Economic Outlook

The Estonian economy has recently maintained growth at above the 3 percent level, which was one of the highest growth rates in the European Union last year and exceeded the authorities’ expectations. The recovery of the Estonian economy from the 2008-09 recession has been bolstered by credible and front-loaded adjustment measures that amounted to about 9 percent of GDP in 2009. These measures helped to restore confidence, contributed to a reduction of imbalances, and increased the resilience to adverse external developments. The Estonian economy has benefitted from the fiscal policy set, consisting of a prudent budgetary position, a low level of public debt, and fiscal reserves. The current low level of monetary policy interest rates in the euro area has eased the balance sheet adjustment and supported domestic demand in Estonia. Therefore, as the strong exports-led recovery has recently given ground, growth has shifted more towards investments and consumption. Looking forward, the Estonian economy is likely to retain steadfast growth, fastening in line with improvements in the external environment. The risks lie predominantly in the external environment and may pass through trade and financial channels.

Inflation has been affected by high commodity prices in the last years but is likely to slow in 2013. Core inflation has remained contained, standing at 2.1 percent in March 2013 and being broadly consistent with a slightly negative output gap. However, the opening up of the electricity market for consumers and SMEs and increases in tobacco and alcohol excise taxes in January 2013 have all withheld a slowdown in headline inflation. According to the authorities’ assessment, ca 1 percent out of 3.8 percent yearly harmonized consumer price inflation in March 2013 can be ascribed to electricity and electricity related components. The staff report claims that Estonian inflation might reflect its intense use of energy. The Estonian primary energy intensity is indeed higher than in other Baltic countries and the European Union. However, this reflects the fact that electricity is extracted from less energy efficient oil-shale. Therefore, higher primary energy intensity does not necessarily refer to higher inflation responsiveness to energy prices.

The staff report highlights the high sensitivity of Estonian inflation to commodity prices, especially in recent years. Vigorous food exports are the essential element why food consumer prices have strongly responded to food commodity price appreciation. The main destination country has been Russia, but also Finland, Latvia, and Lithuania.

The Estonian labor market has undergone a vivid recovery with the unemployment rate declining from 19.8 percent in the beginning of 2010 to 9.3 percent in the end of 2012. This can be ascribed mainly to intensified domestic job creation, but to some extent also to working abroad. Given the very low level of unionization and wage indexation, wage growth has been predominantly productivity driven. According to the labor force survey, ca 1/5 of approximately 25 thousand people from Estonia working abroad in 2012 were employed by companies of Estonian origin. Estonia’s closeness to its Nordic neighbors allows for working abroad but to retain residency in Estonia. This advantage is taken by people working mostly in the secondary sector, construction in particular. However, labor force survey data, referred to also in the staff report, is likely to understate true migration flows. Looking forward, the labor market is likely to remain a source of domestic risk, as is identified also by staff. There are signs of skill mismatches which together with potential migration outflows may add pressure on wages and on core inflation in the medium term.

Fiscal Policy Issues

There is agreement between staff and the authorities on views about the Estonian fiscal sector. The authorities have prioritized a conservative fiscal policy, with the aim that the general government budget will be kept in a structural surplus and that a low level of government debt is maintained.

Estonia’s structurally adjusted budget has been in surplus in recent years. In terms of the unadjusted budget, surpluses of 0.2 and 1.2 percent of GDP were recorded in 2010-11. In 2012 the budget was in a 0.3 percent deficit, being still better than expected. The dynamics of the budgetary position has recently been affected by the net position of the CO2 unit sales revenue and the consequent investment spending. Last year this component contributed in the amount of -1 of GDP as compared to 1 percent in 2011. In 2012, the general government debt was 10.1 percent of GDP, one fifth of which is related to the contributions to the European Financial Stability Facility.

At the current juncture, the Estonian authorities see a heightened need to maintain fiscal prudence. There are still fiscal and financial fragilities in the external environment and the monetary policy stance is also accommodative. Therefore, the authorities consider a broadly neutral fiscal policy stance as appropriate for the years to come. The latest macroeconomic forecast of the Estonian Ministry of Finance from April 2013 predicts small fiscal deficits in 2013-14 and balance for 2015 while the IMF staff forecast foresees small surpluses. These differences are not yet significant, being mostly on the revenue side. Following Estonia’s medium term fiscal strategy for 2014-17, published last week, the authorities expect a fiscal tightening and the structural surplus is expected to gradually reach 1 percent of GDP in 2016.

In the beginning of 2013, the unemployment insurance contribution rate was reduced by 1.2 percentage points to 3 percent, allowing household disposable income to increase. At the same time, excise taxes on tobacco and alcohol were increased. The government previously legislated a decline in the income tax rate by 1 percentage point to 20 percent, which will take effect in 2015. Following the 2013 budget, the public sector wage bill is expected to increase after a freeze in 2009-11 and a 4.4 percent increase in 2012. Capital expenditures as a share of GDP will decrease in the coming years caused by the ending of the current EU financial framework.

Estonia is in the process of setting up a Fiscal Council and a structural budget balance rule, which are expected to enhance the current medium term fiscal framework. These initiatives are yet in the form of draft acts with the expectation to be passed to the Estonian Parliament by autumn this year and approved by the end of 2013. The fiscal rule is expected to impose multi-annual ceilings on state budget expenditures. It prescribes an adjustment path towards structural balance and the mechanism to compensate forecast errors on the deficit side.

Financial Policy Issues

The risks to financial stability stemming from the Estonian economy are low. There is broad consensus between staff and the authorities that the Estonian financial sector has thrived out from recession. The banks are well capitalized, with the capital adequacy ratio standing at 23.5 percent in December 2012 on consolidated basis, as well as being profitable and liquid. The ratio of loans to deposits has reached 110 percent, the lowest level in a decade, and the ratio of non-performing loans has returned to a level of almost 3 percent, as at the beginning of 2013. The parent banks of the banks operating in Estonia, located in the Nordic countries, are sound and internationally favorably positioned. Lending rates are low in Estonia and the loan portfolio started to increase again last year, but without signs of excessive loan growth at the near horizon. A viable recovery of profits in the non-financial corporate sector has allowed the leverage ratio to return almost to the pre-boom level. The banks and borrowers have been called by the authorities to remain aware of the future risks that accompany interest rate increases.

The Estonian authorities see sovereign debt problems in the external environment and a delayed recovery of global growth as the main threats to the domestic financial sector. Therefore, steps towards establishing the SSM and imposing stricter capital and liquidity requirements in 2014 are considered important. Given the highly integrated Estonian and Nordic banking sectors, it is crucial that the current Nordic-Baltic cooperation on financial stability will be preserved, even if the non-euro area countries should choose to opt out from the SSM. The Estonian authorities welcome the steps of the Swedish authorities that placed new liquidity requirements on their largest banks from the start of 2013.

The Estonian authorities plan amendments to the Credit Institution Act that will extend the toolkit and executive power of the Bank of Estonia as the main macro-prudential authority. The expectation is that these amendments will be made over the course of 2014 and will come into force immediately thereafter. The implementation of macro-prudential tools is expected to minimize systemic risks to financial stability and avoid a buildup of economic imbalances, reducing business cycle volatility.

Structural Issues

One of the major concerns in the Estonian economy is the unemployment rate, which has fallen substantially from the peak levels, but remains nevertheless above economically and socially tolerable levels. The authorities have set an aim for the employment rate to reach 76 percent in the productive age cohort of 20-64 by 2020 from the current 71.7 percent.

Long-term unemployment poses risks, especially against the background of skill mismatches between the pool of unemployed and available vacancies. To alleviate these problems, the Estonian Unemployment Insurance Fund (EUIF) has updated and diversified their services portfolio. New measures have become more individualized, and special services for disabled persons and for people who have been out of work for a long time have been developed. The EUIF has established more intense cooperation with municipalities and employers, addressing better the community needs. Although the unemployment rate has fallen, the participation in ALMPs has remained high or even increased (for example work related training, career counseling, work practice, coaching for work life, debt counseling, psychological counseling, and a few others). The EUIF has drawn a multi-year strategic plan for 2013-15 with predefined effectiveness measures.

The Estonian authorities recognize the importance of developing human resources as a pillar of long-term growth. There are yet many challenges to organize the educational system in a way that creates mutually supportive relationships between human resources and economic growth and alleviates pressures from population aging and migration. There are a number of ongoing initiatives, which are aimed to make vocational training more available and competitive, taking better into account the labor market needs. A set of indicators is agreed upon to measure the success rate of these initiatives. Higher participation in lifelong learning has been one of the policy priorities, increasing from 5.4 percent in 2002 to 12.9 percent in 2012. As a part of higher education reform, the academic year of 2013-14 brings along a new financing model of high education, making university studies free for all full-time students and providing allowances, which are adjustable on the basis of family income.