On behalf of the Estonian authorities we thank the IMF mission team for the candid and productive discussions and for the well-focused Article IV and Baltic cluster reports. The authorities share staff’s views on the state of the Estonian economy and highly appreciate their economic policy advice.

Macroeconomic performance and outlook

The Estonian economy has weathered well the recent years’ uncertain external environment. In 2011—the recovery phase—broad based economic growth reached 9.6 percent, being followed by 3.9 percent growth in the stabilization phase in 2012. In that period, the Estonian economy was pushed towards a healthier equilibrium as the imbalances continued to decline and resilience was improved. 2013 brought along a growth slowdown to 0.8 percent, being affected by economic challenges in our neighboring countries, especially in Finland and Russia, and by sector-specific adverse shocks. This has not had a substantial impact on the strong labor market performance, which is keeping consumer confidence high and supporting private consumption.

Looking forward, the latest forecast of the Ministry of Finance expects economic growth to rise to 2 percent in 2014 and to accelerate thereafter to about 3.5 percent. The corporate sector is ready for a growth take-off with the high amount of retained earnings, and a leverage ratio being at the lowest level in ten years. However, uncertainties in the external environment still weigh on investment activity. The evolving geopolitical tension has become the predominant risk for the Estonian economy, which has not yet been penciled into the baseline scenario. Estonia’s competitiveness depends not only on domestic factors but also on the performance of the Nordic economies, being positioned higher in the same global supply chain. Additionally, there are concerns that a re-emergence of global financial spillovers may reach Estonia, if liquidity or financing conditions of the Nordic parent banks are affected. Though, this risk has lessened as bank lending is currently financed by deposits.

Inflation has slowed significantly since mid-2013, reaching 0.2 percent in annual terms in March, but is expected to accelerate to 1.4 percent in 2014. Restrained price developments in the external environment have successfully counterbalanced domestic pressures. A noticeable negative price impulse stems from the energy component. Inflation in Estonia is held back by temporary factors as well because there is less administrative price increases.

However, signs of tightening have appeared in the labor market, escalating wage growth and pressing prices in some segments of the consumer basket. Continued wage growth that erodes competitiveness is the main domestic risk and therefore labor costs need vigilant monitoring. Although unit labor costs have deteriorated, labor costs have not grown faster than corporate turnover, referring to other costs that have squeezed profit margins. In the past, the Estonian labor market has repeatedly shown flexibility that has supported necessary structural adjustment. The unemployment rate has declined by more than 10 percentage points from its peak in 2010 to the current 8 percent, and recent years have seen an increase in labor market activity. If the labor market participation rate had remained constant at the boom years’ level, the unemployment rate would have been now at approximately 5 percent.

Although the actual unemployment rate has fallen, it is worrisome that the structural unemployment rate is relatively high. The latter cannot be measured with high precision and, as a sign of measurement uncertainty, staff’s estimate of structural unemployment is somewhat higher compared to the authorities’, OECD’s, and European Commission’s estimates. The authorities still fully agree that structural unemployment is too high and commit to continued policy action.

The assessment of wage pressures should take into account people’s choice of working abroad as this is a viable option while living in Estonia, especially for some professions. The main driver of this process is declining but still substantial wage level difference. Working abroad has many positive consequences, as it fosters skills transfer and accumulation of human capital. The Estonian authorities highly appreciate the EU common labor market policy, but they would be grateful for policy advice on how to contain wage pressures from work migration.

Fiscal Policy

The Estonian authorities have given high priority to a prudent fiscal policy and the recently formed government has reaffirmed this commitment. In line with the recent amendments to budget position rules in the State Budget Act, the newly published state budget strategy aims to have at least a structural budget balance in the medium term and to achieve a small structural surplus in most years. Estonia has attained structural surpluses since 2009 and prior to the global financial crisis as well. The forecast for 2014 shows a small structural surplus of 0.1 percent of GDP. Given that high uncertainty surrounds the structural balance estimates in real time, high attention is paid on the nominal budget outcome as well. The current outlook prescribes a 0.7 percent nominal deficit for 2014, which is expected to decline over the forthcoming years. A significant part of this deficit comes from the increased payments into the second pension pillar, which were temporarily suspended in the crisis years, and the use of carbon dioxide quota sale revenues, which were received earlier. The authorities consider the fiscal policy stance appropriate at this juncture, especially against the background of a swift wage growth and a high degree of monetary accommodation on the domestic side and fiscal and financial fragilities on the external side. Both the public sector’s current liquid financial assets and gross debt are at about the 10 percent level of GDP.

The Estonian government aims to maintain the tax burden at the pre-recession level of around 32 percent of GDP with the intention to reduce further labor taxes. In an EU country comparison of labor tax burden, Estonia is below average. The planned changes for 2015 include a decrease in the income tax rate from 21 to 20 percent, a reduction in unemployment insurance tax rate by 0.6 percentage points to 2.4 percent and increases in tax-free income, being compensated by increases in alcohol, tobacco, and gas excise taxes. The labor tax burden peaked at almost 37 percent level in 2010 due to the crises measures, but has declined thereafter and is expected to almost reach the 33 percent level in 2015. This is in line with staff’s advice in the Baltic cluster report. Public sector capital expenditures will be almost 5 percent of GDP in 2014, but will gradually decline thereafter.

The government has reached an agreement to reduce tax exemptions and improve tax compliancy with a number of measures. The value added tax incentive will be reduced when a company’s passenger car is used for private use and the preferential excise duty on fuel with special marking (except in agriculture and fishing boats) will be abolished. The introduction of the Annex to the VAT declaration for recording larger transactions is meant to reduce tax avoidance.

A number of amendments to the State Budget Act were passed in February. Hence, the establishment of an independent Fiscal Council, which is responsible for the assessment of the macroeconomic and financial forecasts and for monitoring compliance with the budgetary rules, is currently being implemented.

Financial Policy

The Estonian banking sector is highly liquid, well capitalized, and profitable and the balance sheets of the corporate and household sectors have improved, increasing the resilience to the external shocks. The Estonian banking sector is dominated by the Nordic (Swedish) banking groups, which own over 90 (80) percent of the market. As the real estate price cycle and household borrowing in Sweden have increased the risks to financial stability, the Estonian authorities welcome the steps by the Swedish authorities to further strengthen banks’ capital and liquidity buffers. While the low interest rate environment has eased loan servicing, a prolonged period of monetary accommodation may encourage excessive risk-taking in Estonia, especially in the real estate market.

The strength of the Estonian banking sector is reflected by a high capital adequacy ratio that exceeded 24 percent in end-2013 and by liquid assets that constituted 24 percent of total banking sector assets. As a sign of decreased vulnerability, the loan-to-deposit ratio declined to the 104 percent level in the beginning of this year. Throughout 2013, the level of NPLs has fallen reaching below 2 percent in 2014.

The contraction in the corporate sector credit stock came to an end in mid-2012. However, the recovery stalled a year later as uncertainties in the external environment affected credit demand. The corporate sector balance sheets and bank lending policies are not constraints to credit growth. The predominant factor for the continuation of credit recovery is the renewed growth of Estonia’s major trade partners.

Real estate price developments in Estonia constitute an evolving risk that requires close monitoring. Following a steep decline in the recession years and a vigorous recovery thereafter, apartment prices were still raising by more than 20 percent annually at the end of 2013. Low interest rates enhance the risk that continued growth in real estate prices leads to overly optimistic expectations. An encouraging sign is that a relatively high share of real estate transactions is not credit funded. The planned amendments to the Eesti Pank Act will give the Bank of Estonia the powers of the macro-prudential authority and the Credit Institutions Act defines the implementation of macro-prudential instruments. The expectation is that some of the instruments will come into force over the course of 2014. Given the highly integrated Estonian and Nordic banking sectors, it is important that the modalities arising from the implementation of the EU Banking Union will be effectively integrated into the existing Nordic-Baltic bank supervision and policy cooperation framework.

Structural Policy

Although the income level has considerably increased in Estonia during the last two decades, the gap with the EU average still exists. The Estonian authorities recognize that continued convergence prescribes behavioral and structural flexibility, which is not granted.

Against the background of population aging and migration, affecting potentially future investments, the authorities are concerned about the high level of structural unemployment. They share the view that policies need to address skill mismatches as a high priority. Lowering the tax wedge, which they have already implemented, may also help, but this measure is likely less efficient when skill imbalances between demand and supply are present. Measures that make vocational training more available, competitive, and adaptive to the labor market needs, have been put in place. Nevertheless, skilled labor is highly scarce in some segments of the economy. The Estonian Unemployment Insurance Fund (EUIF) will continue providing their updated and diversified portfolio of ALMPs. The EUIF’s spending will increase by 15 percent in 2014, which allows them to provide more services, especially against the background of a smaller number of unemployed people. Following the draft act of the disability benefit reform, the mandate of the EUIF will be broadened in 2015 to include the assessment of work capacity for disabled people. This reform is likely to increase labor supply as it aims to bring more disabled people to the labor force and to prevent the loss of their work capacity.

Estonia has made progress in connecting its electric grids with Finland, which has resulted in a substantial decline in price differentials between two countries. Discussions are ongoing with Finland to build the Baltic Connector and LNG terminals to connect the gas grids as well and improve energy security. The Estonian authorities are strongly in favor of fast progress in the Rail Baltic project, to improve the rail connection of the whole region with the rest of the EU.