Republic of Estonia: 2014 Article IV Consultation—Staff Report; Press Release; and Statement by the Executive Director for the Republic of Estonia
Author:
International Monetary Fund. European Dept.
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Publication Date:
08 May 2014
eISBN:
9781484373118
Language:
English
Keywords:
ISCR; CR; financial asset; structural surplus; deficit; debt; unemployment rate; government deposit; Estonian authorities; authorities' view; consumer demand; Wages; Global
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This 2014 Article IV Consultation highlights that in 2013, Estonia’s recovery from the crisis continued but at a slower pace. Real GDP growth was 0.8 percent, with private consumption providing the main support, although net exports made a negative contribution. Inflation declined to about 3½ percent, but stayed above the euro average. Public finances remained strong, with a fiscal deficit of 0.2 percent of GDP and a gross public debt of 10 percent of GDP. Real GDP growth is projected at 2.4 percent in 2014, rising toward expected potential growth of 3 to 3.5 percent in the medium term.

Abstract

This 2014 Article IV Consultation highlights that in 2013, Estonia’s recovery from the crisis continued but at a slower pace. Real GDP growth was 0.8 percent, with private consumption providing the main support, although net exports made a negative contribution. Inflation declined to about 3½ percent, but stayed above the euro average. Public finances remained strong, with a fiscal deficit of 0.2 percent of GDP and a gross public debt of 10 percent of GDP. Real GDP growth is projected at 2.4 percent in 2014, rising toward expected potential growth of 3 to 3.5 percent in the medium term.

Context and Outlook

A. Recent Developments

1. Estonia has been governed by coalitions led by the center-right Reform Party since 2005, but a new coalition of center-right and center-left parties was formed on March 26, 2014. On March 4, Prime Minister Andrus Ansip announced his resignation after nine years in office, and the center-right senior partner in the previous coalition has replaced its more conservative junior coalition partner with the center-left Social Democrats. There is broad consensus within Estonia on a conservative fiscal policy stance, and the change in the ruling coalition is not expected to result in substantial changes to economic policy apart from some changes in social benefits and employment taxes. New elections are due in March 2015.

2. Estonia’s recovery from the crisis continued in 2013 but at a slower pace. Preliminary data indicate that growth was 0.8 percent in 2013, with a deceleration during the year (Table 1 and Figures 1 and 2). Private consumption provided the main support for growth, while net exports made a negative contribution. Inflation declined gradually to about 3½ percent (period average) in 2013, but remains above the euro average.1 Some of the slowdown is due to one-off factors, and there are unexplained anomalies in the national accounts data (e.g., a large deflator and unusual changes in implied taxes and subsidies). These anomalies and other indicators from tax revenue and labor market data have led most official and private analysts in Estonia to believe that the actual 2013 growth rate was higher than the current official figure.

Table 1.

Estonia: Selected Macroeconomic and Social Indicators, 2008–15

(Units as indicated)

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

the difference with the current account reflect differences in external trade data between the national accounts (Statistical Office) and the BOP (Central Bank).

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.

Domestic credit to nongovernment euro area resident sectors beginninhg in 2011.

Beginning in 2011 data are for contributions to euro area M2 aggregate.

Figure 1.
Figure 1.

Estonia: Real Sector Developments, 2008–13

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Sources: Haver; and national authorities.1/ Balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
A01ufig01

Estonia: Inflation and Unemployment

(Percent)

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Source: Haver.
A01ufig02

Growth of Wages and Labor Costs

(Percent change)

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Sources: Haver; and national authorities.

3. Unemployment continued to fall in 2013. The period average unemployment rate dropped 1.4 points to 8.6 percent in 2013 (based on the labor force survey) with the number of registered unemployed persons falling by a similar proportion. The unemployment rate is now roughly half of the 2010 peak. In contrast to many other advanced economies, this has taken place against a backdrop of a rising participation rate since the boom, encouraged in part by enhanced benefits for the unemployed. The Eesti Pank estimates that the unemployment rate would be near 5 percent had the participation rate remained at 2006–07 levels.

4. Wage growth accelerated and outstripped productivity growth as labor market conditions tightened. Nominal wage growth accelerated to 7.6 percent in 2013, resulting in an increase in real unit labor costs of 2.5 percent relative to 2012.

5. On balance, the economy seems to be roughly at its potential level. Estimates of potential using a production function method and official national accounts data show a small output gap, while evidence from the labor market suggests that the economy may already be below the NAWRU. However, the conflicting signals between national accounts and other data create more than the usual amount of uncertainty as to where the economy is relative to the potential output level, in particular whether it is closer to potential than the measured level or even above potential.

6. The external sector balances are broadly appropriate and the net international investment position (IIP) is strengthening (Table 3 and Figure 3). The current account deficit is small and shrinking and exports and export market shares have been growing steadily. The key factors influencing exports are moving in different directions; exports based on processing fuels imported from Russia have declined sharply, although value added is low in fuel processing. Exports excluding these goods for processing rose, although their growth rate decelerated in 2013. On the other hand, export market shares and value added in exports are increasing. But the trade balance deteriorated slightly in 2013 due to weakness in demand from some key export markets, notably Finland, and rising imports from robust private consumption demand in Estonia. Gross external debt fell sharply in 2013 and net external debt of the economy is now negative, although the IIP position remains negative due to the large stock of FDI.

Table 2.

Estonia: Summary of General Government Operations, 2008–15

(Percent of GDP)

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

Estonia: General Government Financial Assets and Liabilities, 2008–13

(Millions of Euros)

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Source: Eesti Pank.

Including commitments under the European Financial Stability Fund.

Figure 2.
Figure 2.

Estonia: Putting the Crisis Behind, 2008–13

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Sources: Eurostat; Statistics Estonia; and Bank of Estonia.
Figure 3.
Figure 3.

Estonia: External Developments, 2003–13

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

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

7. Indicators of competitiveness are generally good, but rising wages and producer prices are putting pressure on price competitiveness. Real effective exchange rate indices based on unit labor costs remain well below their pre-crisis peaks (particularly for manufacturing) but they have been rising in 2012–13 (Figure 4).

Figure 4.
Figure 4.

Estonia: External Competitiveness, 2008–13

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

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

8. The exchange rate is broadly appropriate and in line with macroeconomic conditions and policies. EBA estimates are not produced for Estonia, but team estimates based on CGER-like methodology show mixed results with some indicators suggesting an overvalued rate and others suggesting an undervalued rate. These results, together with the evidence on external sector flows and stocks, and competitiveness indicators, point to a generally stable and sustainable external position as well as a broadly appropriate exchange rate.

9. Fiscal policy has remained conservative throughout the cycle (Tables 2 and 3 and Figure 4). The deficit never exceeded 3 percent of GDP during crisis, and the budget has been in near balance from 2010 onwards, with the 2013 deficit at 0.2 percent of GDP. Gross public debt was largely unchanged at just under 10 percent of GDP while net public debt is near zero. While this near-balanced budget policy has kept public debt low, it has also added a pro-cyclical bias to fiscal policy.

10. Estonia’s banks and their Nordic parents are well capitalized, liquid, and have low levels of non-performing loans. The capital adequacy ratio remains high at 20 percent of risk-weighted assets at end 2013, and non-performing loans have fallen to 1.5 percent of the portfolio. With the loan-to-deposit ratio now just close to one, the banking system appears to have reached a sustainable equilibrium (Figure 6).

Figure 5.
Figure 5.

Estonia: Fiscal Developments and Structure, 2003–13

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Sources: WEO; Eurostat; and OECD.1/ Data for Korea are for 2012.
Figure 6.
Figure 6.

Estonia: Financial Developments, 2007–13

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Sources: Haver; national authorities; and IMF staff calculations.1/ In Lithuania, NPLs include impaired loans and 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.
A01ufig03

Estonia: Debt and Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Source: National authorities.

11. Credit growth has resumed, but credit demand remains subdued. Credit growth has been positive but modest for non-financial corporations since mid-2012. While the banks have the capacity to increase lending, both business surveys and balance sheet data indicate that corporations are being cautious in their investment plans, and they are generally able to finance investments from retained earnings.2

12. The housing market is recovering from a very sharp decline during the crisis, but prices and household leverage are well below their peak levels. The housing market peaked in 2007 before house prices lost roughly half of their value by 2009. Prices have risen since then, but they are roughly midway between the peak and the trough. Loan-to-value ratios on new loans have fallen from roughly 100 percent of the purchase price before the crisis to roughly 60 percent since 2010. More generally, households are repairing their balance sheets and are cautious about new borrowing, although credit growth turned positive for households in late 2013. Gross household debt is still high, even after declining sharply since the crisis, but household net financial assets are positive (Table 7).

Table 4.

Estonia: Summary Balance of Payments, 2008–15

(Units as indicated)

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

Excluding interest payments and reinvested earnings.

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, 2008–19

(Percent of GDP, unless otherwise indicated)

article image
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 Economic Vulnerabilities, 2008–13

(Percent of GDP, unless otherwise indicated)

article image
Sources: Estonian authorities; Bloomberg; Standard & Poor’s; and IMF staff estimates.

Total general government and government-guaranteed debt excluding government assets held abroad.

Credit to households and nonfinancial institutions.

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 residen

For 2008-10, EEKs per US$; starting in 2011, Euros per US$.

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: Households’ Financial Assets and Liabilities, 2008–12

(Millions of Euros)

article image
Source: Statistics Estonia
A01ufig04

Residential Housing Price Index

(2010=100)

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Source: BIS.

13. Estonia generally gets very high scores on cross-country evaluations of structural reform. For example, the flexibility of the Estonian labor markets cushioned some of the impact of the crisis and euro area recession on employment through downward flexibility in nominal wages in 2009–10. However, structural unemployment remains high.

Estonia: External Stability Assessment

Estonia’s real exchange rate has remained broadly in line with the fundamentals, although with some vulnerabilities on the horizon. Models based on medium-term equilibrium current account balance point to undervaluation, while direct assessment of the equilibrium real exchange rate suggests an overvaluation. An average of these estimates indicates a small overvaluation (about 5 percent). If the equilibrium real exchange rate estimate is discounted given the view that it might exaggerate overvaluation, the margin of overvaluation would shrink. However, the wide range of values from different approaches imply large confidence intervals that would preclude a firm conclusion on over-or under-valuation.

REER Assessment

(percent)

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Source: IMF staff estimation.

Price-and cost-based indicators confirm gentle decrease in competitiveness. Having declined significantly in 2010–11, the ULC has been climbing again as real wage growth has outpaced productivity increases. Consequently, both ULC- and inflation-deflated REER have been slowly appreciating, with REER-CPI increasing by 2.7 percent in 2013.

After running large current account deficits during the boom, Estonia’s current account has been near balance with a deficit of 1 percent of GDP in 2013. Exports continue to perform well, although demand remains weak in some of Estonia’s main trading partners. In 2013, the trade deficit widened slightly, while the services surplus decreased slightly to 6.7 percent of GDP. Net export of services dominates trade balance, as Estonia capitalizes on its highly-skilled and competitive wages as well as well-developed telecommunication network. Estonia gained market share in each of its top export markets in 2013 (Finland, Sweden, Russia and Latvia).

Net FDI and transfers from the EU cover most of the current account deficit. FDI has been declining, but remained positive with reinvested earnings accounting for most FDI inflows. EU transfers are expected to pick up again in late 2014 or early 2015 with the implementation of the new EU budget for 2014–20.

Gross external liabilities are declining and net debt of the economy became negative in 2013. Net IIP liabilities were halved from the peak during the crisis years to 46 percent of GDP in 2013.

B. Outlook and Risks

14. Growth should pick up in 2014 and the medium-term. Staff project growth of 2.4 percent in 2014 supported by both external and domestic demand rising toward expected potential growth (estimated at 3 to 3.5 percent in the medium term, using a production function approach that accounts for demographic factors). The downward trend in inflation is expected to continue, toward 2 percent over the medium term, but could be slowed by increased wage pressure. This is above the euro-area average, but it is consistent with what would be expected for a country converging with its higher-income partners in the euro area.

15. Risks are tilted moderately toward the downside and mostly relate to trade. Continued contraction in Finland, or lower-than-expected growth in Sweden or Latvia could slow Estonia’s growth through lower exports or FDI. Trade or other shocks from Russia and other CIS countries could also drag down exports or otherwise depress growth. Trade with Russia is dominated by energy imports, much of which is fuels that are re-exported after processing and natural gas for which Russia is the sole supplier, and food exports, some of which are already subject to import restrictions in Russia. On the upside, higher than expected growth in Nordic-Baltic countries or other trade partners could also boost Estonia’s growth.

16. A rise in interest rates from a shock in the Nordic banking system could also adversely affect Estonia. With household debt dominated by adjustable rate mortgages, such a shock would pass through quickly into household debt service, and this could lower consumer demand. Businesses would be less affected as they are increasingly self financed for their investment needs or able to get funding from foreign parent companies. However, a financial market shock outside the Nordic region would have only a limited effect on Estonia given the strong financial position of the Nordic banks and their dominance in the Estonian banking market.

17. The main domestic risk is labor market overheating. Signs of this are already evident as real wage growth is exceeding productivity growth, and this could undercut competitiveness and export growth. With a flexible labor market legal regime and low levels of unionization, these wage increases represent market outcomes.

Estonia: Risk Assessment Matrix1

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The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

Authorities’ views

18. While broadly agreeing with the outlook, the authorities were mostly concerned about rising wage rates in excess of productivity growth. They also expect that growth will rebound in 2014, and that inflation will decline in 2014 and over the medium-term. They agree that excessive wage growth threatened competitiveness and growth, but they noted the strong influence of much higher wages elsewhere in the EU, particularly Finland, and the ease and frequency with which Estonian workers can move to Finland as exogenous factors influencing Estonian wages that are beyond the control of the authorities. They agreed that potential fallout from events in Russia and Ukraine could affect trade with Russia, but they had not observed much immediate effect; the wide margins of uncertainty as to future developments in this conflict rendered any assessment of any economic impact highly speculative.

Policy Discussions

Estonia’s policies and policy agenda since the last Article IV consultation have been marked by continuity in policies (e.g. near-balanced budgets, steady implementation of their own policy agenda, the EU fiscal compact and the Basel III reforms (Box 2)). With output near potential and signs of overheating in labor markets, the consultation focused on the appropriate fiscal stance and labor market policies, and on changes to fiscal and financial sector frameworks to help Estonia better manage within the constraints of the euro zone.

A. Fiscal Policies

19. The fiscal stance in 2014 and medium-term path remain appropriate. With a projected headline deficit of 0.4 percent of GDP and an estimated structural surplus of 0.7 percent of GDP, the fiscal stance in 2014 is largely unchanged from 2013. The budget will maintain Estonia’s strong public finances and keep Estonia well within the limits set by its commitments under EU agreements. Over the medium-term, the fiscal stance will further reduce public debt and restore the net financial asset position of the government (see DSA, Figures 7 and 8).

Figure 7.
Figure 7.

Estonia: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(Percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ Long-term bond spread over German bonds.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r − π(1+g) − g + ae(1 + r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1 + r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Figure 8.
Figure 8.

Estonia: Public DSA – Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Source: IMF staff.

20. Estonia enacted a new State Budget Law in March 2014 that implements provisions of the EU Fiscal Compact. The structural surplus target embodied in the new budget Law could help to address the previous pro-cyclical patterns on fiscal policy. Specifically, the requirement for a structural surplus can help to prevent increases in expenditure during good times that cannot be sustained over the longer-term. While adherence to the structural surplus target would not require counter-cyclical spending during downturns, it provides scope to allow automatic stabilizers to operate fully. The government’s plans to keep the structural surplus well above the medium-term objective for the Fiscal Compact. This could keep the government’s balance sheet strong and provide a margin to accommodate negative fiscal surprises or disagreements as to whether the target is met based on alternative estimates of the structural balance. Care must be taken to ensure that the margin relative to the target does not provide a channel through which to reintroduce pro-cyclicality. Legislation was approved in late March 2014 to create an new, independent fiscal council in line with the Fiscal Compact.

Authorities’ views

21. The authorities were more cautious than staff on allowing automatic stabilizers to work fully in downturns. While they accepted the argument for countercyclical fiscal policy, they felt that this needed to be weighed against the desirability of increasing fiscal reserves in an economy with a declining and aging population that has been exposed to large shocks in the past. They also consider fiscal stimulus rather inefficient because much of it leaks out of the country due to the high import share in the economy. On the fiscal council, the authorities believe that the formation of new independent institution will further bolster Estonia’s resilience and credibility on fiscal policy.

B. Financial Sector Policies

22. Risks to the banking sector remain, but appear contained. The risks on the domestic side stem from possibly weak output growth which may negatively affect credit quality. However, the stress test conducted by the authorities suggests that potential impacts from macro shocks would be largely absorbed by high capitalization. Externally, financial stress in the Nordic banking system, possibly due to the tensions in global funding markets or a correction in housing prices, could induce banks to pull funding from Estonia. However, strong deposit growth in Estonia provides a substantial portion of local funding for now.

23. The Estonian authorities are implementing the new capital and liquidity provisions under Basel III. The capital conservation buffer, the systemic risk buffer, and the countercyclical capital buffer will be implemented shortly after pending legislation is enacted. The capital conservation buffer (of 2.5 percent EU-wide) is expected to be immediately adopted without a transitional period. The systemic risk buffer is expected to be set at 2 percent and the countercyclical buffer is expected to be set at zero initially. The liquidity coverage ratio is to be implemented by January 1, 2015. These actions are not likely to substantially affect the banking sector which is already highly capitalized and liquid. They would complete most of the outstanding domestic agenda on the Basel-III reforms and go a very long way toward ensuring financial sector stability.

24. Estonia is now well advanced in the process of establishing a more complete and stronger macroprudential toolkit. The draft amendments to the Eesti Pank Act and the Credit Institutions Act would establish the Eesti Pank as the macroprudential authority, give it the macroprudential tools specified in the CRD IV, and provide the authority to set macroprudential limits such as loan-to-value and debt-service-to-income ratios requirements rather than guidelines.

25. Implementation of the EU Banking Union will require cooperation between Estonia, the ECB, the Nordic home country supervisors of Estonia’s major banks, and the Nordic-Baltic financial structures. With the implementation of the Single Supervisory Mechanism (SSM) in November 2014, the three subsidiaries (SEB, Swedbank, and DNB) will come under direct supervision of the ECB. The Nordic bank branches (Danske and Nordea) would remain under the supervision of the Swedish and Danish authorities respectively.3 Then, modalities should be in place for close consultation between the Estonian authorities, ECB regulators and the Nordic regulators of the parent banks, both on supervision and on setting regulatory capital and liquidity requirements. The current framework of Nordic-Baltic cooperation on bank supervision and policy (including Nordic-Baltic Stability Group and Nordic-Baltic Macroprudential Forum) will need to be adapted to the Banking Union.

Authorities’ view

26. The authorities’ view is that the banking system is sound, but they also feel the need to closely monitor it. The early adoption of the capital conservation buffer reflects the authorities’ confidence on banking sector soundness, while they plan to assess SSM banks (SEB, Swedbank, and DNB), as well as small local banks with relatively rapid credit growth, through the ECB-led asset quality review later this year. The authorities value the importance of the more complete and strengthened macroprudential toolkit for banking supervision. The authorities believe that the Banking Union will create a positive confidence effect on Estonia’s banking sector and that Nordic-Baltic cooperation has worked well and needs to be preserved.

C. Labor Markets

27. The government should be prepared to respond to further evidence of deteriorating competitiveness from real wage increases. While the first of three roughly 10 percent annual increases in the minimum wage in 2013–15 probably had minimal effect on average wages, the two subsequent increases may become more binding on actual wages. Also, while wages are very largely market determined in Estonia, the minimum wage increases and public health and education wage increases may have had a demonstration effect beyond their direct impact. Until it is clear that recent signs of worsening price competitiveness are not undercutting net exports, the government should refrain from large public sector wage hikes or agree to minimum wage increases after 2015.

28. Estonia’s high level of structural unemployment needs to be addressed. While there is considerable evidence that the Estonian economy is now at or near the level of structural unemployment, the fact that this is taking place with the unemployment rate still above 8 percent suggests scope for medium-term policies to reduce the structural rate. Estonia has a very flexible labor market, but still structural unemployment remains higher than in countries with similar labor market policies. Mismatches in workforce skills and education and the background sought by employers seem to be keeping unemployment high even in good economic times. Some active labor market policies to address skills mismatches and keep people in the labor force are already in place. The authorities are addressing education through several initiatives, including eliminating university tuition for full-time students. The work of the Unemployment Insurance Fund on training and counseling to encourage effective labor force participation by youth, the disabled, and the long-term unemployed has been expanded very substantially to integrate these more difficult segments of the working age population. Specifically, active labor market expenditures per unemployed person rose sharply between 2010 and 2012 in almost every category, with training expenditures (the largest category) rising to more than eight times the 2010 per person level by 2012. More efforts are needed to change the composition of specialization in secondary and tertiary education, but this is inherently a long-term project.

29. Labor taxes and contributions may be an obstacle to reducing unemployment, particularly for low wage workers. The tax wedge is high in Estonia even relative to the Nordics and much higher than in the “Anglo-Saxon” (i.e., majority Anglophone) OECD countries. Labor taxes as a share of business income are particularly high relative to profit taxes for Estonia and this is true in comparison to both the Nordics and Anglo-Saxons. Evidence from other countries suggests that reducing the labor tax wedge would be likely to reduce structural employment. In this context, lowering the tax wedge on lower-wage workers (where unemployment is highest) should be given serious consideration.4 The fiscal costs could be offset by tax reforms, in particular through elimination of regressive tax exemptions or the introduction of property taxes) that preserve the fiscal targets. Lowering the tax wedge would also contribute to containing unit labor costs and improving competitiveness.

A01ufig05

Taxation Rates

(Percent)

Citation: IMF Staff Country Reports 2014, 112; 10.5089/9781484373118.002.A001

Source: World Bank Doing Business.

Authorities’ views

30. The authorities noted that the active labor market policies that have been gradually introduced since 2010 have contributed to the sharp decline in unemployment since then. The Unemployment Insurance Fund (UIF) has developed various assistance programs to help the registered unemployed in their job search, including counseling, disability employment services, and training. They also noted efforts being made by the Ministry of Education and Research to improve life-long learning at all skill levels for those already employed in order to foster productivity growth, and increase the number of people coming out of the education system in technical fields (e.g., science and engineering), including through cooperation between universities and the private sector. Finally, the authorities indicated that they are preparing a reform of disability benefits that would strengthen the possibilities of disabled people for (part-time) work thus increasing employment and at the same time tighten the eligibility criteria for disability benefits and limit abuses (the number of people receiving disability benefits is close to one-sixth of the labor force).

D. Other Policy Priorities

31. Regional efforts to improve infrastructure links to Estonia’s neighbors could also boost competitiveness. Infrastructure in Estonia is rated highly in international comparisons, but regional cooperation needs to be enhanced for some critical systems, such as transport and energy. While progress has been made in linking the electricity grid to Finland, more could be done to build rail links to the rest of the EU and diversify options for natural gas supply. Particularly as EU funds are potentially available to finance most of the costs for rail and gas, Estonia should coordinate with its Baltic and Nordic neighbors to better connect itself to the rest of the EU and diversify infrastructure links to be able to take advantage of better alternatives. 5

Authorities’ views

32. The authorities agreed on the importance of improving infrastructure links to the rest of the European Union, but noted the steps already taken or underway. They noted that the second electricity link had been established with Finland and that there was agreement with Finland on LNG terminals and a gas pipeline linking the two countries. Discussions on a rail link running through the Baltics and connecting them to the rest of the EU through Poland are underway.

Staff Appraisal

33. The near- and medium-term outlook for Estonia is generally positive. While growth slowed in 2013, there is good reason to expect an acceleration of growth in 2014 and the medium term. Inflation has been running above the euro area average, but it is trending down toward 2 percent and remains appropriate for a country rapidly converging with its higher-income euro area partners. Export growth remains strong and competitiveness indicators are generally good, although rising unit labor costs are a source of concern and need monitoring. External risks are mostly related to trade and the outlook for growth in major export markets, although problems in the Nordic banking system could spill over into Estonia and events in Russia and Ukraine could have a negative impact through other channels.

34. The 2014 budget continues the Estonian tradition of prudent fiscal policy. The projected headline deficit of 0.4 percent of GDP is appropriate given cyclical and labor market conditions, while the structural surplus remains largely unchanged at 0.7 percent. This budget should meet the requirements of the Fiscal Compact.

35. The structural surplus target embodied in the new Budget Law should help to address the previous pro-cyclical patterns on fiscal policy. The requirement for a structural surplus can help prevent unsustainable increases in expenditure during good times and provide scope to allow automatic stabilizers to operate, as should be done in downturns. The government’s medium-term plans to keep the structural surplus well above the medium-term objective should keep the government’s balance sheet strong, but they should not be used to reintroduce a procyclical dimension to policy. The new law establishing an independent fiscal council is also welcome. These policies can help to further bolster Estonia’s resilience and credibility on fiscal policy.

36. The authorities’ commitment to maintain a strong financial system in the face of an evolving financial architecture is welcome. The planned early implementation of the new capital and liquidity provisions is appropriate. When credit growth recovers to pre-crisis levels, raising the countercyclical buffer from zero needs to be considered. Close collaboration among the Estonian authorities, the ECB, the Nordic-Baltic sector supervisory, central bank, and governmental structures will be important to smooth Estonia’s transition to the Banking Union.

37. The government should be prepared to respond to further evidence of deteriorating competitiveness from real wage increases. In this context it should refrain from additional large public sector wage hikes or agree to minimum wage increases after 2015, until it is clear that worsening price competitiveness is not undercutting net exports.

38. Estonia’s high level of structural unemployment needs to be addressed. Some active labor market policies to address skills mismatches and keep people in the labor force are already in place and funding for these policies has been substantially expanded in recent years. Programs to improve the skills of those already working and increase the number of people with education in technical fields should address the shortage of highly-skilled workers and help boost productivity. Lowering the tax wedge on lower-wage workers in a budget-neutral manner should also be given serious consideration. Lowering the tax wedge would also contribute to containing unit labor costs and improving competitiveness.

39. Regional efforts to improve infrastructure links to Estonia’s neighbors could also boost competitiveness. Estonia should coordinate with its Baltic and Nordic neighbors to be better connected to the rest of the EU and diversify infrastructure.

40. It is proposed that the next Article IV consultation with Estonia take place on the standard 12-month cycle.

Actions Taken in Areas Relevant to Previous Policy Advice

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1

Annex I of the 2013 Article IV Staff Report discusses Balassa-Samuelson and other factors that might influence the inflation differential.

2

An analysis of credit growth across the Baltic countries and a discussion of alternatives to bank financing can be found in the Chapter II of the Selected Issues paper for the Baltic Cluster Report.

3

The three largest banks (local banks or subsidiaries of foreign banks) in each euro area member will come under ECB supervision. For Estonia, these are SEB, Swedbank and DNB.

4

This is discussed for Estonia and the other Baltic countries in the Baltic Cluster Staff Report prepared in conjunction with this report and in particular in Chapter IV of the Selected Issues Paper for the Baltic Cluster Staff Report.

5

More extensive discussion of challenges for exports trade and joint policies to that end can be found in the Baltic Cluster Report and Chapter III of the associated selected Issues paper.

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Cover IMF Staff Country Reports
Republic of Estonia: Staff Report for the 2014 Article IV Consultation
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2014: Issue 112
Publisher:
International Monetary Fund
ISBN:
9781484373118
ISSN:
1934-7685
Pages:
46
DOI:
https://doi.org/10.5089/9781484373118.002
Figure 1.

Estonia: Real Sector Developments, 2008–13

Estonia: Inflation and Unemployment

(Percent)

Growth of Wages and Labor Costs

(Percent change)
Figure 2.

Estonia: Putting the Crisis Behind, 2008–13
Figure 3.

Estonia: External Developments, 2003–13
Figure 4.

Estonia: External Competitiveness, 2008–13
Figure 5.

Estonia: Fiscal Developments and Structure, 2003–13
Figure 6.

Estonia: Financial Developments, 2007–13

Estonia: Debt and Deficit

(Percent of GDP)

Residential Housing Price Index

(2010=100)
Figure 7.

Estonia: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(Percent of GDP unless otherwise indicated)
Figure 8.

Estonia: Public DSA – Composition of Public Debt and Alternative Scenarios

Taxation Rates

(Percent)