recently passed “Act of Financial Management of Local Municipalities,” which controls local government balances, is a step in this direction. Regardless, Estonia’s strong fiscal position imparts a distinct advantage because it needs a comparably small medium-term adjustment. On the other hand, large swings in its economic structure and activity amid real convergence may obscure cyclical developments.

17. The authorities stressed that conservative fiscal policies would remain the hallmark of Estonia’s economic approach. Tight fiscal policy has served Estonia well and underpinned the success of its currency board arrangement. They stressed that prudent fiscal policy was motivated not by euro adoption—a welcome bonus—but by needed fiscal prudence to support the currency board. Although this need had now passed, with euro accession, the authorities pointed to the 2011 budget that, despite upcoming elections, will exert a tight rein on spending while protecting social spending. In this regard, they highlighted the importance of restoring pillar II pension fund contributions and expressed their intention of continuing to do so.

18. They insisted that restoring a fiscal balance or better in the medium-term would continue guiding fiscal policy, despite euro adoption and low public debt levels. The authorities recognized, nonetheless, that spending pressures could emerge but expressed confidence that continued expenditure efficiency gains would keep fiscal consolidation on track. Moreover, their medium-term goal would maintain fiscal sustainability and ensure that fiscal buffers would be rebuilt to pre-crisis levels. In this connection, while the authorities re-iterated their desire to reduce labor taxation they stated that this would have to be accommodated within their medium-term objectives. They recognized that a MTBF could help avoid pro-cyclical policies and envisaged its implementation to be coordinated with revisions to the Stability and Growth Pact currently under discussion.

B. Financing the Recovery While Maintaining Resilience

19. Estonian banks have so far managed to successfully navigate the crisis (Figure 6). Cumulative loan loss provisions amounted to about 5 percent of assets in mid-2010. A gradual credit tightening, ahead of the global crisis, declining interest rates and rescheduling of loan obligations (about 2 percent of mortgages) have helped contain increases in NPLs (Box 3). Local banks have also held on to properties from defaulting borrowers, thus helping to stabilize the property market. At the same time, banks have maintained high capitalization rates with the core tier 1 ratio close to 12 percent, supported by earlier capital transfers and reductions in assets. Stress tests by the Estonian supervisors reflecting a scenario with sluggish growth and more stringent tests by the parent authorities indicate resilience to cope with renewed credit risk. The authorities in parent banks countries have nonetheless kept in place extensive debt guarantee and financial recapitalization packages introduced during the financial crisis.

Figure 6.
Figure 6.

Estonia: Financial Sector Developments

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Bank of Estonia; Eurostat; European Central Bank, Estonian Financial Supervision Authority; Courts Information System; and IMF staff calculations.1/ For 2010, cumulative profits up to Septemeber 2010 are shown.2/ There is only one bar for each of the Baltics because the latest is the trough. The peak differs across countries: 2008Q3 in Estonia and Latvia; 2008Q4 in Lithuania; 2009Q1 in Hungary and Romania; 2008Q3in Czech Rep. and 2009Q4 for Poland and Bulgaria.3/ Ratios are measured by Price per square meter divided by gross wages.
uA01fig10

Cumulative Gross Banking Sector Losses

(Percent of total assets) 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Oct 2010 GFSR; Haver; and Riksbank.1/ The data for Sweden refer to netloan losses. Losses for other countries are up to 2010 Q2.

20. But banks remain vulnerable to shocks. Even though NPLs have been low, they are high by international comparison. Also, about half of NPL mortgages remain in negative equity, household indebtedness is high, and property markets remain weak and illiquid. New NPLs could emerge if unemployment fails to subside or if lending rates are pushed up by sudden increases in European interbank interest rates. Local banks are also exposed to adverse spillovers effects through parent banks, including a rapid correction of asset prices in home countries or disruptions in international funding markets.

uA01fig11

NPL Mortgages by Loan-to-Value

(Percent) 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Source: Estonian Financial Supervision Authority.1/ Based on survey estimates. The red bars show the proportion of non-performing mortgages in negative equity, e.g. 47 percent in 2010 Q2.
uA01fig12

Unemployment and NPLs

(Percent) 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Eurostat; and IMF staff calculations.1/NPL rate is defined as loans overdue by more than 60 days divided by total outstanding loans.

Why Are NPLs Lower in Estonia Than in Other Baltic Countries?

As elsewhere in the Baltics, the recession in Estonia was severe. Baltic countries could not avoid a credit boom-bust cycle despite attempts to slow credit via restrictive prudential and monetary measures. Yet, Estonia’s NPLs increased to only about 7 percent in the second quarter of 2010, or roughly half those in Lithuania and Latvia. A few factors are at play.

  • Definitional differences. In Estonia, loans are classified as non-performing when they are past 60 days due and, unlike Lithuania, do not include all impaired loans. The latter would increase NPLs (comparable to those in Lithuania) to around 10 percent.

  • Larger presence of foreign-owned banks. These banks reported lower NPLs and accounted for 95 percent of lending in Estonia, compared to 88 (70) percent in Lithuania (Latvia). Foreign subsidiaries were able to benefit from parent-bank liquidity support and liquidity provision in home countries, but domestic banks were more exposed to higher local refinancing costs reflecting increased country and currency risk. In addition, the composition of assets may have also differed. In Lithuania, domestically-owned banks have been more exposed to corporate and consumer credit, both of which experienced higher levels of distress.3 Finally, risk management in some domestic banks may have been weaker than in foreign banks. In Latvia, the second largest bank (domestically owned) was subject to risk management failures and taken over by the government in late 2008. In Lithuania (Latvia), NPLs reached an estimated 18.8 (14.8) percent of loans in the foreign-owned banks compared to 29 (20) percent in other banks in the first quarter of 2010.4

  • Euro adoption. Estonia’s near-term euro adoption prospect encouraged a rapid convergence of interest rates to euro area levels lowering debt servicing. With Latvia and Lithuania facing considerable fiscal challenges, risk spreads in these countries have remained higher.

uA01fig13

Output Declines and NPLs

(Percent) 1/

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Oct. 2010 WEO; Country authorities; and IMF staff calculations.1/ Output declines are the 2008-09 cumulative percent changes; NPLs in both Lithuania and Estonia are defined as loans 60 days overdue, in Latvia as 90 days overdue.

21. Euro area membership can help counterbalance liquidity risks. The reduction in reserve requirements to euro area levels could reduce the banking system’s liquidity buffers and increase liquidity risks. Indeed, preparations by the authorities’ and commercial banks’ to implement the necessary liquidity and collateral management systems and procedures for accessing the Eurosystem’s liquidity facilities are well advanced. This is of particular significance as Nordic parent banks continue to rely heavily on wholesale funding and their (home country) public guarantees may be phased out in 2011.

uA01fig14

Loan to Deposit Ratios of Global Banks, 2010 1/

(percent)

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Bankscope; and the Riksbank.1/ For Santander and Paribas, data are as of end of last year; Green bars indicate Nordic parent banks in Estonia.

22. The banking sector will be shaped by forthcoming legal and regulatory changes at home and abroad aiming to strengthen financial stability and address debt overhang. In this connection, vigilance will be needed so that anticipated changes do not, via pressures on profitability, have undesirable side-effects such as increased risk taking and regulatory arbitrage. Changes to liquidity regulations under Basel 3 are expected to affect Nordic banks the most as they will be required to address their large funding mismatches.5 Banks are also expected to maintain their high ratios of capitalization. In addition, some home authorities are imposing bank levies on parent banks while in Estonia contributions to the deposit guarantee scheme (DGS) are set to nearly double to an annualized 0.18 percent in second quarter of 2011. Also, changes to the insolvency framework such as Estonia’s new household debt restructuring law and the shortening of the bankcruptcy period from 5 years to between 3 and 5 years, can help address debt overhang but could pose risks to credit growth (Box 4).

23. While crisis management preparedness has progressed, bank resolution powers have remained limited and need strengthening. Supervisors’ early intervention powers appear extensive (e.g. to replace management, curtail dividend payments, or impose higher prudential ratios). Estonia’s bank resolution tool kit, however, is restricted to imposing insolvency, a moratorium suspending bank’s activities, and, nationalization following recently approved legislation. The latter also has enhanced crisis-related on-site supervision powers and has aligned the DGS with changes in EU directives.6 Still, weaknesses in resolution powers remain as legal protection of resolution authorities is limited, courts can override their decisions, and breaking up the balance sheet of a distressed bank can be conducted only with the consent of shareholders. Also, deposits cannot be transferred to another bank nor can the deposit guarantee fund be used in crisis resolution.

24. The cross-border crisis cooperation framework has advanced but further progress is essential. The 2010 Nordic-Baltic Memorandum of Understanding (MOU) provides a broad overview of criteria used to establish ex-post sharing of crisis costs.7 In this connection, all authorities commit to identifying obstacles and solutions for coordinated decision making and bank resolution, establishing effective communication procedures and continuing the work on detailing burden sharing criteria. Still, the MOU is not binding and the implementation of crisis preparedness measures remains at an early stage.

Estonia’s Household Debt Restructuring Law

In the wake of the global financial crisis and property market busts, a number of countries have introduced household debt restructuring schemes, (the Czech Republic, 2008), in some cases also involving fiscal incentives (the UK Homeowners Support Mortgage Scheme, 2009). In the same vein, Estonia has also introduced a law—coming into force in April 2011—aimed at facilitating restructuring of debt obligations of natural persons (including entrepreneurs) facing payment difficulties. The law foresees a case-by-case restructuring of all liabilities and does not envisage the use of public funds. Borrowers facing debt payment difficulties can avoid formal bankruptcy by petitioning for restructuring. This entails submitting a restructuring plan to creditors outlining the proposed adjustments (such as extension of maturities or a reduction in claims) to restore solvency. While the law encourages out-of-court settlement, its procedures rely heavily on court input. All secured claims (equivalent to the value of collateral) may be restructured only with consent of secured creditors. For unsecured debts, however, the court has the power to override creditors’ decisions. In all cases, the courts are tasked with supervising the implementation of restructuring plans that may be challenging as Estonia ranks behind its peers in terms of contract enforcement. In this connection, Estonia’s experience with the recently introduced restructuring law for legal persons could provide useful lessons. Specifically, there is evidence of delays in courts’ processing petitions perhaps due to the considerable court input under the law and many judges’ limited specialized financial background. Specialization in insolvency matters has occurred only in larger courts. Debtors may also be reluctant to file for restructuring (and also bankruptcy) possibly due to a number of factors, including high advisory fees, or other costs.

25. The authorities agreed with the need for continued close vigilance and the overall assessment of financial sector strengths and risks. While capital and liquidity buffers of Estonian banks were elevated, they stressed that domestic supervisory scrutiny has been maintained, including by using stress tests to determine the adequacy of capitalization. The authorities saw risks to local subsidiaries mainly stemming from spillovers from shocks to parent banks. In this regard, the authorities underscored the considerable progress made in improving crisis preparedness over the past couple of years. While noting that bank resolution powers were constitutionally constrained, they explained that resolution tools would be expanded further in line with EU decisions and would be mindful of responsibilities vis-à-vis home jurisdictions given the importance of foreign bank ownership. The authorities saw particular merit in using the relatively well pre-funded deposit guarantee scheme in the EU context for bank resolution. But they were more guarded about establishing an additional resolution fund. Regarding the household debt restructuring law, they noted that it was better balanced than initially feared and underscored that the key will lie in its court implementation. Developments would be followed closely to ensure that it not undermine the rule of law nor financial intermediation.

C. Restoring Competitiveness and Fully Deploying Potential Resources

Enhancing external competitiveness will be critical for Estonia’s sustainable growth. Wage increases outstripped productivity gains during the boom that, besides eroding competitiveness, resulted in lopsided expansion of the nontraded goods sector, particularly construction. Sustainable growth however will require rebalancing the economy towards exports as well as continuing to climb up the technology and quality ladder and diversifying export’s destination (Annex II). The initiative to create an environment conducive to foreign direct investment in industries with export potential and high value added represents a welcome step in this direction and can potentially provide access to technology and markets through vertical and horizontal integration. Likewise, the program to improve access to financing to boost investment in these strategic areas can help develop high-value added exports.

uA01fig15

Productivity and Real Labor Compensation

(2000 = 100)

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: Statistics Estonia; and IMF staff calculations.
uA01fig16

Unemployment Rates by Age

(Percent)

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

26. Continued human capital development will support full resource use and income convergence. Addressing skill mismatches through continued progress in enhancing the education system will be essential. In this regard, the authorities have implemented a number of measures focusing on training and education of unemployed workers and introduced a voucher program to help youth complete their tertiary studies. Intensive use of EU-structural funds has improved vocational, unemployment, and in-job training programs. In this regard, exploring synergies among these programs as well as potential efficiency gains and continued focus on life-long learning and language training, in additional to infrastructure development, may further enhance the effectiveness of the education system to support the economy’s needs and bolster labor mobility, including geographically. Needed enhancements in infrastructure will also require continued use of EU structural funds.

27. The authorities underscored their continued commitment to enhance competitiveness and lower unemployment. They stressed that a stable macroeconomic environment and a business friendly climate were central to establish the preconditions needed to support the modernizing of the private sector’s production base supporting Estonia’s world class ICT and enhancing its lagging transportation system. In this regard, the Estonia 2020 Competitiveness Strategy has established two key quantitative targets: increasing the employment rate of working-age individuals by about 15 percentage points to 76 percent, with a similar increase in productivity per worker to bring it to 80 percent of the EU average. This will require attracting investment, including that associated with euro adoption, and continued efforts to enhance cross-border infrastructure, address rigidities in ALMP, and exploit synergies among various programs with a view of enhancing the effectiveness of the educational system.

IV. Staff Appraisal

28. Having successfully adopted the euro, Estonia now faces the challenge of ensuring that its export-led recovery remains sustainable. Euro membership represents the culmination of 18 years of a fundamentally sound currency board arrangement supported by a strong commitment to fiscal rectitude. In 2011, Estonia will see a strengthening recovery with core inflation likely remaining subdued. Recent wage increases have coincided with rising profitability but these increases warrant close monitoring as unemployment lingers and price and cost competiveness, while improving, have remained below pre-crisis levels.

29. Consistent with this challenge, the 2011 budget keeps a tight rein on expenditures. Sticking to the 2011 general government expenditure ceilings will reaffirm the authorities’ commitment to prudent macroeconomic management, and further enhance credibility as the euro area’s newest member. Still, if downside risks materialize low public debt and fiscal buffers provide space for automatic stabilizers to operate up to the Maastricht limit. Should revenues surprise on the upside, strict adherence to spending limits will be used to avert pro-cyclical fiscal policy.

30. Looking forward, the authorities’ medium-term goal of restoring a balanced budget maintains a conservative fiscal stance. Besides being consistent with EU obligations and preserving low debt levels, this goal would safeguard fiscal buffers needed to bolster the economy’s resilience. A balanced budget can be broadly achieved under current policies foreseeing unchanged operational expenditures in real terms and thus implying expenditure compression as a share of GDP. Still, demands to boost spending are bound to emerge and, if offsetting measures are necessary, given the expenditure compression in current policies, these should focus largely on the revenue side. But this should not detract from continuing efforts to improve expenditure efficiency nor impair education and investment spending.

31. A full-fledged medium-term budgetary fiscal framework could usefully support Estonia’s consolidation efforts and avert pro-cyclical fiscal policy. Such a framework by including binding multi-year expenditure ceilings can help avoid procyclical policy. Estonia’s strong fiscal tradition and its relatively small adjustment needs impart a distinct advantage in operating such a framework even though difficulties may arise in identifying cyclical developments, particularly during the income convergence process.

32. The challenge for the financial sector entails preserving stability in light of legacy risks from the earlier credit boom, elevated global financial tensions and forthcoming legal and regulatory changes. Joining the euro system will lessen financial sector risks. But continued ongoing vigilance will nevertheless be required so that all banks are prepared to access the eurosystem’s liquidity facilities and that their contingency liquidity plans remain effective. Also, there will be a need to ensure that provisioning and capitalisation remain ample to cope with potential risks. In the coming years, prompt use of prudential measures should help quell undue risk-taking activities and regulatory arbitrage that may result from changes in the regulatory and legal environment. Estonia’s new household debt restructuring law can help address debt overhang but it will be essential that its implementation not undermine financial intermediation nor harm confidence in a rules-based system. In due time, a broad review of the insolvency framework should be undertaken.

33. The high integration with Nordic financial systems underscores the need for continued efforts to develop effective cross-border and national crisis management and resolution mechanisms. In close collaboration with home authorities of parent banks, there is a need to further strengthen the authorities’ resolution powers and expand available tools. The 2010 Nordic-Baltic MOU on crisis management—a pioneering step in cross-border cooperation—provides an ideal framework for doing so. Joint work should focus on further developing the ex-ante criteria for crisis-related burden sharing. In this context of cross-border cooperation, consideration could also be given to a pre-financed crisis resolution fund.

34. More broadly, sustainable growth entails fully harnessing Estonia’s resources, as well as continuing improvements in productivity and competitiveness. Besides safeguarding Estonia’s stable macroeconomic and business-friendly environment, supported by flexible labor markets, long-term growth will entail reallocating resources to the tradable sector. The authorities’ “Estonia 2020” competitiveness strategy highlights many of these issues. These programs should be implemented promptly and complemented by exploiting synergies and potential efficiency gains among various education and training programs. Also, boosting productivity and competitiveness will require continued use of EU structural funds in support of life-long learning to enhance human capital development and needed infrastructure improvement, increase labor mobility and establish a solid foundation for rising living standards.

35. It is recommended that the next Article IV consultation with Estonia be held on the standard 12-month cycle.

Figure 7.
Figure 7.

Estonia: External Debt Sustainability: Bound Tests 1/2/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2011, 034; 10.5089/9781455216611.002.A001

Sources: International Monetary Fund, Country desk data; and IMF staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. 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/ Large projected declines in 2010-11 reflect in part the expected impact of reserve requirement harmonization associated with euro adoption.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current accountbalance.4/ One-time real depreciation of 30 percent occurs in 2010.
Table 4.

Estonia: Macroeconomic Framework, 2005–15

(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.

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