A. Context and Recent Developments

1. Estonia has been pursuing market-oriented and disciplined economic policies under stable political conditions. A three-party coalition government took office in April 2015 headed by the free-market oriented Reform Party and also comprising the center-left Social Democrats and the center-right Union of Fatherland and Res Publica. Its program seeks to strengthen national security, increase support to families with children, lower labor taxes, reform state and local administrations, and increase support for low-income earners. Increasing labor productivity to 80 percent of the EU average and raising R&D expenditure to 3 percent of GDP are central planks of Estonia’s competitiveness strategy, “Estonia 2020.”

2. Estonia’s economic and institutional fundamentals are strong. The macroeconomic imbalances of Estonia’s credit-driven boom-bust cycle are a thing of the past and unlikely to re-emerge amid credit aversion and strengthened macroprudential tools. The current account has been broadly in balance in recent years and unemployment is nearing its structural level. The business environment and government effectiveness earn high marks, the financial system boasts enviable soundness indicators, public finances are the strongest in the EU in terms of debt and deficits, and Estonia is a leader in e-government. In 2014, per-capita income reached 74 percent of the EU average in purchasing-power parity terms.

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Estonia: Income Convergence, 2003-14

Citation: IMF Staff Country Reports 2015, 336; 10.5089/9781513524788.002.A001

Sources: Statistics Estonia; and Eurostat.

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3. Yet, economic growth has been sluggish in recent years and income convergence has slowed. Following a setback due to the 2008/09 crisis, income convergence has restarted, but at a slower pace. Since mid-2012 the economy has expanded at a moderate annual rate of only 2 percent, a little slower than the Central and Eastern European (CEE) average of 2½ percent over that period and leaving real GDP still slightly below its peak in 2007:Q3. Adverse external conditions are partly responsible, with Estonia being particularly affected because of large exposure to the poorly performing economies of Finland and Russia.

4. Growth came to 2.9 percent last year and 1¼ percent in the first 9 months of 2015. Private consumption was the main driver, as real wages continued to rise at a robust 5 percent and unemployment declined by 2.2 ppts over the past 18 months, falling to 6½ percent. Exports are barely growing and investment, especially for machinery and equipment, is contracting amid weak and uncertain external conditions. Inflation is hovering around zero, but low inflation is unlikely to become entrenched because of brisk wage growth and forthcoming excise tax hikes. The output gap is likely still slightly negative.

5. Estonia’s external position has improved and is solid. In 2014 and 2015:H1, the current account started recording surpluses of 1.0 and 1.4 percent of annual GDP, respectively, reflecting low import growth related to weak investment and inventory drawdowns. Over the past two decades, export market shares have generally been on a rising trend, though gains seem to be flattening out more recently. The net international investment position has improved from -80 to -40 percent of GDP since 2009, reflecting capital account surpluses and the GDP rebound, and is now stronger than in most of the region. Gross external debt is still quite high, but often owed to parent companies, net external debt is negative, and net inward FDI explains the net international investment position two times over. The real effective exchange rate is broadly in line with fundamentals (Box 1).

6. Public debt is close to zero in net terms, and the budget has recorded structural surpluses for several years. Gross public debt is around 10 percent of GDP and is broadly matched by general government liquid financial assets. In addition, second-pillar pension funds have set aside over 10 percent of GDP in assets. The budget has been in structural surplus since 2009. In 2014, public finances overperformed, recording a surplus of 0.8 percent of GDP compared to a budgeted deficit of 0.5 percent of GDP as tax administration improved and public investment fell short with the transition between the 2007–13 and 2014–20 Multiannual Financial Frameworks for EU funds.

7. Indicators of financial soundness are exceptionally strong in Estonia, especially in the large Nordic-owned banks that account for the bulk of the banking system. The capital adequacy ratio averages 27 percent, the liquidity coverage ratio stands at 250 percent, and the non-performing loan ratio has declined to below 2 percent. Strong deposit growth has reduced loan-to-deposit ratios to just below 100 percent and parent bank funding to a historically low 16 percent of bank liabilities. The three banks covered by the ECB’s comprehensive assessment and EBA’s stress tests passed comfortably.

8. Estonia is continuing to emerge from the bottom of the financial cycle. Credit growth firmly moved into positive territory in mid-2014 and loans of credit institutions to non-financial companies and households are now expanding at a rate of 3¾ percent annually. This reflects improved balance sheets of banks, non-financial companies, and households, along with the low-interest environment and recovering house prices. Following a drop by over 50 percent, they are currently growing by 10 percent and are closing in on the 2008 peak in nominal terms, but in real terms or relative to wages they remain 30 and 40 percent lower, respectively.

B. Outlook and Risks

9. Growth should reach 1.6 percent in 2015, pick up to 2.5 percent in 2016, and average 2.8 percent during 2015–20. Robust consumption growth should continue, residential construction is already picking up in response to rising house prices, and investment should benefit from strengthening credit growth and increased availability of EU funds. Russia’s export demand should bottom out after declining sharply, thereby reducing the drag on growth. Medium-term prospects are predicated on potential growth being lifted by the implementation of the government’s pro-growth policies. Inflation should rise with euro-area wide inflation, retain a small premium typical of catching-up economies, and be boosted by between ½ and 1 ppt each year during 2016–19 on account of excise tax hikes. The current account is likely to move into moderate deficit as investment recovers and unusually low imports in 2015:H1 dissipate.

10. Risks to the outlook are predominantly to the downside. A slower recovery in the euro area or unanticipated further declines in the Russian economy would both pose risks to Estonia’s exports. Direct effects from global financial turmoil would likely be limited considering the absence of marketable public debt, Estonia’s small financial markets, and euro area membership. But potential spillovers through the Nordic banks that account for much of Estonia’s financial sector could curtail credit supply. On the domestic front, strongly rising wages could dent competitiveness. If the government’s pro-growth policies are not fully implemented or fail to have the expected effects, medium-term growth could be lower and undermine income convergence.

11. The authorities broadly agreed with the outlook and saw risks mainly in external conditions and strong wage growth. Macroeconomic growth projections by the Ministry of Finance for budget purposes are close to those of staff, while the summer forecast of the Bank of Estonia was somewhat more optimistic. There was agreement that private consumption would remain the main engine of growth and that the external drag would diminish. The external environment remains a risk and export diversification to offset losses in Russia will take time. The authorities saw wage growth in excess of productivity as a risk to competitiveness if it were to continue for much longer. However, the authorities underscored that wage developments were largely outside the government’s control and were also influenced by the much higher pay in Finland, which is only a short commute away. They were not overly concerned about direct financial spillovers through Nordic banks, but stressed that a house price or financial shock to the Nordic economies would simultaneously hit Estonian exporters and their financial standing. Developments in the domestic housing market are also on the authorities’ radar screen.

Box 1.

Estonia: External Stability Assessment

The EBA-lite methodology concludes that Estonia should normally run a current account deficit rather than the surplus that is projected for this year. However, the gap between the actual current account balance and its norm can be largely explained by a number of special and transitory factors. The special factors make the gap appear larger than it really is. Temporary factors should automatically wash out over time and diminish the gap without significant exchange rate adjustment.

• Policies contribute little to the gap, though there is some room to relax fiscal policy.

• Three main factors overstate the strength of the actual current account:

  • As a specific feature of Estonia related to the corporate income tax regime, profit remittance of foreign firms often takes the form of discrete “superdividend” payments every few years. This year, they amounted to 2 percent of GDP. Unlike regular profit remittances, they are classified as negative FDI rather than a debit in the current account. Its balance hence appears better than it really is.

  • The current account balance in 2015 likely benefitted from a drawdown of inventories that satisfied buoyant private consumption in lieu of imports. This is not sustainable and therefore improves the current account balance only temporarily.

  • Eventually, EU funds will decline and support the current account by less. Estonia receives about 2¼ percent of GDP in EU funds in the 2014-20 programming period per year on average, but the available amount could be significantly smaller under the next Multiannual Financial Framework.

• Two main factors understate the cyclically-adjusted current account norm:

  • Important legacies of Estonia’s boom-bust cycle are not picked up by the cyclical correction in the EBA-lite exercise. Very high investment in the boom phase is offset by unusually low investment currently —the investment ratio in 2015 is some 4½ percent of GDP below its historical average. With domestic absorption and imports of machinery and equipment lower, the current account balance is better until these legacies run their course.

  • In the case of Estonia, the EBA-lite current account norm may not accurately capture demographic effects. High dependency ratios are usually associated with low savings, but in former transition economies the old may not have much savings to draw on. And low future replacement rates under Estonia’s public pension system may induce higher savings by the currently young than elsewhere. Limited dissaving by the old and high saving by the young imply a better current account than in other countries with similar demographics. An alternative approach to reflecting demographics in the current account norm would raise it by 1.6 percent of GDP to -2.2 percent of GDP.^*

  • Exchange rate assessments based on different methodologies also conclude that the real effective exchange rate is broadly in line with fundamentals. Models based on medium term equilibrium current account balance point to a small undervaluation, while direct assessment of the equilibrium real exchange rate suggests an overvaluation.

Exchange Rate Assessment using EBA-lite methodology

Exchange Rate Assessment using EBA-lite methodology

Summary Table
	CA-Actual	2.2%	CA-Fitted	−2.9%
	CA-Norm	−4.1%	Residual	5.1%
	CA-Gap	6.3%	Policy gap	1.1%
			Cyclical Contributions	−0.2%
	Elasticity	−0.52	Cyclically adjusted CA Norm	−3.9%
	Real Exchange Rate Gap (adjusted for demgraphics)	−8.5%	CA Norm adjusted for demographics	−2.2%

View Table

Exchange Rate Assessment using EBA-lite methodology

Summary Table
	CA-Actual	2.2%	CA-Fitted	−2.9%
	CA-Norm	−4.1%	Residual	5.1%
	CA-Gap	6.3%	Policy gap	1.1%
			Cyclical Contributions	−0.2%
	Elasticity	−0.52	Cyclically adjusted CA Norm	−3.9%
	Real Exchange Rate Gap (adjusted for demgraphics)	−8.5%	CA Norm adjusted for demographics	−2.2%

^*Demographic parameters (dependency ratio and aging speed) contribute -2.3 percent of GDP to the EBA-lite current account norm. Models taking into account population growth and the interaction between dependency and aging calculate a much lower contribution of -0.6 percent of GDP.

Republic of Estonia: Risk Assessment Matrix¹

Republic of Estonia: Risk Assessment Matrix¹

Source of Risks	Relative Likelihood	Impact on Estonia
Tighter or more volatile global financial conditions: Sharp asset price adjustment and decompression of credit spreads as investors reassess underlying risk and respond to unanticipated changes in growth prospects, Fed policy rate path, and increases in U.S. term premia, with poor market liquidity amplifying the effect on volatility.	High	Medium Nordic cross-border banks are exposed to a number of risks that could spill over to Estonia through credit supply and trade channels. But strong lines of defense for parent banks, reduced reliance on parent bank funding, and strong domestic deposit growth would be important mitigating factors. Existing platforms for cooperation between home and host country authorities are another asset.
Structurally weak growth in key advanced and emerging economies (the “new mediocre”): Euro area: Weak demand and persistently low inflation in euro area/Japan leading to low medium-term growth and accumulation of financial imbalances.	High	Medium Estonia would be affected through trade, confidence, and FDI channels. Economic growth and employment would suffer.
Political fragmentation erodes the globalization process and fosters inefficiency: Russia/Ukraine: the mounting conflict depresses business confidence and heightens risk aversion, amid disturbances in global financial, trade, and commodity markets.	Medium	Medium Estonia would be affected through trade and confidence effects from direct exposure to Russia and indirect exposure through third countries. In the medium run, effects could be mitigated by trade reorientation.
Risks to competitiveness from a further tightening of the labor market: Wage growth continues to significantly outstrip productivity growth for an extended period. External competitiveness is adversely affected.	Medium	Medium/High The external sector, critical for Estonia’s small open economy, would suffer. Lower exports, less FDI, and slower productivity growth would damage income convergence prospects and worsen the current account.
Weakening of medium-term growth: Policies to foster innovation and productivity growth are not fully implemented or prove less effective than envisaged.	Medium	Medium Convergence to EU average living standards would slow with annual real GDP growth some ½ percent lower than in the baseline.

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Republic of Estonia: Risk Assessment Matrix¹

Source of Risks	Relative Likelihood	Impact on Estonia
Tighter or more volatile global financial conditions: Sharp asset price adjustment and decompression of credit spreads as investors reassess underlying risk and respond to unanticipated changes in growth prospects, Fed policy rate path, and increases in U.S. term premia, with poor market liquidity amplifying the effect on volatility.	High	Medium Nordic cross-border banks are exposed to a number of risks that could spill over to Estonia through credit supply and trade channels. But strong lines of defense for parent banks, reduced reliance on parent bank funding, and strong domestic deposit growth would be important mitigating factors. Existing platforms for cooperation between home and host country authorities are another asset.
Structurally weak growth in key advanced and emerging economies (the “new mediocre”): Euro area: Weak demand and persistently low inflation in euro area/Japan leading to low medium-term growth and accumulation of financial imbalances.	High	Medium Estonia would be affected through trade, confidence, and FDI channels. Economic growth and employment would suffer.
Political fragmentation erodes the globalization process and fosters inefficiency: Russia/Ukraine: the mounting conflict depresses business confidence and heightens risk aversion, amid disturbances in global financial, trade, and commodity markets.	Medium	Medium Estonia would be affected through trade and confidence effects from direct exposure to Russia and indirect exposure through third countries. In the medium run, effects could be mitigated by trade reorientation.
Risks to competitiveness from a further tightening of the labor market: Wage growth continues to significantly outstrip productivity growth for an extended period. External competitiveness is adversely affected.	Medium	Medium/High The external sector, critical for Estonia’s small open economy, would suffer. Lower exports, less FDI, and slower productivity growth would damage income convergence prospects and worsen the current account.
Weakening of medium-term growth: Policies to foster innovation and productivity growth are not fully implemented or prove less effective than envisaged.	Medium	Medium Convergence to EU average living standards would slow with annual real GDP growth some ½ percent lower than in the baseline.

A. Securing Strong Growth Potential²

12. Estonia’s long-term growth record is impressive, but the main growth engines are losing steam. Growth since 1995 averaged 4.4 percent per year—together with Lithuania the highest rate in CEE. But growth has come down sharply in recent years and, while external adversities played a role, potential growth is estimated to have fallen to 2¼ percent annually during 2011-14 Total factor productivity (TFP) growth declined to 0.8 percent annually, as relatively “easy” productivity gains from sectoral reallocation, imitation, and upgrading in the nontradable sector have been increasingly exhausted. With capital-output ratios higher and investment ratios lower, capital formation also contributed less than in the past.

13. Considerable effort will be needed to secure strong and sustainable growth for the long haul. One challenge is to cope with demographic headwinds and make the most of a working-age population whose rate of decline will triple to almost 1 percent a year. Raising TFP growth requires structural transformation of an economy that still relies heavily on low-to-medium technology industries with limited absorptive capacity of spillovers from the frontier. More fully restoring Estonia’s traditionally high investment and ensuring its efficient use will also be important. Three scenarios illustrate possible quantitative outcomes for potential growth over the next two decades.

• The central scenario puts potential growth at 2.9 percent during 2015-20 and 2.7 percent over the longer horizon. It assumes that government’s pro-growth policies will lift TFP growth slightly above the 2001-14 average, enhance the labor force, and boost investment. Income convergence with Western Europe will continue, but at only about half its historical pace.

• A pessimistic scenario with growth averaging just 2.4 percent during 2015-20 and 2.2 percent over the longer horizon, reflecting a more modest pickup in TFP growth and investment, which could arise for example if the planned measures are less effective than expected or are not implemented as comprehensively as envisioned.

• A stretch scenario that would require a combination of higher TFP growth and investment and rapid convergence toward the labor force participation rates of Sweden—the highest in the EU—to secure growth of 3.7 percent over the longer horizon.

14. Estonia’s current policy setting is conducive to growth and additional supporting programs are planned. They should go a long way toward mitigating the forces that weigh on future growth, thereby underpinning the central scenario.

• Among the current attractions, Estonia already has one of the most business friendly environments according to the World Bank’s Doing Business Report or the World Economic Forum’s Competitiveness Ranking and highest public investment ratios in the region. Its educational standards are also high. Government policies put an emphasis on promoting R&D and ICT. Almost all classrooms were connected to the internet as far back as 1998. Estonia is a leader in providing integrated electronic government services and is home to a number of prominent IT startups. Private companies can draw on the expertise of government-supported “competence centers” for advice in six scientific areas.

• A number of new initiatives are under preparation, mostly in the context of the new programming period for EU funds. Enterprise support is to be revamped to put more emphasis on innovation and entrepreneurship, increasingly backed by financial instruments rather than grants. Life-long learning is set for an upgrade under a new strategy. Already adopted legislation on “work capacity reform” seeks to put more disability pensioners to work, who currently make up 10 percent of Estonia’s working age population. Further state reforms are also on the agenda, to consolidate the large number of local governments, merge central government agencies, enhance e-government to reap efficiency gains, and reduce government employment in line with the shrinking working age population.

15. Yet, Estonia has room to further enhance pro-growth policies. This would help bring potential growth closer to the rates in the stretch scenario. In the short run, the government should concentrate on getting the planned new initiatives off the ground and making them a success. But to support implementation, which exhibited some deficiencies in the past, and boost the effectiveness of existing and new programs, it will also be critical to now start strengthening the operational policy focus on fostering productivity growth. Boosting productivity should be articulated as the overarching economic policy objective. A strong unit in the Prime Minister’s office should be mandated with overseeing implementation through line ministries; evaluating the relative merits of programs in terms of their contribution to productivity growth; scaling back ineffective programs, boosting successful ones, and initiating promising new initiatives; and keeping track of government spending on productivity support.

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Estonia: Central Scenario for Potential Growth, 2001–33

Citation: IMF Staff Country Reports 2015, 336; 10.5089/9781513524788.002.A001

1/ The disability reform is expected to add significantly more people to the labor force, but the effect on employment will be limited as many will likely be unable to find a matching job, which will push up the structural unemployment rate. The evolution of labor force participation and structural unemployment rates is shown only to ease comparability with historical data and is not factored into labor input or potential growth calculations.Source: IMF staff calculations.

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Estonia: Pessimistic Scenario for Potential Growth, 2001–33

Citation: IMF Staff Country Reports 2015, 336; 10.5089/9781513524788.002.A001

1/ The disability reform is expected to add significantly more people to the labor force, but the effect on employment will be limited as many will likely be unable to find a matching job, which will push up the structural unemployment rate. The evolution of labor force participation and structural unemployment rates is shown only to ease comparability with historical data and is not factored into labor input or potential growth calculations.Source: IMF staff calculations.

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Estonia: Stretch Scenario for Potential Growth, 2001–33

Citation: IMF Staff Country Reports 2015, 336; 10.5089/9781513524788.002.A001

1/ The disability reform is expected to add significantly more people to the labor force, but the effect on employment will be limited as many will likely be unable to find a matching job, which will push up the structural unemployment rate. The evolution of labor force participation and structural unemployment rates is shown only to ease comparability with historical data and is not factored into labor input or potential growth calculations.Source: IMF staff calculations.

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16. A number of programs could be scaled up and expanded in scope.

• In the area of human resources, more resources could be devoted to life-long learning, to address deficiencies in adult skills and help raise the effective retirement age. Spending has been very small in the past and will remain below 0.3 percent of GDP even under the new strategy. Spending on active labor market programs currently stands at just 0.4 percent of GDP and planned increases will go predominantly toward implementation of the work capacity reform. The envisaged strengthening of apprenticeship programs to around 800 participants could go further. It would also be important to raise the statutory retirement age further once the ongoing increase to 65 years is fully phased in by 2026, to bring female labor force participation rates closer to those of Europe’s best performers, including by improving child care provision, and to consider increased reliance on foreign labor.

• In the area of innovation support, the planned new Company Development Program will cover only up to 300-400 out of the over 60,000 companies currently operating in Estonia. More generally, Estonia’s RDI polices follow very much a science-based approach, which risks leaving behind the more traditional sectors that still make up the bulk of employment and value-added creation in the economy. Supporting the upgrading of traditional industries as a second leg of innovation policies should be considered. Also, RDI programs are currently almost fully financed from EU funds. Mobilizing more own funds is imperative for long-term sustainability and would increase flexibility, for example in terms of maximum support for projects and international initiatives, such as cross-border clusters, which are well suited for a small country like Estonia.

• In the area of capital formation, high investment has served Estonia well. It should be maintained, including in the government sector, considering that Estonia’s capital stock per worker is still much lower than in Western Europe. In this context, the Rail Baltica project, further upgrading of the road network, and efforts to improve the intermodality in the transport sector are welcome. R&D expenditure is on par with the EU average, but it is a concern that investment in intellectual property rights, which covers R&D expenditure and also technology imports, is relatively low.

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Estonia: Spending on Innovation

(Percent of GDP, average 2011-13)

Citation: IMF Staff Country Reports 2015, 336; 10.5089/9781513524788.002.A001

Source: Eurostat.

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17. The authorities agreed that securing robust convergence with Western European living standards was the main economic policy challenge. Growth potential seems to have indeed slowed materially in recent years and the high growth rates of the boom years are in any case not a valid reference point for the period ahead. But the authorities noted that adverse external conditions were likely also partly responsible for the recent spell of low growth. Moreover, potential growth calculations are complicated by uncertainties in the measurement of capital accumulation, with measured investment in Estonia curiously much higher than in neighboring countries without seemingly delivering materially better growth. With investment potentially overstated, productivity growth could have been better, implying brighter prospects for the future. Overall, the authorities estimate long-term potential growth to be in the range of 3 to 4 percent per year.

18. Growth-supporting policies are important, with the authorities confident that the existing and planned measures broadly covered all the bases and would deliver important gains. They saw compensating for adverse demographics and moving to a more sophisticated output mix as the main challenges. The environment is generally conducive and the new initiatives will fill most of the remaining gaps, in their view, which they saw as underscoring the importance of implementation. They agreed that domestic resources would need to mitigate the eventual decline of EU funds. They are considering broadening the training mandate of the Unemployment Insurance Fund beyond those unemployed or at imminent risk of losing their jobs. Improving child care support will also need attention in order to boost female labor supply. While the authorities agreed that the upgrading of Estonia’s traditional industries was central, some counterparts were doubtful whether this was a task for the government. But they stressed that universities are important conduits of innovation and that the government should ensure the appropriate availability of financial instruments for the private sector.

B. Aiming for Stability and Growth Support in Public Finances

19. The 2015 budget is headed for another surplus. Thanks to a revenue-friendly composition of growth and further improvements in tax administration, a small surplus of 0.1 percent of GDP is likely, compared to a budgeted deficit of 0.7 percent of GDP. Corporate income tax collection received an unanticipated boost worth ½ percent of GDP from a superdividend distribution by Swedbank, but the effect on the budget balance will effectively be moved into 2016 because of an offsetting postponement of dividend payments by state-owned enterprises. Investment is lagging behind plan because of delays in unlocking EU funds, but with a strong effort in the remainder of the year it could still come close to last year’s level and reach 4.9 percent of GDP. The structural surplus should decline somewhat to 0.8 percent of GDP, exerting a timely fiscal stimulus.

20. The 2016 draft budget envisages labor tax cuts and more generous family benefits financed by excise tax hikes, as well as higher investment. These measures are part of a multi-year plan to lighten the labor tax burden, especially for low-income earners, and provide relief to families with children, all paid for by higher excises on energy, alcohol, and tobacco. They provide a welcome reduction of the labor tax wedge. Investment would climb to 5.3 percent of GDP next year as the new Multiannual Financial Framework for EU funds comes fully on stream. The budget surplus should increase to 0.5 percent of GDP. But, due to the one-off nature of revenues related to the superdividend, the structural surplus is projected to decline to 0.5 percent of GDP—which would provide a useful moderate fiscal stimulus as insurance against the downside risks in the growth forecast.

21. Estonia’s public finances are guided by a strict fiscal rule. The State Budget Act mandates the budget to be at least in structural balance annually. However, in practice the rule generates surpluses because of an asymmetric correction mechanism—deficits need to be compensated by subsequent surpluses while surpluses generate no “credit” that can be spent later on—and because uncertainties in budget execution and structural balance calculations prompt policy makers to build in safety margins and target ex-ante surpluses. Indeed, Estonia’s latest Stability Programme envisages structural budget surpluses through the medium term.

22. Estonia should consider deploying fiscal space to finance additional measures in support of productivity growth while preserving fiscal prudence. With Estonia’s public finances already exceptionally strong, promoting productivity growth should at the margin be the higher priority than strengthening the fiscal position further.

• In the shorter run, room under the existing fiscal rule should be utilized. This could be achieved by implementing the fiscal rule so that budgets are close to structural balance each year and on average in structural balance over a multi-year period, rather than systematically in structural surplus. For 2016, the focus should be on fully executing the budget, especially regarding investment and the planned pro-growth measures. The government should not hesitate to pre-finance these outlays from domestic sources if it takes longer than expected to access EU-funds that are envisaged to finance them, thereby running down the projected structural surplus.

• In the longer term, a moderate relaxation of the fiscal rule could be considered, to unlock additional resources for the promotion of productivity growth or to compensate for declining EU funds. The rule could be aligned with European rules that allow for medium-term objectives of up to a deficit of 1 percent of GDP for countries with strong public finances, such as Estonia.

For both the shorter and the longer run, it will be important to ensure that fiscal resources are indeed used for the intended purpose. It is therefore crucial that the accounting and monitoring of productivity promoting programs is strengthened first, for example in the context of the establishment of the strong dedicated productivity unit in the Prime Minister’s office.

23. The authorities stated that Estonia’s fiscal framework should not be changed anytime soon and maintained that a structural balance should remain a target for fiscal policy. They had a somewhat more conservative take on likely near-term fiscal developments, projecting a balanced budget for this year and a deficit of 0.1 percent of GDP for 2016. Regarding the fiscal rule, they underscored that strong fiscal discipline has been a feature of Estonia’s fiscal policy that long predated European fiscal rules. Fiscal reserves were instrumental in successfully steering Estonia through the crisis of 2008/09. Reopening the debate on the fiscal rule that was only introduced in 2014 was considered premature. With regard to increasing productivity-promoting spending, the authorities noted that they prioritize spending that increases productivity, highlighting that Estonia’s public investment has been one of the highest in the EU. They argued that productivity-promoting spending can be increased further, even without changing the current fiscal rule. Furthermore, EU funds are already being re-directed toward innovation in the new programming period. They argued against weakening of the fiscal rule, which they considered too risky given the high volatility of growth and fiscal revenues. However, some counterparts conceded that the surplus bias in the fiscal rule was unintended and that there may be a case to revisit the fiscal rule once EU funds decline, but this is many years away and does not warrant opening a discussion at this juncture.

C. Remaining Competitive As Labor Markets Tighten

24. The labor market is tightening. Labor market entries are declining with the population aged 20–29 years shrinking by over 2 percent a year since 2012. Wage convergence with neighboring Finland also contributes to pressures. Over the last 36 months the unemployment rate has fallen by 4 ppts and real wages increased by 4.6 percent per year on average. Increases pervade all sectors of the economy.

25. The current pace of wage increases is unsustainable. While current real wage growth is not materially higher than the average since 2002, GDP and productivity growth are now lower. Minimum wage hikes are steep—40 percent over the past three years and 10 percent each for 2016 and 2017 already agreed. The minimum wage will reach 42 percent of the average wage by then and could increasingly weigh on formal-sector employment prospects of the low-skilled, in less developed regions, or labor-intensive industries. Minimum wages are negotiated between unions and employer associations, but government representatives attend the negotiations, the union-employer agreement is extended to the whole economy by government decree, and minimum wage issues feature prominently in political discourse, with the current coalition agreement proposing that social partners raise it to at least 45 percent of the average wage over four years. Public sector wages have also increased disproportionately in recent years and now command an unusually high premium over average wages, although their growth may moderate next year, with the central government granting wage increases only to selected groups of employees. In this context, it will be important to guard against minimum wage hikes unduly spilling over and pushing broader wage growth ahead of productivity growth.

26. Currently Estonia’s external position is solid and the exchange rate broadly in line with fundamentals, but there is a risk for prospects in the tradable sector to become clouded and the exchange rate overvalued unless wage growth and productivity developments align better going forward. Enterprise profitability is declining, including in the manufacturing sector. Profits currently account for a smaller share of value added not only compared to the boom years, but also compared to 2002, when the economy had not yet overheated. Gains in export market shares have also started to peter out, although the downturn of trade with Russia is also partly responsible. This underscores the importance of boosting productivity growth and achieving the structural transformation and the upgrading of human capital that can sustainably support robust real wage growth. But it will also be important for wage growth to cool until the various measures to this effect come to fruition.

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Estonia: Company Profitability, 2002-15

(Profit in percent of value added)

Citation: IMF Staff Country Reports 2015, 336; 10.5089/9781513524788.002.A001

Sources: Statistics Estonia; and IMF staff calculations.

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27. The authorities agreed that the current wedge between wage and productivity growth was unsustainable. Wage developments of recent years were supporting household incomes, but were also eroding companies’ buffers and could soon start denting competitiveness. Nonetheless, the authorities project that wage growth will come down only very gradually going forward because labor supply shortages will persist. Wage developments may induce companies to invest in labor-saving technologies and gradually move out of labor-intensive industries. In this spirit the government’s planned state reforms seek to economize on labor and reduce public employment, which should help alleviate the squeeze on the private sector. The authorities explained that large hikes in the minimum wage were motivated by their low levels coming out of the crisis and the perceived need to bring them closer to average wages. In their view, minimum wage developments are largely outside the government’s control, with government essentially only endorsing what social partners negotiate.

D. Tailoring Financial Sector Policies to Estonia’s Needs

28. Financial risks are primarily external and are mitigated by strong domestic and foreign lines of defense. Nordic cross-border banks dominate the financial sector and are exposed to a range of risks, especially in their home property markets and in wholesale funding markets, but they also have strong lines of defense. Estonian affiliates have large capital and liquidity buffers. Reduced parent-bank funding further adds to their resilience. Nonetheless, potential shocks could adversely affect credit supply in Estonia and simultaneously lead to a deterioration of the quality of loans taken out by Estonian exporters operating in the Nordic region. It will therefore be important to remain vigilant and continue close cooperation with home-country authorities. The Nordic-Baltic Financial Stability Group should be revitalized and secure appropriate involvement of the ECB, which directly supervises the two largest Estonian banks. Joint stress tests could be considered. Risks from the domestic housing market are not acute, considering that recent price increases are not credit driven and price-to-income ratios remain much below previous peaks. Estonia’s small domestic banks pursue riskier business models, but are closely supervised to monitor their soundness.

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Estonia: House Prices and Price-to-Income Ratio

(2005Q1=100)

Citation: IMF Staff Country Reports 2015, 336; 10.5089/9781513524788.002.A001

Sources:Haver Analytics; and IMF staff calculations.

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29. Estonia’s framework for financial sector oversight has undergone important upgrades. The Bank Recovery and Resolution Directive has been transposed, with the Financial Supervision Authority as the designated resolution authority. Recovery and resolution plans for the large banks have not yet been drafted, pending the transposition of the directive in Sweden. The government has approved a new deposit insurance law based on the Deposit Guarantee Scheme Directive. The liquidity coverage ratio and the capital conservation buffer have been implemented, bringing total capital requirements to 12.5 percent of risk-weighted assets. The countercyclical capital buffer is currently set to zero, but a framework for assessment, coordination with the ECB, and communication is in place. A comprehensive set of macroprudential tools is operational—maximum loan-to-value and debt-service-to-income ratios have already been set, though at currently barely binding levels. These tools also apply to foreign branches. Oversight of consumer lending companies is being strengthened through a licensing requirement from March 2016.

30. Traction of macroprudential tools can also benefit from close cooperation with home-country authorities. Deployment of macroprudential tools at more aggressive levels is not currently called for, but their traction in the next credit upswing may be complicated by banks’ overcapitalization and the dominance of foreign-owned affiliates. Mortgage lending appears well covered, unless mortgages were booked at headquarters abroad rather than locally. Controlling corporate loans could be more challenging, considering capital requirements that are far from binding and the possibility to book them abroad. Support from home-country authorities in the form of moral suasion and reciprocity of capital requirements beyond the provisions in the Capital Requirement Directive IV may be helpful.

31. The authorities broadly shared this risk assessment and intend to continue with the close Nordic-Baltic cooperation. Financial soundness is bolstered by high capitalization, ample liquidity, and low non-performing loan ratios. Small banks with riskier business models are closely monitored and supervisors report they are financially sound. The authorities view the current pace of credit expansion at close to nominal GDP growth as near optimal. Supervisors agreed that there were spillover risks from Nordic banks, but were not overly concerned and thought that the trade channel might be more important than the credit supply channel. They were also keeping a close eye on housing prices, but agreed that mortgage lending is not behind recent price increases. They recognized that there has indeed been a hiatus in the activities of the Nordic-Baltic Financial Stability Group, but argued that this reflects disruptions from the establishment of the banking union and that activities would resume. ECB supervisors may choose to be represented indirectly through the national competent authorities, they added. The authorities took note of potential leakages of macroprudential tools, but thought that they should be minimal in the case of mortgages.