Republic of Estonia; Staff Report for the 2011 Article IV Consultation
Author:
International Monetary Fund
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Publication Date:
29 Nov 2011
eISBN:
9781463925895
Language:
English
Keywords:
ISCR; CR; Estonia; government balance sheet; euro; financing; interest rate; money market; market share; output gap; banking sector
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The staff report for the 2011 Article IV Consultation concluded that a vibrant recovery marked Estonia’s first year in the euro area, albeit amid nascent tensions. The economy’s strong rebound has been grounded in a proven track record of prudent macroeconomic policies. Executive Directors endorsed that Estonia faces an increasingly challenging environment as it looks to continue implementing policies preserving macroeconomic policy credibility and safeguarding sustainable growth. They also stated that, for the financial sector, the challenge entails safeguarding stability in the context of heightened global financial tension.

Abstract

The staff report for the 2011 Article IV Consultation concluded that a vibrant recovery marked Estonia’s first year in the euro area, albeit amid nascent tensions. The economy’s strong rebound has been grounded in a proven track record of prudent macroeconomic policies. Executive Directors endorsed that Estonia faces an increasingly challenging environment as it looks to continue implementing policies preserving macroeconomic policy credibility and safeguarding sustainable growth. They also stated that, for the financial sector, the challenge entails safeguarding stability in the context of heightened global financial tension.

CONTEXT

1. A vibrant recovery has marked Estonia’s first year in the euro area, albeit with nascent tensions. A proven track record of prudent macroeconomic policies—underpinning successful euro adoption and a recent credit rating upgrade—has provided a firm grounding for the strong rebound. Still coming on the heels of one of the EU’s deepest economic contractions, the recovery has exposed underlying difficulties. Price pressures have emerged (albeit still mainly imported) and overall unemployment, while declining, remains high with long-term joblessness on the rise.

2. Estonia’s growth has been among the highest in the EU in 2011. Following a 2¼ percent expansion in 2010, activity has strengthened considerably with growth reaching almost 9 percent in the first half of 2011. While it has been predominately export led—exports now exceed pre-crisis levels following six quarters of double-digit growth—final domestic demand has also increased in recent quarters (Figure 1). Capacity constraints have begun prompting investment and an improving labor market has boosted consumer sentiment until recently and increased long-suppressed household consumption. The contribution to growth from inventories has been erratic, largely reflecting initially component imports for subsequent exports.

Figure 1.
Figure 1.

Estonia: The Strengthening Economic Rebound, 2007-11

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Haver.1/ Balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
A01ufig03

Contributions to GDP Growth and GDP Growth

(YoY, percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Statistics Estonia; Haver; and IMF staff calculations.
A01ufig04

Confidence Indicators 1/

(Percent Balance)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Haver.1/ Balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
A01ufig05

Industry Capacity Utilization, SA

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Haver.
A01ufig06

Real GDP Growth in Baltics

(Yoy percent changes)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Haver; Sept. 2011 WEO; and IMF staff projections.

3. Inflation has risen and is the highest in the euro area. While price increases have moderated to about 5½ percent in September, inflation has remained well above the euro-area average since April, 2010. The disproportionate impact of food and energy prices explains the bulk of Estonia’s higher inflation. The HICP-based measure of core inflation (excluding energy, food, tobacco and alcohol) has remained low, but other measures have been higher (Figure 2). Real wages have continued declining despite nominal wage increases. The latter, in part, have reflected a rebound in bonus and profit sharing—squeezed in the downturn—despite double-digit unemployment. The unemployment rate has declined from its peak of almost 20 percent in early-2010 to about 13¼ percent in the second quarter of 2011. Still, long-term unemployment has continued rising reflecting jobs-skills mismatch (Figure 3).

Figure 2.
Figure 2.

Estonia: Recent Price Development, 2010-11 1/ 2/ 3/

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Eurostat.1/ Core is defined as HICP excluding energy, food, alcohol and tobacco.2/ Data for the UK are from Dec. 2010-Aug. 2011 for monthly chart, and from Jun. 2010-Jun. 2011 for quarterly chart.3/ Striped lines are euro area member countries.
Figure 3.
Figure 3.

Estonia: Legacies of the Bust

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Eurostat; Statistics Estonia; and Bank of Estonia.
A01ufig07

Inflation and Contributions in Estonia and Euro Area

(Yoy percent changes)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Eurostat; and IMF staff calculations.
A01ufig08

Vacancy Rates 1/

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Haver; and Statistics Estonia.1/ The vacancy rate measures the proportion of total vacant posts expressed as a percentage of occupied and vacant posts.
A01ufig09

Inflation, 2006Q1-2011Q3 1/

(Yoy percent changes)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Haver.1/ Core I excludes energy, food, alcohol and tobacco; Core II excludes energy and unprocessed food.
A01ufig10

Change in Employment by Sectors

(Millions)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Haver.

4. Domestic credit has continued declining in 2011. By the second quarter of 2011, the stock of outstanding credit had contracted by about 15 percent from its peak at end-2008. Higher frequency data, however, suggest that declines in commercial credit have slowed and credit to the manufacturing sector has increased starting in early-2011. The decline in lending to individuals has also slowed reflecting slower declines in mortgage lending since March, 2011.

A01ufig11

Stock of Bank Loans by Sector

(Billions of euro)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Bank of Estonia.
A01ufig12

Monthly Growth of Loans to Individuals

(YoY percent changes)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Bank of Estonia; and IMF staff calculations.
A01ufig13

Monthly Growth of Loans to Non-Financial Corporations

(YoY percent changes)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Bank of Estonia; and IMF staff calculations.
A01ufig14

Banking System Profits and Liquidity

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Bank of Estonia; and IMF staff calculations.1/Liquid assets defined as liquid foreign securities, claims on the central banks, and claims on other banks.

5. Credit developments have been driven primarily by demand factors. Commercial real estate and mortgage borrowing—almost 60 percent of domestic credit—has continued to be weighed down by the legacy of Estonia’s real estate bust, as a about a quarter of mortgages have loan-to-value ratios above 100 percent. In addition, while household debt (as a share of disposable income) has declined by about 8 percentage points from its peak, it remains elevated at about 92 percent. On the supply side, the banking sector returned to profitability in the third quarter of 2010, as narrowing interest rate margins have been offset by lower cost funding through local deposits. Banks’ usable liquidity (i.e., liquid assets net of required reserves) increased substantially in 2011 reflecting the lowering of Estonia’s reserve requirements to the euro area levels, even as substantial amounts of liquidity were repatriated to parent banks—a further indication of Estonia’s weak credit demand. Banks have tightened credit standards in the aftermath of the bubble, but narrower margins and generally lower interest rates following euro adoption suggest that supply conditions have not inhibited credit.1

6. Estonia’s long-standing commitment to fiscal prudence has continued in 2011. The 2011 budget had envisaged a small general government deficit (about 1.5 percent of GDP), but state budget data for the first half suggest that another small surplus is possible in 2011. This has reflected continuing higher-than-expected revenues, including from the sale of CO2 emission rights that more than offset the initial unwinding of previous “one-off” measures namely, partly restoring pillar II pension contributions temporarily diverted to the budget. Estonia’s public debt has remained the lowest in the EU and its fiscal buffers were about 11½ percent of GDP at end-June 2011.

7. In line with competitiveness gains, the external current account balance was broadly in balance in the first half of 2011. The merchandise trade deficit narrowed by about 1½ percentage points of GDP with robust export growth more than offsetting a recovery in imports in the first half of 2011 (Figure 4). Net income outflows have been robust owing to dividends paid to foreign investors. Competitiveness has continued to improve and the real exchange rate is broadly in line with fundamentals (Box 1). In the first half of 2011, the financial account recorded a deficit as banks further reduced liabilities to foreign parent banks associated with liquidity freed up by the harmonization of reserve requirements. As a result, gross external debt has declined from about 125 percent of GDP at end-2009 to about 110 percent of GDP at end-June 2011. The external DSA suggests that external debt dynamics remain sustainable in plausible risk scenarios.

Figure 4.
Figure 4.

Estonia: External Developments, 2001-11

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

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

OUTLOOK

8. Following a spike in growth in 2011, economic activity is set to moderate in 2012. Given the better-than-expected economic performance in the first half of the year, growth is set to triple to 7½ percent in 2011. Growth is projected nonetheless to slow to about 3 percent in 2012. Abstracting from inventories’ temporarily large contribution to growth in 2011, a smaller contribution to growth from net exports—in line with slowing global markets—is expected to be partially offset by final domestic demand. Fixed investment and, to a lesser extent, consumption are projected to continue gradually strengthen as the economy nears capacity and employment continues expanding. Leaving aside measurement uncertainties, the output gap will continue narrowing in 2012.

Contributions to Growth, 2008–12

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

Includes changes in stocks.

Estonia’s Competitiveness Developments

Competitiveness gains have continued in 2011. Standard measures of real exchange overvaluation have declined since last assessed. Gains measured with current account-based methods, nonetheless, may partly reflect cyclical developments with lower imports driving the results rather than improvements in competitiveness. Still, the rebound of exports and their record levels are notable as reflected in a decline in the mid-point overvaluation range.

Direct assessments of the real exchange rate also indicate favorable competitiveness developments. Since March 2009, the CPI-based real exchange rate has been broadly flat, albeit with a small appreciation in 2010. But the ULC-based real exchange rate has declined by about 10 percentage points (Figure 5). Still, these real exchange rate measures have remained between 5 percent and 10 percent above their pre-crisis levels.

Broader competitiveness indicators also suggest improvements. Estonia’s exports as a share of GDP have remained the highest in the Baltic countries and increased their share in Estonia’s main trading partners markets, namely Finland, Sweden, and Russia. Estonia’s world export market share has held up despite the 2006–08 real appreciation, suggesting that improvements in non-price competitiveness. Productivity and corporate profits—particularly in the booming export-related manufacturing sector—have increased since 2009.

REER Assessment

(Percent)

article image
Source: IMF staff calculations.
Figure 5.
Figure 5.

Estonia: External Competitiveness, 2005-11

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: DOTS; Haver; WEO; and EU Commission.

9. Inflation is projected to slow in 2012. Price increases are expected to exceed 5 percent in 2011, but should moderate to about 3¼ percent in 2012 as the impact of global food and fuel prices shocks dissipate. Core inflation’s outlook remains uncertain in part given wage pressures largely from skill mismatches and increasing capacity utilization. So far, wages increases have not exceeded productivity gains nor have real wages risen. While these trends are likely to broadly continue as activity moderates, pressures may remain on core inflation in 2012.

10. With continued volatility in global financial markets, downside risks to the outlook have risen at end-2011. With two-thirds of Estonia’s exports going to the EU, recent European and global developments have tilted risks to the downside. Besides the domestic risk that the unwinding past real and financial sector imbalances be more protracted and weigh on domestic demand, external risks prevail. In addition to the aforementioned global trade developments, a generalized confidence fallout from the euro area sovereign debt crisis could spill over to Estonia through Swedish parent banks. The Swedish banks and authorities appear well-prepared to deal with liquidity pressures, but Swedish banks rely heavily on short-term wholesale market funding. In an extreme tail-risk event engulfing core EU, Estonia could however face financial distress despite its strong fundamentals.

11. The authorities broadly concurred with the outlook. While official projections had not yet been revised, the authorities agreed that growth would slow in 2012. They noted that, in contrast to the previous downturn, domestic and external imbalances have been greatly reduced. Regarding inflation, they noted that recent increases have been predominately driven by food price increases, partly reflecting limited retail competition and would keep core inflation developments under close review. They confirmed that exporters have been increasingly facing difficulties in filling vacancies due to a lack of skilled labor. Moreover, the shift of labor toward the tradable sector has been slowed by employment opportunities for construction workers in nearby Nordic economies. Both developments were thought to contribute to recent increases in wages. Regarding the financial sector, the authorities agreed that, given the extensive real estate adjustment and rebound in employment, external risks outweigh domestic risks.

POLICY CHALLENGES

12. Estonia must stand ready to address short-term risks, while medium-term polices should focus on sustainable growth and increased employment. The authorities’ policies have been in line with Fund advice (Box 2) and, going forward, uninterrupted income convergence to EU levels will require continued focus 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, including a domestic bank resolution framework to facilitate rapid bank restructuring. Also, the authorities have been discussing enhancements to their medium-term framework to further entrench their strong fiscal position.

A. Enhancing Estonia’s Fiscal Framework

13. Estonia’s fiscal position will likely remain strong. The authorities target small budgetary surpluses starting in 2013. These would be used, when feasible, to reverse crisis-related increases in unemployment contribution rates, cut the personal income tax rate, cap the amount of incomes subject to the social tax excluding health insurance and rebuild fiscal buffers (Figures 6 and 7).

Figure 6.
Figure 6.

Estonia: Fiscal Developments and Structure

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Haver; Erostat; and OECD.
Figure 7.
Figure 7.

Estonia: Statutory and Implicit Tax Rates, 2009-11

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Eurostat.1/ 2011 VAT rates refer to those applicable in May 2011.2/ Includes social contributions.

14. Nonetheless, the 2012 budget will entail a deterioration in the fiscal balance. In contrast to a small surplus in 2011, the 2012 budget before Parliament shows a deficit that staff estimates to be about 2¼ percent of GDP. The deterioration reflects a decline in revenues associated with the fall of CO2-emission permit receipts (equivalent to 1 percent of GDP) and pension pillar II contributions previously diverted to the budget (½ percent of GDP). The budget also shows a limited increase in expenditures, notably a 4.4 percent increase in basic pensions (about ¼ percent of GDP) and increases in public investment (roughly 1 percent of GDP) tied to obligations from previous sales of CO2 permits. It also foresees an unchanged public sector operating expenditures (including the wage bill) and does not include revenue measures with the exception of small increases in excise taxes on tobacco and alcohol.

Estonia: Selected Fiscal Indicators

(Percent of GDP)

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

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

Extraordinary dividends from Eesti Energia and the Port of Tallinn.

Corrected for net EU transfers, and AAU and other “one-off” measures.

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

15. In the central scenario, efforts will be needed to limit the budget’s stimulative impact, albeit uncertainties abound. The budget implies a positive fiscal impulse, largely from CO2-related investments as there is no expansionary impact from the lost revenue related to restoring pillar II contributions. With the output gap continuing to close in the central scenario, fiscal stimulus is not needed and a neutral stance would be appropriate. With further compression of current expenditure unrealistic, adherence to budgetary allocations will help in this regard. Consideration could be given to under executing the budget using existing margins. Should revenue windfalls emerge, these should be saved consistent with the authorities’ long-standing fiscal restraint. But if downside risks materialize automatic stabilizers should be allowed to operate while maintaining credibility, which can require adhering to the Stability and Growth Pact.

16. Estonia’s fiscal buffers provide a comparative strength, but volatile global markets call for caution. Estonia’s liquid fiscal reserves could be used to finance the fiscal deficit. But in the context of heightened financial market uncertainty, this would leave Estonia with potentially fewer and more expensive options should the global shock persist or tail risks materialize. In this connection, alternative sources of financing should be considered, possibly including credit lines with liquid domestic commercial banks and European Investment Bank resources as were previously tapped.

17. Looking forward, the authorities’ medium-term target (a small surplus) can safeguard Estonia’s fiscal position but achieving it will require unwavering expenditure restraint. The authorities have maintained strict expenditure control, but spending pressures will intensify as income convergence to EU levels proceeds. Specifically, the public sector wage freeze—instituted following nominal wage cuts—and the deep cuts in operational spending to meet the Maastricht criteria will likely be tested. Also, medium-term pressures have emerged for the cohort of pensioners that remain in the pre-reform system, as well as from increases in disability pensions. The time-bound nature of CO2 permit-related investment can help limit spending increases. Still, to achieve the fiscal target without raising taxes, staff estimates that expenditures on nonwage goods and services would need to decline by at least 2 percentage points of GDP during 2011–15. In this connection, the pace of consolidation should be mindful of long-term investment needs and cyclical developments.

18. Establishing a fully fledged multi-year fiscal framework can further enhance credibility by supporting the medium-term target and limiting pro-cyclical policies. An array of frameworks has been considered in the European context. The successful implementation and operation of such a frame in Estonia will require that it reflect its tradition of simplicity and transparency, which have facilitated monitoring and accountability (Annex I). Its central element would be multi-year expenditure ceilings. These ceilings could be announced, for instance, when a new government takes office, as in Finland, or on a rolling basis, as in Sweden. These would be set to be consistent with the medium-term fiscal target and macroeconomic prospects. Automatic stabilizers should be allowed to operate in the face of moderate economic cycles. The framework could be established possibly as a reform of the State Budget Act and be mindful of evolving EU obligations, including the forthcoming legislation on economic governance.

19. Fiscal buffers should continue to be an integral part of Estonia’s fiscal framework. Estonia thus faces the question of how large these should be and how quickly to rebuild them. During the downturn, fiscal buffers allowed the authorities to minimize the needed extent for contractionary pro-cyclical fiscal policy without relying on financial markets (Annex II). Buffers should in principle be commensurate with the volatility and risks. Estonia’s recent output and fiscal revenue volatilities suggest that higher buffers would be justified. But judging by Estonia’s low financing needs, the opposite would be true. Regardless, liquid assets entail costs as well as benefits. A speedy accumulation of buffers could run the risk of weakening domestic demand and lowering long-run growth. On balance, given increased global uncertainty gradually rebuilding buffers to their pre-crisis level would be appropriate.

20. The authorities stressed that the 2012 budget addresses the dual goals of maintaining Estonia’s favorable economic environment and increasing stability. CO2 emission-related investments would help address the risks from an uncertain global environment, as would increases in basic pensions exceeding the indexation rule. On the other hand, the freezing of state operating expenditures would accelerate structural reforms and further improve the state’s efficiency. Under their risk scenario (growth of 1 percent), the deficit was projected to increase to 2.9 percent and automatic stabilizers would be allowed to operate. The authorities noted that they would consider expenditure and revenue measures as needed should the slowdown be larger or more protracted. As to its financing, the authorities intended to largely rely on the still-sizable fiscal buffers but did not rule out alternate options.

21. In the medium term, the authorities underscored that a small surplus was needed to maintain stability and support broader economic and social objectives. In the central scenario, they would target a small surplus in 2013 when the EU obligations of CO2-related investments would expire. Future growth-supporting cuts in labor taxation (including unemployment insurance contributions and capping the base for the social tax) were intended to promote employment, while tight expenditure controls would allow for a gradual rebuilding of fiscal buffers. While discussions remained in an early stage, the authorities saw merits in enhancing their fiscal framework to accommodate more formally a multi-year framework, by perhaps amending the “organic” State Budget Act. The merits of expenditure ceilings were acknowledged, with some preference expressed toward rolling ceilings as in the State Budget Strategy. A monitoring role was envisaged for the State Auditing Office in verifying compliance with such a framework.

B. Locking-in Financial Sector Resilience

22. The mostly Nordic-owned banking system has weathered the global financial crisis. Non-performing loans (NPLs, loans at least 60 days past due) rose steadily in the aftermath of the Estonian housing market bust, hastened also in the aftermath of the Lehman Brothers collapse (Figure 8). Still, provisioning against loan losses has kept pace with the deterioration of asset quality. NPLs have started declining recently, mainly due to write-downs and, to a lesser extent, from a strengthening economy. Moreover, Estonian banks’ average capital adequacy ratios have continued to exceed international norms (including the EC’s decisions in mid-October and future Basel III capital requirements).2 Also, banking sector profits turned positive in the second quarter of 2010, following losses in six consecutive quarters, but these remain below their pre-crisis levels.

Figure 8.
Figure 8.

Estonia: Financial Sector Developments

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Haver; Global Property Guide; country authorities; and IMF staff calculations.1/ For countries with only one bar, the latest is the trough. Latest data are as of 2011Q2.2/ In Lithuania, NPLs include impaired loans + loans past due by 60 days but not impaired; in Latvia, NPLs are loans overdue by more than 90 days; in Estonia, they are loans overdue by more than 60 days.
A01ufig15

Asset Quality and Provisioning

(Percent of total loans)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Bank of Estonia.
A01ufig16

Estonian Banks’ Capital Buffers

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Bank of Estonia.

23. Even though asset quality has improved, risks remain and continued vigilance will be needed. Specifically,

  • Domestic risks. The bulk of household debt comprises floating-rate euro-denominated mortgage loans with rates based on the six-month euribor. Given euro adoption, these loans do not face exchange rate risk but still face interest rate risk. Furthermore, with about a quarter of mortgages in negative equity, organic improvement in the health of banks’ assets with individuals depends primarily on house price increases.

  • External risks. Estonian banks have continued to rely on foreign funding, currently about 30 percent of total liabilities. The bulk of this financing consists of Swedish parent-bank deposits that have proven to be a stable financing source. Still, these parent banks have remained largely reliant on short-term wholesale funding3 and are exposed to a booming Swedish housing market as well as indirectly to the euro area periphery through assets in other euro area economies.

A01ufig17

Foreign Support and Local Financing of Assets

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Bank of Estonia; and IMF staff calculations.

24. On balance, financial sector risks appear manageable. A number of mitigating factors are at play. Specifically,

  • Domestically, Estonian banks’ comfortable prudential ratios provide a risk-weighted assets buffer of almost 9 percentage points before breaching the current Basel tier 1 capital ratio minimum (4.5 percent). Furthermore, banks now have access to the ECB’s liquidity facilities providing a solid liquidity backstop. Market indicators suggest broadly stable borrowing costs. Specifically, average interest rates have not yet trended up and eonia forward interest rate swaps through four years do not point to higher interest rates. In addition, Estonian banks have been reducing dependence on foreign funding.

  • Externally, Swedish parent banks are well capitalized and their liquidity management and capital buffers have improved. Recent Fund staff assessment of Sweden’s financial sector indicated that risks were contained, reflecting only a limited potential of external contagion via financial channels to Estonian banks.4 Moreover, Fund staff estimates that a 40 percent drop in Swedish housing prices—compared to an estimated overvaluation up to 25 percent—would be required to reduce banks’ collateral below the face value of outstanding covered bonds. In addition, foreign parents view their Estonian investments as strategically important as a significant source of profits, and thus are less likely to be significantly withdrawn. Finally, Estonia is not directly exposed to the euro area periphery and its indirect exposure through parent banks is small, about 0.5 percent and 3.5 percent respectively of total Swedish and Danish banking sector assets, with the latter mostly consisting of exposure to Ireland.

A01ufig18

Eonia Forward Curve, as of November 2011

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Bloomberg; and IMF staff calculations.

25. The European Banking Authority’s (EBA’s) and Eesti Pank’s stress tests support this assessment. Under the EBA’s adverse scenario, Swedish banks’ average tier I capital ratio would be 9.5 percent in 2012. Danish and Finnish banks have even higher tier I ratios in 2012 under the adverse scenario. Also, The Eesti Pank’s stress test from early-2011 shows that NPLs would increase but that capital ratios would remain adequate.5 Similarly, a more recent exercise by Eesti Pank and Estonia’s Financial Supervision Authority (FSA) recreating the 2008 shock, suggests that capital would remain above statutory minimums. These tests do not reflect, however, the impact of a sharp deterioration in investor confidence nor cross-border contagion in an extreme tail event.

26. Going forward, safeguarding financial stability will require continued efforts in an increasingly challenging global financial environment. In this regard, the authorities should pursue:

  • Further Improving cross-border supervision. While the 2010 Nordic-Baltic Memorandum of Understanding is non-binding, it provides a framework for regional prudential information sharing and crisis resolution. Continued progress to implement its key elements, including defining criteria for burden sharing and establishing a shared financial database, will be needed to ensure its effectiveness. In addition, the authorities, in cooperation with other supervisors, should consider conducting joint cross-border stress tests, including by assessing the impact of more adverse assumptions than those in the EBA’s 2011 stress tests. In view of deep regional financial linkages and rising external risks, the importance of these tools have increased for crisis resolution as well as to safeguard confidence and enhance crisis prevention.

  • Continuing preparations for Basel III. Early institutional adoption of Basel III requirements, particularly regarding the liquidity framework and higher quality capital, should continue and would reduce funding risks and avoid possible credit supply interruptions in times of heightened stress. But this should be balanced against the potential costs of reducing banks’ margins and creating headwinds for the credit recovery. In this regard, understanding the anticipated impact of Basel III on prudential ratios will be needed to ensure that forward-looking capital buffers serve to reassure markets. Coordination with home supervisors will be essential as will be consistency with forthcoming EU directives.

  • Enhancing the deposit guarantee scheme. Since the 2009 FSAP, the authorities have made progress to improve Estonia’s scheme by increasing the fund’s assets and reducing the pay-out period to 20 days. With the deposit guarantee fund’s assets currently about 2.1 percent of eligible deposits, further efforts are needed to reach the authorities’ target of 2.5 percent of deposits, which nonetheless remains short of the FSAP recommendations.6

A01ufig19

NPL Mortgages by Loan-to-Value 1/

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.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.

27. These efforts can also be supported by further improvements in Estonia’s bankruptcy law and restructuring framework. The Estonian Supreme Court’s May 2011 decision on the Reorganization Act for corporations provided a number of clarifications to enhance its effectiveness.7 Also, the FSA has been provided the authority to expeditiously resolve problem banks through nationalization since early 2011. However, the authority for bank resolution through a flexible asset separation tool—before and after nationalization—and framework for cross border resolution could be considered. The bankruptcy regime could be further strengthened to, inter alia, speed up the process. Finally, reforms are needed to facilitate out-of-court debt restructuring and a pre-packed, expedited bankruptcy process could further reduce costs.

28. The authorities expressed commitment to continue bolstering financial stability. They stressed the importance of continued progress on implementing the Baltic-Nordic MOU. The authorities noted that progress in this regard also depends on their regional partners and, in this connection, pointed to the forthcoming December high-level meeting of the Baltic-Nordic Financial Stability Group. They noted that capital and liquidity buffers above Basel III thresholds would support financial stability, and welcomed banks increased funding through local deposits. The authorities agreed that additional tools for bank resolution—notably asset separation and cross-border coordination—were needed and planned, but would this require progress at the EU level and coordination with regional partners. Regarding the bankruptcy process, they noted ongoing the work to identify bottlenecks and, while reform efforts were in their early stages, they hoped to address this by 2013.

C. Tapping Estonia’s Sustainable Growth Potential

29. Besides safeguarding competitiveness gains, bolstering sustainable growth will entail enhancing Estonia’s attractiveness for FDI. In addition to the ongoing rebalancing the economy toward the tradable sector, Estonia will need to move up the export value chain. In this regard, the authorities’ recently approved “Estonia 2020 Competitiveness Strategy” provides a welcome roadmap. Specifically, it targets further improving the business environment to attract FDI with export potential. This will be achieved by building R&D capability, improving education in technical fields, and enhancing infrastructure with continued use of EU funds. Doing so has become increasingly pressing as Estonia’s high trade integration with Nordic countries means it faces growing competition for Nordic FDI from emerging markets, particularly in Asia (Annex III).

A01ufig20

Net Sales, Personnel Expenditures and Total Profit of Business Sector, 2007-11

(2005 = 100)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Statistics Estonia.
A01ufig21

Productivity and Real Labor Compensation

(2000 = 100)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Statistics Estonia; and IMF staff calculations.

30. Fully drawing on Estonia’s resources and developing their potential will also require addressing emerging labor market tensions. While its flexible labor market has enabled rapid declines in unemployment, the duration of joblessness has risen. Despite double-digit unemployment, skill mismatches as well as job opportunities in Nordic neighbors have resulted in labor shortages and increases in manufacturing job vacancies (Annex IV). In this regard, the authorities’ ongoing efforts to harmonize vocational education with the needs of the labor market, increase voucher training programs, and improve job-matching through a new one-stop IT platform are welcome. Looking ahead, continued attention will be required to foster development of human resources in technical fields as well as to attract highly-trained individuals from abroad.

31. The authorities stressed commitment to further enhance Estonia’s business friendly environment and address emerging labor market tensions. In this regard, they underscored their commitment to safeguard competitiveness by increasing human capital and productivity as elaborated in the competitive strategy as well as by lowering labor taxation. The authorities noted that active labor market policies, including targeted wage subsidies for problem populations, have contributed to lower unemployment. In this regard, they pointed to the doubling to €2,000 of the ceiling of the voucher training program for the unemployed. Also, the Public Employment Services introduced a new IT platform providing one-stop services in early 2011, thereby improving the efficiency of the job-matching process. Regarding rising long-run unemployment, the authorities noted that the success in reducing short-term unemployment had also contributed to its rise. In addition to increases in manufacturing job vacancies, they noted that increases in cross-border construction jobs had lowered unemployment but contributed to pressure wages, which may continue in the medium-term.

STAFF APPRAISAL

32. Estonia faces an increasingly challenging environment as it looks to continue implementing policies preserving macroeconomic policy credibility and safeguarding sustainable growth. Following a strong recovery in its first year in the euro area, Estonia’s economic activity will likely slow in 2012. In the central scenario, nonetheless, Estonia’s economy will continue to approach its potential. Inflation is poised to slow even though pressures on core inflation can remain. Recently, downside risks to the outlook have increased. In addition to a slowdown in exports, a generalized confidence fallout from the euro area sovereign debt crisis could spill over to Estonia despite its strong fundamentals.

33. Estonia’s fiscal position will remain strong but there will be a need to limit the stimulative impact of the 2012 budget in the central scenario, albeit uncertainties abound. Time-bound increases in public investment underlie the budget’s positive impulse, while a neutral budget would be appropriate. Recognizing that further significant compression of current expenditures is unrealistic, observance of budgetary allocations will be helpful in this regard. But if downside risks materialize, automatic stabilizers should be allowed to operate while maintaining Estonia’s hard-earned fiscal credibility. In addition, given the uncertainty regarding the extent and duration of the global slowdown, fiscal buffers should be preserved and alternative sources of financing be considered.

34. Looking beyond the current conjuncture, the authorities’ medium-term target can safeguard Estonia’s strong fiscal position. This will require continued expenditure restraint to counter spending pressures that are likely to emerge. The authorities’ ongoing efforts to enhance central government productivity through centralization of accounting and personnel management can help. Still without raising taxes, achieving the fiscal target on a sustainable basis, implementing the authorities’ plan to reduce labor taxation, and restore fiscal buffers will require reducing non-wage goods and services by at least 2 percentage points of GDP in the medium term. The pace of consolidation should be mindful of long-term investment needs and cyclical developments.

35. A fully fledged multi-year fiscal framework can support the medium-term target, bolster Estonia’s high fiscal credibility, and limit pro-cyclical policies. A successful framework should reflect Estonia’s fiscal tradition of simplicity and transparency, which has facilitated monitoring and accountability. The central element of such a framework would be multi-year expenditure ceilings and their strict observance while revenue collections adjust to cyclical conditions. In addition, fiscal buffers should continue to be an integral part of Estonia’s fiscal framework. While there are benefits as well as costs of holding liquid assets, gradually rebuilding buffers appears appropriate given increased global uncertainty.

36. For the financial sector, the challenge entails safeguarding stability in the context of heightened global financial tension. Estonian banks have scant direct and indirect exposure to euro area sovereign debt, while at the same time capital and liquidity buffers have increased substantially since 2007. However, the legacy of the previous crisis continues to burden balance sheets and dependence on financing from parent banks remains high, although both of these factors are declining. The latter has proven a stable source of financing, but parent banks in turn rely on short-term wholesale funding. Limiting potential contagion will thus require continued improvements in cross-border supervision. Developing regional crisis resolution tools—in close cooperation with relevant authorities—can provide critical backstop to Estonia’s sizable fiscal and financial buffers. The scheduled December high-level meeting of Nordic regulators provides an opportunity to make progress in this critical area. In addition, an early and gradual institutional adoption of Basel III requirements can reduce funding risks but its implementation should avoiding creating headwinds for credit conditions.

37. Financial resilience can also be supported by further enhancing the regional and domestic resolution frameworks for banks and addressing weaknesses in Estonia’s bankruptcy law. The recent adoption of a domestic resolution law provides a welcome tool to minimize the cost of a bank failure. This could be supplemented by introducing a bank-asset separation authority as well as by developing cross-border bank resolution tools in coordination with the EU and regional partners. In addition, legal clarifications regarding the Reorganization Act for corporations have improved its effectiveness, while the recent adoption of an analogous law for individuals ensures broader coverage. Still, reforms are needed to shorten the lengthy and costly bankruptcy process.

38. More broadly, sustainable growth will entail enhancing Estonia’s attractiveness for FDI, addressing skill mismatches, and increasing human capital. Estonia’s 2020 Competitiveness Strategy highlights the need for further improvements in the business environment to continue to draw FDI. The urgency of boosting knowledge-based activities and remaining an attractive destination for FDI has been heightened by growing competition from emerging markets. Furthermore, fully drawing on Estonia’s resources and developing their potential will also require addressing skill mismatches and continuing attention to foster human resources in technical fields as well as to attract highly-trained individuals to support sustainable income convergence to EU levels.

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

Figure 9.
Figure 9.

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

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.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. Four-year historical average for the variable is also shown.2/ Large projected declines in 2010-11 reflect in part the actual and 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 account balance.4/ One-time real depreciation of 30 percent occurs in 2011.
Table 1.

Estonia: Selected Macroeconomic and Social Indicators, 2007–12

(in units as indicated)

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Sources: Estonian authorities; Eurostat; 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 was pegged at 15.6466 kroons to the euro. Estonia adopted the euro on January 1, 2011.

Table 2.

Estonia: General Government Accounts, 2001–10

(ESA95 basis; in percent of GDP)

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Sources: Eurostat; Statistics Estonia; and IMF staff calculations.
Table 3.

Estonia: Summary of General Government Operations, 2001–12 1/

(Percent of GDP)

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

Cash basis.

Table 4.

Estonia: Summary Balance of Payments, 2002–12

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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.

Table 5.

Estonia: Macroeconomic Framework, 2005–16

(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.

Table 6.

Estonia: Indicators of External Vulnerability, 2005–11

(Percent of GDP, unless otherwise indicated)

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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.

Table 7.

Estonia: External Debt Sustainability Framework, 2006–16

(Percent of GDP, unless otherwise indicated)

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Source: Estonian authorities; and IMF staff estimates and projections.

Large reductions projected for 2010-11 reflect in part the expected impact of reserve requirement harmonization associated with euro adoption.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = 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 [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r 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.

Table 8.

Estonia: Financial Soundness Indicators of the Banking Sector, 2005–12

(Percent unless otherwise noted)

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Source: Bank of Estonia.

Average of four quarters ending in 2011Q1.

Annex I. A Fiscal Framework for Estonia

1. The success of Estonia’s long-standing currency board arrangement and its accession into the euro area has been predicated on, inter alia, fiscal prudence. Budgetary surpluses were the norm, resulting not only in the lowest level of general government debt in the EU but also in an accumulation of sizable liquid government assets, and sizable cuts in direct flat tax rates.

2. Despite Estonia’s sound fiscal reputation, surging revenue growth during the recent boom period resulted in pro-cyclical expenditure growth, which exacerbated the boom and the following pro-cyclical retrenchment measures once the bust set in. Estonia’s favorable economic circumstances boosted perceptions of the speed of real income convergence and of permanent incomes. This in turn led in the mid-2000s to higher expenditures on public wages (in order to compete with the private sector), and on social benefits, especially pensions, to promote social cohesion and limit income disparities. In addition, rising government surpluses and fiscal buffers during this period increased pressures to boost public infrastructure expenditures to facilitate further income convergence. These pro-cyclical policies, along with income tax cuts motivated and further fueled the unsustainable expansion, requiring contractionary policies once the bust began.

3. In this connection, Estonia’s fiscal framework can be improved further to limit pro-cyclical fiscal policy. The European Commission has noted that performance and accrual budgeting have been gradually introduced in 2010–11.1 Limitations have also been tightened recently regarding the contracting of loans by local governments. Plans are also underway to enhance Estonia’s “soft” medium-term balanced budget rule, possibly by amending the State Budget Act.2 Still, the counter-cyclical operation of the budgetary framework can be improved by introducing binding expenditure ceilings in a multi-year context.

4. The usefulness of fiscal rules has become increasingly recognized, and lies at the heart of recent EU-wide efforts to strengthen economic governance (the so-called legislative “six pack”). In light of the sizable deterioration of overall balances and debt levels during the recent crisis, a number of economies have or are considering enshrining a medium-term objective fiscal target (MTO) in some legal (such as in the “organic” State Budget Law) or constitutional framework for longer-term sustainability. Other economies with a tradition of prudence (Sweden and Finland, for example), in contrast, have found medium-term political commitments to be sufficient to provide the necessary discipline.

5. In Estonia, achieving the medium-term target for the overall balance could usefully be supplemented with a multi-year expenditure rule. The rule would be based on a medium-term macroeconomic forecast consistent with achieving the ultimate fiscally sustainable target. Revenues would be allowed to vary with deviations of actual developments from initial forecasts in order to prevent pro-cyclical policies, thereby enabling automatic stabilizers to operate (with due respected accorded to the Stability and Growth Pact). Consideration could be given to the advice of outside “experts” to monitor the accuracy of the macroeconomic and fiscal forecasts and outcomes. In the Estonian context, the State Auditing Authority already fulfills some of these functions.

6. While multi-year expenditure rules can help minimize pro-cyclical policies, they are not without their own operational difficulties. Expenditure rules should cover as broadly as possible governmental economic activities (e.g., at the general government level), but this may need to be traded off against the cost this exacts in the timeliness of their monitoring. Another tradeoff emerges when specifying the fiscal targets in cyclically adjusted terms, even after possibly excluding some cyclically sensitive components, as this entails estimating output gaps and underlying potential output developments. This poses a greater challenge for economies, such as Estonia, undergoing significant economic changes and real income convergence, as trends and cycles are often difficult to disentangle. The costs that these intrinsic measurement difficulties pose for the transparency and the monitoring of framework must be weighed against potential benefits in economic policy making. A non-cyclically adjusted framework would be simpler to monitor but would be unable to account for movements of a purely cyclical nature.

7. While the use of MTOs, supplemented by medium-term expenditure rules, and possibly by independent fiscal authorities are valuable additional mechanisms, the success of achieving and maintain a sustainable fiscal position will ultimately depend upon political commitments of elected authorities to formulate and deliver prudent policies..

Annex II. A Rationale for Fiscal Buffers and Their Size

1. Fiscal buffers can serve as self-insurance in the event of extreme distress during crises. The higher the degree of uncertainty in output, fiscal revenues, and cyclically-related expenditures (such as social benefits), the larger potential need for insurance for smooth fiscal operations. Larger buffers could also be justified by a higher probability of being shut out of markets or of banking sector recapitalization.

2. Fiscal buffers nonetheless entail opportunity costs. For highly advanced economies, costs will boil down to the foregone interest on higher yielding (nonliquid) assets. In this regard, the size of fiscal buffers would be determined as part of public sector’s asset management. For countries with infrastructure needs, growth-enhancing physical infrastructure investment would be the relevant alternative use of liquid assets. Resources devoted to fiscal buffers would thus be weighed against the benefits of infrastructure development.

A01ufig22

Government Liquid Financial Assets

(Millions of euro)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Statistics Estonia.
A01ufig23

Euro Area: Fiscal Buffers, 2007 and 2010 1/ 2/

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Eurostat Government Finance Statistics.1/ Fiscal buffers include liquid financial assets of the consolidated general government (currency and deposits and securities other than shares).2/ Malta is not included due to missing data for 2010.
A01ufig24

Government Liquid Financial Assets

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Statistics Estonia.
A01ufig25

Euro Area: Another Measure of Fiscal Buffers, 2009 1/ 2/

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Eurostat.1/ Fiscal buffers are measured as a percentage of government deficits and short-term debt due within 1 year.2/ Cyprus and Greece are not included due to missing data.

3. In Estonia, fiscal surpluses during the economic boom had given rise to sizable buffers, which are among the largest in the EU. This reflects its comparatively prudent fiscal policy—a requirement under its previous currency board arrangement—as well as a legacy of the economic boom. During 2001–07 general government surpluses averaged about 1.8 percent of GDP, which were saved as liquid assets (i.e., currency and deposits, and securities other than shares). Over this period, liquid assets rose at their peak roughly seven-fold to about €2 billion and had tripled as a share of GDP by end-2007. After a temporary decline during the crisis, liquid assets have recovered to about €1.8 billion in the second quarter of 2011. The bulk of the buffers has been held at the central government level, with social security and local governments holding the remainder.

4. During Estonia’s sharp economic downturn in 2008-09, fiscal buffers were mainly used to finance fiscal deficits and largely eschewing financial markets. The combined 2008–09 general government deficit totaled €783 million, with the state budget borrowing €215 million in financing from the EIB and a local bank (with the latter, totaling €50 million, has already been repaid).

5. While fiscal buffers have declined, they remain above the euro area average. At roughly 2 percentage points of GDP above average, Estonia’s buffers as a share of GDP rank fifth among the 17 euro area at end-2010. Estonia’s liquid assets nonetheless rank among the highest when compared to fiscal financing needs (fiscal deficit plus short-term debt falling due).1 With the exception of Finland, whose buffers include pension pillar II assets, only Luxembourg’s buffers are larger than Estonia’s.

6. Considering Estonia’s economic and fiscal revenue volatility, fiscal buffers nonetheless do not appear to be out of line (Figure A1). The association of economic volatility and fiscal buffers generally suggest that more volatile countries have larger buffers. In this regard, Estonia’s buffers in relation to its volatility fall below the average (as expressed by the regression line), when measured as a share of GDP. The deviation from the average should not be taken literally—it would imply increasing buffers substantially—but does suggest that some increase might be justified by Estonia’s volatility.

Figure A1.
Figure A1.

Euro Area: Fiscal Buffers, Volatility, Financing Needs and Credit Ratings, 2001-10 1/ 2/

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: WEO; Eurostat; and Bloomberg.1/ Fiscal buffers refer to liquid financial assets of the cosolidated general government (currency and deposits and securities other than shares).2/ The data exclude Finland and Malta. Greece and Cyprus were excluded in the lower left panel due to missing data on short-term debt.3/Output volatility is defined as the average of the deviations from average real GDP growth in the given period.4/ Revenue volatility is definied as the average of the deviations from average growth rate of total revenue in the given period.5/ Sovereign credit rating is the average of three ratings (S&P, Moody’s and Fitch) with a scale of 1-20 (20 being the highest).

7. But judging by Estonia’s low financing needs, fiscal buffers appear above average. There is, however, only a weak relation between fiscal buffers and financing needs, with significant outliers.

8. Turning to fiscal buffers and market access, the relation is weak. Countries with higher probability of accessing markets (proxied by higher credit ratings) hold buffers that if all are slightly less than those with lower probability. This weak relation, however, could be associated with the impact that fiscal buffers have in turn on the probability of market access. A country with higher buffers appears to be deemed more credit worthy and thus would have a higher credit rating.

Annex III. Trade and FDI Linkages

A. Trade Structure and Linkages

1. Estonia’s export performance has benefited from its high integration with Nordic countries, particularly by being part of the Finnish and Swedish global supply chains (Table 1). Finland and Sweden account for 33 percent of Estonia’s exports. Estonia processes imported intermediate inputs and exports these to Finland and Sweden, which in turn export the final goods to third markets. Estonia’s other export markets—the Baltics (14 percent) and Russia (10 percent)—represent a smaller share of Estonia’s exports.

2. Estonia’s trade exposure to EU countries thus includes a significant indirect linkage through Nordic markets. Specifically, in total commodity exports, the indirect Nordic linkage accounts for about ⅓ of Estonia’s total EU exposure. Similarly, Estonia’s exposure to Brazil, India, and China (BRICs) is greater than its direct linkage. In machinery and equipment exports, 17 percent of is actually exported to BRICs, with about 12½ percent exported directly. Such secondary linkages are mostly absent in the Baltic peers as they are not currently part of global supply chains; their main exports are mineral and wood products whose productions processes are less likely to be vertically integrated..

Exports and Imports by Main Trading Partner

(Percent)

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Source: Statistics Estonia.

2010 data.

2009 data.

Trade Exposure via Finland and Sweden, 2010

(Percent)

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Source: IMF Staff calculations.

EU excluding Finland, Sweden, Latvia and Lithuania.

Brazil, Russia, India and China.

Exports and Imports by Main Commodity Sectors, 2010

(Percent)

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Source: Statistics Estonia.

3. Estonia’s trade pattern reflects a large share of intra-industry trade. Machinery and equipment and mineral product exports represent about 40 percent of Estonia’s exports, which mirrors imports of these products. Exports of machinery and equipment mainly entail processing intermediate goods, but a large share of exports of mineral products reflects transit trade of oil: Estonia reexports its Russian oil imports to the Baltics.

4. Even though Estonia’s export markets are mostly Nordic and neighboring countries, its imports come from a broader set of countries. This reflects greater trade integration with EU countries other than Finland, as a large share of imports also comes from Germany and Poland, as well as China.

5. Finland has remained Estonia’s the most important export destination, though its relative importance has declined. Between 2000 and 2010, there was a small decline in Estonia’s export markets to Finland in favor of the Baltics and Russia. In contrast, there was a significant change in the relative importance of the source countries of imports for Estonia. The Baltic peers are the most important for Estonia. The Baltic peers are the most important source of imports for Estonia, taking over from Finland.

A01ufig26

Imports by Source Country, 2000 - 2010

(Percent of total imports)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: IMF Direction of Trade; and IMF staff calculations.1/ Emerging Europe excludes Russia, Latvia and Lithuania.
A01ufig27

Exports by Source Country, 2000 - 2010

(Percent of total exports)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: IMF Direction of Trade; and IMF staff calculations.1/ Emerging Europe excludes Russia, Latvia and Lithuania.

B. FDI Linkages

6. Estonia’s exports have been supported and enhanced by FDI from the Nordic countries. Financial sector FDI from Sweden has accounted for the bulk of total FDI in Estonia. The manufacturing sector is the second largest FDI-receiving sector, which comes primarily from Finland. Finland proximity may explain why it is the largest foreign investor in Estonia.

7. Manufacturing FDI has been found to be linked with a host country’s export performance. This comes about by augmenting domestic capital, helping transfer of technology and new products, and providing training for the local workforce and upgrading technical and managerial skills (text figure).1,2

A01ufig28

Correlations of Trade and FDI, 2007

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: WEO; WIIW Database for Foreign Direct Investment.

8. Estonia faces competition for Nordic FDI from other emerging markets particularly in Asia. Even though Finland’s outward FDI bounced back in 2010, Estonia’s share has declined. Finnish FDI has been increasingly directed towards China and India, while Estonia’s share has remained roughly unchanged. In nominal terms, Finnish FDI in Estonia has been stagnant since mid-2000, with Finland’s FDI in China surpassing that in Estonia in 2006. This partly reflects a loss of Estonia’s price competitiveness and rising unit labor cost during the boom years. During the crisis, recessions had prompted further Finnish and Swedish manufactures to expand overseas production in Asia to cut costs. Estonia continues to attract manufacturing FDI but green-field investments are increasingly from small and medium-sized firms located in Finland.

A01ufig29

Finland: FDI Outflows

(Billions of euro; Percent of GDP)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: WEO; and IFS.
A01ufig30

Finland: Outward FDI Stock by Country

(Billions of euro)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: WEO; and IFS.
A01ufig31

Finland: Outward FDI Stock by Country

(Percent of recipient county’s GDP)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: WEO; and IFS.

9. Estonia’s ability to attract FDI will be a central element in boosting long-run growth. In particular, FDI can be a catalyst for a country to climb up the value chain via transfer of new technology and skills. Estonia has been the best performer in exports compared to the Baltic countries, but it has been caught up by the CEE countries in 2010 (Figure 5). In addition, FDI in the tradable sector (manufacturing) as a share of GDP had declined in Estonia during the boom years. Enhancing human capital and infrastructure would help tilt capital inflows more towards the tradable sector in line with the ongoing rebalancing of the economy.

A01ufig32

FDI Inflow by Country, 2010Q2-2011Q1

(Millions of euro)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Bank of Estonia; WEO; and Kinoshita (2011).
A01ufig33

Composition of FDI Stock, 2007

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Bank of Estonia; WEO; and Kinoshita (2011).

Appendix. Estonia Export Destinations, 2007–09 1/

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Source: Directions of Trade.

Cumulative exports between 2007-09.

Annex IV. Labor Market Development and Skill Mismatches

A. Recent Developments

1. Labor market conditions have improved steadily since the first quarter of 2010. Employment growth has increased by 7¾ percent (year-on-year) and the unemployment rate has declined to about 13¼ percent in the second quarter of 2011 from its 20-percent peak. Likewise, youth unemployment has fallen (Figure A2). Still, long-term unemployment has been rising.

Figure A2.
Figure A2.

Estonia: Labor Market Developments

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Haver; DX; and Statistics Estonia.1/ Defined as youth aged between 15-24 years old.2/ Defined as unemployed by more than one year.3/ The vacancy rate measures the proportion of total vacant posts expressed as a percentage of occupied and vacant posts.

2. Reflecting its flexibility, Estonia’s labor market has adjusted quicker than its neighbors (Figure A2). According to survey data, Estonia has the lowest collective bargaining coverage among EU countries, its wage changes are among the most frequent, and its share of bonus pay ranks among the highest.1 Relatively low level of employment protection legislation (EPL) may also contribute to a high turnover of labor force in Estonia

3. Labor participation rate has been on a rising trend except during 2008–10. Together with a stable trend in population growth, this implies that recent increases in outward cross-border workers to Nordic countries have not yet had significant effect on Estonia’s labor supply.

Baltics and GIPS: Labor Market Efficiency Index 1/

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Source: Global Competitiveness Indicators -- Labor Market Efficiency, World Economic Forum.

Each sub-index is calculated as a ratio of raw score to a cross-country average.

Overall index is an average of all sub-indices. A higher score reflects a more efficient labor market.

A01ufig34

Labor force, Employment, and Participation Rates

(Thousands; and percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Statistics Estonia.

4. Despite a decline in overall unemployment, long-term unemployment—accounting for about half of joblessness—has been rising.2 Labor force surveys show that Estonia’s long-term unemployment has been more prevalent among the youth (people between the ages of 15 and 25 years) lacking higher education. Still job vacancies are rising particularly in the manufacturing sector reflecting mismatched skills.

5. While the unemployment rate has remained in the double-digits, gross wages have started to increase again. This could reflect a number of factors. Given that wage increases have been more pronounced in manufacturing, labor shortage appear to be more acute in this sector. In the construction sector, increases in cross-border workers to Finland have contributed to a rise in wages despite moderate employment growth

A01ufig35

Wages in Manufacturing and Construction Sector

(4 quarter moving average, 2006Q1=100)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Haver.
A01ufig36

Labor Costs, Manufacturing Sector

(Yoy percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Eurostat.

B. Skill Mismatches in Labor Market

6. Addressing skill mismatches in the labor market is one of the main challenges facing Estonia. During the real estate and construction booms, a bloated demand for labor in the construction sector served to divert workers away from other sectors through rapidly increasing wages. The latter peaked in September 2008 and were 60 percent higher than in March 2006. During the bust, labor shedding took place in the construction sector, with about 43 percent of total jobs lost was in the construction sector. With no corresponding pick-up in manufacturing employment, unemployment increased rapidly. While the recovery has strengthened, laid-off construction workers have not been able to secure jobs in the manufacturing sector—where vacancies have increased—mostly due to the lack of needed skills

7. Recent trends in the relationship between vacancy and unemployment rates suggest that job matching has become more difficult. During March 2008 and March 2010, the recessionary phrase in the business cycle can be traced as a movement to the right along the Beveridge curve3. The unemployment rate had started to fall since March 2010 as job vacancies started to pick up. More recently, however, there was an uptick in unemployment despite an increase in the vacancy rate.

8. The job-skill mismatch is more visible in the manufacturing sector. Wages have started to increase in manufacturing despite rising job vacancies, while wages are still stagnant in the construction sector. A risk of the high unemployment rate would become entrenched unless the mismatches are further addressed by retraining and improving education. On this front, there have been a number of measures put in place to reduce unemployment. Wage subsidies targeting high-risk groups have contributed to reduce youth and long-term unemployed.

9. In Estonia, labor market developments suggest that the Beveridge curve could have shifted up in March 2010. Specifically in a simple regression line, a shift dummy is statistically significant and it increases the regression’s explanatory power; the adjusted R2 increases about 50 percentage points to 0.83 compared to a regression without the dummy. The outward shift could reflect a cyclical factor in the early stages of a recovery,4 but it could also imply a structural change in the efficiency of job matching associated with worsening skill mismatches.

10. The job-skill mismatch is more visible in the manufacturing sector. Wages have started to increase in manufacturing despite rising job vacancies, while wages are still stagnant in the construction sector. A risk of the high unemployment rate would become entrenched unless the mismatches are further addressed by retraining and improving education. On this front, there have been a number of measures put in place to reduce unemployment. Wage subsidies targeting high-risk groups have contributed to reduce youth and long-term unemployed.

A01ufig37

Beveridge Curve

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Source: Haver.
A01ufig38

Vacancy and Unemployment Rates from Regression 1/

(Percent)

Citation: IMF Staff Country Reports 2011, 333; 10.5089/9781463925895.002.A001

Sources: Haver; and IMF Staff calculations.1/ Fitted values are calculated from regression: ln Vr=[1.2]-[0.12]*Un+ [0.7]* dummy, where Vr and Un denote the log of vacancy rate and unemployment rate, and dummy is a binary variable that takes on the value of 1 starting in March 2010. The adjusted R-squared for the regression equals 0.83.
1

About eighty percent of third quarter profits are due to the one-off sale of Swedbank Estonia’s assets in Lithuania and Latvia to the Swedish parent.

2

The declines in the second and third quarters of 2011 are associated with the restructuring of the Swedbank ownership structure mentioned in footnote 1.

3

Sweden, Country Report No. 11/172. http://www.imf.org/external/pubs/ft/scr/2011/cr11171.pdf.

4

See Sweden, Country Report No. 11/172. http://www.imf.org/external/pubs/ft/scr/2011/cr11171.pdf.

5

Eesti Pank, Financial Stability Review (1/2011). Stress includes a decline of 1.4 and an increase of 2.0 percentage points respectively in growth and unemployment, as well as higher interest rates.

6

Republic of Estonia: Financial System Stability Assessment, IMF Country Report No. 09/89 (March 2009).

7

The Reorganization Act was adopted in 2008 and the corresponding act for natural persons was adopted in April 2011.

1

“National fiscal governance reforms across EU Member States: Analysis of the information contained in the 2009-10 Stability and Convergence Programmes,” European Economy Occasional Papers 67, August 2010.

2

See “Republic of Estonia—Stability Programme 2011,” http://www.fin.ee/index.php?id=79456.

1

The size of Finland’s large fiscal buffers reflect their publically mandated, and partly funded, pay-as-you-go pillar II pension system, and thus are not strictly comparable to those for Estonia.

1

Higher FDI in the tradable sector leads to better export performance and an improvement in external balance (Kinoshita, Yuko, 2011, “Sectoral Composition of FDI and External Vulnerability in Eastern Europe”, IMF Working Paper, WP/11/123 ).

2

Ibid.

1

Dabušinskas, Aurelijus and Tairi Rõõm, 2011, “Survey Evidence on Wage and Price Setting in Estonia,” Bank of Estonia Working Papers Series 6/2011.

2

Long-term unemployment refers to unemployed persons who have been looking for a job for more than 24 months.

3

The job vacancy rate is negatively related to the unemployment rate in a pattern known as the “Beveridge” curve. Movements along the curve trace the business cycle. In the expansionary phase, for instance, one moves along the curve in a northeast direction as vacancy rates rises and the unemployment rate falls. Shifts in the curve represent changes in structural unemployment. A rightward shift of the Beveridge curve implies a a decline in the labor market’s efficiency: i.e., the job matching process has become less efficient due to mismatches between the unemployed and available jobs (Rodenburg, Peter, 2011, “The Remarkable Transformation of the UV curve”. European Journal of the History of Economic Thought 18 (1): pp.125-153).

4

Tasci, Murat and and John Lindner, 2010, “Has the Beveridge Curve Shifted?” Federal Reserve Bank of Cleveland, Economic Trends, August 10.

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Cover IMF Staff Country Reports
Republic of Estonia: Staff Report for the 2011 Article IV Consultation
Author:
International Monetary Fund
Volume/Issue:
Volume 2011: Issue 333
Publisher:
International Monetary Fund
ISBN:
9781463925895
ISSN:
1934-7685
Pages:
62
DOI:
https://doi.org/10.5089/9781463925895.002
Figure 1.

Estonia: The Strengthening Economic Rebound, 2007-11

Contributions to GDP Growth and GDP Growth

(YoY, percent)

Confidence Indicators 1/

(Percent Balance)

Industry Capacity Utilization, SA

(Percent)

Real GDP Growth in Baltics

(Yoy percent changes)
Figure 2.

Estonia: Recent Price Development, 2010-11 1/ 2/ 3/
Figure 3.

Estonia: Legacies of the Bust

Inflation and Contributions in Estonia and Euro Area

(Yoy percent changes)

Vacancy Rates 1/

(Percent)

Inflation, 2006Q1-2011Q3 1/

(Yoy percent changes)

Change in Employment by Sectors

(Millions)

Stock of Bank Loans by Sector

(Billions of euro)

Monthly Growth of Loans to Individuals

(YoY percent changes)

Monthly Growth of Loans to Non-Financial Corporations

(YoY percent changes)

Banking System Profits and Liquidity

(Percent)
Figure 4.

Estonia: External Developments, 2001-11
Figure 5.

Estonia: External Competitiveness, 2005-11
Figure 6.

Estonia: Fiscal Developments and Structure
Figure 7.

Estonia: Statutory and Implicit Tax Rates, 2009-11
Figure 8.

Estonia: Financial Sector Developments

Asset Quality and Provisioning

(Percent of total loans)

Estonian Banks’ Capital Buffers

(Percent)

Foreign Support and Local Financing of Assets

(Percent)

Eonia Forward Curve, as of November 2011

(Percent)

NPL Mortgages by Loan-to-Value 1/

(Percent)

Net Sales, Personnel Expenditures and Total Profit of Business Sector, 2007-11

(2005 = 100)

Productivity and Real Labor Compensation

(2000 = 100)
Figure 9.

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

(External debt in percent of GDP)

Government Liquid Financial Assets

(Millions of euro)

Euro Area: Fiscal Buffers, 2007 and 2010 1/ 2/

(Percent of GDP)

Government Liquid Financial Assets

(Percent of GDP)

Euro Area: Another Measure of Fiscal Buffers, 2009 1/ 2/

(Percent)
Figure A1.

Euro Area: Fiscal Buffers, Volatility, Financing Needs and Credit Ratings, 2001-10 1/ 2/

Imports by Source Country, 2000 - 2010

(Percent of total imports)

Exports by Source Country, 2000 - 2010

(Percent of total exports)

Correlations of Trade and FDI, 2007

(Percent of GDP)

Finland: FDI Outflows

(Billions of euro; Percent of GDP)

Finland: Outward FDI Stock by Country

(Billions of euro)

Finland: Outward FDI Stock by Country

(Percent of recipient county’s GDP)

FDI Inflow by Country, 2010Q2-2011Q1

(Millions of euro)

Composition of FDI Stock, 2007

(Percent of GDP)
Figure A2.

Estonia: Labor Market Developments

Labor force, Employment, and Participation Rates

(Thousands; and percent)

Wages in Manufacturing and Construction Sector

(4 quarter moving average, 2006Q1=100)

Labor Costs, Manufacturing Sector

(Yoy percent)

Beveridge Curve

(Percent)

Vacancy and Unemployment Rates from Regression 1/

(Percent)